Back Matter

Back Matter

International Monetary Fund
Published Date:
September 1999
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    Annex I: Progress with European Monetary Integration

    A milestone in European integration was achieved when the third and final stage of EMU began on January 1, 1999, with the introduction of the euro.1 This annex provides a progress report on several aspects of EMU: European financial market integration; implementation and performance of the EMU payments and securities settlement systems; the outlook for pan-European capital markets; banking system consolidation and restructuring; and broader financial policy issues, including financial supervision, regulation, and crisis management.

    The launch of the euro went smoothly, reflecting careful preparations for the considerable operational and logistical challenges of the conversion weekend. In the first months of EMU, the TARGET payment system effectively transferred liquidity between participating countries, and arbitrage substantially equalized money market interest rates across the euro area. Even with these early successes, it should not be surprising that a single pan-European capital market has not yet emerged from the previous 11 national markets. Some features of the EMU infrastructure may be impeding the full integration of money and capital markets, especially for secured (repo) transactions, but these obstacles do not seem insurmountable and initiatives are under way to eliminate them. The consolidation and integration of bond, equity, and derivatives markets may be delayed, reflecting remaining challenges in removing problems related to the incomplete and inefficient cross-border links between securities settlement systems. Meanwhile, consolidation and restructuring in the European banking sector are taking place mainly within national boundaries, but it is likely that the single currency will gradually increase pressures for cross-border mergers and the creation of pan-European institutions. National supervisors and regulators are stepping up their coordination efforts, and important agreements have been reached in the area of crisis management.

    Money Market Integration and EMU Financial Infrastructure

    Progressive Integration of the EMU Money Market

    The introduction of a single currency has had an immediate impact on the money markets of the countries participating in EMU. Starting on January 1, 1999, national central banks (NCBs) could no longer tailor monetary policies to the needs of their national economies. While NCBs still implement monetary policy decisions, the ECB decides the timing and the size of refinancing operations on the basis of EMU-wide considerations. Therefore, effective links between national money markets are necessary to redistribute liquidity across national borders whenever national banking systems experience asymmetric liquidity shocks or do not obtain sufficient liquidity through the Eurosystem repo auctions.

    The experience of the first months of EMU has been positive. The TARGET system has provided an effective means for cross-border payments. European private repo and money markets have been distributing liquidity across borders to ensure the convergence of overnight rates across participating countries. Financial systems and institutions that have excess liquidity are able to supply it to those that need liquidity across the euro area.

    At the same time, some elements of the financial infrastructure are impeding full integration. Market participants have noted that some features of the euro financial infrastructure impede cross-border business within the euro area, especially when it involves cross-border transfer of collateral. These features include differences in market structure (such as the extent of bilateral interbank credit lines), national differences in infrastructure (such as payment and securities settlement systems), and national differences in policies (tax, legal, and regulatory environments, including differences in the legal treatment of repo operations). As a result, single integrated markets for money, repo, and securities will probably not emerge until many of the differences in market structure, infrastructure, and financial policies are fully worked out. Some of these features will be difficult and time-consuming to change, reflecting technical problems as well as conflicting interests between EMU financial centers.

    The Supply of Liquidity: ECB’s Auctions and Standing Facilities

    Eurosystem instruments and operating procedures influence the initial distribution of liquidity to the euro-area banking systems2 and also affect the functioning of unsecured and secured (repo) interbank markets in EMU. In addition, banks’ bidding behavior at repo auctions and their recourse to the marginal lending and deposit facilities provide useful indirect information on the conditions in the money market.

    ECB’s Main Refinancing Operations and the “Overbidding Problem”

    The Eurosystem provides the bulk of liquidity to the banking system through weekly main refinancing operations (MRO), based on repurchase agreements with a maturity of two weeks. These tenders have been conducted as fixed-rate rationed allotment auctions, in which a fixed amount of liquidity is offered at a fixed interest rate.3 Banks bid for a share of liquidity by offering collateral.4 If total bids exceed total liquidity on offer, each bank receives a pro rata share of the liquidity, proportional to its share in the overall amount of collateral bid by all banks. For example, if a bank bids 10 percent of the overall collateral bid by all banks, it receives 10 percent of the liquidity offered by the ECB.

    With this auction system, there may be incentives for banks to bid for a larger amount of liquidity than they actually need. Before the start of EMU, overbidding characterized Bundesbank repo auctions, which were conducted with a similar approach. At the start of EMU, banks were bidding more aggressively than pre-EMU German banks. During the first five months of EMU, the average allotment ratio (the ratio of allotted funds to total bids) was only 9.7 percent in EMU, compared with 18.4 percent in Germany during 1998. The stepped-up pace of overbidding might reflect the greater interest of EMU banks in obtaining liquidity directly from the Eurosystem, which may, in turn, result from concerns about the ensuing redistribution of funds by the interbank market, at least during the first months of EMU.

    The fixed-rate auction system allows banks with the most collateral to collect more liquidity than needed at the auction, leaving some banks short of liquidity at the end of the auction.5 In the first months of EMU, this was to some extent a problem fora number of reasons. First, some banks from countries that had previously not used a fixed-rate rationed allotment auction did not allow for the fact that they might have to bid for more liquidity than needed. Second, at the beginning of EMU, some banks had insufficient cross-border credit lines or credit limits. Finally, in the first two months of EMU, it was costly for the less collateralrich banks to acquire liquidity in the unsecured market, instead of at the ECB’s auctions. During January and February 1999, the average overnight rate was some 10 basis points above the main refinancing rate (and exceeded it by 20 basis points for the first two weeks; see the top panel of Figure A1.1). These data are consistent with large banks crowding out both small banks and banks in countries with less eligible collateral.6 More recently, these problems have eased, possibly reflecting an ECB policy directed at holding the overnight rate below the main refinancing rate7 for most of the maintenance period that ended on March 23, which made it unprofitable for some banks to obtain more liquidity than needed at the repo auctions and to lend excess funds in the overnight market.8 The decline in the overnight rate below the main refinancing rate was likely a consequence of the large amounts of liquidity that the ECB injected during March. In recent months, despite persistent overbidding (as shown by the still very low allotment ratios), the consequences of any potential crowding out have subsided as the ECB has been able to reduce the spreads between the overnight rate and the main refinancing rate.

    Figure A1.1.ECB: Interest Rates and Standing Facilities, January 4–June 11, 1999

    Sources: Bloomberg Financial Markets L.P.; Datastream; and European Central Bank.

    To eliminate at the source the distribution problems associated with overbidding in fixed-rate fixed-quantity auctions, the ECB could shift to flexible-rate9 or variable-quantity tenders that could encourage banks to bid only for the liquidity they actually need. The ECB has indicated it is likely to retain the current fixed-rate fixed-quantity auction format for the time being, as it allows the ECB to both signal its view on the appropriate level of interest rates and convey the information it has about the liquidity needs of the euro system. In addition, experience with fixed-rate variable-quantity auctions (in Finland, for example) indicates that such operations could increase volatility in interest rates in unsecured money markets and could require frequent fine-tuning operations to reduce volatility.

    Recourse to ECB’s Standing Facilities

    Banks in EMU can resort to the ECB’s marginal lending and deposit facilities to borrow or deposit overnight liquidity with the Eurosystem. As the recourse to these facilities is unrestricted for a bank having sufficient eligible collateral, the interest rates on them define the floor and the ceiling for overnight rates. In principle, banks would use these facilities only when market rates approach those available through the facilities; otherwise, banks could obtain better terms in the market. In practice, during the first months of EMU, banks made extensive use of the deposit and lending facilities even when overnight rates substantially differed from the rates on the facilities (see bottom panel of Figure A1.1). These episodes cannot be easily explained by intraday interest rate developments.10 On several occasions, both facilities were used for considerable amounts on the same day. There have also been instances of spikes in the overnight rate despite apparently ample aggregate liquidity in the system.11 These occurrences—whose frequency has diminished in recent months—suggest that, at the start of EMU, the interbank market may not yet have been intermediating funds effectively. Moreover, in countries with relatively efficient interbank markets, deposit and lending facilities have been utilized less frequently and to a lesser extent,12 although the heavy reliance on standing facilities mainly reflects start-up inefficiencies of EMU payment systems and banks’ problems in managing payments flows in the new single currency environment.

    TARGET: Prerequisite for Money Market Integration

    The launch of TARGET went relatively smoothly.13 Fewer problems were encountered than some market participants had expected, and some minor glitches were attributable to operational errors by banks rather than shortcomings of the system. The only exception was the January 29 breakdown of the link between the French real-time gross settlement (RTGS) system and TARGET, which resulted in a number of rejected payments and a greater-than-usual recourse to the Eurosystem standing facilities.

    Some market participants14 had suggested before the launch of EMU that the opportunity cost of the collateral needed to obtain intraday credit in TARGET, and its relatively high price per transaction, might encourage banks to send high-value payments—the kind of payments with potential systemic risk—through alternative netting schemes. The first months of EMU have helped dispel these concerns, as most cross-border high-value payments have been sent through TARGET (Figure A1.2).15

    Figure A1.2.Distribution of Cross-Border Payments in EMU Between EBA and TARGET, January–May 19991

    Source: European Central Bank.

    1 Average for the months of January–May 1999.

    The statistics on the first five months of operation of TARGET are reassuring, but it may take some time before judgment can be reached on the role that TARGET will play. First, the distribution of payments observed in the first five months might change—increasing or diminishing the share of TARGET—when the total number, and value, of cross-border payments sent via TARGET, the clearing system of the European Bankers’ Association (EBA), Euro Access Frankfurt (EAF), and the French Paris Net settlement (PNS) will increase in future months with the gradual closure of the numerous remaining correspondent banking accounts. (This prospect is made more likely by the fact that the total volume of cross-border payments sent via the four main payment schemes is currently well below that estimated before the start of EMU.) Second, in view of some technical problems encountered in the initial phase (see below), the overwhelming concern with cross-border payments has so far been timing rather than cost; this may have favored TARGET.16

    The multiplicity of payment systems available for sending cross-border payments within EMU and the preference of different groups of banks for different systems have created some problems in the coordination between paying and receiving banks. In the absence of priority rules regarding the system through which cross-border payments are to be sent, in the first few months after the launch of the euro, a receiving bank did not know whether it would receive funds directly via TARGET, through one of its correspondent banking accounts, or in the account of another branch of the same bank. These difficulties prompted some bank associations to forge common understandings and practices, which have helped to ease some of these problems.

    A remaining issue concerns the timing of payments. In an RTGS system, payments could, in principle, be evenly distributed during the day. Within TARGET, however, there has been a tendency for some large payments to be sent late in the day, which often causes banks to scramble to meet obligations just before closing. Such timing problems seem to stem from a number of factors, including preferences to delay payments and thus minimize demand for costly intraday liquidity.17 If all banks pursued such a liquidity management policy, there would be a substantial risk of gridlock. Concerns have also been raised about the impact of some bank practices on liquidity within TARGET. Banks reportedly minimized their need for costly collateral by requesting payments via TARGET, which settles during the day, while making payments with EBA, which settles at the end of the day.

    In sum, while TARGET seems to have worked reasonably well during its first months of operation, some issues associated with the existence of multiple competing payment systems and the cost of intraday liquidity in TARGET remain. An option for EMU policymakers is to promote more orderly competition among payment systems. Discretion about the timing of payments, and the large number of alternatives for routing payments, may be unduly complicating liquidity management for European financial institutions at a time when the complexity of banks’ treasury operations has already increased owing to the new environment created by the introduction of the euro.18

    Progress Toward a Single EMU Money Market

    Cross-Border Interbank Loans and Deposits

    Although liquidity factors and the outcome of ECB repo auctions may result in an unequal initial distribution of liquidity across banks and banking centers, an integrated and efficient EMU-wide interbank money market could help to effectively transfer liquidity to where it is most needed. The need to redistribute liquidity across national borders will likely lead to a larger share of cross-border interbank loans and deposits vis-à-vis other euro-area countries. By contrast, domestic interbank transactions will likely diminish. In the first three months of EMU, these tendencies were clearly recognizable in Italy and, to a smaller extent, in Germany and France, but no major or sudden change in the pattern of cross-border interbank flows seems to have taken place at the start of EMU (Table A1.1).

    Table A1.1.Distribution of Interbank Loans and Deposits Across EMU Countries Before and After EMU(In percent)
    Interbank LoansInterbank Deposits
    Before EMUAfter EMUBefore EMUAfter EMU
    Other euro area13.014.0
    Other euro area9.210.912.615.2
    Other euro area29.
    Sources: IMF staff calculations based on data from Banca d’talia, 1999, Relazione Animale 1998. Table aD15; Banque de France, 1999, Tendances Monetaires et Financieres (March), Table 4.2; and Deutsche Bundesbank, 1999, Monthly Report (May), Table IV.1.Notes: Data periods for before EMU are as follows: Germany (January–December 1998), France (December 1998), and Italy (June–December 1998); and for after EMU, the data periods correspond to January–March 1999 for Germany and Italy, and to March 1999 for France.

    Interest Rates in the Unsecured Interbank Market

    Whereas quantity data on the recourse to the Eurosystem marginal facilities and cross-border interbank flows suggest that banks in each country still tend to deal primarily with their NCBs and with other domestic banks (as opposed to foreign banks), overnight interest rates data indicate that existing cross-border flows have been sufficient to largely eliminate differentials between countries in the unsecured money market. Figure A1.3, which plots the EONIA (the weighted average of the rates on unsecured overnight contracts reported by a panel of 57 major institutions in the euro area) against selected indices of national overnight rates, confirms that overnight rates in EMU have substantially converged.19

    Figure A1.3.Overnight Rates on Unsecured Interbank Funds in the Euro Area, January 4–June 10, 1999

    (In percent)

    Sources: Bloomberg Financial Markets L.P.; and Datastream.

    Although interbank average rates are well-aligned across markets, and volatility around policy rates is not large, it is not clear that the 11 national money markets linked by TARGET are operating fully as a single market. Bid-ask spreads, for example, are wider in some markets than in others, possibly suggesting that some markets are more efficient than others in intermediating liquidity (Table A1.2). Moreover, whereas bid-ask spreads in EMU countries are not unusually large in relation to U.S. or U.K. spreads, in some countries they are higher than in pre-EMU Germany.20

    Table A1.2.Bid-Ask Spreads of Overnight Interbank Rates for Selected Countries, 1998–99(In basis points)
    EMU Countries
    Non-EMU countries
    United Kingdom11.612.515.312.5
    United States6.36.3
    Sources: Bloomberg Financial Markets L.P.; Datastream; Federal Reserve Bank of New York; Reuters; and IMF staff estimates.

    Progress Toward Integration of Money Markets

    The observation that in EMU there is not a single money market located in one of the EMU financial centers but rather 11 national markets linked to each other by reasonably efficient arbitrage may reconcile the evidence based on quantities (recourse to the Eurosystem marginal facilities and cross-border interbank flows) and interest rates. The initial distribution of liquidity at the ECB auctions would not be an issue if the redistribution of liquidity in the unsecured money market were fully efficient. That there were concerns (among market participants and NCBs) during the start of EMU about the initial distribution of liquidity suggests possible inefficiencies, which may reflect two factors. First, as the data on cross-border interbank deposits and loans seem to indicate, there may still be relatively few bilateral cross-border interbank credit lines to support cross-border lending in the unsecured interbank market. The limited number of such credit lines is partly a legacy of the pre-euro system; until December 31, 1998, the overwhelming majority of interbank credit lines were between banks in the same country, and it will take time for banks to establish new interbank relationships and assess the associated counterparty risks. In this regard, it is also possible that a single consolidated payment system for all EMU countries could have encouraged banks to extend cross-border credit lines more rapidly than in the current, nationally focused, system. A single European electronic money market, linked to a single realtime gross payment system, could also address some of the shortcomings of the current interbank market.

    While there is little doubt that the EMU money market for unsecured funds is integrated enough to ensure the implementation of a single monetary policy across the euro area, it is not clear whether its remaining partial segmentation might have other consequences. There are some—but presumably minor—implications for market efficiency, associated with different bid-ask spreads across countries and with frequent recourse to costly marginal facilities. It is an open question how segmentation affects financial stability. On the one hand, segmentation could limit contagion and systemic effects from the failure of a single financial institution. On the other hand, it could complicate pricing and the distribution of liquidity during times of turbulence. In the event of a liquidity crisis, the unsecured money market might not yet be easily able to distribute the injected liquidity to the institutions that need it most, particularly in a situation in which some of these institutions might also be short of eligible collateral to access the ECB’s lending facilities and might face binding limits on existing credit lines that prevent them from obtaining liquidity from other banks.

    Repo Markets and Securities Settlement Systems

    The development of a single EMU market for private repo transactions would appear to be more challenging than the development of a single unsecured interbank market because of the additional complexities associated with back-office functions within financial institutions and securities settlement systems. While national overnight repo rates seem to have largely converged across EMU (see, for example, Figure A1.4, which compares French and Spanish rates), the main issue regarding EMU repo markets is the absence of reliable and efficient links between national securities settlement systems, which appears to be hampering the cross-border use of collateral.

    Figure A1.4.France and Spain: Overnight Repo Rates, January 4, 1999–June 11, 1999

    (In percent)

    Sources: Bloomberg Financial Markets L.P.; and European Central Bank.

    European securities are now deposited in 31 continental and national depositories in Europe (compared with 3 in the United States) and in a few international depositories (Euroclear and Cedel). While technology permits a single EMU-wide trading platform for all types of securities, it would be difficult to create a system from existing national systems that would clear and settle cross-border transactions with speed and safety. To support pan-European repo trading, these systems could be connected by real-time delivery-versus-payment links or consolidated into a few securities settlement systems.21 Market participants have suggested that the choice between a centralized or decentralized market structure for securities settlement systems seems to be a politically sensitive issue because of its implications for competition among financial centers. So far, the decentralized model has prevailed, but existing national systems are being linked22 and the legal problems associated with a multiplicity of different national repo contracts are being addressed.23 Initially, these links will not be delivery-versus-payment, so that the cross-border use of securities will remain subject to credit risk (loss of principal) and, at a minimum, to liquidity risk. For this reason, counterparties are still reluctant to use these links for operations other than monetary policy operations.24

    To allow for the cross-border use of collateral in monetary policy operations and intraday credit operations in TARGET from the very start of Stage Three of EMU, the Eurosystem created the correspondent central banking model (CCBM). Non-euro-area NCBs also participate in the CCBM for the provision of intraday credit to TARGET participants connected to “out” RTGS systems. The CCBM basically consists of a network of accounts through which securities deposited by a financial institution at one NCB can be used by another institution as collateral in repo operations with another NCB. The model was envisaged only as an interim solution until a market alternative becomes available, but it has already proven successful since more than €65 billion are currently held in cross-border custody through the CCBM. The fact that collateralization is still done primarily on a domestic basis should probably be attributed to the national bias of counterparties’ portfolios rather than to infrastructural barriers.

    The use of the CCBM entails at least two constraints. First, given its temporary nature, the CCBM is not an automated real-time system. Procedures are therefore comparatively slow. In the first months of EMU, not all of these communication links between NCBs have worked efficiently. For example, some institutions that used the CCB links to obtain liquidity from the NCB in their country against collateral deposited at another NCB reportedly waited six hours for confirmation. Owing to this confirmation lag, the banks were required to undertake another (bridge) operation with their NCB, using domestic collateral deposited at the local securities settlement system, to cover immediate needs for liquidity. A similar need for bridge financing apparently exists when a repo is rolled over while NCBs exchange confirmation messages. These problems may be significant enough to prevent private institutions from using collateral cross-border in some instances. Second, the CCBM is construed in such a way that only the NCB in the country where the collateral was issued can act as correspondent central bank. Therefore, assets that had been moved out of the securities settlement system of issuance have to be repatriated before they can be used as collateral for central bank credit.

    Facilitating cross-border transfers of securities may contribute to the development of a single repo market in EMU but, more important, may also contribute to a reduction of systemic risk, owing to a larger share of collateralized cross-border interbank transactions. Options for improvements in the infrastructure for clearing and settlement might include strengthening the links between systems and improving individual systems, or creating a single unified system that could serve all European markets. While private solutions to these problems might be preferable to wholly public ones, there may be some scope for public policy to provide incentives and guidance.

    Enhancing Efficiency and Integration of Unsecured and Secured EMU Money Markets

    The limited integration of unsecured and secured money markets in Europe, particularly at the start of EMU, reflects a common set of features in these markets: the fragmented structure of trading and counterparty relationships and the fragmented (and in some cases weak) supporting infrastructures, including clearing, settlement, and payment systems.25 These features reflect to a certain extent the decentralized operating procedures for the distribution of liquidity used by the Eurosystem. By entrusting the implementation of monetary policy to NCBs, the framers of EMU have (in effect) supported a level playing field in the competition among European financial centers. On the other hand, they have helped to perpetuate the nationally oriented infrastructure of payments and securities settlement systems, as this infrastructure is used to implement monetary policy in a decentralized fashion.

    Summarizing the preceding discussion, there are three measures that might make the current system of European money and private repo markets more unified and efficient. The first measure could be the creation of a single, Europe-wide electronic market for unsecured funds. A second measure might be the improvement of the infrastructure for clearing and settlement. A third could be the creation of incentives to encourage more orderly competition among payment systems. At present, competition among payment systems allows discretion about the timing of payments and the large number of alternatives for routing payments are unduly complicating liquidity management for European financial institutions.

    Outlook for Pan-European Capital Markets

    The development of pan-European capital markets also seems to face some impediments, notwithstanding substantial pressures for consolidation in the European securities markets. As in other areas of financial services, there is excess capacity. Europe has about 25 derivatives exchanges, 20 derivatives clearing houses, and 15 stock exchanges. This fragmentation is costly to market participants that seek pan-European exposures. In an environment in which financial services such as insurance, investment banking, and asset management are increasingly offered by pan-European institutions to customers across Europe, consolidation would help to achieve market depth and reduce costs.

    There appear to be some important obstacles to the creation of pan-European securities markets at two levels: technical obstacles that are (in principle) straightforward to overcome; and policy-related obstacles that will be more difficult to overcome, particularly as they may serve to protect domestic markets.

    As with the money markets, problems in securities settlement systems and other back-office functions are likely to impede the creation of single pan-European markets for bonds, equity, and derivatives. For example, market participants suggested that the main difficulties in creating a pan-European market for blue-chip stocks are related to back-office problems and incompatibilities, particularly in the area of securities settlement. Some technical problems are related to differences in trading platforms across exchanges.

    Some technical problems could be overcome, in part, through linkages among exchanges, as well as through outright mergers. However, the technical capabilities of linked systems would tend to be constrained by the weakest system. Alternatively, the success of prominent initiatives, such as Eurex, Euro-MTS, and the London-Frankfurt stock exchange initiative, might establish standards that could be adopted across Europe. Successful Europe-wide initiatives could also encourage the creation of new pan-European systems to handle back-office functions, including clearing and settlement systems for bonds, equities, and derivatives.

    Second, and more important, there are a number of policy-related impediments to consolidation of exchanges across Europe. Among these are differences in tax regimes and in legal and regulatory environments across countries. These differences can raise considerable legal uncertainties about cross-border transactions. Regulatory arbitrage can create incentives for exchanges to migrate outside of EMU. There have been some official efforts to encourage harmonization, notably the EU’s Investment Services Directive (ISD) and the Financial Services Action Plan of the European Commission, which was approved by the ECOFIN Council on May 25, 1999.26 In some cases, the national implementation of this directive has been helpful in fostering European securities markets; for example, the “remote membership” provision of the ISD, which permits electronic access to foreign securities exchanges, contributed to the success of Eurex (a fully electronic exchange). In general, however, progress in harmonization has been slow. Market participants have noted that this degree of inertia might reflect the reluctance of some domestic authorities to level the playing field, because impediments serve to protect domestic markets and market infrastructures from competition.

    As it is unlikely that these impediments will be addressed soon, market participants themselves may find ways around these barriers. For example, the owners of the successful Euro-MTS system for trading benchmark European government bonds incorporated their company outside of EMU (in the United Kingdom) as a broker-dealer for regulatory reasons. Exchanges could also be located outside the EU or offshore in order to avoid impediments.

    The overall degree of integration is limited and varies from market to market. In the bond markets, no clear national center appears to be emerging for bond trading. In part, this may reflect differences in back-office functions, as custody, clearing, and settlement appear to continue to be organized largely along national lines. It may also reflect past practices, including the concentration of portfolios in domestic securities. As currency matching rules within EMU have become irrelevant with the introduction of the euro, institutional government-bond portfolios are becoming increasingly diversified, and pressures for a single European bond market will grow. One possibility is that a system such as Euro-MTS could evolve into a platform for pan-European trading in a variety of European government securities, although competitors of Euro-MTS are likely to emerge in the near future.27

    In the equity markets of continental Europe, although there are some precedents for foreign listings, trading is still largely organized along national lines. The increased focus on credit risk rather than currency risk, the shift from country to sector analysis, and the growth of institutional funds will provide a strong stimulus to the growth of European equity markets. The expansion of asset management and institutional investment is likely to create demand for a single liquid market in large-capitalization stocks. The realization of such a market is the objective of the London-Frankfurt alliance, although the precise timetable for full integration of the two exchanges remains unclear. In May 1999, discussions on the modalities of the initiative were opened to six new participants (the Amsterdam, Brussels, Madrid, Milan, Paris, and Zurich stock exchanges); it remains to be seen how broader participation will affect the pace of decision-making in the alliance. If the alliance moves forward, the European equity market may evolve into a three-tier system with small-cap stocks traded on Easdaq, AIM, or the Euro. NM system, mid-caps traded on domestic exchanges, and large-caps traded on the London-Frankfurt system.

    In the derivatives markets, Eurex (formed by the merger of the DTB and Soffex) is widely regarded as a success, rivaling or exceeding other global exchanges in terms of turnover. Eurex has taken a clear lead over its U.K. rival Liffe in long-term fixed-income products, although Liffe retains the lead in short-term fixed-income products. Liffe and other continental exchanges have expressed interest in alliances with Eurex, and Eurex is receptive to such arrangements, but little progress has been achieved. At the same time, Matif has formed an alliance with exchanges in Singapore and Chicago (SIMEX and CME) to trade their most popular products (the “Euro Globex” initiative). Italian and Spanish derivatives exchanges (MIFF and MEFF) would be included at some point as well, while Matif’s planned alliance with Eurex appears to have stalled.

