Policy Research l /W fP5 1115 WORKING PAPERS, Financial Sector Development Financial Sector Development Department The World Bank July 1993 WPS 1153 North American Free Trade Agreement 3sues on Trade in Financial Services for Mexico Alberto Musalem Dimitri Vittas and Asli DemirgOu-Kunt Implementation of the North American Free Trade Agreement (NAFrA) will generate substantial efficiency gains forMexico' s financial system and economy. The key to NAFTA's success in the financial sector will be effective prudential regulation and supervision. But Mexican financial institutions will need a reasonable transition period to modernize operations and rise to the challenge of their Canadian and U.S. counterparts. Pblicy Research Working Papers disserinate the findings ofwork in progress and encourage the exchange of ideas arnongBank staffand A othersintewtedindevelopmntissues lhesepapes distributedbytheReseArchAdvi5o1yStaff. carrythenamesoftheauthor. rflect onlyytheirviews, andshouldbeusedand citedaccordingly. Thefindings.intprpeuations. andconclusions amtheauthols'own. Theyshould not be attributed to the Wodld Bank, its Board of Directos, its management. or any of its member countries. Policy Research nonc8a Sector Development WPS 1153 This paper-a product of the Financial Sector Development Department --is based on a report produced for the Mexican authorities in March 1991. It updates the earlier report in relevant areas. Copies of this paper are available free from the Wor.d Bank, 1818 1I Street NW, Washington, DC 20433. Please contact Priscilla Infante, room N9-003, extension 37664 (July 1993, 58 pages). To maximize the efficiency gains from NAFTA, supervision - particularly because of the heavy the regulatory environment for Mexican banking, financial pressures on the newly privatized banks insurance, and securities markets should be and the financial groups that own them. Without further harmonized with those of the more effective supervision, the new owners of the advanced and efficient Canadian and U.S. banks may take excessive risks to recoup the markets. substantial clement of goodwill in the privatization price, before the protection from Musalem, Vitwas, and Demirg(ic-Kunt argue foreign competition and new entrants is phased that a prerequisite for NAFTA's success is to out. remove regulatory distortions and to eliminate opportunities for -egulatory arbitrage. Moreover, An integrated market will presuppose greater eliminating or reducing disparities between the cooperation and informnation exchange among NAFIA countries' tax rates and ways of levying the national regulatory authorities to ensure, for taxes would help prevent distortions, tax evasion, instance, that weak banks do not undermine and tax avoidance. credit standards and that weak insurers do not offer deceptively low-priced policies. In these Complete harmonization may not be feasible areas, Mexico needs intensive training and or even desirable, given the way the three cooperation with the Canadian and U.S. regula- countries' financial systems have evolved and tory authorities. the differences between their industrial structures and stages of economic development. To increase the contestability of the financial markets and benefit from the transfer of financial In banking, insurance, and securities mar- technology, the Mexican financial system should kets, the main free trade issues are the conver- be opened to foreign entry. But Mexico needs to gence of authorization criteria and the removal modemize its financial institutions and Musalem, of most of the obstacles to freedom of establish- Vittas, and Demirgu,c-Kunt conclude that the ment. It is also important to harmonize guarantee proposed NAFTA should allow for a gradual schemes and to create well-defined Mexican approach to foreign entry. A reasonable transi- schemes to protect small, unsophisticated tion period, extending up to the year 2000, will investors rather than mismanaged institutions. give Mexican institutions ample time to achieve The key to NAFrA's success in the financial the efficiency gains that motivated the quest for sector will be effective prudential regulation and the agreement in the first place. |The Policy Research Working Paper Series dissedinates the fidings of work under way in the Bank.rnobjective of the series is to get these findings out quickIy, even if presentations are less than fuDy polished. The rindings, interpretations, and conclusions in these papers do not necessarily rep*resent of ficial Banlc policy. Produced by the Policy Research Dissemination Center NORTH AMERICAN FREE TRADE AGREEAIENT: ISSUES ON TRADE IN FINANCIAL SERVICES FOR MEXICO Alberto Musalem, Dimitri Vittas, Asli DemirguV-Kunt TABLE OF CONTENTS I. Introduction 1 II. Issues in Free Trade in Financial Services 2 III. Subsector Issues: Commercial Banking 9 IV. Subsector Issues: Insurance 19 V. Subsector Issues: Securities Markets 34 VI. Tax Issues 40 VII. Summary and Conclusions 43 References 45 Appendix A: Treatment of Financial Services in Free Trade Negotiations 47 Appendix B: Financial Services in the Proposed NAFTA 54 Notes 56 1. INTRODUCTION' If everything goes well, a North and the possible reform of deposit insurance. American free trade agreement (NAFTA) Canada has gone a long way towards domestic between Canada, Mexico and the United States deregulation, having authorized universal will become effective in January 1994.2 The banking and financial conglomerates. These primary objective of NAFTA will be to reduce issues may raise important questions concerning ye,t further any remaining tariffs collected on efficiency, transitional arrangements and the cross-border trade within North America, pace of integration. This paper aims at allowing each country to concentrate its identifying regulatory and tax issues that may production more in those sectors in which it has constrain Mexico from deriving the maximum a comparative advantage. In addition, NAFTA benefits from the implementation of NAFTA. will likely reduce regulations currently restricting the degree to which firms can shift The paper analyzes the implications of their operations across borders, allowing firms NAFTA for the Mexican financial sector from to take better advantage of economies of scale differences in sector development, in regulations and scope. on banking, insurance and securities markets, in constraints to capital mobility involving direct One sector that has been of particular foreign investment (DFI) regulations and in the concern in NAFTA negotiations is financial tax treatment of financial assets. It is organized services. While the financial sector in Mexico in seven sections. The next section provides a is still developing to attain the most advanced brief sector background and discusses the .iain international standards of efficiency, it has issues involved in free trade in finan^ial reached maturity in the United States and services. Sections 3, 4 and 5 focus on subsector Canada a long time ago. However, the finar.ial issues involving banking, insurance and systems of all three countries have been securities markets. In each case, existing undergoing fundamental change. Mexico has regulations are compared and contrasted, recently dealt with the privatization of transitional problems are discussed, and commercial banks, the restructuring of the recommendations are made. Section 6 analyzes development banking sector, the promotion of issues arising from differences in tax treatment. contractual savings institutions, and the review The last section provides a brief summary and of regulation and supervision of financial conclusions. Appendix A reviews the treatment intermediaries. In the United States there are of financial services in free trade negotiations, the problems of regulation of banking and while Appendix B summarizes the provisions insurance at the state level and restrictions on covering financial services in the proposed universal banking activities, and also the NAFTA that was signed in December 1992. problems with the Savings and Loan insolvencies 1 II. ISSUES IN FREE TRADE IN FINANCIAL SERVICES The Mexican financial services sector assets, cross-border after tax deposit rates are (including commercial banks, development equalized on equally liquid and risky securities. banks, securities markets, and insurance) still On the other hand, not all Mexican firms can represents a comparatively small fraction of issue international tradeable liabilities. Those aggregate output (3.5% of GDP compared to that can are able to consider international 6.5% in the European Community, EC), ;ending rates as their opportunity cost of capital; numbers employed (1.5% of total employment but Mexican firms which do not have the same versus 3% in the EC), and compensation of access to international financial markets will employees (5.5% of total compensation versus bear the full cost of domestic intermediation. 6.2% in the EC). These figures suggest that This implies that competitiveness in the goods compensation is rather excessive in Mexico. In markets for the second group of firms will be 1989, M3 represented 79% of GDP in the USA, negatively affected if prevailing conditions in 71% in Canada and only 29% in Mexico. financial markets generate intermediation cests Hence, by increasing income, and improving that are over and above international standards. income distribution and sector efficiency, Moreover, for those firms that rely on domestic NAFTA will pave the path for an increased role intermediation the ef.-ects on production costs of financial services in Mexico's GDP. will not be uniform, thosc that are relatively financial services intensive will suffer the most. Flnancial Market Integration: The Efficiency- Ownership Trade-off NAFTA will bring additional pressure to improve efficiency due to increased cross border Efficiency. By integrating financial competition and easing of entry barriers. markets across North American borders NAFTA Foreign banks and non-banks regularly operate is likely to have a particularly important impact and compete informally in Mexico's financial on efficiency. It will not only have significant markets. Also Mexican depositors, investors, effects on the efficiency of the sector itself but insured (mainly life and health) and borrowers also on the efficiency of resource allocation in widely use foreign financial intermediaries. sectors using financial markets.3 In addition, Therefore, opening up the sector would provide NAFTA will influence macroeconomic policy greater scope for domestic intermediation, since management, especially if it were to include regulato-s have virtually no control over either exchange rate commitments. Because financial foreign entitic; or Mexican residents performing services are inputs in the production of goods,' cross border financial transactions. In addition, estimation of the effects of NAFTA on financial it would offer greater protection to investors, services should take into account economy wide would add competitiveness to the economy as a effects rather than just following a narrow sector whole, and should increase financial deepening. focus. Therefore, some degree of synchronization in the pace of integration among The main benefits of foreign participation participating markets will be required. are the increase in competition and efficiency, the transfer of technology and skilled An inefficient financial sector will not management, the introduction of new products only increase production cost to final users, but and services, the employment and training of it will also induce subop'imal use of these local staff, and greater access to international services in the production of final goods or markets. These are likely to bring about a services. Since Mexican financial assets are higher quality of service and a lower level of near perfect substitutes with U.S. financial prices. 2 Ownership. In the financial services area, Foreign institutions would tend to retreat from a although the benefits of privatization have gained local market in response to two separate events: wide acceptanc-, the authorities of most when they faced problems in the local market countries, both developed and developing, are (for instance foreign instituti3ns could pull back reluctant to see their banking and financial operations from a local market facing an systems dominated by foreign institutions. economic slowdown) and when they faced Thus, even if they allow DFI in the financial problems in their home market. Local system, most countries impose explicit or institutions faced with difficulties in their home implicit limits on the level and scope of activities market cannot retreat from that market, unless of foreign institutions. the difficulties are so serious that they are forced to go out of business. The impact of a pullout One of the key questions regarding the would be larger the greater the share of a liberalization of DFi in financial services is national market held by foreign institutions. whether national authorities are justified to be worried about the ownership and control of Moreover, the authorities of many financial institutions. Unfortunately, mainstream countries claim that foreign institutions often economic theory highlights the gains in confine themselves to serving the most profitable efficiency and welfare that may result from segments of the market (cream skimming) and greater competition but has little to say on the capturing economic rents that may result from distribution of these gains and on the importance existing regulations or the inefficiency of of ownership and control issues. domestic institutions. Foreign institutions fail to lower prices, although they may provide more An important concern in many countries efficient services and they also fail to extend is the fear that foreign institutions may acquire their services to the retail segments of the dominant positions in domestic markets and may market. In addition, foreign institutions may drive out of business local institutions that are stimulate capital flight and thus aggravate less efficient and have fewer capital and pressures on the exchange rate at times of management resources. Restrictions on foreign external crisis. entry are often justified on "infant industry" arguments. A related criticism is that foreign The experience of foreign institutions in institutions will not provide services to local different countries is not well documented. firms. Although local institutions may be Anecdotal evidence from various countries created to fill such a gap, this argument implies suggests that foreign institutions, especially that such institutions will not be able to survive foreign banks, have been instrumental in either because they will be taken over by the enhancing the quality and lowering the cost of large and capital-rich foreign institutions or services to large corporations, particularly in because they will be prevented from achieving a countries where the latter have been discouraged minimum combination of economies of scale and by restrictions on cross-border transactions from scope by the foreign domination of the wholesale accessing the international markets. Foreign and international segments of the market. institutions have played an important role in stimulating product innovation and introducing A parallel argument against allowing new types of services, such as leasing and foreign institutions to dominate local markets factoring. They have also contributed to a relates to the strength of their local commitment. reversal of the brain drain by attracting foreign- If institutions are assumed to retreat from distant educated nationals and have trained local markets when they are faced with difict. Jies, executives who have later assumed the then their level of commitment to local .a management of domestic institutions. would be lower than that of local institutions. 3 In most countries, however, foreign As regards their alleged role in institutions have not extended their services to stimulating capital flight, the role of foreign the retail segments of the market. The main institutions is little different from that of factors explaining this reticence have been the domestic institutions in countries with an open imposition of restrictive regulations, the high e.-ital account. Both have the means to cost of entry, and political sensitivity to facilitate capital flight if there are strong domestic concerns about acquiring an unduly incentives to do so (e.g., expectations of an large share of domestic business. Many imminent devaluation, unfavorabie interest rate countries criticize foreign institu.ions for failing differential, political instability). In countries to extend their services to retail customers, but with a closed capital account, foreign institutions the fact is that if they did, foreign institutions may contribute to capital flight by providing would be criticized even more for acquiring a contacts to their parent institutions in foreign dominant position in the domestic financial financial centers and by facilitating arrangements system. for the maintenance of bank accounts and other investments in overseas markets. But even in Another important factor that may explain such countries, the main reascn for capital flight the failure of foreign institutions to s.erve small is the pursuit of unsustainable financial policies firms and the consumer market may be the high and adverss political etvironment. Foreign information cests that characterize retail institutions may exacerbate but they do not cause operations. Foreign institutions may have a the fligh. of capital. Even in the absence of comparative advantage over domestic institutions foreign institnions, capital controls have to be in providing financial services to large particularly effective and watertight to prevent a corporations and wealthy individuals but the flight of capital in the presence of adverse reverse is likely to be the case in dealing with macroeconomic conditions. Experience in this small and medium-size firms and retail area indicates that controls on capital mobility consumers.' Thus, the alleged tendency of have been quite ineffective. foreign institutions to specialize in some segments of the market may b explained by Finally, as regards the question of local regulatory and economic factors. commitment, there is no empirical study documenting the response of international The criticism that they engage in cream financial institutions to difficulties in their home skimming is based on the observation that and foreign markets. Both the extensive foreign institutions often report high profits from retrenchment of American banks from European their local operations. This may, however, and Asian markets in the late 1980s and the reflect their higher efficiency compared to behavior of Japanese banks in the eurocurrency domestic institutions. In countries where markets over the 1970s and 1980s provide some domestic institutions have been able to respond support to this argument. The risk for a national to their challenge, foreign institutions have been system that is dominated by foreign institutions unable to build a significant market share in any is that it might be susceptible to greater segment of the market, while their profits on instability than a system where national even the most wholesale or specialized types of institutions are the dominant players. operations have been low. The profitability of foreign institutions depends very much on the Efficiency/Ownership Trade-off. ability of domestic institutions to modernize their Maximizing the benefits of free entry of foreign operations and meet the challenge of increased institutions requires the deregulation of domestic competition. financial institutions and markets and the establishment of a competitive environment. Artificially low interest rates, directed credit 4 programs, barriers to entry, a&d other coordinat, 4 effort in freeing capital movements in pediments make it likely that foreign and financial services. Moreover, while capital iLa.titutions will simply capture regulatory rents mobility and freedom to provide financial rather than promote competition and efficiency. services might both be integral parts of the long Foreign participation may be beneficial even if run objective of the FTA, there does not seem to markets are not fully liberalized but some be an operational plan for integrating monetary restrictions may be necessary to grant domestic policy. institutions enough time to adjust to the new environment, modernize their operations and Monetar and Exchange Rate Policie, meet the challenge of their foreign competitors. The theory of optimal currency areas indicates t5iat a fixed exchange rate system - implying a Because of their location, cross-border passive monetary policy - is the preferred financial transactions between Mexico and the solution for an FTA with a high degree of U.S. and possibly Canada are already quite economic and financial integration and perfect integrated. The capital flight argument is, mobility of factors of production. On the therefore, less inportant for the North American contrary, in a situation where there is immobility market case. Local market comm;.ment may of labor across borders, as it may happen urder still be an issue, and the Mexican authorities NAFTA, the same theory suggests a flexible may have to assess the trade-off between foreign exchange rate system, which would efficiency and ownership. enable the government to pursue employ'nent objectives through active monetary policy. Components of Financial Integration Hence, the Mexican authorities will have to decide on maintaining the existing generalized Finamcial integration involves three fixed exchange rate system or to adopt a flexible distinct but interrelated components: monetary exchange rate system as Canada has. These are and exchange rate policies, capital movements very complex issues that are beyond the scope of and financial services. Capital movements and this paper, although they will need to be financial services can hardly be conceived addressed in the context of NAFTA. Moreover, independently: without capital mobility, the other objectives such as stabilization and placing power of financial intermediaries has credibility may overrule the optimal currency limited scope; conversely, regulatory barriers areas policy suggestions. that prevent operators from supplying services to non-residents threaten to undermine capital Capital Movements under NAFTA. mobility itself. Issues in the liberalization of capital movements within an FTA may require a review of DFI In turn, capital movements and financial regulations. FTA should reduce the screening of services forge a direct link between the balance foreign investments by member countries, of payments and domestic monetary policy. eliminate most trade-distorting performance Capital moves across borders in response to requirements, and provide security and changing (after tax risk-adjusted) rates of return. guarantees for investors in member countries. Equilibrium is maintained through variatiors in Investors are assured that new discriminatory exchange rates or adjustments in relative barriers to investment will not be erected and monetary aggregates. Therefore, full capital that the rules of the game will not be changed mobility under a fixed exchange rate system is unfairly. In short an FTA provides a business only consistent with passive monetary policy. environment conducive to further investment and free trade. The linkages between the three components underscore the need for a 5 The US has traditionally held the first Sector deregulations also facilitated DFI. rank among countries investing in Mexico ,65% New Implementing Rules issued for mining and of the accumulated total DFI into Mexico technology transfer, new Decrees for auto-parts originates in the US, a value of about $15 and petrochemicals, and new rules for billion) while Canada has held an insignificant pharmaceuticals and microcomputers, have all proportion of total DFI in Mexico (1.5% or an opened up DFI in a signiflcant way. New accumulated value of about $300 million). financial sector laws passed in mid 1990 opened up the sector to DFI. Banks, brokerage houses, NAFTA could build on Mexico's and insurance houses are allowed to have up to substantial liberalization of its treatment of DFI 30% foreign ownership.6 In addition, DFI in but it would have to incorporate the principles trust funds is unlimited but these investments do developed in the US-Canada FTA's investment not provide control. chapter. The Reglamento (Implementing Rules) to the DFI Law pa-ssed in mid 1989 contains Under NAFTA, national treatment would measures: (i) allowing automatic 100% DFI grant expanded access to US and Canadian participation in activities comprising about 60% investors