IV New Banking Crisis in Latin America: 1994–95
  • 1 https://isni.org/isni/0000000404811396, International Monetary Fund
  • | 2 https://isni.org/isni/0000000404811396, International Monetary Fund

Abstract

After several years of tight monetary policy in the context of a managed exchange rate system, in 1993 and 1994, the Central Bank of Mexico expanded credit to the banking system at an accelerating pace, increasing by 30 percent in 1993 and by 40 percent on an annualized basis for the first nine months of 1994, compared with an 11 percent increase in 1992. The rapid expansion of domestic credit to the banking system resulted in a loss of international reserves beginning in February 1994. As international investors became skeptical that Mexico could service its large stock of foreign debt, capital inflows, which had characterized the early 1990s, re-versed, accelerating the loss in international reserves. Authorities did not respond promptly to these losses by contracting domestic credit; consequently, pressures on the exchange rate became so severe that a major devaluation was unavoidable in December 1994.

After several years of tight monetary policy in the context of a managed exchange rate system, in 1993 and 1994, the Central Bank of Mexico expanded credit to the banking system at an accelerating pace, increasing by 30 percent in 1993 and by 40 percent on an annualized basis for the first nine months of 1994, compared with an 11 percent increase in 1992. The rapid expansion of domestic credit to the banking system resulted in a loss of international reserves beginning in February 1994. As international investors became skeptical that Mexico could service its large stock of foreign debt, capital inflows, which had characterized the early 1990s, re-versed, accelerating the loss in international reserves. Authorities did not respond promptly to these losses by contracting domestic credit; consequently, pressures on the exchange rate became so severe that a major devaluation was unavoidable in December 1994.

Despite a sharp devaluation of the peso and the establishment of an economic program to restore confidence, investors remained uncertain that Mexico had achieved a sustainable solution to its problems; hence, interest rates remained extraordinarily high.

The effect of the Mexican crisis was felt in a number of other Latin American countries, as reflected in the market for Brady bonds and in the prices of equities issued by Latin American firms (see Charts 9 and 10). Argentina, with a strong commitment to a fixed exchange rate, was especially vulnerable to attack. Like Mexico, Argentina had a growing current account deficit and a large stock of foreign debt. Concerns that these factors would lead to a devaluation and a default on foreign debt resulted in a large drop in bank deposits and Brady bond and equity prices.

As a result of the sharp rise in interest rates caused by the exchange rate crisis, severe problems developed in the banking systems of Argentina and Mexico as it became apparent that many borrowers could not meet the interest and principal payments on their debts. Consequently, investors became skeptical about the solvency of banks despite the improvement in the franchise value of banks over the previous few years (see Section III). As the magnitude of the crisis unfolded, policies were put into place to re-structure the banking systems.

Chart 9.
Chart 9.

Indexes of Brady Bond Prices

(December 1, 1994 = 100)

Source: Bloomberg Business News.

As discussed in the previous section, the evidence from the 1980s strongly suggests that the quality of the franchise going into a crisis is an important determinant of the success of bank restructuring programs. To assess the prospects of recovery in the Mexican and Argentine banking systems, this section provides a detailed look at the banking franchises in these two markets on the eve of the 1994–95 crisis. Specifically, it considers whether the following elements are present to facilitate an effective workout process: accurate accounting standards that make it possible for supervisors to evaluate the quality of banks; the presence of a number of well-managed institutions that can absorb banks with poor management; and evidence that bankers and investors perceive that they will suffer losses if banks fail.

It is shown that the overall quality of the banking systems in these markets improved in the early 1990s, as evidenced by the accounting information available to investors and supervisors for assessing the quality of individual banks. Nevertheless, in retrospect, pockets of weakness have persisted in each system, and, despite the increased reliability of banking data, the authorities permitted weak institutions to expand their balance sheets. As interest rates increased, the weak banks were the first to suffer, and investor skepticism about their soundness exacerbated the crisis.

Chart 10.
Chart 10.

Equity Price Indexes, U.S. Dollar Terms

(December 1994= 100)

Source: Bloomberg Business News.