    Looking ahead, and in view of the substantial impediments to full pan-European markets and the limited amount of consolidation that has taken place thus far, the most likely prospect might be the emergence of a two-tiered system of securities markets. At the top tier, one or two systems in each market could serve as centers for trading European benchmarks. For example, euro-area sovereign bonds may be traded principally on Euro-MTS; large-cap equities on the London-Frankfurt exchange; and derivatives on Eurex (particularly long-term fixed-income derivatives) and Liffe (particularly short-term fixed-income derivatives). A second tier of exchanges could handle securities that are of national but not Europe-wide importance, including non-benchmark government bonds, small- and mid-cap equities, and various derivatives.

    Nevertheless, without pan-European banks, there will be limited pressure for the removal of the impediments that are preventing the formation of truly pan-European markets. As discussed above, some national authorities appear to sustain interest in continuing national securities markets and settlement systems. While cross-border trading platforms (like Euro-MTS in the bond market) help to integrate the “front-end” of securities markets, “back-end” inefficiencies in settlement systems remain. Until pan-European banks are formed, progress in the elimination of these settlement problems may be slow, and the potential efficiency gains from the introduction of the euro may not be fully realized.

    Banking System Consolidation and Restructuring

    For the time being, both official preferences and market forces are encouraging consolidation and restructuring of European banking systems within national markets rather than across borders.28 There are economic reasons for domestic consolidation, including the existence of economies of scale and scope from mergers of retail and universal banks within highly fragmented national systems. There are also cultural and legal features that discourage cross-border mergers. Importantly, authorities in some countries seem to be reluctant to allow increased foreign participation until the process of domestic consolidation has produced “national champions” that are judged large enough both to discourage takeovers by foreign banks and to potentially undertake cross-border acquisitions themselves.

    While there may be reasons for consolidation to continue within national banking systems, there are constraints on the extent and the nature of domestic consolidation. For example, in France and Germany a majority of domestic banking assets are located with banks with legal and ownership structures that largely insulate them from the consolidation efforts of commercial banks. Absent a change in these institutional factors, the pressures to increase size might inevitably lead large banks to look beyond national boundaries even in the face of incomplete domestic consolidation. Further, once one big merger shows that cross-border consolidation is under way, the relatively small number of attractive targets in some countries may lead to a “floodgate” effect as banks will wish not to be left out of the process.29

    There are indications that national authorities sometimes influence the consolidation process involving domestic entities, as in the case of the declared opposition of some supervisors and regulators to hostile takeovers in the banking sector. In France, the authorities expressed a desire for the three large banks (BNP, Société Générate, and Paribas) involved in takeover bids to come to an amicable agreement. In Italy, the authorities expressed a desire for further consolidation, but the Banca d’Italia’s opposition to two proposed mergers (Unicredito and Banca Commerciale Italiana, and San Paolo-IMI and Banca di Roma) was in part attributed by market participants to the hostile nature of the bids.30

    Against the background of these trends, there have been some important recent developments in the restructuring of the banking sector in continental Europe, especially in France and Italy. Privatization in France has culminated in the sale of Crédit Lyonnais and the intended sale of Credit Foncier in July 1999. Meanwhile, reform of the publicly controlled savings bank system has made headway. Pending legislation will transform the savings bank system into a cooperative system, with state participation limited to a core minority interest held by the state-owned Caisse des Dépôts et Consignations. Consolidation, however, remains elusive. Most recent mergers and acquisitions either involved firms with little overlap in lines of business or were conducted under the assumption that redundant employees would not be aggressively shed. One cross-border merger involving the specialized segment of credit to local governments has, however, performed well and is expected to be further advanced by the future introduction of mortgage bonds in France.

    The reorganization of the banking sector in Italy has perhaps been the most accelerated in Europe, as illustrated by the 54 mergers that occurred in 1998, the successful privatization of the Banca Nazionale del Lavoro (BNL), and legislation providing incentives for “charitable foundations” to relinquish controlling stakes in banks in the next four years. Moreover, at end-June 1999, Banca Intesa and Banca Commerciale Italiana announced their plans to merge, creating Italy’s largest banking group and one of the ten largest in Europe. Foreign participation in Italian banks continued to grow, and minority interests of banks from several European countries in BNL, Banca di Roma, and numerous large Northern banks rose. Foreign investment has helped to foster mergers and acquisitions among large banks, some of which have also acquired smaller institutions. Mergers among top banks have, nonetheless, been hampered by two factors. First, several large institutions are linked through cross-shareholdings stemming from historical relationships, and minority interests have often diverged from one another. Second, the Banca d’Italia has indicated to market participants that it does not favor hostile takeovers in the banking sector. Market participants view these factors as temporary hurdles, which may influence the pairing of specific banks but will not stop the consolidation of the sector. The scope for consolidation is likely to increase with the sale of shares in banks that are currently controlled by “foundations,” as new legislation will force foundations to relinquish their interests in banks to retain the special tax status they currently enjoy.

    By contrast, bank consolidation in Germany—while progressing—remains constrained. Growing pressure on cooperative banks—heightened by, inter alia, the phasing in of more sophisticated risk-management requirements—has resulted in mergers (168 in 1998) among cooperative (or mutual) banks. These mergers, however, did not lead to the development of centralized structures that would save operational expenses (e.g., the unification of back-office and other support activities). Furthermore, these mergers have largely taken place within the umbrella organization of cooperative banks (Genossenschaftsbanken), rather than involving commercial banks. Some concerns have also been raised about the interest rate risk incurred by mortgage banks, owing to their increasing lending to regional banks, through the issuance of sought-after mortgage bonds (Pfandbriefe). In Germany, there is apparently little concern about the possibility of foreign takeovers, possibly reflecting low interest margins—due to the large share of savings, cooperative, and public banks (most notably the Landesbanken)—and the perception that the big private banks are strong. By contrast, it is generally expected that German banks will be bidders for banks in other countries.

    Financial Supervision, Regulation, and Crisis Management

    Will Supervisory and Regulatory Frameworks in EMU Keep Pace?

    National supervision and regulation in many countries is being challenged by the increased blurring of commercial banking, investment banking, insurance, and asset management. Challenges are also likely to emerge within the euro area from the likely tendency toward greater reliance on securitized, market-oriented finance than on bank-intermediated finance, the likely emergence of pan-European exchanges for securities and derivatives trading, and cross-border mergers between financial institutions.

    National-level structures in most European countries divide supervisory and regulatory responsibilities among several agencies (with the notable exceptions of Denmark, Luxembourg, Norway, Sweden, and the United Kingdom, all of which recently introduced a single regulator). While European authorities consider the existing division of responsibilities at the national level to be working reasonably well, some rationalization is probably desirable and might enhance supervision. However, full-fledged reforms such as those associated with the Financial Services Authority in the United Kingdom seem unlikely in the near future; some uncertainty about the outcome of the U.K. reform is encouraging a wait-and-see attitude among most continental European authorities.

    As for structures at the euro-area level, although the 11 EMU countries have transferred national monetary sovereignty to the European level, supervisory and regulatory responsibilities have remained a national responsibility. Cooperation currently occurs mainly through bilateral arrangements and meetings in multilateral forums. In the case of banking and securities regulators, there are now bilateral memorandums of understanding between virtually all EMU (and pre-in) countries, providing for both regular meetings and cooperation and information exchange when there are specific concerns or issues. Although memorandums of understanding are typically not legally binding arrangements, cooperation with counterparts in other countries is considered to have worked smoothly. For European banking supervision, the two major multilateral forums are the Banking Supervision Committee of the ECB, a senior-level committee for cooperation between national supervisors, and the Groupe de Contact, a lower-level group that addresses cases involving individual banks. European authorities are generally satisfied with the way EMU-wide cooperation has been taking place within these groups.

    As long as banking systems remain primarily national and banks’ businesses are mainly traditional (with limited reliance on both on- and off-balance-sheet securities transactions involving cross-border exposures), the current decentralized approach that relies on cross-border cooperation will most likely remain workable and effective. As pan-European financial markets and institutions emerge, and the reliance on securitized market-oriented finance expands, pan-European financial supervision and regulation may become more desirable and necessary. European officials have acknowledged these possibilities and seem to be taking a pragmatic approach to enhancing cooperation and coordination, and to considering alternative institutional arrangements. Recent developments in this area include (1) in February 1999, the signing of a multilateral European memorandum of understanding among securities supervisors that are members of FESCO (Forum of European Securities Commissions);31 (2) discussions about a strengthening of the multilateral mode of cooperation and information sharing among banking supervisors; and (3) the creation of a high-level group of representatives of EU finance ministers focusing on supervisory developments in EMU (e.g., consolidated in addition to sectoral supervision, the appropriate relationship between the central bank and the supervisory authority, and the need for some form of European-level supervision).

    There seem to be different degrees of enthusiasm among European officials about centralization, and the development of a single euro-area supervisor seems to be a long way off. By contrast, once a pan-European exchange for securities—like the pan-European platform for blue chips currently under preparation by the London Stock Exchange and the Deutsche Börse—is created, a central securities supervisor and regulator would become more likely.

    Crisis Management

    There has been agreement within the Eurosystem on crisis management procedures along the following lines. The ECB regards the adequacy of financial institutions’ own risk controls as of utmost importance for financial stability. Where supervisory authorities are not satisfied that institutions’ risk management is adequate, they will use available tools to avoid excessive risk taking. The Eurosystem believes it has mechanisms in place to contribute to the smooth conduct of policies by the competent authorities relating to the prudential supervision of credit institutions and the stability of the financial system. The main guiding principles underlying these mechanisms are as follows:

    • the provision of emergency liquidity assistance if and when appropriate is primarily a national responsibility;

    • the associated costs and risks are borne at the national level; and

    • mechanisms ensuring an adequate flow of information are in place so that any potential liquidity impact can be managed in a way consistent with the maintenance of the appropriate monetary policy stance, and any cross-border implications can be dealt with. This agreement clarifies the framework for crisis management within EMU. Two issues remain: (1) whether decentralized arrangements will remain appropriate when pan-European institutions and markets emerge; and (2) whether arrangements are in place—although not spelled out to maintain “constructive ambiguity”—to ensure that the Eurosystem will effectively coordinate with the 11 national supervisors, treasuries, deposit insurance schemes, and EU authorities, in the event of a crisis involving a potentially insolvent institution.

    While a decentralized framework may be adequate to manage a crisis involving a traditional bank operating at the national level with few cross-border interbank links, it may pose challenges in the event of a crisis with EMU-wide systemic implications. In a decentralized framework, it may be difficult to fully internalize the systemic implications of a bank failure. National authorities are likely to take into account the potential costs—which would be borne at the national level—of assisting a troubled institution, but it is not obvious that they would fully consider the benefits of avoiding the cross-border systemic implications of its failure. It is also not unreasonable to expect, even in the absence of pan-European institutions, that the introduction of the euro would increase the potential for systemic events in the European banking industry.32 As discussed, banks are in the process of increasing the number and size of their cross-border interbank credit lines to ensure that they can borrow from and lend to banks across EMU. This implies a need for more cross-border interbank lines than before EMU, with a correspondingly higher systemic risk in case of financial problems in one banking system. To be in a position to assess systemic risk in a timely manner, there are arrangements to exchange information within the Eurosystem and with banking supervisors. Work is currently under way to enhance the capabilities of the ECB and the Eurosystem to monitor the EU financial system as a whole in cooperation with the NCBs and national supervisors.

    For dealing with potentially insolvent institutions, the institutional framework in the EU is decentralized and relies on national legislation and arrangements, the exchange of information in the Banking Supervision Committee, and bilateral agreements to cope with cross-border spillovers. Although the Eurosystem will most likely be involved in crisis management, its actual involvement is not spelled out in laws and regulations. This decentalized approach is relevant in part because of practices associated with “constructive ambiguity,” which introduces a degree of uncertainty about the conditions under which emergency liquidity assistance would be provided to individual institutions or more widely through markets in crisis situations. Constructive ambiguity is regarded by some, but not by all, as a way to limit the adverse potential consequences of moral hazard. As has been discussed before (IMF, 1998, and Prati and Schinasi, 1999), in cases where constructive ambiguity is used to promote strategically a degree of uncertainty, there should be no ambiguity about the mechanisms or the allocation of responsibilities that will be called upon to resolve problems and crises.

    Annex II: Banking System Developments and Corporate Sector Restructuring in Japan

    The Japanese authorities have put in place over the past year a framework for addressing long-standing banking system problems. These measures, together with tighter prudential bank regulation and supervision, also added momentum to corporate restructuring in Japan. Legislation was enacted in October 1998 that sharply increased public funds available to deal with banking problems, toughened the conditionally for bank recapitalization with such funds, and created the mechanism for temporary nationalization of failed banks. In addition, supervision improved under the newly established Financial Supervisory Agency (FSA). Looking ahead, the principal remaining challenges for banks are to set aside adequate provisions for loan losses, address other sources of capital weakness, and restore core profitability. Progress in these areas is important given the planned reintroduction of limited deposit insurance coverage after March 2001.

    Japanese nonfinancial companies have started to take decisive steps toward restructuring. Since the beginning of 1999, the authorities have moved to introduce several measures to facilitate this process, including the drafting of a more workable insolvency law to support firms’ financial reorganization and measures to facilitate labor mobility and the scrapping of excess capacity. In the period ahead, the priorities for corporations are to focus on their core business and strengthen their balance sheets.

    Overview of Banking System Issues

    During much of 1998, market perceptions of the financial soundness of most major banks deteriorated.1 Bank stock prices fell, credit ratings were downgraded, and funding spreads widened (Figure A2.1). The visible difficulties of one of Japan’s major banks and the apparent political deadlock over plans to inject public money into troubled banks contributed to the intensification of market concerns.

    Figure A2.1.Japan: Banking System Strains, 1997–99

    Sources: WEFA; and Bloomberg Financial Markets L.P.

    1 Average U.S. dollar LIBOR of Fuji Bank, Bank of Tokyo-Mitsubishi, and Norinchukin Bank minus the LIBOR fix.

    2 Highest rate minus lowest rate.

    In response to continued banking system problems, legislation was enacted in October 1998 that provides a broad framework for resolving banking problems. The authorities have started to apply the new instruments: two major banks were nationalized in late 1998, most remaining major banks were recapitalized with public funds in March 1999, and the authorities have begun addressing problems in regional banks. In addition, the FSA conducted on-site inspections of all major banks in the summer and fall of 1998 and of all regional banks in the winter and spring of 1999. The expectation of public capital injections helped strengthen bank equity prices, and the loosening of monetary policy in February 1999 contributed to the disappearance of the Japan premium.

    Performance of major banks in FY1998 remained weak, although virtually all major banks reported capital ratios above 10 percent for March 1999 after the injection of public funds. Major banks’ loan-loss charges were, however, more than double their operating profits, resulting in substantial net losses (Figure A2.2). The banks’ net losses would have been even larger in the absence of an accounting change that allowed them to post large deferred tax credits in their unconsolidated accounts. Public funds and deferred tax assets together accounted for more than half of Tier 1 capital as of March 1999.

    Figure A2.2.Japan: Major Banks’ Profits, FY 1988–99

    (In trillions of yen)

    Source: Fitch IBCA.

    Notwithstanding recent progress, Japan’s banking problems continue to be a source of concern for macro-economic performance, pointing to the importance of restoring the full functioning of financial intermediation and ensuring continued financial stability. The need for action is highlighted by the expiration of the current blanket coverage of deposit insurance in April 2001. Weaknesses remain in three key areas:

    • Bad loans are still not fully recognized or adequately provisioned. The scale of uncovered losses remains a major source of uncertainty.

    • Capital adequacy remains unclear, reflecting not only possibly inadequate provisioning, but also unusually large deferred tax assets and the use of book rather than market valuation of securities holdings.

    • Core profitability is weak, owing in particular to the large scale of corporate lending, which earns thin interest margins.

    Asset Quality

    While supervisory standards have improved, concerns remain that uncovered losses from bad loans could be substantial. There are three main measures of problem loans in Japan (Table A2.1).2 The Federation of Bankers’ Associations (FBA) disclosure standard includes loans to borrowers in legal bankruptcy, past due loans in arrears by three months or more, and restructured loans. According to these rules, major banks reported in their financial statements non-performing loans totaling ¥20.3 trillion (6.3 percent of total loans) for March 1999. A second, somewhat broader measure is based on the recently enacted Financial Reconstruction Law. Under this measure, major banks’ nonperforming loans amounted to ¥28.0 trillion (8.7 percent of total loans) in March 1999. Finally, the aggregate figure of banks’ own self-assessments of asset quality provided by the FSA, which covers watchlist, doubtful, and unrecoverable loans, indicated that major banks’ classified loans amounted to ¥44.2 trillion (13.8 percent of total loans) in September 1998, net of collateral, guarantees, and specific loan-loss provisions.

    Table A2.1.Japan: Estimates of Problem Loans for the Major Banks
    Federation of Bankers’ Associations (FBA)Financial Reconstruction LawBanks’ Self-Assessments of Asset Quality
    FeaturesIncludes loans to borrowers in legal bankruptcy, past-due loans in arrears by three months or more, and restructured loans.Requires the disclosure of unrecoverable loans (Class 4), doubtful loans (Class 3), and watchlist loans that are in arrears by at least three months or for which there has been a change in terms or conditions beneficial to the debtor (the substandard portion of Class 2 loans).Covers watchlist loans (Class 2), doubtful loans (Class 3), and unrecoverable loans (Class 4).
    Changes and notes(1) The rule for charging off nonperforming loans (NPLs) was relaxed. Starting in March 1999, banks were allowed to charge off problem loans that were fully covered by specific reserves even before legal proceedings were completed. This reduced reported NPLs but also decreased reported reserves. (2) The definition of NPLs was broadened. Also starting in March 1999, some banks began to include loans to bankrupt or potentially bankrupt borrowers on which interest was not yet overdue. This increased reported NPLs.This definition is somewhat broader than the FBA measure because it includes claims other than loans, such as guarantees.Banks are not required to publicly disclose this information, but the Financial Supervisory Agency reports aggregate amounts for groups of banks with a delay of about four months.
    Estimated value of problem loansMajor banks reported NPLs of ¥20.3 trillion for March 1999. Adding back partial charge-offs, NPLs amounted to ¥27.1 trillion.Major banks’ NPLs amounted to ¥28.0 trillion in March 1999.Major banks’ classified loans, net of collateral, guarantees, and specific loan loss provisions, amounted to ¥44.2 trillion in September 1998.

    The size of uncovered losses associated with problem loans is uncertain. A conservative estimate can be derived from banks’ self-assessment results (Table A2.2).3 Using actual provisioning rates for various categories of loans, disclosed by the Financial Reconstruction Commission, and a Bank of Japan study of banks’ loss experience, the classified loans for September 1998 (latest available) would imply a total uncovered loss in all banks of ¥14 trillion (about $120 billion or 3 percent of GDP).

    Table A2.2.Japan: Estimated Uncovered Loan Losses, September 1998
    Classified LoansTotal
    Class 2Class 3Class 4
    All banks(In trillions of yen)
    Classified loans166.16.90.1
    Uncovered losses210.
    Major banks3
    Classified loans145.55.70.1
    Uncovered losses27.
    Regional banks
    Classified loans120.51.20.0
    Uncovered losses20.60.03.8
    (In percent)
    Provisioning rates
    Sources: Bank o f Japan, 1998, pp. 19–32; Financial Reconstruction Commission; Financial Supervisory Agency; and staff estimates.

    Net of specific provisions.

    Uncovered losses are the difference between appropriate and actual provisions. In turn, actual provisions are equal to gross loans minus net loans. So, uncovered losses = (appropriate rate - actual rate)*(net loans/(1 - actual rate)).

    Including Long-Term Credit Bank and Nippon Credit Bank.

    Based on loan-loss provisions at major banks.

    Derived from Bank of Japan study. Based on historical three-year cumulative loan write-offs at a sample of 18 banks.

    While substantial additional provisions have been made since September 1998, remaining uncovered losses could be considerably higher for three reasons: (1) banks may have been overly optimistic in loan classification, especially with regard to the impact of the current recession on loan quality; (2) loss rates—especially for Class 2 loans—may be higher in the future than during the mid-1990s, when banks were not actively disposing of bad loans (even taking into account the special provisions made in 1995 and captured in some of the figures used in the Bank of Japan study); and (3) possible uncovered losses in credit cooperatives are not included (based on data for March 1998, including credit cooperatives would boost uncovered losses by about ¥3 trillion).

    Overall, despite the substantial charge-offs already effected, provisions in coming years are likely to remain significant relative to banks’ operating profits, possibly requiring further capital injections in selected banks.

    Capital Position

    Notwithstanding banks’ relatively high reported capital ratios, concerns remain about capital adequacy. The failure of LTCB demonstrated that measured capital adequacy may overstate a bank’s true financial position: LTCB reported a capital adequacy ratio of 10.3 percent for March 1998, but was subsequently found to have negative net worth of ¥2.7 trillion (equivalent to 15.3 percent of risk assets) as of October 1998. It is unlikely that the entire deterioration in the bank’s capital strength occurred just during this seven-month period. While inadequate loan loss provisions are clearly the primary concern, there are three other important concerns.

    • Deferred tax assets, which arise mainly from loan loss provisions, amounted to about one-third of major banks’ Tier 1 capital as of March 1999.4 Given that the realization of these credits depends on future taxable income, and that the prospects for bank profitability are uncertain, the regulatory ceiling on deferred tax assets of five years’ taxable profit would appear high. For example, in the United States, deferred tax credits are limited to 10 percent of Tier 1 capital or one year’s taxable profit, whichever is smaller.

    • Unrealized losses on securities holdings. Banks are allowed to value securities holdings at cost, rather than the lower of cost or market, and in practice only one major bank—Bank of Tokyo-Mitsubishi—still uses the latter system. Although major banks in aggregate had net unrealized gains on listed securities as of March 1999, several banks carried unrealized losses. Moreover, major banks’ large equity holdings (whose market value is roughly 2½ times banks’ own equity) imply a significant exposure of capital to market risk.

    • Provisions against Class 2 loans are considered to be general provisions and are therefore allowed to be counted as Tier 2 capital. However, such provisions are specific to a group of assets and should arguably be excluded from capital.5 Although provisions against Class 2 loans are currently only a small fraction of risk-weighted assets, they are becoming larger as loan provisioning standards are tightened.


    Japanese major banks’ core profitability remains weak compared with large banks in other industrial countries. Although Japanese banks have huge asset bases, they have relatively low revenues and consequently relatively low returns on equity or assets—their return on assets is about one-third to one-half that of large U.S. banks.6 A key reason for major banks’ low revenues is that their primary business is wholesale corporate lending, on which interest margins are as thin in Japan as they are in other industrial countries. While large-scale, low-margin corporate lending was important in other countries in the past, over time banks have expanded their retail lending operations and moved into more profitable lines of business, such as the production of “leveraged loans,” that is, loans that are repackaged and sold to institutional investors and other non bank institutions (through securitization), freeing capital and increasing fee income. In addition, in other countries, increased competition has generally resulted in exit, and consolidation also contributed to a widening in interest margins.

    Besides the need for a strategic reorientation, banks must compete in mortgage lending with the Government Housing Loan Corporation and in deposit taking with the Postal Savings System. Outstanding mortgages by the Government Housing Loan Corporation exceed those by domestically licensed banks. Postal Savings deposits have two main advantages over deposits at private institutions: (1) they are viewed as backed by the full faith and credit of the government; and (2) long-term deposits are very liquid, as they can be redeemed without penalty after six months, which provides an attractive hedge against an increase in interest rates.7 In addition, the Postal Savings system pays no taxes or deposit insurance premia and is not subject to the same capital adequacy requirements. Although the interest rate on postal saving deposits is set as a fraction (usually about 90 percent) of the average three-year deposit rate at private banks, the differential appears inadequate—especially when interest rates are low—to compensate for the nonpecuniary benefits of postal saving deposits. As a result, the share of personal deposits with the postal saving system in total personal deposits increased sharply during the 1990s, as market interest rates fell and concerns about the financial positions of some private institutions increased (Figure A2.3).

    Figure A2.3.Japan: Postal Saving Deposits, 1987–98

    (In percent of total personal deposits)

    Source: Bank of Japan.

    Main Policy Developments in Banking

    The authorities have made important progress in addressing banking problems during the past year. A framework—backed by public money and administered by the FRC—was created to resolve banking problems. Through its on-site inspections of all major and regional banks, the newly established FSA improved the recognition of the bad loan problem. Partly as a result, major banks made loan-loss charges of ¥10 trillion in FY1998, bringing cumulative loan-loss charges since April 1990 to over ¥47 trillion (9½ percent of GDP).8 Together, an improved resolution framework and strengthened supervision laid the groundwork for recapitalization of weak but solvent major banks, nationalization of two insolvent major banks, and interventions in regional banks. Banks receiving public funds announced restructuring plans that point in the right direction. These actions stabilized the banking system—as reflected in the virtual disappearance of the Japan premium—and are providing a window of opportunity for further reform.

    Legislative Framework

    Legislation approved in October 1998 expanded and strengthened the framework for ensuring banking system stability. The legislation had three main components.

    • The amount of public funds available to cover banking sector losses was doubled to ¥60 trillion ($500 billion or 12 percent of GDP). Of this, ¥25 trillion was allocated for recapitalization of weak but solvent banks, ¥18 trillion for financial revitalization activities such as temporary nationalization and state administration of banks, and ¥17 trillion for special financial assistance exceeding the pay-off costs.

    • A new high-level body, the FRC, was established to oversee banking system stability and restructuring. The FRC, headed by a cabinet-level minister, is responsible for inspection and supervision, recapitalization, and resolution of failed institutions. The FSA, which assumed inspection and supervisory responsibilities from the Ministry of Finance in June 1998, was placed under the FRC.

    • Two bad loan collection and disposal agencies (the Resolution and Collection Bank and the Housing Loan Administration Corporation) were consolidated into a new agency, the Resolution and Collection Corporation. This new agency has expanded authority to purchase bad loans not only from failed banks but also from solvent institutions.


