## EXECUTIVE SUMMARY

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---

### Overview
- Mexican money markets are well-regulated and function efficiently, with significant mitigants to systemic liquidity risks:
  - dominance of the repo market in system-wide liquidity management;
  - marginal level of interbank unsecured transactions;
  - commercial banks’ full compliance with the Liquidity Coverage Ratio (LCR).
- Development banks are not subject to liquidity regulation and some have significant reliance on short-term funding with low levels of unencumbered high-quality liquid assets—this might contribute to systemic liquidity risk during periods of extreme market stress in severe tail risk scenarios.
- Recommended actions for development banks:
  - improve monitoring of liquidity;
  - leverage internal risk committees to assess risk profile and contribution to systemic risk;
  - make use of Pillar 2 requirements; and/or
  - devise appropriate action(s) to improve maturity transformation.

### Money Market Functioning and Bank Liquidity
- Repo market structure and activity:
  - Daily average turnover in the repo market amounts to 2,400 billion of Mexican pesos (MXN).
  - Typical ticket size for interbank transactions is MXN 800-900 million; trades with pension funds and investment funds are about half that size.
  - About 92 percent of the interbank trading volume is concentrated in the one-day tenor, and 7 percent in the below seven-day tenors; percentages for the market different to interbank are 97 percent and 2 percent, respectively.
  - The unsecured money market is relatively small (2–3 percent of the repo market) and is almost exclusively used by commercial banks for overnight lending.
- Collateral usage:
  - About two thirds of the traded volume is secured by government securities, mostly floating rate bonds.
  - A quarter involves IPAB securities.
  - The remainder involves corporate bonds.
- Securitized money market:
  - Debt funding activity is geared towards medium- and long-term bonds; issuance of commercial papers, certificates of deposits, and other private short-term debt instruments is legally and technically possible but rarely supplied.
- NBFI participation and constraints:
  - Since 2020, investment funds can borrow by repoing securities to increase leverage up to 5 percent of their assets, and in situations of extreme financial stress this percentage increases to 10 percent.
  - Pension funds and investment funds only borrow securities but never lend them in the repo market due to regulation, constraining risk management.
- Funding source diversity (exact shares):
  - Commercial banks: demand deposits account for more than half of total liabilities; term deposits 21 percent; bond issuance 3 percent; repo funding 17 percent.
  - Development banks: more than 30 percent of funding from bond issuance; 34 percent from repo operations; remainder from term deposits, call money transactions and other funding sources including from non-residents.
- Role of collateralized interbank market:
  - The collateralized interbank money market is the first line of defense against liquidity shocks; high usage of repo operations has avoided fragmentation seen when unsecured transactions dominate.

### Interest Rate Benchmarks and Monetary Policy Implementation
- Benchmarks and reform:
  - Interest rate benchmarks are robust and representative; further reform is in progress.
  - Given the overnight repo market’s dominance in banks’ funding structure, a repo-based reference rate is most suitable.
  - A Working Group on Alternative Reference Rates was established to promote adoption of the Overnight TIIE Funding Rate (TIIEF) and to explore development of risk-free term rates.
  - TIIEF is determined as a volume-weighted median of wholesale overnight repo transactions settled by banks and brokerage firms and is transaction-based.
- Banxico’s operational framework:
  - Implements monetary policy through a mid-corridor operational framework that ensures almost perfect control over liquidity.
  - Conducts two open market operations (OMOs) every day (typically around 7:20–7:30 a.m. and around 6:00 p.m.); OMOs are variable-rate, fixed-volume auctions with a reserve price set at the policy rate.
  - Provides collateralized intraday facility (RSP), collateralized overnight overdraft, and FLAO standing overnight facility as backstops.
- Selected facility specifics:
  - Intraday RSP: interest rate charged is zero; eligible collateral includes actively traded securities issued in Mexico by the Federal Government, IPAB, or Banco de México.
  - Overdraft: automatic, overnight and priced at two times the policy rate; with the policy rate as of July 2022 is 7.75 percent makes for an overdraft cost of 15.5 percent.
  - FLAO: priced at 1.1 times the policy rate (provided upon request after a Letter of Request); collateral universe broader than the overdraft and can include peso-denominated securities issued by IPAB, development banks, and others subject to minimum ratings.
- Structural liquidity management:
  - Banxico converted MXN 105 billion of DRM to BREMS; as of end-2021, total outstanding DRM was MXN 270 billion, 62% in cash and 38% in BREMs.

### Eligible Collateral Availability (values as of June 2020; in billions of Mexican pesos where indicated)
- TOTAL market: 9,137,373
- Total holdings by commercial and development banks: 1,667,097
- Encumbered: 450,756
- Available: 1,207,131
- Percentage Available: 72 (In percent)
- Selected lines (values preserved exactly):
  - Mandatory long-term deposits: Total in the Market 167,220; Holdings 167,220; Encumbered 17,020; Available 150,201; Percentage Available 90 (In percent)
  - USD deposits (USD): Total in the Market 4,194; Holdings 4,194; Encumbered 488; Available 3,705; Percentage Available 88 (In percent)
  - OMO term Deposits: 6,895; Holdings 6,895; Encumbered 0; Available 6,895; Percentage Available 100 (In percent)
  - Term TIIE Deposits: 3,400; Holdings 3,400; Encumbered 200; Available 3,200; Percentage Available 94 (In percent)
  - Government securities: Cetes: 1,270,443 total; Holdings 236,457; Encumbered 75,696; Available 160,761; Percentage Available 68 (In percent)
  - Mbonos: 3,247,425 total; Holdings 676,540; Encumbered 150,864; Available 525,675; Percentage Available 78 (In percent)
  - Udibonos: 1,852,829 total; Holdings 30,443; Encumbered 17,028; Available 13,415; Percentage Available 44 (In percent)
  - Bondes: 1,473,995 total; Holdings 223,137; Encumbered 48,235; Available 174,902; Percentage Available 78 (In percent)
  - IPAB Bonds: 1,008,200 total; Holdings 216,039; Encumbered 120,286; Available 86,543; Percentage Available 40 (In percent)
  - Monetary regulation bonds (BREMS): 102,773 total; Holdings 102,773; Encumbered 20,938; Available 81,835; Percentage Available 80 (In percent)