Mexico

To assess the strength of the banking franchise in Mexico prior to the 1994 financial crisis, banks are divided into two categories: large banks, which primarily serve corporate customers, and small, retail-oriented banks. At the end of the third quarter of 1994, large banks held about 40 percent of the assets of the Mexican banking system.45

Evaluating the Banking Franchise

The first step in evaluating the franchise strength of the Mexican banking system is to determine whether accounting standards permit one to distinguish the relative riskiness of the two classes of banks. Perhaps the most prominent accounting measure of bank soundness is the ratio of capital to risk-weighted assets. The Bank for International Settlements has established a minimum acceptable standard of 8 percent, of which half must be equity capital. According to this standard, risky assets, such as loans, are given a 100 percent risk weighting, which means that each dollar of a loan must be covered by 8 cents worth of capital. The risk weighting of other assets varies according to perceived risk. For example, government securities denominated in home country currency are usually given a zero risk weighting. Hence, they do not require any capital at all.

As a proxy for the ratio of capital to risk-weighted assets, the average loan-to-capital ratio is used. In 1992, this ratio was 13.3 percent for large banks and 10.6 percent for small banks, providing an accounting indication that the retail banks had a riskier portfolio than wholesale banks (see Table 8). The question is whether investors relied on this information in determining where and at what interest rate they placed their funds and whether supervisors used this information to constrain the growth of credit in risky institutions.

During 1992, the assets of large banks grew by 18 percent, and small bank assets grew by 20 percent (Table 8). Thus, it appears that neither the market nor regulators constrained the growth of small banks relative to large banks. An analysis of the funding sources and the interest rates at which each group of banks was able to raise funds, however, makes it clear that the market distinguished between these two types of banks.

As indicated in Chart 11, in late 1992, time deposit interest rates were substantially below the interest rates offered on repurchase agreements collateralized by government securities.46 Usually, the interest rate on repurchase agreements should be slightly below deposit interest rates because the former is a collateralized loan to a bank whereas the deposit is not collateralized. This was not the case in Mexico in 1992, however, because posted deposit and repurchase agreement interest rates were affected by the riskiness of the institutions raising funds through each instrument.

Table 8.

Selected Mexican Banking Data

(Percent)

article image
Source: Mexico, Comision Nacional Bancaria, Estadistica de la Banco Multiple (1994).

In 1992, as indicated in Table 8, small banks raised funds primarily through repurchase agreements whereas large banks raised funds primarily by issuing deposits. Deposits at large banks grew by 22 percent during 1992, compared with only 13 percent at small banks. In contrast, repurchase agreements grew by over 60 percent at small banks, compared with negative growth of 8 percent at large banks. The high interest rates in the repurchase market reflected the rates that risky banks had to post to raise funds, whereas the low rates in the deposit market reflected the rates at which safe banks were able to raise funds. The difference in the cost of raising funds in these two markets indicates that investors were well aware of quality differences across banks.

Because investors were willing to supply funds to large banks at relatively low cost, the average cost of funding to average assets at large banks in 1992 was 11.76 percent. This compares with 14.51 percent at small banks.

In 1993, the situation changed from that described above. As investors gained confidence in the Mexican economy, interest rates in general declined, and investors became more willing to offer funds to safe and risky banks on similar terms. As indicated in Chart 11, interest rates on repurchase agreements dropped below deposit interest rates, and small banks were active in raising funds in both markets, with their deposits growing by 35 percent and repurchase agreements growing by 55 percent (Table 8).

However, large banks were very cautious about expanding their balance sheets during this mood of increasing confidence. Assets of large banks grew by 11 percent during 1993, compared with almost 40 percent at small banks, and deposits at large banks grew by only 2 percent (Table 8). Large bank restraint was especially remarkable given the expansion in credit to the banks supplied by the central bank in that year.

In addition, large banks strengthened their capital position between the end of 1992 and the end of 1993 relative to small banks: the ratio of capital to average loans at large banks increased from 13.3 percent to 13.7 percent, whereas, for small banks, the ratio increased by only 1/10 of 1 percent, to 10.7 percent.

