Box 10.1 Tesobonos swaps: a lesson in market/political risk exposure1
The Mexican government raised finance through the issue of peso denominated bond/bills known as cetes. In March 1994, confronted with a new outflow of capital, it began to issue tesobonos, which was debt payable in pesos but indexed to the peso/dollar exchange rate. This meant the government assumed any currency risk arising from a future decline in the value of the peso. By the end of November, they accounted for over half of all government debt outstanding. Most of it was short term, despite pressure from the IMF and Washington to issue longer term debt.
Since the early 1990s, banks’ foreign currency denominated liabilities had not been allowed to exceed 15% of total liabilities. Sophisticated global banks came up with a solution for Mexican banks wanting to circumvent this rule – a tesobonos swap.2 For example, a US bank swapped income from tesobonos in exchange for interest on a loan made by it plus collateral (in the order of $200 million) – the latter to cover the Mexican bank’s obligations under the swap. The Mexican bank received dollar interest on the tesobonos, which was Libor plus 4% – reflecting the higher risk on the tesobonos. The American bank received loan repayments (based on Libor plus a premium of say, 1%). All was well while the peso was stable. The Mexican bank seemed to get a very good deal: access to dollars and a nice profit – the difference between what they paid the western bank for the loan, and the receipts from the tesobonos.
So what was in it for the global bank? The tesobonos covered the holders for any currency risk, but given Mexico’s history of reneging on foreign debt agreements, there was concern that if the currency did fall, the government might have problems servicing the debt. The swap was a hedge against this eventuality, which is exactly what happened. Pressure on the peso resumed in March 1994 (see text), and continued off and on until the currency began its free fall, losing more than 50% of its value after it was floated in December 1994. The markets became increasingly concerned about whether the Mexican government would be able to service and/or honour its debt, especially the tesobonos because the debt obligation grew as the value of the peso declined. In the autumn of 1994, the yield on the tesobonos rose and their capital value collapsed. Under the swap agreement, the New York bank made an additional margin call, which meant the Mexican banks had to sell pesos for dollars. Added pressure came from the Mexican authorities – when they found out about the derivative deals (in September 1994) the banks were instructed to buy an estimated $2 billion to cover their risks, putting more pressure on the peso. These actions contributed to a further decline in the currency.
These swap arrangements provide another example of inappropriate risk taking, in this case, by the Mexican banks, whose employees lacked training in the basic rudiments of credit risk assessment, never mind derivatives. The ethics of the western banks is also questionable – they did very well out of it, buying tesobonos and hedging against the market risk associated with their falling value should the Mexican government encounter debt servicing problems. In fact the government never did default on tesobonos (possibly because of the prompt rescue package); market sentiment drove down their capital value. Some American economists had expressed concern that the peso was overvalued as early as 1992, and if American banks reached the same conclusion, they spotted an opportunity to enjoy fat fees from advising on and arranging the swaps, and cover their market risk at the same time.
The new President took office on 1 December but failed to announce a programme of reforms (e.g. of the banking system). Nor were interest rates increased. The markets quickly lost confidence and a run on the peso began. There was little choice but to allow a free float, which came on 22 December – the peso went into free fall. Mexico’s close relationship with Canada and the USA meant a swift rescue package was forthcoming. It consisted of $18 billion from the US and Canadian governments, the Bank for International Settlements
1 This account adapted from Beim and Calormiris (2001), pp. 313– 314. See also Garber (1998).
2 Tesobonos swaps were the principal method for getting round the foreign currency restriction. Similar instruments were offered to Mexican banks: equity swaps and structured notes. In an equity swap, the foreign bank buys Mexican equity and swaps the dividend payments with the Mexican bank. If it was $2 billion in equity, the Mexican bank is loaned $2 billion (secured by the stock plus collateral) and in exchange gets the dividends plus any change in currency value from the equity. The Mexican bank assumes the market risk related to the price of the equity: should it collapse in value, the bank gets higher margin calls, etc.
Structured notes were also issued: the Mexican bank buys a note from the foreign bank payable in US dollars but indexed to the peso/dollar exchange rate. The note pays principal interest if the peso does not devalue but very little if there is a large depreciation. The foreign bank buys cetes to hedge against its risks.