### Foreign Exchange Market Functioning
- FX market characteristics:
  - The Mexican peso is one of the most actively traded emerging market currencies globally.
  - Mexico maintains a freely floating exchange rate regime with very small central bank footprint.
  - The FX Commission generally abstains from spot FX interventions; Banxico has capacity to respond to FX market stress and benefitted from the Fed’s U.S. dollar swapline in the latest FX funding stress event.
- Information and monitoring:
  - Banxico has timely and accurate information on domestic banks’ FX funding needs via daily reporting.
- FX market structure and participants:
  - Offshore MXN derivatives markets are massive; futures and options open interest and trading volumes of MXN on major exchanges are significantly higher than most other EM currencies.
  - FX derivatives turnover distribution is concentrated in forwards and foreign exchange swaps.
- FX funding structure and vulnerabilities:
  - USD funding sources: FX deposits account for more than 80 percent; FX swaps less than 20 percent; 75 percent of the FX swaps are shorter than one week.
  - USD funding pressures can be measured by the FX swap basis; tail events (e.g., COVID-19) caused USD funding costs to spike considerably.
- NDF hedging program and external resources:
  - NDF hedging program was increased to US$30 billion at the onset of COVID-19; actual take-up was less than US$2 billion in two auctions; current total amount outstanding is almost US$7.5 billion.
  - International reserves: US$207.7 billion at the end of 2021.
  - Bilateral swap lines and contingent facilities: Fed (US$3 billion), Bank of Canada (CAD 1 billion), U.S. Treasury (US$9 billion).
  - IMF Flexible Credit Line: US$50 billion FCL.

### Securities Market Functioning
- Government bond market:
  - Highly liquid and is the most liquid of Mexico’s securities markets.
  - Total debt securities issued by residents: MXN 13,065 billion (about 48 percent of GDP).
  - More than 90 percent are issued by SHCP or guaranteed by the state.
- Non-resident participation:
  - Non-residents still hold about one-fifth (about one-sixth in another passage) of Mexican sovereign debt securities; non-resident ownership of government bonds declined from 35 percent to 17 percent over the last five years.
  - Short-term CETES holdings by foreigners declined from 37 percent to 11 percent; BONOS M holdings by foreigners declined from 63 percent to 38 percent.
- Market liquidity characteristics:
  - Securities lending: less than 1 percent of outstanding government bonds are used in securities lending transactions.
  - BONOS M average bid-ask spread: 4 basis points; in March 2020 spread increased to 9 basis points and average trade size declined by 15 percent.

### Market Support Measures and Emergency Liquidity Assistance (ELA)
- COVID-19 crisis response:
  - Banxico deployed targeted support by providing funding liquidity in well-calibrated amounts and against good collateral; most programs were price-based facilities and served as effective backstops.
  - Design features included collateralization, limited envelopes, and pre-specified terms facilitating exit strategies; actual allocation against committed MXN 800 billion was less than MXN 200 billion.
- Select facilities and outcomes (exact figures preserved):
  - DRM reduction in March 2020: MXN 50 billion reduction bringing stock DRM to approximately MXN 270 billion.
  - FLAO interest rate: reduced to 1.1 times the policy rate (measure became permanent); pre-pandemic rate was 2.0 - 2.2 times the policy rate.
  - Term repo facility for government securities: term three months; interest rate 1.02 times the monetary policy rate; overall envelope MXN 100 billion, adjusted with an extra MXN 50 billion.
  - Corporate bond repo facility: term three months; interest rate 1.1 times (later reduced to 1.03 times) the monetary policy rate; recourse about 10 percent of MXN 100 billion envelope.
  - Funding-for-lending facilities: Facility 7 financed loans up to MXN 250 billion; Facility 8 provided funding up to MXN 100 billion; total funding provided MXN 54.2 billion.
- ELA framework assessment:
  - Legal basis and governance are sound but operational improvements are recommended.
  - Counterparty eligibility limited to credit institutions; ELA decisions are made by the Board on a case-by-case basis with solvency and liquidity assessment by a dedicated internal committee.
  - Credit claims are eligible as collateral but their encumbrance is time-consuming (creation of trust took about two weeks in Facility 8 experience), limiting usefulness in time-critical ELA operations.
  - Recommended ELA improvements:
    - Formalize that the solvency assessment shall be forward-looking.
    - Set a binding minimum threshold for the ELA interest rate above the interest rate of Banxico’s standing liquidity providing facility.
    - Explore options to make credit claims promptly and effectively available as collateral in time-critical ELA operations.
- ELA term and pricing:
  - Maximum term in internal policy: up to 90 days, which can be further extended.
  - Pricing is at Governing Board discretion; recommendation to introduce a minimum threshold to avoid moral hazard.

### Risks, Scenarios, and Near-Term Prospects
- Global tightening and tail risks:
  - The first sustained tightening of global liquidity conditions in many years warrants close monitoring for liquidity stress in Mexico.
  - Severe inflationary pressures and the war in Ukraine have aggravated commodity price spikes.
  - Given non-residents still hold about one-fifth of Mexican sovereign debt securities, a surprise monetary tightening—particularly in the U.S.—could, in a tail risk scenario, result in significant capital outflows and system-wide liquidity stress.
  - Banxico’s liquidity assistance framework and Mexican authorities’ ability to manage liquidity stress will be crucial backstops.

