Manuel Sánchez: The strengths and challenges of Mexico's financial
system
Remarks by Mr Manuel Sánchez, Deputy Governor of the Bank of Mexico, at the Mexico
Financial Day 2011, CEO Roundtable, New York, 8 November 2011.
* * *
It is a great pleasure to be in New York to speak at the Mexico Financial Day 2011 CEO
Roundtable. I would like to thank the organizers of this conference for their kind invitation to
be with you today.
As business leaders and investors, you are aware of the sharp asset price corrections and
volatility that have characterized international financial markets during recent months. Two
central concerns fueling the observed higher risk aversion seem to be the possibility of a
catastrophic event in the European Monetary Union (EMU) and the fear of a global
recession.
To a large extent, these worries reveal underlying problems stemming from the global
financial crisis that began in 2007. The sequel to the crisis includes a protracted stagnation of
the housing and credit markets in the United States, the failure and weakening of important
financial institutions, and significant fiscal burdens in many countries. Also, sovereign and
financial risks feed on each other in some nations in the euro zone, threatening to affect
financial participants in other parts of the world.
It is fortunate that, this time, many emerging market economies do not exhibit notable
intrinsic financial or fiscal fragilities. In particular, I would like to argue that the soundness of
Mexico's financial system, along with its healthy fiscal position and low inflation, constitutes a
fundamental strength of the economy, especially in the current adverse environment.
However, in order to make a greater contribution to long-term economic growth, this system
needs to develop further. Finally, Mexico's economic outlook is one of moderate growth with
the main risks related to the evolution of the world economy. As always, my comments are
entirely my own responsibility and do not necessarily reflect the views of the Bank of Mexico.
The strength of the financial system
To function properly, any economy requires an efficient financial system with a fully
operational infrastructure, developed markets, and competitive intermediaries. Because of
their large role within the Mexican economy and notwithstanding the importance of other
intermediaries, today I would like to focus on the commercial banks. As you know, the
mission of these institutions is to attract savings, channel those resources to the most
productive uses, and contribute to the supply of efficient payment systems. Their
intermediation role is based on trust, which, in turn, requires that they manage risk
adequately and hold sufficient levels of capital, provisions, and liquidity to absorb potential
losses and respond to changes in the composition and duration of depositors' desired asset
portfolios.
Mexico's banking system has performed these activities satisfactorily in recent years, and it
fared notably well during the global financial crisis. In particular, the economic downturn of
2009 resulted in a contraction of lending, some deterioration of the quality of the loan
portfolio, and additional provisioning needs. Yet past-due loan ratios stayed relatively low,
perhaps with the exception of that of consumer loans. More importantly, banks remained
profitable and well capitalized during the crisis and at all times exhibited adequate levels of
liquidly and ample access to funding sources, which, by and large, are based on fairly stable
retail deposits.
As economic recovery has taken hold, lending activity has resumed and the quality of the
loan portfolio has improved. Bank solvency indicators remain strong, as reflected by
capitalization levels, the significant proportion of Tier-1 capital within net capital, and high
ratios of loan-loss reserves to past-due loans.1
The strong position of the banking system has been the result of improvements to the
regulatory and supervisory framework, including stricter capital requirements and rules for
provisioning of reserves based on expected rather than realized losses. It is also a
consequence of lessons derived from experience. In particular, the financial crisis of 1995
dramatically revealed the need for banks to maintain appropriate levels of high-quality capital
potentially able to absorb losses on an ongoing basis. It also taught the importance of
welldeveloped and liquid financial markets in which economic agents can hedge and diversify
their risks.
The reforms put in place during the last few years have helped Mexico fortify its financial
system, revamp its supervisory practices, and develop its financial markets. The attainment
of low inflation has allowed the emergence of long-term contracts, which include longer
tenors for public and private debt in pesos at fixed nominal interest rates.
Hence, in marked contrast to the widespread practice in Mexico prior to 1995 and in the
United States before 2008, mortgage products are mostly based on fixed nominal interest
rates and do not allow for negative amortization. In addition, since banks enjoy highly
profitable domestic opportunities in traditional lending, they were not attracted to taking
exposures to the derivative instruments that became the amplifying vehicles of instability in
the recent great financial crisis.
