Bank Risk Fundamentals And Regulatory Discipline In The Mexican Banking Sector

The 1994 Mexican banking crisis led to wholesale changes in the deposit insurance fund in the country’s banking system. Poor lending decisions allowed banks to transfer risk to the fund, resulting in their capturing returns on performing loans, while limiting downside exposure when the fund covered losses on non-performing loans. Through a series of programs, the Mexican banking system now uses performance bonds in concert with the insurance fund. The bonds adjust in price based on the level of risk, and purport to measure the level of safety for the fund. We measure the effect of regulator actions by monitoring performance bond price levels over a 104-month period. Key bank ratios in the areas of liquidity, profitability, activity, and leverage were collected on the largest seven national banks, which control 87% of the capital in the banking system. Through a regression analysis, effects of these bank indicators demonstrate that, while not all are useful for predicting risk reduction and safety net viability, overall the banking regulators have incentivized lending institutions to reduce the occurrence of riskshifting. This has led to a more stable banking system, and a more effective safety net for deposits.