### Key Recommendations (excerpted)
- Improving money market resilience:
  - Continue progress on interest rate benchmark reform and complete the transition to term alternative reference rates. (¶ 13)
    - Responsible: Banxico
    - Time: NT
    - Priority: M
  - Authorities could (i) improve monitoring of development banks’ liquidity, (ii) leverage their internal risk committees to take stock of their risk profile and contribution to systemic risk, (iii) consider making use of Pillar 2 requirements, and/or (iv) devise appropriate action(s) to improve these entities’ maturity transformation. (¶17)
    - Responsible: CNBV, SHCP, Banxico
    - Time: NT
    - Priority: H
- Emergency Liquidity Assistance:
  - Explore options to make credit claims promptly and effectively available as collateral in time-critical ELA operations. (¶67)
    - Responsible: Banxico
    - Time: NT
    - Priority: H
  - ELA policy should stipulate that the solvency assessment by Banxico shall be forward-looking. (¶62)
    - Responsible: Banxico
    - Time: I
    - Priority: H
  - Set a binding minimum threshold for the ELA interest rate above the interest rate of Banxico’s standing liquidity providing facility. (¶70)
    - Responsible: Banxico
    - Time: I
    - Priority: H
- Time definitions used in recommendations:
  - “I (immediate)” is within one year; “NT (near-term)” is one–two years; “MT (medium-term)” is three–five years.
  - Priority indicators: H: high; M: medium; L: low.

*Source: EXECUTIVE SUMMARY (Technical Note prepared by Istvan Mak, IMF, Monetary and Capital Markets Department, Central Bank Operations Division).*

### EXECUTIVE SUMMARY __________________________________________________________________________ 4

### EXECUTIVE SUMMARY

### Overview
- Mexican money markets are well-regulated and function efficiently, with significant mitigants to systemic liquidity risks. This is supported by:
  - dominance of the repo market in system-wide liquidity management;
  - marginal level of interbank unsecured transactions;
  - commercial banks’ full compliance with the Liquidity Coverage Ratio (LCR).
- Development banks are not subject to liquidity regulation, and some have significant reliance on short-term funding with low levels of unencumbered high-quality liquid assets—this might contribute to systemic liquidity risk during periods of extreme market stress in severe tail risk scenarios.
- Recommended actions for development banks include: improving monitoring of liquidity; leveraging internal risk committees to assess risk profile and contribution to systemic risk; making use of Pillar 2 requirements; and/or devising appropriate action(s) to improve maturity transformation.

### Money Market Functioning and Bank Liquidity
- Repo market structure and activity:
  - Daily average turnover in the repo market amounts to 2,400 billion of Mexican pesos (MXN).
  - Typical ticket size for interbank transactions is MXN 800-900 million; trades with pension funds and investment funds are about half that size.
  - About 92 percent of the interbank trading volume is concentrated in the one-day tenor, and 7 percent in the below seven-day tenors; percentages for the market different to interbank are 97 percent and 2 percent, respectively.
  - The unsecured money market is relatively small (2–3 percent of the repo market) and is almost exclusively used by commercial banks for overnight lending.
- Collateral usage in the repo market:
  - About two thirds of the traded volume is secured by government securities, mostly floating rate bonds.
  - A quarter involves IPAB securities.
  - The remainder involves corporate bonds.
- Securitized money market:
  - Banks, NBFIs, and non-financial companies’ debt funding activity is geared towards medium- and long-term bonds.
  - Issuance of commercial papers, certificates of deposits, and other private short-term debt instruments is legally and technically possible but rarely supplied.
- NBFI participation and constraints:
  - Since 2020, investment funds can borrow by repoing securities to increase leverage up to 5 percent of their assets, and in situations of extreme financial stress this percentage increases to 10 percent.
  - Pension funds and investment funds only borrow securities but never lend them in the repo market due to regulation; this asymmetry may constrain their risk management activity since they can only reduce exposure to government bonds via interest rate swaps or outright sales.
  - Authorities should continue to explore and address the remaining impediments to NBFIs’ more balanced participation in the repo market.
- Funding source diversity:
  - Commercial banks: demand deposits account for more than half of total liabilities; term deposits 21 percent; bond issuance 3 percent; repo funding 17 percent.
  - Development banks: more than 30 percent of funding from bond issuance; 34 percent from repo operations; remainder from term deposits, call money transactions and other funding sources including from non-residents—this reflects a more concentrated funding profile.
- Role of collateralized interbank market:
  - The collateralized interbank money market is the first line of defense against liquidity shocks; Mexico’s high usage of repo operations has avoided fragmentation seen when unsecured transactions dominate.

### Interest Rate Benchmarks and Monetary Policy Implementation
- Benchmarks and reform:
  - Interest rate benchmarks are robust and representative; further reform is in progress in line with international best practices.
  - Given the overnight repo market’s dominance in banks’ funding structure, a repo-based reference rate is most suitable.
  - A Working Group on Alternative Reference Rates has been established to promote adoption of the Overnight TIIE Funding Rate (TIIEF) and to explore development of risk-free term rates.
  - Banxico’s assessment of suitable methodology for computing risk-free term rates is in progress and options considered are in line with best international practices.
- Banxico’s operational framework:
  - Banxico implements monetary policy through a state-of-the-art mid-corridor operational framework that ensures almost perfect control over liquidity.
  - The framework supports efficient pricing and distribution of liquidity, provides banks certainty about day-to-day liquidity conditions, and grants access to a collateralized intraday facility and an overnight overdraft facility as backstops.
  - The collateral policy provides a sufficient volume of securities to efficiently implement policy while high quality and liquid nature of securities minimizes risks to Banxico’s balance sheet.

### Foreign Exchange Market Functioning
- FX market characteristics:
  - The Mexican peso is one of the most actively traded emerging market currencies in the global FX market.
  - Mexico maintains a freely floating exchange rate regime with very small market footprint by the central bank.
  - The FX Commission generally abstains from spot FX interventions and FX funding support measures, incentivizing prudent market-based risk management by participants.
  - Regulatory limits for bank net open position are in place.
- Information and monitoring:
  - Banxico has timely and accurate information on domestic banks’ FX funding needs; domestic banks provide daily information on FX funding needs and FX market activity.
  - Banxico keeps market monitoring tools up to date amid continuously changing conditions.
- Capacity to respond to FX stress:
  - Banxico has capacity to effectively respond to FX market stress where market-based risk management is no longer possible.
  - In the latest FX funding market stress event, Banxico benefitted from the Fed’s U.S. dollar swapline, but it also has other means such as credit facilities and its own reserves to provide adequate U.S. dollar funding.