to all sectors where the Mexican of GDP and only requiring the registration of private sector is allowed to operate. Also the investment with tne National Registrar for performance indicators and investment Foreign Investment (NRFI) (this procedure conditionalities may have to be relinquished. applies if minimum requirements concerning Under NAFTA, investors from partner countries exports, regional development, technology and would be treated equally as domestic investors. investment size are met); (ii) increasing Also, national treatment may require phasing out participation of the private sector (domestic and screening of investment originated from member foreign) in areas subject to specific regimes; (iii) countries. Finally, Mexico would need to adjust increasing transparency and speed of decision portfolio investment in listed securities making by the National Commission for Foreign originated from the US and Canada to Investment (NCFI); and (iv) simplifying and incorporate national treatment. However, some deregulating registration procedures in the exceptions might be granted for strategic, NRFI. political, environmental or cultural reasons; while many cases may be subject to a phase-out While the Law defines the activities strategy given the disparities in economic reserved for the Government and for Mexican development of the associating country investors and maximum DFI participation in members. petrochemicals, auto-parts and mining, the Reglamento clearly defines concepts that were Any foreign investors in Mexico will also rather obscure in the Law. These reduce have to forecast carefully the risk they face of discretionality and define precisely the scope of future adverse policy changes, i.e., political DFI. This goes a long way towards eliminating risks. The nationalizations of the banks in 1982, the case by case approach to DFI approval and as well as Mexico's restructuring of its registration in a significant number of activities. international debt, are both recent events, Another objective of the Reglamento was to forcing investors to take these risks very simplify procedures for those cases for which seriously. In general, investors will enter authorization is still required. The time elapsed Mexico only if they can earn an after-tax rate of between application, approval and registration return as high as they can get elsewhere. To the was reduced from about l 1/2 years, before, to extent the existing policy regime leads investors about 2 months now. Therefore, for the first to rationally anticipate some chance of adverse time clear, transparent and automatic rules have policy changes, foreign (and Mexican) investors been established. will cut back their investments in Me.ico until 6 the ex ante return is again comparable to that measures that are expected to provide market available elsewhere, after taking account of these access under the na.donal treatment principle and risks. a minimum degree of convergence in regulations and supervision. General issues involved in The types of policy changes investors may integration of financial F rvices are discussed fear are many and diverse. For one, Mexico below. As background information Appendix A may increase its corporate or withholding taxes contains - discussion of how financial services in the future, to try to earn more from the wer6 6reated under the GAIT negotiations, the investment that has taken place in Mexico. EC single market approach and the US-Canada More simply, it could again nationalize some FTA. firms, providing only partial compensation, or again default on interest payments to foreign The liberalization of trade in financial creditors. Domestic investors would also fear services covers two areas: cross-border higher personal taxes in the future on assets they transactions and DFI. Cross-border transactions make visible to th-e tax authorities through occur when the customer and supplier of investing them in Mexico. Foreign investors secvices reside in'different countries. Cross- could also fear fiscal, trade, financial and border transactIons may be restricted by controls monetary policy changes leading to a on foreign travel or by controls that prohibit depreciation of the exchange rate. Other types residents from purchasing financial services in of policy risks could include restrictions on the overseas markets. repatriation of profits, requirements that profits be exchanged into dollars at an unfavorable Controls on cross-border transactions are exchange rate, etc. often justified on balance-of-payments grounds and aim to limit capital flight. Many countries, Mexico's inability to credibly commit itself however, support cross-border transactions that to its present policy reduces capital investment in result in capital inflows, such as borrowing in Mexico without reducing the ex ante rate of overseas markets by large corporations. Cross- return earned by rational investors, whether border transactions mav also be restricted to foreign or domestic. As a result, it lowers the protect local financial institutions. country's growth rate and wage rate. Any credible commitment not to change policy The liberalization of controls on foreign adversely would be a welfare gain for Mexico. travel and capital movements that has characterized the economic policies of most Since firms and individuals decide on the developed and many developing countries in location of their investments based not only on recent years has reduced the importance of current government policies but also on cross-border transactions in trade negotiations. expectations of future policies, it is important to However, many countries that continue to apply reassure investors concerning the stability of controls on cross-border transactions are these policies. NAFTA offers the best possible concerned that relinquishing control of foreign opportunity to assure investors on Mexico's excl^.,e and capital flows may have serious commitment to stay on the course of the sound implications for their balance of payments and policies already implemented. may undermine their control over monetary policy. There is also concern that freeing cross- Financial Services. The third component border transactions may encourage tax evasion. of financial integration is the liberalization of financial services involving banks and securities DFI involves the presence of foreign firms, stock exchanges and insurance companies. institutions in the domestic market. This may be For these three sectors the FTA should envisage affected by restrictions on the right of 7 establishment and scope of operations of foreign mitigated fears about the possible abuse of firms. Restrictions on DFI are more likely to be monopoly power by foreign suppliers of public motivated by strategic and protectionist utility services. considerations than by concerns about the balance of payments. The pice of financial integration under NAFTA depends on the existing level of Much of the recent debate regarding the integration already present among the member liberalization of trade in services has been about countries, and Mexieo's pace of progress in the rules of DFI rather than cross-border developing prudential regulations and transactions. Financial services, strengthening its supervisory process. There is telecommunications and utilities are the main a great deal of financial integration between the service seetors where DFI has been discouraged US and Canada. In contrast, Mexican banks for strategic and protectionist purposes. These have some small activities in the US a-ad none in sectors have traditionally been seen as occupying Canada, while TJS and Canadian banks have not a central position in the national infrastructure been able to provide a full range of banking for promoting economic development and they services in Mexico since 1982. They are just have been reserved nut only for national but now entering the insurance industry through often also for public ownership and control.' acquisitions oc minority interest in existing firms. However, cross border financial In recent years, the emphasis on public transactions between Mexico and the US are ownership and control of utilities has given way thought to be important. While progrw.s in in many countries to an acceptance of the regulations may encourage a quick financial benefits not only of private but also of foreign integration, the differences in stages of ownership. This has been facilitated by the development, implementation of supervisory strengthening of the administrative powers and standards and deposit insurance schemes may effectiveness of regulatory agencies, which has provide some justificaticn for a slower pace under a NAFTA than under the US-Canada FTA. 8 III. SUBSECTOR ISSUES: COMMERCIAL BANKING Regulatory Considerations banking system, and with improvements in prudential regulation and supervision. With the implementation of NAFTA, differences in regulatory systems between The financial systems of all three Mexico, the United States and Canada will gain countries are thus in a process of fundamental ; 'portance. There are fundamental structural structural change. There appears to be a changes underway in all countries. Canadians common trend in the development of all three are the most advanced in their reform process financial systems towards regulatory reform that towards achieving universal banking. The aims to extend the powers and activities of government reform proposal, which was various institutions and allow common ar' -niced in September 1990 (enacted ownership of firms within the financial sector. December 1991 and became effective June This trend towards universal banking is also 1992), has three main goals: to expand the coupled with an increased emphasis on powers and functions of financial institutions; to improving prudential regulation and supervision. establish new rules governing ownership and Still, each country is moving along this path at capitalization; and to strengthen regulatory its own pace. For Mexico it is important to controls and prudential safeguards8. In 1990 keep abreast of these developments in order not the United States also considered a reform to adopt or continue regulations that might package which aimed to abolish branching impede tne competitiveness of Mexican restrictions and the separation between banking institutions. and commerce, reform the deposit insurance system, strengthen the supervisory system, and The following discussion groups issues reduce regulatory and supervisory duplicatic ?9. that merit attention in evaluating the Mexican However, the reform bill failed to pass the banking regulations under four headings: (i) Congress. market structure and barriers to entry and exit, (ii) FONAPRE and the banks savings protection The Mexican banking system has also fund, (iii) other regulatory issues, and (iv) been going through major restructuring and supervision. reform. Following successive regulatory reform in October 1988 and April 1989, the banking Market Structure and Barriers to Entry and Exit system has been freed from the restrictive controls that inhibited competition. A Maximizing the benefits of foreign entry privatization plan for commercial banks was requires the deregulation of domestic financial announced in May 1990, proceeded quickly, and .nstitutions and the establishment of a was successfully completed by July 199210. In competitive environment. If impediments to August 1990, the banking law was also amended competition exist in the domestic economy, it is to relax restrictions on bank ownership. likely that foreign financial institutions will Restrictions on financial conglomerates have also simply capture monopoly rents rather than been relaxed and the formation of financial promote competition and efficiency. The greater groups that might include banks, insurance the extent of liberalization of the markets, the companies, securities brokers, leasing and greater will be the benefits of foreign factoring companies, etc. has been permitted. participation. Mexico has also been simultaneously dealing with the restructuring of the development Although most of the impediments to competition, such as interest rate ceilings, 9 directed credit controls, and other constraints, In the US and Canada, obtaining a have been removed with the recent banking charter requires lower initial capital and deregulations, there are still barriers to entry and is relatively straightforward. For example, in exit in the Mexican banking system. The the United States charters and initial capital Mexican banking system is a highly concentrated requirements of national and state banks are one. Out of the 18 domestic banks, the six handled by the Office of the Comptroller of the largest account for around 75% of the assets of Currency (OCC) and the state banking the entire banking sector. However, authorities, respectively. The OCC's regulations concentration in itself does not necessarily imply stipulate that the initial capital of a national bank inefficiency. For example, the Canadian must be in excess of US$1 million. Although banking system is also a highly concentrated there is variation among states, the New York one, dominated by six large banks." Banking Board sets the minimum initial capital Nevertheless, studies of Canadian banking have of state-chartered banks at US$1.2 million. found it to be highly competitive.12 Only banks in large metropolitan centers, such as New York City, Los Angeles, and San One key factor in being able to foster Francisco may be required to have an initial competition within a concentrated banking capital of US$5 million."3 The application for environment is market structure. Levels of a charter becomes the part of a publicly competition approaching perfect competition are available file, and generally within possible in contestable markets where entry and approximately four to six months a new national exit to the market is costless. By eliminating or bank can commence operations in a key minimizing barriers to entry and exit bank commercial state. regulators can induce competition among existing banks since market discipline will be In Canada, initial capital requirements are imposed by not only the number of actual higher, yet rules for obtaining a banking charter competitors, but also by potential competitors. are less cumbersome. The capital requirement which was Can$5 million (US$4.3 million) has Leaving the issue of foreign bank entry recently been increased to Can$10 million aside, the Mexican Banking Law does not seem (US$8.7 million). However, given that the to encourage the chartering of new banks. To volume of financial operations is much higher in charter a new bank the minimum capital the United States and Canada than in Mexico, requirement is determined by 0.5% of the paid the Mexican initial capital requirement appears capital and reserves of the whole banking system to be unduly restrictive. at the 31st day of December of the preceding year. An estimate of this requirement is around Another issue that is related to entry US$20 million based on 1990 year-end capital of restrictions regards the limits imposed on the the banking systnim, obtained from the Banco de participation of foieign banks. Until recently, Mexico. Conditioning initial entry requirements Mexico did not allow foreign banks to establish on the total capital of the banking system branches or subsidiaries. Following the increases entry barriers as the value of the privatization of banks, foreign banks (and other banking system increases. Therefore, as the investors) are allowed to hold up to a cumulative Mexican banking system continues to capitalize, 30% of the capital of a commercial bank (or of new banks will face stricter barriers to entry. a financial holding company). Individual Furthermore, issuance of bank charters is at the holdings of either Mexican or foreign investors discretion of the Federal Government and there cannot exceed 5%, although the Ministry of are no clear rules or procedures. Finance may authorize a greater percentage up to a maximum of 10%.14 This rule does not apply to the Federal Government, institutional 10 investors (whose individual participation may As discussed above, for developing amount to as much as 15%), the Bank Savings countries allowing foreign bank entry has trade- Protection Fund and financial holding offs between maximizing benefits from foreign companies. However, it is debatable whether entry and retaining control of domestic this 10% rule can be enforced effectively given institutions. Foreign ownership of banking the complex relationships among international institutions is a politically sensitive topic. The institutions. In addition, foreign tax credit in the role of banks in implementing monetary policy US is only allowed to entities having at least and financing government out of seigniorage 10% ownership control (see Section 6). makes the banking industry a very important policy instrument whose control cannot be The United States do not have such relinquished. restrictions; foreign banks can own state or national banks or operate wholly-owned For Mexico, the 30% ownership branches and subsidiaries. But the acquisition of restriction in already existing institutions, management control in insured banks, which is coupled with future free entry of wholly-owned deemed to occur if more than 25% of bank subsidiaries, may be adequate to retaining capital (or in the case of individual shareholders control, while reaping the benefits of foreign more than 10% of bank capital) is subject to participation. To ensure that Mexicans retain approval by the regulatory authorities"5. control of large intermediaries, the Canadian Moreover, differences in regulations for system of Schedule I and II banks can be different states are cumbersome and banks are adopted. Schedule I banks would be the existing subject to interstate branching restrictions. large Mexican banks that are widely-held and Mexican-controlled, with maximum single In Canada, banks have a variety of ownership of 10%. Subsidiaries of foreign ownership structures; chartered banks can be banks and new domestic banks could be widely-held, or closely-held fer a temporary established as closely-held Schedule II banks, period. Schedule I banks, which include the and if their capital increases over a certain largest six Canadian banks, have to be widely- threshold, they would be required to go public. held with no one person or group owning more than 10% of their shares. Schedule II banks can Opening up a domestic market to foreign be started and owned on a closely-held basis for competition can also be accomplished by the first 10 years, or directly-owned by widely- permitting the cross-border provision of banking held regulated financial institutions that are not services. This requires the protection of banks. Foreign banks can establish subsidiaries nonresident depositors by extending insurance in Canada, designated as Schedule II banks, coverage of deposits to nonresidents (see below), subject to restrictions on market share, asset as well as closer cooperation and coordination of growth, transfer of loans to their parent banks, information sharing across the borders to branch approval, and capital expansion. minimize possible fraudulent activities. Schedule II banks whose capital exceeds Can$750 million are required to have at least Branching restrictions are another way of 35% of the total voting rights attached to shares restricting entry that lead to market that are widely-held. After the US-Canada Free segmentation. In Mexico branching is no longer Trade Agreement, US banks are no longer subject to specific aathorization. Banks are subject to foreign bank restrictions and are required to submit an annual plan of their treated as Canadian banks, except that Canadian branching policy to the authorities but are branches of US banks are considered otherwise free to open and close branches. But independent Schedule II banks."6 banks should also have the right to buy and sell branches to each other as this would facilitate 11 their expansion in areas where they may be With the privatization of the banking underrepresented or where business is more system, a Banking Savings Protection Fund profitable. This would allow banks to mobilize (BSPF) is envisaged to take over the functions of funds from the cheapest sources. the FONAPRE. The purpose of this fund will be to provide preventive support for banks that Canada does not have branching are likely to encounter financial problems. For restrictions. In the US, the ban on interstate a newly-privatized and relatively inexperienced branching (McFadden Act, 1927) and the curb banking system, having a vaguely-defined on affiliation between banks in different states insurance fund may create more problems than [Section 3(d) of the Bank Holding Company Act it can solve. Timely exit of insolvent of 1956] are still in force, although the institutions is important to foster healthy constraints on the geographic expansion of banks competition. Preventing individual institution and bank holding companies are being steadily insolvencies may destabilize the financial system eased by reciprocity agreements between states. by distorting risk-taking incentives and Unless US restrictions of interstate branching are undermining market discipline." The amended, at some stage Mexico may have to experience of the US savings and loan industry enter into the same kind of arrangements with exemplifies the importance of allowing timely every state. exit. The BSPF should have very well-defined powers and its purpose should be to protect Exit in the Mexican banking system is small, unsophisticated (resident and non- equally difficult. Banks with financial resident) investors rather than mismanaged difficulties are financed and restructured by institutions. Such a deposit insurance scheme, FONAPRE, the Mexican insurance fund. coupled with strong and effective supervision Deposit insurance is another issue that deserves can establish public trust in the newly-privatized special attention for the newly-privatized banking system and allow Mexican banks to Mexican banking system and the implementation compete with foreign banks on equal ground. of NAFTA. If properly designed and implemented, and coupled with effective risk In the United States, the Federal Deposit management and supervision, a deposit Insurance Corporation (FDIC) was established in insurance system can also enhance the 1933, after the massive bank failures that competitive ability of Mexican banks with occurred during the Great Depression of 1930- respect to foreign banks. 