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and several American commercial banks. A $50 billion rescue package soon followed, organised by the same parties plus the World Bank and IMF. A new recovery plan was announced in March 1995 which included a bank bailout fund (see below), fiscal cutbacks, wage controls and higher taxes.
In 1994, the official percentage of non-performing loans stood at 7.3%, but given the way they were calculated, this figure was a gross underestimate. Thus, on the eve of the peso devaluation, the banks were already in trouble, though delinquent loans were not their only problem. The top Mexican banks, including Bancomer, had been persuaded by US investment banks that they could circumvent a law that prevented them from holding more than 15% of their liabilities in foreign currencies. They did so by engaging in tesobonos and other swaps. While the Mexican economy and government were perceived to be stable by investors, the banks earned good returns on the swaps, and relaxed because they were hedged against currency risks. They apparently failed to appreciate that these instruments exposed them to a high degree of market risk, which would create problems as soon as investors grew concerned with the Mexican government’s ability and/or willingness to repay its debt. For the detail on the losses incurred as a result of these swaps, see Box 6.1.
Within a few months of the peso being floated, it had lost half its value against the dollar. The banks really began to suffer when interest rates rose by more than 25% after the peso was floated, peaking at 80% in March 1995. Interbank rates hit 114% in the same month, reflecting the volatility and uncertainty of the markets, though they fell to 90% by the end of the month. The annual inflation rate was 101%. This high inflation, high interest (nominal and real), recessionary environment badly affected many businesses, especially the smaller ones, just when entry into NAFTA left them exposed to foreign competition. Households and businesses found it increasingly difficult to service their debt. The banks began to feel the strain of the rising non-performing loans. To make matters worse, some banks demanded repayment of credit denominated in dollars.
In January 1995, credit rating agencies downgraded the deposits and debt of Mexican banks, including that of Bancomer. The downgrading, it was feared, would precipitate a wholesale loss of confidence in Mexican banks and force them into bankruptcy. In the first three months of 1995, average non-performing loans (NPLs) as a percentage of total loans jumped 15% – an increase of about 45% compared to the period before devaluation. The banking sector, already fragile, immediately collapsed.
The Finance Ministry and central bank announced a rescue plan for commercial banks in March 1995. Problem loans were to be recalculated as investment units – unidades de inversion´ (UDIs) – the debt’s principal was indexed to inflation, paying up to 12% in real interest rates.37 It meant 14% of the banks’ total loan portfolio, all non-performing, was removed from their balance sheet. Weaker banks were taken over, restructured, and sold or merged.
By December 1994, the signs of increasing problems were reflected in Bancomer’s results. Table 10.3 shows a real profit decline of 65%. The bank cut back on its branch expansion
37 Source: ‘‘Lifeline Cast to Mexico’s Troubled Banks’’, Financial Times, 30 March 1995.
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and slashed jobs again, by about 15%. However, Bancomer along with Banamex weathered the crisis better than other banks because both benefited somewhat from a flight to relative safety by depositors, worried their own banks could fail. At Bancomer, provisioning for bad debt was increased, to cover about 62% of its non-performing assets. Even though Bancomer’s profits fell in 1994 and 1995, they recovered dramatically in 1996, only to decline again in 1997 (see Table 10.1). Bancomer’s return on assets rose from 0.34% in 1995 to 1.31% in 1996. Compare these results with Banca Serfin, the country’s third largest bank by tier 1 capital. In 1995, pre-tax profits stood at $35 million, and its ROA was 0.18%, with a Basel ratio of just 5%. By 1996, Serfin was reporting losses of just under a billion, had a negative return on assets of just under 5%, and did not report a Basel ratio. Serfin never did recover from its problems, and was effectively nationalised (see below).
Under the 1995 rescue scheme, Bancomer sold 15.6 billion pesos worth of NPLs to the government. Nonetheless, Bancomer’s NPL stood at 9.2% in April 1996. Though much lower than the average NPL for Mexican banks, it was very high by international standards. The bank announced it had created extraordinary reserves (2.8 billion pesos) to provision for the full amount of its bad loans. It was the first bank to do so, Bancomer slipped into losses during the first quarter.38
As Table 10.1 shows, the cost to income ratio, a measure of efficiency, was not reported until 1996. Bancomer’s rose from 1996 onwards, reaching a high of 74.4% in 1998 – a period during which it was trying to cut costs. Between 1998 and 1999, this ratio was reduced by 12%, only to rise again in 2000, the year it was taken over. From 1993 onwards, the Basel risk assets ratios for both Banamex and Bancomer were quite respectable, well above the Basel minimum of 8% and in double digits. But in the takeover year, Bancomer’s dropped by nearly 11%, to 7.8% in 2000.