    The FSA conducted special on-site inspections of major banks in the fall of 1998 and of regional banks in the winter and spring of 1999. These inspections were more intensive than in the past and provided the authorities with effectively simultaneous evaluations of banks’ asset quality. Following the inspections, the FSA sent letters to banks, detailing its evaluation of each bank’s loan classification. Banks were required to respond within a month and were encouraged to incorporate recommendations into subsequent loan classification exercises. The FSA’s policy is not to comment publicly on any individual bank (with the exception of nationalized banks), but the FSA retains the ability to use market pressure to encourage compliance, for example through frequent examinations, which would become known in the financial community.

    The FSA found that major banks had understated classified loans by ¥5.4 trillion in March 1998 (Table A2.3). However, the bulk of the FSA’s reclassification (¥3.6 trillion) was from Class 1 to Class 2, which implied little additional provisioning, and the only significant reclassification (¥1.6 trillion to Class 3) applied mainly to banks that were subsequently nationalized. Similarly, the FSA found significant discrepancies in loan provisioning only in the nationalized banks. These results were not surprising, given that the FSA’s evaluation of the adequacy of loan classification and provisioning was based on banks’ own criteria. The FSA also found that regional banks had understated their problem loans as of March 1998, with the amount of reclassification (1.4 percent of loans) being similar to that in major banks.

    Table A2.3.Japan: Financial Supervisory Agency’s Special Inspections of Major Banks, December 1998(In trillions of yen)
    Assessment of Credit Quality, as of March 19981
    Total credit394.2394.20.0
    LTCB and NCB27.527.50.0
    Class 1344.7350.1−5.4
    LTCB and NCB19.621.5−1.9
    Class 243.840.23.6
    LTCB and NCB5.25.00.2
    LTCB and NCB2.41.01.4
    LTCB and NCB0.30.00.3
    Required loan-loss provisions8.67.61.0
    Of which:
    LTCB and NCB1.60.80.8
    Source: Financial Supervisory Agency (FSA).Note: LTCB stands for Long-Term Credit Bank; NCB stands (here) for Nippon Credit Bank.

    Classified loans are reported net of specific provisions.

    A new inspection manual was issued in April 1999 and will become effective in July. Although the new manual is intended to clarify—rather than strengthen—existing standards, it will effectively tighten standards by removing loopholes. The new manual is not expected to have a large impact on loan loss provisioning.

    The increase in supervisory resources will allow for more frequent regular on-site inspections. Staff of the FSA’s Inspection Department are to increase from 165 to 249. Although about 90 percent of current FSA staff are on secondment from other ministries, most are expected to remain at the FSA because it is already the principal agency for financial issues and will acquire the financial planning system function from the Ministry of Finance in 2000. The FSA’s current objective is to inspect all major banks and about half the regional banks every year, and to inspect the remainder of the regional banks (generally the stronger ones) every other year. In addition, special inspections will focus on particular issues, such as Y2K preparedness.

    Nationalization of Two Major Banks

    The new bank legislation and the special inspections prepared the ground for the temporary nationalization of two major banks. LTCB’s stock price had started to drop sharply in June 1998 on reports that the bank was having difficulties raising funds. The authorities’ initial plan—announced at the end of June—was to merge LTCB with smaller Sumitomo Trust Bank, but this plan was eventually abandoned, in part because Sumitomo Trust was reluctant to take over LTCB’s substandard loans. The failure in September of Japan Leasing, one of LTCB’s main affiliates with more than ¥1.5 trillion in debt (including ¥256 billion to LTCB and ¥150 billion to Sumitomo Trust), left little doubt that LTCB was insolvent and contributed to the buildup of market pressures. After LTCB applied for nationalization on October 23, the Deposit Insurance Corporation acquired all the outstanding shares and provided financial support, thus allowing LTCB to continue its regular operations and meet all of its obligations.

    LTCB’s capital turned out to be much lower than originally believed. LTCB reported a capital adequacy ratio of 10.3 percent for March 1998 and 6.3 percent for September 1998. At the time LTCB was nationalized in October, the FSA’s special inspection found that the bank had negative net worth of ¥340 billion (about 1.9 percent of risk-weighted assets) as of end-September, including unrealized losses on securities holdings. In March 1999, the FRC declared that LTCB’s negative net worth was in fact ¥2.7 trillion (15.3 percent of risk-weighted assets as of end-September) as of October 1998. LTCB’s losses were borne in part by its former shareholders, as the share price for the nationalization was set at zero.

    LTCB’s government-appointed management is currently seeking a buyer for the bank with the assistance of a foreign investment advisor. To increase its attractiveness to potential buyers, LTCB has begun to restructure by reducing employment and withdrawing from overseas operations, and is expected to transfer all of its bad assets to the Resolution and Collection Corporation. While several investment groups have expressed interest in LTCB, the original goal of finding a buyer by the end of April was not met. Although the government would prefer to sell the bank as an ongoing business, potential investors are reportedly more interested in buying the assets alone.

    The authorities acted more swiftly with Nippon Credit Bank following the FSA’s special inspection. During 1997–98, this bank had struggled through a series of attempts to restructure, including the complete withdrawal from overseas operations and cuts in employment and salaries, with financial assistance from other commercial banks and the Bank of Japan. The FSA notified Nippon Credit Bank in November 1998 that, based on its special inspection, the bank had negative net worth as of March 1998. Nippon Credit Bank failed to develop an acceptable remedial action plan; on December 14, the authorities put the bank under state control.

    Public Capital Injections into Major Banks

    The banks that applied for public funds were largely those that had received public money under the previous recapitalization scheme in March 1998; the main exception—the Bank of Tokyo-Mitsubishi—did not apply for the more recent recapitalization. As in the 1998 recapitalization exercise, to qualify for public funds, banks had to demonstrate positive net worth and the ability to generate long-term profits.

    The standard for determining net worth was more rigorous than in March 1998, as the FRC included all unrealized losses on securities holdings and applied somewhat stricter provisioning standards for classified loans. Specifically, the FRC called for 70 percent coverage of the unsecured portion of Class 3 (doubtful) loans and 15 percent coverage of the unsecured portion of substandard Class 2 (special mention) loans. However, the base for the higher provisioning ratios was rather narrow—the unsecured portion of substandard loans was only about 10 percent of Class 2 loans—so the net impact on provisioning was small compared with the magnitude of potential uncovered losses. Major banks made provisions and charge-offs of about ¥10 trillion in FY1998.

    Banks submitted detailed restructuring plans to show long-term profitability (Table A2.4). These had four main components.

    • Expansion of profitable activities. Gross income is to be raised on average by about 3 percent over four years, by increasing housing loans and loans to small enterprises, expanding ATM networks and business hours, offering private banking services to wealthy clients, and selling investment trusts (mutual funds). These efforts will occur against the background of strong competition in retail banking: regional banks have large branch networks and finance companies dominate the technology-intensive consumer loan business. Also, the weak economic environment may continue to depress interest margins, while alternative strategies to raise profitability beyond that in retail banking, such as derivatives trading, are usually associated with greater risk.

    • Cost reduction accounts for much of the projected improvement in net income. Operating expenses are projected to be reduced on average by about 8 percent over four years, mostly through cuts in personnel costs. The number of bank branches is expected to decline, with a sharp reduction in overseas branches, though all but one major bank expect to remain internationally active. Room for cost cutting may be limited by the fact that, compared with other international banks, Japanese banks already have low costs and need to upgrade information technology.9

    • Strategic alliances. Trust banks have been especially active in strategic alliances. Yasuda Trust has become a subsidiary of Fuji Bank, and Mitsui Trust and Chuo Trust plan to merge in April 2000.

    • Balance sheet adjustments. Banks are planning to increase sales of distressed unsecured loans and loans secured by real estate, and some banks are planning to reduce their holdings of equities. The announced plans to sell equity holdings appear modest (¥100–200 billion per year for five years) and do not involve selling the shares of keiretsu members.

    Table A2.4.Japan: Major Banks’ Restructuring Plans, FY1998–FY2002(Percent changes)
    Net Income1Gross Income1Operating Expenses1Personnel CostsNumber of EmployeesNumber of DirectorsNumber of Branches
    City banks
    Dai-Ichi Kangyo19.83.0−7.8−16.1−18.20.0−13.2−20.5
    Long-term credit bank
    Industrial Bank of Japan−11.9−12.6−9.9−0.9−6.2−42.9−11.1−22.2
    Trust banks
    Mitsubishi Trust−53.3−28.1−0.6−7.1−2.8−13.9−9.4−47.4
    Sumitomo Trust−14.6−1.6−2.9−14.8−11.9−9.4−3.6−53.8
    Mitsui and Chuo Trusts17.023.8−6.3−1.8−10.8−20.0−12.7−70.0
    Toyo Trust39.010.3−14.3−17.2−14.6−40.0−35.7−80.0
    Regional bank
    Bank of Yokohama−14.9−21.1−36.8
    Sources: Merrill Lynch; and Nikkei Weekly.

    Change from FY1997 to FY2002.

    In addition to restructuring, banks applying for public funds agreed to seek new capital from private sources (about ¥2 trillion) and to increase lending by ¥6.7 trillion in FY1999, of which nearly half (about ¥3 trillion) is earmarked for small and medium-sized businesses.

    The public capital injections in March 1999 amounted to ¥7.5 trillion, about four times the amount injected in March 1998 (Table A2.5).10 In contrast to last year’s, the bulk of the public funds in 1999 were structured as convertible preferred stock, which—in principle—will give the authorities considerable leverage over banks that fail to perform. If the government converted its entire holdings of preferred stock into common stock (at book values), it would gain majority stakes in three major banks and a near-majority stake in a fourth. The government could exercise its right to convert stock at these four banks as early as July 1999; conversion dates are longer—up to seven years—for stronger banks. The average yields to be paid on the public funds are low—even lower than the interest rates on last year’s injections of subordinated debt—and little differentiated across banks. The injections were funded by the Deposit Insurance Corporation, which borrowed ¥6.3 trillion from private financial institutions with a government guarantee.

    Table A2.5.Japan: Public Capital Injections, March 1999(In billions of yen, unless otherwise specified)
    Total FundsConvertible Preferred SharesNonconvertible Preferred SharesSubordinated DebtAverage Yield
    AmountGrace period1
    (Number of months)(In percent)
    City banks
    Dai-Ichi Kangyo900400643002001.27
    Long-term credit bank
    Industrial Bank of Japan6003505102501.06
    Trust banks
    Mitsubishi Trust3002005201001.34
    Sumitomo Trust2001002401001.28
    Mitsui Trust400250301501.44
    Chuo Trust1501503000.90
    Toyo Trust2002003001.15
    Regional bank
    Bank of Yokohama20010028001.50
    Source: Financial Reconstruction Commission.

    Some banks issued two tranches of convertible preferred shares, with different convertibility dates. In these cases, the time to the first date is shown in this column.

    Application of Prompt Corrective Action to Regional Banks

    The regulatory authorities began implementing the prompt corrective action (PCA) framework for domestically active banks in April 1999 (internationally active banks became subject to PCA in April 1998).11 On the basis of the FSA’s special inspections, three second-tier regional banks—Kofuku, Kokumin, and Tokyo Sowa—have been declared insolvent and three more have been required to implement a capital enhancement plan. The authorities confirmed that all deposits would be fully protected and appointed receivers to manage the banks’ operations while buyers are sought. Receivership can last up to one year, though a bridge bank can take over within one year, and the banks are expected to sell their bad loans to the Resolution and Collection Corporation. Three more banks—first-tier Hokkaido Bank and second-tier Niigata Chuo and Namihaya—have been ordered to increase their capital to meet the newly effective 4 percent capital adequacy ratio for banks that only operate domestically.

    Measures to Facilitate Debt Workouts and Bad Loan Disposal

    The tax code was amended in June 1998 to facilitate debt workouts. Specifically, banks were permitted to deduct from taxable income the losses incurred from out-of-court debt restructuring agreements, and debtors were allowed to offset the corresponding windfall gains against past losses. To benefit from this favorable tax treatment, the debt workout agreement must involve a comprehensive restructuring plan and be approved by all creditors.

    The October 1998 bank legislation aided disposal of bad loans by legalizing private loan collection companies. Until recently, only lawyers had been allowed to collect loans on behalf of financial institutions. Under the new law, private companies not only may collect loans on behalf of financial institutions but they may also buy collateralized loans from financial institutions and collect loans on their own account. Thus far, the Ministry of Justice has licensed 4 companies and expects to license about 30 altogether by the summer. Legislation enacted in June 1998 facilitated the creation of special purpose vehicles. The new secutiliza-tion law, which regulates securities backed by loans collateralized by real estate, enhances the special purpose vehicles’ ability to secure claims on specific assets by creating a centralized system for registering secured interest in (or ownership of) specified financial assets. Under the new law, the original borrowers no longer need to be notified about the sales of their loans. Favorable tax treatment was also granted to special purpose vehicles and related transactions.

    Implementation of Big Bang Reforms

    The “Big Bang” financial reforms remain on schedule. Following the enactment of the Financial System Reform Law in June 1998, most remaining measures were implemented during the course of FY1998. Important recent changes include allowing banks to sell investment trusts (mutual funds), establishing investor protection schemes for the life insurance, non-life insurance, and securities industries, abolishing the securities transaction tax, instituting market pricing of short-term government financing bills, and allowing finance companies to issue bonds to raise funds for lending.12 Among the remaining reform measures, three major ones are scheduled to take effect in October 1999: commercial banks will be allowed to issue straight bonds, restrictions on the stock brokerage business of banks’ securities subsidiaries will be lifted, and brokerage commissions will be fully liberalized. Cross-sectoral competition between banks and insurance companies will be allowed at some time in the future.

    Remaining Challenges

    Planned Removal of Blanket Deposit Insurance

    The planned removal of blanket deposit insurance in 2001 is refocusing attention on banking sector restructuring. Given that there are potential uncovered losses and given the uncertainty about banks’ future profitability, the planned replacement of blanket deposit insurance with limited insurance in April 2001 is raising interest spreads on bank debentures with maturities greater than two years. While the prospect of market discipline could spur bank restructuring efforts, markets could begin anticipating liquidity problems well ahead of April 2001. The government must be prepared in case important weaknesses remain.

    Recognition and Provisioning of Bad Loans

    Notwithstanding the improvement in supervision, concerns remain that bad loans may not be fully recognized and adequately provisioned. The authorities might consider four steps to address these concerns. First, loan classification and provisioning standards, especially for Class 2 loans, as well as capital adequacy requirements, might be further strengthened. Second, supervision could be further improved by increasing the FSA’s resources, to allow more frequent on-site inspections of troubled banks, and increasing its autonomy, including through independent funding (such as levies on supervised institutions) and the authority to set its own salaries.13 Third, adequate provisioning could be encouraged through the automatic tax deductibility of specific provisions consistent with loan classification standards, subject to future recapture if actual losses turn out to be less than expected.14 Finally, disclosure standards could be strengthened by increasing the frequency and depth of disclosure, with, for example, quarterly rather than semiannual disclosure and full disclosure of self-assessments, including gross amounts of loans by asset class, the amounts covered by collateral or guarantees, and provisions.

    Bank Restructuring

    Major banks’ restructuring plans by themselves may not boost core profitability. Market participants consider that banks need to more aggressively consolidate (to generate economies of scale), securitize corporate loan portfolios, and expand fee-based income. Although the mergers announced so far are welcome, they are probably not sufficient to eliminate the excess capacity in the banking system. The authorities could facilitate restructuring in three ways. First, the injection of further public funds could be tied to a market test, such as a requirement to raise matching funds from private markets. Second, the early exit of nationalized banks from the marketplace could be encouraged, for example, by allowing them to cease functioning as ongoing concerns while selling off their assets and liabilities. Finally, strategies to reduce the role of the public sector in financial intermediation (e.g., the Postal Savings system) could be considered.

    Disposal of Bad Loans

    The pace of bad loan disposal remains slow. Analysts have often noted the importance of sales of loans and collateral to introduce better recognition of value and to establish realistic floors on asset prices. Delayed progress on this front is impeding restructuring in banks and nonfinancial corporations. The main obstacle is inadequate recognition of bad loans, as disposal would force banks to realize additional losses. In addition to ensuring the full recognition of loan losses, the authorities could encourage the Resolution and Collection Corporation to periodically auction bad loans that it has acquired from failed financial institutions.

    Financial Reorganization and Corporate Restructuring

    Japanese corporations have lagged behind their counterparts in several large industrial countries throughout the 1990s. While a number of large export-oriented companies remain international leaders, a general concern has surfaced that many Japanese firms are too highly leveraged, inefficient, and in need of real or financial restructuring. The depletion of many firms’ financial resources and a gloomy profit outlook have led to a persistent decline in equity prices since their high at the start of 1990. Credit ratings have been reduced for many Japanese corporations—including major trading companies. Indeed, the consequences of the large expansion of credit during the years of rapid increases in asset prices (notably land) in the 1980s, and the surge in investment that accompanied it, continue to have ramifications throughout the corporate sector, contributing to low corporate profitability. A reallocation of resources continues to be hindered by several factors, including shortcomings of existing insolvency laws, the weak capital position of banks, and firms’ reluctance to shed labor.

    Several factors have raised concerns about the Japanese corporate sector. First, the high level of corporate investment during the late 1980s yielded low real rates of return; much of this investment was directed to sectors in which Japan likely did not have a comparative advantage, and similar diversification strategies pursued by many large firms led to excess capacity in several markets.15 Second, Japanese companies have recently been adversely affected by cuts in credit availability and widening credit spreads linked to Japanese banks’ attempts to maintain adequate capital. Third, the economic slowdown in Japan has been accompanied by deflationary pressures that have contributed to an imbalance between firms’ cashflow and debts. These problems have been compounded by the weakness of corporate accounting systems and financial control mechanisms, as well as by the accumulation of corporate pension liabilities. For example, when accounting rule changes16 cause firms to disclose the size of corporate pension underfunding, market pressures may spur firms to take steps to improve profitability.17

    Pressures in the corporate sector have resulted in a string of recent announcements of restructuring plans, mainly by major corporations. Market reaction to these announcements has generally been positive, but concerns remain, reflecting doubts about whether the degree of planned restructuring is on par with the magnitude of the challenges. The Economic Planning Agency has estimated that corporate restructuring could entail asset write-downs totaling up to ¥85 trillion (about $700 billion), and market analysts have suggested that top companies might need to shed 10–15 percent of their employees to achieve average historical rates of return similar to those observed in the 1980s.18

    There have also been official initiatives to encourage corporate restructuring in Japan. The government has considered measures to facilitate restructuring of corporate assets and liabilities, as well as reallocation of labor across sectors. A three-pillar strategy appears to be emerging, which can be summarized as follows. First, several tax incentives have been proposed to reduce production capacity. Second, the government is working toward introducing measures to address the debt overhang. Measures are likely to include reforms of the bankruptcy law to simplify reorganization procedures, financial cushions for creditors and small enterprises, changes in the commercial code and other laws to facilitate debt-for-equity swaps, corporate spin-offs, and exchange of stocks for debt in connection with firms’ restructuring. Third, the government has announced that additional funds will be provided for retraining programs and is considering measures to reinforce the social safety net.

    Approaching a Crossroad

    The Degree of Leverage in the Corporate Sector

    Aggregate corporate leverage is higher in Japan than in the United States and the United Kingdom, although less than in continental Europe. The aggregate figure is boosted by the leverage of small and medium-sized firms (which is about 600 percent and about twice that of large firms).19 Moreover, the most indebted large Japanese firms are becoming more leveraged over time: the average net debt-equity ratio of the top quartile (in terms of indebtedness) of firms listed in the TSE1 First Section of the Tokyo Stock Exchange has increased by about one-third since 1992.

    The main sources of corporate leverage in Japan are bank credit and intercorporate credit. Roughly 70 percent of bank corporate loans in Japan are to small and medium-sized firms. Although banks are an important source of financing to large corporations, bond issuance has increasingly been substituted for bank finance by many large firms. Corporate indebtedness also varies across sectors of the economy. As is typical in most countries, leverage in Japan is higher in non manufacturing than in manufacturing.20 Average leverage has been pushed up by increases in leverage in the construction sector (a fourfold increase since 1990), the retail and trading sectors, and some segments of the manufacturing sector (e.g., electrical machinery and pulp and paper).

    The high leverage of Japanese corporations can be attributed in large part to two factors: Japanese firms have relied more on external sources of funds than is the case for firms in some other major economies, and Japanese firms have historically had high levels of investment. For most of the post-World War II period, retained earnings were insufficient to finance the investment plans pursued by Japanese firms: internal funds accounted for less than 60 percent of corporate investment in nonfinancial assets in the late 1980s (a share that increased only marginally when the economy slowed down), which is much lower than in Germany or the United States. These factors, in conjunction with stimulative monetary policy in the 1980s and corporate diversification strategies that fueled a 60 percent increase in the stock of reproducible fixed assets, have contributed to a rapid rise in corporate debt.

    Strains Caused by High Debt Loads

    Until recently, leverage in the Japanese corporate sector was not a major issue, in part because of the relief provided by declining interest rates—a trend that has now ended. Average interest rates on loans declined from 8 percent to 2 percent during 1991–97, allowing the ratio of gross interest expenses to revenues to decline by 40 percent, despite the deterioration of firms’ revenues during this period. Beginning in late 1997, the impact on banks of financial turbulence and the tightening of regulatory standards have changed the dynamics of corporate debt. Credit spreads have widened and credit lines have been curtailed. Adding to pressures on debt service, sales have declined by 6 percent and profits have dropped by more than 30 percent over this period. In sum, despite further declines in market interest rates through 1998, the ratio of interest payments to sales has begun to increase.

    Widespread corporate losses and troubles in the banking system have weakened traditional sources of mutual support among corporations. Historically, firms belonging to an economic group (kigyio shudan and associated keiretsus) could count on support from their peers, parents, and main banks when facing financial distress. The financial deterioration of banks and nonfinancial corporations has weakened this support mechanism. This development underlies warnings by credit agencies that the relationship between Japanese firms’ credit ratings and their leverage will converge toward that of U.S. firms if the trend continues. As a consequence, Moody’s downgraded 82 Japanese nonfinancial corporations between February 1998 and March 1999, while Standard & Poor’s placed 22 companies on CreditWatch in late 1998, and eventually lowered the ratings on more than two-thirds of these companies.

    The growth rate of new corporate bankruptcies peaked at 35 percent (year-on-year) in May–July 1998. Moreover, for the first time, some large firms have declared bankruptcy, which has contributed to the growth in the aggregate debt of failing companies; in 1997–98, such debt stood 70 percent above 1995–96 levels. In the second half of 1998, several steps were taken to cap the rise in corporate bankruptcies. They included Bank of Japan credits to banks that extended new corporate loans, widespread loan guarantees for small and medium-sized enterprises, and special credit lines for some firms facing redemption of maturing bonds.

    Directions for Change

    How Much Restructuring Will Be Needed?

    The deterioration of corporate balance sheets appears to largely reflect overcapacity in several industries. Return on equity in Japan has dropped from about 7.5 percent in the late 1980s to an average of 2.8 percent in FY1991–98.21 The capital-output ratio in Japan is currently above trend and capacity utilization in the manufacturing sector is below trend. Excess capacity is greatest in many industries in which capacity increased the most in the 1990s, and arguably cannot be fully attributed to cyclical factors.

    The burden of excess capacity has been compounded by a rise in labor costs that has outpaced sales. In the 1990s, corporate sales have grown by a cumulative 2 percent, while labor costs among large Japanese companies and their subsidiaries have increased by more than 25 percent. Although a large part of the increase in labor costs occurred in the early 1990s, and reductions in bonuses have recently contributed to a decline in labor costs, the disconnect between costs and revenues has become more prominent with time. For instance, in 1998, labor costs declined by 1 percent, but sales dropped by 6 percent.

    Increasing corporate return on assets to international levels would require substantial real restructuring. Since 1990, return on assets for Japanese firms has halved to about 2 percent, compared with 5.5 percent for U.S. companies. According to some financial analysts, restoring the return on assets to its historical average would require (assuming constant revenues) a 15 percent reduction in total labor costs, or asset write-downs equivalent to $5 trillion.

    Institutional Factors and Recent Restructuring Measures

    Traditionally, corporate sector adjustment in Japan has followed a pattern in which large firms use their intra-group relationships to internalize adjustment costs (e.g., reshuffling labor), whereas small and medium-sized companies downsize or exit. That pattern was broadly maintained through mid-1998, but since then new patterns of corporate restructuring have emerged. In particular, some large firms have undertaken significant efforts to restructure, while small and medium-sized firms have been given some breathing room by temporary special loan guarantees.

    The number of announced corporate restructuring plans surged in 1999. The announcing firm’s stock price rose when markets viewed its plans as underpinned by genuine change (Box A2.1). The surge in announcements was in part because of the magnitude of losses that many firms expected to incur in 1998–99,22 and possibly in part because of the example set by a few large, profitable firms that have announced restructuring plans. In the past, the majority of restructuring plans were aimed at restoring near-term solvency rather than improving longer-term profitability. By contrast, more recent plans have increasingly focused on the establishment of clear lines of authority and stronger mechanisms for financial control, withdrawal from non-core business lines, and the forging of links with foreign partners.23

    Box A2.1Stock Market Reaction to Recent Restructuring Announcement in Japan

    During the first three months of 1999, several listed Japanese firms announced restructuring plans, often coinciding with the forecast of large losses for the fiscal year. Many plans involved marginal adjustments, such as a reduction in labor through attrition. Other plans involved improved corporate governance mechanisms, including a reduction in the size of the board of directors (which, in Japan, often include more than 50 directors comprised of present and past managers). Several firms appeared to take larger steps, including major structural changes aimed at refocusing businesses’ activities, notably through divestment of non-core businesses and consolidation of subsidiaries. Mergers and acquisitions figured prominently among recent announcements, in some cases reflecting increased reliance on foreign partners, and in a few cases the outright transfer of control to them. Some plans took advantage of the upcoming introduction of consolidated accounts to simplify corporate structures and establish “in-house” units aimed at identifying cost and profit centers, which are key ingredients, together with the clarification of lines of authority, for restoring the profitability of Japanese firms.

    The ultimate effectiveness of these plans is difficult to discern, although they certainly indicate an incipient change in attitude. Changes in stock prices in reaction to announcements are one way to gauge the potential effectiveness of these plans, because they provide insight into the market’s reaction to these announcements. An event study, based on a sample of about 60 announcements made in the first two-and-a-half months of 1999, is therefore undertaken here.