### Securities Market Functioning
- Government bond market:
  - The government bond market is highly liquid and is the most liquid of Mexico’s securities markets.
  - Liquidity is underpinned by a diverse investor base and availability of interest rate derivatives for risk management.
  - Market participants have high degree of information about SHCP issuance plans with annual announcements and quarterly updates on volumes and instruments.
- Corporate and private short-term debt:
  - Domestic corporate bond market activity is moderate.
  - Private short-term debt securities are marginal.
- Non-resident participation:
  - Non-residents’ participation in the government bond market has gradually declined in recent years; they still hold about one-fifth of Mexican sovereign debt securities.
  - Non-resident sell-off created liquidity stress during the COVID-19 crisis; local commercial banks and NBFIs substituted foreign investor presence benefiting from Banxico’s liquidity support—highlighting the liquidity aspects of the sovereign-financial nexus in tail risk scenarios.

### Market Support Measures and Emergency Liquidity Assistance (ELA)
- COVID-19 crisis response:
  - During COVID-19, Banxico deployed targeted support to securities market participants by providing funding liquidity in well-calibrated amounts and against good collateral.
  - Programs were introduced as price-based facilities and served as effective backstops; direct market intervention was very limited and risk transfer to Banxico’s balance sheet remained completely controlled.
  - Exit strategies were provided from the onset as most facilities were effectively term repo or swap transactions.
  - The COVID support programs had several design features that provide useful lessons for future programs.
- ELA framework assessment:
  - Banxico carries out lender-of-last-resort function through the ELA framework, which has sound legal basis and robust governance but would benefit from some improvements.
  - Credit claims are eligible as collateral, but their encumbrance is time-consuming and operational arrangements could be enhanced.
  - Counterparty eligibility is limited to credit institutions (commercial and state-owned banks) and ELA decisions are made by the board on a case-by-case basis.
  - Current practice includes a solvency and liquidity assessment by a specially devoted internal committee that considers indicators beyond regulatory requirements and includes a forward-looking analysis.
  - Recommended ELA improvements:
    - Formalize in the ELA policy that the solvency assessment shall be forward-looking.
    - Set a binding minimum threshold for the ELA interest rate above the interest rate of Banxico’s standing liquidity providing facility to discourage moral hazard.
    - Explore options to make credit claims promptly and effectively available as collateral in time-critical ELA operations.

### Risks, Scenarios, and Near-Term Prospects
- Global tightening and tail risks:
  - The first sustained tightening of global liquidity conditions in many years warrants close monitoring for liquidity stress in Mexico.
  - Severe inflationary pressures have led many central banks, including Banxico, to hike policy rates; the war in Ukraine has aggravated spikes in commodity prices.
  - Given non-residents still hold about one-fifth of Mexican sovereign debt securities, a surprise monetary tightening—particularly in the U.S.—could, in a tail risk scenario, result in significant capital outflows and system-wide liquidity stress.
  - In such a case Banxico’s liquidity assistance framework and Mexican authorities’ ability to manage liquidity stress will be crucial backstops.

### Key Recommendations (excerpted from Table 1: Mexico: Recommendations on Systemic Liquidity Management)
- Improving the resilience of the money market:
  - Continue the good progress made on the interest rate benchmark reform and complete the transition to term alternative reference rates. (¶ 13)
    - Responsible: Banxico
    - Time: NT
    - Priority: M
  - Authorities could (i) improve the monitoring of development banks’ liquidity, (ii) leverage their internal risk committees to take stock of their risk profile and contribution to systemic risk, and (iii) consider making use of Pillar 2 requirements, and/or (iv) devise appropriate action(s) to improve these entities’ maturity transformation. (¶17)
    - Responsible: CNBV, SHCP, Banxico
    - Time: NT
    - Priority: H
- Emergency Liquidity Assistance:
  - Explore possible options to make credit claims promptly and effectively available as collateral in time-critical ELA operations. (¶67)
    - Responsible: Banxico
    - Time: NT
    - Priority: H
  - ELA policy should stipulate that the solvency assessment by Banxico on which counterparties’ eligibility is based shall be a forward-looking one. (¶62)
    - Responsible: Banxico
    - Time: I
    - Priority: H
  - Set a binding minimum threshold for the ELA interest rate above the interest rate of Banxico’s standing liquidity providing facility. (¶70)
    - Responsible: Banxico
    - Time: I
    - Priority: H
- Time definitions in the recommendations table:
  - “I (immediate)” is within one year; “NT (near-term)” is one–two years; “MT (medium-term)” is three–five years.
  - Priority indicators: H: high; M: medium; L: low.

*Source: EXECUTIVE SUMMARY (Technical Note prepared by Istvan Mak, IMF, Monetary and Capital Markets Department, Central Bank Operations Division).*

### 21.      The repo market exhibited resilience during the COVID-19 crisis in terms of volume

### 1mexea2022003 - 21.      The repo market exhibited resilience during the COVID-19 crisis in terms of volume

### Repo market resilience and interest rate benchmarks
- Repo market trading remained relatively stable in the main channels of funding between market participants during the COVID-19 crisis; volatility of interest rates increased only temporarily and moderately.
- Banxico introduced the overnight TIIE funding rate (TIIEF) as the new near risk-free reference rate.
  - TIIEF is determined as a volume-weighted median of wholesale overnight repo transactions settled by banks and brokerage firms.
  - Banxico ensures TIIEF methodology is in full compliance with the IOSCO principles on financial benchmarks.
  - TIIEF is transaction-based, removing manipulation risks associated with contribution-based benchmarks (e.g., LIBOR or the TIIE), and repo-based benchmarks ensure the reference rate is near risk-free.
- A Working Group on Alternative Reference Rates was established with broad market representation (banks, brokerage houses, inter-dealer electronic and voice brokers, stock exchanges, financial authorities, non-banking financial entities and corporates) to promote adoption of TIIEF and to develop risk-free term rates.
- Options under assessment for risk-free term-rate methodology:
  - In advance structure: reference an average of TIIEF observed before the current interest period begins.
  - In arrears structure: reference an average of TIIEF over the current interest period.
  - In arrears better reflects realized interest over the period but provides very little notice before payment; conventions used in other jurisdictions (payment delays, lookbacks, lockouts) can provide longer notice within an in arrears framework.

