FOR OFFICIAL USE ONLY FINANCIAL SECTOR ASSESSMENT MEXICO MARCH 2017 FINANCE AND MARKETS GLOBAL PRACTICE LATIN AMERICA AND THE CARIBBEAN REGIONAL VICE PRESIDENCY The Financial Sector Assessment was prepared in the context of a joint World Bank-IMF Financial Sector Assessment Program mission in Mexico during April and June 2016 led by Alfonso Garcia Mora, World Bank and Ghiath Shabsigh, IMF, and overseen by Finance & Markets Global Practice, World Bank and the Monetary and Capital Markets Department, IMF. Further information on the FSAP program can be found at www.worldbank.org/fsap.1 1 The team was led by Ghiath Shabsigh, IMF and Alfonso Garcia Mora, World Bank, and included Maria Oliva (IMF deputy mission chief), Luisa Zanforlin (World Bank deputy mission chief), Jorge Chan-Lau and Julian Chow, Darryl King, and Alexander Klemm (all IMF staff) as well as Carlos Barsallo, Jan Brockmeijer, Michael Deasy, Claire McGuire, David Scott (IMF external experts), Leyla Castillo, Caroline Cerruti, Maria Teresa Chimenti, Mateo Clavijo, Catiana Garcia Kilroy, Valeria Garcia Salomao, Eva Gutierrez, Fedesvinda Montes, and Heinz Rudolph (all World Bank staff), John Wilson (IFC), Olivier Hassler, Jose Rutman (World Bank external experts). Executive Summary ....................................................................................................................................... 1 I. MACRO-FINANCIAL BACKGROUND ....................................................................................................... 4 II. FINANCIAL SYSTEM STRUCTURE AND CHALLENGES ............................................................................. 6 A. Banking Sector ................................................................................................................................. 7 B. Pensions.......................................................................................................................................... 12 C. Insurance ........................................................................................................................................ 14 D. Mutual Funds.................................................................................................................................. 15 E. Other Financial Intermediaries ....................................................................................................... 15 III. FINANCIAL MARKETS .......................................................................................................................... 16 IV. FINANCIAL MARKETS INFRASTRUCTURE ............................................................................................ 16 A. Payment Systems ............................................................................................................................ 16 B. Insolvency and secured creditor rights ........................................................................................... 17 C. Credit Reporting Systems ............................................................................................................... 18 V. MICRO-PRUDENTIAL REGULATION, SUPERVISION AND OVERSIGHT ............................. 19 A. Banking .......................................................................................................................................... 20 B. Securities ........................................................................................................................................ 23 VII. MACRO-PRUDENTIAL POLICY FRAMEWORK ..................................................................... 24 VIII. SYSTEMIC LIQUIDITY: FRAMEWORK and RISKS ................................................................ 25 IX. CRISIS MANAGEMENT and FINANCIAL SAFETY NETS .......................................................... 25 A. Bank Recovery and Resolution ...................................................................................................... 25 B. Deposit Insurance ........................................................................................................................... 27 X. FINANCIAL SECTOR DEVELOPMENT STRATEGIES ............................................................... 28 A. State-Owned Financial Institutions ................................................................................................ 29 B. Increasing Financial Access ........................................................................................................... 32 C. Developing Long-Term Finance .................................................................................................... 37 Appendix I: Mexico Selected Economic And Structural Indicators ............................................................ 42 Appendix II: Financial Sector Reform – Key Measures ............................................................................. 47 Appendix III: Risk Assessment Matrix ........................................................................................................ 48 Appendix IV: Stress Testing ........................................................................................................................ 49 Appendix V: Mexico’s Approach to Managing Pension Fund Risks .......................................................... 61 Appendix VI: State owned financial Institutions ......................................................................................... 62 Appendix VII: 2012 and 2016 Table of Recommendations......................................................................... 63 GLOSSARY AFORES Administradora de Fondos para el Retiro APF Administración Pública Federal AML Anti Money Laundering AT1 Additional Tier 1 (capital) ATM Automatic Teller Machine BANSEFI Banco del Ahorro Nacional y Servicios Financieros Banxico Banco de México BCP Business continuity plan BU ST Bottom Up Stress Test CAR Capital Adequacy Ratio CASP Centro de Atención para los Sistemas de Pagos CDPQ Caisse de Dépôt e Placement du Québec CEB Comité de Estabilidad Bancaria—Banking Stability Committee CEFER Calificación de Entidades Financieras con Enfoques de Riesgos (Financial Entities Risk Based Score) CerPI Certificados de Proyectos de Inversión (publicly listed private equity fund specific to Mexico) CESF Consejo de Estabilidad del Sistema Financiero—Financial System Stability Council CET1 Core Equity Tier 1 CIEN Certificado de Infraestructura en Escolar Nacional CKD Certificado de Capital de Desarrollo (publicly listed private equity fund specific to Mexico) CLS Continuous Linked Settlement CNBV Comisión Nacional de Bancos y Valores—Banks and Securities Supervisor COFECE Comisión Federal de Competencia Economica CONAIF Consejo Nacional de Inclusión Financiera CNSF Comisión Nacional de Seguros y Fianzas CONDUSEF Comisión Nacional para la Protección y Defensa de los Usuarios de Servicios Financieros (National Commission for the Protection and Defense of the Users of Financial Services) CONSAR Comisión Nacional de Sistema de Ahorro para el Retiro (Pension funds supervisor) CPs Core Principles for Effective Deposit Insurance Systems CUT Cuenta Única del Tesoro (Treasury single account) C-VaR Conditional Value-at-Risk DB Development Banks DI Deposit Insurance D-SIB Domestic Systemically Important Bank DSP Dirección de Sistemas de Pagos EFT Electronic Funds Transfers ELA Emergency Liquidity Assistance ENIF Encuesta Nacional de Inclusión Financiera FHC Financial Holding Company Fibra E Fideicomiso de Inversión en Energía y Infraestructura (Publicly Listed REIT Type Fund for Equity Investments in Mature Infrastructure Assets) FIPAGO Trust Fund for the Strengthening of the Saving and Loans Cooperatives and their Depositors (Fondo para el Fortalecimiento de la Sociedades Cooperativas de Ahorro y Préstamo y de Apoyo a su Ahorradores) FND Financiera Nacional de Desarrollo FOBAPROA Fondo Bancario de Protección al Ahorro—Banking Fund for the Protection of Savings FONADIN Fondo Nacional de Infraestructura FONE Fondo de Aportaciones para la Nómina Educativa FSAP Financial Sector Assessment Program FX Foreign Exchange G2P Government-to-person payments GDP Gross Domestic Product G-SIB Global Systemically Important Bank HHI Hirshman-Herfindahl Index HQLA High Quality Liquid Assets IADI International Association of Deposit Insurers IMF International Monetary Fund IMSS Instituto Mexicano del Seguro Social IPAB Instituto para la Protección al Ahorro Bancario—Deposit Insurer IPAB Law Law for the Protection of Bank Savings KA Key Attribute LAC Latin America and Caribbean LCM Ley de Concursos Mercantiles LCR Liquidity Coverage Ratio LIC Ley de Instituciones de Credito, Banking Law LRAF Ley para Regular las Agrupaciones Financieras—Financial Holding Companies Law LIC Ley de Instituciones de Credito, Banking Law LTV Loan-To-Value Ratio MCM Monetary and Capital Markets Department, IMF MoU Memorandum of Understanding MXN Mexican Pesos MSME Micro, Small, and Medium Enterprise NAFIN Nacional Financiera, S.N.C. Institución de Banca de Desarrollo (DB) NBFI Non-Bank Financial Institution NOP Net Open Positions NPL Non-performing loans NSFR Net Stable Funding Ratio OBA Open Bank Assistance OTC Over-The-Counter P&A Purchase and Assumption PD Probability of Default PE Private Equity PNI Plan Nacional de Inversiones POS Point of sale PPP Public Private Partnership ROA Return on Assets ROE Return on Equity ROSC Report on the Observance of Standards and Codes RSP Módulo Reportos para Proporcionar Liquidez al Sistema de Pagos del Sistema RUG Registro Único de Garantías SHCP Secretaria de Hacienda y Credito Público—Ministry of Finance SHF Sociedad Hipotecaria Federal (development bank for housing finance) SIAC Sistema de Atención a Cuentahabientes de Banco de México SME Small and Medium Size Enterprise SOCAP Cooperative Societies of Savings and Credit (Sociedades Cooperativas de Ahorro y Préstamo) SOFINCO Popular Financial Societies (Sociedades Financieras Comunitarias) SOFIPO Popular Financial Companies (Sociedades Financieras Populares)- SOFOM Multiple Purpose Financial Companies (Sociedades Financieras de Objeto Múltiple) SOFI State-Owned Financial Institutions SPEI Sistema de Pagos Electrónicos Interbancarios SST Simple, standardized and transparent securitization ST Short Term STP Straight through processing TD ST Top Down Stress Test TIE Interbank Rate (Tasa Interbancaria de Equilibrio) T2 Tier 2 (capital) UDI Unidades de Inversion, unit of account linked to inflation, set daily by UFA Universal Financial Access VaR Value-at-Risk WB World Bank 1 EXECUTIVE SUMMARY Mexico’s macroeconomic policies are strong and the financial system was found to be broadly resilient to adverse shocks. The medium term outlook for the Mexican economy foresees steady growth supported by corporate investment and external demand, albeit vulnerable to a possible slowdown of U.S. growth, continued weakness in oil prices, and heightened volatility in global financial markets. Banks solvency and liquidity was found to be strong while the corporate sector could cope with adverse exchange rate, earnings and interest rate shocks. Financial sector regulation was strengthened since the last FSAP, in line with the international reform agenda, however some important gaps remain in the supervisory framework. Notably, weaknesses in the governance structure of supervisory agencies assessed by past FSAPs reduce operational independence while limited budget autonomy and poor legal protection of supervisors hamper activities. As noted by other FSAPs, there continues to be a need to implement a framework for consolidated supervision to enhance the quality of prudential oversight given the many financial conglomerate structures in Mexico. The crisis management framework was enhanced but could be further improved. Following recommendations from earlier FSAPs, the special bank resolution regime was enhanced, but has yet to be extended to financial holding companies and is still in need of further legislative action to simplify the conduct purchase and assumptions on non-systemic banks. The deposit insurance framework broadly complies with international standards despite the agency being still burdened by a multiplicity of mandates which may ultimately undermine its effectiveness. Bank recovery and resolution planning is underway, although further work remains to be done on developing formal contingency plans and simulation exercises to deal with a systemic crisis. Authorities have been developing macro-prudential oversight. A Financial System Stability Council (CESF) was created to support a system-wide approach to evaluate financial stability risks. However, further work is needed for the CESF to be able to assess the potential stability implications of the introduction or the application of new macro-prudential policy instruments. It will be necessary to increase contribution rates to ensure that the reformed pension system provides for adequate income in old age. In line with calculations undertaken during the last FSAP, the projected replacement rates under the reformed pension system, which will be fully effective in twenty years, still indicate replacement incomes will be significantly below OECD country averages. Authorities should strive to increase them now, or wide income disparities among retiring cohorts could undermine the pension reform. Financial sector development challenges remain across a range of topics, notably access to finance and provision of long term financing. Credit to the private sector has picked up only recently and hardly reaches 30 percent of GDP, one of the lowest in Latin America. Financial services penetration lags behind peer countries in particular for the SME sector, where barely one third of SMEs have a loan, and households, as only 29 percent of the poorest 40% Mexicans have an account in a financial institution. The scarcity of long-term financial resources has been hampering the development of the housing and the infrastructure sectors. 2 Wide-breadth legislation was enacted to foster sound financial development, although results have yet to fully materialize. Authorities enhanced the role of development banks in spurring credit but should ensure more closely that the publicly-supported lending programs are sustainable and are generating the right incentives. Policies should be more focused on “crowding-in� the private sector, avoiding market distortions, ensuring sustainability of pricing programs, and phasing-out gradually from those beneficiaries that can already be served by the private sector. Financial access could be broadened through a vibrant ecosystem of financial institutions complementing the commercial banking sector. The numerous types of “other financial institutions� already coexist in Mexico but lack the scale to provide an alternative solution to banks. They attend a large number of clients in remote areas but offer limited services. Consolidating and articulating common initiatives to reduce costs could overcome the issues posed by their small size, limited funding capacity, and low profitability, which remain big challenges. Improvements to the financial infrastructure would support increased lending to SMEs and households. High informality and the difficulty in overcoming informational barriers are still hindering the supply of credit to SMEs. While the legal framework for credit products to support SME credit, including insolvency proceedings, was strengthened, the use of non-credit products is well below its market potential. Further actions are needed to make the movable collateral registry fully operational to foster the use of mobile collateral guarantees. In addition, the creation of a credit registry would support financial information available to lenders. To expand household access, the regulatory framework could be revised to facilitate agent networks and enable payment service providers. Long-term financial resources could be mobilized after enhancing the regulatory framework and policies for long-term instruments. Funding of mortgage portfolios still remains a major challenge, particularly since the failure of the Sofomes model after the global financial crisis, and new long-term funding instruments for the housing market need to be developed. In particular, covered bonds and simplified MBS inspired by the “simple, standardized and transparent securitization� (STS) based on the EU project,2 would allow credit institutions better assets and liabilities management. Further efforts could be directed to introducing more flexible instruments to support infrastructure financing and broadening the investor base. Authorities could support the development of infrastructure debt funds while designing a unified and stronger framework for the implementation of PPPs. In addition, mature infrastructure assets of SOFIs could be sold off to the market and guarantees could be used, rather than direct lending from development banks. Finally, the development of a long-term investor base would benefit from measures to support long-term investments by the pension funds including creating a single lifecycle benchmark. 2 Designed in fact to support SME lending, the securitization of which is different from mortgages. 3 Executive Summary Recommendations TM Institutional Arrangements and Governance Amend relevant laws to (a) clearly establish financial stability as the primary mandate for supervisors, other mandates MT (e.g., development) are secondary and should be narrowly defined, and (b) ensure the institutional, supervisory and budgetary independence of the supervisory agencies. Financial sector oversight Establish functioning consolidated supervision framework, including broadening legal powers of the CNBV’s to perform ST consolidated supervision and strengthening the regulatory reporting framework for related party lending. The corporate governance of development banks should be revised in line with international best practices in some key ST areas such as the composition of board members and mechanisms for the election of CEOs. The definitions of “common risk� and “related party� should be enhanced, including explicit definition of “economic ST dependency� in exposures to corporations, provision for grouping loans that are collateralized by the same collateral, and explicit references to persons who, while not having a quantitative relationship with other borrowers, exercise significant control over them. Ensure that development banks are subject to some form of liquidity measurement discipline. ST Streamline the regulation and supervision of “other financial institutions� to facilitate and promote consolidation and MT integration. Deposits insurance, crisis management and resolution Restructuring of the legacy debt at IPAB and transfer it to the SCHP balance sheet. MT Adopt legislation to ensure shareholders and subordinated debt holders’ of systemic banks bear the first losses at all times. ST Adjust the regulation to strengthen the framework to use bridge banks to resolve systemic banks. ST Development Banks Revise the strategy and objectives for development banks targets to include indicators of financial inclusion and private ST sector crowding-in, eliminating quantitative targets. Pensions Increase the contribution rates to fully funded pension schemes to ensure higher replacement rates and reduce fiscal risk. ST SME Finance Redesign the instruments of development banks for SMEs by implementing a gradually phase-out of the guarantee ST programs for firms with enough credit history and including sunset clauses in new programs Create a credit registry to increase financial information available to lenders MT Long term finance Introduce new instruments to facilitate long term finance: infrastructure debt funds, covered bonds and standardized MT securitization bonds Develop a unified and stronger institutional framework to oversee the implementation of PPPs ST 4 I. MACRO-FINANCIAL BACKGROUND 1. Mexico’s economic growth has been steady and inflation remained low despite a significant depreciation of the exchange rate in the last 18 months. The economy grew by an average of 2.5 percent per year since the last FSAP in 2012,3 supported by both external and domestic demand. Inflation has been low and still remains well within the band of 2-4 percent. The external sector position has deteriorated slightly following adverse movements in the terms of trade, but the level of foreign exchange (FX) reserves remains adequate according to standard measures (Appendix I) The Flexible Credit Line arrangement with the IMF was increased in June 2016 to provide additional insurance against tail risks. 2. The medium term outlook for the Mexican economy foresees stable growth and inflation. Economic growth is projected to average about 2.8 percent per year in 2016–20 (Table A1.1), underpinned by strong external demand and a pickup in domestic demand, as structural reforms are expected to counterbalance any negative impact from the tightening of U.S. 4 monetary conditions. The pass-through from exchange rate depreciation is projected to remain low thus inflationary pressures will remain contained. A fiscal consolidation program is underway while a credible monetary policy framework has kept inflation close to target. Lower oil revenues have not had a significant impact on the fiscal position to date5 and the exchange rate has acted as the main shock absorber. 3. After several years of contained growth, commercial bank credit grew by 14 percent in 2015, albeit from a very low base. Credit has been mirroring developments in the real Figure 1: Domestic Banks Private Sector Credit (In percent of GDP) economy, picking up recently but it remains below its expected value based on its income and level of development, regional average and peer countries (Figure 1). Mortgage lending, has increased although only for the upper segments of the housing market while credit to companies and SMEs was moderated. Credit extended by development banks, spurred by government initiatives, reached 25 percent growth rate in 2015, and accounted for approximately 30 percent of the total private sector credit portfolio.6 Source: Finstats. 3 Growth dipped in 2013 to 1.4 percent reflecting weak external demand and a decline in construction activity, but picked up in 2014 following a rebound in manufacturing production and exports. 4 This report was completed prior to the US presidential election in November 2016. 5 The one-year ahead hedging of oil prices has helped the authorities mitigate the effects of the oil price decline in the short-run. The structural adjustment to lower prices remains. In early 2016, the authorities approved an expenditure cut of 0.7 percent of GDP to safeguard the fiscal target. The hedging policy for 2017 has not yet been announced. 6 This figures includes both direct credit and so-called “credito inducido� which are partially guaranteed credit lines. 