During the first nine months of 1994, investors perceived increased risk in the Mexican financial environment, and interest rates rose by 800 basis points. Investors, however, showed continued willingness to place funds with small, risky banks, as these banks’ assets grew by 25 percent, compared with 14 percent at large banks. An indicator of increased risk taking by small banks is that their loan portfolio grew by 20 percent during this period, compared with 8 percent at large banks.47 As a result, the ratio of loan loss reserves to average loans fell behind the ratio at large banks. At year-end 1993, this ratio stood at 3.7 percent for large banks and 3.9 percent for small banks. By September 1994, it stood at 4.5 percent for large banks and 4.1 percent for small banks.

Chart 11.
Chart 11.

Mexico: Deposit and Repurchase Agreement Rates, Sep. 92-Dec. 94

(Percent)

Source: Mexico, Comision Nacional Bancaria (1994).

The fact that relatively risky banks were able to grow rapidly during 1993 and the first nine months of 1994 demonstrates that, in periods of rising economic confidence, the role of the regulator becomes crucial. In 1992, investors restrained riskier banks by demanding premiums on the funds they supplied to these institutions, whereas in 1993 and the first nine months of 1994, this restraint disappeared. Bank supervision was not strong enough to offset the weakened market discipline that permitted small, riskier banks to expand rapidly. While weak supervision did not lead to banking problems during 1993, when prosperity was evident, it became a crucial factor in magnifying the banking problems associated with the crisis in 1994, as will be described below.

During the fourth quarter of 1994, as the crisis unfolded, depositors began to show some preference for quality. As indicated in Chart 11, by the end of the fourth quarter, deposit rates were some 20 percentage points below interest rates on open market paper. Under these conditions, large banks experienced deposit growth of over 17 percent, compared with a 10 percent growth rate at small banks. Assets at the two sets of institutions grew by about 18 percent during the quarter. Unlike 1992, however, small banks could not access the repurchase agreement market for funds to make up for limited access to the deposit market. Instead, asset growth at small banks was financed by credit from the central bank, which grew by over 110 percent at small banks compared with less than 60 percent at large banks.

An evaluation of regulatory and supervisory efforts over the last few years yields mixed results. The authorities have substantially improved accounting standards, thereby allowing investors to evaluate the riskiness of banks. The differences in interest rates among banks at which investors placed deposits indicate that the market distinguished among banks by their quality. Thus, the crisis presents an opportunity to demonstrate that bankers and large depositors taking undue risk will bear the consequences of their actions. Regulators must ensure that those that pay a premium suffer some losses.

At the same time, however, the authorities permitted an excessive expansion of the weakest banks, signaling some deficiencies in supervisory practices. In fact, in late 1994, the authorities actually funded the expansion of weak institutions, rather than placing institutions that could not access the market under strict supervisory control.

Restructuring the Banking System

The Mexican banking authorities are currently in the process of restructuring their banking system, which has suffered substantial losses. To effect this rescue, they have established a program to recapitalize the banks and a program to restructure nonperforming loans, similar to that used by Chile in the 1980s.

The recapitalization program, known as Programa de Capitalización Temporal, or PROCAPTE, provides for the insurance fund, Fondo Bancario de Protección al Ahorro (FOBAPROA), to lend funds to the banks in the form of subordinated debt that will count as capital. In five years, this debt will be converted to equity. FOBAPROA can exercise conversion rights before the end of the five years if bank capital (excluding the subordinated debt) falls to less than 2 percent of assets or if the regulators believe that the solvency of the bank is impaired.

In the loan restructuring program, the government will issue zero coupon bonds, paying interest indexed to inflation, to a trust fund established for the purpose of holding banks’ nonperforming loans. To fund the government bonds, the trust fund will issue liabilities to the government. The trust fund will then exchange the government bonds for nonperforming loans currently held on banks’ balance sheets. As a result of these transactions, the trust fund’s assets will be nonperforming loans, funded by liablities issued to the government.

Although the loans are held in a trust fund, the banks will remain in charge of managing these loans back to health. The interest on the government bond will be paid from the portfolio of nonperforming loans. The authorities recognize that this program may create liquidity shortages. The zero coupon bond has no cash flow whereas bank deposit liabilities are relatively liquid. If depositors withdraw their funds and accumulated interest, banks will not have the cash flow from their assets to meet these demands. If the liquidity shortage is in U.S. dollars, FOBAPROA will provide liquidity assistance; if it is in pesos, the central bank will provide a facility to purchase securities from banks under short-term repurchase agreements.