    Event studies are a standard method to identify the information content of market news by measuring abnormal returns on stocks around corporate actions or announcements. In these studies, the actual return on a share within a time window around the event day is computed and compared to the prediction of some benchmark model such as the Capital Asset Pricing Model (CAPM) portfolio model. Here, abnormal returns are also computed against the average returns in the second half of 1998, in order to address the possibility that the results using the CAPM might be biased by the cumulative effect of announcements on overall market sentiment.

    Variables that reflect the nature of the announced plan, recent changes in the firm’s profitability, and the firm’s industry sector are used to assess market reactions. Plans were grouped into five categories, and firms were grouped in three sectors: manufacturing (37 observations), finance (13 observations), and other sectors (construction, services, and light industry) (20 observations). Two financial variables were used: the percentage change in earnings per share between FY1998 and FY1999, and a discrete variable indicating whether or not the 1999 dividend was expected to be zero. The allocation of plans into the five categories was based on news reports and comments by market analysts from major investment banks in Japan, which unavoidably involved some judgment. For example, major restructuring plans typically involved reductions in the labor force and divestment in non-core activities, and divestment of single lines of business could be considered a merger and acquisitions activity. Results were, however, broadly unchanged by the re-classification of some plans that had ambiguous features. Also, the results using the CAPM and those based on historical average returns were similar.

    The results suggest that markets were in general cautious about restructuring announcements, particularly those of financial institutions. Only a small fraction of announcements resulted in cumulative abnormal returns during the subsequent four days that were in excess of two standard deviations from those predicted by the CAPM or from the average return on individual stocks in the second half of 1998. It is noteworthy that some of the largest in-es were associated with an announced acquisition by a foreign firm. It should also be noted that the low significance of stock price changes around announcements could also reflect information leakage, market skepticism, and simply the high level of volatility of Japanese stock prices in recent months owing to macroeconomic factors that are not captured fully by the CAPM.

    Japan: Stock Price Reaction to Recent Restructuring Announcements
    VariableCAPMAverage returnCAPM
    Percent change in earnings per share−2.E-04−4.E-04−2.E-0.4−4.E-0.4−7.E-0.4−4.E-0.4−7.E-0.4
    No dividend in 1999−0.20−0.31
    Financial sector−1.01−0.85−0.84−0.80−0.72−1.32−1.10−1.18
    Major restructuring2.402.701.181.612.39
    Note: Numbers in brackets indicate the significance level of the estimated coefficient.

    Industry excludes construction and beverage.

    An alternative to the above approach is to assess the qualitative reaction of markets rather than the magnitude of these effects. A probit model can be used for this purpose. The probit analysis indicates that an announcement by a financial institution involving a reorganization plan was viewed by the market, more often than not, less positively than those made by other companies. A second finding from the probit analysis is that announcements of major restructuring plans, mergers and acquisitions, and the sale of non-core businesses were generally favorably viewed by the market, while plans based on attrition were associated with a decline in stock prices. The coefficient on the variable indicating plans based mainly on a multiyear reduction in the workforce through attrition was significantly negative in all model specifications. In contrast, the coefficient associated with plans based on other strategies was uniformly positive. A third finding is that financial variables appear to suggest that market discipline contributed to more rigorous corporate restructuring: expected declines in earnings per share were negatively correlated with changes in stock prices.

    Bank-led informal reorganizations, which have been hindered in recent years by banks’ weak financial condition, have also picked up recently, owing to the injection of public funds into major banks and recent tax provisions associated with asset write-downs by banks. About a dozen midsized companies, notably in the construction and trade sectors, reached agreements with their bank creditors in the first half of 1999.

    Corporate restructuring, nonetheless, still faces significant institutional impediments. One major impediment is the high cost to firms of reducing employment. Job separation from large Japanese firms has historically been voluntary. Court rulings in the late 1970s made dismissals cumbersome (thus favoring the shift of labor across subsidiaries), which has led firms to offer voluntary early retirement programs. The typical early retirement program is estimated to cost about ¥22 million ($180,000) a worker. Although financial analysts have noted that the recent performance of some companies suggests that the payback period of eliminating redundancies could be as short as three years, cash-strapped firms may have trouble financing such cuts. Other impediments to restructuring include the low net tax benefits to restructuring; remaining obstacles to securitization (despite the 1998 law promoting asset-backed securities) that include multiple liens on loan collateral and inadequate loan documentation; inadequate debt segregation within companies (parent companies often offer loans or comprehensive loan guarantees to subsidiaries); and the lack of effective bankruptcy proceedings.

    Reform of bankruptcy laws is an important priority for public policy because of weakness in the banking sector and the general lack of other mechanisms that enable debtors to engage creditors in negotiations. There are three laws regulating corporate financial reorganization in Japan, in addition to two laws regulating liquidations (Table A2.6). Under current laws, debtors in Japan face numerous restrictions and incur large risks when they attempt to initiate formal reorganization procedures.24 Formal reorganization procedures are thus seldom used in Japan: only about 300 petitions are filed in a typical year, of which a large number are withdrawn before proceedings actually start. By contrast, some 20,000 petitions for reorganization under Chapter 11 of the U.S. Bankruptcy Code were filed every year in the United States during 1983–93. In the past, the lack of effective formal procedures might not have posed a major problem because banks were not financially constrained and thus could initiate necessary workouts.

    Table A2.6.Japan: Legal Procedures for Insolvent Companies
    BankruptcyLiquidationCompositionCorporate rearrangementCorporate reorganization
    ProcedureHansan (under the Bankruptcy Law of 1922).Tokubetsu-seisan (Section 432 et. seq. of the 1899 Commercial Code).Wagi (Composition Law of 1922).Kaisha-seiri (Section 381 et. seq. of the Commercial Code, modified in 1938 to add features of U.K. laws).Kaisha-kousei (Corporate Reorganization Law 1952, revised in the 1970s).
    ApplicationSimilar to U.S. Chapter 7 although inspired by German law. Can be transformed into a reorganization. Conversely, it may result from the failure of reorganization efforts.Applicable to companies being wound up that are considered to be insolvent. Any joint stock company may use it. It is more efficient than bankruptcy if the creditors are cooperative.Popular system where an arrangement with creditors can allow the firm to continue in businessReorganization occurs under minimal supervision by the court. Can be used only by unanimous agreement among creditors. Typically applied to small and medium-sized companies.Similar to Chapter 10 of the old U.S. Bankruptcy Code, or the “Administration Order” under the U.K. Insolvency Act. Typically used by large corporations; it often takes a long time to be completed.
    Control of the firmA trustee (a lawyer) is appointed, who will liquidate the company independently of the creditors and distribute money pro rata.A former director of the company is chosen as liquidator; no trustee is appointed.An appointed trustee retains the power of administration over the firms’ assets (management retains some control over ordinary business actions).The company retains its administrative powers, except if the court decides otherwise.A reorganization trustee is appointed, who holds all necessary management powers.
    Secured creditsMay be executed separately.Separate execution may be restricted by court order.May be executed separately.Separate execution may be restricted by court order.May be executed only through the procedure.
    Unsecured creditorsParticipate in the procedure; seniority rights not absolute.“Equality” is required by law, but may be adjusted reflecting agreement by a majority of creditors.Absolute priority subject to trustee’s decision.Individual execution of claims is suspended, but the firm may repay specific debts (preference).All creditors participate in the procedure.
    VotingVotes equivalent to three-fourths of claims required.Votes equivalent to three-fourths of claims required.Unanimity.Qualified majority by class of creditor.
    Power to ratify plansAmounts recovered are divided by the court; typically they add to less than 10 percent of the claim.Payments will be made according to a convention approved by the legal majority of creditors, after approval by the court.The court approves the sharing arrangement, subject to agreement by creditors.The firm has discretion on which payments it makes, subject to agreement by creditors.The scheme of reorganization should be agreed by the majority of creditors. The scheme itself and execution are subject to the supervision of the court.

    Official Initiatives

    The Ministry of International Trade and Industry has issued a set of proposals in advance of the introduction of government legislation to facilitate corporate restructuring. The following are among proposals that reflect early suggestions made by the Economic Strategy Council, and have in part been incorporated in recent government plans:

    • Tax incentives to reduce production capacity and promote corporate reorganization. The measures include exemptions of capital gains realized in connection with the transfer or reorganization of subsidiaries and divisions; an extension of favorable tax treatment of land transactions not involving sales (such as in-kind transfer of land to newly incorporated firms); tax breaks for asset write-offs in connection with the scrapping of production capacity (e.g., a firm absorbing a loss-making operation could carry losses forward for 10 years rather than 5 years). Consideration has also been given to shifting corporate income taxation to a consolidated basis. This would permit firms to offset taxable income from one subsidiary with losses in other subsidiaries, and could lead to uniform corporate tax rates and fewer subsidiaries (small firms are currently subject to lower corporate tax rates).

    • Legal changes to facilitate corporate reorganization and change in corporate ownership structures. These include proposals to permit banks to exceed the 5 percent limit on equity holdings in a nonfinancial firm in the event of a swap of debt for equity;25 more flexible implementation of antimonopoly laws, to permit Japanese companies competing in the global economy to hold a large share of the Japanese market; and changes in the Commercial Code to facilitate change in ownership structures (that includes broadening the ability of corporate boards to dispense with a general shareholders’ meeting when deciding on the sale of businesses or other restructuring steps, to force minority shareholders to sell their shares when a bidder has acquired over 50 percent of company shares, and to allow payment in shares of the acquiring firm for corporate acquisitions).

    • Use of public funds, such as a public lending facility to finance capacity reductions at special interest rates; subsidies to firms that increase employment (in designated sectors); and the financing of individual training.

    The authorities are also reviewing bankruptcy laws with the aim of improving the efficiency of corporate rehabilitation procedures. Specifically, the Ministry of Justice has announced the acceleration of plans to complement the law typically applied to small and medium-sized companies (the Composition Law) with a new Financial Rehabilitation Law. The latter would incorporate several provisions paralleling those in Chapter 11 of the U.S. code (see Table A2.7). Although some of the proposed provisions already exist in Japanese law, they are scattered over three different laws and are therefore not fully operational. Main proposed features include:

    • Relieving debtors of the need to prove that their firm is insolvent (or nearly insolvent) when petitioning for court protection, and embracing the debtor-in-possession principle. This principle permits incumbent management to maintain control of the firm during the procedure, and to propose the reorganization plan; it is also associated with the granting of seniority of debt acquired after filing for court protection over previous debts.

    • Greater protection against creditors, by allowing the court to stay secured creditors, thus reducing the risk of the firm being stripped of essential assets and winding up in liquidation. Also, a (qualified) majority of creditors will suffice for approving reorganization plans, rather than the unanimous consent of creditors.

    • Priority rules will be weakened to permit debt-for-equity swaps whereby debt would be converted into equity through the issuance of additional equity, rather than by replacing existing equity (i.e., absolute priority would not be observed); and debtors will be able to satisfy claims of secured creditors by paying off the current (estimated) value of the collateral and aggregating the residual part of the loan with other unsecured debts. This provision may be important because, given the decline in land prices since 1999, banks often consider holding a title on a loan with real estate collateral to be akin to holding an option on the value of that land. By permitting debtors to satisfy the secured part of those claims by paying cash for the current value of collateral, the law provides a way for companies to eliminate that option and creates an incentive for banks to renegotiate.

    Table A2.7.Japan: Features of Reorganization Procedures in the united States and Germany and the Prospective Financial Rehabilitation Law in Japan
    United StatesGermanyJapan
    ProcedureChapter 11 of Bankruptcy Code1994 Bankruptcy Code(Prospective) Financial Rehabilitation Law
    Main objective and applicationReorganization of the firm as an ongoing concern; only indirect consideration for stakeholders other than the debtor.Liquidation, reorganization (composition), or possible auction; some consideration for “social” and other external objectives.Financial rehabilitation of individuals, unincorporated firms, and corporations through a streamlined procedure.
    Solvency and other requirementsFirm need not be insolvent; protection is often sought by debtor.Firm cannot meet payments or is over in debted. It needs to prove it has enough funds to pay for procedural costs (after netting out secured assets).Solvent firms can apply if debt burden becomes excessive; prepayment of court costs is likely to still be required.
    Control rights and authority to propose a reorganization planDebtor in control: in 50 percent of cases, previous managers retain control; in remainder, new managers are appointed by debtors. Managers have 120 days after the filing (extendable by the court) to present reorganization plan. The 1995 reform somewhat increased the power of creditors to reject that plan.Power is shared. Court appoints a creditors’ committee and an administrator, who proposes a reorganization plan to the creditors’ assembly within three months. If the plan is rejected, the administrator may be allowed to propose a new plan or a chance can be offered for the debtor to take the lead.Debtor-in-possession principle is embraced; similar to current practice under the commercial code, incumbent managers may retain control of the firm, with some supervision from the court, and propose the reorganization plan. Implementation of the plan will be overseen by court, but without deep involvement.
    Automatic stay against creditor claimsMost creditors’ claims and the service of those claims are stayed (with exceptions such as lease payments).Automatic minimum three-month stay for all claims; stay can be extended by creditors’ assembly.Stays against secured creditors are not automatic, but are expected to be granted liberally and expeditiously by courts (comprehensive stays will substitute for the current system where the debtor has to seek individual injunctions against each creditor).
    Renegotiation of liabilities and voting rightsGreat discretion to renegotiate debt contracts. Impaired creditors vote by class; plan is approved by simple majority by number and ⅔ majority by claim, subject to court confirmation. Court can “cram down” junior creditors.Ample scope for renegotiation (in the past, essentially only the repayment schedule of claims could be renegotiated). Creditors vote by class; plan is approved by simple majority by number and by size of claim, and subject to court confirmation.Creditors are likely to vote as one class, with plans to be approved by a qualified majority by number and size of claim. Firms will be able to be sold as going concerns during the procedure.
    New financingNew financing is easily accommodated because it has priority over existing claims, under the debt-in-possess ion (DIP) statute.New senior financing allowed (it was the case in the old code).New financing to receive senior status.
    Preservation of residual claims on equity holders and deviations of absolute priorityEquity often retains value, usually through creditor’s consent, and sometimes through a court “cram down.” Junior creditors may be paid while senior creditors may not be paid in full, when the latter were undersecured, or made concessions.Deviations can be proposed, but must be agreed by a creditor’s vote. In compositions, they tended to occur.Deviation from absolute priority expected, e.g., debtors will be able to satisfy the claims of secured creditors by paying off the actual value of the collateral (arbitrated by a third party) and debt-for-equity swaps will not require the wiping out of shareholders’ wealth.
    Other options for distressed firms and their main objectives“Prepackaged” Chapter 11 (in which
    impacted creditors agree on a plan before filing); informal debt workouts, including through the exchange of claims; liquidation under Chapter 7 of the Bankruptcy Code.
    The new code combined the compulsory liquidation (Konkurssordnung) and composition (Vergleichsordnung) procedures; informal debt workouts most common.All existing legislation (Composition, Rearrangement, and Corporate Reorganization Laws) will remain in place until they are fully revised and possibly unified within a 3–5-year horizon.

    Prospects and Risks

    Official proposals to encourage financial and real restructuring in the Japanese corporate sector are, on balance, positive. The government has recognized the importance of establishing an environment conducive to corporate restructuring, while ensuring that primary responsibility for initiatives rests with individual firms. For the most part, the government appears to have resisted the temptation to provide direct corporate subsidies. In addition, current proposals may stimulate restructuring efforts and the implicit fiscal contribution may help the corporate sector to absorb the costs of restructuring. These fiscal measures could reduce the burden on banks and possibly also reduce the magnitude of required public injections of capital into the banking system. The possible expansion of the social safety net could help cushion the social impact of dismissals while helping to promote the needed reallocation of labor in the corporate sector; it could also dampen the rise in precautionary saving, reducing downward pressures on prices and corporate revenues. On the other hand, provision of public loans to firms undergoing reorganization could become a lifeline to impaired businesses that are not financially viable. Similarly, subsidization of jobs in designated sectors has the potential to introduce distortions into the market mechanism.

    The reform of bankruptcy laws points in the right direction, but efficiency considerations highlight the importance of also fostering a market for corporate control. The incorporation of several Chapter 11 mechanisms into the new Financial Rehabilitation Law would tend to encourage the early use of formal procedures that could help mitigate the existing debt overhang problem. By giving protection to incumbent management, these provisions could favor firms that are not viable and should exit rather than be reorganized. The new German bankruptcy code addresses these issues, inter alia, by giving prominence to creditors’ committees in the decision about whether to reorganize or liquidate the firm. The new law in Japan is expected not to include explicit mechanisms such as those in the German code. Hence, greater reliance on a strong market for corporate control might be required, as suggested by the experience in the United States, where the existence of such a market has been an important factor to balance any pro-management bias in the law.

    The effectiveness of new bankruptcy laws will also hinge on the amount of resources made available for their implementation. Key factors in the success of bankruptcy laws in the United States are the powers embodied in bankruptcy courts and the role of private trustees in relieving judges of much of their administrative responsibilities. In Japan, there are only two specialized bankruptcy courts. As a consequence, debtors may be discouraged from more use of formal procedures against creditors because of perceptions that the courts may not be expeditious. A review of court procedures and available resources, including in the legal profession, may therefore help improve the legal resolution of financial reorganizations.

    Effective corporate governance is also an important factor in facilitating restructuring of the corporate sector. An increasing number of Japanese companies have professed that their main goal is to maximize shareholder value. Nonetheless, mechanisms to enforce management accountability remain limited. The high degree of corporate cross-shareholding significantly limits the scope for hostile takeovers. Although the forthcoming mandatory marking to market of cross-shareholdings could create incentives for firms to unwind them, prospective measures that would allow companies to reduce their exposure to these assets by shifting the ownership rights of stockholdings to trusts (to fund corporate pension commitments), but retain the associated control rights, may perpetuate this problem. On the other hand, the new holding-company law as well as the possible move toward consolidated corporate taxation have helped spur the reorganization of large firms into vertical organizations under holding companies, which may facilitate managerial accountability.

    Further development of domestic capital markets could improve corporate governance and the efficiency of Japanese firms. For example, increased market incentives from well-functioning corporate debt and equity markets for small firms could facilitate the streamlining of existing keiretsus through an aggressive divestment policy supported by the redirection of domestic savings to new financial instruments (also helping address potential concerns of excessive ownership concentration on the heels of a relaxation of the antimonopoly law). Wider use of these markets could also provide a potentially lucrative advisory business to banks, while submitting a larger share of the corporate sector to the discipline and disclosure implied by the reliance on public corporate instruments. Debt-for-equity swaps could also play an important role in supporting financial reorganization in Japan, provided other constraints on corporate restructuring are addressed. Specifically, banks may be reluctant to engage in such operations with firms that are limited in their ability to shed labor or take other measures to improve their performance.

    In summary, there are encouraging signs that further restructuring will occur. There is recognition of the need for restructuring, and firms are increasingly committed to change. The Japanese authorities have shown increasing resolve in advancing that process, for example, by encouraging large firms to restructure, considering an expansion of the social safety net to protect dislocated workers, and introducing measures to stimulate the development of start-up firms. Nevertheless, some observers have noted that the positive reaction of markets to steps taken to date could result in complacency. Although a rapid restructuring could lead to a temporary contraction in GDP, this shock may be partially cushioned by public policies. By contrast, a greater risk could arise from delaying corporate restructuring, as that might dampen economic growth for many years and entail considerable fiscal costs.


      Bank of Japan, 1998, “Utilization of Financial Institutions’ Self-Assessment in Enhancing Credit Risk Management,”Quarterly Bulletin, Vol. 6 (February), pp. 1932.

      Fitch IBCA, “Japan: Major Banks’ Results for 1998/99” (Tokyo, June).

      International Monetary Fund, 1998, International Capital Markets: Developments, Prospects, and Key Policy Issues, World Economic and Financial Surveys (Washington, September).

      James, Christopher,1995, “When Do Banks Take Equity in Debt Restructurings?”Review of Financial Studies, Vol. 8 (Winter), pp. 120934.

      James, Christopher,, 1996, “Bank Debt Restructurings and the Composition of Exchange Offers in Financial Distress,”Journal of Finance, Vol. 50 (June), pp. 71127.

      Lipworth, Gabrielle,1996, “Postal Saving in Japan,” in Japan: Selected Issues, IMF Staff Country Report No. 96/114 (Washington: International Monetary Fund, September).

      Mitsuhiro, Seki,1994, Beyond the Full-Set Industrial Structure: Japanese Industry in the New Age of East Asia (Tokyo: LTCB International Library Foundation).

      Morgan Stanley Dean Witter, 1999, Japan Restructuring (Tokyo, May).

      Moriaki, Tsuchiya, and KonomiYoshinobu,1997, Shaping the Future of Japanese Management: New Leadership to Overcome the Impending Crisis (Tokyo: LTCB International Library Foundation).

    Annex III: Developments in Emerging Market Banking Systems

    The turbulence in global markets in the aftermath of Russia’s devaluation and unilateral debt restructuring imposed severe pressures on most systemically important emerging market banking systems, which was reflected in weaker earnings and asset quality. Many Asian and Latin American banks experienced substantial cuts in international interbank credit lines and losses in international repo lines, but their domestic deposit bases proved resilient to the turbulence in 1998—in many cases aided by extensive government guarantees. Banks’ responses magnified the transmission of the external liquidity squeeze to local capital markets and the real economy, as they scrambled to restore the liquidity of their balance sheets shifting funds away from the corporate sector and into government securities. Losses in some banks’ securities portfolios were followed by increased delinquencies in their loan portfolios owing to a deteriorated operating environment.

    Emerging market banking systems outside of Asia weathered the consequences of capital outflows reasonably well, but the recovery of the domestic credit cycle has been elusive—with the exception of some central European banks. Most banks in emerging Asia remained focused on restructuring their bad loans, and uncertainties about the creditworthiness of the (unrestructured) corporate sector kept lending flows subdued. The lack of progress in corporate debt restructuring across the region remains one of the key risks to the strengthening of banks’ balance sheets. The largest banking systems in Latin America have shown an enhanced ability to withstand the external liquidity squeeze, but the pronounced slowdown in economic activity has not yet been fully reflected in banks’ balance sheets and is leading to further consolidation in the systems. The healthiest banking systems in emerging Europe have continued to attract sizable capital flows and to expand credit to a fledging corporate sector, as competition grows and foreign banks contribute to a more stable and efficient financial intermediation.

    Most emerging market banking systems strengthened their regulatory and supervisory frameworks and many are in the process of phasing out full deposit insurance schemes. Following the imposition of extensive guarantees in the wake of financial crises, many emerging market banking systems are considering or have even announced effective timetables to limit the coverage of these guarantees. Large losses in Latin American banks’ securities portfolios led to some degree of regulatory forbearance in the immediate aftermath of the Russian unilateral debt restructuring, but regulators moved subsequently to enhance regulation on the classification and valuation of securities, as well as on capital requirements for market risk.1 Emerging markets in central Europe have strengthened their regulatory frameworks, but significant challenges remain as they face the prospect of full capital account liberalization and contemplate joining the EU. In particular, capital adequacy requirements need to be broadened to include market risks and off-balance-sheet exposures, which are growing in most countries.


    Bankers and government officials in the Asian crisis countries are dealing with the task of bank restructuring and recapitalization, as the credit cycle lags relative to the recovery in financial markets and capital flows. Different countries have followed diverse approaches to financial sector restructuring, but results have been slower than expected. Korea and Malaysia have followed more interventionist approaches to financial restructuring that are producing balance sheet results faster than in Thailand, which has followed more market-driven changes that are likely to prove more resilient. The former countries, which forced banks to reserve/write-off nonperforming loans or to sell them to asset management companies, have made substantial progress in strengthening banks’ balance sheets and have successfully encouraged mergers and acquisitions. Both countries also have fairly effective bankruptcy and foreclosure laws, but concerns remain about the extent and depth of their achievements in corporate restructuring—especially among Korean chaebol. Analysts worry that the rapid results of this strategy may lead to a recurrence of problems and further rounds of recapitalization. Indonesia has closed several banks, but widespread insolvencies and low loan recoveries are hampering progress in financial restructuring. Foreign participation in bank recapitalization has not been large, and more government support than originally expected has been needed. Despite the recovery in financial markets and economic activity in most of the crisis countries, the turnaround in the credit cycle has yet to happen and asset quality is only now starting to bottom out.

    China has began to set up individual asset management companies to tackle the bad loan problems of the state banks and while the bankruptcy of Guangdong ITIC has reduced foreign banks’ exposures to mainland borrowers, Hong Kong SAR banks have continued to handle the deflationary pressures well. Banks in Singapore are preparing to face increased competition after the authorities’ gradual move to liberalize the banking sector.


    The resolution of the insolvent Indonesian banking system has left the government as the owner of more than 80 percent of the system’s assets and the implied costs—currently estimated by rating agencies at more than 50 percent of GDP—could continue to escalate unless a forceful loan collection strategy is implemented. The authorities announced a bank recapitalization program in August 1998, which was refined in December 1998. The plan aimed to recapitalize state and local government banks and those private banks that had met minimum capital requirements and had fit and proper managers and shareholders, a viable business plan, and owners that could supply 20 percent of the costs of recapitalization. On March 14, 1999, the authorities announced that 38 banks would be closed, 7 would be taken over by the Indonesian Bank Restructuring Agency, and 9 private banks would be recapitalized. The government will subscribe for up to 80 percent of the banks’ rights issues by issuing bonds and the original shareholders will subscribe to the other 20 percent and will have an option to buy back the government shareholding within three years at cost plus a premium (based on an average bond yield). The banks also signed performance contracts that stipulated that banks would reach a capital adequacy ratio of 8 percent, return on equity of 20 percent, and nonperforming loans of less than 5 percent by 2001. Analysts perceive these targets set by the central bank as too optimistic. While the merger of four state banks to create Bank Mandiri—which will have 30 percent of the deposit market—is moving ahead, the restructuring of three other large state banks and 12 Indonesian Bank Restructuring Agency banks has been delayed. In their latest letter of intent to the IMF, the authorities stated that the large state-owned banks would start proceedings against their 20 largest debtors by end-August 1999, and a consistent strategy to improve loan recoveries includes the closely intertwined task of accelerating corporate restructuring (see Box A3.1).