5 4. Nonfinancial sector balance sheets show little sign of stress. Household debt is low at about 15 percent of GDP (Figure 2), also relative to other Figure 2: Mexico’s Household Debt EMs. Corporate debt has increased but remains low at the (in percent of GDP) aggregate level when compared with other EMs (Figure 16 3). The debt maturity profile of large listed private 15 corporations has been extended and liquidity buffers 14 appear sufficient at present. FX debts, on average, 13 12 represent about half of total debts and appear to be offset 11 by natural and financial hedges. However, suppliers of 10 PEMEX, the national petroleum company are exposed to 9 liquidity risks arising from delay in debt payments by 8 PEMEX.7 2008 2009 2010 2011 2012 2013 2014 2015 Source: Bank of Mexico 5. Key risks to the macroeconomic outlook are mostly external in nature and stem from the close connection to US markets, the dependency on oil Figure 3: Mexico’s Corporate Debt1 revenues, and potential resurgence of market (in percent of GDP) volatility. A negative U.S. growth shock would spill over 105 into Mexican growth through the strong trade links, and 85 the likely weakening of public and non-financial sector 65 balance sheets, ultimately weakening their repayment 45 capacity. Lower oil prices would weaken both the current 25 account balance and public finances, thereby requiring 5 Malaysia Chile Mexico India China Poland Brazil Hungary Philippines Turkey Indonesia Peru Russia Bulgaria Thailand Argentina South Africa further fiscal consolidation and generating upward pressures on interest rates, which would combine to reduce growth. Finally, a recurrence of global market External Debt Domestic Capital Market Debt volatility could translate in sudden capital outflows, Bank Loans Total Corporate Debt in 2010 stronger depreciation pressures could push authorities to Sources: Bloomberg, External Debt Statistics, Financial raise interest rates to stem the outflows, and this policy Soundness Indicators would increase debt service burdens and weaken the growth outlook. 6. A comprehensive financial reform was approved in November 2013 with the objective of increasing the financial sector’s contribution to economic growth. The financial reform encompassed revisions to the banking law and other legislation to encourage credit expansion. This entailed a more active role of development banks in extending credit and measures to ensure that private financial institutions would channel credit to productive activities. 8 Several legislative amendments sought to enhance the efficiency of the financial sector, including by revising the bank restructuring and resolution framework, by requiring all financial institutions to 7 Mining revenues declined considerably in 2015. To certain extent, dollar appreciation and natural hedges from foreign currency earnings have helped mitigate large margin declines and meet FX debt service. The authorities have taken actions to support PEMEX suppliers, including an extension of $15 billion to development banks to help pay PEMEX’s overdue loans, support to suppliers raising bonds from capital markets, an exempting banks from classifying restructured loans as NPLs for 12 months in five oil-rich states. 8 The financial reform sought to achieve these objectives by modifications and amendments to different financial sector related laws (Law of Credit Institutions (LIC), Law of Capital Markets, Law of Credit Unions, etc.) and with the creation of the Law of Financial Groups as per Decree issued on 10-01-2014. 6 report to at least one credit bureau, and by strengthening the oversight of anticompetitive practices and the consumer protection framework. (Appendix II) II. FINANCIAL SYSTEM STRUCTURE AND CHALLENGES 7. Numerous financial institutions operate in Mexico, however credit levels remain low and still lag behind regional averages. (Figure 4, Figure 5 and Table A1.2: Structure of Financial Intermediaries).9 Mexico has one of the most diversified financial sectors among peer countries and other countries in the region despite its relative low depth. Banking activities represent the largest share of the system assets and six development banks (DBs) accounting for 11 percent of assets. Pension funds have grown to represent 17 percent of financial system assets. Two large provident funds, Infonavit and Fovisste, originate two thirds of total mortgage loans.10 Other Financial Intermediaries (OFIs)— regulated and unregulated non-deposit-taking financial institutions (Sofomes),11 microcredit savings and credit institutions (Sofipos), cooperatives (Socaps) and Credit Unions, which a provide a limited range of financial services— are small, have a geographic focus, and represent less than 2 percent of total financial sector assets (Table A1.4: OFIs Key Indicators). Figure 4: Mexico’s Financial Sector Figure 5: Commercial Banks’ Total Assets (In percent of total asset) (In percent of GDP) Popular savings 210 Unregulated and credit Regulated Surety sofomes , 1.7 entities , 1.1 sofomes , 0.3 companies, 0.1 General deposit 160 Brokerage warehouses, firms, 3.5 0.1 Insurance 110 companies, 7.1 Development Commercial banks , 10.7 60 banks , 47.3 Mutual funds, 11.7 10 Indonesia Malaysia China India Turkey Brazil Mexico Pension funds , 16.4 -40 Source: Financial Soundness Indicators. Source: Bank of Mexico. 8. Domestic capital markets are unevenly developed with a very efficient government bond market, but shallow corporate equity and debt markets. Government bond markets are competitive, provide a reliable yield curve up to 30 years to price long term assets while non- government bonds outstanding barely reach 9 percent of GDP. Mexico’s corporate structure biased towards large corporations closely controlled by owner families has discouraged equity 9 Informality continues to play a major role in Mexico’s economy. Borrowing from private lenders (individuals and nonbank lending entities) and relatives remains a major source of financing and a challenge. 10 These are housing funds to which salaried employees in the social security systems for the private and public sector contribute, which have been historically providing housing loans to their members at low rates under specific conditions. 11 These are financial institutions that obtain funding from financial institutions and public debt issues, and perform operations such as leasing and factoring. A sofom cannot raise funds from public deposits, they account for only 1 percent of the financial system assets. 7 placements. The investor base is diverse with high participation of foreign investors, in particular in the government bond markets, mutual funds, insurance companies and pension funds. A. Banking Sector 9. Conglomerate structures are prevalent for the seven largest banks, all belonging to financial groups, five of which are internationally-owned. All of the largest banks (known as G-7),12 have been designated as domestically systemic for prudential purposes and the parents of three of them are designated as Global Systemically Important Bank (G-SIBs), namely Santander, Banamex, HSBC. The two locally owned banks are associated with industrial groups (Banorte and Inbursa). Ten more G-SIBs operate in Mexico although their operations are relatively small.13 Overall, banks belong to financial groups, which usually include a bank, a pension fund, a brokerage company, an insurance company, and a mutual fund-account for about 80 Figure 6: HHI for Commercial Banks 14 percent of total bank assets. 10. Asset concentration remains high yielding significant market power. The five largest financial groups hold about 70 percent of the banking system assets. The Hirshman- Herfindahl index (HHI) has been historically high although declining somewhat in recent times and the H-statistic places Mexico in worse competitive Source: CNBV. position that regional peers (Figure 6) (Box 1). 11. Development banks have been supporting an increasingly large share of private sector credit. DBs provide 19 percent of credit to the private sector both directly in first-tier (12 percent) and through second tier credits to intermediaries (7 percent). In addition, DBs provide guarantees for 12.6 percent of credit extended by the banking system (Figure 9). These shares are projected to rise in line with the lending targets established in the National Financing Plan (PRONAFIDE) to foster financial deepening, altering the traditional role of DBs from countercyclical to pro-cyclical. 12 In 2016, there were 49 licensed commercial banks in Mexico. 13 Eight of these operate as banks, namely:Bank of America, JP Morgan, Deutsche Bank, Credit Suisse, ICBC, Barclays, UBS and UBS and Mitusbischi UFJ. Additionally, Morgan Stanley and Goldman and Sachs operate as brokerage houses. 14 The subsidiaries include two Spanish banks (BBVA and Santander) leading in assets, followed by a U.S. bank (Citibank), a U.K. bank (HSBC), and a Canadian bank (Scotia bank). La Caixa has 20 percent of shares of Inbursa. 8 Box 1. Competition issues Concentration indices for the Mexican banking sector show potential limitations to a competitive provisioning of financial services and products. There have been no significant changes in the market share of Mexico’s largest banks in past five years and provision of financial services continues to be concentrated in the largest five financial groups which hold 71 percent of commercial bank assets, as compared to 66 percent in countries such as Chile and Colombia. Concentration is also high in financial infrastructure, with close to 80 percent of ATMs and bank branches belonging to the country’s five largest financial institutions and in the pension fund industry, with the largest four funds accounting for 70 percent of the system assets. H-Statistics calculations suggest Mexico operates under monopolistic competition. The statistic measures the elasticity of banks interest revenues to input prices. It will equal 1 under perfect competition, less than or equal to 0 under a monopoly, and under monopolistic competition between 0 and 1 (Table 1) as is the case for Mexico. Table 1: H-Statistics and Equilibrium Tests1 P-value P-value P-value for null long run Country H-statistic null: H=0 null: H=1 equilibrium condition Colombia 1.01 0.00 0.89 0.60 Chile 0.81 0.00 0.22 0.50 Mexico 0.64 0.00 0.00 0.91 Argentina 0.54 0.00 0.00 0.41 Turkey 1.27 0.00 0.12 0.03 Brazil 0.60 0.00 0.00 0.00 1 Calculated for commercial banks for 2010-2015. Calculations based on methodology in Claessen and Laeven (2004) Source: WB staff calculations based on CNBV and Bankscope data Gains in efficiency in the banking sector have been limited in the past 5 years. Intermediation margins of commercial banks appear to have increased slightly in recent years, when computed directly and do not show evidence of gains in efficiency (Figure 7). Mexican commercial banks’ overhead costs are higher than in peer countries such as Brazil and Chile, and have not been declining nor have administrative costs (Figure 8), and account for over 70 percent of gross income, well above many peer economies, while the spread between lending and deposit rates has been high and stable, at around 10 percentage points. Figure 7: Net Interest Margins Figure 8: Administrative Costs (in percent of asset) (in percent of assets) Based on Hansen & Rocha (1986) methodology Source: CNBV. Source: WB Staff calculations based on CNBV data 9 Figure 9: Development Bank lending DBs account for around 30 percent of banking sector … with expansion concentrated more in first tier credit… lending… (a) Direct and Induced Credit (b) First and Second Tier Lending (in percent of total banking sector credit) (billions of pesos) Source: CNBV Sources: CNBV … and led mostly by infrastructure, trade and SME …first tier expansion to the private sector… financing (c) Public and Private First Tier Lending (d) First Tier Lending by DB (billions of pesos) (billions of pesos) Source: CNBV Source: CNBV 10 12. Commercial banks show a sound financial position with capital and liquidity ratios well in excess of the Basel III-compliant regulatory limits (Table A1.5: ). Profitability and asset quality have been improving. NPLs are low Figure 10. NPLs ratio and well-provisioned, with the NPL to total loans (in percent) ratio declining steadily from a peak of 3.2 percent in 2013 to 2.6 percent in 2015 (Figure 10).Total capital adequacy ratio (CAR) stands at 15 percent for the banking sector, among the highest in emerging markets (Figure 11) while liquid assets represent about a third of total assets. 15 As of September 2015, all banks had met the minimum LCR requirement of 60 percent (Figure 12), with a large number exceeding the 100 percent requirement that will apply from 2019. Source: CNBV Figure 11: Regulatory Tier 1 Capital Ratio Figure 12. Liquidity Coverage Ratio (in percent) (in percent) 120 18 16 110 2019 Regulatory minimum 14 100 12 90 10 80 8 70 6 2016 Regulatory minimum China Malaysia Chile Russia Brazil Thailand Poland Indonesia Argentina India Turkey Mexico South Africa Philippines 60 50 Bank 1 Bank 3 Bank 5 Bank 7 Bank 9 Bank 11 Bank 13 Bank 15 Bank 17 Bank 19 Bank 21 Bank 23 Bank 25 Bank 27 Bank 29 Bank 31 Bank 33 Bank 35 Bank 37 Bank 39 Bank 41 Bank 43 Source: Financial Soundness Indicators Source: CNBV 13. Exchange rate risks are actively hedged. Foreign currency loans accounted for 13 percent of total loans in 2015, reportedly extended to corporations with FX revenues. 16 The use of OTC derivatives has reduced NOPs, but reflects in a gross derivative exposure relatively high - at 126 percent of capital - relative to other emerging market countries, also favored by the high liquidity in the peso FX markets. 17 14. Development banks show no signs of asset quality deterioration, however rapid growth warrants monitoring to ensure underwriting quality is not jeopardized. Capitalization levels are high at 14.1 percent, but have been declining (Table A1.3) and are 15 In March 2015, the Basel Committee declared Mexico in compliance of the regulatory implementation of the LCR, including for the LCR and LCR disclosure requirements subcomponents. 16 Prudential regulations are in place to limit FX risks, with caps on net FX open position (at 15 percent of Tier 1 capital) and liquidity requirements to limit currency mismatches. 17 Most emerging market countries have gross total derivative exposures of below 40 percent of capital. In 2006, Lehman Brothers’ total on-balance sheet derivative position was around 130 percent of capital. 11 unevenly distributed, such that the SHCP has reallocated dividends across DBs to ensure capital is sufficient to support each bank’s lending targets. Profitability has also been falling following the compression of intermediation margins by increasing deposit rates. The NPL ratio for all development banks has remained below 2 percent since 2010 and is lower than for private banks (Figure 10). Reported provisions levels cover 262 percent of NPLs. Vulnerabilities and Contagion Risk 15. Overall, the banking system appears resilient to adverse and severe macro-financial scenarios resembling past crisis episodes after conducting solvency and liquidity stress tests, as well as systemic risk analysis. 18 19 The stress tests covered commercial banks, including G-7 and the three largest development banks. The analysis focused on the adequacy of capital, provisions, and on the ability to face liquidity shortages of individual banks.20 Solvency stress tests used both bottom-up and top-down methodologies, using the same scenarios. Two negative macroeconomic scenarios were simulated over a three-year horizon, a short-lived adverse scenario (V-shaped) and a protracted recession scenario, (U-shaped) (Appendix IV). 16. Active balance sheet management would allow large banks to withstand significant credit losses but smaller banks would experience large declines in capital. As expected, a protracted recession would be more damaging to the banking system than a V-shaped recession. Managing balance sheets and reducing their credit exposures would allow banks to withstand the fall in earnings from the shocks, 21 but if defaults and thus expected losses were to increase, the system CAR could fall by as much as 6 percentage points, causing one of the G-7 banks to fail. 22 Some of the smaller banks would suffer significant capital losses of around 50 percent. Development banks were found to be resilient to both the adverse scenarios, after the re- distribution of withheld profits across DBs mandated by SHCP (Figure A4.5). 23 17. Only small banks are vulnerable to a foreign currency liquidity shortfall and to losses triggered by default of an individual firm. All large banks have ample liquidity in all currencies, although potential foreign liquidity problems appeared for a number of small banks24. The simulation of the impact on solvency of an individual firm’s failure which determines the worst possible contagion chain, i.e. the one that generates the largest impact on the system, all of the affected banks were small. The result is partly explained by banks’ low exposures to foreign financial institutions in response to stricter regulatory limits on net open positions in foreign currency. 18 The solvency stress tests were conducted by Banxico and the CNVB in close coordination with the FSAP team. 19 Based on the performance of the following risk metrics: probability of default (PD), loss given default (LGD), and delinquency rates, for banks accounting for more than 80 percent of the commercial banks’ assets.. 20 A bank would fail the test if its CAR falls below 8 percent. The threshold of 8 percent was taken despite the regulatory ratio of 10.5 percent to allow banks to take advantage of the full absorption capacity of the regulatory buffers under Basel III, although they would be subject to regulatory restrictions once ratios fall below 10.5 percent. 21 This occurs in bottom up stress tests. 22 To adjust the CAR for PD-based RW in a given quarter, the unadjusted CAR was multiplied by the ratio of the minimum required capital for a unit exposure, calculated using the bank-weighted PD at end-December 2015; to the required capital calculated using the bank-weighted PD at the end of the quarter. The required capital was calculated using the asymptotic single risk factor approach proposed by Basel. 23 The authorities also indicated that even if one or more development banks were to face capital shortages, as long as there was excess capital at the aggregate level for the development bank sector, the capital could be redistributed among the banks facing capital shortages to ensure all firms were adequately capitalized. 24 Representing around 15 percent of the system’s assets. 12 18. Spillovers to the banking sector would come from a combination of shocks on corporate sector balance sheets would be limited. Of the top 50 largest corporations, when subject to a combination of shocks to earnings, interest and exchange rates, only six companies could fall short of meeting debt service requirements.25 Given the current capitalization levels, banks were projected to be able to absorb these losses and remain solvent even in the worst case scenario (Figure A4.6). B. Pensions 19. The reformed pension system, based on defined contributions, will cause replacements rates to drop abruptly in 2034 when it will become fully effective. The projected replacement rates under the fully funded scheme are in the range of 28 to 34 percent as compared with the replacement rates offered by the pay-as-you-go scheme offered by the Mexican Institute of Social Security (IMSS), which are in the range of 80 to 100 percent of the last wage. However, since workers who started contributing to the system before 1997 are still entitled to receive their pension under the defined benefit rule, replacements rates will fall abruptly only when the reformed system becomes fully effective. (Table 2). 20. Significant increases in contribution rates will be necessary to ensure adequate income in old age. As current contribution rates are significantly below prevailing levels in OECD countries, to smooth the trajectory of replacement rates, authorities should increase in the contribution rates. As a further step, a sunset clause on the accumulation of benefits from the IMSS should also be introduced. This would avoid wide disparities in income among retiring cohorts of workers which could make the reformed system politically unsustainable when it becomes fully effective. Table 2: Expected Replacement Rates of the Mandatory Funded System Systema Men Women Mean 31.3% 31.3% 31.2% Std. Dev. 4.4% 4.6% 4.1% p50 30.8% 30.9% 30.7% P25 28.1% 28.0% 28.3% p75 33.9% 34.1% 33.6% 1 For IMSS workers Source: World Bank team calculations 21. Ensuring competition among pension fund managers has been challenging. With 70 percent of the system’s assets under management concentrated in the four largest pension fund managers (Afores), all belonging to financial groups, competition has taken place more on marketing than on investment performance.26 CONSAR has been seeking to manage the current fee setting process to generate persistent and gradual decreases in fees. However, close to half of the fees are still directed to remunerate the sales force and the proposed introduction of success fees to reward Afores’ good performance may emphasize short-term returns even further. Thus, 25 A corporation is defined to fall short of its debt service needs when the Interest Coverage Ratio (ICR) falls below 1. 26 Contributions to the fully funded system by individual accounts are managed by pension fund managers and placed in different funds (SIEFORES) organized in five categories according to workers’ age groups. 13 it would be important to maintain the current structure of fees, based exclusively on asset management fees, in line with international best practices. A Swedish-like system of blind accounts could help reduce the emphasis on marketing. By separating of the account management from the asset management functions (blind accounts) the asset managers do not have information about the identity of their clients and compete only investment performance. Thus sales persons cannot justify the switching of clients and consequently the business model disappears, thereby reducing marketing expenditures and fees. 22. Recent initiatives by CONSAR of establishing portfolio benchmarks are providing some incentives to the Afores to shift the focus towards long-term performance. Portfolio benchmarks are helping Afores to rethink the investment strategy but, to extent that tracking the portfolio remains voluntary, there are still incentives to modify the portfolios to show high short- term returns. Consideration could be given to designing a single long-term benchmark (lifecycle) which could help align the interests of the pension fund managers with those of the contributors better than the current multiple undisclosed benchmarks. Different portfolio allocations could be explained as movements toward an optimal long-term portfolio, while multiple investment styles (passive or more active strategies) while allowing for differentiated fees. However, it would be important that the single portfolio benchmark be designed by an independent committee to avoid any interference in the investment rules of pension funds. 23. Regulatory VaR limits on investments tend to skew allocations toward short-term assets. (Appendix V) Regulatory VaR limits adjust automatically as volatility increases to prevent fire sales, however they have been found to skew pension funds’ portfolio allocations too much towards minimizing short-term volatilities rather than the maximization of long-term returns.27 The regulatory framework for the use of derivatives by Afores also needs to be revisited. (Appendix V). While not all Afores are authorized to operate with derivatives, it would be important to carry out a comprehensive analysis of the role of investment limits, the CVaR differential, the internal control procedures, adequacy of reporting requirements, governance structure and adequacy of the infrastructure to ensure portfolios are not subject to excessive risk. Portfolio sensitivity analysis (Appendix V) showed that a combination of shocks could lead to significant declines in portfolio values, mostly because of holdings of fixed income securities holdings despite some exchange rate gains on foreign portfolios. 