33. The original role of deposit insurance was to protect the nation's payment and credit FONAPRE and the Bank Savings Protection systems from system-wide disruption and to Fund shelter small deposit holders from los, - s. Through time, the FDIC's preference for Mexican banks that have liquidity or keeping insolvent banks afloat and handling solvency problems are financed by the inescapable failures through mergers or assisted FONAPRE. Banks pay fixed premiums to transactions has taken the US deposit insurance FONAPRE. Those receiving support are to a system of de facto 100% coverage. regulated more closely till they reachieve financial stability. Before the privatization, By providing insurance coverage to most since the banks were also publicly owned, moral bank depositors, FDIC destroyed an important hazard problems were minimal and insolvent external discipline on bank risk-taking. Without banks could be pressured to curb their unsound insurance, large depositors have strong management practices. incentives to monitor the financial condition of their banks. The possibility that depositors may withdraw their funds gives banks an incentive to 12 avoid excessive concentrations in risky and without such formal requirements. Banks are iHliquid assets and to stay well capitalized. required to maintain minuscule reserves that on Without such market discipline it is difficult for average should not be less than 0.5% of eligible regulators to ensure safe and sound banking liabilities. Solvent banks, when allowed to pay practices. The US needs a deposit insurance market rates on their liabilities, are expected to reform that would reinstate market discipline. handle liquidity requirements in normal The reform should include improved accounting circumstances. During crises, the central bank and insolvency-resolution procedures, risk-rated is trusted to handle runs on the banking system. insurance premiums, decreased coverage, and expanded powers for deposit-insurance Reserve requirements in US were regulators that would increase transparency and simplified by the Depository Institutions allow sophisticated investors to play an Deregulation and Monetary Control Act of 1980. important role in disciplining banks. To a They now vary from zero to 12% of deposits certain extent some of these issues were based on the type and size of the account. addressed by the Federal Deposit Insurance Reserves do not earn interest. Canada also has Improvement Act of 1991 (FDICIA). cash reserve requirements that vary from one to 10% based on the type and size of the account. The Canadian Deposit Insurance Canadian banks also have a secondary reserve Corporation (CDIC) was established only in requirement of 4%. In Canada there is a 1967 in response to the failure of several trust proposal to phase out the cash reserves within companies, again to protect small depositors. two years. However, the decision of the banking authorities to protect uninsured depositors in 11 of the 18 With the April 1989 deregulation, loan and trust companies, and all three of the Mexican reserve requirements were eliminated. banks that failed during the 1980s, sparked a Instead, banks were required to hold 30% of debate about whether the government has created their deposits in qualified tradable paper. Only incentives for depository institutions to take CETES (Mexican treasury bill) was eligible. excessive risks. For a number of years, the This liquidity requirement allowed banks to earn banking industry has been advocating some market interest rates and was justified on minimal level of market discipline through prudential grounds. However, this requirement deposit coj-insurance by individual depositors on imposed a tax on banks since more profitable deposits exceeding a certain limit. No major uses were available for these funds. changes in bank failure resolution procedures are Furthermore, having only one government paper currently under consideration in Canada. as qualified tradable paper was an unjustified restriction. Other Regulatory Issues Generally, continuing liquidity problems The following specific points also deserve are considered to be an indication of the consideration in eliminating impediments to institution's underlying insolvency which is competition. better controlled by capital requirements. Elimination of liquidity requirements would be Liquidity requirements. Both in US and feasible if institutions are sound and well- Canada reserve requirements are seen as an capitalized and a strong bank supervisory system instrument of monetary policy. However, it has is in place. In the case of Mexico, liquidity been shown that the imposition of formal, requirements were justified as a transitional legally enforced reserve requirements is not regulation. In fact, as steps were taken to essential for monetary control." In fact, the improve bank capitalization and supervision, in Bank of England executes its monetary control mid-1991 liquidity requirements on additional 13 deposits were eliminated, and a phase-out plan it is difficult to evaluate the effectiveness and for the already existing limits was put in place. accuracy of on-site inspections which are crucial in bank supervision. Capital requirements. The Mexican Banking Law requires banks to have a net Both US and Canada have well- capital of at least 6% of their assets, contingent established supervisory systems. In the US liabilities, and any other operations that are sound banks with assets of US$300 million and subject to significant risks, taking into account above are examined annually. Supervision the international capital adequacy standards. responsibilities are shared among national and The US and Canadian banks are subject to state authorities. Canadians also conduct annual international risk-adjusted capital adequacy rules inspections. The Superintendent of Financial which state total capital must be 8% of risk- Institutions is the main supervisory authority. In adjusted assets. Of the total capital, at least both countries on-site and off-site methods are 50% must represent core capital (common used in order to obtain information about the equity) and the remainder can be supplementary economic condition of the institutions. Off-site capital (preferred shares and debentures). monitoring consi. s of analyzing quarterly Mexican banks are expected to reach the income and balance sheet statements filed with international standards of capitalization to ensure the authorities. To a limited extent off-site Lhat they have adequate equity cushion for monitoring also makes use of market data (such competition. as growth rates, deposit rates, and stock prices), public disclosures, and credit ratings assigned by Supervision of the Banking System private analysts. On-site examinations consist of a team of inspectors that visit the head office of Deregulation of the financial system the bank. Examiners rate the bank based on the without adequate prudential regulation and detailed CAMEL criteria. The criteria used by supervision is dangerous. This is especially true both countries consist of Capital adequacy, Asset if the institutions are not well-capitalized, or if quality, Management quality, Earnings, and they are newly-privatized as in the case of Liquidity. The team of examiners carries on Mexico. Moreover, since the privatization price discussions with senior management and for some Mexican banks was much higher than prepares a formal report pointing out strengths their book value of capital, these banks will be and weaknesses in the bank's operation. under additional pressure to recoup their expenses before the negotiations are completed Given the importance of supervision for and their protection is phased out. Thus, a newly-privatized banking system operating in improving bank supervision is as crucial as a deregulated environment, Mexican bank- deregulation of the banking industry. supervision reform should receive the attention it deserves. A good supervisory system requires Mexican banks are supervised by the a well-defined supervisory framework, adequate Comision Nacional Bancaria (CNB). resources and technology for the supervisors to Supervision is performed through off-site obtain and monitor information in a timely monitoring of bank performance and visits to the fashion, and sufficient authority for supervisors banks to review their financial condition. The to enforce their decisions. supervisory system is currently being computerized. Efforts are being made to The Mexican supervisory system should improve the loan classification system and be evaluated within the context of Mexico's monitoring of the bank portfolios. Although banking environment. The banking environment after these developments, the Mexican off-site has been changing from a controlled and highly monitoring facilities will be quite sophisticated, regulated market to one with many free market 14 characteristics. The private sector has started requirements need to be reexamined, Mexican gaining an increasingly greater access to capital adequacy requirements are expected to be commercial bank credit and services. The in line with international standards within the privatization of the banks also presents next few years. additional challenges to both banks and supervisors. Loan concentration should be monitored carefully and rollover practices and interest With increased competition and private accrual policies should be judged based on the banking, institutions will make an effort to repayment capacity of the borrowers. Mexican maximize their profits. One outcome of this bank supervisors may have to be especially strict process will be the need to reduce operating about placing controls on the capitalization of costs and increase efficiency. However, banks delinquent and unpaid interest. may also be inclined to increase their credit, interest, and liquidity risks. Credit risk will In addition, improving disclosure rules, inevitably increase as banks increase their using internationally comparable accounting lending activities to the private sector, especially techniques would increase transparency and into new and profitable areas with which they make supervision easier not only for the are unfamiliar. As banks compete for regulators but also for the general public. customers, decreasing margins will make higher Encouraging development of private rating risk borrowers attractive. Banks may also be agencies would also improve information subject to interest rate risk, given the liberalized dissemination and help establish market interest rates, and the possibility of mismatching discipline. Audits of bank statements by the durations of assets and liabilities. Liquidity independent auditors may be required to provide risk would also increase as increases in default independent checks. risk and duration gaps would hamper the bank's ability to meet its maturing obligations. To be able to obtain timely information Therefore, for Mexican regulators it will be on the banks, supervisors should have adequate quite a challenge to maintain the safety and resources. They should be able to hire, train, soundness of the banking system without placing and retain a sufficient number of employees, as an unnecessary regulatory burden on the well as acquire appropriate technology. For industry. example, CNB has already computerized its off- site monitoring. Statistical early-detection A well-defined supervisory framework models can be utilized to improve monitoring requires many components. Loan classirication and make maximum use of this computerized and provisioning rules based on risk of default data base. Frequency of on-site inspections can are important in monitoring asset quality and be increased or priority can be determined based early detection of deteriorating bank portfolios. on such models. As mentioned above, CNB is already in the process of improving its loan classification and Supervisors should also be able to have provisioning rules. sufficient authority to deal with mismanaged institutions. They should be able to discontinue Capital adequacy rules should be based insurance coverage, issue cease and desist on the riskiness of bank operations and should orders, force write-offs or provisions, and grow paraiiei to the expansion of these demand capital increases. operations. Initial capital requirements should be low enough to allow entry to the system but Even if supervisory regulations are at the same time adequate to enable safe start-up adequate, and the above conditions are met, lack of operations. Although initial capital of an appropriate incentive structure may 15 prevent financial institution regulators from expenditures and failures must be eliminated. doing their job properly and may thus jeopardize This may be achieved through greater enforcement." Therefore, it is also important transparency. In addition, independent hearings to protect supervisors from political and held by budget committees can be used to assess bureaucratic pressures. For example, in the US the adequacy of regulators' compliance with the deposit-institution regulators face pressures from procedures. politicians, their regulatory clientele, and lobbyists. As appointed officials, regulators face For Mexico, it is important to learn from pressure from politicians to leave problems international experience in structuring its unsolved since tackling them openly would cause supervisory system. Bank regulators and conflict with various constituencies and supervisors should have the necessary incentives adversely affect the chances of winning a to avoid conflicts of interest. This is again reelection. Following a cover-up strategy keeps possible through very well-defined supervisory involved constituencies and political action rules, transparency, necessary mandate for the committees willing to pay tribute to politicians. regulators to perform their duties, and periodic Regulators also face oversight controls from independent checks on regulatory activities. their regulatory clientele, that is, from the institutions they regulate. If regulators can Operating Efficienc) successfully complete their term in government service, they can generally expect higher wages One of the potential benefits from in postgovernment employment. Their success NAFTA for the Mexican financial sector is the is determined by the "perceived" quality of their likely increase in operating efficiency of the performance, which makes them very sensitive Mexican banks. After a long consolidation to the opinions of the institutions they regulate, process, the number of banks has been reduced as well as to those of the trade associations and in Mexico from around 200 in 1975 to 18 state- lobbying groups connected with these owned banks and 2 private banks (Obrero and institutions. These career-oriented incentives Citibank) by the mid-1980s. Concentration is and political and bureaucratic constraints lead quite high with 6 banks holding about 75% of regulators to be influenced by their total assets. As already discussed, concentration constituencies, avoiding solutions unfavorable to in itself is not necessarily a problem. It is the them, or promoting solutions that they find combination of high concentration with extensive particularly desirable. state-ownership and restrictive regulations that usually result in high inefficiency reflected in One of the most challenging features of high staffing levels and wide bank margins. financial reform in the US is improving the incentive structures for regulators and Analyzing bank efficiency is a difficult politicians. For regulators this entails additional and complicated process. The main problem is obligations imposed in the form of requiring the lack of a satisfactory definition of bank improved accounting practices and strictly output. Most accounting ratios that relate enforcing capital requirements and tough revenue and expense items to total assets, gross insolvency-resolution procedures. Additional income and equity suffer from the effects of market checks and balances on the exercise of differences in capital structure, product mix, and governmental powers through private insurance accounting conventions (with regard to the agencies are envisaged. Greater powers for treatment of inflation, asset valuation and regulators are also deemed necessary for amortization, loan loss provisioning, and hidden successful enforcement of regulations. To better reserves) among banks, across countries and motivate politicians, the option of covering up over times. problems by focusing on only acknowledged 16 Although detailed data for Mexican banks suffer adjustment costs due to the changes that are comparable to those of Canadian and US brought by privatization and increased banks are not readily available, it is generally competition. The evaluation of the impact of held that Mexican banks exhibit much higher NAFTA should be based on "net" welfare gains, operating asset and equity ratios than their also taking into account the costs of the counterparts in their northern neighbors2". For adjustment process. instance, in the United States and Canada, the return on bank assets averaged around 1 % Clearly the most important issue to be during the second half of the 1980s, while in addressed during the transition is how to handle Mexico it has been well over 2%. Gross the bad-loan portfolio and unfunded bank labor income margins were less than 3.75% in liabilities. Two extreme transition paths can be Canada, between 4.5% and 5% in the United visualized. On the one hand, the transition may States, but well over 7% in Mexico. As around take place quickly with minimum impact on the 70%-75% the cost/income ratio of Mexican financial institutions and maximum benefits for banks was not particularly high by international the users of financial services. However on the standards, but staffing levels at 40 employees other hand, transition can also be relatively more per branch were significantly higher than the difficult and be very costly for the government. average of 26 staff per branch prevailing in Canada and the United States. This partly Although not likely, if many banks are reflects the lower branch density in Mexico, expected to emerge undercapitalized after the where there are about 50 bank branches per privatization, the government may consider a million people as against between 250 and 500 very gradual transition period during which in the other two countries. The return on equity barriers to entry remain.2 In this way, newly- of Mexican banks is high in nominal terms, but privatized banks and their foreign minority in view of the very high level of inflation in the shareholders will be able to keep their margins 1980s and the unsatisfactory accounting high, and slowly write-off their bad loans, fund treatment of gains from the revaluation of assets, their labor liabilities and recapitalize. Only after it is very difficult to compare the real the financial health of the banks are restored, an profitability of Mexican banks with that of their opening up will be considered. However, there northern counterparts. are two serious drawbacks to recapitalizing through rent instead of equity: Despite the difficulty of comparing the operating efficiency of Mexican banks with that A Multisector Approach. As already of US and Canadian banks, it is generally discussed, financial services provided by expected that opening the Mexican banking financial institutions are basically intermediate market to greater competition will result in goods. Therefore, protection of financial greater efficiency. This will be reflected in institutions is similar to protecting industries of lower operating costs and lower margins that intermediate goods. Tn protecting financial will benefit all users of banking services. intermediaries, gradual transition policies will prevent domestic producers from accessing The Transition Process cheaper credit and an expanded set of financial services. Furthermore, if the real sector is at a With the implementation of NAFTA, more advanced stage of liberalization, as in the there will be welfare gains for the users of case of Mexico, protecting the financial sector or financial services due to increased competition allowing its gradual transition, taxes the real and availability of a wider range of financial sector which faces international competition in instruments at more favorable terms. However, pricing its output. This tax is also at the same time, commercial banks may have to disproportionally born by smaller producers as 17 explained in Section 2. In order to avoid this greater disclosure is very important in enforcing undesirable outcome, liberalization in the real regulations and establishing market discipline. and financial sectors should be synchronized. Further deregulations are necessary to remove barriers to entry and exit. The deposit insurance The Political Economy Arguments system should have well-defined purpose and Against Gradualism. Financial liberalization powers. Also discrepancies between different involves transfers of wealth and income from the financial institution regulations should be financial institutions to the users of financial eliminated. services. An abrupt transition exaggerates and makes these transfers more visible. Naturally, Opening up the Mexican banking sector to adversely affected groups oppose the reform new entry is likely to reduce the value of process. In the case of Mexico, since the large existing Mexican banks. To the extent proportion of financial institutions were state- privatization prices paid included a premium for owned, these problems were minimal, remaining entry barriers (the average price was However, if the government were to keep three times the book value and 14 times the barriers to entry in order to allow slow expected earnings), the institutions may have recapitalization of the newly-privatized banks, expected to collect "protection" rents for an political economy considerations would start to extended period of transition during which they become important. Gradualism may allow can recapitalize through these rents. This is not extensive lobbying opportunities for the now a desirable solution since it would impose a private banks, which in turn endanger specific tax on the real sector and may weaken continuation of the reform. This may explain the commitment of the government to financial why governments that appear to be committed to reform due to opposition from the newly reforms have difficulty abolishing temporary privatized banks. controls. If the issue of financial liberalization is not dealt with at the time of privatization, Having concluded the privatization, efforts to abolish entry restrictions would surely Mexico still needs to remove remaining face opposition. Clearly these concerns favor a uncertainties and strengthen its supervisory relatively faster liberalization to gradualism. systems. Improving systems of prudential supervision and regulation are crucial given the Conclusions and Recommendations newly privatized, relatively inexperienced banking system. Ensuring transparency, To maximize the efficiency gains from and clarifying rules for new domestic as well as liberalization, the regulatory environment of the foreign entry and exit will help remove banks can be further reformed through uncertainties about expected future rents. In deregulation and better defining and addition, adoption of the Canadian system of implementing prudential supervision. Schedule I and II banks would allow wholly- Establishing an effective supervisory system is owned foreign institutions without jeopardizing crucial and will determine the pace of Mexican control of large intermediaries. liberalization. Improving transparency through 18 IV. SUBSECTOR ISSUES: INSURANCE Regulatory Considerations Market Strmcture and Barriers to Entry Since the extensive deregula,ion of the The Mexican insurance sector comprises Mexican insurance industry in 1990, the 45 companies, two of which are state-owned, 37 regulatory differences between US, Canada and are private primary insurers, 4 are mutual Mexico have been reduced substantially. insurers and two are private reinsurers. No branch or local subsidiary of foreign companies In terms of financial conglomerates, is authorized to operate in Mexico, although Mexico has already enacted legislation that there are over 260 registered foreign reinsurers permits the creation of financial holding that are authorized to reinsure Mexican risks. companies able to own banks, insurance Mexican companies operate in both life and companies and securities firms (as well as other nonlife business and are not required te financial companies specializing in leasing, segregate their capital accounts, although they factoring, data processing, etc.). maintain separate technical reserves. Marke concentration is very high, with 80% of In Canada, new legislation enacted in premiums accounted for by the klrgest 8 December 1991 has permitted the desegregation companies. The level of concentration is much of banking and insurance by allowing the higher than in either Canada or the United creation of financial groups that own subsidiaries States. in both sectors. Canadian banks and insurance companies have earlier been allowed to own Until the deregulation of 1990, insurance securities firms through holding companies. companies were authorized to operate by means of concessions that were granted by the In the United States, insurance companies government. Insurance business was effectively can be organized either as independent entities treated as a public service. There were strict or as controlled subsidiaries of holding limits on individual shareholdings (10% but up companies. Insurance holding companies are to 15% with government permission), while no not subject to direct insurance regulatory foreign insurer could sell insurance in Mexico supervision and are permitted to own and no increase in foreign ownership of subsidiaries engaging in virtually any other insurance companies was allowed. However, sector, except banking. However, the United several grandfathered firms had a higher States continue to impose a legal separation concentration of domestic and foreign between commercial and investment banking, ownership. between banking and insurance, and between banking and commerce. Following the extensive financial deregulation of the past two years or so, the new The discussion of issues on Mexican authorization system treats insurance as a insurance regulations is organized under four commercial activity. 