As part of the reform of the banking system, it was announced that the banks were to use US Generally Accepted Accounting Principles (GAAP) from 1997. The Bancomer announcement regarding its bad debts was in preparation for this, but it was not enough – when GAAP was applied, NPLs rose to 18% of capital and net income (1996) fell by nearly 70%. Bancomer and other banks would require a great deal more capital, and looked to foreign banks to invest in them. In 1996, the Bank of Montreal had purchased 16% of Bancomer, but the capital injection was not nearly enough to meet its needs.
At the end of March 1999, Bancomer and Banamex announced they had entered into talks about merging, and informed the competition authorities. This move reflected the continued weak state of the banking sector, despite attempts to revive it postcrisis. The government had absorbed a total of $65 billion of bad debt from the banks’ balance sheets, and many weaker banks were taken over and/or restructured. From December 1998, foreign banks had been given the legal backing to take over the top three banks – up to that time they were limited to a maximum of 20% of the bank. Merger talks by the top two was a defensive action, based on the idea that being bigger would in some way resolve their joint problems of insufficient capital. They expected
38 Crawford, L. (1996), ‘‘Bancomer in the Red After Provisions’’, Financial Times, 18 April 1996.
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to make a saving of $700 million through cutting back on overlap, etc. This, the banks argued, together with their large size, would give them greater access to capital markets. However, if these two banks were to merge, they would have a 40% share of the deposit market, creating concerns about lack of competition and rising inefficiency. The authority monitoring anti-competitive practices was seen as weak because of the degree of monopoly power that had been allowed to prevail in other sectors of the economy. This raised fears about more cartel-like behaviour, pushing up what were already unusually high spreads, which were costly for both borrowers and savers. Furthermore, should this new large bank get into trouble, there would be serious systemic problems, a cause for special concern in a country with a past history of financial/banking crises. However, soon after the two banks declared their merger intentions, the head of the Federal Competition Commission announced he would prevent any merger from taking place.
Despite the economic recovery between 1995 and 2000, the inability of the banks to deal with their bad debt problems together with weak bankruptcy laws and the lack of protection of creditor rights meant virtually no new credit was extended over this period, Firms had to look elsewhere: through bond issues (if large enough), or seeking foreign or domestic investors willing to inject capital or make loans. However, it was clear Mexico needed a banking system willing to lend, prompting the government to take the initiative.
In 1998, the punto final was introduced, and was to be the last of a series of loan loss sharing agreements between the banks and government. Creditors and debtors were given a certain date to resolve their claims. If they did, creditors got up to two-thirds of the debt they were owed, and debtors were given the last opportunity to receive government support to pay off their debts. For example, there could be a write off of mortgages of up to 50%. These generous terms resulted in over a million claims being settled, mainly individual borrowers and small firms. Large debts remained outstanding – most banks thinking they could recover more than what they would get from the state.
The extent of ongoing problems in Mexico’s banking sector, four years after the 1995 crisis, was made apparent when, in May 1999, the Institute for Protection of Bank Savings (IPAB) was established with a remit to deal with banks with ongoing problems. It quickly took control of Mexico’s third largest bank, Serfin Bank. It was estimated at the time that the cost of supporting the troubled banking sector had reached $100 billion. The IPAB is similar to a ‘‘bad bank’’, but has the power to take over whole banks. It is estimated to have about $50bn of bad loans on its books, of which $12bn originate from Serfin. The IPAB reported that it could take up to 20 years to deal with this bad debt. It also began to dismantle the 100% deposit insurance scheme and instructed existing banks, including Bancomer, to raise more capital. In December 1999, Bancomer complied and sold off its insurance subsidiary. At the same time Bancomer announced the development of bancassurance, i.e. that insurance products would be sold through its bank branches. Normally banks expand into bankassurance after they acquire an insurance subsidiary or partner.