28 Annuity Providers 24. Annuity providers comprise pillar III, voluntary private income replacement schemes, of the Mexican system. The annuity market is a market that is currently concentrated in the segment of disability and survivorship. This annuity companies manage assets for approximately USD 15 billion and have four active participants that compete for clients through a quotation system, which is similar to the one that operates successfully in Chile since 2004. There are only four competitors in the annuity market, and two of them with a market share of 27 Since the automatic VaR adjustment was introduced in February 2010, the regulatory limits have been adjusted 14 times in line with market volatility. There is a period of six months to regularize compliance to regulatory limits where there are breaches. 28 A market risk sensitivity analysis was performed on 73 pension funds (covering 100 percent of total assets under management). The exercise was similar in nature to the insurance sector analysis, but also assumed: (a) inflation linked bonds are revalued with reference to UDIBONOs, and (b) overseas equities in developed markets are revalued using shocks to the S&P 500 Index, and equities in other emerging markets are revalued based on shocks to the MSCI Emerging Market Equity Index. 14 approximately three quarters. However, the margins of operation are so tight that, while bringing new actors into the market may help to make this market more sustainable, it is not evident there are incentives for new entrants 25. The liberalization of the reference rate of annuity providers in 2014 increased competition in the industry. Such liberalization, in line with previous FSAP recommendations, has allowed price differentiation which resulted in further increases in the interest rate offered to clients. This has reflected in reductions in the transfers to annuity providers that both the IMSS (Mexican Institute of the Social Security) and the ISSSTE (Institute of Insurance and Social Security for Civil Service) make on account of the total pension entitlements of their workers. However, the near-absence of liquidity at the longer end of the inflation linked yield curve complicates pricing and investment strategies for annuity providers. 29 C. Insurance 26. The insurance sector was found to be sound, profitable, and liquid (Table A1.5). The insurance sector remains small (7 percent of total financial system assets) absent mandatory insurance protection in the Mexican framework. Non-life insurance premium accounts for 53 percent of total premia. Insurance companies are well-capitalized, with the solvency ratio standing 1.9 in 2015, the technical reserve coverage ratio at 1.1, and the ratio of liquid assets to current liabilities at 3.5. Mexico has introduced new regulations requiring the implementation of Solvency II-type risk-based capital and mark-to-market valuation of assets and liabilities. 27. Investment portfolios of insurances are generally resilient to market risks however, they are vulnerable to increases in interest rates. 30 Portfolios are largely invested in fixed- term government securities held till maturity (60 percent of total securities) with a relatively high share of foreign currency securities (17 percent of total securities). 31 32 Solvency ratios of insurance companies increase when simultaneous shocks are applied in both scenarios used for banks stress tests, U-shape and V-shape, as the revaluation losses in mark-to-market securities are largely offset by exchange rate gains on foreign securities holdings. 33While, insurance funds are very sensitive to interest rate shocks, 34 given large holdings of fixed income securities, the insurance sector was found to be is generally resilient to a combination of interest rate, exchange rate, and equities market shocks (Figure A4.9). 29 The Brazil government is currently piloting this innovative approach for debt issuance, and it has the potential of bringing other clients into the long term market, including foreign investors. 30 The shocks applied to the portfolios implied a combination of interest rate, exchange rate, and equity market shocks, using parameters similar to the banking sector stress test (Appendix Table 5) estimating losses for: (a) all shocks materializing simultaneously, (b) interest rate shocks alone, (c) exchange rate shocks alone, and (d) equity market shocks alone. Portfolios for the10 largest insurance companies representing 80 percent of insurance assets were taken into consideration. 31 Regulatory limit of 20 percent of net investment base portfolio. 32 Revaluation of liabilities is not taken into consideration in this exercise, thus the reported figures are conservative, and the overall impact could be substantially less. 33 In this exercise, CNSF also took into consideration the compensation effects between assets and liabilities in foreign currency by applying similar exchange rate shocks in the valuation of technical reverses. 34 Two to four insurers were projected to end up with solvency ratios below 1, but with a limited capital shortfall, at only up to 3.7 percent of assets. 15 D. Mutual Funds 28. Mutual fund portfolios are concentrated Figure 13. Fixed Income Mutual Funds: on liquid assets, and benefit from a range of tools September 2015 to manage redemption pressures. Mutual funds’ Others Public Sector assets under management have more than doubled 5.4% from 2005, to 11 percent of GDP in 2015. Most Investment funds Bank securities funds active in Mexico are short-term debt funds 3.6% 10.5% Non-financial (Figure 13). Constant asset value funds are not Private 7.0% allowed. Funds must state the minimum proportion Cetes, Bondes, Bonos, IPAB (repo) Udibonos of liquid assets they will hold and the redemption 9.5% (direct) 31.9% terms. Cetes, Bondes, Bonos, Udibonos (repo) IPAB (direct) 18.1% 14.1% Source: CNBV E. Other Financial Intermediaries 29. OFI are small in size and have scarce resources but they attend a relatively large share of the population. Size, resources, and some regulatory constraints hinder the expansion of operations. The smallest OFIs have been plagued by low profitability and weak corporate governance (Table A1.3). The Sofomes, the largest sector among OFIs, have not recovered operations since the global financial crisis and have struggled to fund themselves from anything other than public sector credit lines. Some of the other OFIs are also limited by regulations in the range of financial products the offer, thus are constrained in expanding activities. 30. Authorities have recently extended the regulatory perimeter to certain OFIs and both regulated and unregulated OFIs are now subject to market conduct supervision and mandatory reporting to the credit bureaus. In 2014, an after the recent failure of a SOCAP, legislative changes have assimilated OFIs and banks in certain aspects. However, still differentiated legal and regulatory frameworks different OFIs are straining supervisory resources and should be minimized to simplify the supervisory process, promote integration of OFIs sector, and increase competition. 35 Authorities could consider replacing the current four levels of operations of OFIs with a system that links the authorized operations with the implementation of necessary prudential requirements, so that well managed financial institutions could compete by providing a higher range of products, while subject to appropriate prudential requirements. 31. The sector would benefit from some degree of consolidation. In particular the articulation of common initiatives (e.g. through second tier institutions) involving, for example the development of common IT systems (e.g. core banking), products and services, the provision of auditing services, and certain back office services, among others, could improve profitability and efficiency. 35 SOFOMs remain unregulated. SOCAPS and SOFIPOs are overseen by auxiliary supervisory committees and federations, but solely SOFIPOs designate which federation will exercise auxiliary supervision. The reduced number and urban location of these institutions, as well as the conflicts of having the federations as supervisors, turns preferable the direct supervision of CNBV. 16 III. FINANCIAL MARKETS 32. The money markets are well-regulated and function efficiently, with few unsecured interbank transactions and restrictions on leverage of financial intermediaries. Almost all transactions are overnight and unsecured transactions account for only around 4 percent of the total. Banks also undertake a significant volume of customers repos (17.7 percent of liabilities) motivated by avoidance of the deposit insurance levy (around 40 basis points). All assets used as collateral in repo must be liquid, as determined by Banxico, and only banks and brokerages are allowed to borrow through repo transactions, thereby constraining leverage in OFIs. 33. A sound and transparent debt management strategy enhances liquidity in sovereign bond markets. Participants have certainty about the SHCP issuance plans with annual announcements and quarterly updates on volumes and instruments. Most hedging is done through the interest rate swap market, which is very liquid. While bid offer spreads remain narrow (around 1 basis point for on-the-run Mbonos), trade sizes have been declining over recent years, although overall volumes remained robust. In 2014, pre and post trade transparency requirements were clearly set for transaction in electronic platforms and about 24 percent of trades take place through such platforms. 34. The Mexican Peso is the eighth most traded currency in the world as ongoing changes in market activities pose challenges for effective monitoring. Liquidity in the Peso markets also stems from hedging activities on other emerging market currencies. Oversight of the foreign exchange market is complicated by the increase in electronic trading, the high proportion of trades done outside of Mexico, and the rise of algorithmic trading. The level of offshore investment in government securities market has potential ramifications for the foreign exchange market in the event of a reversal of long bono positions. IV. FINANCIAL MARKETS INFRASTRUCTURE A. Payment Systems 35. Banxico has taken a lead role in developing a comprehensive national payments system (NPS). Banxico operates a number of the Mexican payment, clearing, and settlement systems. There are three systemically important payment systems in Mexico, 36 an agency providing deposit and custody services for all registered securities37 and two central counterparties (CCPs) for settling securities trades. 38In April 2016, Banxico launched an interbank settlement system in dollars, with the objective to facilitate and increase the efficiency 36 These comprise the Sistema de Pagos Electrónicos Interbancarios (SPEI) a near real-time, hybrid electronic funds transfer system, owned and operated by Banxico, and Sistema de Atencion a Cuentahabientes, SIAC – a central bank-operated system to implement open market operations and administering intraday liquidity. SIAC is a real-time gross settlement (RTGS) system, and has been operating since 1990. 37 INDEVAL. 38 The Contraparte Central de Valores de México is a for traded stocks but does not qualify as a payment system under the Payment System Law. ASIGNA Compensación y Liquidación is the CCP for all derivatives contracts traded on MEXDER market and, since 2014, on trading platforms. 17 of local USD-denominated interbank transfers. 39This system allows reducing the reliance on correspondent banks in the US and on checks in USD. 40 36. Banxico ensures the smooth functioning of the payment system as a whole through the SPEI, and it has been working to improve its functionality to conform to market needs. The SPEI is overseen by Banxico’s board, which approves material decisions on design and risk management. However, the oversight division should have an independent reporting line, additional to the current one, in line with international best practices. In addition, stakeholders in the SPEI should also be involved in decision-making processes, leaving Banxico to elaborate the risk-based participation criteria. The creation of a users’ committee would increase transparency and accountability. 37. Liquidity risk is borne solely by SPEI participants, with intraday liquidity provided by Banxico under pre-established limits. Banks overdrafts are collateralized against banks’ cash deposits at Banxico, and only Federal Government securities can be used as collateral for intraday repos. Any credit has to be re-paid by the end of day or a penalty rate applies. Collateral pledged in repos is marked-to-market daily and haircuts are conservative. 38. The operational risk management framework of SPEI is robust. Banxico internal control system assigns clear responsibilities with regard to the identification, monitoring, and management of sources of operational risk. Controls encompass all DSP-managed systems, and include backup facilities. It has defined operational reliability objectives and indicators and the system’s performance is reported to the Board and disseminated publicly as appropriate. B. Insolvency and secured creditor rights 39. The financial reform introduced many needed amendments in the Mexican insolvency framework, 41 in line with the recommendations of the 2012 ROSC. 42 In particular: the influence of related parties in the voting on a reorganization plan is reduced; there is a procedural consolidation of large corporate groups in insolvency; debtors are allowed to file for reorganization (“concurso�) in cases of imminent insolvency; and first priority post- commencement financing in now allowed for distressed businesses.43 However, preserving the going-concern value of businesses during Mexican lengthy insolvency proceedings continues to remain challenging, in particular because enforcement actions for workers’ claims are not stayed during the conciliation process as occurs with those of secured creditors. 39 Sistema de Pagos Interbancarios en Dolares (SPID). 40 SPID participants are banks that offer USD accounts to legal persons in Mexico, and that meet enhanced anti-money laundering/combating the financing of terrorism (AML/CFT) requirements. The system allows no credit between participants or with Banxico. 41 The Ley de Concursos Mercantiles (LCM) governs the insolvency of companies is a federal law and the federal courts have exclusive competency over its application. The LCM states that it is a matter of public interest to preserve companies and avoid the general non-payment of obligations. 42 In 2012, the World Bank, at the request of the Government of Mexico, conducted an Insolvency and Creditor Rights (ICR) assessment under the joint Bank/Fund Standard and Codes Program. The assessment produced a detailed benchmarking of the Mexican ICR framework in the form of a Report on the Observance of Standards and Codes (ROSC). 43 This amendment was accompanied by changes to banking regulation which also reduced provisioning requirements for post- commencement loans. 18 40. Some features of the insolvency procedures may be making out-of-court restructuring a common feature. In particular, there is hardly any use of creditor committees or creditor meetings, which makes it difficult for those with economic stakes to determine how the insolvency proceedings will be managed. To underline this, in the last ten years there have been an average of only 43 cases of commercial insolvencies, while out of court restructurings are common. However, for the successful conclusion of out of court restructurings there is still an need for a set of principles and good practices adopted by financial entities for the negotiations of debt restructurings to facilitate cases involving several financial entities. 41. The legal framework for secured lending through immovable collateral (real estate) works relatively well while that for through movable collateral (equipment, inventory, accounts receivables and cash) has been modernized. However, origination costs are high and enforcement takes an average of 36 months, even for real estate collateral and high costs (notary and registration fees) add significantly to loan fees. Movable assets can be used as collateral under the guarantee trust and the non-possessory pledge, although recent reforms missed consolidating the long list of existing security mechanisms into a single uniform law. The guarantee trust structure allows a creditor to immediately seize ownership of the property without court involvement upon default, but it is expensive (given the duties required of a trustee) and seldom used for SME loans. By contrast, the non-possessory pledge is accessible, but enforcement has traditionally taken place through the courts, generating uncertainty and increasing credit risk. Accordingly, prudential lending standards followed by the banks, allow the use of the guarantee trust without the need for cash reserves at loan origination, but do not provide this incentive to the use of the non-possessory pledge. 42. The procedure for the extrajudicial enforcement of movable collateral still needs to be tested. The reforms introduced an extrajudicial remedy for cash deposits claims and a new federal jurisdiction. For these to become fully effective, implementation is critical in both state and federal courts. Similarly, the framework for movable collateral also benefited from the creation of a modern collateral registry (Registro Único de Garantías – RUG), though challenges remain in terms of its on-line functionality, system capabilities, high-volume registrations, and user friendliness. 43. Out-of-court restructurings have not allowed the enforcement of secured interests and precautionary and procedural action can add significant delays. Despite the recent reforms which added out of court enforcement for security interests in deposit accounts, court- based enforcement is still the norm, and judicial proceedings still do not differentiate between immovable and movable collateral. In the latter case, the process generally outlasts the period of utility or economic value of the movable goods which, unlike real estate, can depreciate rapidly and can be removed from their original location. In addition, courts have been protective of small firms, and have not been supportive of efforts to realize collateral. C. Credit Reporting Systems 44. The credit reporting systems in Mexico is composed by two consumer credit bureaus and one commercial credit bureau. Buro de Credito and Circulo de Credito serve the consumer credit market with comprehensive credit information and sophisticated value added services. However, the credit bureau industry is largely based on consumer credit and there is 19 little attention paid to SMEs. Along the years, a number of international credit bureaus have tried to enter the market but with no success. Legal and regulatory reforms, also enabling data sharing, have resulted in increased reporting to the credit bureaus by financial intermediaries, which includes exchanges of both positive and negative information. 45. Despite recent enabling legislation, there is no credit registry to capture borrower information from credit provided by regulated entities. The information in the current system is not granular enough and does not cover all entities that provide some type of finance to the micro and small and medium enterprise sector (MSMEs).44 In this respect, a well-developed credit registry could be used for financial supervision and regulation and would allow authorities to better monitor the credit market without requiring consumers’ consent, to improve the quality of the database through centralizing the information in a specialized unit, and to have a unified diagnosis of the credit information within the country. 46. There may be cases when the business interests of shareholders and board members could conflict with the operations of the credit bureaus. The shareholders of the bureaus are the largest banks and they may have limited interests that the bureaus develop products allowing for increased competition for certain clients. Additionally, some Board members are also associated with technology service providers, and could actively oppose decisions conflict with the interests of such providers. As a result, there appear to be few incentives for bureaus to develop value added services. 47. Identification of individuals and companies could be improved by adopting a unique identification number for individuals and companies. The efforts led internationally by Legal Entity Identifier (LEI) could help the authorities in Mexico to develop a common identifier which is also broadly used in financial sector globally. V. MICRO-PRUDENTIAL REGULATION, SUPERVISION AND OVERSIGHT 48. Significant progress was made to enhance the effectiveness of the regulatory and oversight framework by strengthening the prudential regime and the legal framework for financial groups, in line with the recommendations of the 2012 FSAP. 45 The CNVB has also, among others, revised limits for related party lending, and implemented Basel III capital framework and introduced, together with Banxico, Liquidity Coverage Ratios. In addition, the resolution regime for insolvent banks was strengthened as were the CNBV’s sanctioning powers for large infractions. 49. Important gaps still remain in the area of CNBV’s operational independence, budget autonomy, and legal protection, which risk jeopardizing supervisory effectiveness.46 Such weaknesses were also noted in the past FSAPs. All the CNBV Board members are ex- officio, and five out of 13 are directly appointed by the SHCP with other five members being indirectly under SHCP’s control. The Board positions have no defined terms and the reasons for 44 The CNVB captures information for the system through the supervisory reporting file R04, while Banxico captures information from the regulated entities through the Portfolio Responsibilities Relationship Report (previously SENICREB). 45 The 2016 FSAP conducted a focused review of the regulatory and supervisory framework of banking and securities. The review covered aspects deemed material, including the 2014 reforms, and gaps identified in the 2012 FSAP 46 Most of the income of CNVB is based on fines, which could lead to rent-seeking incentives and the imposition of fees associated with non-material infractions. 20 the dismissal of board members or the president are not clearly specified. The CNBV lacks autonomy on its own budget, which is approved by the SHCP, has been subject to a salary freeze that has been in place for well over a decade which has resulted in unusually high staff turnover and a number of vacancies that raise concerns on capacity to perform high quality supervision.47 Finally, the legal protection framework for supervisors is still limited and does not provide statutory immunity to the supervisors for the lawful performance of their duties.48 50. The SHCP has responsibilities in public policies for development which might compete with the safety and soundness objectives of CNVB and CONSAR. In addition, the new LIC charges the CNVB with the performance evaluation of banks with respect to developmental targets, which might conflict with CNVB’s stability objectives. In this context, it is important that authorities ensure that there are no changes in the prudential requirements on an ad hoc basis. Loans should continue to be appropriately classified in line with their risk profile, to ensure that the risk assessment of the lenders loan portfolios is not distorted. In addition, CNVB should pursue practices essential to support the conduct of risk-based supervision. 