### Bank liquidity conditions and vulnerabilities
- Liquidity Coverage Ratio (LCR) outcomes:
  - As of Q3 2021, all commercial banks surpassed the 100 percent LCR threshold.
  - The LCR increased steadily over recent years, including through the COVID-19 crisis.
  - The average LCR for the whole banking system and the LCRs of six D-SIBs are currently well above 150 percent.
- Temporary regulatory easing during COVID-19 (from February 28, 2020, to August 31, 2021; exceptions gradually unwound until March 1, 2022):
  - Banks could continue to register as liquid assets those classified as liquid on February 28, 2020.
  - Banks could exclude March data from liquidity reserve calculations (Look Back Approach).
  - Temporary exceptions to consequences and corrective measures when LCR falls below 100 percent.
- Development banks’ liquidity profile and risks:
  - Some development banks rely on short-term wholesale borrowing and repos (mostly overnight), which account for more than 50 percent of aggregate funding of the sector.
  - Development banks have low levels of “unencumbered” high-quality liquid assets; monitored ratios (e.g., unencumbered HQLA to short-term liabilities) are low.
  - All liabilities of development banks are explicitly guaranteed by the federal government, but low liquidity levels raise potential for idiosyncratic liquidity distress in acute market stress that could transmit to other regulated financial entities via repo transactions and lending operations.
- IMF staff view and suggested ex ante containment:
  - High reliance on short-term funding might amplify stress in future episodes.
  - During COVID-19, Banxico extended the perimeter of its FLAO facility to include development banks to “provide an alternative source of liquidity to [them] so that they [could] channel resources to productive projects ....”
  - Suggested steps to strengthen liquidity risk mitigation for development banks include:
    - (i) improve monitoring of development banks’ liquidity;
    - (ii) leverage their internal risk committees to take stock of their risk profile and contribution to systemic risk;
    - (iii) consider making use of Pillar 2 requirements; and/or
    - (iv) devise appropriate action(s) to improve their maturity transformation.
  - Authorities should apply proportionality to two small deposit-taking development banks, consistent with the Basel Committee’s Core Principles for Effective Banking Supervision (BCPs).

### Recommendations (explicit)
- Authorities should continue the good progress made on the interest rate benchmark reform and complete the transition to term alternative reference rates.
- Authorities could:
  - (i) improve the monitoring of development banks’ liquidity;
  - (ii) leverage their internal risk committees to take stock of their risk profile and contribution to systemic risk;
  - (iii) consider making use of Pillar 2 requirements; and/or
  - (iv) devise appropriate action(s) to improve these entities’ maturity transformation.

### Monetary policy implementation and liquidity management in normal times
- Banxico operating framework features enabling precise control over liquidity:
  - Fiscal authorities must provide one-day notice of any change to their accounts held at Banxico, making the effect of government transactions on liquidity known with certainty.
  - Banxico conducts two open market operations (OMOs) every day: usually lending at around 7:20–7:30 a.m. and deposit taking around 6:00 p.m.; operation type can change according to autonomous factors.
  - The afternoon OMO is conducted after autonomous liquidity factors are settled and can compensate for unexpected transactions.
  - Banks are typically able to square off their accounts at Banxico to zero at the end of almost every day.
- OMO allocation mechanism:
  - OMOs (typically 1–25 days) are variable-rate, fixed-volume auctions with a reserve price set at the policy rate (floor for injections, ceiling for withdrawals); prices are invariably very close to the reserve price.
- Banxico liquidity-providing facilities (layers):
  - Intraday repo operations (Repos for Liquidity Provision to the Payment System, RSP) to ease payment system liquidity pressures.
    - RSP can be initiated anytime between Banxico’s morning and afternoon OMOs; collateral must be prepositioned in the morning.
    - Eligible collateral includes actively traded securities issued in Mexico by the Federal Government, IPAB, or Banco de México.
    - Interest rate charged for intraday RSP is zero; repos mature when INDEVAL closes for repo operations.
    - Eligible counterparties: payment system participants (banks and brokerage firms); brokerage firms require authorization of at least one bank to act as conduit and limit the value of repo agreements they can enter.
  - Collateralized overnight overdraft against banks’ deposits in the central bank or in the form of repo:
    - Overdraft limit equals the amount of Monetary Regulation Deposits (DRM), Special Deposits from repo operations with specified securities, OMO Term Deposits, Deposits for determining current term TIIEs, and segregated USD deposits—haircuts applied to USD deposits.
    - Overdraft is automatic, overnight and priced at two times the policy rate.
      - With the policy rate as of July 2022 is 7.75 percent makes for an overdraft cost of 15.5 percent.
    - Positive cash balances at Banxico are not remunerated, incentivizing efficient liquidity management.
  - FLAO standing overnight facility (provided upon request, priced at 1.1 times the policy rate):
    - FLAO is automatic after Banxico receives a Letter of Request from the requesting bank’s director general.
    - FLAO collateral universe is broader than the overdraft and can be extended without additional request letters.
    - Eligible additional collateral for FLAO includes peso-denominated securities issued by IPAB, development banks, public sector enterprises, local and municipal governments, commercial banks with minimum AA local rating and minimum global rating equal to the Federal Government (provided issuance at least six months prior), securities linked to inflation and foreign currency, and securities issued by foreign governments and central banks, all subject to a minimum rating of AA.
- Structural liquidity management:
  - Managed mainly by sale of Government Securities; in rare large withdrawals, Banxico can impose monetary regulation deposits (DRM).
  - Banxico converted MXN 105 billion of DRM to BREMS; conversion did not alter quantum of collateral available but increases amount usable in repos with market participants.
  - As of end-2021, total outstanding DRM was MXN 270 billion, 62% in cash and 38% in BREMs.

