| By Robert V. Bubel and Edward C. Skelton Federal Reserve Bank of Dallas |
The Promise of Sustained Loan Growth
An examination of the primary problems inhibiting growth in lending activity over the past 10 years reveals substantial progress toward resolution, suggesting the recent widespread growth in lending will continue.
Reparation. The fallout from the Tequila Crisis explains banks' initial reluctance to lend. Banks had to work out problem loans, raise their low capital levels and engineer a quality-led escape from high funding costs. Other problems included generally inefficient operations and inadequate information technology. In response, the banks streamlined their operations, rationalized costs and generated increased revenue. For most of the largest banks, however, full balance sheet recovery did not occur until foreign banks began to purchase them. These purchases, which commenced in 2000, often involved infusions of capital.
One reason for the delayed business credit recovery involves the nonnegotiable notes the government gave banks in trade for their bad loans. Banks could not sell these bonds and use the proceeds to lend to businesses. Beginning in the fourth quarter of this year, the nonnegotiable notes will begin to mature and will likely be rolled over into negotiable notes. These new notes will provide banks with a fresh source of liquidity, as the notes will no longer tie down bank funds that otherwise could be diverted to support loan growth.
Regulatory and Risk Management Infrastructure. The years following the Tequila Crisis have been a time of profound regulatory change. Mexican regulations now generally conform to international standards—or are even more demanding—in risk management, internal control policies and loan provisioning.
At the time of the Tequila Crisis, and for many years thereafter, credit bureaus were not fully developed and banks did not use them. However, a subsequent regulatory change requires banks to obtain, review and document a borrower's past repayment performance and current financial situation before making a loan. Consumer and mortgage loans extended without following these procedures are subject to a specific reserve requirement equal to 100 percent of the loan balance.
Though reluctant at first, bankers now embrace these procedures. Credit bureaus have grown in importance, and the public now values a good credit rating, helping to establish a positive repayment culture. With the new credit rating infrastructure, consumer lending has experienced strong, sustained growth. Spillovers of these methods and technologies, together with increased regulatory attention on all types of lending, suggest business credit is poised to expand.
Legal Infrastructure. Another impediment to loan growth, and secured lending in particular, has been the legal environment. Understaffing and overwork have plagued the Mexican courts. Court personnel, especially judges, tend to be poorly paid. These problems have been particularly acute at the local level. Many bankers and industry analysts feel the local courts are corrupt and susceptible to political meddling. And, until relatively recently, Mexican bankruptcy and collateral repossession laws were vague and heavily tilted in favor of the borrower. As a result, banks turning to the judicial system to collect delinquent loans often found the proceedings lengthy and unfruitful. Before the recent reforms, observers indicated court decisions on foreclosure and repossession required at least five years.
Recent years, however, have ushered in significant improvements in Mexico's legal infrastructure. In 2000, the Mexican Congress passed a law implementing new processes governing bankruptcy and the repossession of collateral. A subsequent reform in 2003 further clarified the resolution process behind bankruptcy and loan default.
Anecdotal reports suggest the laws overhauling bankruptcy proceedings and detailing collateral repossession have proven generally effective and have greatly shortened the time for a decision. Moreover, most such cases now can be resolved outside the court system. These options have also permitted financial institutions to become more adept at working directly with customers in encouraging payment.
Still, in some cases, contract enforcement may be difficult. Property rights systems involve numerous mutually reinforcing institutions. Some local authorities responsible for enforcing property rights in Mexico are still weak, reflecting the country's not too distant history of authoritarian rule. These circumstances may prove difficult to remedy, as they can involve political institutions or informal customs. [5]
Even so, positive financial system developments associated with improvements in the legal infrastructure are not hard to find. Mexico's burgeoning asset-backed securities market is testament to a growing faith in the enforceability of secured lending contracts. Despite a slight rise in interest rates over the second half of the year, Mexico's securitization market almost quadrupled in 2004, making it the top such market in Latin America. Some examples of new, structured financial transactions include securitizations of truck, auto and credit card loans, as well as municipal and state government debt. Mexico's first mortgage- backed security (MBS) issuance occurred in December 2003. The MBS market increased from a single $53 million issuance in that year to six issuances totaling $477 million in 2004. Continued economic and political stability, emergence of new securitization products for a broader group of assets and liberalization of regulations have all worked to increase institutional demand for securitized assets. All this bodes well for continued expansion in bank lending activity.
Bank Competition. In their continuing struggle to regain adequate financial footing in the wake of the Tequila Crisis, banks invested in government securities, replaced high-cost time deposits and borrowings with low-cost demand deposits, cut overhead expenses through layoffs, shed unprofitable operations, and pushed up transaction volume and service fee income. Opportunities for further advances along these lines appear rather limited. Net interest margins have thinned and stabilized. With increased accuracy in credit scoring, monitoring and contract enforcement, a return to loan markets seems to be the next step in increasing profitability.
Economic Conditions and Loan Demand. In spite of strong economic growth, high real interest rates and price fluctuations did not moderate in Mexico until 1999-2000. By then, business lending seemed ready to grow, but the subsequent economic slowdown in the United States stalled economic growth in Mexico and ended the momentum behind the initial signs of credit expansion.
Fortunately, economic growth has resumed in both the United States and Mexico. The comovement of these two economies partly reflects the unifying effects of
1995's North American Free Trade Agreement in promoting further integration of their business and economic cycles (Chart 4). The increase in loan demand associated with stronger economic activity should work along with the other factors discussed to generate lasting growth in business loans at Mexico's banks.
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Outlook
Mexico represents a unique banking opportunity. Macroeconomic conditions are stable and improving, the country's financial infrastructure continues to develop and modernize, and business cycle convergence with the United States should help spur future growth. Slowly but surely, various impediments to the supply of, and demand for, business loans have been resolved. By rebuilding capital and improving risk management systems, Mexico's banks have positioned themselves to take advantage of the positive trends shaping business loan demand. Stable net interest margins and limited ability to raise fees and cut costs will help propel the supply of loans as banks pursue profits to boost shareholder value.
These considerations suggest Mexico's 10-year slump in business lending is over. Lending's rejuvenation is the latest step in the monumental restoration of Mexico's banking system, characterized by sound loan growth and the types of achievements present in the most advanced banking systems.
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Notes 5. "Why Institutions Matter: Banking and Economic Growth in Mexico," by Stephen Haber, Stanford Center for International Development, Working Paper No. 234, November 2004. |
About the Authors
Bubel and Skelton are international financial analysts in the Financial Industry Studies Department of the Federal Reserve Bank of Dallas.
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