100% ownership through headings: (i) market structure and barriers to a financial holding company is allowed, while entry, (ii) insurance guarantee funds (iii) other foreign participation is permitted up to 30%.2 regulatory issues, and (iv) supervision of However, individual shareholdings in insurance. independent insurance companies are still limited to 15%. The state continues to have discrctionary powers in authorizing new 19 companies and no new licenses have been In Canada, insurance companies can be issued. But most insurance companies now have authorized at either the federal or the provincial 49% participation from large foreign insurers level. The minimum caspital requirements for that include such companies as AIG and Cigna federally-licensed insurance companies are from the United States, Allianz from Germany, Can$1.5 million for nonlife companies and Mafpre and Banco Santander from Spain, and Can$2 million for life insurers (between US$1.2 Generali and RAS (the Italian subsidiary of and 1.6 million). Federally-licensed companies Allianz) from Italy. In some cases, foreign must also be authorized by the provinces in companies are reported to have effective control which they operate. There is a large number of through friendly shareholdings from individual foreign companies that are authorized at the investors. federal level. In contrast to banking where the minimum The Canadian insurance market comprises capital requirement is set in relation to the total over 500 companies, of which 14 are composite capital of the sector, in insurance the minimum insurers, 175 are life insurers and over 250 are capital requirements have been set by regulation nonlife insurers. Foreign presence is very at a fixed level. This reflects the need for extensive - over 80% of all companies are either healthy competition and balanced growth of the local branches and agencies of foreign sector but does not directly depend on the total companies or foreign controlled local companies. capital of the industry (capital requirements can Foreign companies account for 32% of be changed by future regulations). The current premiums in life and 61% in nonlife insurance requirements specify a minimum of Mex$2 (1988). These are the highest among OECD billion for life insurance and Mex$1.5 billion for countries for which data are reported.2' one line of general business, rising to Mex$2 Foreign companies also generally have a much billion for two lines and Mex$2.5 billion for higher share of reinsurance business. three lines or more. These limits (which range from US$0.5 million to less than US$1 million) In the United States, insurance companies are considered to be quite reasonable and are authorized only at the state level. There are unlikely to act as a barrier to entry. no federal or national companies. As in banking, home state authorization is not yet Although the minimum capital accepted but, unlike banking, interstate requirements are quite reasonable, the expansion of operations has long been permitted. discretionary powers that the authorities continue Companies from other states (which are to enjoy may act as a barrier to entry if they are described as "foreign" in most state regulations) not applied objectively. Ideally, the and companies from other countries (which are authorization process should allow all insurers described as "alien") are allowed to expand their that are deemed "fit and proper" and can show operations in particular states through the proof of solvency to enter the market. establishment of local subsidiaries or through Moreover, a procedure for appealing denials and branches. Local subsidiaries must meet the revocations of license should also be established. minimum capital requirements of state The threat of potential competition from new companies, while branches are also generally entry is a necessary ingredient of a contestable required to place deposits that are secured by market. Developing countries may have some trust agreements and are equivalent to the reservations about granting automatic market minimum capital requirements imposed on local access to foreign insurers but such reservations subsidiaries. Several states do not allow do not apply to the case of more liberal domestic companies owned or controlled by foreign entry. governments to establish operations in their states. Such prohibitions reflect concerns about 20 unfairly subsidized competition, location of criteria to ensuring the fulfillment of 'fit and assets, quality of regulation and management, proper" and "adequacy solvency" criteria. To and uncertainty of contract enforcement in the ensure more liberal entry a procedure for case of diplomatic disputes. appealing denials and revocations of license should also be established. Minimum capital requirements vary across states but in general they range between Insurance Guarantee Funds US$0.5 and US$2 million. Both out-o-state firms and firms from other countries that wish to As in banking, guarantee or compensation operate nationwide have to incur the additional funds raise many issues. They are created in administrative costs of dealing with over 50 sets order to protect small policyholders from of criteria, while some states also impose special insurance company insolvencies but they give requirements that discriminate against "foreign" rise to prnblems of moral hazard. Policyholders and "alien" firms, such as higher minimum have no incentive to choose sound companies capital requirements, higher premium taxes, US and may prefer companies offering cheaper citizenship or state residency for board directors policies or promising higher returns and or managers, local maintenance of records, and disregard the higher risks that may be involved. frequent periodic renewal of licenses. For Guarantee funds also provide strong incentives instance, in New York, alien insurers must make to directors and owners of companies that are a deposit of 150% of the amount required from near insolvency to invest in highly risky assets domestic insurers, while in Texas premium and effectively "bet" their companies. taxes, which are levied on gross premiums, are Regulatory authorities must develop their higher for companies that maintain less than supervisory capabilities and must be empowered 90% of their investments in Texas. to take timely action to prevent weak institutions from magnifying potential losses. The US insurance industry comprises about 3,800 property and casualty companies Guarantee funds are of greater importance and 2,300 life and health insurance. Most of in systems that comprise large numbers of small these companies are small and market institutions. In the United States, there are concentration is not much different from that separate guarantee funds in most states for life prevailing in Canada or European countries, and nonlife companies. These are funded by although it is much less than Japan.' A assessments on covered companies that depend relatively small number (less than 200) of on the required payouts. However, assessments generally larger companies are "alien", i.e. they are subject to limits and although losses from are owned or controlled by foreign residents. insolvencies of insurance companies have not "Alien" companies account for about 5% of life been large, there have been cases when state premiums, 10% of nonlife premiums and 33% guarantee funds have come very close to running of reinsurance premiums (US Treasury, 1990). out of headroom. Major coordinating and loss allocation problems also arise if insolvent firms Despite the increase in competition that have multi-state operations. To cope with these has resulted from the deregulation of the problems, there are proposals to create national industry, the Mexican market is still guarantee funds. However, these would imply characterized by high concentration. Although federal regulation of insurance and any progress a concentrated market may exhibit a high degree is likely to be slow. Other proposals include the of competition, allowing more liberal domestic removal of coverage from sophisticated entry would increase pressure for competitive corporate buyers of insurance and the assessment behavior. Thus, the Mexican authorities need to of risk-related premiums that would depend on limit discretion in applying the new authorization 21 the degree of riskiness of operations and markets, is to discourage the offer of deceptively investment portfolios. low-priced contracts. Canada has a privately-run guarantee fund Prior to 1990, Mexican insurance for life and health insurance - known as companies were subject to a wide array of price CompCorp. This is mutually owned by its and product controls. Tariffs required the prior member companies, is funded with assessments approval of the regulatory agency and, although levied on its members and covers policies issued some differentiation was allowed between life for residents and up to clearly specified limits companies, there was in general little room for per policyholder per member company. competition and innovation. In property and CompCorp covers both life and annuity policies casualty business, a single tariff for all and both individual and group business. companies was in force and no discounts or rebates were permitted. Moreover, approvals of There do not appear to be any guarantee tariff changes were often subject to long delays funds for nonlife insurance in Canada, while that affected the performance of the industry in insurance guarantee funds for either life or the face of the accelerating inflation of the mid- nonlife business have yet to established in 1980s. Because of these delays, prices were Mexico. However, to ensure a level playing sometimes increased without authorization. field and protect the competitive position of the Mexican market, prompt action may need to be Since the reform of regulations, insurance taken in establishing appropriate guarantee companies are free to fix their prices and funds. develop new products, but they are required to file any chan2es with the regulatory agency at Other Regulatory Issues least 30 days prior to their use (except for large risks where no filing is required). Market The following specific points also deserve sources indicate dramatic reductions in the prices consideration in eliminating impediments to of some lines of business, although without hard competition. price data it is difficult to document these' claims. Premium Regulation. Insurance regulation has traditionally followed two Data compiled by insurance brokers approaches. One approach has emphasized the BMZ, the local affiliate of Marsh & McLennan, fixing of premiums at levels that are adequate to show that the premiums for home insurance (fire pay future claims and avoid insolvencies, while and extended coverage for building and contents) the alternative approach has relied on solvency fell from 1.4 per mil to 1.1 per mil (a reduction monitoring. of 22%). In commercial fire and theft insurance, the reduction in premiums was nearly Erring on the side of caution, price 30%, while even greater reductions occurred in controls tend to fix premiums at high levels. industrial risks. However, motor insurance Insurance companies then tend to return some of became more expensive in view of the big the excess prices in premium rebates and/or to increase in loss ratios. In fact, rates for motor engage in nonprice competition, especially by insurance more than doubled between 1989 and mounting more aggressive and lavish marketing 1991. Market practitioners from US brokers campaigns and paying higher commissions to and companies with active involvement in the selling agents. The main rationale for Mexican market compare the recent changes to controlling prices, an approach that has long those that occurred in the Chilean market after been followed in Germany and other European the insurance reform of 1981.1 countries with large and generally quite efficient 22 In Canada, insurance companies have ratios stipulate that solvency margins for long enjoyed freedom in setting their prices and property and casualty insurance should be the developing their products. The regulatory highest of either 22.8% of retained premiums or tradition has been similar to that prevailing in 35% of retained losses. For motor insurance, Britain, which grants insurance companies the corresponding ratios are 32.5% and 45.8%. "freedom with responsibility and disclosure". In Canada, solvency regulation is well In the United States, most state regulators established although solvency margins are allow price freedom and product innovation to mostly set by provincial authorities. US state insurance companies, although some states regulators also place increasing emphasis on impose limits on increases in premium rates for solvency monitoring. Under the aegis of the some lines of business, such as in particular National Association of Insurance motor insurance.' Alternatively, insurance Commissioners (NAIC), model laws and regulators may impose rate-of-return limits. In regulations have been developed that include many cases, such intervention is prompted by IRIS (Insurance Regulatory Information System), consumer pressure as in the well known a computer-based system of solvency monitoring "Proposition 103" in California.21 that is based on an array of financial and solvency ratios that are reported regularly to To allow greater scope for competition both NAIC and the respective state regulators. and product innovation in the Mexican market, IRIS calculates financial ratios for each the authorities should eliminate the filing and insurance company that measure solvency, approval requirement. The law should also liquidity, profitability and other aspects of clearly recognize the primacy of solvency insurance operations. They serve as preliminary monitoring, which can be used for discouraging tests of financial condition and identify irresponsible competition and the offer of companies whose ratios are not within acceptable deceptive policies. ranges and thus require further regulatory attention. Solvency Regulation. The alternative approach to insurance regulation, which is now Although the new solvency margins finding greater favor with regulatory authorities appear to satisfy the basic requirements of a around the world, is based on solvency solvency-based system of regulation, the monitoring, whereby insurance companies are Mexican authorities should elaborate further required to maintain adequate technical reserves their methodologies for valuing assets and and solvency margins that are based both on assessing risks. Moreover, the solvency margins premiums and on claims. In this way, insurance should be kept under review to ensure that they companies that engage in too aggressive price reflect changes in loss experience and do not competition and offer deceptive packages are impose an unnecessary burden on Mexican caught by the claims-based solvency margins insurers. Assets and liabilities, including that depend on the loss experience of the lines technical reserves and capital, should be valued they write. at market prices to the maximum extent possible. Mexican insurance regulation is now firmly based on solvency monitoring. Again, Investment Regulations. The regulation US market practitioners consider the regulation of investments is an integral part of solvency setting out the minimum solvency margins as a monitoring that aims to ensure the soundness of model regulation, combining the use of both insurance companies and safeguard the interests premium-based and claims-based solvency of policyholders. However, in many countries margins. For instance, the required minimum investment controls have been used to make 23 insurance companies a captive source of funds to monitoring approach. This is likely to affect the finance large public deficits or to direct their investment yield of Mexican insurance funds into high priority sectors, such as export companies and to weaken their competitive industries and housing. position in the integrated insurance market that is likely to emerge from the implementation of The main objective of investment NAFTA. Moreover, as discussed in Section 6, regulations should not be the subsidization of these minimum requirements have important tax particular activities with low-cost funds but the implications. prudent diversification of risks. To this end, investment regulations should place maximum Another issue in investment rules is the limits on investment assets by broad category of limit on foreign assets. Currently, insurance risk. Minimum requirements should not be companies are not allowed to invest in overseas used. markets. However, consideration should be given to allowing investment in foreign assets, Prior to 1990, investment regulations in especially default-free and liquid securities in US Mexico were unclear and restrictive. Although and Canadian markets. This would allow a they were supposed to protect the real value of better diversification of risks and could also lead assets to back both the technical reserves and the to a higher overall return, although the latter equity capital of insurers, in practice they would depend on the differentials in real rates of imposed limits that had the opposite effect. For return. instance, insurance companies were required to invest 30% of their reserves in nonmarketable In Canada, insurance companies are government securities yielding below market subject to investment regulations for prudential rates of return. When inflation took off in the purposes. The approach adopted in Canada is 1980s, these holdings yielded highly negative more restrictive than that followed in Britain. A real rates of return. The investment regulations major difference is the imposition of restrictions were modified after 1985 when insurance on investments in overseas markets. In Britain, companies were allowed to place any increase in insurance companies are free to diversify their their mandatory investments at market rates of assets by instrument, sector and country, subject interest. In 1989, insurance companies were to a general requirement to satisfy regulators further allowed to place all their mandatory about the prudent valuation of assets and the investments in marketable securities yielding adequacy of reserves. In Canada, strict ratios market rates of interest that were highly positive are imposed that limit investments in foreign in real terms. markets, real estate, equities, etc. For instance, Canadian life insurance companies are not Mexican insurance companies are now allowed to invest more than 25% of their funds subject to investment regulations that broadly in equities or more than 10% in directly owned reflect a proposal put forward by AMIS, the real estate. They are also required to hold Mexican insurance association, regarding the use domestic assets to match their domestic of risk-based capital requirements for investment liabilities. assets. This is also considered as a model regulation by US market practitioners. In the United States, investment regulations differ between states. The insurance The regulatiow- impose maximum limits department of New York state, which is by type of asset, except for a continuing generally considered to impose very tough minimum 30% requirement for government prudential controls, imposes limits on holdings securities. However, a minimum ratio is not of foreign assets and foreign equities. The fully compatible with an effective solvency approach favored by NAIC applies risk-based 24 weights on different assets and requires higher owned by domestic insurance companies. The coverage by capital and reserves of more risky purpose of such restrictions is twofold: to reduce assets. Under the NAIC approach, life the outflow of foreign currency and to promote insurance companies must maintain mandatory the development of the local market. Although securities valuation reserves (MSVR) that range many countries allow domestic insurers to seek from 1% for high quality bonds to 20% for low coverage in the foreign reinsurance market if quality bonds and for equities. local reinsurance is unavailable, the strong bias in favor of local reinsurance often results in The investment regulations should impose large losses and inadequate coverage of risks. maximum limits to ensure adequate diversification of risks. The Mexican authorities Foreign reinsurers are usually required to should consider abolishing the minimum be registered and authorized to accept requirement for investment in government reinsurance for domestic risks. In the United securities. They should also consider States and Canada, domestic insurers are introducing valuation and risk-based investment allowed to reinsure with unauthorized foreign reserves that are more in line with those applied reinsurers, but they are not allowed to take in Canada and the United States as well as credit in their solvency ratios for such business. permitting investment in default-free and liquid US and Canadian securities to start with, and In Mexico, reinsuring with unauthorized later on expanding to othei well reputed foreign reinsurers is not allowed. But following markets. the losses suffered in the aftermath of the 1985 earthquake, the Mexican authorities have relaxed Reinsurance, The regulation of the previously tight restrictions on foreign reinsurance is one of the most controversial reinsurance. Minimum retention ratios have issues in the international regulation of been removed, although primary insurers are insurance. The main purpose of reinsurance is expected to have a local bias in their reinsurance to spread the insured risks. This can take place programs. either through domestic reinsurance or through foreign reinsurance. The latter is very important One issue that concerns the Mexican for covering catastrophic risks, such as authorities as well as the authorities of other earthquakes and other natural disasters. In large countries is the practice of "fronting". This countries, such as the United States, domestic involves the use of local subsidiaries of foreign reinsurance can be very effective for most types insurance companies as generators of local of risks and in fact, there is a considerable insurance policies that are then automatically exchange of insurance portfolios among reinsured with the parent company overseas. domestic reinsurance groups in the United One way to tackle these problems is to introduce States. regulations that require a diversification of reinsurance so that no local subsidiary of a In countries with smaller or less foreign insurer would be allowed to place all its developed markets, the ability of the local reinsurance business with its parent company. reinsurance market to spread risks is more limited and this calls for greater reliance on Another concern, which is more foreign reinsurance. However, many countries pronounced in the United States, is the possible that have a much smaller market than the United use of brokers both in primary insurance and in States impose minimum local retention ratios and reinsurance as a means of placing substandard require primary insurers to reinsure with state- business, delaying the reporting of premiums owned reinsurance companies or with and losses, and failing to establish adequate loss reinsurance companies that are collectively reserves. Because such improprieties have 25 played a prominent part in recent insolvencies in The organization of the distribution the United States, the NAIC has created two system has important implications for the Model Acts, the Reinsurance Intermediaries functioning of insurance markets. There is Model Act and the Managing General Agents growing evidence that direct mailers incur lower Model Act, that aim to establish minimum costs than direct writers who, in turn, incur requirements for the relationship between lower costs than agency companies. The main primary insurers, intermediaries and reinsurers. difference is the level of commissions, although this is partly offset by the higher overhead costs To improve the efficiency of the market, incurred by direct mailers and direct writers. the Mexican authorities should remove any bias For the United States, market estimates suggest in favor of local reinsurance. To discourage the that the cost of selling whole-life policies practice of "fronting", a requirement for a through agents may be one-third to two-thirds diversification of reinsurance could be imposed. more expensive than selling th:ough Moreover, as in the case of primary insurers, stockbrokers, and up to twice as expensive as greater cooperation and exchange of information selling directly to the customer. For annuities, with regulatory authorities in other countries, the cost of selling through life insurance agents and especially Canada and the United States, is 6-6.5%, about 5% through stockbrokers, 4% would be required. through banks and perhaps 2.5-3% through a direct-mail mutual fund.' Distribution Systems. Distribution plays a very important part in the insurance sector, These differences in selling costs, which mainly because insurance, especially life imply some important economies of scale and insurance, is a service that is sold rather than scope, explain the strong interest of banks to bought. In all three countries, insurance brokers expand into insurance operations and sell and intermediaries need to be registered with insurance products