51. At CONSAR is important to ensure that interests of contributors are represented while designing new regulations. The independence of Consar could be further strengthened by appointing of a board of directors, nominated by the government and ratified by the Senate. Board positions could be full time and incompatible with other government appointment. Board members should have a fixed term mandate, for example of 10 years, and positions will be renewed in a staggered way, in order to ensure continuity in the decision making. A. Banking 52. The CNBV has been developing a more risk-sensitive approach to supervision. Supervisory activities are composed of a mix of on-site examinations and off-site surveillance, supported by a broad set of data, reports, and dedicated and knowledgeable staff. In addition, the CNBV performs system-wide assessments on particular topics, model validation (credit risk), stress testing and other functions. The CNBV has put significant efforts over the last two years in developing a more risk sensitive supervisory approach and standardizing tools and reports. 53. The CEFER, an important element of risk-based supervision, is yet to achieve its full potential as a supervisory rating system. The CEFER aims to be a systematic and structured mechanism to evaluate risk, while minimizing idiosyncratic assessment through a framework of quantitative and qualitative key risk indicators. Notwithstanding recent improvements, further enhancements are needed to ensure that supervisory priorities and concerns are contemplated more fully in CEFER, and to incorporate the systemic relevance in the rating. While all systemic banks are subject to a minimum of a general inspection a year, the decisions on minimum periods for examinations should be based on the CEFER. 47 A dedicated legal fund (fideicomisso) is in place to cover legal fees of active supervisors being sued for decisions made in bona fide, there is no protection after the bona fide discharge of official functions. 48 The early preventive actions framework referred to here, sometimes denominated PCA (prompt and corrective actions), refers to actions the supervisor may ask a financial institution to take when it sees the financial health of the institution deteriorating rapidly and expects it to become in breach of regulatory requirements, including Pillar 2 absent corrective actions. These powers should be different from the “prompt corrective action� powers described in the CNVB website that are triggered once regulatory thresholds are breached. 21 54. Resources do not seem to be allocated on a risk-basis approach. Disproportionate staff resources seem to be allocated to administration (about 20 percent) and the oversight of development banks and OFIs (about 40 percent), despite constrained resources, many vacancies, and the increased complexity of supervisory issues. In contrast, resources allocated to commercial banking supervision, including on operational risk, AML and on-site examination, are stretched and further diluted by requiring the assigned teams to supervise specific OFIs, such as general deposit warehouses, certain foreign exchange bureaus, and SOFOMES that issue debt. 55. The CNBV has broad corrective and sanctioning powers but no policies to request early preventive actions before regulatory triggers are reached, including Pillar 2 requirements. CNBV powers include, among others, imposing limitations on dividend payments, limitations on operations, as well as changes in management. Sanctioning powers include mandatory fines for serious law violations and fines on individuals such as bank directors and management. However, under the Banking Law, the trigger points for implementation of corrective action are the required minimum capital (including the capital conservation buffer) and liquidity levels. The thresholds are evaluated using past data, implying action is taken only when capital and liquidity levels are already below the minimum. 56. A fully functioning consolidated supervision framework is not yet in place. The Financial Groups Law enacted in 2014 has increased the CNBV powers to exercise consolidated supervision but its effective implementation is incipient and incomplete. The regulatory reporting framework for related party lending has been strengthened. FHC are required to report financials on a consolidated basis but are not subject to prudential requirements on a consolidated basis. However, CNBV has no legal power to request information directly from companies linked to supervised banks and OFIs within the FHC. There are also no procedures in place to systematically monitor those companies or to be acquainted with the strategies, governance and perspectives of the group as a whole. In addition, capital requirements and related party and concentration limits are required on an individual entity basis. Coordination arrangements with CONSAR and CNSF are in place and are used to coordinate examinations, however there is no evidence of cooperation to establish procedures to systematically monitor banking groups. 57. The definitions of “common risk� and “related party� should be enhanced. Currently there is no explicit definition of “economic dependency� in exposures to corporations,49 and no provision for grouping loans that are collateralized by the same collateral. The definition of “related party� is currently framed largely in terms of quantitati ve parameters, but there are no explicit references to persons who, while not having a quantitative relationship with other borrowers, exercise significant control over those other borrowers. 50 Changes in the law are needed to give the CNBV discretion power in determining what constitutes connected exposures and related party. 58. Corporate governance rules for commercial banks are comprehensive but could be improved to allow the CNBV formal powers to approve the appointment of a CEO (or other key senior positions) on an on-going basis. In addition, the CNBV could enhance its oversight of 49 The Securities Markets Law and amendments to the Law on Credit Institutions. 50 Economic dependency could occur where one borrower, although not related to another borrower, could depend on that other borrower for its livelihood, e.g. in the case of a major supplier. If the first borrower runs into financial difficulties, it could have adverse impact on the second. 22 the Board by periodically attending Board meetings to help it assess the effectiveness of individual directors and the workings of the Board as a whole. Finally, the Audit Committee advises the Board on the design and implementation of the internal control system, giving rise to potential conflicts of interest in that the Audit Committee, through the internal audit function, would be asked to adjudicate on its own work. 59. Corporate governance rules for DBs should be revised in line with international best practices in some key areas. The composition of DB board members and the mechanisms for the election of CEOs could be strengthened to assure some representatives and all CEOs have demonstrated financial sector expertise and that decisions are taken independently of political pressures. Also according to best practices, DBs should operate in a way that is directed at maintaining their financial viability and preserve their capital base, to avoid undue calls on fiscal outlays and their price-setting does should not distort competition in the markets. 60. The role of Banxico in providing an opinion when CNBV imposes additional capital requirements should be reviewed. It would be important to strengthen CNBV independence as a supervisor that Banxico’s opinion may not be sought in matters concerning capital requirements. As the agency charged with the prudential supervision of banks, should assume sole responsibility for such functions, however there would need to be legislative changes for this. 61. Unlike commercial banks which must comply with the LCR, development banks do not have to observe any liquidity ratio. Banxico calculates the LCR for development banks using the same methodology of commercial banks, but development banks are not required to meet any minimum requirement. The rationale is based on the notion that the Mexican State is the guarantor of development banks and that these banks rely largely on wholesale funding, which makes the LCR to be a non-suitable measure of their liquidity levels. DBs monitor liquidity levels held at Banxico for internal purposes and have begun to extend the profile of their liabilities to limit funding gaps. Nonetheless, all banks, including development banks, should be subject to some form of liquidity measurement discipline. 62. There are significant shortages in AML on-site inspection personnel. The AML supervisory regime appears to be well-developed (see Box 2 on de-risking issues). However, implementation is seriously compromised by the inadequate level of on-site surveillance. There are two inspection teams to cover 456 institutions, including banks. 23 Box 2. De-Risking Mexican financial institutions suffered from international de-risking, especially from the U.S. A number of U.S. banks closed their correspondent accounts of a number of Mexican financial institutions, prohibited transactions of their clients with certain Mexican financial institutions, encouraged domestic de-risking practices, and restricted the repatriation of U.S. dollars by some Mexican financial institutions. The large G-7 banks were not affected by the U.S. banks decisions, while the impact has been mostly on small and medium sized-banks and OFIs. As a response the authorities have taken pro-active steps to adopt higher standards and change perceptions. In the last three years, efforts aimed at strengthening the country’s AML/CFT regime and cover FATF standards. The central bank is implementing tools to facilitate and strengthen domestic banks Know Your Customer and due diligence process. Work also focused on the implementation of risk-based supervision and enhancing infrastructures in the sector. The authorities have also been engaging with the U.S. authorities via working groups, unilateral information sharing from Mexican banks on their clients with the U.S. and foreign banks, and seek for guidance from different international fora including the FSB’s Correspondent Banking Coordination Group. The IMF comprehensive assessment of Mexico’s application of the FATF 2012 recommendations is to take place between August 2016 and October 2017. 63. The accounting and auditing framework for banks could be strengthened. Currently, IFRS is used for all listed companies except listed banks which use the Mexican Financial Reporting Standards (MFRS) plus certain accounting criteria issued by the CNVB. To ensure transparency and effective reporting, IFRS could be extended to all listed banks while maintaining the supervisor’s powers to set adequate prudential provisioning requirements and their deductibility from taxable income should be provided for in relevant legislation. In addition, external auditors should be given explicit protection regarding breaches of confidentiality when informing the CNVB of matters of significance in banks. It is also recommended that the CNBV provide for rotation of external audit forms (in addition to the current practice of rotating audit partners and teams). B. Securities 64. As of 2014, new powers to regulate and oversee securities markets were granted to CNBV’s, while Banxico was charged with regulating and supervising derivatives. The new legislation defines CNBV’s powers to enact and enforce regulations over a broad range of entities. The regulation and oversight of derivatives instruments is to be performed by Banxico while the regulation of derivatives exchanges and central counterparties relies on provisions jointly issued by the SHCP, Banxico and CNBV.51 Furthermore, a law for OTC derivatives is not yet in place, which could impair the enforcement by the CNBV of current regulations in this area. The CNBV is to formally start applying strengthened risk-based supervision in the securities area for intermediaries in 2017. 65. CNBV’s capacity to enforce regulations was strengthened, in line with previous FSAP recommendations, however, implementation could be impaired by staffing constraints. Poor enforcement was linked to inadequate policies, poor guidance, lack of 51 As detailed in the FSAP Technical Note on Supervision and Regulations. 24 procedures supporting a prompt attention of the requests for sanctions, and, most importantly, the lack of legal option to abstain from imposing a sanction. The guidelines for using the abstention to sanction option are now in place and the backlog of has been cleared increasing the effectiveness of the CNBV’s oversight. However, the CNBV allocate less than 8 percent of its staff to carry out tasks related to the securities markets. Retention of qualified experienced staff, particularly at senior levels, has been an issue due to the lack of budget autonomy of the CNVB (see above). VI. STRENGTHENING FINANCIAL SECTOR OVERSIGHT GOVERNANCE AND INSTITUTIONAL ARRANGEMENTs 66. Despite significant progress in several areas, the governance of the supervisory framework governance remains an important concern. Persistent weaknesses in the supervisory arrangements and governance, as documented by this and previous FSAPs, could potentially undermine the supervisor’s credibility and ability to effectively implement the regulatory reforms, and monitor and address rising and new risks. The governance weaknesses have, at times, led the SCHP and Banxico to take actions, outside their natural mandates, in support of the supervisor; further undermining the supervisor’s credibility. 67. Reforms to the current governance arrangement should ensure the institutional, supervisory, and budgetary independence of supervisory agencies. Safety and soundness of the supervised institutions should be the clear and primary mandate for the supervisor. Other mandates (e.g., development) are secondary and should be narrowly defined. Institutional independence requires governing boards composed of independent members, clear rules and process for the appointment and dismissal of senior personnel,52 and transparent decision making process. Supervisory independence provides the supervisor with the capability to use the tools needed to ensure the stability of the financial system by exercising its judgment and powers, including with respect to licensing, on-site inspections and off-site monitoring, sanctioning and enforcement. Budgetary independence allows the supervisor to plan its budget and to allocate budgetary resources according to priorities that are set within in pursue of its mandate. 53 68. Autonomous supervisory functions could be performed under different architectural structures. Alternatives to the current supervisory model could be considered to address the specific problems affecting the Mexican financial sector. In particular, an integrated supervisory approach could enhance the effectiveness of supervising financial conglomerates that dominate the financial system in Mexico. In some countries consolidating all financial supervisory functions into a twin-peak arrangement has worked well. VII. MACRO-PRUDENTIAL POLICY FRAMEWORK 69. The Financial System Stability Council (CESF) has sought to strengthen coordination and collaboration in the identification of potential risks. The formal mandate to 52 Established by Presidential Decree in 2010 and recognized by law in 2014. 53 This concern extends as well to IPAB, as discussed in section B , Chapter IX, and the CNSF (although the insurance sector has not been assessed in this FSAP). 25 promote financial stability sits with the CESF,54 which has provided a dedicated platform for collaboration and coordination, but is has no authority to prepare and execute macro-prudential policies in the pursuit of financial stability. Authorities could consider revising CESF’s arrangements to enable it to formulate appropriate macro-prudential policy recommendations after ensuring these will not reflect undue political considerations.55 70. There is still no formal arrangement at the CESF for systemic crisis management or any contingency plans. Each agency, including IPAB, the resolution authority, should envision the conduct of a crisis simulation exercise for a systemic crisis or the failure of a systemic bank, to test the effectiveness of the authorities’ cooperation and their ability to communicate effectively in times of crisis. VIII. SYSTEMIC LIQUIDITY: FRAMEWORK AND RISKS 71. Banxico’s operating framework fully supports the efficient pricing and distribution of liquidity in normal times. While there is a relatively narrow range of accepted securities, for intraday liquidity purposes, outstanding amounts and amounts held by financial institutions are significant. Banks have certainty about day-to-day liquidity conditions and have access to a collateralized overdraft facility in the event of operational problems. To-date, the accepted collateral pool has not been a constraint on Banxico’s ability to conduct operations efficiently. 72. The LCR is being implemented in Mexico in line with the internationally agreed timetable. Current required compliance is 70 percent while all major banks are above 100 percent. It is expected that the LCR will eventually be applied in foreign currency but for the moment the existing foreign currency liquidity metric, which is more stringent than the LCR, will continue to apply. Banks must also provide annually a Contingency Funding Plan to the CNBV, detailing the sources of funding and procedures for dealing with liquidity stress. 73. Banxico has made good progress in upgrading its contingent liquidity arrangements – an outstanding issue from the last FSAP. There are two levels of potential support: i. Standing Additional Ordinary Liquidity Facility and ii Emergency Liquidity Assistance (ELA) for extra- ordinary liquidity needs of solvent banks. Loans from both facilities are subject to eligible collateral requirements. IX. CRISIS MANAGEMENT AND FINANCIAL SAFETTY NETS56 A. Bank Recovery and Resolution 74. The special resolution regime for insolvent banks was enhanced by including, among others a regime for insolvent banks, in line with the recommendations of the 2012 FSAP. This includes clear timeframes for resolution actions, a clarified the role of courts –in 54 This could be the case if formal voting arrangements were introduced in the CESF, and a recommendation was made by majority vote. 55 In a systemic liquidity event, the regulators can relax the LCR. 56 The mission reviewed institutional arrangements, the legal framework, policies and practices and used Financial Stability Board’s Key Attributes of Effective Resolution Regimes for Financial Institutions (KA), as a point of reference for formulating relevant FSAP recommendations. A detailed assessment of the Deposit Insurance was undertaken to evaluate compliance with the Core Principles for Effective Deposit Insurance Systems utilizing the Methodology for Compliance Assessment adopted in December 2014 by the Bank for International Settlements and the International Association of Deposit Insurers. 26 particular the courts’ ability to suspend resolution actions was removed— an expansion of the powers of the deposit insurance agency (IPAB), and, a strengthening of the process to conduct purchase and assumption (P&A) transactions. These changes have brought the legal regime more in line with the “Key Attributes of Effective Resolution Regimes� 57 58 75. The institutional arrangements are clearly defined, among IPAB, the resolution authority, CNBV, SHCP, and Banxico. The heads of the four bodies act collectively as the Banking Stability Committee (CEB) and are empowered to determine whether a failing bank is systemic and therefore to trigger a special resolution process. However, the representatives of SHCP on the boards of CNBV and IPAB potentially could allow for the SHCP to have a stronger role in the decision making process than its institutional position would otherwise convey. 76. The CNBV retains discretion in establishing the operating regime of a bank until the CET1 capital falls below 4.5 percent. When a bank has a capitalization index between 10.5 and 4.5 percent, CNBV may allow it to continue operations provided that corrective measures are in place and if capitalization falls below 8 percent (but CET1 remains above 4.5 percent), a capital restoration plan has to be developed. Alternatively, CNBV could put the bank under a conservatorship regime by appointing a temporary administrator if capitalization falls below 8 percent, or when the CET1 falls below 4.5 percent and the bank is deemed systemic. Automatic revocation of the license would occur if the CET1 falls below 4.5 percent and the bank is not deemed systemic. 77. Potential delays in initiating the resolution process may prove very costly to IPAB. It would be important for CNBV to develop written guidelines to include consultations with IPAB whenever a decision is made not to revoke the license after capital falls below 8 percent. These should define the terms under which a bank is allowed to operate with capitalization below 8 percent and CET1 above 4.5 percent and IPAB should be able to influence such terms and conditions, as timely entry into resolution allows for maximizing recovery values. 78. There are still areas that require to be enhanced to ensure an effective resolution process. It would be important to extend the special resolution regime to FHCs given Mexico’s financial sector structure. In addition, the temporary administrator should have powers to impose losses on shareholders, most importantly, during all stages of the regime of Open Bank Assistance, which allows IPAB to recapitalize banks that are deemed systemic. Furthermore, resolution actions through purchase and assumption (P&A) with third parties may be constrained by legal provisions strictly restricting information sharing ahead of P&As. 79. Recovery and resolution planning are underway. While all banks submitted recovery plans for the first time in March 2016, CNVB could increase guidance. IPAB has been in charge of guiding the process of formulating resolution plans and plans for two banks are expected by end 2016. However, faster progress is needed for the development of plans of complex locally- owned banks. 57 The “KA are the internationally agreed standards promulgated by the Financial Stability Board. The FSAP did not undertake an assessment of adherence to the KA but use the standard as a point of reference for formulating certain recommendations. 58 See the 2014 Core Principles For Effective Deposit Insurance Systems, Core Principle 9, Essential Criteria 8; Directive 2014/59/EU (Bank Resolution and Recovery Directive) Article 110. 27 B. Deposit Insurance 80. The deposit insurance framework broadly conforms to best international practices. IPAB is a loss minimizer deposit insurer managing an ex-ante fund. It collects quotas based its on members’ liabilities so that even those licensed to take deposits but not yet accepting them are required to pay a quota to the fund. Deposits up to 400,000 UDIs are covered under DI, (approximately US$128,000) per person, natural or legal, per institution. The current limit allows for coverage of approximately 99 percent of depositors but only 55 percent of total deposits in the system. 