The Political Economy of Canada's "Widely Held" Rule for Large Banks

I. INTRODUCTION: A TALE OF TWO COUNTRIES When representatives of the United States, Canada, and Mexico signed the North American Free Trade Agreement(1) ("NAFTA") in 1992, the schedule of reservations and commitments on the annex relating to financial services gave the distinct impression that Mexico and Canada were not inclined to embrace fully the idea of free and unfettered trade in banking services. While NAFTA broke new ground by setting out a principles-based approach to liberalized trade in financial services,(2) Canada and Mexico made it clear that they intended to keep in place the non-tariff barriers(3) that ensured that their largest banks would remain under domestic control. At the outset, it appeared that Mexico had a stronger commitment to banking protectionism.(4) At the time of NAFTA's negotiation, Mexico's banking market was dominated by six large national banks, with seven regional institutions playing a secondary role.(5) Prior to NAFTA, Mexico's banking market was closed to U.S. and Canadian banks.(6) NAFTA changed that by permitting U.S. and Canadian banks to establish wholly owned banking subsidiaries in Mexico.(7) But while Mexico opened its banking system through NAFTA, it also negotiated for some protections to prevent foreign domination of the Mexican banking industry; specifically, Mexico set out aggregate capital limits for foreign subsidiaries.(8) As originally conceived, U.S. and Canadian institutions would have been permitted to acquire outright existing Mexican banks after a transition period, subject to the limitation that the sum of the capital of the acquired bank and any affiliate of the foreign acquirer not exceed four percent of the aggregate capital of all commercial banks in Mexico.(9) The clear purpose of these restrictions was to protect Mexico's six largest banks from foreign acquisition.(10) Events overtook the original protectionist plan, however, forcing Mexico to liberalize its foreign ownership rules.(11) Viewed through the lens of history, this turn of events is not surprising--throughout its past, Mexico has been dependent on foreign capital for economic development.(12) The NAFTA provisions were intended to break that cycle of foreign dependence and continue the revitalization of the Mexican banking industry initiated by the reprivatization of the state-controlled banks in 1990-92.(13) Nevertheless, the protectionist provisions clearly appear to have failed in their goal of safeguarding domestic banks from foreign control. The protectionist provisions were designed to nurture the recently privatized Mexican banks, but, ironically, the privatization process itself sowed the seeds of the protectionist scheme's demise. After reprivatization in the early 1990s, Mexican banks grew at a furious rate.(14) Most banks were owned by financial groups dominated by securities firms with high risk tolerances, and the bank managers hired to run these institutions felt pressure to recover the rich premiums paid to acquire the banks.(15) Consequently, loan quality dropped, while loan growth soared; eventually, banks had to increase significantly their loan loss reserves.(16) The devaluation of the peso in late 1994, together with the credit quality problem, sent Mexico's banks into crisis. In response to the crisis, international and Mexican banking concerns took action to stabilize the Mexican banking system.(17) In the immediate aftermath of the 1994 peso crisis, Mexico modified, but did not abandon, its foreign ownership rules to permit greater foreign influence in the banking system.(18) As times got more difficult, however, Mexico once again turned to foreign capital. Although Mexican banks showed a revival and demand for peso-denominated loans had been increasing,(19) the weaknesses in the banking system were serious, and Mexican banks had a great deal of difficulty attracting capital.(20) Politically, it became extremely embarrassing for the Mexican federal government to bail out the troubled banking institutions, especially as political reforms permitted the formation of meaningful opposition to the ruling Institutional Revolutionary Party in Congress. …