30 Jan 2013  Working Papers

These Are the Good Old Days: Foreign Entry and the Mexican Banking System

Executive Summary — In this paper, the authors take on an aspect of contract design that is fundamental to explain economic development and financial stability. They study the incentives contained in the "partnership" contract between bankers, the government, depositors, and bank shareholders, and examine how the incentives that come out of that contract explain the volatility of the banking system. The main insight is that bankers in developing countries with weak property rights demand rents (such as high barriers to entry) and lax regulation, as a way to compensate them for the political risk they face of being expropriated by the government or used for policy objectives (for example, if the government forces banks to buy its debt). Depositors, on the other hand, demand deposit insurance in case bankers are reckless, while minority shareholders demand high returns to compensate for the risk of insider lending or reckless behavior on the part of bankers. Then, the combination of high barriers to entry, lax regulation, and deposit insurance induces bankers to take on more risks to try to maximize their rents, and does not encourage depositors and minority shareholders to monitor bankers either (as the government limits downside risk for them). This dynamic, in the case of Mexico, led to frequent banking crises between the 1970s and the 1990s. This was the case until 1997, when the government allowed foreign bankers take over the largest domestic commercial banks and improved the monitoring of banks. This increased the stability of the system. There has not been a crisis since then, partly because of improvements in regulation and partly because foreign bankers have been more conservative, not only because they have standardized procedures to deal with risk but also because they are closely monitored by their parent banks abroad. Key concepts include:

  • Stability in the Mexican banking from the 1920s through the 1960s came at a price: Commercial banks could shift risk to government-owned development banks and hence to taxpayers.
  • From the 1970s until 1997, the Mexican banking system was extraordinarily unstable. This was due to the tenuous partnership between the Mexican government and Mexico's bankers.
  • These days, Mexico's foreign bankers have much to lose and little to gain from being opportunistic partners.
  • When the government opened the market, it reformed accounting standards. Mexico's foreign bankers are subject to much greater oversight.
  • Foreign bankers have protections against the Mexican government that Mexican bankers do not have.
  • Regardless of their national origin, Mexico's bankers can no longer be expropriated with the stroke of a pen.

 

Author Abstract

In 1997, the Mexican government reversed long-standing policies and allowed foreign banks to purchase Mexico's largest commercial banks and relaxed restrictions on the founding of new, foreign-owned banks. The result has been a dramatic shift in the ownership structure of Mexico's banks. For instance, while in 1991 only 1% of bank assets in Mexico were foreign owned, today they control 74% of assets. In no other country in the world has the penetration of foreign banks been as rapid or as far-reaching as in Mexico. In this work we examine some of the important implications of foreign bank entry for social welfare in Mexico. Did liberalization lead to an increase (or decrease) in the supply of credit? Did liberalization lead to an increase (or decrease) in the cost of credit? Did liberalization lead to an increase (or decrease) in the stability of the banking system? In order to answer these questions, we must first ask, "increase (or decrease), measured on what basis?" There are, in fact, two distinct conceptual frameworks through which one can assess the impact of foreign bank entry. One is concerned with measuring the short-run impacts of foreign entry on credit abundance, pricing, and observable stability using reduced form regressions. The other is an institutional economics conception of how to measure performance. It is focused on understanding whether foreign entry gave rise to difficult-to-reverse changes in the political economy of bank regulation, which will affect competition and stability in the long-term, outside the period that may be observed empirically. We employ both conceptions in this paper.

Paper Information