To reduce the interest burden on borrowers, the principal of the nonperforming loans will be indexed to inflation.48 This will also aid the banks in restructuring nonperforming loans because it will give them time to work with borrowers without forcing them into bankruptcy. For this indexation policy to be viable, the principal of liabilities issued by the trust fund to the government must also be indexed.

If the nonperforming loan portfolio cannot earn enough income to pay off the zero coupon bond, the banks must cover the interest and principal on the bond from their own capital account. If this causes a bank’s capital account to fall to less than 2 percent, FOBAPROA will have the right to close the bank and sell the assets. If a bank has enough funds to pay off the government bonds but not enough to buy back the subordinated debt of FOBAPROA, the insurance agency maintains a claim on bank income as an equity shareholder at the end of five years.

To reduce the interest rate burden on solvent borrowers, banks will be encouraged to index the principal of their loans to inflation. The success of this program depends on depositors’ willingness to accept an indexed principal contract as well. Otherwise, banks will have a liability with a much greater cash-flow payment than they receive on their assets. To overcome this problem, the Banco de México has announced that the principal of its outstanding loans to banks will be indexed to inflation.

With the central bank supplying indexed credit to the banking system, the size of its balance sheet will increase at the rate of indexation. The authorities recognize that, if the central bank funds its balance sheet with nonindexed liabilities, it will face large deficits for several years to come, which could cause the fiscal situation in Mexico to deteriorate. To mitigate this problem, the authorities are using inflation to control a priority in the design of their economic program.

If restructuring actually forces the riskiest banks out of business, future growth will be more disciplined throughout the banking system. The data indicate that, as the Mexican authorities restructure their banking system in the current crisis, they have several well-managed banks that can take the lead in establishing loan workout programs and can also acquire riskier banks whose loan portfolios will never be able to cover the cost of the government bond.

Argentina

In the years preceding the current crisis, the Argentine banking situation differed from that of Mexico. As mentioned in Section III, the experiences of depositors during the hyperinflation of the late 1980s had a severe effect on their willingness to hold deposits in the domestic banking system. Despite the adoption of a strong economic program in 1991 that brought inflation down sharply, by 1992, Argentine investors were not as confident as their Mexican counterparts in the quality of their banking system because the deposit-to-GDP ratio remained substantially below its level of the early 1980s. In 1993, deposits rose sharply relative to GDP, to 14 percent from 10 percent, indicating improved confidence in the economy and the banking system (Chart 8). This ratio, however, was among the lowest in Latin American countries. Reintermediation into the banking system continued during most of 1994. As in Mexico, it is important to determine whether this increase in confidence was based on tangible improvements in the quality of the banking system.

Evaluating Banks

To make this assessment, the banking system is divided into classes of banks to determine whether accounting data risk classifications correspond to investor perceptions of risk. The analysis is based on a comparison of March 1993 and November 1994 balance sheets for four categories of banks: national public, provincial, private, and foreign.49 National public banks, dominated by Banco Nación, are owned by the central government. Provincial banks are owned by the provincial governments. In 1994, national public banks accounted for 26 percent of large bank assets, municipal and private banks accounted for 29 percent each, and foreign banks accounted for 16 percent of large bank assets. The sample for each category of banks is limited to the largest banks in each group, which together accounted for about 70 percent of the deposits in the banking system at the end of 1993.

Compared with the Mexican banking system, in 1993 all segments of the Argentine banking system appeared to be strongly capitalized. Capital-to-loan ratios were more than 20 percent for all categories of banks with the exception of foreign banks, where the ratio stood at about 16 percent (see Table 9). Hence, the relative quality of banks cannot be ascertained from capital ratios. As will be demonstrated below, however, the behavior of investors indicates that they did not accept high capital ratios as evidence that all banks were safe.

Table 9.

Selected Argentine Banking Data

(Percent, unless otherwise indicated)

article image
Source: Argentina, Superintendencia de Entidades Financieras.Note: Data are for March 1993 and November 1994.