The soundness of Mexico's banking system represents an economic strength in the face of
external shocks, but not because it could potentially shield the country against external
financial volatility. In fact, asset price fluctuations, independently of their origin and extent,
convey useful information to investors and market participants. For the exchange rate,
flexibility helps prevent the build-up of unsustainable balance-of-payments disequilibria which
in the past were common causes of currency and banking crises. In any case, hedge
products are available for those who are less willing to bear risk.
The fundamental contribution of a sound banking system, especially in times of crisis, is that
it does not magnify financial instability. Also, rather than acting as a drag on the economy,
through continued intermediation and within limits, it can buttress the pace of economic
expansion. In the case of Mexico, this support has been further reinforced by the continued
health of public finances and low inflation.
The negative effects of weak financial systems interacting with unsustainable public debt and
escalating inflation can hardly be exaggerated.2 These three elements were behind the
Mexican crisis of 1995. Also, the negative feedback loop between the fiscal problems of
some EMU member countries and the risk exposures of significant financial institutions are
prominent causes of the current maladies in that region, which are threatening to further
affect the rest of the world.
Challenges for the financial system
Beyond its key role of contributing to economic stability, Mexico's banking system faces
challenges in order to more deeply contribute to long-term economic growth. Perhaps the
most crucial task for the system is to increase its scale and scope, as standard indicators of
penetration, such as bank loans to GDP, are low compared to those of other economies. It is
well documented that financing and economic growth are positively correlated, and causation
seems to run from the former to the latter.3
But credit expansion may not necessarily be desirable unless it is done prudently. In
particular, risk management should not be traded away for size, as the impetus could be
short-lived and the banks' contribution to stability and growth could easily evaporate or
become negative. For example, the ratio of bank loans to GDP in 1994 reached levels more
than twice as high as the current ones, but poor origination and servicing led to disastrous
consequences.4
Also, the development of the banking system should be carried out at the initiative of the
participating financial firms in a highly competitive environment. In particular, it should not
depend on credit targets set under the influence of government authorities. Such an
approach proved to be a contributor to the excessive risk-taking in mortgage lending to the
crisis in the United States.
Moreover, competition has its own benefits, including a wider variety of financial products
and services at lower prices. A larger scope of competitive activities can be expected to
cover broader geographic areas, incorporating underserved communities or remote and
lowincome communities not served at all. The different types of non-bank banks and niche
financial intermediaries that Mexican regulation currently allows, such as multiple-purpose
financial institutions (sofomes) and popular financial institutions (sofipos) play a
complementary role by contributing to making basic financial services accessible to
previously unbanked regions and families.
Two additional recent developments promise to be an important means of financial inclusion
in Mexico. One is the incorporation of retail stores as bank agent premises. Retail stores can
facilitate the population's access to basic financial transactions, such as deposits,
withdrawals and bill payments. In fact, using them is an efficient way to expand the banks'
distribution channels to communities in which it is not profitable to open a branch or even to
maintain an ATM. Agent premises have already equated in size the commercial banks'
branch network.
A second emerging development is mobile banking using cell phones to conduct basic
transactions. Cell phones in Mexico are a common means of communication for rich and
poor alike and have seen an exponential rate of expansion. As of August 2011, the number
of mobile phones reached almost five times that of fixed telephone lines in the country.5
In any case, the future progress of banking activities will have to occur within an efficient and
well-balanced regulatory and supervisory framework for financial institutions. This is all the
more important given the extreme complications the world economy is suffering from the
financial excesses that led to the global financial crisis. At the same time, regulation should
not inhibit the innovation and flexibility necessary for the banking system to accomplish its
mission.
As I said, Mexico has made substantial improvements on regulation and supervision.
However, the agenda for financial authorities needs to embrace the further enhancement of
micro-prudential standards for banks, such as capitalization and liquidity requirements;
macro-prudential measures to detect early systemic risk factors and counteract them; and
the design of an expedient bank resolution mechanism.6
Economic outlook
During the third quarter of 2011, the Mexican economy continued the process of recovery
that began two years earlier. In particular, during July and August, the latest months for
which full production data are available, the General Indicator of Economic Activity (IGAE), a
monthly GDP proxy, exhibited a year-on-year average rate of growth of 3.8 percent, slightly
higher than the corresponding figure in the previous quarter.