81. DI reserves are still relatively low, at approximately 1 percent of insured liabilities. As noted by previous FSAPs, IPAB’s ability to accumulate reserves is hindered by its obligation to destine 75 percent of IPAB’s premiums towards repayment of the debt it acquired from FOBRAPROA, the vehicle used during the 1994-1995 banking crisis to acquire distressed assets from the banks. The outstanding debt that has now grown to MXN800 billion to constitute an ongoing claim on DI premiums. 82. There is no set limit to IPAB’s contribution to the restructuring or resolution of a systemic bank. Common international guidance for such contribution would limit such contribution at no more than the costs the deposit insurer would otherwise have incurred in a payout of insured depositors in a liquidation net of expected recoveries. 83. The many mandates of IPAB require its funding structure and resources to be reconsidered. IPAB’s role as deposit insurer should require that it has sufficient funding for depositors of small and medium banks to be protected. However, IPAB also acts as successor of FOBRAPROA, resolution authority, and as provider of resolution funding for banks deemed systemic, and the legacy FOBRAPROA debt service is draining most if its reserves. Therefore an alternative solution to such debt service obligations should be sought. 59 At the very least, the funds accumulated on account of the protection of depositors of small banks should be ring- fenced against other operations IPAB can do, such as OBA of a systemic bank. 84. It should be noted that IPAB, still retains the authority, acquired from FOBRAPROA to issue government guaranteed debt, and up to 6 percent of its member institutions’ liabilities, without formal executive approval. This option, does provide an ex- ante large buffer to deal with a number of systemic banks. However, its ability to do so may be limited in periods of market turmoil, and therefore of little use in an actual resolution, thus requiring alternative sources of contingent financing. 59 As previous FSAPs, this mission recommended the authorities could recognize Ipab’s debt as debt of the federal government and destine tax resources to its service. 28 X. FINANCIAL SECTOR DEVELOPMENT STRATEGIES 85. Financial sector development challenges remain across a range of topics, notably access to finance and provision of long term financing. Increasing financial service penetration to the lower income segments and the SMEs sector remains a primary challenge in Mexico, while long-term financing instruments are necessary to provide for the much needed infrastructure projects. However, new loan origination by commercials banks sector has remained subdued until recently relying on development banks to spur credit growth to the Figure 14: Financial Access (a) Account at a financial institution (b) Borrowed from a financial institution (% age 15 +) (% age 15 +) Source: Findex 2014 Sources: Findex 2014 (c) Saved at a financial institution in the past year (d) Has a debit card (% age 15 +) (% age 15 +) Source: Findex 2014 Source: Findex 2014 economy, through first and second tier lending and guarantees. 86. Despite numerous financial institutions, financial services penetration remains low. Overall, savings, at 29.6 percent of GDP are below levels in other countries in the region, even though the percentage of adults with savings accounts increased in recent years. Mexico is one of the countries in Latin America with the lowest number of adults holding an account at a financial institution, obtaining credit, and owing debit cards (Findex 2014) (Figure 14). Of the poorest 40 29 percent of the Mexican population, only 29 percent has an account as opposed to 41 percent in LAC. 87. Infrastructural constraints are still prevalent in rural areas. The number of financial institutions’ branches per population is significantly below countries with similar levels of income and population, and the number of access points (branches, correspondents and ATMs) of banks, cooperatives and SOFIPOS is only 10 per every 10,000 adults. Travel time to financial institutions and transportation costs are high. Bank agents only cover 19 percent of rural municipalities, leaving the large majority of rural municipalities underserved. 60As a reflection, almost all Mexicans still pay in cash for buying goods and services, notwithstanding 84 percent of account holders having a debit card (ENIF 2015). 88. Small and medium-sized enterprises (SME) remain underserved by the formal financial sector. Only 37 percent of recorded SMEs have a loan—as compared to 67 percent for large companies— and represent about 13 percent of total banking sector credit. In the last two years, bank credit growth to large enterprises has grown faster than the average credit growth to SMEs, which has remained largely unchanged. The most important sources of finance are the OFIs which are the main (or even single) providers of SME finance. 61 89. A scarcity of long term financial resources hampers growth in retail mortgage lending and constrains the financing of large infrastructure projects. Further efforts are needed to develop for a broader long term investor base in the country. Total mortgage lending amounted to 12.1 percent of GDP, a relatively favorable ratio in Latin America, but still relatively low compared to global middle income countries. Very positive progress was made in developing equity and debt instruments for the financing of infrastructure, however improvements in the ecosystem are necessary, including strengthening the PPP framework and better framing DBs support for the sector. A. State-Owned Financial Institutions 90. Several state-owned financial institutions (SOFI) provide credit as well as other financial services to virtually all market segments. SOFIs operate under different licenses including development banks, development agencies and development trusts (see Appendix VI). DBs fund infrastructure, international trade, housing and micro, small and medium size enterprises (MSMEs). Development agencies provide mortgage and consumer credit to workers as well as credit to rural firms. Finally, development trusts focus on the provision of funding for underserved sectors with marked social component. Development banks (DBs) are, after the development agencies, the largest SOFIs in terms of size. Of the existing 6 DBs, only the smaller ones (Bansefi and Banjercito) collect deposits from the public given their focus on financial inclusion. There are also a variety of development trust created by states and municipalities that provide loans and guarantees but there is no comprehensive record of them. 62 60 With population less than 50,000 inhabitants. 61 Excluding the regulated SOFOMs, which are controlled by a bank or other regulated OFIs, and the ones issuing debt in the capital market. 62 As NAFIN has ventured in project financing its balance sheet increasingly looks like that of Bancomext; its share of tier-1 lending has increased to 40 percent, asset dollarization has raised from about zero to 16 percent, as well as its asset-liability duration gap. 30 91. In 2013 the government launched a program that broadened the role of DBs in providing credit to the economy63. The amendment to Article 65 of the LIC broadened the range options through which DBs can extend the credit and guarantee programs to enterprises. In addition, the 2013-2018 National Financing Plan (PRONAFIDE) establishes ambitious lending targets for DBs with the explicit intention of transforming the countercyclical role DBs have been playing so far into an intentionally pro-cyclical development agenda. The lending targets for DBs are set to accelerate credit growth so as to expand to 40 percent the share of private sector credit supported by DBs in 2018 (Figure 15 and Figure 16) and stabilize thereafter. For this, the LIC was amended to increase DBs flexibility in providing credit and awarded them more operational autonomy, including that of providing adequate compensation to retain talent. 92. Credit support by DBs has been provided through first and second tier loans and guarantees schemes. First-tier, direct, lending now accounts for the great majority of lending operations, of which about ½ is extended to public sector entities, and increasingly, project financing. New guarantee schemes, have been extended as well as the traditional ones, and most of them are targeted to improve SME access to finance, with NAFIN providing about half of total DB PCGs extended. 64 93. However, quantitative lending targets have generated incentives to compete directly with the private sector. While DBs should be focusing on increasing financial access of excluded sectors, the lending targets in the program generated incentives to compete for market quotas. DBs have lowered interest rates, particularly for larger loans, rolled over operations where private banks would be willing to take over, and extended credit to economic sectors, even without the necessary expertise. In some cases, credit committees have approved projects more on the basis of capital management considerations than on the capacity of the financial institution. 94. Competition may have pushed some new credits to have interest rate levels that undermine the sustainability of the schemes. Lending rates ceilings should be carefully set with consideration to operational, funding costs (including ROAs) and to include a credit risk premium based on expected loss, in particular to avoid that specific programs became loss- generating. In addition, rates for all loans (either direct or guaranteed) should not be so low that, absent the subsidies, borrowers could not afford credit lines after exiting the access programs. 63 The reform modified the terms for the legal obligation of ensuring financial sustainability of the institution and widen the range of guarantees that could be accepted by DBs excluded any Federal Public Administrative agency from signing off on the approval of the DB’s organic structure or salary, promotion, recruitment, retirement and training policies. This power was le ft solely to the governing board of each DB, subject to the proposals coming from its human resources and institutional development committee. 64 First loss-schemes provide 100 percent of coverage for portfolio losses up to 5 or 10 percent of portfolio. Pari-passu guarantees typically covered 50 up to 100 percent of loan loss (the later only in disaster emergency situations). Thus the introduction of first loss-schemes has allowed to reduced average public sector coverage over all guaranteed loan portfolios to below 40 percent. 31 Figure 15: Financial Deepening Targets (a) DBs supported credit (b) Credit to the private sector (in percent of GDP) (in percent of GDP) Source: National Funding Plan Sources: National Funding Plan Figure 16: Induced Credit and Guarantees from DBs (a) Induced credit from guarantees (b) Guarantees (billions of pesos) (billions of pesos) Includes Garantias, Avales and Cartas de Seguro de Credito *Includes Garantias, Avales and Cartas de Seguro de Credito Sources: CNBV Source: CNBV 95. The effects of guarantee programs on financial inclusion should be regularly evaluated on the basis of cost-efficiency. The current performance indicators used for DBs should be complemented with indicators of financial inclusion as this would support rebalancing the focus toward extending services to the financially excluded and implementing a gradual graduation process for current borrowers.65 In addition, specific indicators could be developed to measure how DBs have been improving financial inclusion of SMEs and households and the infrastructure gap. 66 65 These could include: the accumulated stock of funding provided for infrastructure projects, the number of projects where DBs are the leading bank, or the share of institutional investors funding. 66 These could include: numbers of firms included in the financial system; comparative reports on access conditions under DB programs versus private sector loans and data of firms and individuals exiting the program and continuing accessing credit, or DB loans refinanced by the private sector, would all help is assessing the impact of the programs. 32 96. DBs risk management systems should be carefully evaluated and any shortcoming promptly addressed. 67 While credit origination seems to be subject to prudent practices, there are areas for improving market, liquidity, technological, and operational risk management. Limits on liquidity risks should be introduced in addition to the monitoring funding gaps and, interest rate risk should be hedged on their fixed rate loan programs. In addition, a structural net open position would help hedge capital in the event of a depreciation when there is a portfolio of FX loans. 97. Publicly-sponsored financial support programs need to ensure strong borrower discipline and avoid creating moral hazard. The new project of supporting DBs through a specialized vehicle dedicated to bad loan collection may carry the risk of weakening borrower discipline on DBs originated loans, support complacency, and introduce moral hazard. While some features may seem to have a strong private sector business orientation, the ownership structure of the vehicle will inevitably associate it to a public sector support program. Extreme care should be taken in ensuring the project is designed to reflect best practices, and that, in particular, strong pricing criteria should ensure all losses from bad loans are correctly recognized by DBs if transferring loans. This will allow for transparency and appropriate evaluation of the DB credit programs. In addition, moral hazard could be limited by introducing a sunset clause. In general, private sector participation in the form of equity financing could enhance independence and market-oriented business principles. B. Increasing Financial Access Small and Medium Enterprise Sector 98. The still high level of informality and the difficulty in overcoming informational barriers hinder the supply of credit to SMEs. Of the reported 4.2 million of enterprises in the country, only around 1.2 million are formal, and of these, close to 34 percent have been less than two years in business, about the minimum time required to establish history for loan origination purposes. Younger firms also face hurdles in providing reliable financial information to the lenders and in establishing a commercial relationship, since banking institutions are cautious in extending credit to borrowers with little existing information in credit bureaus. In these cases, credit by suppliers is prevalent in the sector as their position allows them for better information on the borrowers’ financial condition. (Figure 17 and 18). 67 The minimum capital of a credit union required by the NAFIN´s credit policies is MXN 40 million, compared with the MXN 14 million included in the regulation of CNBV. 33 Figure 17: SME Structure (a) Total firms by sector (b) Firms Age and Sector Source: INEGI Sources: INEGI Figure 18: Loans to SMEs (a) Number of companies with Loans (b) Credit portfolio by firm size (millions of MXN) Sources: INEGI Source: INEGI (c) Credit growth (percent) 35% 30% 25% 20% 15% 10% 5% 0% 2013 2014 2015 Micro SMEs Large Sources: INEGI 34 99. There have been sustained efforts to develop financing instruments suitable for SMEs. Authorities have developed enabling legal conditions for instruments now in use. Factoring plays a major role, and value chain financing has produced benefits under the NAFIN system for suppliers, reaching almost 700 large firms (buyers) and approximately 100,000 SMEs (suppliers). However, alternative non-credit products, such as financial leasing transactions, are still scarcely used as compared with more standard credit lines. More recently, warehouse receipt financing has been significantly amended to boost its usage. 100. Credit conditions on existing SME credit lines appear to be relatively favorable. Interest rates appear to be below peer countries and average tenors of 24-36 months are relatively long. However, this may reflect a fragmented market with few (larger) firms enjoying very favorable credit conditions and low access for rest of the SME sector. Smaller SMEs only have access to working capital loans, as most of the credit originated by OFIs, of shorter tenor in the form of credit cards, and therefore at high rates. There are few loans for investments and credit to finance fixed assets is almost inexistent. 101. Different financial intermediaries cater to the SME business, however structural issues in the OFI sector constrain credit growth. Commercial banks serve the largest SMEs, providing standardized credit products. Smaller and micro SMEs turn to the OFIs but often the lack of proper credit processes, adequate corporate governance, and sound risk management practices significantly hamper credit origination. Only the relatively larger OFIs can qualify to access second-tier lines of credit for SMEs offered by NAFIN.68 In addition, strict diversification limits for SOFIPOs, limit maximum credit exposure to natural persons, which often are SME owners. There is a need to provide technical assistance, possibly through a cost-effective centralized framework, that could help OFIs develop specialized credit products for SMEs, and strengthen risk management practices and internal systems and procedures. 102. DBs have been supporting about half of total credit to SMEs but without including new borrowers. Commercial banks have adapted their business models to qualify for the government support schemes, reducing interest rates on guaranteed loans and increasing their SME lending portfolios.69 However, these programs have not been equally successful in introducing new borrowers to the system, not least because there is no provision preventing firms that already have long credit histories from accessing the program. Available data show that both in volume and in number the stock of outstanding loans to SMEs has remained very stable. 103. Eligible firms with no prior access should be the explicit target of the guarantee programs while current beneficiaries should graduate from the programs. One way of facilitating the transition of current beneficiaries to market rates would be to substitute the first loss or pari-passu guarantees for mezzanine guarantees (Box 3), The programs should also 68 A CNBV study found guarantees reduced interest rates by about 100 bps (on average) and that increased coverage in pari- passu guarantees was associated to larger loan amounts but not in the case of first loss guaranteed loans. A study from UNAM found that the main effect of the guarantee was that recipient firms were able to maintain the current number of employees, however it found no widespread effects on productivity, employment generation or installed capacity. [2] This practice favors banks with large networks robust data collection practices and sophisticated databases versus small players that do not have such sophistication or outreach capacity. 35 introduce sunset clauses to as a way to provide incentives to banks to focus on new entrants while improving risk management systems and origination procedures. The SME lending business could benefit from the development of products that allow for the effective evaluation of SMEs creditworthiness. The establishment of a credit registry, would broaden the information on entities providing SME financing, as the supervisory reports collected by CNBV and Banxico are not granular enough and do not have sufficient coverage. Moreover, credit information on SMEs in the bureaus does not reflect the repayment behavior of companies in a comprehensive manner. Financial institutions tend to use transactional proprietary information to offer credit related products to their own SME clients[2], and most of them reported70 using internal scoring models to assess new SMEs and only to limited extent recurring to credit bureau reports. The bureaus could develop products that collect relevant information to properly evaluate the creditworthiness of SMEs and their shareholders.71 Authorities could also explore the option of allowing third parties72 access credit bureau data sets to develop value added services to banks and other financial institutions. Box 3. Mexico: Development Bank Support Programs for SME Finance NAFIN and Bancomext operate several MSME programs with well-defined target segments. NAFIN attends MSMEs in services, manufacturing and commercial construction. Bancomext targets export and import oriented SMEs (larger on average that NAFIN target population) and SMEs in tourism mainly for construction or rehabilitation of facilities. All NAFIN operations in the SME space are second-tier; either credit lines to financial intermediaries servicing MSMEs or guarantees. Bancomext provides mostly direct loans as well as guarantees for firms providing dollar loans to exporting SMEs. In addition, FIRA and FND offer products for MSEMs in agricultural sector and rural areas. Guarantee schemes in Mexico are portfolio schemes in which the lender request the guarantee, analyses the credit risk of the borrower and assume credit risk jointly with the DB. NAFIN manages both pari-passu and first-loss guarantees, while all Bancomext schemes (administer by NAFIN as well) are pari-passu. Coverage ratios depend on the program1. Banks are only allowed to require additional real estate guarantees on top of the guarantee for larger sized loans. The fact that SMEs do not know their credit is guaranteed, mitigates moral hazard behavior on the part of the borrower. To mitigate moral hazard on the part of the lender, price of the guarantee is risk-adjusted. NAFIN allocates its guarantees through an auction to the banks requesting the lowest coverage level. Interest rates in the biggest program is caped at TIEE+ 7. Two years ago the coverage rate was fixed and banks would bid on the interest rate. This change was expected to reduce the final coverage rate demanded by banks, increasing the multiplier effect of the guarantee on total SME portfolio. However, more granular data on final recipients together with stronger monitoring and evaluation of the schemes are needed to assess the impact of the program. 1 Coverage ratios depend on the program, with a final auctioned coverage ratio in the case of the global massive programs, and going up to 80% in the case of sectoral directed credit programs –with the exception of disaster support programs that have a coverage of 100 percent. 71 Additional information could include age of the company, latest date of activity, related parties, information from supplier financing arrangements and information on collateral (e.g. value and date of valuation). 71 Additional information could include age of the company, latest date of activity, related parties, information from supplier financing arrangements and information on collateral (e.g. value and date of valuation). 