Despite the sale of the large insurance subsidiary and an earlier capital injection by the Bank of Montreal in 1996, the bank was still under pressure to find a capital rich partner. In March 2000, Banco Bilbao Vizcaya Argentaria (BBVA) of Spain and Bancomer agreed that
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BBVA would take a controlling interest (30%) in Bancomer. The $1.2 billion deal would create the largest bank in Mexico. BBVA would also take responsibility for managing the bank, to be known as BBVA-Bancomer. BBVA had purchased Probursa Bank in 1995 at the height of the crisis, and it was intended to integrate the operations of BBVA-Probursa into BBVA-Bancomer.
The first hostile bid in Mexican history came in May 2000 when Banacci, the parent of Banamex, announced its intention to purchase 65% of Bancomer, in a $2.4 billion bid. This came as a surprise, especially after the Federal Competition Commission had declared it would block any merger of these two banks. Now, in an apparent U-turn, the authority announced it might allow it to proceed if the banks agreed to sell off parts where they had a clear monopoly, including credit cards and private pensions. Within a month, however, the competition authority appeared to revert to it original position, expressing concern about potential problems arising from too concentrated a banking industry.
Five weeks later, the Bancomer Board approved the BBVA bid, after it offered an additional $1.4 billion in cash, bringing the total capital raised to $2.5 billion, which is exactly what Bancomer needed given its bad debt problems. The bid meant BBVA would own 32% of the bank, which rose to 45% after buying up the Bank of Montreal’s holding in April 2001, and again to 54% in November 2002. It intends to own up to 65% of the bank.
This friendly takeover of Bancomer was part of a trend of consolidation and increased foreign ownership of Mexico’s largest banks. Spain’s largest bank, Santander Central Hispano (SCH), had bought 30% of Bital Bank, which boasted the largest retail branch network, and in 2001 ING took a 17.5% stake in Bital. In May 2000 the IPAB, having cleaned up the balance sheet of the troubled Serfin, sold it to Spain’s SCH for $1.5bn. The new bank was called Santander Mexicano. By 2001, Citigroup had taken control of Banamex. Mexico’s banking system was now owned and controlled by giant foreign players.
Post-consolidation, it is hoped that two new banking laws will help ensure the stability of the banking system. In April 2000, a new bankruptcy code of practice was established, modelled after the US system of chapter 11 administration which gives the indebted firm an opportunity to restructure its loans for a specified period of time. The courts protect the firm from creditors in this period. A second law was enacted in 2000, which protects creditors’ rights to collateral should a firm go bankrupt. In a judicial system which had always favoured debtors (a common feature in the legal systems of many merging markets), the two new laws went some way to redress the balance.
Questions
1.Use the description of Bancomer as a nationalised bank to discuss the pros and cons of having a nationalised banking system. Is it a sound public policy objective?
2.In the context of the case, explain the meaning of:
(a)financial leasing;
(b)brokerage services;
(c)factoring;
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(d)warehouse bonding;
(e)correspondent banking.
(f)market segmentation within a retail branch.
3.What did the Visa group expect to gain from the purchase of Bancomer, one of the newly privatised major banks in Mexico?
4.Mexico is an emerging market economy. What factors are unique to banks in this type of economy? Did the new owners of Bancomer (Visa) address these issues? The answer should focus on the newly privatised bank’s strategy in terms of human resources, segmenting its markets within a branch, loan policy.
5.Define ‘‘connected lending’’ and discuss whether it is likely to be a problem given Visa’s complex ownership structure.
6.Why did the currency crisis of 1994 – 95 lead to a downgrading of Bancomer and other banks’ credit ratings by private rating agencies?
7.(a) The government initiated a series of financial reforms between 1991 and 1992. To what extent were these reforms a contributory factor to the subsequent banking crisis?
(b)Draw a list of financial reforms which might have reduced the chances of the Mexican currency crisis from turning into a banking crisis.
(c)With the benefit of hindsight, how did Bancomer’s strategic initiatives contribute to the problems the bank faced during the crisis?
8.Were New York banks hedging against market risk, political risk or both when they engaged in tesobonos swaps?
9.Using Table 10.1:
(a)Compare the performance of Bancomer’s risk assets ratio with the Basel minimum requirement.
