Cross-Border Supervisory Cooperation June 2006

1. On Cross-Border Supervisory CooperationJosé Sidaoui Cross-Border Supervisory Cooperation June 2006

2. Content • Introduction • Effects of foreign ownership on: • Soundness of local banks • Local financial markets • Challenges • Providing the right incentives • Improved supervisory cooperation

3. I. Introduction Mexican Financial System

4. I. Introduction 1.- Mexico’s banking system is highly concentrated. 2.- Foreign banks manage 83% of Mexican banks assets. 3.- Foreign banks own Mexico’s largest banks. 4.- All foreign owned banks are incorporated under Mexican law (they are subsidiaries, not branches). 5.- No single foreign country has a dominant position in the banking sector.

5. I. Introduction Bank of Mexico’s concerns 1.- Banks are special: • Central nervous system of the economy. • Provide access to payments systems. • Subject to systemic risks. • Have access to the safety net: deposit insurance, liquidity assistance. 2.- Host-country authorities are responsible for locally incorporated banks: taxpayer money. 3.- Central bank provides liquidity assistance and regulates financial markets. 4.- Development of financial markets

6. I. Introduction • Compliance with capitalization rules is not enough. • Banks should be solvent, profitable, efficient and able to stand alone, even if the parent bank decides not to support them. • The way global banks operate may: • weaken subsidiaries’ abilities to stand alone. • have adverse effects on host-country financial markets.

7. Content • Introduction • Effects of foreign ownership on: • Soundness of local banks • Local financial markets • Challenges • Providing the right incentives • Improved supervisory cooperation

8. II.a. Effects of foreign ownership on: Soundness of local banks • “The formal legal distinctions and separation [between parent and subsidiary] are not matched by a similar economic separation” • Charles Goodhart • Parent banks and subsidiaries are different legal entities • In practice, global banks manage their subsidiaries as branches • Parent bank responsibility is limited to capital invested.

9. II.a. Effects of foreign ownership on: Soundness of local banks • Global banks maximize risk- adjusted returns on a global portfolio basis. • Business and investment decisions that contribute to maximize benefits of the global bank are not necessarily positive for the subsidiary.

10. Board CEO Parent bank Treasurer Risk Unit Auditor Board/ CEO Treasurer Risk Unit Subsidiary Auditor II.a. Effects of foreign ownership on: Soundness of local banks Accountability • Among global banks matrix reporting arrangements prevail. Local managers report directly to parent banks’ line managers. • These arrangements weaken accountability of local CEOs and boards

11. II.a. Effects of foreign ownership on: Soundness of local banks Cherry picking • Global banks book operations where funding and regulatory costs are lower and not where business is originated. This practice shifts income away from subsidiaries. Outsourcing • Subsidiaries outsource key activities and systems. Outsourcing has an adverse impact on subsidiaries’ ability to stand alone.

12. Listed 13% Not Listed 27% Listed 73% Not Listed 87% II.b. Effects of foreign ownership on:Local financial markets • Market discipline • Global banks rise capital where it is cheaper: • Subsidiaries are delisted from local stock exchange. • Their stock of subordinated debt has declined rapidly. Mexican Listed Banks (% of total assets) Outstanding Subordinated debt (billions of pesos) 2005 1998 35 30 25 20 15 10 5 0 1997 1998 1999 2000 2001 2002 2003 2004

13. II.b. Effects of foreign ownership on:Local financial markets Constraints to the activity in host country • Global banks at times set limits to credit exposure to the host country. • These limits force subsidiaries to reduce their local credit exposure, inhibiting growth potential and their activities in host financial markets.

14. II.b. Effects of foreign ownership on:Local financial markets • Accounting and financial market activity • Subsidiaries consolidate financial statements with those of parent banks. Consolidated balances have to comply with home-country regulations. • Market operations by subsidiaries are conditioned by their impact on parent bank’s balance sheets. • Regulatory differences among home-countries result in different attitudes towards risk taking.

15. II.b. Effects of foreign ownership on:Local financial markets • Example: Accounting practices and security trading. • Securities held by local banks and funded through repos: • Spain: • Must be registered as “held for trading” • Mark to Market valuations: must be reflected in income • statements. • U.S.: • Could be registered as“held to sell” • Mark to Market valuations: do not have an impact on income statements.

16. 8 6 U.S. owned subsidiary 4 2 0 Spanish owned subsidiary -2 -4 2002 2003 2004 2005 II.b. Effects of foreign ownership on:Local financial markets Trading Income Reported in Host-Country (MEX/GAAP) Billion pesos, Quarterly Data Result: Subsidiaries of U.S. banks are more able to sustain large swings in valuations than Spanish subsidiaries and thus are willing to take larger positions in local securities financed through repos. Subsidiary of U.S. banks obtain a dominant position in host-country securities markets. • US/GAAP: Changes in the fair value of available-for-sale securities are recognized in a component of stockholders’ equity net of taxes.. • IAS and MEX/GAAP: Securities financed through repos have to be registered in trading and changes in their fair values are recognized in earnings.

17. 7 Home-Country (US/GAAP) 5 3 1 -1 -3 Host-Country (MEX/GAAP) -5 -7 2002 2003 2004 2005 II.b. Effects of foreign ownership on:Local financial markets Parent banks restate subsidiaries financial statements. Wide swings in income reported at host-country (from large trading positions) disappear when financial statements are restated according to home-country regulations. Home-country regulations end up prevailing over host-country ones. Net Income of a U.S. subsidiary reported in Host and Home-Countries (Billion pesos, Quarterly Data)

18. II.b. Effects of foreign ownership on:Local financial markets Subsidiaries of U.S. banks are able to take higher risks Value at Risk (VaR) as a percentage of assets (Semester Data) U.S. 30 Spanish 25 20 15 10 5 0 2003 2004 2005

19. Content • Introduction • Effects of foreign ownership on: • Soundness of local banks • Local financial markets • Challenges • Providing the right incentives • Improved supervisory cooperation

20. III.a. Challenges: Providing the Right Incentives How to enhance subsidiaries’ ability to stand alone? Policy options • Strengthen corporate governance arrangements at local level providing the local managers and CEOs the incentives to look after the subsidiaries’ best interests. • Minority shareholders • Listing in local exchanges • Reinforce market discipline

21. III.a. Challenges: Providing the Right Incentives • Corporate Governance • Statutory responsibilities of local boards & CEO’s • Basel Committee July 2005 • New Zealand’s experience

22. III.a. Challenges: Providing the Right Incentives • Compulsory inclusion of minority shareholders • Subsidiaries do not automatically reap the benefits of belonging to a widely-held parent bank. • Minority shareholders may serve as watchdogs of local boards and CEOs. Compulsory listing requirement • Price signals. • Research by independent bank analysts.

23. III.b. Challenges: Improve upon Supervisory Cooperation • Mexican banking supervisor has established close arrangements of cooperation with foreign supervisors (MoU’s). However, there is a need to include Mexican Central Bank and other members of the safety net participants in arrangements to deal with cross-border crisis management. • Speed up harmonization efforts of home-countries’ regulatory standards. • Carry out cross-border crisis management drills (specially between US, Europe and Latin America).