    The successful completion of the second interbank debt exchange is expected to contribute to the restructuring of the banking system, but foreign participation in the bank recapitalization process has been minimal so far. The Indonesian authorities and the Bank Steering Committee reached an agreement on a second interbank exchange offer on March 29, 1999, and most of the $3.8 billion of Indonesian bank external debt due through December 2001 has been rescheduled under better terms than the first exchange. Of the eight private banks that had deposited additional capital under the recapitalization program, only one included the entry of a major international bank. However, some market participants believe that this particular transaction could provide a significant psychological boost to the recapitalization process, and two foreign financial institutions have reportedly expressed an interest in taking a stake in another of the medium-sized private banks. Two large banks that were nationalized last year are slated for privatization in the second half of 1999.


    The Korean authorities have completed the initial stages of the process of recapitalization and restructuring of the banking system, but much remains to be done, in particular on corporate debt restructuring, the cleanup of nonbank financial intermediaries, and the efficiency of the intermediation process. After the closure of five insolvent banks and their absorption by healthier institutions, six other commercial banks were persuaded to merge in 1998 and a four-bank merger was completed in early May 1999—to bring the number of commercial banks to 17 (from 27 in December 1997).2 The government spent W 41 trillion last year (and plans to spend another W 23 trillion this year) to rehabilitate the banking system—roughly half spent in nonperforming loan purchases and the other half used to pay for deposits and inject new capital in restructured banks—to own more than 90 percent of the equity of the second- and third-largest banks. Korea’s Financial Supervisory Commission estimates that nonperforming loans amounted to 7.4 percent of outstanding loans at the end of 1998 after the Korea Management Corporation (KAMCO) purchases of bad loans.3 Bank analysts estimate that the actual nonperforming loan ratio is much higher and, more important, is likely to increase once corporate restructuring takes hold, loan classification is tightened to reflect capacity to repay, and public guarantees for small- and medium-enterprise loans are limited. Banks are downsizing, cutting costs (employment is down by one-third and a number of branches were closed), and effecting some changes in management. However, building up risk management and credit assessment skills will be further hauled by the resources involved in the process of corporate restructuring (see Box A3.1).

    As foreign confidence in the Korean economy improved in the first half of 1999, the external funding profile of the banking system strengthened considerably. Rollover rates for financial institutions’ term loans continued to increase in 1998 and net flows turned positive in January 1999 for the first time since the crisis began. The improved short-term external liquidity position allowed the banks to repay $3.8 billion in one-year foreign debts rescheduled as part of the March 1998 landmark agreement with 134 foreign creditors. Foreign ownership in Korean banks has increased and will continue to drive the reform process. However, as of June 1999, negotiations to sell two large nationalized banks had not been concluded. Apart from strategic foreign investments in nationalized and private banks, foreign ownership of shares in many of the top-tier banks exceeds one-third of total shares.


    The Malaysian authorities have moved decisively to restructure the banking system, have established a coherent approach to financial sector restructuring, and are moving rapidly to implement it. However, some analysts remain concerned about the loosening of prudential requirements and moral suasion to expand lending in a still over-leveraged environment. The condition of the banking system deteriorated quite rapidly during 1998, and by end-1998 the nonperforming loan ratio reached 20 percent—using the three-month default period and including loans sold to Danaharta, the government-run asset management company. The combined efforts of Danaharta (which by end-June had bought about 30 percent of the banks’ nonperforming loans), and Danamodal (which has recapitalized 10 banks) have contributed to the rehabilitation of the banks and the investors’ perception of the country and its banking system. Some analysts believe the 37 percent average discount on the purchase of nonperforming loans4 has been fairly generous, but the authorities are confident that the discount will be moving up as the acquisition phase is completed. Banks are allowed to amortize the resultant losses over a maximum five-year period, and Danaharta will attempt to restructure the acquired bad loans and if possible avoid auction them off at an early stage—with a view to maximizing the recovery value of its assets. Although shareholders absorbed losses before receiving Danamodal’s funds, the authorities have been more cautious about removing managers—owing to the relative lack of local banking skills—and are hoping to use their role as strategic shareholders to effect internal changes in banks’ lending and risk management practices. In early April, the central bank announced new regulatory measures, including higher capital adequacy ratios for banks with higher risk profiles, disassociating banks from entities (such as securities houses) not supervised by the central bank, disallowing lending to controlling shareholders, intensifying on-site bank examination, and reviewing the performance of bank directors and managers biannually. Market participants worry that the latter could be used to press banks to meet the targeted 8 percent lending growth, a potentially dangerous goal in the context of prescribed maximum lending margins and overleveraged corporations.


    The severe recession and liquidity squeeze suffered by the Thai corporate sector in the aftermath of the financial crisis, together with a breakdown in the repayment culture, have led to large operating losses and a massive deterioration in Thai banks’ asset quality. Nevertheless, nonperforming loans seem to have peaked in February–March 1999, when they reached 52 percent of total commercial lending. The deterioration in economic conditions has been exacerbated by the weak legal infrastructure, which gives creditors scant power over delinquent debtors. The weak legal environment has allowed even healthy borrowers to avoid repaying loans, the so-called “strategic nonperforming loans.” Analysts estimate that while roughly 40–50 percent of the banks’ nonperforming loans are distressed but fit for restructuring, 30 percent of non-performing loans are not, and about 20–30 percent are “strategic” nonperforming loans that could easily become performing with a tightening of the legal/judicial environment. To speed up the debt restructuring process (see Box A3.1), the Bank of Thailand has relaxed the rules on the classification of nonperforming loans: instead of waiting for three months of renewed debt service on a restructured loan, these will now be classified as normal as soon as the loan restructuring is approved. While this relaxation should encourage debt restructuring, analysts fear that it may not resolve the bad loan problem and runs the risk of encouraging banks to disguise loan restructurings as a way of avoiding loan-loss provisioning, without regard to the debtor’s repayment capacity. The Bank of Thailand has introduced safeguards to prevent such potential abuses in the reclassification of restructured loans, such as requiring that restructurings be done under the Corporate Debt Restructuring Advisory Committee framework or through the judicial courts.

    Box A3.1.Corporate Debt Restructuring in Asia

    Corporate debt restructuring is an essential complement to bank recapitalization, and slow or uneven progress in either one is likely to lead to renewed financial distress and continuing vulnerability. Two factors that make corporate debt restructuring in Asia a major challenge are the lack of an institutional framework to address the issue and the systemic nature of the problem—related to the large number of cases and the involvement of foreign creditors.

    Many countries have moved ahead in improving the institutional framework, and the degree of government involvement in the restructuring process differs across countries. Most countries are following a market-based, voluntary approach to debt restructuring, where the government plays the role of a facilitator of both formal and informal debt workouts. Formal debt workouts require an effective bankruptcy procedure, that is, one that has clear liquidation and rehabilitation procedures, where the latter attempts to maximize the ex post value of the firm while preserving the ex ante bonding role of debt. The presence of an effective bankruptcy system creates appropriate incentives for debtors and creditors to reach out-of-court (or informal) debt restructuring, and most Asian countries have adopted variants of the so-called “London Approach” to facilitate voluntary debt workouts in an environment where courts lack the experience or resources to handle a large number of cases. Government agencies coordinate, mediate, and arbitrate (and some times even dictate) negotiations between debtors and creditors, encouraging also the use of standard agreements to speed up the process. In Korea, the government has played a much more direct role than elsewhere, imposing quantitative targets for the deleveraging of corporates and using its increased position as bank shareholder to encourage restructuring by withholding credit.

    A fundamental problem with the voluntary market-based approach is that the London rules were not designed for systemic corporate debt crises, and a case can be made for a bigger government role and a limited use of taxpayer resources in resolving the corporate debt problem (such as the provision of guarantees on exchange rate risk). While this may create moral hazard, there is also the need to recognize that overburdened debtors and creditors have little incentive to arrive at voluntary agreements when the debt overhang problem is related to macroeconomic developments beyond their control. This was recognized in the restructuring of corporate debts in Chile and Mexico in the early 1980s and is behind the government exchange rate guarantees of the Indonesia Debt Restructuring Agreement.

    The establishment of an adequate institutional framework is just a first step toward an efficient debt-restructuring process, and implementation is critical. The extent of progress is small relative to the severity of the underlying problems, which makes banks weak and vulnerable to future shocks. In what follows, we briefly describe the main features of the Asian crisis countries’ frameworks for corporate debt restructuring and the extent of progress.


    Indonesia has moved to increase the flexibility of a comprehensive framework for debt restructuring that has so far shown few concrete results. A framework for the voluntary restructuring of corporate debt—the Jakarta Initiative—was announced in September 1998 to complement the Indonesia Debt Restructuring Agency (INDRA) scheme and the amended bankruptcy law. The INDRA scheme provides exchange rate risk protection to private debtors who agree to restructure their external debts, while the Jakarta Initiative provides a set of principles to guide and streamline out-of-court corporate restructuring. In late March 1999, the authorities announced modifications to the INDRA scheme to make it more attractive, including an extension of the deadline for entry to end-1999, which remove election-related uncertainties, cap debtors’ annual payments to INDRA during the grace period, and reduce the minimum maturity for rescheduled foreign debt if the original debt is reduced through debt forgiveness or debt-equity swaps. As of end-April, 170 companies owing $20.6 billion in foreign currency debt (an estimated 28 percent of the total corporate external debt) had signed up with the task force in charge of managing the Jakarta Initiative, although only 16 firms had reached agreements in principle and just 4 had standstill agreements. A recent Supreme Court ruling in favor of creditors has reduced negative market perception of the implementation of the bankruptcy law, but market participants are skeptical about many more deals being settled before the elections. Analysts worry that if it takes too long to make further progress on debt restructuring through this largely voluntary process the government might be forced to adopt a more interventionist role.


    Corporate restructuring in Korea is proceeding on two separate tracks: (1)a debt workout framework for the smaller chaebol and other large corporations, which follows the London Approach in its voluntary and extra-judicial nature; and (2) a different approach for the top five chaebol, which relies on heavy government involvement. A Corporate Restructuring Agreement has been signed by 200 financial institutions, under which the institutions agree to follow specific procedures for debt workouts—including an automatic standstill on debt repayments and emergency (syndicated) loans—and to subject themselves to binding arbitration by the Corporate Restructuring Coordinating Committee. Lead banks or groups of institutions holding more than 25 percent of a corporation’s debt can form a creditors’ committee and the lead bank—assisted by a group of foreign advisors—negotiates with the debtor corporation. The authorities negotiated with the top five chaebol the so-called “big deals”—swaps of subsidiaries and affiliates—and, more recently, Capital Structure Improvement Plans, designed to reduce the number of subsidiaries and affiliates and to reduce their total debt-to-equity ratios to below 200 percent by the end of 1999.

    The results so far under this framework are mixed, showing some progress with the smaller chaebol under the voluntary debt workout framework and little progress with the top five chaebol As of end-December 1998, workouts for 45 companies had been agreed under the Corporate Restructuring Agreement, but a number of weaknesses emerged from the completed workouts—including concerns about the quality of the due diligence and workout proposals, the banks’ reluctance to disclose information and fully integrate their foreign advisors in the process, and the low level of debt write-downs. The unwinding of cross-guarantees has proceeded rapidly but the “big deal” swaps and other aspects of the restructuring of the top five chaebol have faced a series of economic and political hurdles and progress has been slow. The authorities’ success early in the year in forcing one chaebol to comply with the terms of its “big deal” obligations, by ordering the chaebol’s principal bank to suspend its credit lines, is encouraging, but rating agencies remain uncertain whether similar results can be achieved for the others. As of December 1998, the debt-equity ratio of the top 30 chaebol had declined to 380 perce m (and that of the top five to 335 percent), from 519 percent in 1997, but rating agencies have suggested that substantive deleveraging and restructuring has not yet occurred and that it is likely that the banks will bear a disproportionate share of the debt-reduction burden.1


    The legal framework in Malaysia is relatively effective but only a few cases have been resolved so far. Following amendments to Section 176 of the Companies Act in late 1998, a series of loopholes have been tightened, and creditors now have a reasonably effective legal framework to work out debt problems. Previously, a highly leveraged company could seek protection against its creditors without the creditors’ consent or even knowledge. A company now applying for protection under Section 176 would first have to seek the consent of creditors amounting to more than 50 percent of its liabilities. Arrangements would have to be formalized within a stipulated period, and creditors’ rights have been greatly enhanced (with debtors facing stricter requirements in terms of disclosure and asset sales during the 60-day standstill period). Despite the creation of a Corporate Debt Restructuring Committee to encourage informal debt restructuring arrangements, as of mid-March 1999 only 48 companies had applied for such arrangements and only two restructuring plans have been implemented. As of end-June 1999, the committee has been able to implement a total of 10 debt restructuring plans.


    The institutional framework for debt restructuring has recently been strengthened in the context of a mostly voluntary, market-based approach. The new Bankruptcy Law, approved in April 1998, has recently been strengthened, with the approval of amendments to remove uncertainties on the degree of protection afforded to new money and the establishment of a specialized bankruptcy court. Also, creditors’ rights legislation has been amended, with a view to facilitating foreclosure on assets. The creation of a Corporate Debt Restructuring Advisory Committee and the introduction of intercreditor and debtor-creditor agreements is expected to speed up out-of-court debt restructuring. The intercreditor agreement provides a model for an arbitration panel to seek consensus on a restructuring plan when there is agreement of at least half the creditors holding more than 50 percent of total outstanding debt (but less than the 75 percent required under the Bankruptcy Law). Under the debtor-creditor agreement, individual debtors are encouraged to sign debtor-creditor mediation contracts, whereby a legally time-bound resolution process automatically triggers intercreditor arbitration contracts. This contract-driven process is intended to result in debt restructuring or automatic filing for liquidation within six months: much of the restructuring completed so far has taken more than a year to accomplish.

    Progress has been slow, but the authorities have taken further steps to accelerate corporate debt restructuring. As of end-April 1999 about 48 percent of the total non-performing loans had entered the restructuring process but only about 15 percent had been successfully restructured. While no comprehensive database on the terms of the restructuring is available, anecdotal evidence points to small debt reductions for the case of extension in maturities and discounts of about 30 percent in the case of debt-to-equity conversions (reaching as high as 80 percent in at least one prominent case). To accelerate the process, the Corporate Debt Restructuring Advisory Committee has extended its mandate to take on additional cases, has introduced abbreviated versions of the intercreditor and debtor-creditor agreements to cover small firms, is in the process of hiring its own advisors and professional mediators—deal-makers—to guide debtors and creditors toward early settlement, and has eased rules on the classification of restructured loans. Also, the Stock Exchange of Thailand has announced that listed firms under rehabilitation have until the end of the year to reach agreements with creditors before they risk being delisted.

    Progress in bank recapitalization has been relatively slow, but a successful initial deal under the state-supported capitalization program and other private initiatives may serve as blueprints for other banks to follow.5 However, the banking system remains very weak, and current levels of capital and reserves are considered to be far short of the amount by which loans will have to be written down—especially in the midsized and intervened banks.6 So far, only three of Thailand’s smaller banks have been successful in forging partnerships with foreign banks, as the privatization of three nationalized banks—originally scheduled for March 1999—was delayed to decide the details of the guarantees to be offered to cover non-performing loans. The government is committed to sell the three banks in the next several months. During the first quarter of 1999, the three largest private banks raised capital using hybrid financial instruments in an attempt to avoid the loss of control (see Box A3.2). In late April, the country’s fourth-largest bank completed a landmark $1.8 billion capital-raising deal whereby the government matched the share purchases of private institutional investors to become the largest shareholder in the bank.7 Provisioning levels would be raised after the capital injection, reducing the dilution born by the original shareholders.


    The Chinese banks’ asset quality continued to deteriorate in 1998 and the authorities are trying to hold back the rise in nonperforming loans by creating asset management companies in the four state-owned commercial banks. Analysts believe that the four state-owned commercial banks’ financial fundamentals have continued to deteriorate in 1998 as a result of falling profitability—which hinders loan provisioning and write-offs—and continued policy lending.8 While there is a perception outside China that the country is making little progress on financial reforms, the authorities have taken their most aggressive step to date to stem the rising nonperforming loans: the establishment of asset management companies to repackage and sell the problem loans of the big four banks. In a pilot scheme, China Construction Bank’s nonperforming loans will be sold to Cinda Asset Management, which was established in April to either collect what it can from these loans or repackage them and sell them off at a discount. The government has reportedly given Cinda the power not only to force the restructuring of state-owned enterprises—including forcing lay-offs—but also to convert unpaid debt into equity—although enabling legislation has yet to be enacted. However, analysts have raised doubts about whether China has the financial infrastructure to enable the asset management companies to work properly and they foresee problems in the valuation, pricing, and management of the assets. Also, even if the asset management companies were to relieve the banks of their old bad debts, preventing them from generating new problem loans would be a more difficult task. To improve asset quality and profitability, the four banks will sign “governance contracts”—setting out performance goals and supervisory boards—and are in the process of developing new accounting systems, setting up risk management divisions, and cutting back branches and employment.

    The closure and bankruptcy of Guangdong ITIC prompted a reduction in foreign banks’ exposure and an increasing differentiation between sovereign and nonsovereign entities in China, but, despite the external financing pressures, the domestic deposit base remained stable. Foreign creditors have complained of a lack of transparency in the liquidation of Guangdong ITIC (see Box 3.4, Chapter III) and are calling for a clear definition of repayment priorities. Several other ITICs have encountered liquidity pressures in recent months and total ITIC external debt—including Guangdong ITIC—is estimated by the authorities at $12 billion—but analysts estimate it could reach $20 billion with the inclusion of unregistered external claims and guarantees. However, only about 20 ITICs (out of a total of 240) have borrowed abroad and the ITICs together account for only about 5 percent of total assets of the financial system. The People’s Bank of China has announced that the ITIC sector will be restructured through mergers and the reduction in the scope of ITICs’ operations. There have been reports of a migration of corporate deposits from small and medium-sized financial institutions to the large state commercial banks, but domestic deposits in the system as a whole have continued to grow.

    Box A3.2.Hybrid Instruments in Asian Bank Recapitalization

    Capital inflows to Asia’s banking sector have slowed to a trickle since the currency crises and banks have struggled to satisfy capital adequacy requirements while facing a mountain of bad debts to write off. With the primary equity markets no longer available as a cost-effective source of capital and the controlling shareholders unwilling to dilute their holdings, the largest Thai private banks have developed innovative solutions—including Stapled Limited Interest Preferred Securities (SLIPS) and Capital Augmented Preferred Securities (CAPS)—to replenish their capital bases. Other Thai banks followed the lead of the large banks, and analysts expect the issuance of similar hybrid capital instruments to become a popular route for banks to recapitalize in other Asian countries.

    Both types of instruments have essentially the same structure: each one combines noncumulative preferred shares with nondetachable (straight or convertible) subordinated debt. In one prominent case, a fixed coupon of 22 percent is paid on the subordinated debt. The preferred shares pay a return to investors only if the bank has positive retained earnings and pays a dividend to ordinary shareholders, up to a maximum of 23 percent of the face value of the shares.1 The bank has the option to repurchase the subordinated debt at the end of the fifth year. If the bank does so, then it has the option to repay the preferred shares at par. The result of this rather complex structure is that investors would receive a minimum return of 11 percent and a maximum return of 22.5 percent; both tranches are equally valued at issuance.

    The issues have been aimed at individuals with a high net worth who already have deposits at the bank, although the institutional investor base is also expected to expand. The good reception that the instruments have received indicates that there is a ready retail investor base for high-yield securities. Bank deposit rates have fallen to such low levels that depositors have been ready to switch into these instruments, which offer better returns—up to 600 basis points over deposit rates, even if the risks are considerably higher. Indeed, while public guarantees are in place for depositors and senior creditors, the position of subordinated creditors and preferred shareholders has generally been left unprotected. A key risk is that the bank comes under regulatory control and, as a result, there is a write-down of common and preferred equity. Institutional investors have also demonstrated an appetite for the instruments, and the Life Insurance Association of Thailand has already received in-principle approval from the authorities for bank-subordinated debt to qualify as reserves for insurance companies.

    The Basel Committee on Banking Supervision advises that hybrid equity instruments should account for no more than 15 percent of a banks’ Tier 1 capital but analysts do not view these instruments as pure capital. In October 1998, the BIS included noncumulative preferred shares as qualifying as Tier 1 capital up to 15 percent of the total minimum, but each country is free to define its specific capital requirements and the Bank of Thailand has said that banks will only be allowed to issue SLIPS/CAPS in an amount up to 33 percent of total Tier I capital. Analysts and rating agencies see these instruments as a temporary measure that will eventually be re-placed by pure equity within five to seven years, when the banks would be able to obtain a better price in a friendlier capital-raising environment.

    1 Provisions for loan losses are only shared with the SLIPS/CAPS holders when Tier 1 capital falls below 4.25 percent—the minimum regulatory requirement.

    Hong Kong SAR

    The exposures of banks in Hong Kong SAR to the ITICs appear to be manageable and those to the property sector are beginning to recover. Moreover, these risks have to be judged relative to the banks’ individual strengths: while nonperforming loans jumped in 1998to5.1 percent of total loans—from 1.8 percent in 1997—the average capital adequacy ratio stood at a healthy 18.6 percent by end-1998. The direct exposures of the Hong Kong SAR banks to mainland China entities are relatively small (around 4.5 percent of total assets) and market participants estimate that the indirect exposures (through a slowdown in mainland China) are unlikely to do more than slightly delay the recovery in Hong Kong SAR. The property market appears to have bottomed out in the first half of 1999 and, in particular, residential prices—where the majority of the property exposures are—have rebounded since the last quarter of 1998 (see Figure 3.10, Chapter III).


    Singapore’s banks were adversely affected by the Asian financial crisis and the authorities have moved ahead with reforms to enhance financial sector transparency and position the financial sector for the next wave of regional growth. A sharp increase in nonperforming loans combined with conservative provisioning contributed to a large fall in profits in 1998. The authorities have been promoting consolidation in the sector, and two mergers last year saw the number of domestic banks decline to five. In 1998, the Monetary Authority of Singapore raised disclosure standards for banks and announced plans to fully liberalize the banking system within five years. In mid-May 1999, the Monetary Authority removed the 40 percent cap on foreign investors’ total shareholdings in local banks, and over 1999–2001 the authorities will issue up to six licenses to foreign banks to designate them as “qualified full banks,” allowing them additional branches and automatic teller machines. Singapore will also raise the number of restricted banks from 13 to 18 by 2001, while offshore banks will gain greater flexibility in Singapore-dollar wholesale business—including larger lending limits and freedom to engage in Singapore-dollar swaps. Meanwhile, the Monetary Authority of Singapore is expected to further ease capital adequacy requirements—currently at 12 percent of risk-adjusted assets—to boost the attractiveness of Singapore to foreign banks and to enhance domestic banks’ regional competitiveness.

    Latin America

    In most Latin American banking systems, the extent of reforms after the Tequila crisis—including increased foreign ownership—and the commitment to improvements in prudential supervision and regulation have served to enhance the resilience to external liquidity pressures and domestic volatility. Although Brazilian banks were most affected by the retrenchment of international banks from Latin America after August 1998, banks in Argentina and Mexico also suffered external liquidity pressures as well as a flight to quality that concentrated external flows in the largest banks. The reductions in international interbank exposures, and subsequent pressures in currency and securities markets, led to losses in the banks’ securities portfolios that were absorbed through a reduction in earnings and the equity accounts—and, in the case of Mexico, through regulatory forbearance and central bank support. The persistence of high real interest rates and of the recession has reversed the recent recovery in asset quality across the region, but analysts believe most large banks have adequate capital bases to withstand the increases in delinquency rates. Nevertheless, foreign banks with operations in the region remain extremely cautious about lending decisions, and have reportedly shelved expansion plans to the middle market and consumer sectors and focused on consolidating big corporate clients, asset management, and private banking activities.


    While Argentine banks faced liquidity pressures from cuts in international interbank credit lines and losses of repo lines following the Russian crisis, the deposit base remained relatively stable even after Brazil’s devaluation. This was in sharp contrast to the experience during the Tequila crisis, when the Argentine banking system lost nearly 20 percent of its deposits. This stability reflected a number of factors. There has been a drastic improvement in prudential regulation since the Convertibility Plan was introduced, with capital adequacy requirements exceeding minimum Basel Committee recommendations, much improved disclosure and oversight, and liquidity requirements amounting to 20 percent of deposits and other liabilities of less than 90 days’ residual maturity.9 Moreover, as banks became increasingly concerned about spillover effects from Brazil, they sharply increased their holdings of liquid assets to levels above those required by official liquidity requirements. Despite the difficulties associated with maintaining the external contingent repo facility (see Box 3.8, Chapter III), the facility enhanced the perceived liquidity cushion for Argentine banks since it would allow the central bank to make credit lines available to domestic banks in times of a severe liquidity crisis. Also, the periodic disturbances since the Tequila crisis generated several flights to quality that resulted in a concentration of deposits in the top-tier banks that are mostly foreign-owned institutions.10 Finally, a number of banks have been forced to close since 1997, and the authorities have shown an increasing capacity to respond quickly to these situations—particularly in finding buyers to take over the banks’ branch networks—avoiding spillovers to other banks and providing further resilience to the system.

    In addition to building up their liquidity positions, banks responded to the combination of reduced external credit and greater market volatility by reducing the flow of domestic lending. What lending did take place was directed to the top corporates, which had for some time been directly accessing international capital markets. This re-intermediation of the top corporates through the domestic banking system has continued to squeeze the small and medium-sized enterprises that have all but lost access to private credit. The pronounced slowdown in economic activity has not yet been fully reflected in banks’ balance sheets, and non-performing loans increased slightly to just above 10 percent at end-December 1998 from 9.5 percent in September 1998.11 Banks with significant exposures to securities faced a reduction in earnings or deferred the losses by shifting securities into investment accounts. In response to these developments, a few weak banks being taken over were allowed some time to bring their liquidity requirements up to the norm. In a further strengthening of the regulatory framework, capital requirements for market risk and changes to the accounting standards for securities—initially scheduled for 1998 and aimed at the elimination of the “available-for-sale” account—were implemented on March 1, 1999. The requirement that banks issue 2 percent of their liabilities as marketable debt securities was also implemented on that date, and banks that were unable to issue such securities at that time incurred an increase in both liquidity and capital adequacy requirements of 1 percentage point each.