through their branches and regulatory authorities, which in the United States by direct mail. However, in both Canada and and Canada means the state or provincial the United States, there is strong resistance by departments of insurance. Regulation of brokers independent insurance brokers to allowing banks may include proof of professional qualification to enter the insurance broking business. For (by examination or experience), minimum instance, in Canada, banks are allowed to working capital and solvency margins, expand into insurance through separate professional indemnity insurance and an subsidiaries of financial holding companies, but adequate system of client accounting. they are barred from selling insurance products through their branches. In the United States, In general, there are four types of state-chartered banks are allowed in several distribution systems: independent multiple agents states to sell insurance products either by direct who sell the products of many companies; mail or through their branches and also to exclusive or tied agents who sell the products of engage in insurance underwriting through only one company; salaried employees (also subsidiaries but national banks are not yet known as direct writers); and mail order authorized to do so. insurers. Indepeadent brokers are presumed to sell to consumers the best products for their In both Canada and the United States, needs and to offer best advice, although in direct writers and direct mail insurers have been practice the advice of brokers may be influenced gaining market share at the expense of agency by the commission they earn on different companies. In Mexico, independent brokers are products. In the other three systems, the still the most important distribution system. products of only one company or group of Many of the leading insurance brokers are related companies are sold. affiliates of large international groups, such as 26 Marsh & McLennan. However, exclusive on all types of systems (including direct writers agencies as well as direct writing are on the and direct mailers) to disclose to policyholders increase and are likely to become more all commissions and other distribution costs. important in the future. Other Regulatory Issues. Another The independent agency system has been regulatory issue concerns limitations on public criticized as inefficient and expensive because sector procurement of insurance. In Mexico, agents have an incentive to sell the insurance state-owned firms currently enjoy sizable captive policy with the highest commissions.'0 markets in the public sector. A level playing Because of this, many countries impose limits on field between state and private insurers would commissions although such limits have adverse require elimination of these captive effects on competition. In recent years, arrangements. Permitting private Mexican firms insurance companies have been allowed to set to compete for public sector business would their commissions but insurance agents are allow them to reap greater economies of scale required to disclose to policyholders the and thus become more efficient and able to meet commission they earn on different policies. In the challenge of foreign competition. Britain, insurance agents must also indicate clearly whether they operate as exclusive agents Private insurers business opportunities in selling the products of a single group or whether Mexico are also constrained by the Social they act as independent multiple agents. In the Security System (SSS). By providing latter case, they are expected to offer best advice comprehensive health and disability insurance it and to disclose their commissions. In Mexico, competes with private providers. The commissions used to be regulated but an contractual savings study suggests reforming the efficient market should only provide for full SSS.31 It recommends restricting the SSS at disclosure. providing basic coverage to comply with the minimum requirements of a safety net program, The structure of the distribution system while supplementary health and disability has important implications for the prospects of coverage should be provided by private insurers. international trade in insurance. A market that In addition, the study suggests introducing is dominated by exclusive agents and direct compulsory complementary term life insurance writers is more difficult to penetrate than one for workers and issuing secondary regulations on where there is a substantial independent broking insurance company competence on providing network. New foreign insurers will be able to pension plans. Adopting these reforms would gain market access more cheaply and quickly if expand market opportinities for insurance they sell through existing multiple agents than if companies allowing them to exploit furfier they have to set up their own distribution economies of scale. network of exclusive agents. However, insurance regulations should favor the most Supervision of Insurance efficient distribution system and this would call for permitting exclusive agencies and direct The supervision of insurance operations is writing even if such a system puts foreign based in all three countries on off-site companies at a cost disadvantage. surveillance through detailed computerized analysis of financial reports that are submitted In Mexico, the distribution system is not on a regular basis. Detailed on-site inspection yet fully developed. The regulatory framework of accounting and other records is effected at should not discriminate between different infrequent intervals, ranging from 3 to 5 years, systems. Limits on commissions should be unless a company is revealed to be in financial removed, but a requirement should be imposed trouble by the analysis of its solvency ratios, 27 when detailed examinations and close regulatory Strengthening the effectiveness of action are undertaken. supervision is of paramount importance for the functioning of a system of regulation based on In Mexico, the supervision of insurance solvency monitoring. Greater cooperation and companies is entrusted with the Comision exchange of information with the supervisory Nacional de Seguros y Fianzas (CNSF). CNSF authorities of Canada and the United States has already developed a sophisticated computer would also be essential. The Mexican model that analyses in great detail the financial authorities should also consider the need for performance and solvency margins of insurance establishing guarantee funds to safeguard the companies. CNSF is also empowered to take interests of small policyholders and protect the drastic action against companies that do not meet competitive position of the Mexican market. the specified minimum requirements. Already, one company has been ordered to increase its Operating Efriciency reserves to comply with the solvency margin regulations. The measurement and comparison of efficiency in insurance are as difficult as in In Canada, insurance supervision is banking. International comparisons are shared between the provincial and federal complicated by differences in accounting governments. In 1987, the Office of the conventions, market structure, business mix and Inspector General of Banks and the Federal data coverage. A basic problem, as in banking, Department of Insurance were consolidated into is the lack of a satisfactory definition of output. a new Office of the Superintendent of Financial Traditional definitions of insurance output are Institutions (OSFI). OSFI has full supervisory based on premium income, but this is a revenue responsibilities for all chartered banks and for rather than an output measure and depends as federally incorporated nonbank financial much on changes in prices as on changes in intermediaries, including insurance companies, quantities. trust and loan companies, and cooperative credit associations. However, responsibility for General insurance companies use four supervising insurance companies is shared with main ratios as measures of efficiency and the provincial authorities. The role of performance. The loss ratio, which relates CompCorp in the supervisory arrangements is losses to earned premiums, shows the percentage unclear. of premiums that are paid back to the insured in the form of claims for losses. Because payments In the United States, NAIC plays a central for losses may be spread over a number of part in analyzing the financial performance of years, insurance companies make transfers to companies with multi-state operations. loss reserves to cover future payments. The loss However, NAIC is a voluntary association of ratio also includes the loss adjustment expenses. state commissioners and has no statutory power Differences in reserving policies and to intervene. NAIC relies on moral suasion in manipulation of reserves for tax and other trying to improve solvency monitoring and purposes reduce the usefulness of this index of supervisory standards. In recent years, it has efficiency. The expense ratio is computed as tried to develop an accreditation system that administration costs plus commissions paid on rates state insurance departments by the sales less commissions received from reinsurers effectiveness of their regulatory standards. as a percentage of direct premiums. This NAIC granted accreditation to the insurance provides a measure of the acquisition costs of departments of New York (traditionally the insurance business. The combined ratio, which toughest in the country) and Florida in is often used as a measure of insurance December 1990. profitability, is the sum of the two ratios. 28 Finally, the operating ratio takes account of the In Canada, general insurance companies investment income earned on loss reserves by operated with an average loss ratio over the 3- deducting the investment income ratio from the year period 1987-89 of 76%. Their expense combined ratio. ratio was 31%, giving a combined ratio of 107% and an underwriting loss of 7%. Investment Traditionally, insurance companies aimed income amounted to 18% of premiums so that to earn a 5% profit on their premiums without net income before taxes was equal to 11% of taking account of investment income. With an premiums. However, the ratio of premiums to average leverage of premiums over equity of 3, equity amounted to only 1.35 in Canada, this resulted in a satisfactory return on equity of resulting in a ROE of 15%. 15%. This approach made sense when loss reserves were low in relation to total equity and In Mexico, the average loss ratio for all when inflation and nominal rates of return on nonlife lines between 1985 and 1989 was 80% investment assets were also low. But over the of earned premiums. The expense ratio was a years the growing complexity of general very high 43%", giving a combined ratio of insurance business has led to the building of 123% and an underwriting loss of 23%. But larger loss reserves32, while the high inflation investment income corresponded to 61% of experience of the 1970s forced insurance premiums, a result of the very high nominal companies to take into account the investment rates of return prevailing in Mexico during a income on their assets and to charge lower period of very high inflation. Nonlife business premiums on their policies. The practice of generated a net income before taxes of 38% of cashflow underwriting has resulted in companies earned premiums. However, the reported net incurring underwriting losses which were more income before taxes was 23%, because insurance than made up by investment income. companies have been allowed to set aside tax- free precautionary reserves equal to 10% of Available data show substantial retained premiums. Mexican companies are not differences in the loss ratios and financial required to segregate their capital accounts and performance of insurance companies in the thus it is not possible to calculate separately the United States, Canada and Mexico, although ROE on nonlife insurance operations. great caution is needed in interpreting these data because of the differences in accounting In all countries, substantial differences conventions and business mix mentioned above. exist in the performance ratios of different lines of business. There are various reasons for this. The loss ratio for all nonlife lines of US Some lines incur high loss ratios but have companies was 83% over the five year-period relatively few underwriting costs. Professional 1984-88, while the expense ratio reached lines, such as medical malpractice, fall under 27%.3 The combined ratio was 110%, this category. Other lines, especially motor implying an underwriting loss of 10%. insurance, have both high loss and expense Insurance companies earned net investment ratios, mainly because they involve compulsory income equal to 17% of premiums so that the insurance and there is consumer resistance to net result before taxes amounted to 7% of higher premium rates. Finally, some lines premiums. With a ratio of premiums to equity involve weaker consumer resistance to high costs of 1.75, the average return on equity was and low loss ratios. Fire insurance and 11 %.3 But the ROE fluctuated widely over homeowners multiple perils fall under this this period, ranging from 2% in 1984 to 19% in category. Loss ratios varied in the United States 1987. from 56% for fire and 72% for homeowners multiple perils to 93% for motor insurance and 128% for medical malpractice. In Canada, loss 29 ratios varied from 63% for personal lines to The results of the combined life and 91% for motor insurance. In Mexico, the nonlife business of Mexican insurance companies average loss ratio for fire insurance was 49% show investment income of 50%, a total loss against 93% for motor insurance. The fire loss ratio of 809%, an expense ratio of 43% and a net ratio fluctuated widely. It was 99% in 1985, the income ratio of 27%. With a ratio of premiums year of the earthquake, against less than 40% in to average total equity (reported equity capital all other years. plus precautionary reserves) of 1.7, the nominal return on average equity was 44.4%. This is Performance in life insurance is generally considerably greater than the rates of return more stable than in nonlife business. But achieved by US and Canadian companies. because life insurance is based on long-term However, annual inflation in Mexico averaged contracts, it is affected more by the 55% between 1985 and 1989, so that their accumulation of reserves. In th- United States, effective real ROE before asset revaluation gains investment income over the five-year period was substantially negative. The nominal 1985-89 corresponded to 47% of premiums. revaluation gains amounted on average to 28%, Benefits and dividends paid to policyholders and so that the real ROE was 17%. This figure is additions to technical reserves, which over the not comparable to the return rates shown for US long run represent the premiums paid back to and Canadian companies, which are expressed in policyholders, amounted to 119% of premiums. nominal terms and do not take account of both Expenses and commissions absorbed 23% of inflation and asset revaluation gains. premiums, leaving a net income before taxes of 5% of premiums. With a ratio of premiums to The above data show that Mexican firms equity of 2.9, life insurance companies achieved exhibited both higher expense and profit ratios, a ROE of 13.8%. a result that can be attributed partly to the very high rate of inflation that prevailed in Mexico in Canadian life insurance companies had an the mid-1980s, partly to the real rates of interest even greater investment income of 67% of in 1988 and 1989 and partly to the protection premiums. Total benefits to policyholders, afforded Mexican firms by the regulatory including additions to reserves, corresponded to framework that prevailed until 1989. As 128% of premiums, while underwriting expenses inflation and real interest rates come down to were equal to 31 %, leaving a net income before more moderate levels and deregulation opens the taxes of 9%. Canadian life insurance companies market to greater competition, Mexican have a very low ratio of premiums to equity of insurance companies will have to improve their only 0.9 and as a result their pre-tax ROE was performance and achieve operating ratios that only 7.7%. are more in line with those of their counterparts in Canada and the United States. In Mexico, life insurance achieved a pay- back ratio of 78% over the 5-year period 1985- This will bring considerable benefits to 89. This includes benefits paid to policyholders the customers of insurance companies, will and additions to technical reserves. The expense lower the costs of insurance for industrial and ratio was 44% of retained premiums. The commercial companies, and will increase the investment income of life companies was on welfare of consumers both by lowering the cost average 38% of premiums, a level that was in of insurance and by encouraging an expansion of fact substantially lower than that of property and the insurance habit. Like banking, insurance casualty lines. The net income before taxes as services are intermediate goods for producers a proportion of net retained premiums was 16%. and final goods for consumers. Any reduction in their cost will enhance efficiency in industry and commerce and increase consumer welfare. 30 The Transition Process the life insurance and pension business without adequate safeguards about the solvency and In general, the authorities of different integrity of the institutions involved. This will countries can adopt various policies to ensure require greater international cooperation among that the benefits of foreign participation exceed regulatory and supervisory authorities. the costs, such as requiring a diversification of reinsurance and increasing the exchange of The more liberal attitude of national relevant information with supervisors in other authorities towards entry of foreign insurance countries. As already discussed in earlier companies is shown by the share of foreign chapters, realization of the potential net benefits companies in the generation of insurance depends on the regulatory environment. A premiums. Among OECD countries, in life competitive but properly supervised system is business, this ranges from 10% in Germany and more likely to produce net benefits than a Spain to 16% in Australia, 21% in the system that is oppressed by detailed controls on Netherlands, 29% in Austria and 51% in products, prices and market shares. In the latter Portugal. In nonlife business, foreign companies case, the most likely outcome is that foreign generally controlled a bigger share of the companies will simply grab a big share of the market, ranging from 14% in Germany to 23% economic rents enjoyed by domestic companies. in Portugal, 24% in the Netherlands, 27% in New Zealand, 37% in Spain, 46% in Austria Most developed and developing countries and 54% in Australia (1988).36 These shares have adop(ed a more liberal attitude to foreign are generally much greater than those found in insurance companies than to foreign banks. In banking markets. part, this may be explained by the greater concern to maintain control over monetary and Opening up a domestic market to foreign credit policy and over the functioning of the competition can take many different forms. The payment system. But in part it may also be first form is to permit the cross-border provision explained by the complexity of insurance of insurance services. As already noted, this business and by the fact that a relatively small requires adequate protection of nonresident number of people had any dealings with policyholders by the authorities of foreign insurance companies. markets by supervising closely companies that may specialize in selling insurance in less Technology transfer is very important in developed insurance markets and by extending general insurance where business is quite coverage of guarantee funds to policies issued to complex and risks are often difficult to assess. nonresident policyholders. In life insurance, where contracts are long-term and may generate substantial long-term savings, A second form is to allow joint ventures there has been greater concern about control and minority participation in domestic over the utilization of such funds and less companies. Allowing minority participation of willingness to allow foreign companies to play a between 30% and 49% is likely to produce big part in this market. It is likely that a many of the potential benefits of foreign entry, substantial expansion of long-term savings and especially if the sector is free from product and personal pension plans will accentuate concern price controls, is subject to a market-based and about ensuring adequate control over the effective system of prudential regulation and utilization and safety of long-term funds. supervision, and allows liberal domestic entry. Although the need for greater risk diversification Mexico has already authorized 49% foreign will call for allowing investments in foreign participation and has made considerable progress assets, national authorities will be reluctant to in reforming the regulation of insurance permit foreign companies to play a big part in business. The benefits of foreign participation - 31 greater competition, lower prices, better broadly similar level of development and their products - are already evident in the market. closer integration is not likely to create major problems. However, large companies in Canada and the United States have a strong cultural For Mexico, market integration through preference for total ownership and control over NAFTA will pose a greater challenge. The their foreign operations. Denying either 100% Mexican authorities need to take various foreign ownership or local presence through measures to enhance the ability of the local branch operations will deprive the Mexican market to compete effectively with the US and market of the potential benefits of a more closely Canadian markets. These include the following: integrated North American insurance market. 1. Complete the reform of regulatory A possible solution could be to allow framework and emphasize the primacy of foreign companies to establish fully-owned local solvency regulation and monitoring. This would subsidiaries but to require them to sell to the involve the effective elimination of any bias in public a minority participation once they reach favor of domestic reinsurance and the adoption a certain size (expressed in terms of total assets, of a more liberal policy on domestic entry. total equity or total revenues). In addition, limits on maximum individual shareholdings in 2. Strengthen the supervisory capabilities very large companies could be imposed. of regulatory agencies by hiring and training Shareholding restrictions may dissuade some qualified staff, improving regulatory incentives firms from seeking further growth once they and granting regulators necessary powers for reached a certain size. Although these successful intervention. Swift action to require restrictions may prevent companies from the recapitalization of insurers with inadequate exploiting economies of scale and may solvency margins will be needed to prevent discourage them from transferring the insolvencies and losses for policyholders. technology that is adequate for handling a larger Effective mechanisms to facilitate the exit of volume of transactions, competition and failing companies, through either merger or contestability would be unlikely to suffer much closure, must also be developed. in a market with liberal entry and good prudential regulation and supervision. 