The Health of Mexican Banks
In 2007-2008, while banks in the United States were losing billions of dollars, Mexican banks were generating 15% returns on equity. Similarly, from 2007-2009, domestic credit extended by banks in the US shrank at an annual rate of 2.53% while in Mexico domestic credit grew at annual rate of 8.39%.
The financial crisis, however, was not all rosy for Mexico. After the collapse of the US investment bank Lehman Brothers in September 2008, Mexican banks and Mexico more generally experienced the dual shocks an interbank lending contraction and diminished export demand, especially from the US.
This, combined with a fall in the global price of oil (Mexico’s largest source of foreign currency), caused concern about Mexico being able to meet its foreign obligations—a problem Mexico has faced in the past. However, Mexico was able to overcome these challenges without any of the interventions witnessed or ongoing in the developed world.
Some have argued that profits from narcotrafficking are what supplied the Mexican banks the liquidity they needed to weather the financial crisis without being recapitalized or even nationalized. Though there is anecdotal evidence in the OS to suggest that this is the case, there are both quantitative and qualitative[1] reasons that suggest an alternative answer: namely the deleveraging and increased regulation that Mexican banks underwent following the Tequila Crisis of 1994-1995 left Mexican banks less exposed to the credit crunch that wreaked havoc in the highly leveraged banks of the developed world.
Estimating Mexican Drug Profits
Estimating the revenues, profits, and profits margins of illegal enterprises is very difficult. Unlike licit enterprises that report earnings, pay taxes, and generally standardize prices, illicit enterprises, like Mexican DTOs, try to keep as much information about their operations as possible concealed.
According to the US Department of Justice and previous STRATFOR estimates, annual Mexican drug revenues are between 35-45 billion USD while profits are between $28-$36 billion (assuming an 80% profit margin). A 2010 study conducted by RAND (cited here), however, estimates Mexican drug profits at closer to $6.6 billion a year.A recent report from the Wilson Center’s Mexico Institute confirms the range is between $6.0-$36 billion.
For our purposes, we interested in how much of this $6.0-$36 billion actually ends up in Mexico’s banks. I have come up with estimates ranging from $13.6 billion to $25.6 billion.[2] For simplicity sake, we’ll use a range of $10-$30 billion.
Liquidity, Loan to Deposit Ratio, and Drug Profits
The financial crisis was primarily a crisis of liquidity. When the housing bubble burst in the United States, overleveraged banks (banks with high amounts of debt relative to their cash)could not get the money they needed to meet their current obligations.
One way to measure liquidity—there are several—is to look at a bank’s loan to deposit ratio. Loans represent a bank’s assets, while deposits represent a bank’s liabilities. A loan to deposit ratio of 1 or 100% means that all of the bank’s assets are held in the form of loans, while a lower ratio means that the bank is keeping some of its assets in cash. A lower ratio means higher liquidity.
From 2005 to the beginning of 2010 Mexico’s banks had an average loan to deposit ratio of 77.5%. Over this same period, the United States had a loan to deposit ratio of 97.4%. When the credit crunch hit, US banks were, understandably, hit harder. (Banking System Spreadsheet).
But how would Mexican banks have faired without drug money? If you were to subtract out the $10-$30 billion of drug money that found its way into Mexico’s banking sector from 2005-2010, Mexico’s loan to deposit ratio only rises to 77.98%-78.95%. This is not a significant enough decrease in liquidity to have exposed Mexico to the adverse effects of the credit crunch.
An Alternative Explanation: Macroprudential Policy Reform
According to a report from the Bank of International Settlements, Mexico was able to whether the initial period of the crisis, 2007 to September 2008, for 3 reasons: 1) adequate levels of capital; 2) low leverage ratios; 3) continued profitability which gave banks more cash to use. I would argue the third is merely a byproduct of the former two.
Mexican banks did not have adequate levels of capital and low leverage ratios by accident. They were economic and policy responses to Mexico’s peso crisis of 1994-1995, more popularly known as the Tequila Crisis.
In 1994, the Mexican government ran a large current account deficit (7% of GDP), which it financed by selling peso denominated dollar indexed assets. When the government could not longer buy the pesos it needed to pay its foreign and domestic creditors, the government devalued the peso. Creditors responded by cutting off lending and over leveraged banks were could not meet their obligations.
In response, Mexican authorities took over 15 banks, and the United States Treasury bought up $20 billion worth of Mexican bonds to support lending (and US banks exposed to Mexican debt).
The end result was a number of reforms including a new deposit insurance scheme, and stricter rules on capital quality.
From the end of the Tequila Crisis to the start of the financial crisis, Mexican banks deleveraged by XX% or $X billion dollars. This is a much more substantial sum than the $10-$30 billion dollars a year in drug profits flowing into the Mexican banks and better helps explain how Mexico’s banks were able to weather the early part of the financial crisis.
[1] I will focus on the quantitative here. Qualitatively, there is evidence that indicates both that a large amount of illicit funds from Mexico end up in banks in the developed world and/or flow to dollarized economies like Panama or Ecuador where they are used to pay cocaine suppliers
[2] Based on estimates from a US Law enforcement official quoted by Reuters and projections of the amount of drug money laundered through Sinaloa state compared to Sinaloa’s share in Mexican GDP