(b)After takeover, BBVA-Bancomer’s risk assets ratio slumped from 18.7% in 1999 to 7.83% in 2000. Review the reasons why this ratio might have dropped so dramatically in a year.
(c)Based on your observations in (a) and (b), is the Basel ratio a good measure of performance and/or the bank’s risk profile?
10.By early in the new century, the Mexican banking system was largely owned and controlled by foreign banks.
(a)Within 9 years of being privatised, Bancomer (and other key Mexican banks) had been taken over or sold off. Why? (Crisis, bad loans, not enough capital, banking law changed in 1998.)
(b)Were there sound reasons for discouraging a merger between Banamex and Bancomer?
(c)What are the advantages and disadvantages of foreign ownership of banks in emerging markets (see Chapters 1 and 6 for discussion).
(d)How has BBBV-Bancomer performed since it was taken over in 2000? [Use Bankscope (if students have access to it) OR the July editions of The Banker.]
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10.6. Credit´ Lyonnais39
Relevant Parts of the Text: Chapters 5, 6 (political risk), Chapter 8.
‘‘Seldom in the field of finance has so much been squandered so quickly by so few.’’40
On the last working day of 1992, Monsieur Jean-Yves Harberer, Chairman of Credit´ Lyonnais (CL), once again reaffirmed his plan to transform CL from a staid, state-controlled French bank into a high-performance pan-European universal bank, a key player in both commercial and investment banking markets and a cornerstone of European finance by the turn of the century. January 1993 was the eve of the EU’s first attempt41 to achieve a single market in goods/services throughout Europe, including financial services. Monsieur Harberer could cite an important milestone in the road to this goal, achieving a controlling interest in Bank fur¨ Gemeinwirtschaft, giving CL a major stake in Europe’s largest and toughest financial services market, Germany.
According to Harberer, the banks likely to be the future leaders in Europe were Deutsche Bank (Germany), Barclays Bank (Great Britain), Istituto Bancaira San Paolo di Torino (Italy) and Credit´ Lyonnais of France. These leading banks would come to dominate the pan-European banking markets. They would possess the capital strength, the domestic market share and the intra-European networks to intimidate rivals and repel competitive threats from all sources. Few others, in the opinion of Harberer, had much of a chance.
Harberer had chosen the grandest strategy of all. It was a strategy designed to have enormous appeal to CL’s sole stockholder, the French government, given its proclaimed vision that a few Euro-champions needed to be nurtured in each important industry through an aggressive ‘‘industrial policy’’ of protection, subsidisation, ministerial guidance and selective capital infusions. Each Euro-champion (as many as possible French) must be capable of conducting commercial warfare on the global battlefield. In financial services, according to Harberer, CL would be France’s chosen instrument.
To achieve this objective, Harberer had three goals:
žTo make CL very, very large, with 1% to 2% of all bank deposits in the 15 (25 since 2004) European Community countries. To achieve this goal, CL would have to capture significant market share in multiple areas of banking and securities activities at once. Given the competitive dynamics of the financial services sector, speed was of the essence. Acquisitions of existing businesses would be made in various countries on several fronts, simultaneously.
žCL needed to expand and operate Europe-wide. This meant going up against the entrenched domestic competition in most of the national EU markets simultaneously, either via aggressive expansion, strategic alliances and networks, or local acquisitions.
39A version of the first part of this case appeared as Case 40 in the New York University Salomon Center Case Series in Banking and Finance, written by Roy C. Smith and Ingo Walter (1993). The case that appears here has been extensively edited and updated by Shelagh Heffernan.
40Source: ‘‘Debit Lyonnais’s Encore’’, The Economist, 25 March 1995, p. 18.
41Now, more than a decade later, Europe continues to strive for a single financial market. The latest plan is to dismantle all barriers under the Financial Services Action Plan, 2005. See Chapter 5 for more detail.
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The strategy was clear, but no one tactic would be enough. Opportunism and flexibility were essential to success.
žCredit´ Lyonnais had to exert significant control over its corporate banking customers, using strategies such as deep lending, ‘‘relationship’’ investment banking with key nonfinancial firms, and having ownership stakes in many of these same firms. Only in this way, he felt, could CL exert sufficient influence over their financial and business affairs to direct large and profitable businesses his way. Harberer called this banque industrie, a French version of the classic German Hausbank relationship. Unlike British or American banks, owning part or all of industrial or manufacturing concerns was the norm for the major German and French universal banks.