    The generalized reassessment of international banks’ exposure to emerging markets strongly affected the external liquidity position of Brazilian banks, but the pressures somewhat subsided after the arrangement of an IMF-led financial package in mid-November 1998 and its revision in mid-March 1999.12 Following a gradual process of reduction in international banks’ exposures to Brazil in the third quarter of 1998, the process intensified between mid-October and mid-November 1998, and rollover rates on interbank credit lines for a group of 10 large international banks declined to less than 20 percent. The process of reduction in interbank exposures was particularly pronounced for international banks with significant local operations, a result of head offices’ reduction of funding to local offices on concerns about a possible forced rollover. The announcement of the details of the authorities’ IMF-supported adjustment program in mid-November allied these concerns, and rollover rates on interbank credit lines increased to more than 70 percent in December. The uncertainties surrounding the devaluation of the real prompted another reduction in the rollover of interbank credit lines to about 65 percent in January and February 1999, but in mid-March the authorities obtained assurances from several creditor banks on the maintenance of their interbank and trade credit lines to Brazilian borrowers for at least six months at levels outstanding at end-February 1999. Also, some large Brazilian banks regained access to the international bond market, with issuance rising to $850 million in the first half of 1999 (through end-May) compared with $2.2 billion in the same period of 1998 (and just $130 million in the second half of 1998).

    Brazilian banks have weathered the economic downturn and market volatility reasonably well, and although analysts expect a deterioration in their financial fundamentals, most market participants perceive systemic risks to be relatively low. Most Brazilian banks adopted a cautious approach to new lending in response to the poor operating environment in 1998 and applied surplus liquidity to building up holdings of high-yielding short-term government securities. Nonperforming loans rose from 6 percent of the total loan portfolio in mid-1997 to 9.5 percent by end-1998, but the level of provisioning remained above 120 percent of total nonperforming loans. Most banks were protected against the devaluation by means of hedge mechanisms and long U.S.-dollar positions and recorded extraordinary profits during the first quarter of 1999.13 The ratio of nonperforming loans is expected to increase, especially in those banks with large U.S. dollar-indexed leasing and consumer portfolios, and rating agencies worry about the repayment capacity of banks’ borrowers and the fact that debt refinancings may not be adequately captured in the delinquency ratios. However, total loans account for a small part of the loan portfolio and banks continue to report capitalization in excess of both BIS and local requirements,14 which may cushion them against the expected increase in delinquencies. Considering the fact that banks are the main holders of government securities, with nearly 60 percent of the total stock, some analysts continue to perceive a government debt restructuring as the main risk to the banking system—but attach a very low probability to such event. Other analysts do not believe that there is any imminent risk of default by the federal government.


    The low reliance of Chilean banks on short-term external financing shielded them against the external liquidity squeeze affecting most markets in the region, but the combination of a tightening of domestic liquidity and a sharp deterioration in economic activity damaged the banks’ asset quality. To prevent a sharp peso depreciation following a severe terms of trade deterioration, the monetary authorities increased interest rates several times in the first three quarters of 1998, which adversely affected those banks whose liabilities reprice faster than their assets. As a result, profitability in the banking system fell during 1998, while lending increased only slightly and nonperforming loans increased to 1.5 percent in 1998 (from 1 percent in 1997). Nevertheless, provisions rose to 147 percent of impaired loans and the system capital adequacy ratio reached 12.5 percent of risk-weighted assets. Moreover, banks tightened underwriting guidelines and restricted lending to high-risk sectors such as consumer and middle-market. In response to market volatility, new regulations were introduced to allow banks to classify securities as held for trading (with unrealized gains and losses charged to earnings) or held to maturity (with unrealized gains and losses charged to equity), while all securities of less than one year maturity are marked to market.


    The Mexican banking system had a diminished role in the transmission of the international liquidity squeeze because its role in the credit process continued to shrink, and losses in securities portfolios prompted further official support for the sector. As the financial intermediation activities of the Mexican banking system stagnated after the crisis of the mid-1990s and gradually shifted offshore and to nonbank financial intermediaries, banks focused on purchasing government securities and only recently started to lend to the upper segment of the corporate sector. Also, banks had gradually extended the duration of their securities portfolios in the first half of 1998, demonstrating limited concern about downside risks. As interest rate spreads on emerging market securities widened in the aftermath of the Russian unilateral debt restructuring and the central bank tightened monetary policy, domestic interest rates rose sharply, and the ensuing losses in banks’ securities portfolios wiped out the capital of some institutions and prompted the authorities to allow retroactive changes in the classification of securities in banks’ portfolios—from trading (marked to market) to investment accounts (valued at cost). In addition, the central bank engaged in floating-for-fixed-rate swaps to reduce the banks’ interest rate exposure. It is widely believed that these swaps were carried out at subsidized rates. In the event, the subsequent turnaround in interest rates did not help the banks since they had given up the upside potential of their original positions.

    After four years of extensive government support, many Mexican banks are still in a weak position, and a rapid recapitalization of the system is critical to help offset the incentives created by unlimited guarantees and regulatory forbearance. The approval in December 1998 of the IPAB Law15 allows banking reform to go forward by providing a clearer institutional framework to address bank problems and a timetable for the phasing out of unlimited guarantees (see Box A3.3). During 1998, banks continued to be hampered by both economic and political factors, and profitability remained very low. While asset quality has improved since the Tequila crisis, bankers reported that during the past year, expectations of a further bailout program led debtors to reduce their debt-service payments, and past-due loans edged up to 11.3 percent of total loans by end-December 1998—from 10.7 percent at end-June 1998.16 Analysts argue that if banks fully provisioned and used international best practices for the classification of loans, several banks would be insolvent and others seriously undercapitalized. In April 1999, the Bankers Association estimated that the industry must boost overall capitalization by at least $5 billion over the following 12 to 24 months to complete the unfinished cleanup of loan portfolios and to build up an adequate capital base to resume normal lending operations. More recently, Moody’s estimated the capital gap of the system to be about US$13 billion.17

    In conjunction with the IPAB Law, the authorities approved the Punto Final program, which provides government-subsidized debt relief for mortgage holders, small and medium-sized businesses, and agricultural and fishing entities.18 Mexican banks have a large share of their assets frozen as a result of the FOBAPROA programs, and IPAB is set to convert the illiquid FOBAPROA notes into liquid securities. Also, the Law has lifted foreign ownership constraints in Mexican banks—prompting talk of a merger between the country’s two largest banks—and has paved the way for the resolution of some smaller banks.


    Instability in international markets, coupled with political uncertainties and tight monetary policy, precipitated an economic slowdown and a relatively pronounced deterioration in Venezuelan banks’ asset quality, which is likely to accelerate the consolidation of an overbanked banking system. Although loan growth was very strong in 1997 and the first half of 1998, it slowed down considerably during the second half of 1998 as interest rates peaked and macroeconomic conditions worsened. Asset quality deteriorated, with nonperforming loans increasing to 5.5 percent by end-1998, up from 2.8 percent at end-1997.19 The ratio of provisions to nonperforming loans fell slightly to 123 percent of nonperforming loans, while the capital adequacy ratio increased to 17.7 percent by end-1998—from 133 percent and 16 percent, respectively, at end-1997. The deterioration in asset quality was larger in some small and medium-sized banks with sizable consumer loan portfolios, which continue to represent the system’s main weakness. However, analysts believe that, given the structural improvements, this weakness would be more likely to intensify the trend to consolidation than to provoke a systemic crisis.20 The ratio of net worth to risk-weighted assets was 15.9 percent in March 1999, and liquid assets (reserves at the central bank, holdings of central bank paper, and net foreign assets) represented 36 percent of banks’ total deposits. In addition, the authorities have taken measures to help accelerate the consolidation and have continued to improve the revamped regulatory and supervisory framework—including the marking to market of securities and inflation-adjusted accounting. Still, the system continues to be relatively inefficient, owing in part to high reserve requirements and deposit insurance contributions, as well as a recently approved tax on bank debits.

    Central Europe

    After 10 years of transition in the region, restructuring and privatization have strengthened the banking systems in Hungary and Poland more than that in the Czech Republic. The three banking systems continued to receive sizable foreign capital inflows, but exposures to Russia uncovered the fragilities of the largely state-owned Czech banks and have prompted the authorities to relaunch the bank privatization process. Capital inflows supported strong loan growth in Hungary and Poland, while competition has led to declining profits and a search for higher yields through lending to the small and medium-sized corporate and consumer segments. Losses in brokerage subsidiaries of foreign-owned banks in Hungary led to funding support from head offices in the wake of capital outflows during the Russian crisis, providing an example of the resilience afforded by this ownership structure. All countries have strengthened their regulatory and supervisory frameworks, but significant challenges remain as they face the prospect of full capital account liberalization and contemplate joining the EU. In particular, capital adequacy requirements need to be broadened to include the market risks and off-balance-sheet exposures that are growing in most countries.

    Czech Republic

    The onset of economic recession and exposures to Russia uncovered weaknesses in the Czech banking system and prompted the authorities to relaunch the bank privatization program and a revision of the regulatory framework. The Czech banks showed an increasing liquidity preference during 1998 and, as a result, total lending fell in real terms. Bank capital positions therefore improved, even though the operating environment deteriorated. While nonperforming loans remained stable at about 18.5 percent of total loans, the banks’ average capital adequacy ratio rose to 12 percent at end-1998 from 9.5 percent at end-1997. Despite the stable asset quality, banks’ profits in 1998 were negative for the second year in a row, with losses amounting to 0.2 percent of assets. This dismal performance led the authorities to relaunch the bank privatization program. Following the sale of one of the four large state-owned banks in early 1998, the government sold the fourth-largest bank in early June 1999 and announced a timetable for the privatization of the other two—to be completed in 1999. One of the latter two banks—indeed, the second-largest in the country—incurred large losses in Russian securities and derivatives markets and had to be recapitalized by the government at end-1998. The other is also likely to receive an injection of government funds to improve its risk profile in the run-up to privatization. A second revision to the Act on Banks, which strengthened bank licensing and supervision, became effective in September 1998, but more changes are needed to comply with the EU directives—especially on accounting standards. Also, in June 1998 the central bank imposed stricter loan-loss-provisioning requirements, disallowing the netting out of collateral from loans overdue more than 365 days.

    Box A3.3.Deposit Insurance: Issues for Emerging Markets

    Recent developments in emerging market banking systems have led to a reassessment of the optimal design of bank safety nets, in particular deposit insurance systems. Several academics and rating agencies have stressed that moral-hazard-driven lending played an important role in the Asian banking crises, adding to the existing evidence that explicit deposit insurance increases the probability of systemic banking problems.1 In part recognizing this role, many of the countries suffering from recent banking crises are considering or even have effective timetables to limit the coverage of their deposit insurance systems. In addition, the results of a recent survey suggest a trend toward the adoption of explicit deposit insurance systems, to make them compulsory (to avoid adverse selection), funded (but, in most cases backed up by governments), and to have risk-based pricing—all elements that improve the incentive effects of the deposit insurance system.2 However, despite some convergence to best practice among the emerging markets, improvements are still needed in many countries, and several proposals to improve the deposit insurance system have emerged.

    Full Coverage During Crises and the Moral Hazard Issue

    The immediate consequences of recent banking crises seem to support a strengthening of guarantees during crisis periods, but doubts remain on the feasibility of ameliorating the moral hazard effects during and after a crisis. The example of Indonesia, where the closure of only a few banks—when the solvency of many others was questionable on the basis of information available to depositors—led to bank runs, would suggest that less-than-full insurance under incomplete information on banks’ asset quality may be quite costly. However, private information about banks’ assets is one key feature of banking, and the historical evidence suggests that the emphasis on the fragility of banking systems in the absence of a government safety net may be overstated.3 Moreover, full coverage during crises means that guarantees are strengthened precisely when incentive problems are worse—that is, when banks’ capital is very low. Also, a tightening of supervision and regulation to prevent the “gambling for recovery” of insolvent banks may be economically undesirable and politically infeasible, as it would require banks to either raise capital in a very difficult environment or reduce loans in a procyclical way.

    The recent experience of Mexico and Turkey provide clear examples of the problems created by extensive guarantees several years after a crisis. Both countries suffered severe banking crises in 1994–95 and established full deposit guarantees thereafter. The incomplete cleanup of their banking systems has meant that, as the international capital markets dried up last year, some small and insolvent banks raised interest rates to levels substantially above that of interest rates offered by larger and relatively more solvent banks.4 As the distortionary effects of the former banks’ pricing behavior in the interbank and money markets grew, the government reportedly provided assurances of official support in the case of one Mexican institution to ensure the availability of credit lines, and many Turkish banks were placed under enhanced surveillance.

    Limited Deposit Insurance and the Exit Issue

    In an attempt to balance the benefits of avoiding bank runs and the costs of increased risk-taking, many countries have limited deposit insurance coverage. Indeed, 62 out of 68 countries surveyed in Garcia (1999) already cover only a fraction of the depositors’ accounts, on the grounds that large, informed depositors would exert market discipline on the banks. Also, all of the Asian crisis countries—which are excluded from the survey—as well as Mexico, have announced their intention to limit the coverage of their deposit insurance schemes.5

    Although a precommitment to limit deposit insurance in countries that already have an explicit deposit insurance scheme entails some risks, it also helps focus reform efforts and muster the support to effectively clean up the system and make it more transparent. Japan is an example where the expectation that the full guarantee of deposits will be eliminated by 2001 has contributed to re-focus attention and efforts on restructuring and recapitalization of the banking system (see Annex II). In end-May 1999, Mexico announced that it will phase out unlimited deposit insurance from 2003—when the government expects to complete the cleaning up of the banking system—to guarantee deposits of no more than about US$100,000 by 2005.

    While there is some evidence that depositors in emerging markets do exert some sort of discipline on banks, the small extent of depositor losses in recent crises and the strengthening of safety nets casts doubts on the credibility of just limited support in the event of a recurrence of crises. Empirical evidence from Argentina, Chile, and Mexico suggests that depositors (both small and large) do punish banks that take excessive risk, by withdrawing their funds.6 However, many depositors in these countries had suffered losses from previous crises—usually derived from delayed payments after a deposit freeze—and analysts worry that the lack of meaningful losses in recent crises, combined with a more explicit and credibly funded deposit insurance scheme, may weaken depositor discipline. Moreover, the savings and loan crisis in the United States vividly showed how depositor discipline, and even that of regulators, cannot be fully trusted.

    Alternative Proposals

    Several alternative proposals for the reform of deposit insurance schemes have been put forward, and they can be broadly classified into three groups or approaches.

    The early intervention/closure approach has the advantage of maintaining (and strengthening) the existing banking and deposit insurance structures, but critics note that the approach’s main flaw is that it relies only on regulators to enforce discipline on the banks. The proposals are inspired by the U.S. experience after the Federal Deposit Insurance Corporation Improvement Act and the Chilean Banking Law of 1986, which attempts to enact clear, explicit principles for a timely regulatory intervention of troubled banks.7 The principles include prompt corrective action from the banks to restore capital to the required regulatory ratios and a precise specification of several alternative closure and recapitalization mechanisms. The main problem with this approach is that it relies only on bank regulators to identify undercapitalized banks and to enforce regulations, while experience in many countries has shown that regulators are not immune to political pressure that may exacerbate incentive problems and fiscal losses.8

    The functional approach is based on the view that there are significant costs in maintaining the current institutional structure. It holds that an efficient solution is for commercial lending to be financed by standard instruments such as debt, preferred stock, and equity, and for deposit insurance to be limited to institutions or accounts that collateralize demand deposits with liquid, riskless securities—such as U.S. treasury securities.9 This proposal is similar to the “narrow-banking” proposals, but allows institutions that take transaction/demand deposits to also engage in other financial activities, including risky lending. It avoids the difficulties inherent in an effective marking to market of the early intervention/closure proposals, but is subject to the credibility problem that, in the event, other liabilities used to finance loans may end up also being fully guaranteed by the government.

    The market-discipline approach attempts to combine government deposit insurance and regulation, with monitoring and discipline imposed by the market.10 The key to this approach is to require banks to maintain minimum ratios of subordinated debt relative to insured deposits, such that private agents that do not share on the upside of bank risk-taking behavior have an incentive to constrain that behavior. The proposal requires that the subordinated debt be rolled over gradually—to avoid sudden rollover crises and allow time for corrective action; that it be subject to a maximum spread over a riskless instrument; and that it be held by parties unrelated to the bank holding company or the government—preferably, by foreign banks or institutional investors. Argentina has implemented some of the elements of this proposal, together with the requirement that banks obtain and make publicly available ratings from two well-established private rating agencies.11 Although some Argentine banks have had difficulties issuing such subordinated debt, this was a result of the currently difficult international environment—which has restricted access to most private entities—and the good reception of the Thai hybrid capital instruments—which include a subordinated debt component (see Box A3.2)—suggest that it may be feasible for emerging markets to follow this approach.

    1 See, for instance, Corsetti, Pesenti, and Roubini (1998) and Demirgüç-Kunt and Detragiache (1998).2 See Garcia (1999)3 See Kroszner (1998)4 Over the last year, the smaller lower-tier banks in Turkey were reportedly offering dollar interest rates of over 20 percent a year, while the top-tier banks were paying rates under 10 percent.5 The convergence of limited deposit insurance to the same level of deposits in the EU has mea nt that poorer countries, on average, would offer higher coverage in relationship to income than richer countries. Hence, countries with potentially weaker banks could be subject to a higher moral hazard problem.6 See Martinez and Schmukler (1999).7 See Benston and Kaufman (1997) and Brock (1992).8See Calomiris (1999).9Merton and Bodie (1993).10 See Calomiris (1997, 1999).11 The recent proposals to modify the Basel Accord incorporate the use of credit ratings for all sovereign lending and for a limited amount of corporate lnding (see Chapter IV).


    The strong growth in the external liabilities of the Hungarian banking system was slowed marginally in the aftermath of the Russian crisis, and the repercussions of the events in Russia on local capital markets demonstrated the resilience imparted by a strong foreign presence in the banking sector. Banks’ foreign liabilities increased by 18 percent (adjusted by the forint depreciation) in 1998, despite declining marginally in the period after the Russian crisis. The Russian crisis and its spillovers to Hungarian money and capital markets resulted in a decrease in profits and substantial shifts in banks’ balance sheets. The share of foreign currency assets rose to 36 percent of total assets at end-1998—roughly the same as that of foreign currency liabilities—from 30 percent at end-June 1998, led mostly by strong growth in foreign-currency-denominated loans. Also, the share of government securities increased to 14 percent of total assets, from 11 percent at the end of the first half of the year. Banks experienced a significant decrease in profits, owing to a deterioration in the quality of their portfolios, the introduction of country risk provisioning, and losses in trading and brokerage operations. Problems at banks’ brokerage subsidiaries, as a result of defaults of highly leveraged retail investors,21 did not lead to many closures, as parent banks—including the head offices of many foreign banks, which dominate the Hungarian banking sector—transferred funds to support their securities subsidiaries. Brokerage losses and the failure of the second-largest retail bank—which was recapitalized by the authorities at year-end—prompted changes to a still well-regarded supervisory and regulatory framework.


    International bank exposure to Polish banks increased during 1998, in part owing to the stable bank relationships with western European banks and the prospects of EU accession, and contributed to strong lending growth. Strong capital inflows led to persistent excess liquidity in the banking system, which was offset by central bank sterilization and through the maintenance of high reserve requirements. Combined with strong competition, this fueled aggressive credit growth—especially in foreign-currency-linked loans to (generally unhedged) borrowers; strong growth in off-balance-sheet activities, albeit from very low levels; and a 35 percent decline in net profits. Restrictions on foreign participation in the banking sector were lifted early last year, and as of end-1998 foreign banks with wholly owned subsidiaries or major equity stakes in privatized banks accounted for 44 percent of total share capital. Foreign ownership is bound to increase substantially with the privatization of the country’s largest bank by mid-1999 and that of the last of the nine regional banks later in the year. As a result of the growth in off-balance-sheet positions, the authorities have introduced prudential regulations to limit derivative transactions to 30 percent of equity and have extended solvency requirements to encompass counterparty risks related to off-balance-sheet positions. Although securities are almost one-third of the banks’ balance sheet, no capital adequacy requirements for market risk have yet been implemented. Also, while the Polish banking system is evolving rapidly toward a universal banking model, financial sector supervision in Poland is not carried out on a consolidated basis.


    The Turkish banking system faced increased funding and credit risks during 1998, owing to curtailed access to international funding by the lower-tier banks, higher domestic interest rates, and an economic downturn. However, the strength of a core group of well-managed top-tier banks, the treasury’s readiness to accept high interest rates, and the stability of the depositor base allowed the banking system to weather the global crisis well. Despite substantial capital outflows in the aftermath of the Russian crisis, external liquidity pressures abated in the last quarter of 1998, and international syndicated loans to the top-tier Turkish banks were rolled over at a higher-than-expected rate. The predominant reason for the renewal of credit lines was relationship banking with international banks, aided by the sophisticated and flexible risk management of the top-tier banks and the treasury’s readiness to accept high interest rates in the scheduled bills and bond auctions.22 The high domestic interest rates have raised questions about the dynamics of the government’s debt, but this has so far not been a key concern with the domestic investor base. Domestic depositor confidence was supported by the blanket guarantee of deposits, which allowed some smaller banks and the state-owned banks to offer above-market interest rates to attract deposits (see Box A3.3). Despite concerns about the available resources of the deposit insurance fund, the interventions in two banks that experienced runs were relatively smooth, and some twelve unidentified banks have reportedly been on the treasury’s watchlist of financially weak institutions. The maturity mismatch in the sector is not large—except for a few banks that rely heavily on repo transactions—but the large currency mismatch remains a source of concern, despite the tighter regulations that attempt to bring the open positions to 30 percent of equity. As the economy slowed down, asset quality—widely perceived to be overestimated23—deteriorated, with the biggest credit risk being the concentration of intragroup lending and guarantees that are not readily apparent in the analysis of banks accounts. Market analysts see the approval of a new banking law that calls for the establishment of an independent bank supervisory body as a crucial step toward reforming the Turkish banking system.


      Benston, George, and GeorgeKaufman,1997, “FDICIA After Five Years,”Journal of Economic Perspectives, Vol. 11 (Summer), pp. 13958.

      Brock, Philip,ed., 1992, “If Texas Were Chile: A Primer on Banking Reform” (San Francisco, California: Institute for Contemporary Studies Press).

      Calomiris, Charles,1997, “The Postmodern Bank Safety Net: Lessons from Developed and Developing Economies” (Washington: AEI Press).

      Calomiris, Charles,, 1999, “Building an Incentive-Compatible Safety Net,” Journal of Banking and Finance (forthcoming).

      Corsetti, Giancarlo, PaoloPesenti, and NourielRoubini,1998, “What Caused the Asian Currency and Financial Crisis?”Banca d’Italia, Temi di Discussione No. 343 (Rome, December).

      Demirgüç-Kunt, Asli, and EnricaDetragiache,1998, “The Determinants of Banking Crises In Developing and Developed Countries,”Staff Papers, International Monetary Fund, Vol. 45 (March), pp. 81109.

      Garcia, Gillian,1999, “Deposit Insurance: A Survey of Actual and Best Practices,”IMF Working Paper 99/54 (Washington: International Monetary Fund).

      International Monetary Fund, 1998, International Capital Markets: Developments, Prospects, and Key Policy Issues (Washington).

      Kroszner, Randall S.,1998, “Rethinking Bank Regulation: A Review of the Historical Evidence,”Journal of Applied Corporate Finance, Vol. 11 (Summer).

      Martinez, M. Soledad, and SergioSchmukler,1999, “Do Depositors Punish Banks for “Bad” Behavior?: Examining Market Discipline in Argentina, Chile, and Mexico”World Bank Policy Research Working Paper No. 2058 (Washington: World Bank, February).

      Merton, Robert, and ZviBodie,1993, “Deposit Insurance Reform: A Functional Approach,”Carnegie-Rochester Conference Series on Public Policy, Vol. 38 (June), pp. 134.

      Moody’s Investor Service, 1999a, “Corporate Restructuring and the Impact on the Korean Banking Sector” (New York, April).

      Moody’s Investor Service, 1999b, “Banking System Outlook: Thailand” (New York, May).

      Moody’s Investor Service, 1999c, “Special Comment: Look Who’s Talking About Capital: The Mexican Banking System and Economic Capital” (New York, June).

      Moody’s Investor Service, 1999d, “Banking System Outlook: Venezuela” (New York, January).

      SalomonSmith Barney, 1999, Mexican Bank Reference Guide, Equity Research (April).

    Annex IV: Proposals for Improved Risk Management, Transparency, and Regulatory and Supervisory Reforms

    Dynamic changes in financial institutions and capital markets are posing increasingly complex challenges for financial regulation and supervision. Wider circles of counterparties now interact with each other in a larger number of business lines; financial instruments have become more complicated; and financial intermediation relies increasingly on fast-changing financial markets. Consequently, the distinction between commercial banks, securities firms, insurance companies, and other financial institutions has become blurred, and large diversified financial conglomerates have been created that span the spectrum of financial services and global markets. Highly leveraged activities and institutions engaged in these activities, including unregulated hedge funds, have emerged on a scale that could pose systemic risks. All in all, financial innovation (especially off-balance-sheet activities) and globalization may have reduced the transparency of the global financial system and increased challenges for market participants and supervisory agencies alike. This annex briefly describes the proposed revisions to the Basel Accord on Capital Adequacy and the newly established Financial Stability Forum and then summarizes regulatory and supervisory developments during the past year in the following areas: (1) risk management and internal control systems; (2) disclosure and market discipline; (3) HLIs, including hedge funds; and (4) the supervision of financial conglomerates and international accounting standards (see Table A4.1). The summary focuses on the broad issues and does not cover regulatory developments in particular countries.