3. To safeguard the interests of small policyholders and protect the competitive Conclusions and Recommendations position of the Mexican market, consideration should be given to the case for establishing The US-Canada FTA has adopted the guarantee funds. principle of national treatment in the insurance sector, which is covered under Chapter 13 that 4. In addition to encouraging domestic deals with services generally rather than Chapter entry by applying the authorization criteria in a 17 that deals with the financial sector. But consistent and transparent way, the authorities because insurance regulation is primarily the would be expected, as part of NAFTA, to allow responsibility of state and provincial authorities, a further opening of the market by authorizing insurance companies will face many the establishment of fully-owned local impediments due to the restrictions imposed by subsidiaries and branches of US and Canadian political subdivisions. These restrictions will not firms. This will stimulate a greater integration limit market access, but will cause additional of the North American insurance markets. But costs to be incurred by companies that wish to greater integration will also require progress in operate in many states or provinces. The US resolving issues in the taxation of insurance and Canadian insurance markets are already at a companies in different countries, the cross- 32 border provision of insurance and the protection involve the compulsory sale to the public of a of nraresidentpolicyholders. Supervision of the minimum part of their capital, while for very institutions also have to be coordinated large companies specific limits on individual internationally. shareholdings could also be introduced. However, in accordance with the principle of 5. An integrated market will presuppose national treatment enshrined in NAFTA, such greater cooperation and exchange of information shareholding restrictions should not discriminate among the respective regulatory authorities to against US and Canadian residents. But .se ensure that individual insurers are prevented restrictions may prevent companies from from exploiting loopholes in prudential exploiting economies of scale and from regulations and engaging in deceptive and transferring the technology that is adequate for unsound business practices. Consideration handling a larger volume of transactions. should also be given to the case for organizing joint training programs to enhance staff expertise 7. One of the most difficult and sensitive and achieve greater consistency in regulatory issues is the timing of the further opening of the approach. market to Canadian and US companies. The timing should be determined in connection with 6. The Mexican authorities may wish to the period needed to improve further the impose restrictions on shareholding on firms effectiveness of supervision. Given the progress above a clearly specified size. These may already made, a relatively short adjustment period would probably suffice. 33 V. SUBSECTOR ISSUES: SECURITIES MARKET Regulatory Considerations sectors of the economy will be traded off against changes in the financial sector. The securities market as a subsector of the Mexican financial system will inevitably be The regulation of securities markets and affected by whatever changes in regulations will brokerage houses is generally mare restrictive in be carried out in other parts of the system. Mexico than in the other North American Mexico stands to gain substantially from a closer countries. The emphasis is on restricting the link with the more developed markets, especially introduction of new instruments, regulating because the basic precondition for a flourishing mutual funds' portfolios and limiting the scope securities market is credibility and stability. of brokerage houses' activities. However, in recent years the authorities have moved to a The National Securities Commission more liberal approach, at the same time trying to (Comision Nacional de Valores, CNV) has strengthen supervision. Major changes in the already established a close consultative respective regulations are currently being relationship with the US SEC. A Memorandum discussed. In the following paragraphs only of Understanding has been signed formalizing those issues that affect international securities bilateral cooperation on enforcement, market transactions are addressed. The information exchange and technical assistance. discussion focuses on (i) market structure and Further substantial topics currently u. der barriers to entry, (ii) other regulatory issues, discussion between the two agencies include (iii) establishing guarantee funds, and (iv) recognition by the US of INDEVAL as a supervision of securities markets. designated custodian for US institutional investors; simplified procedures for listing of Market Structure and Barriers to Entry Mexican securities on US stock exchanges; procedures for simultaneous public offerings in The present Mexican securities market is the two jurisdictions; simplified procedures for quite small compared to the USA and Canada recognition of Mexican brokerage house (Mexican market capitalization is approximately subsidiaries in the US; and criteria that would equal to .5 percent of U.S. and 7 percent of permit US brokerage houses to participate in the Canadian market capitalization). In Mexico the financial groups that are likely to be formed in principal providers of securities market services Mexico as a result of the changes to the are brokerage houses, the stock exchange and securities law enacted in July 1990. the clearing house. But the main occupation and source of income for each of these providers is This pattern of negotiated agreements in fact the conduct of the money market, not the between the relevant agencies is similar to that long-term securities market. The former between the USA and Canada.3 It is a process accounts for nearly 90% of trades by volume which allows careful consideration of the and value. This distinguishes Mexico from the interplay between the complex regulatory USA and Canada, where money market regimes in each jurisdiction. It enables well activities are generally conducted off-exchange thought-out adjustments to be made to each by counter-parties or by banks as intermediaries. regime which will bring desired efficiency gains without compromising investor protection and The general opinion in the Mexican system stability. And it diminishes the securities industry is that the securities market likelihood that negotiated liberalization in other will become increasingly important and that the 34 money market will take a relatively less house so long as the regulatory regime is important position in the medium term. equipped to ensure compliancs. Certainly interest rate and inflation rate trends currently support such a shift, and Ministry of Brokerage houses are at present key Finance and CNV policy is to expand the market intermediaries and market makers in securities market, especially the corporate government paper, although they are not long- equities market. term holders of the paper. There may be concern that foreign ownership of brokers may These trends may be accelerated by the leave the Government vulnerable to artificially opening up of the real economy to foreign created distortions in its market-based financial competition, the formation of financial groups management operations. This is not true for the which will lead to brokerage house operations same reason as given above - domestic being split into discrete subsidiary operations regulation should ensure proper prudential and and by the development of the role of conduct compliance regardless of the source of institutional investors in the market. ownership. And growth in the long-term end of the government paper market has added to the The positive side of the existing Mexican Government's protection from short-term market situation is that brokerage houses are generally movements. well-capitalized and profitable and both the stock exchange and clearing-house are efficient and Free capital movement and openness to forward-looking. The negative side is that none foreign investment are key elements of the of these parties is greatly experieneed in the Government's implementation of the 1988-1994 growing area of high value sophisticated National Development Plan and should be securities market operations, especially in long- proscribed only where national interest is clearly term debt instruments and equities. at risk. Foreign participation in ownership of brokerage houses does not of itself bring such In addition to existing restrictions in risks. The Government could remove entry and licensing new brokerage houses, foreigners are ownership barriers, perhaps gradually and prohibited from owning more than 30% of a conditionally, and ensure that the national Mexican brokerage house and from having interest is protected. control of the board irrespective of percentage holding. Brokerage houses are one of the very At the federal level the USA and Canada few industries so protected. The CNV is allow free entry to the securities industry of considering increasing the number of new foreign-owned brokerage houses and investment brokerage houses (there are 25 operating), but banks. Foreigners may hold shares in local the rules are not yet transparent and refusal of brokerage houses without limit. But these admission seems to be left to the discretion of freedoms are proscribed under laws operating in CNV. the States and Provinces. This is not as serious in the case of Canada as it is in the case of the The Mexican government is rightly USA. concerned that the prudential and conduct supervision of brokers operating under its In the USA, securities offered or sold jurisdiction is sufficient to ensure investor within a state usually must be registered in that protection and system stability. But these aims state, as must broker-dealers, investment can be met through domestic regulatory advisers and other persons in the securities requirements on new entrants irrespective of the business. At the least this provides an source of investment capital in the brokerage unnecessary duplication of registration at the Federal level and at worst can act as a barrier to 35 entry by foreign brokerage houses, either No significant product, client and location explicitly or implicitly. In practice these barriers have been identified at the Provincial barriers have worked to the disadvantage of level in Canada. Mexican brokerage houses, especially those wishing to operate in the border states of the Instruments Offered and Traded. Articles USA. 11 and 13 of the Securities Market Act prohibit the public offer and secondary market trading of This matter should be raised with the securities not listed in the National Registry of USA Federal Government and the relevant states Securities and Intermediaries. Article 14 sets in order to achieve simplicity, uniformity and out the general requirements for registration. compliance with the I deral Government's The CNV develops and applies the specific national treatment approach. It is probably requirements which d" ive from these general however that only minor improvements will be principles. obtained because of the constitutional power of the states in this area. Securities registered, offered and traded in foreign jurisdictions may be also registered in The same topic should be examined in the National Register for offer and trading in relation to Canada. The Provincial-Federal Mexico. To obtain registration the issues must differences there are less than in the USA but comply with all the requirements of the CNV. still may disadvantage Mexican brokerage houses. Because the Mexican market is relatively small, the cost of complying with the Other Regulatory Issues requirements tends to discourage foreign issuers from seeking Mexican registration. As a Product. Client and Location Restrictions, consequence, Mexican investment and trade in The source of investment capital in a brokerage those securities is conducted off-shore. The house should not of itself determine the products Mexican market would benefit from having as or clients the broker may deal with: domestic much of that business as possible brought home. regulation can ensure adequate protection. Restriction on foreign access to clients or Domestic trading of securities issued abroad products unnecessarily limits the innovation and unrestricted foreign placement of Mexican potential inh-rent in opening the market to securities would be a precondition for a full foreign access. integration of securities markets. Under these conditions mutual fund shares would also be At the Federal level the USA substantially available in all FTA countries. This in prohibits commercial banks from participating in particular could substantially improve resource the securities business, whereas Canada does mobilization and promote equity financing. not. However, it would also imply that Mexican mutual fund companies must be free to At the state level in the USA, product, determine their portfolios as it is the case in the client and location restrictions are a significant US and Canada. barrier to operations by Mexican brokerage houses. This should be raised with the USA There are a number of difficult problems Federal Government and the relevant states. It to be resolved before the requirements for re- is probable however that only minor registration in Mexico can be modified. These improvements will be obtained. relate primarily to differences in accounting and disclosure requirements. And there may be benefit in placing some general limit on access 36 to automatic Mexican registration, for example The CNV places these restrictions on on the basis of a well-established record of brokerage houses in order to ensure that: market liquidity and business history. * brokers do not trade against the This topic should be examined in regard interests of their own clients. to establishing some form of reciprocal or common prospectus agreement between Mexico, * trade in a way which may distort the USA and Canada. It would be to Mexico's the market; and advantage to negotiate an agreement on multijurisdictional offerings with both the USA * brokers do not carry a large, and Canada. variable and inadequately monitored portfolio risk. Voting _)i:hts. At present foreign holders of most Mexican corporate equities are These three objectives -- protection of the precluded from exercising attached voting rights. fiduciary relationship between broker and client, This is achieved either through allowing protection against market manipulation, and foreigners to hold only non-voting shares or maintenance of strict prudential control, can be requiring that voting shares be held in trust by achieved in other ways. The USA and Canada NAFINSA with all benefits except voting rights achieve the objectives but they do not place the flowing through to the foreign holder. time period, counterparty or holding limitations of Mexico. Instead, the USA and Canada One benefit of having substantial require brokerage houses to accurately value institutional holdings of corporate equities is that their securities holdings on a daily basis (mark such investors can n.onitor the performance of to market) and tc adjust their capital position to company management and exercise some maintain the prescribed prudential ratios. These influence over management decisions. Because valuations are independently audited and are foreign investors are precluded from exercising monitored by the regulatory authorities. With that influence by way of voting rights they are regard to trading, the authorities require a left with only the decision to buy and sell as an brokerage house to disclose to its client when the expression of their assessment. This is a spur to client's order is traded from the brokerage greater market volatility and may therefore not house's own account and to disclose to the stock be desirable. exchange when a large tranche from the broker's own account is traded. Consideration should be given to allowing foreigners to hold and exercise voting rights There may be some value in Mexico attached to equities. This would be in line with adopting a regime similar to the USA/Canada the principle of national treatment. one. This would be in line with the market liberalization po.icies of the Government. It Trading for Own Account Mexican could allow Mexican brokers to better compete brokerage houses may hold and trade for their with their foreign counterparts. Foreign brokers own account only those securities allowed by the operating in Mexico would of course be subject CNV. In Circulars 10-126 and 10-118 the CNV to whatever rules apply in Mexico, but it could prohibits the direct holding and trading of be argued that their ability to trade in their home variable rate securities such as corporate equities market, without the Mexican limits, and places a strict time limit on the holding of unnecessarily diminishes the competitive power fixed rate securities. of Mexican domestic brokers. 37 Before removing the present limits the Supervision of Securities Markets CNV would need to be assured that: In the US and Canada regulation attempts * effective portfolio valuation to minimize interference with contractual mechanisms are in place; freedom. Instead the emphasis is on close supervision of market activities and strict rules * prudential regulations are effective on accounting and disclosure. Self regulation in accounting for changing plays an important role in ensuring proper and portfolio values; transparent market procedures. However, serious restrictions towards the freedom to * there are effective reporting and provide services result from political federalism monitoring procedures; and, in the case of the US, from the sep1aration of investment and commercial banking. These * market manipulation is not restrictions also affect international securities facilitated by the use of brokerage market transactions. house account trading; and With the implementation of NAFTA 3 brokerage house clients are fully Mexico should improve its prudential regulation aware of the fact when their broker and monitoring of brokerage houses in the light takes the other side of any of more complex cross-border, intra-group, transaction with them and that the term-related and exchange rate risks which are broker's fiduciary responsibility to likely to arise. the client is not compromised. The Transition Process Brokerage Commissions, The fixed brokerage requirements for secondary market Mexico is likely to reap benefits from trading that used to exist in Mexico contrasted continuing with the process of liberalization it with the negotiated brokerage rates which apply has begun. But the balance of benefit will be in the USA and Canada. Retaining fixed determined to a considerable degree by the commissions would have acted as a brake to effectiveness of domestic regulation in Mexico competitive pressures for lowering commissions and by the extent to which efficiencies and on large trades. The introduction of negotiated innovations are transferred to Mexico. commissions has removed this obstacle to the integration of the Mexican market with its North In order to ensure that Mexico receives American counterparts. Although the levels of the maximum benefit from the liberalization it commissions have remained the same, there is may be appropriate to implement the necessary little doubt that with growing foreign reforms in stages over time and to place some participation, they will be adjusted downwards. conditions on implementation of some reforms. The advantage of such an approach is that the Establishing Guarantee Funds domestic financial sector may adjust and position itself to compete with the foreign entrants. The To protect small unsophisticated market Government may consider that this is an participants consideration may be given to the important objective. If so, freer domestic entry establishment of guarantee funds. These funds could come almost immediately together with the generally cover losses incurred due to the failure definition of a short time period to allow of brokerage institutions. adjustment prior to complete opening of the market to foreign participation, which could be economically justified because delay in 38 implementation denies the cost saving and other * improved prudential regulation and benefits which will accrue to the real goods monitoring of brokerage houses in sector. the light of more complex cross- border, intra-group, term-related In any case the Government may wish to and exchange rate risks which are impose some conditions on the authorization of likely to arise. new foreign entrants to ensure a diffusion of the technical and other skills which they can bring * improved prudential regulation and to Mexico. Such conditions would not be in line disclosure requirements to replace with the principle of national treatment. They the present restrictions on brokers could be justified, however, on the grounds that trading their own account. they are temporary and will be superseded at the time that complete openness is achieved. A * improved arrangements for second important justification is Mexico's cooperative monitoring considerable relative disadvantage in the finance investigation and enforcement area which should be acknowledged and activities across borders, including accounted for by way of a structured information exchange, proceeds of developmental effort. crime sequestration, and methods for acting in one jurisdiction to Conclusions and Recommendations prohibit a cross border activity conducted there which is unlawful In light of the above Mexico should make in the country across the border. a commitment in NAFTA to remove, in stages, all barriers to entry by some agreed upon date, * more detailed, consistent and subject to satisfactory performance of foreign effective rules of conduct for entrants during the transition period. An brokers who are members of the important advantage of a commitment to staged Mexican Stock Exchange to implementation of reforms is that it will allow minimize regulatory arbitrage Mexico to pursue the co-operation and technical across borders by USA and assistance initiatives already underway between Canadian brokers who may face the relevant regulatory agencies and to add new stricter regulation at home. areas as they become relevant. In this way Mexico may assure itself that its regulatory * free domestic entry and regime is fully equipped to deal with the new deregulation of brokerage fees to entrants. Grant or loan funded technical allow the maximum competitive assistance from the USA and Canada may price benefit to arise from opening further this process. Some key regulatory areas the market to foreign participation. to be considered include: 39 VI. TAX ISSUES This section analyzes issues arising from The principal conclusions reached in this differences in the tax treatment of trade in section involve recommendations for both financial services. How will the existing tax long-term tax reform and more specific structures in the three countries affect the short-term tax changes. The recommended relative competitiveness of financial long-term reforms are as follows: intermediaries with different ownership structures? Existing tax laws distort in many 1) Mexico may consider reducing ways the location of financial activity, the restrictions on the fraction of foreign pattern of ownership of financial firms, and their ownership in firms located in Mexico. financial structure. Each country's tax system Foreign subsidiaries in Mexico qualify for a tax can have substantial effects on the resulting credit against their home-country corporate taxes structure of the industry. The chosen tax for any corporate taxes paid in Mexico only if treatment for the financial sector will not only the parent firm owns at least 10% of the voting affect the relative competitiveness of shares of the subsidiary. There are further tax domestically owned vs. foreign firms, but will advantages in the home country from having the also affect the cost of financial transactions for parent own a majority of the shares. Allowing domestic residents, most importantly including firms these tax advantages in their home country the cost of funds to domestic investors. What would increase investment in Mexico. Of beneficial tax changes can Mexico make on its course, allowing a higher ownership share gives own, taking as given the tax structures in the foreign investors more than just tax advantages. other two countries? Their incentive to transfer technology, or simply invest effort in improving the performance of the Financial institutions doing business in subsidiary, depends critically on the share of the Mexico in principle can be located in the US, resulting increased profits that they receive. Canada, or other countries, as well as in Mexico. US banks, for example, can accept 2) Financial services should be exempt deposits from Mexican investors and can make from value-added taxes. At present loans to Mexican firms. In addition, financial transactions in the Mexican securities markets institutions located in any given country can in pay VAT. This tax discriminates against this principle be owned by investors located form of intermediation. In addition, a VAT on elsewhere. Taxes can have substantial effects on financial services transacted in Mexico simply the relative competitiveness of firms in different induces Mexicans to conduct their financial locations, or firms with owners residing in transactions abroad. While in principle, this different locations. In addition, taxes affect the distortion could be avoided by imposing a VAT prices charged for financial services to both on all financial transactions conducted by individuals and firms. To what degree does the Mexicans, regardless of location, such a existing Mexican tax system affect the ownership broad-based tax would be administratively structure, location, and costs, ef financial infeasible. institutions, or corporations more broadly, doing business in Mexico? What changes in the 3) Requirements to invest In tax exempt Mexican tax system might be appropriate, in government bonds should be removed. light of the increased international competition Currently insurance companies have to invest that will likely result from a NAFTA? 