73 Circular Única de Bancos (CUB), art. 318(IVe) and CUB, art. 318(VIIb) 36 Households 104. Infrastructure for retail payments has been enhanced. Banxico has a long-standing track record in the promotion of mobile-initiated electronic funds transfers, and ensures interoperability through SPEI. The payment cards market has undergone substantial regulatory changes in the wake of the financial reform aimed at increasing transparency (e.g. interchange fees, operational requirements) and mitigating a number of factors that restricted fair access to central clearing infrastructure (e.g. differentiated fees based on volumes) and competition (e.g. coercive tied selling and bundling of fees). At the same time, regulations stimulate healthy cooperation for ATM infrastructure sharing through convenios to minimize duplication of infrastructure on the one hand, and reduce the cost of new investments in underserved areas. 105. However, there has been limited success in deepening financial inclusion. As of December 2015, mobile banking contracts (i.e. bank accounts associated to a mobile phone number) represented only 8.5 percent of transaction accounts and transaction volumes are still low, with the total volume of mobile payments about 1.3 percent of electronic funds transfers at the bank teller (Appendix Box 3). Agent networks have not significantly enhanced the coverage of banking infrastructure to underserved areas (agents cover 19 percent of rural areas). Among the pitfalls of the Mexican model, the agent banking relies to a great extent on large retailers rather than on small shop owners and the number of services offered is limited to mostly deposits and loan repayments. The recent authorization of agents of Socaps and Sofipos is intended to fill a gap in rural areas where these entities have had traditionally a stronger presence. 106. To expand household access, the regulatory framework could be revised to facilitate agent networks and enable payment service providers. Authorities should determine whether the current requirements for agents do not unintentionally exclude actors who may be the most promising agents due to their existing network of retail locations in underserved areas.73 Regulatory restrictions on payment service providers (PSP) should only be based on safe and sound considerations to extend access to transaction accounts. Authorities should consider removing the legal barriers that prevent non-banks to providing e-money services (i.e. funds received in exchange for e-money should not be treated as a deposit). At the same time, authorities should ensure the protection of customer funds held by non-deposit-taking PSPs, by setting prudential measures according to risks inherent to the services provided by non-bank PSPs as well as any other risks identified by the regulatory authorities (Box 4). 107. Authorities should also consider revamping the basic deposit account product by taking advantage of simplified KYC and electronic means and channels . In Mexico, different typologies of bank accounts exist which are matched by the strictness of the identification requirements to the outstanding balance of the account. Measures to establish low transactional accounts with a simplified identification system were issued in 2009 and had the objective of enabling the nature of deposits to be better suited to the needs of individuals while increasing banking penetration in Mexico. There are actually four levels of operations allowed for deposit accounts, each level is associated with a maximum allowable limit of monthly payments, identification requirements and minimum requirements for opening the account. For example: level 2 accounts – up to USD 871 of monthly deposits – can be accessed through e- 73 Circular Única de Bancos (CUB), art. 318(IVe) and CUB, art. 318(VIIb) 37 banking and mobile phone, and have rapidly increased to reach 15 million as of December 2015. Know-Your-Customer (KYC) tiered accounts are not subject to pricing regulations or guidelines, though fees must be registered at and authorized by Banxico. However, all banks are required to offer basic deposit account products at no cost74, which are traditional accounts with full KYC and a maximum monthly balance of 165 times the daily minimum wage. Box 4: The regulatory framework of mobile payments and payment cards – selected highlights Mobile payments. Regulations applicable to mobile payments have laid the foundations of an interoperable and non-discriminatory environment (Circulars 17/2010, 22/2012, 3/2012, and 3/2013). At the outset, customers can request that a mobile number be associated to their deposit account. Also, the institutions who offer mobile payment services must enable interbank payments, and are prevented from charging their customers higher fees for interbank transactions as opposed to intrabank transactions, and from setting interchange fees. The licensing requirements for mobile payment clearinghouses also entail that (i) access criteria be open and risk-based, and (ii) participation fees and charges be non-discriminatory, i.e. do not discriminate in favor of shareholders or reward participants with higher volumes. Non-discrimination rules also apply in relation to telcos: in practice, this translates in no customer locked out of a mobile payment scheme based on his/her choice of mobile operator. Payment cards. The lack of transparency and a number of factors that restricted competition and in the payment cards market were addressed by the Banxico and the CNBV in regulations on payment networks and payment card switches (2014). As a result, payment networks are subject to transparency requirements with regard to interchange fees. Also, coercive tied selling and bundling of fees are prohibited to networks and clearinghouses alike, and differentiated fees based on the volumes of operations are either limited (for clearinghouses, to 5percent maximum differential between the highest and lowest fee) or forbidden altogether. From a governance perspective, the regulation establishes that at least 25percent of board must be comprised of independent members. Banxico regulations also provide certainty and clarity with regard to the rules applicable in case of default. Ultimately, these regulations create room for potential new competitors. Finally, new regulations institutionalize the figure of the agregador, i.e. a non-bank that enters in contract with the merchant to provide card acceptance services and/or the POS infrastructure. Non-banks can now also serve as acquirers (previously card acquiring was limited to bank). C. Developing Long-Term Finance Housing 108. Funding of mortgage portfolios remains a major challenge. Bank-originated mortgages are entirely funded by deposits, with the exception of a few and already old outstanding securitizations. The stable deposit base and the low cost of this funding – in the order of 1 percent for checking accounts – reduce the incentives to issue bonds in capital markets while the private securitization markets have not recovered after the crisis. Two provident funds (“the Institutes�), funded by mandatory workers contributions, now provide the largest share of 74 LIC, art. 48 Bis 2. Free services include: account opening/closing and maintenance; debit card issuing; cash withdrawals at own branches and ATMs; balance inquires at branches and ATMs; debit card payment at points of sale, and; direct debits. 38 mortgage finance – 55 percent and 15 percent of the stock of loans for Infonavit and Fovissste respectively – is even growing in terms of number of loans extended). 75 109. Housing needs have been growing and construction has fallen short of needs. Housing needs continue to grow in parallel with the rate of household formation of 550,000 per year, mainly in urban areas. The housing deficit is estimated to be 8.9 million units-, Construction of new houses has fallen short of household needs, with Mexico’s housing deficit barely falling over the past five years. 110. Lending by commercial banks has been increasing also through support of the housing development bank (SHF). Mortgage lending now represents 27 percent of total loans outstanding and 16 percent of the credit portfolio of commercial banks. The mortgage finance companies (Sofomes) were wiped out in the 2008/ 2010 financial crisis,76 SHF, has been supporting the mortgage market through guarantees and direct lending to developers, providing mortgage insurance for high LTV retail mortgage and supporting Fovissste with credit lines and credit enhancements on RMBS issuance. 111. Interest rates have been falling, in particular with loans in local currency and lower fixed rates. Loans by banks are provided in Peso for maturities of 15 to 20 years, and with interest rates between 8.5 percent and 10.5 percent.77 Outstanding loans by the Institutes are still mostly indexed to the minimum wage –4 percent or 6 percent real interest in the case of Fovissste, but both Institutes are re-orienting new origination towards lending in pesos,78 the totality of Infonavit‘s new production.79 Infonavit cross-subsidizes lower income borrowers, which implies that higher end customers who pay 12 percent do not switch to banks – with which besides both Institutes have joint lending products. A diversification of products has also started, including resettable rate loans, loans to rental investments supported by SHF, or housing improvement loans. 112. The legal infrastructure for the mortgage market is need of further improvement. Titling is still not available or reliable all over the country80, and mortgage enforcement is a slow judicial process. Legislative reforms have improved consumer information and facilitated mortgage transfer process – an option however affected by some legal uncertainties-, which contributed to the refinancing of existing loans. However, the recent revisions to the secured credit legal framework are expected to bring some improvement. 113. Mortgage portfolio performance is adequate although some origination practices raise concerns. The level of NPL is reasonable– hardly 3 percent for banks, 5.2 percent and 4.2 percent for Infonavit and Fovissste respectively. However, an increasing number of households have had high debt-to-income ratios –up to 60 percent— and LTV ratios in excess of 100 percent 75 The Institutes, especially FOVISSSTE, are active the only remaining active issuers of MBS. 76 The majority of real estate SOFOMES have been wound down or bought by banks. A large part of their portfolios have been transferred to SHF as repayment in kind for refinance loans or market liquidity support. 77 Origination fees result in actual cost of borrowing significantly higher 78 Following the 2016 Constitutional Reform. 79 A recent regulatory measure drives Infonavit to provide now non-indexed loans 80 A program of modernization property registers is ongoing by SEDATU 39 needs raises concerns81. In addition, about 30 percent of new mortgages are originated by mortgage brokers, calling for close monitoring and ex-ante provisioning. 114. The public sector housing strategy for the low and low-middle income groups needs to be revamped. The housing construction fund’s (CONAVI) should review it its subsidy policy to require that new developments have affordable units, that local governments participation is ensured, and that low cost builders are relied upon. The guarantee scheme should be restructured to provide a risk sharing arrangement for lenders of self-employed workers, rather than the current mortgage insurance products. The mandate of the housing development bank, SHF, should be revisited to target explicitly lower income segments of the population and to phase out direct support both to developers and to FOVISSTE. SHF should instead pro-actively support alternative lenders and lenders that develop to the Perimetros de Contencion Urbana PCUs, and contribute to and manage the proposed guarantee scheme for unaffiliated borrowers. 115. New long term funding instruments for the housing market need to be developed. Across countries, two instruments are often used to increase market financing of mortgages: covered bonds and simplified MBS inspired by the “simple, standardized and transparent securitization� (STS) based on the EU project.82 Both have their benefits and shortcomings. STS would allow better assets and liabilities management, and possibly some capital release. Covered bonds would be less costly for issuers, and offer more liquidity to investors.83 Both could be created, and the choice of their usage left to the market. The investment regulation of institutional investors and banks should be adjusted to take into account the quality of these new assets classes. Infrastructure 116. There is a need for long-term private capital resources to finance the commitments under the National Infrastructure Plan (PNI) for 2013-2018. The program aims at USD 596 billion of investments of which 37 percent would come from the private sector. The recent Energy Sector Reforms and Financial Sector Reform, both enacted in 2014, as well the new PPP Law enacted in 2012, support a stronger engagement of the private sector, but need to be accompanied by a comprehensive ecosystem of innovative set of policies, regulations and instruments. 117. The investor base for long-term products is still limited. The main holders of the new financing instruments are currently pension funds, which are large, concentrated, and very influential in any pricing process in the long tenors, and have a buy-and-hold investment profile which reduces liquidity in secondary markets. 118. After a number of enacting regulations since 2009, infrastructure equity and debt- type financing products have enabled hybrid vehicles between listed and private equity (PE) funds. The development of hybrid capital markets instruments, between private and public 81 The availability of mortgage insurance offered by SHF 81 acts a risk transfer with prudential benefits for lenders more than a risk mitigation instrument. 82 Designed in fact to support SME lending, the securitization of which is different from mortgages. 83 The structural subordination of depositors is a real question raised by covered bonds, but many countries have solved it – e.g. Australia, New-Zealand or the UK where banking laws were an obstacle to the issuance of secured debt. 40 offerings regimes, so called CKDs, has produced promising results. As of December 2015 CKDs reached around US$ 6.2 billion, after growing 22.3 percent in 2014. About 30 percent of CKDs are related to infrastructure funds and have opened up the opportunity for pension funds to invest in infrastructure beyond project bonds, into higher yielding equity of greenfield or brownfield projects. However, current tenors and fees are more aligned with Private Equity funds (PEF) (e.g. 10 years) than with the long tenors and lower returns of mature infrastructure investments which would be preferred by pension funds. In other countries pension funds have dealt with this misalignment by creating their own collective investment platform. 84 119. Two new equity investment vehicles were created in 2016 that are expected to attract a greater range of investors: CeRPI and Fibra E. The CeRPI is an evolution of the CKD, closer to PEFs that requires another entity to co-invest a minimum of 30 percent. This rule seeks to attract sophisticated foreign and domestic investors along pension funds participating in CERPI’s. Pension funds are not required to be in the investment committee, but foreign investors could find co-investment arrangements attractive. The FIBRA E is an equity vehicle, with some fiscal advantages, which targets mature projects, specifically in the energy sector, producing stable cash flows. It can provide an exit strategy for projects initially financed through CKDs or CeRPI’s during the construction and rump up phases. Both products are very specific to the Mexican regulatory context and may require several adjustments as they are implemented. 120. Existing debt instruments could be broadened to include infrastructure debt funds to appeal to a broader range of private sector investors. Debt Infrastructure Funds (maybe under private placements, CKDs or CeRPIs format) could be designed as vehicles through which pension funds and other institutional investors could provide long-term loans along with banks, as is already happening in other markets. Support by Banobras could be provided through partial credit risk guarantees (e.g. for construction, liquidity and political risk), which would be more efficient than extending direct long tenor loans. It will also offer pension funds and other investors a new instrument with a risk-return profile between an equity CKD and a project bond. 121. While domestic project bonds for infrastructure are still small - one percent of GDP- they are the largest among EMEs and are an ideal alternative for large mature infrastructure projects. Main holders are pension funds with around 63 percent of outstanding volume, and insurance companies holding around 7 percent. Project bonds present the same features as ordinary corporate bonds with ratings above AA and very low liquidity. However, banks cannot afford the large size, lower returns and longer tenors typical of mature infrastructure assets under project bonds which are features sought by pension funds. They generally trade at a spread over corporate bonds of equivalent ratings, signaling greater risk aversion to the fiduciary structures they are based on, or the higher perceived risk of the underlying asset. Around 26 percent of these bonds have partial credit guarantees provided by either Banobras or FONADIN. Further analysis on how to align the spread with bonds with similar ratings is recommended. 122. Project financing could also be structured as a securitization of future income flows. While securitization instruments differ from project bonds, a similar type of instruments can be 84 This structure is similar to the recent joint venture between Caisse de Dépot of Québec (CDPQ)84and Infrastructure Mexico CKD with several pension funds and FONADIN. 41 used to mobilize private financing for specific projects. An example of such structures can be found in the securitization instrument was recently created to finance education infrastructure (CIEN). However, in this particular case, attention must paid to the ultimate borrower, and correctly analyze the sustainability of the servicing flows. 123. The PPP Law enacted in 2012 and its subsequent reforms still leave two important gaps. First, the PPP law does not cover all projects, as some projects that contractually and financially operate as PPPs can still be structured under the sectorial concession laws. This reduces the degree of standardization PPPs should have (e.g. contractual arrangements, risk allocation matrix, tendering, etc.). Second, there is not a formal PPP unit in charge of providing guidance and standards in the project preparation cycle that would develop a structured and sizeable PPP program. This is a critical function that generally resides in the Ministry of Finance. The investment Unit at SHCP is currently partially conducting the role of PPP unit but it does not cover the whole spectrum of PPPs and its resources are limited. An option is to strengthen it so it becomes a full-fledged PPP unit. 124. It is important to structure public support of infrastructure financing so to avoid market distortions. DBs and FONADIN have played a very important role to mobilize private financing into infrastructure, which was shaped through an ongoing shift towards a more efficient use of their balance sheet through guarantees and other instruments. A more systematic use of guarantees could be considered, by adding to the current menu political risk guarantees, guarantees and/or co-investments to support the launch of new products such as the proposed infrastructure debt funds. Public support should be downsized through issuances of project bonds of mature and profitable projects currently on the balance sheet. 42 APPENDIX I: MEXICO SELECTED ECONOMIC AND STRUCTURAL INDICATORS Table A1.1: Selected Economic Indicators I. Social and Demographic Indicators GDP per capita (U.S. dollars, 2015) 9,457 Poverty headcount ratio (% of population, 2014) 1/ 46.2 Population (millions, 2015) 121.0 Income share of highest 20 percent / lowest 20 percent (2012) 11.1 Life expectancy at birth (years, 2015) 74.9 Adult illiteracy rate (2012) 5.8 Infant mortality rate (per thousand, 2015) 12.0 Gross primary education enrollment rate (2012) 2/ 105.0 II. Economic Indicators Proj. 2012 2013 2014 2015 2016 2017 (Annual percentage change, unless otherwise indicated) National accounts (in real terms) GDP 4.0 1.3 2.3 2.5 2.4 2.6 Consumption 4.7 2.0 1.9 3.0 1.6 1.5 Private 4.9 2.2 1.8 3.2 2.8 2.3 Public 3.5 1.0 2.4 2.3 -6.0 -4.1 Investment 5.9 -2.0 3.0 3.3 1.8 3.1 Fixed 4.8 -1.6 2.9 3.8 1.9 3.2 Private 9.0 -1.6 4.9 6.3 6.4 4.7 Public -9.0 -1.3 -4.7 -6.8 -20.3 -6.5 Inventories 3/ 0.3 -0.1 0.0 -0.1 0.0 0.0 Exports of goods and services 5.8 2.3 7.0 9.0 7.6 8.0 Imports of goods and services 5.5 2.6 6.0 5.0 5.3 6.4 External sector External current account balance (in percent of GDP) -1.4 -2.4 -1.9 -2.8 -2.6 -2.6 Exports of goods, f.o.b. 6.1 2.5 4.5 -4.2 1.1 7.7 Export volume 5.9 1.7 7.1 8.2 7.9 8.2 Imports of goods, f.o.b. 5.7 2.8 4.9 -1.2 0.5 7.6 Import volume 5.6 2.5 6.2 5.3 5.4 6.4 Net capital inflows (in percent of GDP) 4.6 5.4 4.5 3.0 3.1 2.6 Terms of trade (improvement +) 0.2 0.4 -1.2 -5.6 -1.7 -1.6 Exchange rates Real effective exchange rate (CPI based, IFS) (average, appreciation +) 4/ -2.8 6.1 -1.0 -10.1 -15.6 … Nominal exchange rate (MXN/USD) (average, appreciation +) 5/ -6.0 3.0 -4.1 -19.2 -12.4 … Employment and inflation Consumer prices (average) 4.1 3.8 4.0 2.7 3.0 3.0 Core consumer prices (average) 3.4 2.7 3.2 2.4 2.7 3.0 Formal sector employment, IMSS-insured workers (average) 6/ 4.6 3.5 3.5 4.3 3.7 … National unemployment rate (annual average) 4.9 4.9 4.8 4.4 4.1 3.9 Unit labor costs: manufacturing (real terms, average) 4/ -2.6 1.0 -1.2 1.7 1.6 … Money and credit Financial system credit to non-financial private sector 9.9 9.2 8.6 14.6 11.9 10.9 Broad money (M4a) 7/ 14.5 8.7 11.9 6.3 9.7 8.6 Public sector finances (in percent of GDP) 8/ General government revenue 23.9 24.3 23.4 23.5 22.6 21.1 General government expenditure 27.7 28.0 27.9 27.6 25.2 24.1 Overall fiscal balance (public sector borrowing requirements) -3.8 -3.7 -4.6 -4.1 -2.6 -3.0 Gross public sector debt 43.2 46.4 49.5 54.0 54.4 54.6 Memorandum items Output gap 0.9 -0.3 -0.6 -0.5 -0.5 -0.4 Sources: World Bank Development Indicators; CONEVAL; National Institute of Statistics and Geography; National Council of Population; Bank of Mexico; Secretariat of Finance and Public Credit; and IMF staff estimates. 1/ CONEVAL uses a multi-dimensional approach to measuring poverty based on a “social deprivation index,� which takes into account the level of income; education; access to health services; to social security; to food; and quality, size, and access to basic services in the dwelling. 2/ Percent of population enrolled in primary school regardless of age as a share of the population of official primary education age. 3/ Contribution to growth. Excludes statistical discrepancy. 4/ 2016 based on data available through February 2016. 5/ 2016 based on data available through May 2016. 6/ 2016 based on data available through March 2016. 7/ Includes public sector deposits. 8/ Data exclude state and local governments and include state-owned enterprises and public development banks. 