    Table A4.1.Key International Supervisory and Regulatory Reports and Guidance Notes
    SubjectDocumentDate Issued
    Capital Adequacy
    Basel Committee on Banking SupervisionA New Capital Adequacy FrameworkJune 1999
    Risk Management and Internal Controls
    Basel Committee on Banking SupervisionCredit Risk Modelling: Current Practices and ApplicationsApril 1999
    Framework for Internal Control
    Systems in Banking Organisatons
    September 1998
    Operational Risk ManagementSeptember 1998
    International Organization of Securities Commissions (IOSCO)Risk Management and Control Guidance for Securities Firms and Their SupervisorsMay 1998
    U.S. Federal ReserveSupervisory Letter 99-3February 1999
    U.S. Office of the Comptroller of the Currency (OCC)OCC Bulletin 99-2January 1999
    Counterparty Risk Management Policy GroupImproving Counterparty Risk Management PracticesJune 1999
    Institute of International FinanceReport of the Task Force on Risk AssessmentMarch 1999
    International Swaps and Derivatives Association (ISDA)ISDA 1999 Collateral ReviewMarch 1999
    Disclosure and Market Discipline
    Basel Committee on Banking Supervision and the IOSCO Technical CommitteeRecommendations for Public Disclosure of Trading and Derivatives Activities of Banks and Securities FirmsFebruary 1999
    Basel Committee on Banking SupervisionEnhancing Bank TransparencySeptember 1998
    Basel Committee on Banking Supervision and the IOSCO Technical CommitteeSupervisory Information Framework for Derivatives and
    Trading Activities
    September 1998
    Highly Leveraged Institutions (HLIs)
    Basel Committee on Banking SupervisionBanks’ Interactions with Highly Leveraged InstitutionsJanuary 1999
    Sound Practices for Banks’ Interactions with Highly Leveraged InstitutionsJanuary 1999
    United States President’s Working Group on Financial MarketsHedge Funds, Leverage, and the Lessons of Long-Term Capital ManagementApril 1999
    Deutsche Bundes bankHedge Funds and Their Role in the Financial MarketsMarch 1999
    Reserve Bank of AustraliaHedge Funds, Financial Stability and Market IntegrityMarch 1999
    Supervision of Financial Conglomerates and International Accounting Standards
    International Accounting Standards CommitteeFinancial Instruments: Recognition and MeasurementMarch 1999
    Joint Forum on Financial ConglomeratesSupervision of Financial ConglomeratesFebruary 1999
    Basel Committee on Banking SupervisionSound Practices for Loan Accounting and DisclosureJuly 1999

    Most of the regulatory and supervisory issues are part of the wider agenda on the international financial architecture.1 Key pillars of the reform agenda are the development, dissemination, and adoption of internationally recognized standards, and the promotion of greater private sector transparency to bolster market discipline. In the wake of the 1997 Asian crisis, numerous regulatory initiatives were proposed, mostly targeted at setting global standards and guidelines that are in many cases derived from practices in developed countries. These standards were gathered in the Core Principles for Effective Banking Supervision2 and have recently been extended in some areas, such as bank transparency. In addition, the 1998 financial market turbulence and in particular the near-collapse of LTCM spawned a wave of regulatory and supervisory reports, guidelines, and forums in both the public and private sectors that are primarily directed at improving risk management, strengthening market discipline by increased transparency and disclosure, improving oversight of banks’ interaction with HLIs, and enhancing consolidated supervision of financial conglomerates.

    The supervisory authorities strive to bring regulatory standards up to date with financial innovations that often seem a step ahead. To adapt regulations flexibly to the increasing pace of innovation and change, supervisors have shifted away from specific regulatory rules and have moved toward a more risk-focused approach to regulation. A key development is the proposed revision to the 1988 Basel Accord on Capital Adequacy that aims at correcting weaknesses in the existing capital regulations and would adapt them to financial innovations and changed banking practices. The consultative paper A New Capital Adequacy Framework, issued by the Basel Committee on Banking Supervision in June 1999, proposes capital adequacy rules that would be more closely aligned with risk profiles.3 The new framework would rest on three pillars: minimum capital requirements that expand the “standardized approach” in the current Accord; supervisory review of a bank’s capital adequacy and internal assessment processes; and strengthened market discipline as a lever to encourage prudent and sound banking practices. The Committee proposes to use external credit assessments for determining risk weights for claims on sovereigns and banks, and to some extent for claims on corporates. For some sophisticated banks, the Committee believes that, subject to supervisory approval, internal ratings could form the basis for setting capital charges more closely aligned with underlying risks. To improve incentives for the use of risk-mitigating techniques, the Committee also examined the capital treatment of credit derivatives, collateral, guarantees and on-balance-sheet netting. As part of the second pillar—supervisory review—supervisors would have the authority to require banks to hold capital in excess of minimum requirements to ensure that the capital position is consistent with the bank’s overall risk profile and strategy. Preconditions for the third pillar—market discipline, which is viewed as supplementing supervision and regulation in encouraging prudent banking behavior—are high disclosure standards. The Committee will issue concrete proposals on public disclosure in a separate paper.

    The financial turbulence of 1998 revealed scope for strengthening efforts to identify incipient vulnerabilities in national and international financial systems. To that end, the Financial Stability Forum was established in February 1999 (following the Tietmeyer Report to the G-7 Finance Ministers). It comprises representatives of national and international authorities responsible for questions of financial stability (ministries of finance, central banks, and supervisory authorities of, initially, the G-7 industrial countries, and representatives from international financial institutions and international regulatory groupings).4 While there is a multitude of national and international bodies that regularly monitor aspects of financial system stability, none was thought to have the breadth of information and capacity to assess evolving risks comprehensively. Regulatory bodies deal primarily with micro-prudential issues pertaining to the stability of individual institutions, but it has become increasingly important to consider micro-prudential policies in a wider market-based setting. The Forum would also identify gaps in international standards and codes of conduct and ensure that consistent international rules and arrangements apply across all types of significant financial institutions. Three working groups have been established. One working group has been asked to recommend measures to reduce the destabilizing potential of HLIs. A second working group will evaluate measures to reduce the volatility of capital flows and the risks of excessive short-term external indebtedness. The third working group will investigate the impact of offshore financial centers on global financial stability and assess progress in enforcing international prudential standards by offshore centers.

    Proposals to Strengthen Risk Management and Internal Control Systems

    Market disturbances in 1997 and 1998 revealed weaknesses in counterparty credit risk and market risk assessments. Analyses since the market turbulence have noted that risk management systems failed in part because of technical weaknesses—for example, correlations across market prices behaved erratically and other key assumptions underlying the techniques proved incorrect. The interaction of financial institutions with hedge funds and other HLIs also revealed the close link between market risks and credit risks. Moreover, seemingly adequate amounts of collateral and margins proved insufficient. These and other shortcomings point to the need to also improve internal control systems. The main challenge is therefore how to adapt risk management tools and internal controls to increasingly global and interrelated markets, new financial products, and potentially more volatile market conditions (including the potential loss of market liquidity).

    New supervisory initiatives that have recently been brought under way also aim at narrowing the gap between leading-edge risk management practice and the average industry standard. In part owing to significant losses at some banking institutions, banking supervisors are putting more emphasis during inspections on the review of a banking organization’s risk management and internal control processes. To underpin these efforts by national supervisors, international forums of regulatory authorities (such as the Basel Committee on Banking Supervision and the International Organization of Securities Commissions (IOSCO)) and private groups (such as the IIF and the Counterparty Risk Management Policy Group) have drafted reports and guidelines on various aspects of risk management.

    Public Sector Reports

    The Basel Committee’s report on Credit Risk Modelling: Current Practices and Applications (April 1999) assesses the state of the art in credit modeling with a view to judging whether existing credit risk models could be used in the regulatory oversight of banking organizations and whether internal credit modeling approaches could serve as the basis for formal regulatory capital requirements to cover credit risk. To be used for that purpose, the report emphasizes that models should be “conceptually sound, empirically validated, and produce capital requirements that are comparable across institutions.” At this point, the Basel Committee sees significant hurdles, principally concerning data availability and model validation. As to data limitations, most credit instruments are not marked to market, and credit risk predictions can typically not be derived from statistical projections of future prices based on a comprehensive record of historical prices. The validation of credit risk models is more difficult in part because backtesting needs to rely on a longer time horizon (typically one year or more) than market risk models (a few days).

    The Basel Committee’s Framework for Internal Control Systems in Banks (September 1998, previously issued for consultation in January 1998) complements the Basel Core Principles on issues of internal controls. Recognizing that sound internal controls are essential for the prudent operation of banks and for promoting financial system stability, the paper emphasizes that an effective system of internal controls must be consistent with the nature, complexity, and risk inherent in the bank’s on- and off-balance-sheet activities. It outlines 13 principles for use by supervisors to evaluate banks’ internal control systems. The principles stress the role of management oversight in understanding the major risks run by a bank, and in taking steps necessary to identify, measure, monitor, and control these risks. A precondition is that the material risks that could adversely affect the bank are being recognized and continually assessed. Control activities should be an integral part of daily activities of a bank, with controls defined at every business level. The principles also stress that reliable information systems and effective communication channels should be in place. The paper recommends that the effectiveness of the banks’ internal controls be monitored on an ongoing basis by an internal audit unit that reports directly to the board of directors or its audit committee.

    The Basel Committee’s paper on Operational Risk Management (September 1998) reports the results of a survey among some 30 major banks. While there is no universally agreed upon definition of operational risk, it is largely considered to be risk arising from human or technical error. Managing operational risk is becoming more difficult as financial instruments and institutions become more complex. Many banks in this survey expected most operational risk events to be associated with internal control weaknesses or lack of compliance with existing internal control procedures. The survey also indicates that while awareness of operational risk among senior bank management was increasing, banks were only in the early stages of developing operational risk measurement and monitoring systems. Some conceptual difficulties that need to be overcome stem from the fact that, unlike market and credit risk, operational risk factors are largely internal to the bank. In light of these problems, many banks thought that the processes were not sufficiently developed for bank supervisors to mandate guidelines specifying particular measurement methodologies or quantitative limits on operational risks.

    The IOSCO document on Risk Management and Control Guidance for Securities Firms and Their Supervisors (May 1998)—like the Basel Committee paper on internal controls—provides guidance to securities firms and supervisors about internal controls and risk management. It echoes many of the themes in the Basel documents and outlines recommendations and identifies elements of effective risk management and control systems designed to serve as benchmarks. The recommendations stress that controls should be set and monitored at the senior management level. Risk management and controls should include loss tolerance limits at the level of the firm and individual trading desks and should cover market, credit, and operational risk, as well as liquidity and legal risk. Written documentation on control procedures should contain general guidance at the most senior levels and more specific and detailed guidance for smaller business units and trading desks. Firms and supervisors should ensure that control policies, once established, are effectively applied and keep pace with new products and industry technology. Firms also need to establish mechanisms that ensure that inadequacies and breakdowns in controls are reported to senior management on a timely basis.

    The U.S. Federal Reserve and the U.S. Office of the Comptroller of the Currency (OCC) have issued guidance notes on risk management that echo many of the messages contained in international regulatory initiatives. In the U.S. Federal Reserve Supervisory Letter 99-3 (February 1, 1999), the Federal Reserve points to “substantive lapses in fundamental risk management principles regarding counterparty risk assessments, exposure monitoring, and the management of credit risk limits” revealed by the turbulence in both emerging and mature markets during 1997 and 1998.

    The Federal Reserve provides guidance on two elements of counterparty credit risk management that may need special attention: adequate internal policies and sufficient internal controls to ensure that practices comply with these policies. As to the assessment of counterparty creditworthiness, supervisors and examiners should pay close attention to the appropriateness, specificity, and rigor of the policies, procedures, and internal controls used to assess counterparty risks. In particular, general policies that broadly apply to all types of counterparties may prove inadequate, as the example of hedge fund counterparties has demonstrated. Examiners should ensure that bank policies address the risk profiles of particular types of counterparties and instruments. Internal controls, in the form of periodic independent reviews by internal auditors, are necessary to ensure that practices conform with stated policies. As to the measurement of credit risk exposures, the standard calculation of potential future exposures can be inadequate and may need to be supplemented by more realistic measures of collateralized exposures in times of market stress. Credit enhancements, such as collateral arrangements and contractual closeout provisions, can mitigate but cannot eliminate credit risks. Institutions should ensure that over-reliance on collateral does not compromise other elements of sound counterparty credit risk management, such as due diligence. Examiners should focus special attention on meaningful exposure measures, exposure monitoring, and limit systems, which are considered central to the effective management of counterparty risk.

    In the same vein, the OCC Bulletin 99-2 (issued on January 25, 1999) provides new risk management guidance on derivative and other bank activities. It highlights weaknesses in existing risk management systems and identifies sound practices for banks’ derivatives and trading activities. While the bulletin focuses primarily on credit risk, it also addresses other sources of risk, including market, liquidity, transaction, and compliance risks. The OCC outlines five key risk management principles:

    • Banks must fully understand the strengths and weaknesses of their risk management systems.

    • Risk outputs (e.g., value at risk) must be stress tested. Stress testing is an essential component of the market and credit risk management process, and requires the continuing attention of senior management.

    • Due diligence, careful customer selection, and sound credit risk management—not competitive pressures—should drive the credit decision process.

    • Risk oversight functions must possess independence, authority, expertise, and corporate stature to provide to senior management effective early warning of negative market trends.

    Private Sector Reports

    Parallel to official reports and guidelines, private institutions and ad hoc working parties are also analyzing the issues surrounding risk management practices. In March 1999, the IIF and the International Swaps and Derivatives Association (ISDA) released reports on risk management and collateral management, respectively. Recently, the Counterparty Risk Management Policy Group, which had been formed by 12 large financial institutions, published a comprehensive list of recommendations.

    The Counterparty Risk Management Policy Group (co-chaired by Gerald Corrigan, Goldman Sachs; and Stephen Thieke, J.P. Morgan) released its report on Improving Counterparty Risk Management Practices in June 1999. The report contains a set of recommendations for effective management of counterparty credit risk, market risk, and liquidity risk. The Group emphasizes the need for constant adaptation and modification of risk management practices as financial environments evolve. The Group is, therefore, critical of any attempt to codify risk management practices.5 The quality of risk management is not only viewed as a matter of improving the sophistication and precision of risk estimation models but also as dependent on experience and sound judgment. The Group links the key elements of its recommendations through a conceptual framework that rests on six building blocks:

    1. Information sharing between counterparties (particularly credit providers and credit users) constitutes the foundation of effective risk management. The Group therefore proposes to intensify the exchange of information, but it recognizes that the required intensity of information sharing is a function of, inter alia, the credit exposure, the liquidity of the underlying transactions, and the degree of independent oversight of the counterparty. The paper proposes safeguards to protect proprietary client information.

    2. The Group outlines an integrated analytical framework for assessing the consequences of leverage on various forms of risk, including credit, market, and liquidity risk. It points out that leverage is not a separate source of risk but a factor that can amplify market and credit risk. Financial institutions should take steps to manage the magnifying effect of leverage on their market risk, funding arrangements, and asset liquidity risk.

    3. Measures of counterparty exposures should include liquidity-based potential exposures that take account of the potential for adverse price movements and the liquidity characteristics of contracts and collateral. Stress tests should be based on meaningful customized scenarios. These tests have to be integrated into the firm’s risk management process so that risk managers together with trading and credit managers develop stress scenarios that probe for vulnerabilities within and across key portfolios.

    4. Strong internal credit practices should combine the various risk elements and take account not only of current credit worthiness but also of potential future exposures. Credit intensive transactions with counterparties that rely heavily on leveraged portfolios should be supported by initial collateral. Appropriate internal cost allocation and valuation practices of counterparty credit risk could provide incentives for traders and credit risk managers to manage counterparty risks proactively.

    5. The Group notes scope for improved information for senior management and, potentially, for the regulatory authorities. An independent risk management function should provide relevant information to enable top management to monitor the firm’s risk profile. Senior management should convey clearly the overall tolerance for risk. Financial institutions with significant counterparty risk and market risk exposure should be prepared to meet informally with their primary regulator to discuss their principal risks. Clear understandings between the financial institution and its supervisor should detail permissible use of such information.

    6. The Group identifies scope for improvements and harmonization in standard industry documents, including the need to ensure that netting arrangements can be carried out in a timely fashion. Financial institutions should have in place written policies to manage documentation risk.

    The Report of the Task Force on Risk Assessment (March 1999), issued by the IIF, contains recommendations for both financial institutions and policymakers. Financial institutions are advised to perform comprehensive stress testing regularly to assess the potential impact of extreme events on portfolios and risk profiles. The report also urges integration of country economic analysis with stress testing and scenario analysis. Communication between senior management, portfolio managers, and line managers needs to be adequate, and a strong independent risk control unit should be in place. Methods would need to be developed to improve the integration of market and credit risk, and the understanding of the relationships between market movements, liquidity risk, and credit risk. To strengthen public policy, the IIF advocates changes in regulation to enhance transparency in financial markets (including consolidated financial statements), which is viewed as essential to determine potential credit exposures. Emerging market countries should issue long-dated domestic debt instruments and eliminate impediments to the development of local capital markets. Robust legal frameworks need to clarify bankruptcy proceedings and enforce netting arrangements.

    The International Swaps and Derivatives Association, as part of its 1999 Collateral Review, issued an assessment of how collateral management performed during the periods of market volatility in 1997–98. The review finds that the use of collateral proved to be a successful risk-mitigating tool, but also emphasizes that it creates risks of its own, primarily legal and operational risk. Other risks can arise from asset concentrations and correlations between an underlying exposure and collateral to mitigate that exposure, as well as potential difficulties in selling collateral assets. In light of the survey results, the ISDA provides a series of recommendations concerning, inter alia, the management of the risks associated with collateral, dispute resolution, initial margins, and cross-product netting and collateral use.

    Disclosure and Market Discipline

    Meaningful, accurate, and timely information provides an important foundation for the decisions of market participants and thus is indispensable for imposing market discipline on the conduct of financial institutions. The national and international proposals focus on several aspects of the connection between disclosure and transparency. They emphasize that to achieve transparency the information must be timely, accurate, and relevant to users trying to make proper assessments about financial institutions and their risk profiles. Well-informed market participants can bolster financial institutions’ incentives to operate prudently and can reinforce effective supervision and regulation. Lack of transparency may also be a source of excessive price movements, because asymmetric information can contribute to herd behavior (when some investors’ valuation of assets are based not on fundamentals but rather on their expectations of the behavior of others). By contrast, the reports indicate, promptly disclosed and disseminated information can enable market participants to react more appropriately before economic difficulties reach the point of having systemic implications. Recent initiatives recognize this channel for potentially beneficial interaction of prudential supervision and market discipline in promoting financial stability.

    Concerning public disclosure, the Basel Committee and the IOSCO Technical Committee jointly issued a consultative paper on Recommendations for Public Disclosure of Trading and Derivatives Activities of Banks and Securities Firms (February 1999).6 The recommendations relate to two areas: information on trading and derivatives activities, and disclosure of internal risk measurements. The Committees emphasize that institutions should disclose meaningful summary information, both quantitative and qualitative, on the scope and nature of their trading and derivatives activities and information of the major risks associated with these activities. Second, institutions should disclose information produced by their internal risk management systems about their risk exposures and the actual performance of exposure management.

    The Basel Committee’s guidance note on Enhancing Bank Transparency (September 1998) complements the Basel Core Principles in this area. The guidelines are based on the premise that there are significant benefits of transparency from a supervisory point of view as well as from a financial stability perspective. The report provides recommendations—albeit rather general—in six broad categories of information: financial performance, financial positions (including capital), risk management practices, risk exposures, accounting policies, and management and corporate governance. The document provides general guidance to banking supervisors, legislators, and standard setters to improve the regulatory framework for supervisory reporting and public disclosure, and to the banking industry on standards for public information disclosure. The report points out that enhanced public disclosure allows market discipline to work earlier and more effectively, thus reducing the severity of market disturbances. Conversely, market disruptions are likely to be greater if the flow of information is irregular. But the report also acknowledges potential drawbacks of public disclosure, including the potential for market overreaction to adverse information about a bank and the possibility of contagion that could spread to healthy institutions. But the report claims that contagion is less likely “in an environment of adequate ongoing disclosure.”

    Specifically on supervisory information, the Basel Committee and the IOSCO Technical Committee jointly released a revision to the Supervisory Information Framework for Derivatives and Trading Activities (September 1998). In a continuing effort to monitor the trading and derivatives activities of banks and securities firms, this revised standard (to the 1995 framework) is designed to bring the framework in line with current practice in risk management, particularly market risk. The new supervisory framework presents first a catalogue of data considered important for an evaluation of risks. Second, a common minimum framework, designed to serve as an internationally harmonized baseline, contains information items useful for assessing institutions’ involvement in derivatives activities and their credit risk and for assessing market risk inherent in trading and derivatives activities.

    Among ongoing initiatives are the activities by the G-10 Committee on the Global Financial System (formerly the Euro-currency Standing Committee) and its various working groups. The Working Group on Enhanced Disclosure by Individual Institutions (the “Fisher Group,” chaired by Mr. Peter Fisher of the Federal Reserve Bank of New York) aims to increase transparency and strengthen market discipline by determining useful disclosure standards and practices. The working group’s mandate is to identify information suitable for public disclosure that would provide an accurate picture of an institution’s exposure to market and credit risk; to explore good practices for public disclosure; and to identify steps toward implementation of such practice. The working group is developing a model template for public disclosure that would include information on credit, market, and liquidity risk (such as the aggregate VaR). Another working group, the Working Group on Enhanced Transparency Regarding Aggregate Positions (the “Patat Group,” headed by Mr. Jean-Pierre Patat of the Banque de France), is investigating the usefulness of aggregate position data for improving financial system transparency, particularly given the large number of OTC trades. The working group is also analyzing foreign exchange positions in small markets to examine whether concentrations in holdings can be identified as precursors to market turbulence.

    Highly Leveraged Institutions

    Last year’s financial turbulence, and in particular the near-collapse of LTCM, has cast the spotlight on the highly leveraged activities of largely unregulated hedge funds and revealed potential systemic risks for the global financial system.7 An important issue raised by the LTCM incident and highlighted by several reports is the control of leverage and risk taking by unregulated financial institutions so that they do not become a source of systemic risk. But transactions with HLIs pose special challenges to the risk management process of counterparties, given the opaqueness of the activities of HLIs and the dynamic nature of their trading strategies. In particular, standard accounting and balance-sheet concepts do not reveal meaningful details about a fund’s risk profile and concentration of exposures in certain markets.

    Since the turbulence revealed a breakdown of the disciplining power of market forces, supervisors and regulators have embarked on efforts to promote market discipline, guided by the view that it presents the most immediate and effective way to minimize the potential for systemic risks arising from the activities of HLIs. International supervisors have recommended that market discipline be made more effective by improving risk management practices of creditors and counterparties of hedge funds and by increasing disclosure of information on the risk profiles of hedge funds and their creditors—to the extent that a hedge fund’s proprietary information is not compromised. Timeliness of disclosure is particularly important since funds can alter their positions quickly and frequently.

    Except for some debate coming out of Europe, direct regulation of HLIs, by contrast, is currently not being considered since most regulators are concerned that it would significantly weaken market discipline by creating and exacerbating moral hazard. It would also risk moving HLIs offshore—beyond the reach of any substantive (indirect) supervision. However, as explicitly stated by the Basel Committee on Banking Supervision and by the U.S. President’s Working Group on Financial Markets, the indirect approach, which relies on the risk management of HLI counterparties, does not exclude the possibility of introducing more direct regulation of HLIs if the indirect measures prove to be insufficient.

    A Working Group of the Basel Committee, chaired by Mr. Jan Brockmeijer, released a report on Banks’ Interactions with Highly Leveraged Institutions (January 1999), which evaluates the potential risks from the activities of HLIs, assesses deficiencies in banks’ risk management practices vis-à-vis HLIs, and evaluates alternative policy responses to address these risks. The report concludes that recent events, most notably the near-collapse of LTCM, have highlighted deficiencies in banking institutions’ risk management. It therefore urges supervisors to put in place incentives, procedures, and standards to encourage prudent management of bank exposures to HLIs. The report identifies deficiencies in due diligence procedures and in the ongoing exposure monitoring. As a result of limited financial information, credit decisions were, to some degree, based on nonsystematic and largely qualitative assessments of risks and on the reputation and perceived risk management capabilities of the HLIs concerned. Collateral management systems appeared to adequately provide cover for direct exposures, but not necessarily for secondary market exposures. Banks generally obtained little information on HLIs’ off-balance-sheet exposures or risk management strategies.

    The report compares features of possible indirect and direct policy measures for HLIs. Concerning indirect approaches, which would focus on the major counterparties of HLIs, the report concludes that many of the risks associated with HLIs can be addressed through better risk management at banks and securities firms. The report recommends standards for sound practices in dealings between banks and HLIs, and a more comprehensive due diligence process and stress testing, as well as improved measures of potential future exposure. The Committee notes that more prudent risk management by banks could also limit the leverage of HLIs. Among measures to enhance the transparency of HLI activities, the report discusses, inter alia, public disclosure by global players and a credit register for bank loans to HLIs. According to the report, direct regulation of HLIs, such as through licensing requirements and minimum standards for capital and risk management, may be necessary, if the indirect measures together with enhanced transparency should prove to be insufficient. The report notes, however, key obstacles for direct regulation, including arriving at a workable definition of HLIs and establishing jurisdiction over the activities of institutions that are located in offshore centers.

    In a companion paper, the Basel Committee outlined Sound Practices for Banks’ Interactions with Highly Leveraged Institutions (January 1999). The paper contains sound practice standards for the management of counterparty credit risk inherent in banks’ trading and derivatives activities with HLIs. Among other items, these sound practices call upon banks to:

    • establish clear policies and procedures governing their involvement with HLIs;

    • adopt credit standards addressing the specific risks associated with HLIs;

    • develop meaningful measures of potential future exposure resulting from trading and derivatives transactions;

    • establish meaningful overall credit limits, incorporating the results of stress testing;

    • link credit enhancements, including collateral and early termination provisions, to the specific characteristics of HLIs; and

    • frequently monitor exposure vis-à-vis HLIs.

    The report Hedge Funds, Leverage, and the Lessons of Long-Term Capital Management by the U.S. President’s Working Group on Financial Markets (April 1999) focuses on the systemic issues raised by hedge funds and points out that the impact of HLIs on market dynamics needs further study. The report concludes that the central policy issue raised by the events in global financial markets in the summer and fall of 1998 is how to constrain excessive leverage more effectively—an issue not limited to hedge funds. The Working Group recommends a number of measures to constrain excessive leverage. These measures are designed to improve transparency in the system, enhance private sector risk management practices, develop more risk-sensitive approaches to capital adequacy, support financial contract netting in the event of bankruptcy, and encourage offshore financial centers to comply with international standards. The Working Group does not recommend direct government regulation of hedge funds at this time. However, it indicates that if indirect approaches are not effective, direct regulation may be given further consideration. Specific recommendations were made in the following three areas.