30% of their portfolio in government tax-exempt bonds (this requirement has been phased out for banks). While their interest income is 40 tax-exempt under Mexican law, it is not interest and overhead expenses among a parent tax-exempt under the US or Canadian tax law, and its branches can induce a firm to shift its so that this provision discourages investment by overhead activity and its borrowing to its these foreign firms in Mexico and foreigners in branches, thereby reducing foreign tax payments domestically issued public debt. There are three while leaving the firm's total tax liabilities alternative solutions to this issue. First, unchanged. Mexico should try to undo these eliminate the tax-exempt status of government distortions, for example by adopting the US bonds. This will increase the interest rates on sourcing rules. these bonds by the amount of the tax (the after tax yields are equalized across borders and thus 7) National tax treatment of dividend will remain unchanged, since Mexico is a income. For firms holding internationally "small" country). This solution would also diversified portfolios of equity, dividends promote pension plans and life insurance by received from domestic firms are normally rebating this taz on interest income earned on exempt from tax, but dividends received from the assets held by these programs, and will foreign firms are normally fully taxable. Given encourage holdings of domestically issued the frequent gains from the international government debt by foreigners in general and diversification of portfolios, this tax distortion not only foreign owned financial intermediaries. penalizing corporate holdings of foreign equity Second, elinminate the 30% requirement. may be very costly, particularly for financial Although there is no problem for implementing intermediaries, and requires rethinking. One it immediately, insurance companies (and alternative would be to allow such firms a credit financial intermediaries in general) would like to for foreign corporate taxes even when they own maintain government bonds as a part of their less than 10% of any given foreign firm (i.e., liquid portfolio. Third, have the previous two granting national tax treatment under NAFTA). solutions simultaneously implemented. Another alternative, adopted by the Canadians with respect to life insurance companies, would 4) Profit-sharing payments should be be to exempt these firms from domestic taxes on tax deductible for corporations. If their foreign operations. profit-sharing payments, unlike other forms of labor compensation, are not tax deductible for 8) National tax treatment for foreign corporations, then the corporate tax discourages life-insurance in the US. The US has different use of labor by profitable corporations, and tax treatment to domestic branches of foreign more so the more profitable the corporation. life-insurance companies. Canadian firms are This provision also tends to put firms located in also subject to this treatment in spite of national Mexico at a competitive disadvantage. treatment under the US-Canada FTA. In order to prevent such companies from shifting their 5) Adopt better tax policies for taxable income abroad, the US government has Insurance companies. Contributions to build set their minimum net investment income equal up precautionary reserves should not be tax to the product of their required US assets deductible. On the other hand, the yield of the multiplied by the domestic investment yield. technical reserves from life and disability Since other insurance firms operating in the US insurance policies should be tax exempt to avoid do not face this restriction, they may be put at a double taxation of saving (i.e., ensure competitive advantage. consumption tax treatment for this form of contractual savings instrument). 9) Allow loss-offset provision to holding companies. If firms are likely to end up with 6) Harmonize sourcing rules for unused tax losses, then they have an incentive to income/deductions. The US rules for allocating engage in potentially costly rearrangements of 41 their financial portfolios or their form of annual minimum salary. Unless the tax sharing ownership in order to make use of these tax information is capable of detecting cross-border losses. Also, it discourages financial holding arbitrage transactions, this could result in companies, thereby preventing the exploitation considerable revenue losses for the Mexican of economies of scope derived from universal Treasury. banking practices. These distortions should be avoided, either by allowing groups of firms with Group insurance should lead to the same common ownership to file consolidated tax tax treatment of final beneficiaries as individual returns, or by indexing carry-overs by the insurance does, that is, if workers are not taxed nominal interest rate. on the basis of the premiums paid by firms on their behalf, they should be taxed on the basis of 10) Correct loophole in personal income the benefits they receive (i.e., insurance tax treatment of group insurance. Group payments). insurance premiums are tax deductible if such insurance is regarded by the tax law as a fringe benefit for employees. A loophole arises, however, since the premium is not part of workers' taxable income, and the insurance payments are untaxed up to nine times the 42 VII. SUMMARY AND CONCLUSIONS In summary, to maximize the efficiency intermediaries and cooperation among national gains from liberalization of the financial sector, tax administrations. the regulatory environment of banking, insurance, and securities markets can be further In banking the issues are the convergence reformed through deregulation and better of general criteria for authorizing firms to defining and implementing prudential engage in banking business and to remove many supervision. Harmonization of regulatory and of the obstacles to freedom of establishment. supervisory rules is a key issue in liberalization. Other provisions may prove useful in the present An integrated market will presuppose greater phase of integration, such as the creation of a cooperation and exchange of information among Banking Advisory Committee to assist in the the respective regulatory authorities to ensure preparation of banking measures aiming at that individual insurers are prevented from greater convergence in regulations and exploiting loopholes in prudential regulations supervision. and engaging in deceptive and unsound business practices. Discrepancies between different There is the issue of branching and financial institution regulations should be interstate banking, i.e., the territorial eliminated so as to create a level playing field segmentation of the market. Because of the US for all participants, domestic as well as restrictions on interstate banking Mexico may international, between member countries. For have to enter into separate arrangements with each subsector, establishing an effective each state. supervisory system is crucial and will determine the pace of liberalization. International Strengthening supervision still remains a cooperation between regulators and examiners priority issue. This is especially true since the should be ensured. Improving transparency banking system is being newly privatized. through greater disclosure is very important in Given that the privatization price for some enforcing regulations and establishing market Mexican banks was much higher than their book discipline. Finally, guarantee funds should have value of capital, these banks will be under well-defined objectives and powers to avoid additional pressure to recoup their expenses moral hazard problems. before their protection is phased out. In addition to harmonizing regulation and Also, the issue of harmonizing deposit supervision, eliminating or reducing the guarantee schemes deserves considerable disparities between NAFTA countries in both tax analysis. The Mexican deposit insurance system rates and the way taxes are levied would help should have very well-defined powers and its prevent distortions, tax evasion and tax purpose should be to protect small, avoidance linked to the diversity of national unsophisticated investors rather than mismanaged systems. Although the harmonization of taxation institutions. of income from capital may not be a legally binding prerequisite for full capital mobility, Turning from the legislative to the proposals designed to eliminate these distortions executive aspect of supervision, it should be should also be evaluated. Related issues are the emphasized that the FTA design will not foresee development of a common system for the a central body with responsibility for the day-to- transmission of information to tax authorities by day supervision of banks: this function will be left to the authorities of individual member 43 countries. Bilateral contacts between national would involve primarily issues of investor authorities should be encouraged and protection rather than prudential concerns. strengthened in dealing with individual cases. But there will clearly also be a need for a A second set of more general problems permanent forum for the coordination of concerns the importance the rules should practices and policies among ali the national attribute, in promoting the supply of services in authorities with banking supervision a regime of mutual recognition, to whether or responsibilities. not investment firms are part of an organized market. Finally, minimum capital requirements In insurance, convergence in regulations and the regulation of market risks (chiefly, and supervision is again the central issue. interest rate and exchange rate risk) will have to Consideration should be given to the case for achieve equality of treatment and neutrality with organizing joint training programs to enhance respect to both credit institutions and investment staff expertise and achieve greater consistency in firms. regulatory approach. The issue is whether the aim of NAFTA In Mexico cross-border insurance business is to develop a truly unified capital market by is relatively less developed but foreign both increasing transparency and ensuring access participation in local establishments is more fcr issuers to stock exchanges throughout the developed. However, domestic entry is area. If so, there will be a need to harmonize restricted and the establishment of fully-owned the rules on listing particulars, on the foreign subsidiaries is not allowed. A more information to be published on a regular basis by liberal entry policy for both domestic and listed companies, on the information to be foreign-owned institutions is necessary. Mexico published when major holdings are acquired in also needs to remove any biases that exist in a listed company, on the mutual recognition of favor of domestic reinsurance. listing particulars, on the prospectus to be published when transferable securities are first Also to safeguard the interests of small offered to the public, on rules and procedures policyholders and protect the competitive for takeover bids, and on inside trading. On the position of the Mexican market, consideration last one, the rules should define inside should be given to the case for establishing information, identify the persons with access to limited guarantee funds. such information and establish their obligations. In securities markets there will also be a In conclusion, implementation of NAFTA need to harmonize essential prudential will pose a major challenge to the Mexican regulations. NAFTA will have to pursue an financial system and the Mexican supervisory appropriate balance between investor protection, authorities to modernize their operations, market efficiency and the regulation of risk enhance their efficiency and strengthen their management. effectiveness. In some areas, there will be a strong need for intensive training and A first set of problems concerns the cooperation with the regulatory authorities of internal rules that investment firms will need to Canada and the United States. The inclusion in adopt on prudential grounds and with the aim of NAFTA of a reasonable transition period, which minimizing conflicts of interest. One possibility extends up to the year 2000, provides a that could be considered is mutual recognition of reassurance that Mexican institutions will be able home-country disclosure requirements. to rise to the challenge and achieve the Moreover, any agreements in this area, in efficiency gains that have motivated the quest for contrast to banking and investment services, the agreement in the first place. 44 REFERENCES Barnes, Guillermo (1992): Lessons from Bank Privatization in Mexico, World Bank, Policy Research Working Papers, WPS 1027, November. Economist (1990): Survey on American Insurance, The Economist, October 27. Friedman, Charles (1992): "Universal Banking - The Canadian View" in Dimitri Vittas (ed): Financial Regulation - Changing the Rules of the Game, EDI Development Studies, The World Bank, Washington, D.C. Joskow, Paul (1973): "Cartels, Competition and Regulation in the Property-Liability Insurance Industry", Bell Journal of Economics, Autumn. Kaminow, I. (1977): "Required Reserve Ratios, Policy Instruments and Money Stock Control," Journal of Monetary Economics, 389-408. Kanatas, G. and Greenbaum, S. (1982): "Bank Reserve Requirements and Monetary Aggregates," Journal of Banking and Finance, 507-20. Kane, E. (1985): The Gathering Crisis in Federal Deposit Insurance, Cambridge, MA, MIT Press. ________ (1989): The S&L Insurance Mess: How Did It Happen?, Cambridge, MA, MIT Press. Kareken, J. and N. Wallace (1978): "Deposit Insurance and Bank Regulation: A Partial Equilibrium Exposition," Journal of Business. Kryzanowski, L. and G. Roberts (1990): "Bank Structure in Canada," in Kaufman eds. Bank Structure in Major Countries. Meier, Kenneth (1988): The Political Economy of Regulation: The Case of Insurance, SUNY Press, New York. Nathan, A. & E. Neave (1989): "Competition and Contestability in Canada's Financial System: Empirical Results" Canadian Journal of Economics, August, 579-594. OECD (1991): Statistics on Insurance, Comparative Tables on Insurance Statistics for 1988, OECD, Paris. Pyle, D. (1983): Pricing Deposit Insurance: The Effects of Mismeasurement, Federal Reserve Bank of San Francisco and University of California, Berkeley. ________ (1984): "Deregulation and Deposit Insurance Reform," Economic Review, Federal Reserve Bank of San Francisco. 45 Shaffer, S. (1990): A Test of Competition in Canadian Banking, mimeo, Federal Reserve Bank of Philadelphia. Sharpe, W. (1978): "Bank Capital Adequacy, Deposit Insurance and Security Values," Journal of Financial and Qualitative Analysis, Proceedings Issue, 701-718. US Treasury (1990): National Treatment Study, Department of the Treasury. US Treasury (1991): Modernizing the Financial System, Department of the Treasury. Vittas, Dimitri (1991): Measuring Commercial Bank Efficiency - Use and Misuse of Bank Operating Ratios, World Bank, Policy Research Working Papers, WPS 806, November. World Bank (1990): Mexico: Contractual Savings Report, World Bank, Report No 9017-ME, October. 46 APPENDIX A TREATMENT OF FINANCIAL SERVICES IN FREE TRADE NEGOTIATIONS This appendix reviews the treatment of payments. But there is also agreement that the financial services in the GATT negotiations, the scope for cross-border transactions is limited to European Community single market, and the large corporations and wealthy individuals who US-Canada free trade agreement. can overcome the high information and transaction costs of obtaining financial services Financial Services in the GAIT Negotiations from institutions established in foreign countries. However, some cross-border services, such as Financial services are one of the most marine insurance. reinsurance, and financial controversial sectors in the GATT negotiations advisory services, are suitable for inclusion in an regarding the liberalization of trade in services. agreement on multilateral liberalization. There are two main reasons for this. First, there are very large differences in the level of The discussion of modes of delivery is development, efficiency and sophistication of the focussed on the local commercial presence and financial systems of different countries. And, the right of establishment of foreign institutions. second, there are substantial differences in On this issue, a distinction is drawn between financial structure and practice that reflect market access and national treatment. Market different philosophies about the role of banks access refers to the right of local commercial and other financial institutions, their permissible presence which can take many different forms scope of activities and their links with other such as a local branch, local subsidiary, joint financial institutions and nonfinancial venture, minority participation or acquisition of corporations. local institution. There is general agreement that market access will not be an automatic The GATT negotiations aim to establish obligation under the framework agreement, but a framework of principles and rules that should there is considerable debate on whether it should govern the liberalization of trade in services. be a general obligation against which countries The main issues under discussion include: the have the right to enter reservations or whether it modes of delivery of financial services (i.e. should be treated as a qualified right under the through cross-border transactions or through framework that would be granted only through local commercial presence); market access; negotiations and an exchange of concessions. reciprocity; national treatment; equality of Moreover, there is some debate as to whether competitive opportunity; the right to regulate;38 some forms of market access (such as local the transparency of regulations; the pace of branch or acquisition of local institution) may be liberalization; the resolution of disputes; and the subject to tighter restrictions to ensure that question of cross-linkage. domestic control is maintained over the core of the banking and financial system. Linked with As regards modes of delivery, the the issue of market access is the question of prevailing view is that cross-border transactions temporary entry of essential foreign personnel. raise complex issues in connection with the There is general agreement that entry of liberalization of capital and foreign exchange essential personnel is necessary but opinions controls. There is concern that liberalizing differ on how "essential" personnel should be cross-border services might hamper the stability defined. of developing countries' financial systems and have adverse implications for the balance of 47 Historically, DFI in financial services has for foreign financial institutions in a host been permitted either on a unilateral basis or country. In general, a policy of national through reciprocity. Reciprocity can involve treatment is the US policy toward foreign banks unduly tight restrictions on the operations of and other DFI in the US. The overall US policy foreign institutions. These may affect the of national treatment is based on the belief that number of foreign institutions that are granted open and competitive markets facilitate a more market access, their individual or total share of efficient, a more innovative and dynamic, and a domestic business, and their range of activities. more financially sound banking system. A particularly restrictive type of reciprocal arrangements is the so-called "mirror image" Use of a financial service reciprocity reciprocity. This implies that foreign institutions concept as a bargaining tool in the general are allowed to engage in identical activities in context of trade negotiations could also create two or more countries, irrespective of the problems because of differences between trade in permissible range of activities of national financial services and trade in other services and institutions in each market. goods. As has been emphasized above, financial services involve issues of prudential regulation, Because of the highly uncertain outcome, monetary policy, and stability of financial a strategy based on the use of reciprocity as a markets. Thus it may be inappropriate for bargaining tool could be very risky. If a financial services to be the subject of reciprocity policy is in fact used to bar entry by "recipcocal" concessions for goods or for some foreign financial institutions, the ultimate nonfinancial services in a global trade effect of the policy could be to close rather than negotiation context. Moreover, it is to open markets. Moreover, if any reciprocity conceptually and practically difficult to measure policy is adopted and a review procedure is set trade in financial services in a meaningful way. up, a bureaucratic structure will have been In part to avoid these kinds of trade-offs and created that, once in place, has the potential for measurement issues, the US Treasury has always being used in an increasingly restrictive manner. urged that trade in financial services be viewed in terms of equality of competitive opportunity A reciprocity policy, depending on its in a national market for foreign and domestic definition and implementation, could result in a financial institutions, that is, in terms of national complex regulatory structure for operations of treatment. banks from different countries outside the FTA. Such a structure could involve discrimination not Because of the restrictive effects of only between foreign and FTA members-owned reciprocal agreements and the danger of financial institutions but also among foreign retaliatory action in response to grievances and financial institutions from different countries. disputes, there is now widespread consensus that Moreover, a reciprocity review procedure could once market access is granted, the principle of delay applications by non-members banks to national treatment should apply, whereby foreign establish or acquire banks within the FTA institutions receive the same treatment as countries. Such delays could be particularly domestic institutions in like circumstances. burdensome if reciprocity were to be determined There is some uncertainty as to the exact on a case-by-case basis rather than by an meaning of the term "like circumstances" as well established rule for each non-member country. as to the implications of the principle of national treatment for different modes of delivery, and Insisting on a reciprocity policy will not especially for local subsidiaries and local earn the support of the US, since it will branches. Under national treatment, a local undermine its efforts pursued in various subsidiary of a foreign institution should receive international fora to achieve national treatment identical treatment as a domestic institution but 48 in the case of local branches, national treatment foreign participation, including participation may confer regulatory advantages to foreign from other subdivisions, national treatment may institutions. The principle of equivalent impose considerable limits on market access on treatment may then be applied, whereby foreign foreign institutions.29 In addition, restrictions branches may be treated less favorably than at the level of political subdivisions may even domestic branches but the effect would be to deny national treatment to foreign institutions. achieve equivalent treatment between domestic institutions and the local operations of a branch Effective market access (which the EC of a foreign institution. sometimes refers to as the "broad definition of national treatment") appears to encompass two There is also considerable debate different concepts: national treatment and tegarding the concepts of dejure and defacto "progressive liberalization" of laws and natioinal treatment. Defacto national treatment regulations relating to banking and other is associated with the concept of equality of financial services. In other words, national competitive opportunity. The latter refers to the treatment in the context of a restrictive, highly prevention of various practices and regulations regulated banking system might not be that have the effect of discriminating against considered to provide effective market access. foreign institutions. Thus, de facto national The concept of effective market access appears treatment and equality of competitive to be based on the arguments that (a) a highly opportunity imply that foreign institutions are regulated host-country environment may have a not impeded by regulations or the