Why Have Banks Stopped Lending In Mexico Since the Peso Crisis in 1995

Lending from commercial banks to the non-financial private sector shrank from 10% to 0.3% of GDP in 1994 and 2000 respectively. There has been a general reduction in the depth of traditional financial markets since 1994. The purpose of this paper is to answer why banks have reduced lending so dramatically since the peso crisis? The paper will argue, that the two conventional explanations: (i) low capitalization/lack of access to capital and (ii) poor legislation to repossess collateral or “barzon” like debtor club behavior are inconsistent with the stylized facts. Rather the problem is one of perverse incentives created by the banking bailout scheme. In particular, IPAB bailout bonds have reduced/eliminated the incentive for banks to lend to the non-financial private sector. Because banks cannot perfectly discriminate among depositors or creditors, banks have no incentives to increase deposits or lines of credit because the losses incurred due to the overall rise in the interest rate on the cost of funds outweigh the gains from increased lending. Equivalently, higher lending lowers the lending rate which also lowers the return on existing income from IPAB bonds. Capital injections are not profitable because they lower average returns to capital. The policy implication is that if Mexico wants banks to lend again, it will have to buy back the bonds and perhaps even replace them with foreign debt.