Unlike Mexican banks, Argentine banks have a large portion of their assets and liabilities denominated in U.S. dollars.50 They have two primary sources of dollar funds: interbank borrowings and deposits accepted from the public. In 1994, provincial banks began having difficulty raising dollar funds. Dollar interbank funds declined by 10 percent at provincial banks, compared with a 28 percent expansion rate for all banks, a 53 percent expansion rate at private banks, and a 94 percent expansion rate at foreign banks. This suggests that banks lending dollars in the interbank market had grown skeptical of the quality of provincial banks.

To finance dollar assets, provincial banks had to turn to the deposit market, and, between March 1993 and November 1994, they increased their dollar deposits by 55 percent (Table 9). This increase, however, was substantially less than the 76 percent increase in dollar deposits experienced by the system as a whole. Although depositors were less discriminatory in their choice of banks than interbank lenders, they required a relative increase in the interest rate on dollar deposits to supply these funds. In April 1993, dollar deposits were paying 500 basis points less than peso deposits of similar maturity (see Chart 12). By December, the spread was less than 300 basis points.

In contrast to the dollar market, in the peso market there is not enough evidence to determine whether investors distinguished between the quality of banks. Peso deposits at provincial banks expanded by 31 percent, faster than the 25 percent increase experienced by the system as a whole but slower than the 68 percent and 50 percent increases at private banks and foreign banks, respectively. Peso deposits declined at Banco Nación, and most of these deposits flowed into private and foreign banks rather than provincial banks. But most of these deposits were probably in the Buenos Aires metropolitan area, and it would have been difficult for outlying provincial banks to capture them.

Chart 12.
Chart 12.

Argentina: Peso and Dollar Interest Rates on Bank Deposits and Loans, 1993

(Percent)

Source: Argentina, Superintendencia de Entidades Financieras (Buenos Aires, 1994).

Rescuing Banks

The spillover effects from the Mexican crisis caused heavy deposit withdrawals from the provincial banks and many smaller commercial banks. To aid these institutions, the Argentine government established a “safety net” fund, supported by large banks and managed by Banco Nacion, which was used to provide liquidity assistance to banks losing funds. The central bank also provided liquidity assistance to banks through swap arrangements. Under these programs, the central bank has lent foreign exchange to banks, collateralized by banks’ highest–quality paper sold to the central bank under repurchase agreements. The scope of this program has been limited because regulations are in place that severely restrict the central bank’s authority to act as lender of last resort.

In recognition that many banks face problems greater than can be managed by providing liquidity facilities, the government has instituted policies to restore investor confidence in banking. The philosophy underlying these policy measures is to use the crisis as an opportunity to strengthen the banking system by closing badly managed banks. The authorities will encourage sound banks, whether of domestic or foreign ownership, to purchase closed banks. The authorities have demonstrated their strong commitment to establishing a sound banking system by placing no restrictions on the degree of foreign ownership of their banking system that may result from the restructuring.

The government has established a trust fund to re-capitalize banks. The fund will be partially financed by the proceeds of US$2 billion in government bonds with a three-year maturity paying a below-market floating interest rate sold to domestic private investors and foreign financial institutions.51 The remainder of the trust fund will be financed by international multilateral agencies. The fund will purchase subordinated debt in banks with a maturity of three years, which will be converted to equity if a bank fails to repay interest and principal. An important feature of the program is that recapitalization will be available only to those banks that can be managed back to solvency. A significant portion of the re-sources from the fund will be used to finance mergers and acquisitions.

To further restore investor confidence in the banking system, the government also established a deposit insurance system. This system will be funded through a levy of between, 03 percent and,06 percent on average daily deposit balances each month. The fund will expand until it covers 5 percent of the deposit base or Arg$2 billion. Banks will not be able to bid aggressively for insured deposits because interest rates payable on these deposits will be capped to a reference rate.

Although the Argentine restructuring program contains crucial elements to improve the quality of the domestic banking system, some risks remain. An important one is that the scale of the bad loan problem at banks might exceed the funds available in the trust account and through the deposit insurance scheme. If this were the case, short-term pressures on the fiscal situation could be avoided only if the authorities were able to mobilize additional funds from the private sector.

Comparison of Franchise Value in Mexico and Argentina on the Eve of the Crisis

In both markets on the eve of the crisis, it was apparent that investors attempted to distinguish banks by the quality of their portfolios. In Argentina, portfolio quality was reflected in the rapid growth of U.S. dollar interbank borrowing at large private and foreign banks relative to provincial banks. In Mexico, it was reflected in the interest rates that small banks had to pay for funds to maintain a growth rate substantially higher than that of large banks.