use of differential impact on foreign and domestic discretionary authorizations from obtaining local institutions and (b) host-country treatment may currency funding from the money and capital be so restrictive in comparison with the markets, having equal access to refinancing and regulatory framework for banking services in other central bank facilities, and participating in other countries, that market distortion is created. preferential domestic credit programs. A sharper interpretation of the principle of equality The first argument implies that in a highly of competitive opportunity requires that foreign regulated environment it is much more difficult institutions should not be prevented from to achieve national treatment for foreign banking introducing new instruments or services by organizations than it is to achieve such treatment delays in authorization procedures that in a more open system. But it does not discriminate in favor of domestic institutions. necessarily follow that is impossible to achieve national treatment under such circumstances. If, The principle of national treatment is part however, it is assumed that national treatment of the non-discrimination principle of trade cannot be defined or achieved in a restrictive negotiations that covers both the "most favored environment, liberalization of the regulatory nation (MFN)" clause and national treatment. structure is necessary to achieve meaningful MFN requires that imports from all sources access to domestic markets. should face identical barriers, while national treatment requires that, once through customs, The second argument, because it is based foreign goods should not be subject to taxes and on a more global comparison of regulatory regulations that are more onerous than those on structures, raises the issue of harmonization. At equivalent domestic goods. But with regard to least for the industrial countries, "progressive DFI in financial services, application of the liberalization" could be viewed as a somewhat national treatment principle is complicated by less formal and less structured GATT equivalent the role of political subdivisions in regulating of one aspect of the EC process of financial institutions. In those countries where harmonization of essential laws, regulations, and political subdivisions impose restrictions on practices. Because the degree of liberalization is 49 measured against that existing in other major progressive liberalization. The pace should industrial countries, trying to achieve depend on progress made in implementing progressive liberalization in countries with domestic financial reform and deregulation, restrictive structures amounts to an attempt to restructuring domestic institutions and bring those structures into rough conformity modernizing their operations, and strengthening with the more liberal structures in other national regulatory and supervisory agencies. countries. The pace of liberalization is relevant not only with regard to the question of market access and The next issue in the GATI negotiations the allowable mode of delivery, but also with concerns the right to regulate and the regard to the permissible new instruments. transparency of regulations. There is general Authorization of new financial instruments and agreement that the liberalization of trade in services must be linked to the ability of services should not put into question the right of regulators to assess their implications for the national authorities to regulate the financial stability of the financial system and control system for prudential and other purposes. There possible abuses that might negate their benefits. is a legitimate need to ensure the safety and New products need to be monitored and soundness of financial institutions and the supervised to ensure the protection of depositors, stability of the financial system, to maintain fair policy holders and investors. and orderly market conditions, to preserve the integrity of the national payment system and to Two additional issues in the GATr protect the interests of consumers and investors. negotiations are the establishment of an effective Moreover, there is widespread concern, mechanism for the resolutioii of disputes and the especially among developing countries, that question of cross-linkage between different liberalization of trade in financial services should sectors. These two issues are interrelated since not prevent developing countries from using if there is cross-linkage, countries may threaten their banking systems to promote natioii,"' to retaliate in the financial services area for development objectives and should not leave disputes arising in a nonfinancial sector. It is them with inadequate powers to control money generally agreed that financial markets should and credit growth and foreign exchange flows. not be exposed to such de-stabilizing threats but it is rather difficult to avoid any cross-linkage. Although the right to regulate is widely Establishing an effective dispute resolution accepted, strong emphasis is placed on the need mechanism is also a very sensitive issue because for regulations to be transparent and non- disputes in the financial services area may discriminatory against foreign .nstitutions. challenge the transparency of regulations and the Regulations should be taken for legitimate discretionary powers of national authorities. reasons and not for the purpose of circumventing a liberalization agreement. However, the broad In a world of complete convergence, the scope of regulations, the legitimate concerns of policies of national treatment, reciprocal national many countries to maintain domestic control treatment, mirror-image reciprocity, and over the core of their banking and financial effective market access would produce identical system, and the difficulty of devising effective results. Pending such convergence, however, settlement dispute procedures would make a the differences among these concepts are still universally acceptable multilateral agreement important. And some of the most difficuit rather difficult to reach. problems are presented by the lack of agreement among the major industrial countries regarding A crucial issue in the GATT negotiations the permissible activities of banks, in particular, concerns the pace of liberalization. There is whether to separate commercial and investment widespread agreement in favor of gradual or banking. 50 In the banking, investment services, and The EC base the completion of integration insurance sectors, national treatment, as on the principle of mutual recognition, whereby embodied in the OECD Codes of Liberalization each member state recognizes the validity of the and the National Treatment Instrument, is in laws and regulations in force in each of the general the currently accepted approach. other, and agrees not to exploit the differences Whether national treatment or effective market between regulatory systems to protect its access might become the accepted approach if national market. The traditional approach, by any agreement is reached on trade in financial contrast, saw integration as involving the services in connection with the current Uruguay detailed harmonization of the entire corpus of Round of GATT negotiations remains to be laws and regulations applicable to each sector. seen. The principle of mutual recognition To sum up this brief review of the GATT implies that every member countries sets of negotiations, financial services raise many national rules, which differ in significant difficult and sensitive issues and it is unclear respects, will all be in force and co-exist in the whether they will be included in any agreement same 'arge market. This is bound to trigger that might eventually result from this round of arbitrage. Thus, the convergence of national negotiations. In fact, there are many officials regulatory systems, which would have been and practitioners who express the view that reached through the traditional approach of financial services should be the subject of complete top-down harmonization, should be separate negotiations and should not be part of a brought about by market forces instead or, to be general agreement on trade and services. more precise, by the interaction between market However, it is now too late to change this forces and national regulators. approach without undermining the momentum for agreeing a general framework for trade in In principle, the outcome will not services. necessarily be complete convergence since different market segments may place differenm Financial Services in the European values on regulatory standards and product Community Single Market prices. In the financial sphere, for instance, some customers may be ready to pay more for The proposals for the creation of a single the services of an intermediary that is subject to market in financial services in the EC is based the stricter prudential controls of a particular on the three principles of home country member state. However, the internationalization authorization and control, mutual recognition of of financial services is already creating market national supervisory authorities and an pressure for greater convergence of prudential approximation of rules and regulations that standards on a world wide basis. A single include such items as the permissible range of market may accelerate this process further. activities (a universal financial services approach has been adopted) and solvency controls. The danger inherent in mutual recognition is that relying exclusively on market forces to The approach of the EC differs from that determine regulatory standards may lead to a of traditional bilateral and multilateral FTAs sub-optimal outcome, with excessive or because it envisages a progressive economic and, inappropriate deregulation. This is why, both ultimately even political, integration of member on financial services, the principle of mutual countries with the ultimate objective of creating recognition has been tempered by that of institutions with EC-wide operations and minimal harmonization. To avoid leap- ownership. frogging by member states seeking to offer the most favorable regulatory conditions, the EC 5' should make the application of mutual member countries with no discrimination against recognition conditional on the introduction of nationals of other member countries. common regulations to safeguard fundamental public interests. Financial Services in the US-Canada FTA The crucial question is, of course, how The US-Canada FTA went into effect in "minimal" minimal harmonization can be while January 1989. It is based on the principles of still ensuring an acceptable level of regulatory national treatment, the right to sell across standards. In the financial sector, the definition borders, the right of establishment, and of what is necessary to harmonize has already transparency in regulations. The US-Canada been found not to be a once-and-for-all process. FTA contains a unapter on services that grants On the contrary, it calls for continuous national treatment to insurance companies but evaluation and is likely to require more common banking is covered in a separate chapter that legislation than originally thought. does not grant national treatment to banks from the two countries. It does not cover securities In the financial field, a corollary of the markets per se. However, the agreement two key principles of mutual recognition and removes several restrictions on market access minimal harmonization is the principle of home- and scope of operations, e.g. expands the scope country control, which assigns supervisory of banking into securities transactions. responsibility to the authorities of the member state in which the financial institution was National treatment assures that any new originally authorized to operate. An important Canadian (US) law or regulation must treat US aspect of home country control is how deposits (Canadian) financial service providers no less of branches overseas are protected. In the EC favorably than Canadian (US) providers. This countries, they are covered by the national will provide stability and predictability for US deposit protection system of the home country. (Canadian) businesses in thd Canadian (US) market. However, despite the objectives of a single market and even economic and political However, this does not mean that Canada integration (which, if implemented, should and the US must always give identical treatment. remove concerns about national ownership of Differential treatment may occur between financial institutions), there is currently domestic and foreign service providers for considerable apprehension in some countries prudential, fiduciary, consumer protection, or about the likelihood of national institutions other valid reasons. coming under the control of institutions from other member countries. At present, the right of For example, with respect to insurance, regulatory authorities to approve controlling new provincial (state) requirements which are stakes in individual institutions, coupled with the higher for a foreign insurer than a domestic widely dispersed ownership of most institutions insurer in Canada (US) would not necessarily be of national importance, allows member countries inconsistent with the FTA. However, any to influence the ownership of national financial differences in treatment must not be disguised institutions. Member countries can still barriers to trade and must be justifiable. introduce regulations similar to those used in Canada, whereby no individual shareholdings of The FTA assures US and Canadian large banks are allowed to exceed 10% of share service providers of the right to sell across the capital. However, any such requirements would border. This is important when it is more have to grant equal treatment to all citizens of economical for a business to provide the service from the home-country, rather than establish 52 itself in the host-country. This right is and regulations relating to services trade so that especially important for many high-technology persons and firms who may be affected will have services, such as credit reporting services, where an opportunity to make their views known. the normal means of delivery is over telephone Transparency also includes clear criteria in lines to all customers from one central computer exercising discretionary powers. Such installation. Conversely, when a local presence transparency will enable US (Canadian) is the preferred (or only) method to provide a services providers to participate with Canadian service in the host-country, the FTA guarantees (US) firms in the Canadian (US) regulating the right of establishment. process. It is essential to know the rules of the game. The two countries have agreed to make publicly available (to make transparent) all laws 53 APPENDIX B Financial Services In the Proposed NAFrA This appendix summarizes the main In the insurance sector, the aggregate provisions regarding financial services in the limit will rise from 6% in 1994 to 12% by proposed NAFTA that was signed in December 1999. The single-institution market limit will 1992 and, subject to the completion of domestic remain 1.5% throughout the transition period. approval procedures, will enter into force on US and Canadian insurance companies that enter January 1, 1994. into joint ventures with Mexican firms will be permitted to expand their equity participation on Each NAFTA country must grant an accelerated schedule, reaching 51% in 1998 "national treatment" and "most-favored-nation" and 100% in 2000. Moreover, these treatment to participants from other NAFTA investments will not be subject to either countries. Market access is limited to individual or aggregate limits. individuals or companies that already engage in their country of origin in financial services. It The provision of cross-border financial may also be limited to subsidiaries rather than services includes both the concept of the direct branches. "mobility of provider" and the concept of the "mobility of consumer". Each NAFTA country Mexico is allowed to impose on US and must permit its citizens and residents to purchase Canadian participants individual and aggregate financial services from providers located in other market share limits. These will be stated as a NAFTA countries. Except for insurance proportion of the total capital in each sector and companies, Mexico may require that a Mexican will be phased out by the year 2000. The whole subsidiary must be wholly owned by the US or issue will, however, be revisited if US and Canadian parent institution. Mexico may also Canadian participants acquire a combined market deny access to Canadian or US banks or share in excess of 25%. securities firms that are affiliated with industrial or commercial corporations. In banking, the aggregate limit will rise from 8% in 1994 to 15% by 1999. The single- There are various provisions for the institution limit will be 1.5% throughout the creation of limited-scope financial institutions transition period. Both during and after the that would be subject to less onerous capital transition period, acquisitions of Mexican banks requirements and less restrictive market share will be subject to an individual, per institution limits. Warehousing, bonding, foreign exchange limit of 4%. and mutual fund management will not be subject to market share limitations. In the securities industry, the aggregate limit will increase from 10% in 1994 to 20% by The right to provide new financial 1999. The single-institution limit will be 4% services and to transfer information for data throughout the transition period. Within two processing is also covered in the proposed years of entry into force, Mexico will decide agreement. No requirement to employ nationals whether to authorize new types of limited-scope in key positions will be allowed. securities firms that would be subject to lower capital requirements. Finally, the proposed NAFTA does not constrain the right of each country to impose regulatory or restrictive measures for prudential S4 reasons, in pursuit of monetary, credit or exchange rate policies, for balance of payments reasons or for taxation and social security purposes. 55 NOTES 1. This paper is based on a report produced by a World Bank mission to Mexico in which Roger Gordon and Robert Pardy also participated. The report was completed in March 1991. The paper includes a limited amount of updating, mainly to note some main recent developments in financial regulation. 2. This follows the free trade agreement between Canada and the U.S. that has already been in place for a number of years. 3. To give an overall quantitative perspective, the average price reduction in the cost of financial services for the EC as a whole was estimated, in a study conducted by Price Waterhouse, at 0.7% of GDP (1.5% for Spain alone). 4. In the EC, excluding interest payments or capital raised, credit and insurance services accounted in total for about 6% of intermediate inputs into industry. 5. Some of these arguments may explain, for example, the co-existence of small and large intermediaries in California, New York and other states with state-wide branching. 6. Before the new law, insurance companies were allowed 49% foreign ownership. These companies are now grandfathered. 7. To some extent this attitude may be explained by the fact that these sectors provide services to the majority of the local population and generate little foreign exchange earnings. It is worth noting that DFI in the hotel industry, which deals with foreign tourists, has been positively encouraged, in part, because it contributes to improve the current account of the balance of payments. 8. For a review of Canadian developments, see Friedman (1992). 9. For an official study supporting the proposed reforms, see U.S. Treasury (1991). 10. A succinct review of bank privatization in Mexico is provided in Barnes (1992). 11. For a review of bank structure in Canada see Kryzanowski and Roberts (1990). 12. For empirical tests of competition in Canadian banking see Nathan and Neave (1989) and Shaffer (1990). 13. Low initial capital requirements in small cities is one of the causes for the large number of commercial banks in the United States. There is now growing consensus that the fragmentation of the banking industry may have contributed to the widespread problems of nonperforming loans and insolvency that have afflicted the US banking system in recent years. 14. Allowing less than 10% equity holdings per foreign entity raises some tax issues (discussed in Section 6) so that consideration should be given to increasing the limit to 10% for all foreign participations. 56 15. The OCC is responsible for approving changes in control of national banks, the Federal Reserve Board for bank holding companies and state- chartered member banks, and the Federal Deposit Insurance Corporation (FDIC) for insured state-chartered banks that are not members of the Federal Reserve System. 16. See Appendix for a discussion of financial integration under the Canada- US FTA. 17. The distorted incentive effects of mispriced insurance schemes are widely discussed in the literature. See, for example Kareken and Wallace (1978), Sharpe (1978), Pyle (1983, 1984), and Kane (1985, 1989). 18. See Kaminow (1977) and Kanatas and Greenbaum (1982). 19. This section draws on Kane (1989), which contains a detailed discussion of the incentive structure of the US deposit-institution regulators and a reform proposal. 20. For a detailed discussion of these issues, see Vittas (1991). 21. A main reason for the lack of comparable data is the impact of the very high rates of inflation that prevailed in the mid-1980s. These led among other things to the introduction of new products that evaded the restrictive banking regulations but created difficult accounting issues. 22. Indeed, the Wall Street Journal reported that "privatized Mexican banks found many undisclosed problem loans" (5/15/1992). 23. This limit was set for a couple of years at 49%. These companies are now grandfathered. 24. OECD (1991). 25. The ten largest US companies account for almost 40% of premiums in the life sector and for nearly 50% in nonlife business. In Canada (as in most European countries) the concentration ratio of the largest ten companies is well over 55% in life and, with few exceptions, less than 50% in nonlife insurance (Economist, 1990). 26. Comments made at a meeting of the International Insurance Council in New York on February 28, 1991 to review insurance developments in Latin American countries. 27. Premium regulation in the United States used to emphasize minimum tariffs to prevent deceptive policies and insolvencies. But since the mid- 1970s, regulators have allowed greater price competition among insurance companies. In recent years, regulators in several states have shown increasing concern about "excessive" increases in premiums. For an excellent review of insurance regulation in the United States, see Meier (1988). 28. Proposition 103 was voted by Californian residents in November 1988. It mandated a rollback of 20% in most property and casualty rates, including motor insurance, and established tougher rules for rate setting. However, the impact of Proposition 103 has been watered down by court decisions, following appeals by insurance companies. 29. Market estimates quoted in Economist (1990). 57 30. See Joskow (1973). 31. World Bank (1990). 32. For US property ard casualty companies, loss reserves increased from 30% of equity in 1940 to almost 180% of equity in 1988 (Bath, 1990). 33. The expense ratio is not expressed in this paper as a percentage of direct premiums (as is the customary practice) but as a percentage of earned premiums. This tends to overstate the ratio because earned premiums are equal to direct premiums less net premiums ceded to reinsurance less transfers to unearned premium reserves. The overstatement is greater, the larger the net reinsurance ceded and the lower the retention ratio. 34. These ratios are unweighted averages of annual ratios and differ slightly from those published in Best Aggregates and Averages. 35. The high level of the ratio may be explained by the use of earned premiums as the denominator. Expressed as percentage of direct premiums, the expense ratio was 33.4%. 36. OECD (1991). 37. In addition, mutual recognition of home-country disclosure requirements has been the basis of discussions among the US, Canada, and the UK for several years. 38. It includes prudential regulation and supervision. 39. In this respect, it is somewhat ironic that liberalization in international trade and DFI in financial services is actively promoted, while restrictions continue to be applied on domestic trade and direct investment between political subdivisions of individual countries. 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