13

**Table 5 Decomposition of the Lending Rate1,**

|Macroeconomic<br>Factors|Percent|
|---|---|
|1) Base Rate (US Treasury Bills) (1 month)|3.0|
|2) Country Risk Premium .,|_1.5_|
|_ -~~~~~~~~~~~~~~~~~~~~~~~.<br>3) Real Exchange Rate Risk y,|_3.0_|
|4) Inflation differential Risk,|4.5|
|5) GOM Government Borrowing Rate (Cetes Rate) (2+3+4)|12.0|
|Microeconomic Factors||
|6) Taxes applied to bank liabilities vs. Government liabilities|2.0|
|7) Risk of Banks6/|2.0|
|8) Average Cost of Funds to Commercial Banks (CPP rate)_(5-t-6+7)_|16.0|
|9) Bank Operating Costs, Profit Margin, and Implicit and Explicit Taxes7|6-10|
|10) Estimated average lending rate (8+9)|22-26|
|1 1) Rates to Prime Borrowers|17-22|
|12) Rates to SME Borrowers|_27-3_|

**Source:** Central **Bank and authors estimates**

1/ Assumes the foliowing levels for interest rates: ic (Cetes)=12%: it (Tesobonos)=4.5%: ia(Ajustabonos)=5%: iTB(US T.Bill)=3%. Tesobonos are dollar-indexed domestic debt instruments, A justabonos are inflation-indexed domestic debt instruments: Cetes are peso-denominated domestic debt instruments. We also assumed foreign inflation of 2.5%.

2/ Equal to: **(it** - iTB)

- - 3/ Equal to: (ic it) + 2.5 (ic - ja)

(foreign inflation) expected domestic inflation

**4/** Equal to: ic - i - 2.5a- To the extent that ajustobonos are of maturity 3-5 years and of longer duration that CETES (28 days) this approximation is biased downwards because of the liquidity premium inherent in the ajustobonos rate which is not reflected in the CETES rate.

5/ The exact size of the tax effect is dependent upon whether it is foreigners or domestic residents that purchase government or commercial bank liabilities as tax treatment differs. If it is foreigners it is 15% (tax rate applied to foreigners) of 15% (rate on bank liabilities) or 2.2%: if it is a mix of foreigners and domestic corporations. it would be (2.2% + 1.4%)/2 = 1.8%.

6/ These rates reflect the risk differential between government and commercial bank liabilities. The bias introduced by comparing marginal government borrowing rates to average bank deposit rates is not allowed for but should be borne in mind.

7' Recent reforms suggest that the most important components of commercial banking spreads are profit margins and operatina and administrative costs. Implicit and explicit taxes taking the form of reserve requirements of liquidity coefficients have been eliminated in local currency. The exception relates to limitations on dollars denominated liabilities (no greater than 20%). 15% of which are subject to special investment guidelines relating to liquidity. This latter limitation obviously has implications for domestic lending rates as it limits the extent to which banks can pass on the lower costs of funding abroad to domestic borrowers. These calculations only consider banks and do not consider other entities within the financial group where other explicit taxes such as the value added tax of 10% would apply thereby having implications tbr the pricing of these services or for spreads charged in commercial bank lending operations as a means of compensating for these taxes.

8/This spread was estimated by comparing the cost of a typical leasing contract (i.e.) where repossession is not a problem with the terms of credit contracts for small and medium enterprises. Note that this spread may understate the effective rates paid by small and medium sized borrowers as they must post collateral to obtain the loan that can amount to more than the value of the loan contracted.