Credit´ Lyonnais had to retain the confidence of the French government because the state owned the bank. The government was expected to inject a great deal of capital, and clear the way to ensure CL achieved its acquisition and ownership plans. It would also have to look beyond the inevitable accidents that occur on the road to greater glory. Credit´ Lyonnais would have to become an indispensable instrument of French and European industrial policy. The special relationship between the government and CL would have to transcend all political changes in France, even those which involved the privatisation of CL and other state owned banks.
Little did he know that his strategy for CL would culminate in the bank being nicknamed ‘‘Debit Lyonnais’’,42 the costliest single bank bailout in European history (estimates of between $17 and $30 billion), and a Los Angeles Grand Jury indicting43 Monsieur Harberer, along with five other CL executives, for fraud.
10.6.1. Credit´ Lyonnais and Le Dirigisme Francais¸
Credit´ Lyonnais first opened for business in Lyons in 1863 as a banque de dep´otsˆ, which collected deposits, made loans and underwrote new issues of debt and equity for its corporate clients. The bank extended its operations to London during the Franco-Prussian war and, in the 1870s, expanded throughout France and to the major foreign business centres. By 1900, it was the largest French bank, measured by assets.
During the First World War, many of the personnel from the large French banks were conscripted, and competition in French banking increased. Smaller banks took advantage of larger banks’ staffing difficulties and expanded rapidly. From 1917, the Credits´ Populaires, a new form of banking establishment, arrived, adding to domestic competition. The 1917 Russian revolution led to the withdrawal of many deposits by wealthy Russian nationals who had fled the country. Though it was profitable in the 1920s, CL was not making nearly the profits it had enjoyed before the Great War.
During the Great Depression of the 1930s, CL adopted a cautious approach, closing about 100 offices in France and abroad. With the onset of the Second World War, CL remained essentially apolitical, continuing the majority of its banking activities, although some of
42‘‘Debit Lyonnais, Again’’, The Economist; 28 January 1995, p. 15.
43Under the US system, an indictment contains charges that an individual committed a crime, but all defendants are presumed innocent until proven guilty.
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the foreign offices fell out of the control of Head Office during the German occupation. The restoration of peace in 1945 brought with it a number of events central to determining CL’s future course.
1945
The French government nationalised the banques de dep´otsˆ, including Credit´ Lyonnais, Societ´e´ Gen´erale,´ Comptoir National d’Escomptes de Paris (CNEP) and Banque Nationale de Commerce et d’Industrie (BNCI). In 1966, the government merged the two smaller banks, CNEP and BNCI, into Banque Nationale de Paris (BNP).
1970
The president of CL, Francois¸ Bloch-Laine,´ adopted a strategy of forming partnerships with other banks in the form of a Union des Banques Arabes et Francaises¸ (UBAF) and Europartners.
1973
A law was passed allowing the distribution of shares to the employees of nationalised banks and insurance companies such as Credit´ Lyonnais. The election victory of the Gaullists, led by Valery´ Giscard d’Estaing, resulted in the appointment of Jacques Chaine to replace Francois¸ Bloch-Laine´ as chief executive of CL.
1981
The Socialists won a resounding election victory and Francois¸ Mitterand became President of France. Jean Deflassieux, financial advisor to the Socialist party, was appointed to replace Jacques Chaine at CL.
1982
The ruling Socialists nationalised all the major French banks not already owned by the state. The declared objective of the government was to influence the functioning of banks to favour the small and middle-sized businesses, as well as to help define and implement a new and more interventionist industrial and monetary policy. For Credit´ Lyonnais, the only effect was the renationalisation of shares sold to employees in 1973.
1986
The Gaullists took control of the French Legislative Assembly, and Jacques Chirac was appointed as Prime Minister. There was a period of ‘‘cohabitation’’ with President Mitterand. Jean Deflassieux was replaced as CL chief executive by Jean-Maxime Lev`eque,ˆ known for his advocacy of privatisation. A privatisation law authorised the public sale of 65 large industrial companies, though CL was not targeted in the first round. Both Groupe Financiere´ de Paribas and the Societ`e` Gen`erale` were successfully privatised.