### Eligible collateral availability (Table 2 summary, as of June 2020)
- Table 2 totals and selected items (In billions of Mexican pesos, as of June 2020):
  - TOTAL market: 9,137,373
  - Total holdings by commercial and development banks: 1,667,097
  - Encumbered: 450,756
  - Available: 1,207,131
  - Percentage Available: 72 (In percent)
- Selected collateral lines (values preserved exactly):
  - Mandatory long-term deposits: Total in the Market 167,220; Commercial banks and development banks Holdings 167,220; Encumbered 17,020; Available 150,201; Percentage Available 90 (In percent)
  - USD deposits (USD): Total in the Market 4,194; Holdings 4,194; Encumbered 488; Available 3,705; Percentage Available 88 (In percent)
  - OMO term Deposits: 6,895; Holdings 6,895; Encumbered 0; Available 6,895; Percentage Available 100 (In percent)
  - Term TIIE Deposits: 3,400; Holdings 3,400; Encumbered 200; Available 3,200; Percentage Available 94 (In percent)
  - Government securities: Cetes: 1,270,443 total; Holdings 236,457; Encumbered 75,696; Available 160,761; Percentage Available 68 (In percent)
  - Mbonos: 3,247,425 total; Holdings 676,540; Encumbered 150,864; Available 525,675; Percentage Available 78 (In percent)
  - Udibonos: 1,852,829 total; Holdings 30,443; Encumbered 17,028; Available 13,415; Percentage Available 44 (In percent)
  - Bondes: 1,473,995 total; Holdings 223,137; Encumbered 48,235; Available 174,902; Percentage Available 78 (In percent)
  - IPAB Bonds: 1,008,200 total; Holdings 216,039; Encumbered 120,286; Available 86,543; Percentage Available 40 (In percent)
  - Monetary regulation bonds (BREMS): 102,773 total; Holdings 102,773; Encumbered 20,938; Available 81,835; Percentage Available 80 (In percent)

### Foreign exchange market functioning
- MXN global role and volatility:
  - Global use of the MXN as a proxy for managing EM exposure gives it a high correlation (beta) to global risk shocks.
  - Offshore MXN derivatives markets are massive; futures and options open interest and trading volumes of MXN on major exchanges are significantly higher than most other EM currencies and comparable to major currencies.
  - As a result, MXN exchange rate volatility tends to increase the most among peers in periods of global risk aversion due to non-resident asset sales and position closing in offshore venues.
- FX derivatives market structure and participants:
  - Foreign exchange derivatives in Mexico are an effective and liquid alternative to complement or hedge spot positioning; turnover distribution is concentrated in forwards and foreign exchange swaps.
  - Mexican banks, subsidiaries of foreign banks, and non-resident participants use derivatives for hedging and arbitrage.
  - NBFIs’ participation varies by business model:
    - Insurance companies are less active and concentrate mainly on hedging.
    - Pension and investment funds use derivatives for both hedging and arbitrage, usually with longer time horizons than banking institutions.

*Source: IMF staff summary of chapter content.*

### 41.      Commercial banks’ FX risk management is supported by FX liquidity limits. Commercial

### 1mexea2022003 - 41.      Commercial banks’ FX risk management is supported by FX liquidity limits. Commercial

### FX risk management and regulatory limits
- Banks must hold enough liquid assets in foreign currencies to cover the sum of the largest gap (liabilities minus assets) for maturities of 1 day, 1–8 days, 1–30 days, and 1–60 days, as well as a percentage of all other liabilities up to 60 days that are not covered by assets (excluding derivatives) with the same or shorter maturity.
- Structural FX liquidity requirement:
  - At the end of each day, no commercial bank may have an amount of Net Foreign Currency Liabilities (excluding derivatives) greater than 1.83 times its core capital.
  - Net Foreign Currency Liabilities are defined as the difference between liabilities weighted by maturity (with 100 percent weight for maturity up to 1 year and decreasing to 0.05 percent for liabilities maturing beyond 3 years) and assets weighted by maturity and degree of liquidity (with 100 percent weight for liquid assets and 50 percent weight for highly graded loans up to 1 year).
- Net open FX position limits:
  - Net open position in foreign currency is limited to 15 percent of Tier-1 capital (including peso denominated products linked to the exchange rate).

### FX funding structure and vulnerabilities
- USD is the most important foreign funding currency for Mexican banks; primary sources:
  - FX deposits: more than 80 percent.
  - FX swaps: less than 20 percent.
  - 75 percent of the FX swaps are shorter than one week.
- USD funding pressures can be measured by the FX swap basis (deviation from covered interest rate parity between the MXN and the USD).
- Funding costs depend on global and local factors: interest rate differentials, local currency outlook, and derivatives market conditions.
- Key risks and differential impacts:
  - Episodes of globally increased volatility and risk aversion can trigger USD funding squeezes, exacerbated by low liquidity and one-side positioning by local market participants.
  - Distortions in funding markets have been short-lived in recent years except for tail events (e.g., COVID-19), when USD funding costs spiked considerably.
  - Domestic banks have relied on market-based USD funding sources over a longer period and to a greater extent than subsidiaries of foreign banks; subsidiaries can potentially benefit from parent banks’ access to funding alternatives.

### Securities market structure and participation
- Total debt securities issued by residents: MXN 13,065 billion (about 48 percent of GDP).
  - More than 90 percent are issued by SHCP or guaranteed by the state (e.g., CETES, BONDES F, UDIBONOS, BONOS M, SOE debt, IPAB, development banks).
- Institutional investor base:
  - Domestic institutional investors hold almost half of locally issued debt securities.
  - NBFI sector total assets: less than 50 percent of GDP (only half that of emerging market peers).
  - NBFI sector growth has been gradual and one of the slowest among EM peers.
- Foreign participation trends:
  - Non-resident ownership of Mexican government bonds declined from 35 percent to 17 percent over the last five years.
  - Short-term CETES holdings by foreigners declined from 37 percent to 11 percent.
  - Fixed-rate BONOS M holdings by foreigners declined from 63 percent to 38 percent.
  - The fastest pace of decline occurred in the first half of 2020: 10 percentage points for CETES and 6 percentage points for BONOS M.