The difference in the two markets is that in Mexico, accounting information was a more useful guide to evaluating bank quality than in Argentina. This is an important distinction because in Argentina, while investors avoided a group of highly specialized banks—those owned by provinces—their decision was based not on specific information about these banks but on the financial situation of the provinces. Without reliable accounting standards, it is much more difficult to judge the performance of individual banks engaged in lending to the private sector. For example, are low loan loss reserve ratios of many private banks a reflection of good loan quality or underprovisioning? Are high capital ratios derived from marking up the value of fixed assets, or are they based on a solid stream of retained earnings from a performing loan portfolio?

Thus, it appears that the availability of information in Mexico will help the authorities determine the ability of individual banks to generate cash flow from their loan portfolios. This can make it easier for them to determine which banks ought to be forced into bankruptcy. It also permits them to better deter-mine which banks are the best candidates to take over failed institutions.

An important similarity between the financial markets in Mexico and Argentina is that the authorities in both countries permitted banks deemed relatively weak and risky to expand. In Mexico, these were small banks; in Argentina, they were provincial banks. A major conclusion that emerges from this analysis, therefore, is that, although the reversal of capital flows triggered banking problems, more stringent controls on the activities of weak banks be-fore the crisis would have reduced the magnitude of the bad loan problem and the cost of bailing out banks in both Mexico and Argentina.

If the lessons from the 1980s have been well learned, the current banking crises will have a much shorter and less devastating effect on the region’s economy than the earlier crises. The current difficulties provide an opportunity for Latin American authorities to dispose of poorly run institutions that have become insolvent, thereby permitting their banking systems to emerge from the crisis on a sounder footing. If they take advantage of this opportunity, the prospects for returning to the growth path of the early 1990s look promising.

45

The chief characteristic that distinguishes wholesale and retail banks in Mexico is their deposit mix: in 1994, 36 percent of deposits at Mexican wholesale banks were demand deposits, compared with 19 percent at small banks. In contrast, in the United States, wholesale banks have fewer demand deposits as a percentage of deposits than retail banks. Large U.S. corporations hold repurchase agreements for short-term liquidity whereas in Mexico large corporations hold demand deposits. However, Mexican households use cash for liquidity much more frequently than U.S. households.

46

A repurchase agreement is the sale of a security with an agreement to repurchase at a specified date at a specified price. Thus, for the seller, this agreement is a way to fund a securities portfolio; that is, the agreement is a liability. Hence, banks can use repurchase agreements rather than deposits as a means to fund their securities.

47

Despite the rapid growth in the assets of small banks during the first nine months of 1994, the ratio of capital to average loans at these banks increased from 10.7 percent at the end of 1993 to 11.1 percent at the end of September 1994, indicating some effort to improve their balance sheet quality (Table 8).

48

During inflation, the principal of loan contracts with fixed nominal value depreciates in real terms. Lenders are compensated for this with high interest rates; however, borrowers must pay off real principal at a faster rate than in noninflationary times, which increases their cash-flow burden.

49

Owing to differences in reporting periods across banks, data for the private banks cover the first half of 1994 as well as 1993.

50

Argentina permits domestic investors to hold dollar deposits in the domestic banking system on the same terms that they are permitted to hold domestic currency deposits. In 1992, Argentine banks borrowed substantial amounts of dollars from foreign banks as dollar loans exceeded dollar deposits. In addition, they financed a portion of their dollar assets with peso deposits.

51

The government has been able to raise funds at below-market interest rates by appealing to private investors’ stake in the success of economic reforms.

  • View in gallery

    Indexes of Brady Bond Prices

    (December 1, 1994 = 100)

  • View in gallery

    Equity Price Indexes, U.S. Dollar Terms

    (December 1994= 100)

  • View in gallery

    Mexico: Deposit and Repurchase Agreement Rates, Sep. 92-Dec. 94

    (Percent)

  • View in gallery

    Argentina: Peso and Dollar Interest Rates on Bank Deposits and Loans, 1993

    (Percent)

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