Even though in August the level of the IGAE surpassed that of June, different economic
indicators suggest that the rebound is losing steam. For example, the increase in activity in
July was followed by a contraction in August. This fall occurred both in the industrial and
service sectors, which account for approximately 95 percent of total output. The lower activity
was partly compensated for by a significant rise in agricultural production, mainly as a result
of government support programs for re-sowing land after harvest losses due to bad weather
in the first quarter of 2011.
Deceleration was clearer in industrial production, which seems to reflect a quarterly reduction
of manufacturing exports to the United States, the destination of almost 80 percent of total
non-oil exports. The contraction of shipments to Mexico's northern neighbor was
concentrated in non-automotive products, although automotive sales to that market saw
growth that was somewhat attenuated.
Additionally, domestic demand growth has apparently begun to slow down. Retail sales
during July and August suggest that consumption probably increased at a declining rate. On
the other hand, although gross fixed investment in July continued expanding at a significant
pace, imports of capital goods during the third quarter fell.
In all, third-quarter GDP quarterly growth was probably similar to or a little lower than that of
the preceding three months. However, slowing could become more evident in the coming
quarters, should consensus forecasts turn out to be correct, at least approximately. For
example, in the October survey of analysts' expectations conducted by the Bank of Mexico,
annual GDP growth is forecast to decline from 3.7 percent in 2011 to 3.2 percent in 2012.
Relative to what was forecast a year earlier, expected growth is slightly higher for 2011 but
almost a full percentage point lower for 2012.
It is worth noting that, although less than ideal from the point of view of social wellbeing,
projected growth for 2012 is not negligible. In fact, it surpasses the expected growth of
advanced economies as well as the somewhat disappointing, average yearly expansion of
the Mexican economy during the last decade, even after excluding the 2001 and 2009
recessions.
Certain currently positive factors, such as the strong upturn in formal employment and bank
lending to the private sector, particularly to the consumer and small- and medium-sized
enterprises, may be expected to continue supporting domestic demand in the coming
months. However, since the downward revision in growth prospects for 2012 was mainly a
reflection of substantial cuts in the forecasts for U.S. industrial production, a
deeper-thanexpected deceleration in that country would necessarily translate into further downward
adjustments for Mexico's growth forecasts.
Finally, monetary policy continued to be oriented toward the 3 percent annual inflation target,
which the Bank of Mexico established at the end of 2003. As you know, the policy overnight
interest rate has been maintained at 4.5 percent since August 2009. This stance has proved
adequate, as inflation has been gradually converging to the central bank's objective. In
particular, during 2011, inflation has remained substantially close to albeit above this
benchmark, averaging 3.4 percent.
In the future, the Bank of Mexico will have to continue monitoring the various risks that may
potentially impede further progress in the consolidation of price stability. This commitment is
its main contribution to economic certainty, which is of paramount importance, especially
during these times of financial turbulence.
In an inflation-targeting regime, what really matters for the guidance of monetary policy is
future inflation and how this relates to the policy objective.7 In this sense, I believe that the
main risk to the consolidation of price stability is the stickiness that various measures of
expected inflation have persistently shown. On the basis of some analysts' surveys, average
expected inflation for several time horizons, including medium- to long-term, continue to be
above the target. Also, the break-even inflation implicit in the bond market has remained
close to 4 percent.
The anchoring of these expectations around the inflation target remains an important
challenge to monetary policy. I expect that this anchoring will be achieved through the
maintenance of a consistent monetary policy, and that the Mexican economy will continue on
the convergence path to the inflation target in an environment of economic growth.
Concluding remarks
Mexico's financial system, along with its healthy fiscal position and low inflation, constitutes a
fundamental strength for the economy in the face of adverse external conditions. This
strength has been the result of improvements in the regulatory and supervisory framework as
well as in firms' management models. On the other hand, the banking system faces
important challenges in order to more deeply contribute to long-term economic growth.
Perhaps the most important endeavor is for the system to prudently increase its scale and
scope within a competitive environment.
Mexico's economic outlook is one of moderate growth at a rate that surpasses that of
advanced nations but with the main risks coming from those economies. Inflation is likely to
remain subdued, sustaining its convergence to the permanent 3 percent target.
Nevertheless, the Bank of Mexico will have to continue monitoring the risks that may hinder
progress toward the consolidation of price stability.