43 Table A1.2: Structure of Financial Intermediaries Number of Total Assets Share of Nominal Percent entities (billions of total assets growth 2011- of GDP pesos) (percent) 2015 (percent) Bank and Non-bank Financial Institutions 16,423 100 47.2 90.6 Commercial banks 1/ 49 7,772 47.3 37.7 42.9 Siefores (afores) 2/ 79 (11) 2,688 16.4 79.7 14.8 Mutual funds (managers) 3/ 517 (53) 1,927 11.7 52.3 10.6 Development banks 4/ 10 1,759 10.7 49.1 9.7 Insurance companies 104 1,165 7.1 73.6 6.4 Brokerage firms 36 576 3.5 34.2 3.2 Unregulated sofomes 5/ 1407 273 1.7 30.5 1.5 Popular savings and credit entities 6/ 290 173 1.1 57.0 1.0 Regulated sofomes 7/ 52 54 0.3 -55.2 0.3 Surety companies 16 24 0.1 9.0 0.1 General deposit warehouses 8/ 19 13 0.1 13.8 0.1 Source: Banco de Mexico 1/ Commercial banks’ total assets include regulated sofomes that are consolidated with the respective bank when they are subsidiaries. 2/ The number in brackets show the number of pension fund managers (Afores); the number without brackets show the number of pension funds 3/ Asset information corresponds to the balance sheets of investment funds, not management companies. 4/ Includes development banks and trusts (FIRA, FOVI, Fifomi and Financiera Rural). 5/ Figures referring to the number of unregulated sofomes come from a Condusef record of them. However, information about assets only contains information from those entities associated with the AMFE, a sector trade association which to date has 36 unregulated members. 6/ Includes savings and loan associations (SLA), popular finance corporations (sofipos), savings and loan cooperatives (socaps) and credit unions. 7/ The share of total assets considers sofomes that are regulated because they belong to a financial group but do not consolidate their assets with a multiple banking institution. Those that do consolidate their assets with banks are included in the commercial banking heading. 8/ Infonacot 44 Table A1.3: Capitalization of Development Banks Capitalization Ratio (%) 2008 2009 2010 2011 2012 2013 2014 2015 Development Banks 14.8 14.5 15.5 14.6 14.9 14.2 14.0 14.1 Nafin 12.5 12.6 14.2 15.1 16.4 15.3 14.6 14.7 Bancomext 14.0 14.4 15.2 12.4 14.5 13.7 13.1 12.4 Banobras 18.6 17.0 18.1 14.5 14.3 13.0 13.9 14.4 SHF 12.9 12.9 13.0 13.7 12.4 13.0 11.5 11.5 Bansefi 26.0 27.8 38.6 30.7 25.8 25.0 16.7 17.4 Banjercito 25.7 20.0 19.7 19.4 20.2 20.7 20.4 20.4 Private Banks 15.3 16.5 16.9 15.7 16.0 15.5 15.8 15.0 Source: CNVB Table A1.4: OFIs Key Indicators SOCAPs SOFIPOs Credit Unions Dec ´13 Dec ´14 Dec ´15 Dec ´13 Dec ´14 Dec ´15 Dec ´13 Dec ´14 Dec ´15 Total Assets 78.1 89.2 100.9 21.6 24.2 26.9 41.6 42.9 45.9 Total Loans 52.4 58.4 64.4 15.7 16.8 18.5 30.9 32.3 36.0 NPL 6.1% 5.9% 5.2% 8.4% 9.8% 8.5% 3.0% 2.5% 2.5% Coverage Ratio 112.9% 115.2% 120.6% 120.5% 103.8% 108.6% 81.8% 97.6% 87.4% ROA 1.6% 1.5% 2.0% -0.6% -0.5% 1.0% 1.0% 1.1% 1.2% ROE 10.2% 9.4% 12.0% -3.4% -2.7% 6.3% 6.1% 7.1% 7.1% * Does not include regulated and unregulated SOFOMs. Source: Statistical Reports CNBV and CNBV 45 Table A1.5: Financial Soundness Indicators 2010 2011 2012 2013 2014 2015 Commercial Banks Ownership Number of banks of which: Affiliates of foreign financial entities 15 15 15 14 13 13 of which: Controlled by local individuals 21 22 23 27 27 27 of which: Controlled by non-financial entitties 5 5 5 5 5 4 Number of banks under liquidation process - - - - 1 - Concentration (%) Share of assets of largest bank 82.2 82.7 81.6 82.7 81.2 81.6 Share of assets of the largest seven banks 82.2 79.7 77.9 78.9 81.2 79.2 Capital Adequacy Regulatory capital to risk-weighted assets 16.8 15.7 15.9 15.5 15.8 15.0 Regulatory Tier 1 capital to risk-weighted assets 14.9 13.6 13.8 13.5 13.9 13.3 Capital to assets 10.7 10.3 10.6 10.4 11.0 10.5 Asset Quality Nonperforming loans to total gross loans 2.3 2.4 2.5 3.4 3.1 2.6 Provisions to Nonperforming loans 200.0 191.1 185.5 147.6 132.7 140.1 Earnings and Profitability Return on assets 1.8 1.6 1.8 2.0 1.7 1.6 Return on equity 16.6 15.5 17.5 18.6 15.9 15.5 Interest Margin to Gross Income 70.9 72.3 72.1 70.1 72.1 73.0 Spread Between Reference Lending and Deposit Rates (percentage points) 10.2 10.9 11.7 11.7 10.9 10.6 Trading income to total income 4.4 3.4 4.8 7.5 4.0 3.3 Liquidity Liquid assets to short-term liabilities 41.6 39.5 36.2 35.9 35.4 34.6 Liquid assets to total assets 56.4 53.0 49.6 47.5 46.5 45.5 Customer deposits to total (noninterbank) loans 94.4 89.7 88.5 88.7 89.5 87.7 Exposure to FX Risk Net Open Position in Foreign Exchange to Tier 1 Capital n.a. n.a. 11.9 17.4 -0.7 -0.2 Foreign-Currency-Denominated Loans to Total Loans 10.3 12.4 11.1 10.9 12.2 13.3 Foreign-Currency-Denominated Liabilities to Total Liabilities10.8 14.1 12.2 12.3 15.7 16.7 Derivatives Gross asset position in financial derivatives to capital 56.5 77.5 77.1 73.5 56.0 61.0 Gross liability position in financial derivatives to capital 55.6 79.6 76.1 72.7 59.6 65.1 Development Banks Regulatory capital to risk-weighted assets 15.5 14.6 14.9 14.2 14.0 14.1 Return on assets 0.8 0.7 0.7 0.4 0.5 0.3 Return on equity 9.4 8.5 8.9 5.5 7.0 4.0 Nonperforming loans to total gross loans 1.2 1.0 0.8 1.2 1.2 1.1 Provisions to Nonperforming loans 363.7 416.4 438.7 286.3 257.6 261.6 Total liquid assets to total liquid liabilities 196.9 176.0 192.5 176.9 142.3 120.5 Household Sector Household Debt to GDP 12.6 12.7 13.6 14.1 14.2 15.0 Household Debt to Income 18.4 18.7 20.3 20.5 20.6 21.7 Residential Real Estate Loans to Total Loans n.a. n.a. 16.5 16.9 16.8 16.2 n.a. Residential Real Estate Prices (percent year-over-year change) n.a. n.a. 4.1 5.1 8.3 Sources: Banco de Mexico, CNBV 1/ End of period, unless otherwise noted. 46 Table A1.6: Insurance Soundness Indicators Total Insurance Market 2011 2012 2013 2014 2015 Capital Adequacy Solvency Ratio 1.81 1.95 1.76 1.75 1.90 Capital/ Total Assets 15.8% 15.7% 14.7% 13.8% 12.9% Capital/ Technical Reserves 21.0% 20.6% 19.0% 17.6% 16.3% Return on Asset 2.3% 2.8% 2.5% 2.4% 1.8% Return on Equity 14.3% 18.0% 16.8% 17.6% 14.1% Asset quality (Real estate+Unquoted Equities +Debtors)/ total assets 4.8% 4.6% 4.6% 4.6% 4.2% Debtors/ (Gross Premium + Reinsurance Recoveries) 23.8% 22.7% 23.2% 24.7% 24.3% Equities/ Total Assets 7.8% 8.6% 8.6% 8.9% 8.5% Reinsurance and Actuarial Issues Risk Retention Ratio (net premium/ gross premium) 82.3% 83.2% 82.6% 83.8% 82.8% Technical Reserves Coverage Ratio 1.08 1.10 1.09 1.07 1.08 Net Technical Reserves/ Average of net claims paid in the last three years 42.4% 43.7% 43.6% 52.3% 54.3% Net Technical Reserves/ Average of net premium received in the last three years 39.3% 37.1% 38.0% 42.0% 45.5% Liquidity Liquid Assets/ Current Liabilities 3.8 3.9 3.8 3.6 3.5 Sensitivity to Exchange Rate Risk Net open foreign exchange position/ Capital 3.1% 1.2% 2.0% 3.2% 2.8% Source: CNSF 47 APPENDIX II: FINANCIAL SECTOR REFORM – KEY MEASURES Measures Explanation BOM can impose administrative sanctions (with max and min defined limits) to Enhanced sanctions infractions such as failing to share information to the BOM and/or obstruct BOM's work BOM is authoritzed to conduct onsite supervision of financial intermediaries as Expanded supervision stand alone or in coordination with other supervisory authorities. CNBV's supervisory responsibilities are expanded to securities firms and others. The regulatory and supervision framework was enhanced, with the obligation to Sofomes register at Condusef and share of up-to-date information to BoM and CNBV too. Creation of a bureau for financial institutions and an arbitration system in Strengthening CONDUSEF financial matters. New legislation addressing the 2000 Bankrupcy Law loophols on creditors’ Enhancing past legislation on creditors' propery rights property rights (e.g., intercompany liabilities, director and manager responsibility) Reform to reduces obstacles to expediency in the judicial process to recover Founding of specialized commercial-law courts at the federal level collateral, illustrated by the possibility for debtors to choose the court level and select assets to be seized. Approval of rules for the authorities to manage the resolution or liquidation of banks in cases of liquidity squeezes and insolvency. The framework encompasseslending of last resort with equity shares as collateral, bank Banking resolution/liquidation framework contingency plans for adverse scenarios, and ring-fencing actions, for example, in the case of majority shareholder problems. An expedient bank judicial liquidation process and a legal framework for transfer of assets and liabilities are established. Basel III capital requirements are now mandatory and procedures for applying Basel requirements liquidity requirements were set. Financial System Stability Board Its existence is now recognized by Law Source: Banxico and IMF Staff. 48 APPENDIX III: RISK ASSESSMENT MATRIX Overall Level of Concern Source of Risk Likelihood of Severe Realization in 1–3 years Expected Impact on Financial Stability High Medium Turmoil in emerging markets, including a A disorderly selling of government bonds held by non-residents and slowdown in China, could trigger portfolio large funds, in particular, could amplify liquidity pressures in the rebalancing and capital outflows in search domestic market, and exacerbate price corrections. Country risk Global market volatility for safe heavens. ratings would be revised, country risk premia widen, and fueled by the funding costs increase. Pressures on the peso, the main shock absorber, decompression of could trigger further domestic market Commercial banks' profitability would be eroded by asset quality spreads. volatility and weaken investors’ confidence. decline, rising defaults, and contraction of lending to the economy. Pressures on corporate, banks and to lesser extent households would increase as a result of higher refinancing risks and costs, and lower growth. [Portfolio reallocations towards high risk-return assets and under- regulated sectors.] Policy response: Exchange rate adjustment, provision of liquidity, and implementation of the macro prudential policy toolkit to manage incipient bubbles in particular markets. Maintain strong fundamentals. Medium High From the trade channel, lower exports would Banks’ earnings would be affected by a reassessment of corporate reduce Mexican growth. This would reduce exposures, market liquidity pressures, and capital outflows corporate earnings and thereby expose the reducing access to external funding. Weaker global banks’ lending to them. Lower growth would also weaken the public finances, putting Confidence could be eroded, triggering foreign portfolio funds’ economic growth than outflows. expected, particularly upward pressure on the interest rate. in the U.S. From the financial channel, a negative medium- Lower capital inflows with banks and institutional investors’ having term growth outlook in the United States to absorb more sovereign debt, would result in the crowing out and Mexico could reduce investors’ appetite of credit to the private sector. for peso-denominated instruments, and a Policy response: Keep FX flexibility, with temporary interventions to disorderly adjustment of the peso/dollar smooth excessive volatility. In addition, in the short-term continue could not be ruled out. monitoring vulnerabilities associated with a sudden decline in liquidity and stand ready to intervene by providing temporary liquidity where buffers allow. In the medium-term, deepen domestic capital markets to support domestic liquidity. Medium Medium The lower fiscal revenues would add pressures A decline in capital inflows and/or reversal of outflows would on PEMEX’s already weak finances, and for increase corporate and sovereign funding costs. Borrowers’ Protracted low oil additional fiscal adjustment efforts. creditworthiness, defaults, write-offs, and loan impairment prices charges are expected to increase. The exchange rate would further weaken, increasing the stock of FX-denominated In addition, roll over and new government funding needs (resulting debt. from lower receipts) would add pressure on the domestic capital market (which is relatively small) and crowd out credit to the private sector. Policy response: Steadfast implementation of structural reforms to increase competitiveness; swift implementation of PEMEX restructuring reform. 49 APPENDIX IV: STRESS TESTING The FSAP examined the resilience of the banking system using solvency and liquidity stress tests (ST), as well as interconnectedness risk analysis. The STs covered at least the seven largest commercial banks (G- 7 banks), which account for more than 80 percent of the commercial banks’ assets, as well as the three largest development banks. Solvency stress tests The exercise included bottom-up (BU) and top-down (TD) STs. The CNBV conducted the BU ST, which covered the seven largest commercial banks (G-7 banks). The CNBV specified the risk parameters (PD and LGD) taking into account the banks’ portfolio characteristics for eleven asset classes while the bank projected net income, credit losses, loss reserves, and changes to their credit portfolio under stress scenarios. The CNBV conducted the BU ST for all banks while Banxico conducted the TD ST, for the largest top twenty one banks in the system. Banxico projected the risk parameters, net income, credit losses, loss reserves and changes to the credit portfolio for each bank considering three asset classes. A bank fails the test if its capital adequacy ratio (CAR) falls below 8 percent. A vector autoregressive (VAR) specification was used consistent with the key risks. In addition, a TD ST probabilistic approach was applied, in which a bank’s CAR was calculated for the set of variables over each scenario. Scenarios The STs used two sets of simulated negative macroeconomic scenarios over a five-year horizon generated using a vector autoregressive (VAR) specification and consistent with the key risks and transmission channels outlined above. The scenarios covered the period 2016 Q1 – 2020 Q4. The first set of scenarios corresponded to short-lived adverse conditions, e.g. the V-shaped scenario set, where the economy recovered rapidly from the initial shocks. The average severity of this set of scenarios resembled the 2008-09 financial crisis (Figure A4.1). The second set of scenarios corresponded to a protracted recession, e.g. the U-shaped scenario set. 50 Figure A4.1: Economic activity index (IGAE), year on year percent change Global recession U-shaped V-shaped 90s recession 10 8 6 4 2 0 -2 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 -4 -6 -8 -10 Source: Bank of Mexico and IMF staff calculations The macroeconomic scenarios included both domestic and international economic and financial variables, in particular: the exchange rate, the rate of the 28-day Cetes (Mexican Federal Treasury Certificates), the Mexican stock index (IPC), the domestic index of economic activity (IGAE), the consumer price index (CPI), commercial bank credit, and the unemployment rate. The set of international variables included the U.S. industrial production index, the West Texas Intermediate oil price, the U.S. three-month Treasury bill yield, the U.S. 10-year Treasury bond yield, the VIX, and the Dow Jones Industrial Average index. Only the domestic variables served as inputs in the satellite modes (Table A4.1) Results are showed in Figures A4.2. A4.3 and A4.4. If banks were to manage their balance sheets and reduce their credit exposures, they would withstand the fall in earnings from the shocks; if not, large banks’ CARs would decline as much as 1¼ percentage points (Figure A4.2, red solid lines). In a scenario where the default probabilities of the loan portfolios were also adjusted, the system CAR could fall by as much as 6 percentage points (Figure A4.2, dotted lines), and would cause one of the G-7 banks to fail. 85 (Figure A4.3) Some of the smaller banks would suffer significant capital losses of around 50 percent (Figure A4.4Figure A4.2) but no one would fail. 85 To adjust the CAR for PD-based RW in a given quarter, the unadjusted CAR was multiplied by the ratio of the required capital for a unit exposure, calculated using the bank-weighted PD at end-December 2015; to the required capital calculated using the bank-weighted PD at the end of the quarter. The required capital was calculated using the asymptotic single risk factor approach proposed by Basel. 51 Table A4.1: Stress Test Scenarios Year 2016 2017 2018 Quarter I II III IV I II III IV I II III IMF forecast IGAE (YoY growth rate) 2.53 2.48 2.26 2.33 2.50 2.57 2.64 2.69 2.75 2.80 2.83 Cete28 3.41 3.75 4.00 4.25 4.50 4.75 5.00 5.25 5.25 5.50 6.00 Unemployment 4.05 4.05 4.05 4.05 3.90 3.90 3.90 3.90 3.83 3.83 3.83 Inflation 2.71 2.82 3.01 3.32 2.94 2.95 2.98 3.02 3.01 3.00 3.00 FX 18.04 18.16 17.93 17.69 17.68 17.73 17.79 17.86 17.81 17.84 17.89 U-shaped scenario (protracted recession) IGAE (YoY growth rate) 1.66 0.00 -1.18 -2.19 -2.64 -1.41 -0.87 -0.16 0.43 0.87 2.47 Cete28, rate 3.80 5.18 4.33 5.17 5.03 5.79 6.21 6.21 6.45 6.03 5.55 Unemployment, in percent4.19 4.92 5.28 5.46 5.79 5.87 6.54 6.53 6.75 6.71 6.43 Inflation 2.60 2.38 2.96 3.25 3.50 4.02 5.08 5.45 5.22 4.84 4.66 Exchange rate, USD-MXN 17.74 20.01 19.74 21.31 22.53 25.09 27.01 28.24 29.91 30.21 30.46 V-shaped scenario IGAE (YoY growth rate) 1.66 -3.24 -4.80 -5.69 -5.53 -0.39 2.42 4.55 3.95 3.05 3.07 Cete28, rate 3.80 5.36 6.54 5.67 5.97 5.83 5.28 5.40 5.34 4.97 4.62 Unemployment, in percent4.19 4.97 5.38 5.84 5.93 5.87 5.79 5.75 5.86 5.75 5.64 Inflation 2.60 3.35 4.03 4.93 5.07 5.11 5.02 4.91 4.73 4.53 4.39 Exchange rate, USD-MXN 17.74 20.63 22.81 24.09 26.04 26.04 26.49 27.78 28.53 28.37 28.37 Year 2018 2019 2020 2021 Quarter IV I II III IV I II III IV I IMF forecast IGAE (YoY growth rate) 2.83 2.84 2.89 2.93 2.99 3.04 3.06 3.10 3.15 3.13 Cete28 6.00 6.00 6.00 6.00 6.00 6.00 6.00 6.00 6.00 6.00 Unemployment 3.83 3.79 3.79 3.79 3.79 3.77 3.77 3.77 3.77 3.76 Inflation 2.99 3.00 3.00 3.00 3.00 3.00 3.00 3.00 3.00 3.00 FX 17.95 17.90 17.93 17.98 18.04 18.00 18.04 18.10 18.18 18.14 U-shaped scenario (protracted recession) IGAE (YoY growth rate) 2.74 2.89 2.82 2.67 2.56 2.48 2.57 2.24 2.06 1.95 Cete28, rate 5.54 5.60 5.42 5.08 5.17 5.27 5.43 4.95 4.99 4.84 Unemployment, in percent 6.43 6.57 6.51 6.56 6.33 6.43 6.57 6.47 6.35 6.17 Inflation 4.53 4.48 4.38 4.29 4.08 3.96 3.76 3.64 3.47 3.35 Exchange rate, USD-MXN 30.81 31.03 30.75 30.62 30.51 30.46 30.41 30.27 30.26 30.11 V-shaped scenario IGAE (YoY growth rate) 3.03 2.90 2.91 2.80 2.75 2.68 2.62 2.59 2.55 2.53 Cete28, rate 4.74 4.70 4.44 4.16 4.30 4.30 4.08 3.84 3.97 3.98 Unemployment, in percent 5.61 5.76 5.66 5.59 5.59 5.76 5.68 5.62 5.63 5.81 Inflation 4.20 4.08 3.94 3.85 3.73 3.66 3.57 3.51 3.42 3.37 Exchange rate, USD-MXN 28.62 28.71 28.76 28.88 29.08 29.32 29.59 29.86 30.03 30.17 Source: Banco de Mexico and staff calculations. 52 Figure A4.2: CAR, bottom-up stress tests, in percent U-shaped scenario 18 16 14 12 10 Fixed RWs, dynamic b/s Fixed RWs, static b/s 8 Varying RWs, dynamic b/s Varying RWs, static b/s 6 V-shaped scenario 20 18 16 14 12 10 Fixed RWs, dynamic b/s Fixed RWs, static b/s 8 Varying RWs, dynamic b/s Varying RWs, static b/s 6 Source: CNBV and IMF staff calculations Figure A4.3: System-wide CAR distribution across scenarios in TD ST, in percent U-shaped set of scenarios, no RW adjustment V-shaped set of scenarios, no RW adjusment 16 16 15 15 Upper bound Upper bound 14 14 13 13 Median Median Lower bound 12 Lower bound 12 11 11 10 10 U-shaped set of scenarios, RW adjustment V-shaped set of scenarios, RW adjustment 53 16 16 15 15 14 13 14 Upper bound 12 13 Upper bound 11 Lower bound Median 12 10 Median 9 11 Lower bound 8 10 Dec-15 Sep-16 Jun-17 Mar-18 Dec-18 Sep-19 Jun-20 Dec-15 Sep-16 Jun-17 Mar-18 Dec-18 Sep-19 Jun-20 Source: Banco de Mexico and staff calculations Source: Banco de Mexico and staff calculations Figure A4.4: Average CAR distribution across banks in TD ST, in percent (December 2015 =100) U-shaped set of scenarios V-shaped set of scenarios 120 110 Upper bound 110 Upper bound 100 100 90 Median 90 Median 80 80 70 70 60 60 Lower bound Lower bound 50 50 40 40 Source: Banco de Mexico and staff calculations Source: Banco de Mexico and staff calculations 14 Figure A4 5: Development Banks, CAR, bottom-up U-shaped V-shaped stress tests, in percent 13 12 11 10 9 8 Source: CNBV and staff calculations. 54 Table A4.2: Liquidity Stress Test Paramaters A. Eligibility of liquid assets LCR 2013 LCR 2010a LCR 2010b Level 1 Assets 100% 100% 100% Coins and bank notes Qualifying marketable securities form sovereigns, central banks, PSEs, and multilat. Dev banks Qualifying central bank reserves Domestic sovereign or central bank debt for nonzero risk-weighted entities Level 2a Assets 85% 85% 85% Qualifying marketable securities form sovereigns, central banks, PSEs, and multilat. dev banks (with 20% risk weighting) Qualifying corporate debt securities rated AA- or higher Qualifying covered bonds rated AA- or better Level 2b Assets Qualifying Mortgage Backed Securities 75% 0% 0% Qualifying corporate debt securities rated between A+ and BBB- 50% 0% 0% Qualifying common equity shares 50% 0% 0% B. Haircuts on Inflows of liquid assets (over 30 days) LCR 2013 LCR 2010 LCR 2010 Level 1 assets 0% 0% 0% Level 2a assets 15% 15% 15% Level 2b assets Eligible RMBS 25% 100% 100% Other 50% 100% 100% Margin lending backed by all other collateral 1/ 50% 50% 50% All other assets 100% 100% 100% Credit or liquidity facilities 0% 0% 0% Operational deposits held at other financial institutions 0% 0% 0% Other inflows, by counterparty Retail counterparties 50% 50% 50% Nonfinancial wholesale counterparties, transactions not listed above 50% 50% 50% Financial institutios and central banks, transactions not listed above 100% 100% 100% Net derivative cash inflows 100% 100% 100% Other (contractual) cash inflows 2/ 100% 100% 100% Liquidity Stress Tests To test the resilience to sudden cash outflows three different liquidity STs were performed using: i. parameters proposed in Basel III; 86 ii. parameters in the 2010 LCR proposal; and, iii. projected outflows of stable deposits by 10 percent. Banks would fail to meet the liquidity ST if the corresponding ST LCR is below 60 percent. The LCRs are required to be met in the domestic currency, and for significant currencies separately, i.e. the Mexican peso and the US dollar to identify potential currency mismatches. 87 86 Since not all banks in Mexico have foreign currency operations, the ST LCRs in domestic currency and consolidated across currencies covered 44 banks whereas the ST LCRs in foreign currency only covered 29 banks. 87 According to Banxico, the average foreign currency revenue to total revenue of these companies is 31 percent. 