### Market liquidity characteristics and vulnerabilities
- Securities lending: less than 1 percent of outstanding government bonds are used in securities lending transactions; overall volume has not grown significantly over five years.
- BONOS M liquidity:
  - Average bid-ask spread: 4 basis points (in line with most liquid emerging markets).
  - In March 2020, BONOS M bid-ask spread increased to 9 basis points and average trade size declined by 15 percent.
- Vulnerabilities:
  - Prospects for the first sustained tightening of global liquidity conditions could cause liquidity stress for emerging markets such as Mexico.
  - Strong inflationary pressures and potential faster-than-anticipated monetary tightening (particularly in the U.S.) could result in significant capital outflows and system-wide liquidity stress, given non-residents still hold about one-sixth of Mexican sovereign debt securities.

### Central bank market support measures: objectives and design principles
- Central bank interventions can address:
  - Funding liquidity risk (shortage of funding or increased precautionary demand): tools include short- and long-term repo operations, standing facility operations, FX swaps, and reserve requirement reductions.
  - Market liquidity risk (impaired asset markets): outright asset purchases or programs to buy or sell securities or FX.
- Five key features of effective market support programs:
  - Identify and address key market failures.
  - Be conscious of side-effects and maximize positive spillovers while mitigating adverse effects on other markets.
  - Minimize financial risks to the central bank’s balance sheet.
  - Strive to minimize moral hazard to foster prudent market behavior.
  - Prepare an exit strategy before launching the support program.

### Banxico’s COVID-19 market support programs and lessons
- Banxico’s measures included: funding provision, general liquidity provision and collateral easing, USD lending, targeted market liquidity support, and funding-for-lending facilities.
- Design features and lessons:
  - Programs were price-based facilities serving as effective backstops.
  - Moral hazard was addressed; program sizes were well-calibrated and collateralized to contain risk transfer to Banxico’s balance sheet.
  - Exit strategies were built in, as most facilities were term repo or swap transactions.

### Select Banxico facility actions and details
- DRM reduction:
  - In March 2020, Banxico reduced the DRM held by commercial and development banks by MXN 50 billion, bringing the stock DRM to approximately MXN 270 billion.
- FLAO instrument:
  - Pre-pandemic FLAO interest rate: 2.0 - 2.2 times the policy rate.
  - Reduced to 1.1 times the policy rate (measure became permanent).
  - Access to FLAO was temporarily extended to development banks from April 2020 to February 2021.
  - Collateral eligibility was temporarily relaxed from April 2020 to September 2021 (local scale rating equal to or higher than “A” (previously AA); global scale equivalent “BB+” for foreign currency securities).
- Term repo facility for government securities (facility 4):
  - Term: three months; interest rate: 1.02 times the monetary policy rate.
  - Overall envelope: MXN 100 billion, reached by July 2020; adjusted with an extra MXN 50 billion.
  - Securities limited to: Cetes, Bonos M, Udibonos, Bondes D and BPAs.
  - Facility was phased out by Q4 2021 as repos matured.
- Security swap window (facility 5):
  - Allowed banks to provide securities eligible for the FLAO and receive government securities.
  - Initial envelope MXN 100 billion (later reduced to MXN 50 billion); recourse was less than 30 percent of the envelope; all swaps matured by January 2022.
- Corporate bond repo facility (facility 6):
  - Term: three months; interest rate: 1.1 times (later reduced to 1.03 times) the monetary policy rate.
  - Recourse about 10 percent of the allocated MXN 100 billion envelope; all repos matured by November 2021.
- Debt exchange auctions (facility 9):
  - Program amount: up to MXN 100 billion; only MXN 15 billion were allotted.
- Funding-for-lending facilities targeting SMEs:
  - Facility 7 financed loans to SMEs and households up to MXN 250 billion.
  - Facility 8 provided funding for existing credit lines up to MXN 100 billion.
  - Total funding provided: MXN 54.2 billion (less than 1 percent of the banking system’s loans to non-financial corporates).
  - Term up to 36 months; interest rate equal to the monetary policy rate.
  - Facility 7 eligible collateral: universe of assets eligible for the FLAO or funds from the DRM reduction.
  - Facility 8 eligible collateral: existing credits to firms with local scale credit rating equal to or above “A” (as ranked by at least two rating agencies).
  - Banks developed capacity to encumber credit claims as collateral for Banxico in approximately two weeks.

### FX market support: FX hedging auction program
- Program history and design:
  - In place since 2017, originally with an initial envelope of US$20 billion; US$5.5 billion were allotted in the initial year.
  - Offered non-deliverable forwards (NDFs) denominated and settled in Mexican pesos via interactive, competitive auctions to local banks.
- Advantages:
  - Provided local banks an effective hedging instrument against FX risk without impacting international reserves (denominated in Mexican pesos).
  - Local banks could offer the instrument to corporates and other market participants.
  - Large program size provided a strong signaling effect and a backstop to adjust FX exposure instead of causing sizeable spot transactions.

*Source: IMF staff summary of the provided chapter content.*

### 67.      The NDF hedging program was increased to US$30 billion at the onset of the COVID-

### 1mexea2022003 - 67.      The NDF hedging program was increased to US$30 billion at the onset of the COVID-

### FX market interventions and outcomes
- The NDF hedging program was increased to US$30 billion at the onset of the COVID-19 crisis.  
- Actual take-up was small: demand was less than US$2 billion in two auctions at various maturities up to three months.  
- This amount has been added to regular roll-over auctions with a current total amount outstanding of almost US$7.5 billion.  
- Banxico’s participation in the Federal Reserve’s USD swapline arrangement supported the FX funding market amid the global USD shortage in March 2020, which led to widening of exchange rates FX swap basis spreads.  
- Following the swapline announcement, Banxico initially received US$6.6 billion and lent it to domestic banks for three months; further roll-over auctions showed lower demand until the swap line expired in December 2021, reflecting a relatively fast improvement of USD funding conditions.  
- Figure referenced: One-Month FX Swap Basis Spreads of Selected Exchange Rates (In percent).