55 Table A4.3: Liquidity Stress Test Paramters (continued) C. Outflows of liquid assets (over 30 days) LCR 2013 LCR 2010 LCR 2010 Retail Deposits Demand deposits Stable deposits 3% 5% 10% Less stable retail deposits 10% 10% 10% Term deposits, residual maturity > 30d 0% 0% 0% Unsecured Wholesale Funding Demand and term deposits, residual maturity < 30d, small business Stable deposits 5% 5% 5% Less stable deposits 10% 10% 10% Operational deposits generated by clearing, custody, and cash management activities 25% 25% 25% Portion covered by deposit insurance 5% 25% 25% Cooperative banks in an institutional network 25% 25% 25% Nonfinancial corporates, sovereigns, central banks, multilat development banks, PSEs Fully covered by deposit insurance 20% 75% 75% Not fully covered by deposit insurance 40% 75% 75% Other legal entity customers 100% 100% 100% Secured Funding Secured funding with a central bank, or backed by Level 1 assets 0% 0% 0% Secured funding backed by Level 2A assets 15% 15% 15% Secured funding backed by non-Level 1 or non-Level 2a asset, with domestic sovereign, multilat dev banks, or domestic PSEs as a counterparty 25% 25% 25% Fundign backed by RMBS eligible for Level 2B 25% 100% 100% Funding backed by other Level 2B assets 50% 100% 100% Other secured funding transactions 100% 100% 100% 56 Table A4.4: Liquidity stress tests: Results, in percent Consolidated across currencies By Currency Foreign currency Domestic currency LCR 2013 LCR 2010a LCR 2010b LCR 2013 LCR 2010b LCR 2013 LCR 2010b Panel A: Seven largest banks 25th percentile 137 94 87 80 71 91 60 Median 148 115 105 150 88 119 94 Average 208 136 124 128 89 166 98 75th percentile 276 163 150 155 112 176 97 Panel B: Banking system 25th percentile 123 81 78 10 8 97 59 Median 180 109 107 66 29 164 103 Average 173 114 107 127 84 155 100 75th percentile 354 212 204 157 112 413 284 Source: Bank of Mexico Contagion Risk Tests The contagion model covered foreign financial intermediaries (119 firms) and international conglomerates (133 firms); and domestic financial firms, including commercial banks (47 firms), development banks (6 firms), brokerage firms (36 firms), mutual funds (327 firms), pension fund managers (77 firms), insurers (56 firms), and other domestic financial intermediaries (125 firms). Direct exposures in the network were due to, in decreasing order of importance, to securities holdings, foreign exchange transactions, deposits, loans, and derivative transactions, including repo operations. Table A4.5: Interconnectedness Risk Number of institutions failing to meet the Percentage of assets affected relative to total Date regulatory minimum standards (worst case) assets of banks and brokerage firms Number of Of which Banks and Of which institutions Of which Of which Banks Brokerage brokerage Brokerage below Banks firms firms firms minimum JUN 2015 15 5 10 6.85% 1.64% 5.20% SEPT 2015 17 6 11 8.07% 3.59% 4.47% DIC 2015 9 4 5 4.47% 1.29% 3.17% Source: Bank of Mexico Stress Tests of the Corporate Sector Balance Sheets Sensitivity calculations for the corporate sector were done under three scenarios developed for the banking sector assuming the corporations had: (i) “natural� hedges; 88(ii) “natural� and financial hedges; 88 While FX hedging instruments and markets are more developed now than during the late-1990 crises, it is important to note that some of these instruments are complex. For example, some currency hedges would terminate when the exchange rate 57 89 and (iii) no hedges. 90 A corporation is defined to fall short of its debt service needs when the Interest Coverage Ratio (ICR) falls below 1.91 Shocks were designed to include an increase in borrowing costs by 380 basis points, nearly triple the median borrowing cost increase of 127 basis points during the GFC. A peso exchange rate depreciation of 30 percent against the U.S. dollar, similar to the depreciation during the first six months of the start of the GFC. Earnings shocks of one standard deviation decline in “earnings before interest, tax, depreciation and amortization� (EBITDA) for each firm. This is equivalent to a median EBITDA decline of 61 percent. In Mexico, the median decline in EBITDA during the GFC was 34 percent. In a situation where hedges were taken into account, the corporations failing the ICR test accounted for 2.9 to 3.4 percent of total corporate sector debt (0.02 percent to 0.22 percent of total bank loans).92 In a worst case scenario where no exchange rate hedges were assumed, six companies would have an ICR below 1, with debts accounting for 6.6 percent of total corporate sector debt (1.12 percent of total bank loans). Figure A4.6. Banking Sector Gross Figure A4.7. Banking Sector Loss Absorbing Corporate NPL ratio (in percent of total corporate Buffers (in percent of risk-weighted assets) loans) Current After Shock Current After Shock 16.0% 3.8 15.5% 3.4 15.0% 14.5% 3.0 14.0% 2.6 13.5% 2.2 13.0% 1.8 12.5% Regulatory Minimum 12.0% 1.4 11.5% 1.0 11.0% Sc 1: With Sc 2: With Sc 3: No hedges Sc 1: With Sc 2: With Sc 3: No hedges “natural� hedges “natural� and 50% “natural� hedges “natural� and 50% FX hedges FX hedges Note: Assuming no recovery. Source: IMF Staff computations depreciates beyond a certain “knock-out� threshold, thus rendering the hedge worthless. Moreover, firms are exposed to liquidity and rollover risks when these contracts expire. 89 “Natural� hedges from exports in foreign currencies are proxied by the ratio of foreign currency revenues to total revenues for each firm. Financial hedges on exchange rate risk were derived based on a simple assumption that 50 percent of FX debt interest expense is hedged through derivatives. This takes into consideration the availability and effectiveness of the hedges. In the sample of 50 firms, the average share of foreign currency debt to total debt is 42 percent. 90 The market capitalization and debt of 50 largest companies amounts to 34 percent of GDP and 30 percent of total corporate debt. 91 Bank loans are based on data provided by CNBV. 92 There are about 73 pension funds as of end 2015. 58 Stress Tests of Portfolios of Pension Funds CONSAR and the FSAP team conducted a market risk sensitivity analysis on 73 pension funds (covering 100 percent of total assets under management). A market risk sensitivity analysis was performed on 73 pension funds (covering 100 percent of total assets under management). assumed: (a) inflation linked bonds are revalued with reference to UDIBONOs, and (b) overseas equities in developed markets are revalued using shocks to the S&P 500 Index, and equities in other emerging markets are revalued based on shocks to the MSCI Emerging Market Equity Index The exercise was similar in nature to the insurance sector analysis (see below), but also assumed: (a) inflation linked bonds are revalued with reference to UDIBONOs, and (b) overseas equities in developed markets are revalued using shocks to the S&P 500 Index, and equities in other emerging markets are revalued based on shocks to the MSCI Emerging Market Equity Index. Table A4.6 shows the asset allocation of the five pension fund categories (SIEFOREs). Table A4.6: Composition of Investment (in percent) SIEFORE 0 SIEFORE 1 SIEFORE 2 SIEFORE 3 SIEFORE 4 Total Near Workers' Age 60-65 46-59 37-45 Below 36 retirement Equity-Mexico 1.5 6 6.9 8.9 6.8 Equity-Foreign 2.2 11.9 14.2 18 13.8 Commodities 0.1 0.2 0.2 0.1 Private Sector Debt-Mexico 26.8 21.3 20 18.8 20.2 Structured Products 3.5 4.7 4.1 3.8 FIBRAs 0.4 2 2 1.8 1.8 International Debt 2 0.8 0.8 0.6 0.8 Mexican Government Debt 100 67.1 54.4 51.1 47.6 52.7 Source: CONSAR Results are presented in Figure A4.8. 59 Figure A4.8: Pension Funds’ Performance (in percent change in net asset value of investment portfolio) (a) All shocks materializing simultaneously (b) Interest rate shocks only "U" shape "V" shape "U" shape "V" shape Aggregate Siefore 0 Siefore 1 Siefore 2 Siefore 3 Siefore 4 Aggregate Siefore 0 Siefore 1 Siefore 2 Siefore 3 Siefore 4 0% 0% -2% -2% -4% -4% -6% -6% -8% -8% -10% -10% -12% -12% -14% -14% -16% -16% Aggregate Siefore 0 Siefore 1 Siefore 2 Siefore 3 Siefore 4 Aggregate Siefore 0 Siefore 1 Siefore 2 Siefore 3 Siefore 4 No.of breaches 1/ No.of breaches 1/ Scenario 1 (U-shape) 8 - 2 1 2 3 Scenario 1 (U-shape) 6 - 2 1 1 2 Scenario 2 (V-shape) 4 - 1 - 1 2 Scenario 2 (V-shape) 9 - 3 1 2 3 (a) Exchange rate shock only (b) Equities shocks only "U" shape "V" shape "U" shape "V" shape 7% Aggregate Siefore 0 Siefore 1 Siefore 2 Siefore 3 Siefore 4 0% 6% -2% 5% -4% 4% -6% 3% -8% -10% 2% -12% 1% -14% 0% -16% Aggregate Siefore 0 Siefore 1 Siefore 2 Siefore 3 Siefore 4 Aggregate Siefore 0 Siefore 1 Siefore 2 Siefore 3 Siefore 4 Aggregate Siefore 0 Siefore 1 Siefore 2 Siefore 3 Siefore 4 No.of breaches 1/ No.of breaches 1/ Scenario 1 (U-shape) 14 - 5 1 3 5 Scenario 1 (U-shape) 2 - 2 - - - Scenario 2 (V-shape) 25 - 6 6 6 7 Scenario 2 (V-shape) 1 - 1 - - - 60 Stress Tests of the Insurance Companies Figure A4.9: Solvency ratio and capital needs of top 10 largest insurance companies (a) Scenario 1 (“U-shape�) (b) Scenario 2 (“V-shape�) 10 10 9 9 8 8 7 7 6 6 5 5 4 4 3 3 2 2 1 1 0 0 -1 Before After Before After Before After Before After Before After Before After Before After Before After Shock Shock Shock Shock Shock Shock Shock Shock Shock Shock Shock Shock Shock Shock Shock Shock Simultaneous Interest rate Exchange rate Equities shock Simultaneous Interest rate Exchange rate Equities shock shocks shocks only shocks only only shocks shocks only shocks only only Number of Capital shortfall (in percent Number of Capital shortfall (in percent Institutions with of total assets of affected Institutions with of total assets of affected Simultaneous shocks Solvency- Ratio companies) - Solvency Ratio companies) Simultaneous shocks falling-below - Interest rate shocks 2 0.0 to 1.5 Exchange rate shocks - - Interest rate shocks 4 0.1 to 3.7 Exchange rate shocks - - Equities shocks - - Equities shocks - - 61 APPENDIX V: MEXICO’S APPROACH TO MANAGING PENSION FUND RISKS Regulations require pension funds to comply with regulatory value-at-risk (VaR) limits to manage market risk. CONSAR calculates VaRs for each type of pension fund (Siefores) on a daily basis, taking into account of 1000 historical scenarios that affect portfolio valuations.93 Pension fund managers must comply with the VaR limits established for the pension funds under their management. The VaR methodology was adjusted in February 2010 to eliminate pro-cyclical effects. The adjustment, by adapting the VaR confidence level according to market volatility, allows VaR to accommodate periods of high market volatility.94 The VaR confidence level widens automatically as market volatility increases to allow pension funds maintain their investment positions and prevent forced portfolio rebalancing, especially during times of heightened market volatility. When market volatility eases, the VaR confidence level would gradually shrink to the original confidence level of 95 percent. The pro-cyclicality of the regulatory VaR declined under the post-2010 VAR methodology. VaR requirements, which typically can induce fire sale of assets, were relaxed when needed during crisis periods, thus reducing systemic risk from pension funds unwinding positions in a disorderly way. Since the VaR adjustment, the VaR limits have been adjusted 14 times to cope with market volatility, and the number of breaches declined significantly from 189 to 78. To reduce pro-cyclicality the authorities also allowed a regularization grace period of six months to restore compliance. In addition to the regulatory VaRs, pension funds are required to control derivatives-driven leverage with SIEFORE DCVaR limit DCVaR limits. CONSAR established DCVaR limits SIEFORE 0 No Derivatives (difference between the Conditional VaR of the portfolio and Conditional VaR that excludes derivatives) to monitor and SIEFORE 1 0.3percent gauge leverage from derivatives. SIEFORE 2 0.45percent Currently, the authorities are exploring replacing the VaR-based regulatory approach with a long-term strategic SIEFORE 3 0.7percent benchmark-based approach. This new approach would further encourage stable long-term investment strategies. SIEFORE 4 1percent Also, pension fund managers can use internal VaR limits subject to certain criteria and to CONSAR’s risk management and governance assessments. CONSAR also conducts off-site supervision to track pension funds’ portfolio performance and compliance on a daily basis. 93 The VaR uses a 95 percent confidence level (or a one-tail interval of 97.5 percent confidence level). 94 See: “Adjustments to Mexican Pension Funds’ Investment Rules, February 18, 2010� 62 APPENDIX VI: STATE OWNED FINANCIAL INSTITUTIONS Name Market Segments Assets Main Funding (Billions Sources of MXN, Dec-2015) Development Banks Banobras Infrastructure and Public services 488.5 Nafin MSMEs, entrepreneurs and priority 359.3 investment projects Bancomext Exporters and their suppliers and FX 219.1 earners Sociedad Hipotecaria Federal (SHF) Housing (construction and acquisition) 97.9 Bansefi Savings and credit for poorer 32.4 Deposits and population loans Banjercito Savings and credit for army personnel 50.6 Deposits Development Agencies Financiera Nacional de Desarrollo Credit to rural population 48.6 Loans and own Agropecuario, FND capital Fondo Nacional dela Vivienda para los Mortgage loans to private sector 1067.1 Payroll Trabajadores INFONAVIT workers contributions Fondo de la Vivienda del Instituto de la Mortgage loans to public sector workers Payroll Seguridad y Servicios Sociales de los contributions Trabajadores del Estado FOVISSSTE and security issuance Instituto del Fondo Nacional para el Consumer credit 14.9 Securities issued Consumo de los Trabajadores and loans INFONACOT Development Trusts Fondo de Operacion y Financiamiento Social Housing (construction and 17.2 Own capital and Bancario de la Vivienda (FOVI) acquisition) loans Fideicomisos instituidos en relación Agricultural producers 121.9 con la Agricultura (FIRA) Fideicomiso de Fomento Minero Mining companies 6.7 Own capital and FIFOMI loans 63 APPENDIX VII: 2012 AND 2016 TABLE OF RECOMMENDATIONS 2012 Recommendations Paragraph in 2012 FSSA Short Term Increase budget autonomy for CNBV and CNSF; increase resources commensurate with new 19 responsibilities (wider regulatory perimeter). Extend scope of CNBV regulatory and supervisory powers to financial and mixed-activity 19 groups. Fully implement Pillar 2 supervisory processes, including ICAAP and criteria to require 21 buffers above regulatory minima. Tighten concentration limits (including applicable standards) and introduce capital charge for 21 concentration risk under Pillar 2. Establish emergency contingency funding mechanism for IPAB, guaranteed by SHCP; transfer 38, 39 IPAB’s debt to the Federal Government. Change pension fund investment guidelines and regulatory tools to encourage focus on long 50 term returns, including using long-term benchmarks. Improve legal framework for derivatives. 49 Establish program to address weak and not yet regulated cooperatives. 53 Revisit the structure of commissions and ensure bank account contestability to promote access 52 to finance. Medium Term Enhance independence and accountability of the CNBV and CNSF (including by revisiting 19 supervisory architecture) and strengthen the legal protection of supervisors. Strengthen powers and increase resources at CONDUSEF and study allocation of 6 responsibilities with PROFECO. Increase replacement rates at retirement. 50 Promote greater competition for mutual fund providers by facilitating entry by independent 49 operators. Promote regional integration of capital markets; prepare a medium-term strategy for capital 49 market development. Short Term Increase budget autonomy for CNBV and CNSF; increase resources commensurate with new 19 responsibilities (wider regulatory perimeter). Extend scope of CNBV regulatory and supervisory powers to financial and mixed-activity 19 groups. Fully implement Pillar 2 supervisory processes, including ICAAP and criteria to require 21 buffers above regulatory minima. Tighten concentration limits (including applicable standards) and introduce capital charge for 21 concentration risk under Pillar 2. Establish emergency contingency funding mechanism for IPAB, guaranteed by SHCP; transfer 38, 39 IPAB’s debt to the Federal Government. 64 2012 Recommendations Paragraph in 2012 FSSA Change pension fund investment guidelines and regulatory tools to encourage focus on long 50 term returns, including using long-term benchmarks. Improve legal framework for derivatives. 49 Establish program to address weak and not yet regulated cooperatives. 53 Revisit the structure of commissions and ensure bank account contestability to promote access 52 to finance. Medium Term Enhance independence and accountability of the CNBV and CNSF (including by revisiting 19 supervisory architecture) and strengthen the legal protection of supervisors. Strengthen powers and increase resources at CONDUSEF and study allocation of 6 responsibilities with PROFECO. Increase replacement rates at retirement. 50 Promote greater competition for mutual fund providers by facilitating entry by independent 49 operators. Promote regional integration of capital markets; prepare a medium-term strategy for capital 49 market development. 65 2016 Main Table of Recommendations Priority TM Institutional Arrangements and Governance Amend relevant laws to (a) clearly establish financial stability as the primary mandate for High MT supervisors, other mandates (e.g., development) are secondary and should be narrowly defined, and (b) ensure the institutional, supervisory and budgetary independence of the supervisory agencies. Amend the law to strengthen IPAB’s operational independence, introduce fixed term High MT appointments and criteria for removal for cause for board members and president. After ensuring institutional independence, consideration may be given to consolidating all High MT financial supervisory functions into a twin-peak arrangement. This would entail the integration of all prudential supervision, presently performed by CNBV, CNSF and CONSAR, into one Prudential Supervisory Agency, the Conduct Supervisory Agency would oversee conduct. Financial stability policy framework Establish more clearly the status of the CESF as the preeminent voice of its members regarding High ST the assessment of financial stability risks. Increase staff to support the functioning of the CESF. High/Medium ST Strengthen the communication of the CESF. High/Medium ST Maintain a record at the CESF of macroprudential tools that have been applied by member Medium ST authorities, including those that are under consideration. Sponsor a strong research agenda on financial stability related topics under the aegis of the CESF. Medium MT Invite highly respected independent experts into the CESF process. Medium MT Systemic Liquidity Banxico could broaden the collateral framework mitigate increased financial risks through higher High MT haircuts. Adopt measures to stimulate the securities lending market. Medium MT 95 Financial sector oversight Establish functioning consolidated supervision framework, including addressing legal gaps that High ST limit the CNBV’s ability to perform consolidated supervision and strengthening the regulatory reporting framework for related party lending. The corporate governance of development banks should be revised in line with international best High ST practices in some key areas such as the composition of board members and mechanisms for the election of CEOs. The definitions of “common risk� and “related party� should be enhanced, including explicit High ST definition of “economic dependency� in exposures to corporations, provision for grouping loans that are collateralized by the same collateral, and explicit references to persons who, while not having a quantitative relationship with other borrowers, exercise significant control over them. Ensure that development banks are subject to some form of liquidity measurement discipline. High ST 95 The extended table of recommendations is elaborated in the Technical Note on Supervision and Regulatory Framework. 66 2016 Main Table of Recommendations Priority TM The role of Banxico in determining certain capital requirements should be reviewed. The CNBV, High MT as the agency charged with the prudential supervision of banks, should assume sole responsibility for such functions. Strengthen the CNBV disclosures to the public, including sharing CNBV’s regulatory agenda High ST with market participants. Streamline the regulation and supervision of “other financial institutions�. High MT 96 Deposits insurance, crisis management and resolution Restructuring of the legacy debt at IPAB and transfer it to the SCHP balance sheet. High MT Adopt legislation ensuring shareholders and subordinated debt holders’ of systemic banks absorb High ST first losses. Develop formal contingency plans and simulation exercises to deal with a systemic crisis. High MT Development Banks Revise the strategy and objectives for development banks targets to include indicators of financial High ST inclusion and private sector crowding-in, eliminating quantitative targets. Explore opportunities to increase efficiency and effectiveness in the role of SOFIs by sharing High MT central services or consolidate SOFIs. Revise the strategy and objectives for development banks targets to include indicators of financial High ST inclusion and private sector crowding-in. Explore opportunities to increase efficiency and effectiveness in the role of SOFIs by sharing Medium MT central services or consolidate SOFIs Evaluate the cost-efficiency of guarantee programs. High MT If setting an AMC for the resolution of distressed assets ensure it will be in line with best High ST practices to avoid generating moral hazard in the system.1/ 1/See World Bank Document Public Asset Management Companies: A Toolkit. By C Cerruti. Other Financial Intermediaries Reinforce the regulation and supervision of OFI to facilitate and promote consolidation and Medium MT integration. Pensions Increase the contribution rates to fully funded pension schemes to ensure higher replacement rates High ST and reduce fiscal risk. Introduce a single long-term benchmark (life-cycle) to align better the interest of the pension fund High ST managers with the contributors. 2016 Main Table of Recommendations Priority TM Introduce a blind account system, Swedish stile, to increase the commercial factors in pension Medium MT 96 The extended table of recommendations is elaborated in the Technical Note on Financial Safety Nets and Crisis Management/Resolution and DAR of Deposit Insurance. 67 fund management Financial Access Eliminate barriers to the entry of new types of payment service providers and business models Medium ST alongside with the consolidation of the framework for other financial intermediaries that ensure proper risk management and costumer protection. SME Finance Redesign the instruments of development banks for SMEs by implementing a gradually phase-out High ST of the guarantee programs for firms with enough credit history and including sunset clauses in new programs. Create a credit registry to increase financial information available to lenders. High MT Design a pilot guarantee product to stimulate the use of movable collateral by banks. High ST Revise the diversification limits for SOFIPO to facilitate the development and placement of credit Medium/High ST products for SMEs. Design a pilot guarantee product to stimulate the use of movable collateral by banks. Medium/Low MT Credit reporting service providers should develop value added services tailored to SMEs and High MT include additional relevant data into the credit reports. Housing Finance Develop a simplified and standardized mortgage securitization structure and covered bonds. Medium MT Strengthen the integrated strategy for low income housing by implementing a public risk-sharing Medium MT scheme for loans to households non-affiliated to the Social Security system. Re-design the mandate of the housing development bank more toward providing mortgage High ST insurance products and mortgage guarantee schemes. Long term finance Introduce new instruments to facilitate long term finance: infrastructure debt funds, covered High MT bonds and standardized securitization bonds. Develop a public guarantee program to gradually replace direct lending from development banks. High ST Develop a unified and stronger institutional framework to oversee the implementation of PPPs. High ST