### Official external and contingent resources
- International reserves: US$207.7 billion at the end of 2021.  
- Bilateral swap lines and contingent facilities: Fed (US$3 billion), Bank of Canada (CAD 1 billion), U.S. Treasury (US$9 billion).  
- IMF Flexible Credit Line: US$50 billion FCL.

### Evaluation of market-support programs
- Large-scale funding liquidity provision combined with limited and targeted acquisition of debt securities via swaps helped restore banks’ market-making activity.  
- Programs were designed to mitigate side-effects: most were price-based, with firm total envelope amounts set to limit risk transfer to Banxico’s balance sheet and collateral requirements to minimize risk transfer.  
- Against the initially committed total MXN 800 billion, the combined actual allocation was less than MXN 200 billion and only one program was exhausted, suggesting moral hazard was likely contained.  
- Most facilities were swap or repo operations that enabled self-liquidation, simplifying the exit strategy.

### Emergency Liquidity Assistance (ELA): role and principles
- An effective lender-of-last-resort (LOLR) function is essential to manage systemic liquidity risk and to avoid overburdening monetary policy, moral hazard, and suboptimal monetary policy implementation.  
- A well-designed LOLR/ELA framework has four fundamental features: (i) institutional eligibility criteria, (ii) collateral eligibility, valuations, and risk controls, (iii) clear pricing and term of emergency support, and (iv) high-frequency liquidity monitoring arrangements.

### Banxico’s ELA framework: legal basis, governance, and practice
- Legal and policy foundation: Banxico’s ELA framework is based on a sound legal foundation and includes an internal policy covering several parameters, but leaves the interest rate to be set by the Governing Board on a case-by-case basis.  
- Governance: The Governing Board has broad flexibility and can assess whether an ELA application has systemic aspects; final determination on systemic aspects is taken by the Banking Stability Committee (CEB).  
- CEB composition: Ministry of Finance (Minister and Deputy Minister), Banco de Mexico (Governor and a Deputy Governor), CNBV (President and the Vice-president in charge of the supervision of the specific troubled bank) and IPAB (Executive Secretary and a member of the Board).

### Counterparty eligibility and solvency assessment
- Counterparty scope: Counterparty eligibility is limited to credit institutions (commercial banks and development banks can receive ELA); guidelines to deploy ELA to commercial banks are public.  
- Solvency thresholds and conditions: Banks requesting ELA must submit a credible liquidity restoration plan. Eligible banks must have a CAR over 8 percent, be under COR (with CAR between 4.5 and 8), or be deemed systemic for resolution purposes by the CEB. Banks under conservatorship and bridge banks operated by IPAB can also receive ELA.  
- Solvency assessment practice: The framework includes an internal committee assessment with solvency and liquidity indicators beyond regulatory requirements. Recommendation to formalize the forward-looking solvency assessment practice.

### Collateral eligibility, valuation, and operational issues
- Range of eligible collateral: Additional collateral listed for ELA includes debt instruments denominated in MXN or foreign currency, common stock of the bank or its subsidiaries, the applicant’s loan portfolio (credit claims), and, in extreme circumstances, physical assets.  
- Valuation approach: Valuation methodologies exist for some assets but are not included in the ELA policy to allow flexibility; valuation process is based on a quantitative risk assessment (CVaR for market risk and credit risk).  
- Practical limitation: Credit claims cannot be promptly and effectively used as collateral under current arrangements because Banxico only accepts credit claims as collateral if they are transferred into a distinct trust to ensure legal certainty; creation of such a trust was found to require about two weeks in Facility 8 experience, which is too long for time-critical ELA operations.  
- Operational trade-off: The ELA framework currently prioritizes legal certainty over operational feasibility for credit-claim collateral. Prepositioning of credit-claim collateral (frontloading legal due diligence and related checks) is discussed as an operational approach used in other jurisdictions to address this trade-off.  
- Possible interim measures: Under extreme circumstances, the Board could approve immediate delivery of funds if owners endorse, shares are pledged, and there is a commitment to create the trust as soon as possible.

### Risk sharing and indemnities
- Indirect indemnities: IPAB would pay Banxico an amount equal to the credit Banxico granted to a commercial bank if the CEB resolves that a default may pose systemic risk; IPAB assumes the rights Banxico had against the borrowing bank, including guarantees.

### ELA term and pricing
- Maximum term: Banxico’s internal ELA policy stipulates that ELA can be provided up to 90 days, which can be further extended.  
- Pricing: The ELA interest rate is left completely to the Governing Board’s discretion; absence of guidance may risk setting rates low enough to create moral hazard. Introducing a minimum interest rate threshold above the interest rate of Banxico’s standing liquidity providing facility is recommended.

### Liquidity monitoring and bank preparedness
- High-frequency monitoring: Routine liquidity monitoring is performed by Banxico and CNBV, including indicators such as the LCR, NSFR, survival horizon, concentration metrics, Liquidity-at-Risk, interbank funding conditions metrics (funding rates in interbank market, terms of funding, volumes of funding, etc.), and other funding indicators.  
- Reporting cadence: Banks are required to comply with the LCR regulation daily and report daily information to Banxico, with a 10-day lag since 2017; banks must immediately inform authorities if they fail or are likely to fail to comply with the LCR.  
- Bank governance requirements: Banks must maintain an up-to-date documented framework and governance arrangements to assess potential liquidity needs, including policies and operational procedures to request liquidity from Banxico, procedures to determine and trigger liquidity requests and monitor resource use, and periodic evaluation of available collateral.

### Recommendations (as listed)
- Banxico should explore the possible options to make credit claims effectively available as collateral in time-critical ELA operations.  
- The ELA policy should formalize the current practice that the solvency assessment by Banxico on which counterparties’ eligibility is based is a forward-looking one.  
- The ELA policy should set a minimum threshold for the ELA interest rate above the interest rate of Banxico’s standing liquidity providing facility.

*International Monetary Fund — Mexico staff report excerpt.*

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_Source: https://www.imf.org/-/media/files/publications/cr/2022/english/1mexea2022003.pdf_