    Public disclosure

    • Hedge funds should be required to disclose their financial statements to the public; and

    • all public companies, including financial institutions, should publicly disclose a summary of their direct material financial exposures to significantly leveraged financial institutions.

    Risk management

    • Financial institutions should enhance their practices for counterparty risk management (the report suggests areas where private risk management can be strengthened);

    • regulators should encourage improvements in the risk-management systems of regulated entities; and

    • regulators should promote the development of more risk-sensitive but prudent approaches to capital adequacy.

    Other areas

    • Regulators’ authority to obtain financial information about unregulated affiliates of broker-dealers and futures commission merchants should be enhanced;

    • the close-out netting regime for financial contracts should be reformed;

    • the interplay between bankruptcy laws across countries should be improved; and

    • through stronger incentives, offshore financial centers should be encouraged to comply with international standards.

    A report by the Deutsche Bundesbank on Hedge Funds and Their Role in the Financial Markets (March 1999) points out that, on balance, hedge funds contribute to greater market efficiency but their investment strategies may contain specific risks. The available evidence, the article notes, suggests that hedge funds played a major role in the 1992 ERM crises but that appeared not to be the case in recent episodes of financial turmoil such as the Mexico crisis and the East Asian crisis. The systemic risks associated with hedge funds depend crucially on the degree of the financial integration of the funds with the banking sector. According to the Bundesbank, calls for regulation of hedge funds appear warranted since the insolvency of hedge funds could jeopardize the stability of the financial system. To enable counterparties of hedge funds and supervisory authorities to assess the risks involved, the Bundesbank suggests that it would be desirable if hedge funds would have to comply, under direct supervision, with extended reporting rules and possibly also with investment and capital requirements. But the Bundesbank acknowledges that at a practical level questions remain on how regulatory measures could be made effective in the context of globalized markets and complex investment strategies. Nonetheless, owing to potential conflicts of interest if banks are at the same time investors in and lenders to hedge funds, relying solely on the disciplining effects of the market is unlikely to suffice. The Bundesbank proposes the introduction of an international credit register for large exposures to provide banks with an efficient monitoring system, which—together with better risk management—could contribute to crisis prevention.

    A Reserve Bank of Australia report on Hedge Funds, Financial Stability and Market Integrity (March 1999) found that large hedge funds are systemically important institutions that can affect the stability of the financial system and could potentially undermine market integrity by manipulating prices. The report, therefore, concludes that there is a strong case for a public policy response to the emergence of hedge funds. Although regulation of some types of hedge funds may be warranted, the report acknowledges considerable practical difficulties, including the possible move by hedge funds to nonregulated offshore centers and the emergence of new institutions outside the regulatory framework. Therefore the most effective approach, according to the report, would include improving disclosure standards, enhancing the risk monitoring by the creditors of hedge funds, and removing distortions in the Basel capital framework that favor bank exposures to hedge funds.

    The report notes that more disclosure is required in three areas: information on market concentration; information for sound counterparty risk assessments; and information to assess the health of financial markets. The report proposes, inter alia, large position reporting requirements, an international credit register, and disclosure of information on risk exposures and stress test results. Regulators could enforce disclosure standards by a penalty capital charge on exposures to noncompliant counterparties. The BIS could expand its banking and derivatives statistics coverage to investment banks, hedge funds, and other institutional investors. The report also emphasizes that supervisors have a role in ensuring sound risk assessment by bank management and that regulation should not encourage inappropriate risk taking. In this context, the paper notes that, according to the current Basel Accord on Capital Adequacy, inter alia, banks’ derivative exposures to nonbanks receive only a 50 percent risk weight (implying a 4 percent capital requirement compared with the standard 8 percent for claims on the private sector), that short-dated foreign exchange contracts are zero weighted, and that on-balance-sheet exposures to hedge funds are treated just like any other claim on the private sector.8 Notwithstanding ongoing efforts toward international coordination, the report points to scope for unilateral action by national regulators, particularly in the United States, with beneficial effects for the global financial system.

    Supervision of Financial Conglomerates and International Accounting Standards

    Supervision of the global financial system is still largely fragmented both functionally and geographically, while global financial markets are becoming increasingly integrated. In response, efforts at international coordination of regulation and supervision (of banks, securities firms, and insurance companies) are being accelerated to improve supervision both across functional lines and across borders. Given the increasing emergence of large global financial conglomerates that are supervised by numerous supervisors of different industries and nationalities, in February 1999 the Joint Forum on Financial Conglomerates issued a set of papers on the Supervision of Financial Conglomerates (which had previously been issued for comments in February 1998).9 The papers cover issues of capital adequacy, fit and proper principles for top management, and the sharing of supervisory information with the objective to work toward a more effective supervisory framework for financial conglomerates that stretches across various lines of business and national borders.

    The papers concerning capital adequacy outline measurement techniques and principles to assess capital adequacy on a group-wide basis for financial conglomerates. A paper on fit and proper principles provides guidance for supervisors to assess the competence of the management of the various separate entities of a financial conglomerate. Two papers deal specifically with facilitating information sharing between supervisors of regulated entities within internationally active financial conglomerates by outlining a framework and by providing guiding principles for such information sharing. In certain circumstances it might be beneficial to designate one supervisory agency involved in supervising a conglomerate as a coordinator to facilitate information sharing. One of the papers provides guidance on the choice of a coordinator. It points out that the choice of coordinator and the design of its responsibilities are influenced by the trade-off between the benefits of improved coordination and the risks of creating (or appearing to create) a new layer of supervisory oversight or an extension of a government safety net to normally unprotected entities within a conglomerate.

    Although sound loan accounting and disclosure practices are essential to ensure transparency and to facilitate effective supervision and market discipline of financial institutions, national rules and practices on the recognition of deteriorating credit quality vary widely. To address this issue, the Basel Committee on Banking Supervision released a paper on loan valuation, loan-loss provisioning, and credit risk exposure, entitled Sound Practices for Loan Accounting and Disclosure (July 1999). The paper complements the Basel Core Principles for Effective Banking Supervision and is designed to advance international harmonization in loan valuation and accounting. The paper provides guidance on key loan accounting issues, such as the recognition and valuation of loans, the establishment of loan-loss allowances, and credit risk disclosure.

    On accounting standards more generally, the International Accounting Standards Committee (IASC) has been in the process of developing a core set of international accounting standards. In March 1999, it published a comprehensive standard on accounting for financial instruments, including derivatives such as futures, forwards, swaps, and options contracts. The new standard IAS 39 (Financial Instruments: Recognition and Measurement) requires that all financial assets and liabilities be recognized on the balance sheet, including derivatives. IAS 39 significantly increases the use of fair-value accounting for financial instruments, and it permits hedge accounting, provided that the hedging relationship is clearly defined, measurable, and actually effective. The Technical Committee of IOSCO has begun its assessment of the standard to decide whether to recommend that IOSCO members permit foreign issuers to use IASC standards in lieu of national standards for cross-border offering and listing purposes.


      Basel Committee on Banking Supervision, 1997, Core Principles for Effective Banking Supervision (Basel: Bank for International SettlementsSeptember).

      Basel Committee on Banking Supervision, 1998a, Enhancing Bank Transparency (Basel: Bank for International Settlements, September).

      Basel Committee on Banking Supervision, 1998b, Framework for Internal Control Systems in Banking Organisations (Basel: Bank for International Settlements, September).

      Basel Committee on Banking Supervision, 1998c, Operational Risk Management (Basel: Bank for International Settlements, September).

      Basel Committee on Banking Supervision, 1999a, Banks’ Interactions with Highly Leveraged Institutions (Basel: Bank for International Settlements, January).

      Basel Committee on Banking Supervision, 1999b, Credit Risk Modelling: Current Practices and Applications (Basel: Bank for International Settlements, April).

      Basel Committee on Banking Supervision, 1999c, A New Capital Adequacy Framework (Basel: Bank for International Settlements, June).

      Basel Committee on Banking Supervision, 1999d, Sound Practices for Banks’ Interactions with Highly Leveraged Institutions (Basel: Bank for International Settlements, January).

      Basel Committee on Banking Supervision, 1999e, Sound Practices for Loan Accounting and Disclosure (Basel: Bank for International Settlements, July).

      Basel Committee on Banking Supervision, and the Technical Committee of IOSCO, 1998a, Supervisory Information Framework for Derivatives and Trading Activities (Basel: Bank for International Settlements, September).

      Basel Committee on Banking Supervision, and the Technical Committee of IOSCO, 1998b, Trading and Derivatives Disclosures of Banks and Securities Firms: Results of the Survey of 1997 Disclosures (Basel: Bank for International Settlements, November).

      Basel Committee on Banking Supervision, and the Technical Committee of IOSCO, 1999, Recommendations for Public Disclosure of Trading and Derivatives Activities of Banks and Securities Firms (Basel: Bank for International Settlements, February).

      Board of Governors of the Federal Reserve System, 1999, Supervisory Letter 99-3 (Washington, February).

      Corrigan, Gerald, and Stephen G.Thieke,1999, Testimony on behalf of Counterparty Risk Management Policy Group before the Subcommittee on Capital Markets, Securities and Government Sponsored Enterprises, Committee on Banking and Financial Services, United States House of Representatives, March3.

      Counterparty Risk Management Policy Group, 1999, Improving Counterparty Risk Management Practices (New York, June).

      Deutsche Bundesbank, 1999, “Hedge Funds and Their Role in the Financial Markets,”Monthly Report, Vol. 51 (March), pp. 2942.

      Institute of International Finance, 1999, Report of the Task Force on Risk Assessment (Washington, March).

      International Accounting Standards Committee, 1999, Financial Instruments: Recognition and Measurement (London, March).

      International Organization of Securities Commissions, 1998, Risk Management and Control Guidance for Securities Firms and Their Supervisors (Montreal, May).

      International Swaps and Derivatives Association, 1999, ISDA 1999 Collateral Review (New York, March).

      Joint Forum on Financial Conglomerates, 1999, Supervision of Financial Conglomerates (Basel: Bank for International Settlements, February).

      Office of the Comptroller of the Currency, 1999, OCC Bulletin 99-2 (Washington, January).

      Reserve Bank of Australia, 1999, Hedge Funds, Financial Stability and Market Integrity (March).

      United States, President’s Working Group on Financial Markets, 1999, Hedge Funds, Leverage, and the Lessons of Long-Term Capital Management (Washington, April).

      Working Group on International Financial Crises, 1998, Report of the Working Group on International Financial Crises (Basel: Bank for International Settlements, October).

      Working Group on Strengthening Financial Systems, 1998, Report of the Working Group on Strengthening Financial Systems (Basel: Bank for International Settlements, October).

      Working Group on Transparency and Accountability, 1998, Report of the Working Group on Transparency and Accountability (Basel: Bank for International Settlements, October).

    Annex V: Credit Ratings and the Recent Crises

    This annex provides background material to Chapter V. The first section covers factors considered by rating agencies in sovereign credit ratings and empirical studies of the determinants of such ratings. The second section provides a chronology of sovereign credit ratings during the recent financial crises in emerging markets. The third section proposes criteria by which to evaluate rating agencies and attempts to assess recent sovereign rating trends. A survey of credit rating agencies’ methodology and resources is provided in the final section.

    Factors in Sovereign Ratings and Empirical Studies of Determinants

    In assessing the solvency and liquidity of sovereigns, rating agencies have focused on a number of factors that are quite distinct from those that apply to corporates. Notably, political risk as well as overall pressures on the balance of payments and the macro-economic situation have been the focus of attention. The list in Table A5.1, from S&P’s, illustrates which factors agencies focus on when rating sovereigns. Boxes A5.1 and A5.2 provide the definitions of S&P’s and Moody’s issuer ratings.

    Table A5.1.Variables Used in Sovereign Rating Analysis by Standard & Poor’s
    Political risk
    Form of government and adaptability of political institutions
    Extent of popular participation
    Orderliness of leadership succession
    Degree of consensus on economic policy objectives
    Integration into global trade and financial system
    Internal and external security risks
    Economic factors
    Income and economic structure
    Economic growth prospects
    Fiscal flexibility
    Public debt burden
    Price stability
    Balance of payments flexibility
    External debt and liquidity

    The rating agencies emphasize that they do not use a specific formula to combine the various political and economic factors in deciding on an overall rating. However, a number of empirical studies can help illuminate which factors have historically received the greatest weights in the decision-making process. In particular, Cantor and Packer (1996) and subsequently Juttner and McCarthy (1998) examined the determinants of the levels of Moody’s and S&P’s ratings for a range of mature and emerging market economies in the mid-1990s.

    Cantor and Packer (1996) used ratings from Moody’s and S&P’s on 49 countries as of September 1995. After converting these ratings to a numerical scale (with the highest Aaa/AAA = 16 and the lowest B3/B− = 1), they regressed these ratings on a set of economic variables that had been identified by the agencies as influencing the level of a sovereign’s rating. The results indicated that high ratings were associated with high per capita income, low inflation, more rapid growth, a low ratio of foreign currency external debt to exports, the absence of a history of defaults on foreign currency debt since 1970, and a high level of economic development (as measured by the IMF’s classification as an industrial country). The coefficients on the fiscal position (as measured by the average annual central government budget surplus relative to GDP in 1992–94) and the external balance (as measured by the average annual current account surplus relative to GDP in 1992–94) were statistically insignificant. The statistical analysis also suggested that Moody’s and S&P’s broadly shared the same rating criteria, but Moody’s appeared to place more weight on external debt and less weight on default history as negative factors than did S&P’s.

    In a follow-up study, Juttner and McCarthy (1998) found that the factors identified by Cantor and Packer continued to adequately explain ratings in 1996 and 1997, but that this relationship broke down in 1998, in the wake of the Asian crises. For 1998, additional variables appeared to have come into play—notably, problematic bank assets as a percent of GDP and the interest rate differential (a proxy for expected exchange rate changes).

    The above studies focused on the use of the ratings of the two largest rating agencies—Moody’s and S&P’s—and this raises the issue of whether there are significant differences between the ratings issued by these agencies and those of other rating agencies. Although this issue has not been addressed in the case of sovereign ratings, Cantor and Packer (1997) compared the corporate ratings from Moody’s and S&P’s with those from Duff & Phelps Credit Rating Agency (DCR) and Fitch Investor Service for ratings published at the end of 1993. If all agencies rated all firms, then differences in the ratings could be analyzed directly to see if there are differences in ratings scales. However, some firms were not rated by DCR or Fitch, which creates the possibility of sample selection bias. A firm might know that one particular agency provides more favorable treatment to firms in an industry with its specific characteristics. Alternatively, a firm might be told its likely rating by a particular agency before it is required to commit fully to the new agency’s rating process. In either situation, ordinary regression analysis would produce biased estimates of the factors influencing each agency’s rating process and the differences be t ween processes. Cantor and Packer used a two-step procedure developed by Heckman (1979) to eliminate sample selection bias. They first sought to identify those factors that influence a firm’s decision to seek a rating, and then analyzed whether there were significant differences between the ratings by Moody’s and S&P’s and the other two agencies. The empirical results indicated that firms were more likely to obtain two or more ratings if they were large and experienced issuers in capital markets. However, there was little evidence that third agencies were employed either to resolve ex ante uncertainty about ratings outcomes or to clear regulatory hurdles. Moreover, while the rating scales of the third agencies appeared to be somewhat higher than others, there was little evidence that decisions of issuers to use them were influenced by that factor.

    Box A5.1.Standard & Poor’s Issuer Ratings

    Issuer Credit Rating Definitions

    An S&P’s Issuer Credit Rating is a current opinion of an obligor’s overall financial capacity (its creditworthiness) to pay its financial obligations. This opinion focuses on the obligor’s capacity and willingness to meet its financial commitments as they come due. It does not apply to any specific financial obligation, as it does not take into account the nature and provisions of the obligation, its standing in bankruptcy or liquidation, statutory preferences, or the legality and enforceability of the obligation. In addition, it does not take into account the creditworthiness of the guarantors, insurers, or other forms of credit enhancement on the obligation. The Issuer Credit Rating is not a recommendation to purchase, sell, or hold a financial obligation issued by an obligor, as it does not comment on market price or suitability for a particular investor.

    Counterparty Credit Ratings, ratings assigned under the Corporate Credit Rating Service (formerly called the Credit Assessment Service), and Sovereign Credit Ratings are all forms of Issuer Credit Ratings.

    Issuer Credit Ratings are based on current information furnished by obligors or obtained by S&P’s from other sources it considers reliable. S&P’s does not perform an audit in connection with any Issuer Credit Rating and may, on occasion, rely on unaudited financial information. Issuer Credit Ratings may be changed, suspended, or withdrawn as a result of changes in, or unavailability of, such information, or based on other circumstances. Issuer Credit Ratings can be either long term or short term. Short-Term Issuer Credit Ratings reflect the obligor’s creditworthiness over a short-term time horizon.

    Long-Term Issuer Credit Ratings


    An obligor rated AAA has extremely strong capacity to meet its financial commitments. AAA is the highest Issuer Credit Rating assigned by S&P’s.


    An obligor rated AA has very strong capacity to meet its financial commitments. It differs from the highest-rated obligors only in small degree.


    An obligor rated A has strong capacity to meet its financial commitments but is somewhat more susceptible to the adverse effects of changes in circumstances and economic conditions than obligors in higher-rated categories.


    An obligor rated BBB has adequate capacity to meet its financial commitments. However, adverse economic conditions or changing circumstances are more likely to lead to a weakened capacity of the obligor to meet its financial commitments.

    Obligors rated BB, B, CCC, and CC are regarded as having significant speculative characteristics. BB indicates the least degree of speculation and CC the highest. While such obligors will likely have some quality and protective characteristics, these may be outweighed by large uncertainties or major exposures to adverse conditions.


    An obligor rated BB is less vulnerable in the near term than other lower-rated obligors. However, it faces major ongoing uncertainties and exposure to adverse business, financial, or economic conditions which could lead to the obligor’s inadequate capacity to meet its financial commitments.


    An obligor rated B is more vulnerable than the obligors rated BB, but the obligor currently has the capacity to meet its financial commitments. Adverse business, financial, or economic conditions will likely impair the obligor’s capacity or willingness to meet its financial commitments.


    An obligor rated CCC is currently vulnerable, and is dependent upon favorable business, financial, and economic conditions to meet its financial commitments.


    An obligor rated CC is currently highly vulnerable.

    Plus (+) or minus (-)

    Ratings from “AA” to “CCC” may be modified by the addition of a plus or minus sign to show relative standing within the major rating categories.

    An Issuer Credit Rating is withdrawn upon the first occurrence of any of the following events: (1) a payment default on any financial obligation, rated or unrated, other than a financial obligation subject to a bona fide commercial dispute; (2) a voluntary bankruptcy filing by the issuer or similar action; or, (3) in the case of banks, upon seizure of the bank by a regulator, or, in the case of insurance companies, upon placement of the insurer under regulatory supervision due to its financial condition.

    Public Information Ratings

    Ratings with a “pi” subscript are based on an analysis of an issuer’s published financial information, as well as additional information in the public domain. They do not, however, reflect in-depth meetings with an issuer’s management or incorporate material nonpublic information, and are therefore based on less comprehensive information than ratings without a “pi” subscript. Ratings with a “pi” subscript are reviewed annually based on a new year’s financial statements, but may be reviewed on an interim basis if a major event that may affect an issuer’s credit quality occurs. Ratings with a “pi” subscript are not modified with ‘+’ or ‘-’ designations. Outlooks will not be provided for ratings with a “pi” subscript, nor will they be subject to potential CreditWatch listings.

    Short-Term Issuer Credit Ratings


    An obligor rated “A-1” has strong capacity to meet its financial commitments. It is rated in the highest category by S&P’s. Within this category, certain obligors are designated with a plus sign (+). This indicates that the obligor’s capacity to meet its financial commitments is extremely strong.


    An obligor rated “A-2” has satisfactory capacity to meet its financial commitments. However, it is somewhat more susceptible to the adverse effects of changes in circumstances and economic conditions than obligors in the highest rating category.


    An obligor rated “A-3” has adequate capacity to meet its financial obligations. However, adverse economic conditions or changing circumstances are more likely to lead to a weakened capacity of the obligor to meet its financial commitments.


    An obligor rated “B” is regarded as vulnerable and has significant speculative characteristics. The obligor currently has the capacity to meet its financial commitments; however, it faces major ongoing uncertainties which could lead to the obligor’s inadequate capacity to meet its financial commitments.


    An obligor rated “C” is currently vulnerable to nonpayment and is dependent upon favorable business, financial, and economic conditions for it to meet its financial commitments.

    An Issuer Credit Rating is withdrawn upon the first occurrence of any of the following: (1) a payment default on any financial obligation, rated or unrated, other than a financial obligation subject to a bona fide commercial dispute; (2) a voluntary bankruptcy filing by the issuer or similar action; or (3) in the case of banks, upon seizure of the bank by a regulator, or, in the case of insurance companies, upon placement of the insurer under regulatory supervision due to its financial condition.

    Local Currency and Foreign Currency Risks

    Country risk considerations are a standard part of S&P’s analysis for credit ratings on any issuer or issue. Currency of repayment is a key factor in this analysis. An obligor’s capacity to repay foreign currency obligations may be lower than its capacity to repay obligations in its local currency, owing to the sovereign government’s own relatively lower capacity to repay external versus domestic debt. These sovereign risk considerations are incorporated in the debt ratings assigned to specific issues. Foreign currency issuer ratings are also distinguished from local currency issuer ratings to identify those instances where sovereign risks make them different for the same issuer.

    Rating Outlook Definitions

    An S&P’s Rating Outlook assesses the potential direction of a long-term credit rating over the intermediate to longer term. In determining a Rating Outlook, considerat ion is given to any changes in the economic and/or fundamental business conditions. An Outlook is not necessarily a precursor of a rating change or future CreditWatch action. Positive means that a rating may be raised. Negative means that a rating may be lowered. Stable means that a rating is not likely to change. Developing means a rating may be raised or lowered. N.M. means not meaningful.


    CreditWatch highlights the potential direction of a short- or long-term rating. It focuses on identifiable events and short-term trends that cause ratings to be placed under special surveillance by S&P’s analytical staff. These may include mergers, recapitalizations, voter referendums, regulatory action, or anticipated operating developments. Ratings appear on CreditWatch when such an event or a deviation from an expected trend occures and additional information is necessary to evaluate the current rating. A listing, however, does not mean a rating change is inevitable, and whenever possible, a range of alternative ratings will be shown. CreditWatch is not intended to include all ratings under review, and rating changes may occur without the ratings having first appeared on Credit Watch. The “positive” designation means that a rating may be raised; “negative” means a rating may be lowered; and “developing” means that a rating may be raised, lowered, or affirmed.

    Source: Reproduced from

    Box A5.2.Moody’s Issuer Ratings

    Foreign Currency

    Moody’s Foreign Currency Issuer Ratings are opinions of the ability of entities to honor senior unsecured financial obligations and contracts denominated in foreign currency. These ratings are subject to Moody’s Foreign Currency Country Ceilings. Issuer Ratings are unlike Moody’s long-term debt ratings in that they are assigned to issuers rather than specific debt issues. Specific debt issues of the issuer may be rated differently, and are considered unrated unless individually rated by Moody’s. Unless specified, obligations guaranteed by the issuer are considered unrated and are not covered by the issuer rating.

    Domestic Currency

    Moody’s Domestic Currency Issuer Ratings are opinions of the ability of entities to honor senior unsecured financial obligations and contracts denominated in their domestic currency.

    Rating Symbols

    Moody’s rating symbols for Issuer Ratings are identical to those used to show the credit quality of bonds. These rating gradations provide creditors a simple system to measure an entity’s ability to meet its senior financial obligations.

    Aaa Issuers rated Aaa offer exceptional financial security. While the creditworthiness of these entities is likely to change, such changes as can be visualized are most unlikely to impair their fundamentally strong position.

    Aa Issuers rated Aa offer excellent financial security. Together with the Aaa group, they constitute what are generally known as high grade entities. They are rated lower than Aaa entities because long-term risks appear somewhat larger.

    A Issuers rated A offer good financial security. However elements may be present which suggest a susceptibility to impairment sometime in the future.

    Baa Issuers rated Baa offer adequate financial security. However, certain protective elements may be lacking or may be unreliable over any great period of time.

    Ba Issuers rated Ba offer questionable financial security. Often the ability of these entities to meet obligations may be moderate and not well safeguarded in the future.

    B Issuers rated B offer poor financial security. Assurance of payment of obligations over any long period of time is small.

    Caa Issuers rated Caa offer very poor financial security. They may be in default on their obligations or there may be present elements of danger with respect to punctual payment of obligations.

    Ca Issuers rated Ca offer extremely poor financial security. Such entities are often in default on their obligations or have other marked shortcomings.

    C Issuers rated C are the lowest rated class of entity, are usually in default on their obligations, and potential recovery values are low.

    Moody’s Short-Term Prime Rating System—Taxable Debt and Global Deposits

    Moody’s short-term debt ratings are opinions of the ability of issuers to repay punctually senior debt obligations. These obligations have an original maturity not exceeding one year, unless explicitly noted.

    Moody’s employs the following three designations, all judged to be investment grade, to indicate the relative repayment ability of rated issuers.


    Issuers rated Prime-1 (or supporting institutions) have a superior ability for repayment of senior short-term debt obligations. Prime-1 repayment ability will often be evidenced by many of the following characteristics:

    • Leading market positions in well-established industries.

    • High rates of return on funds employed.

    • Conservative capitalization structure with moderate reliance on debt and ample asset protection.

    • Broad margins in earnings coverage of fixed financial charges and high internal cash generation.

    • Well-established access to a range of financial markets and assured sources of alternate liquidity.


    Issuers rated Prime-2 (or supporting institutions) have a strong ability for repayment of senior short-term debt obligations. This will normally be evidenced by many of the characteristics cited above but to a lesser degree. Earnings trends and coverage ratios, while sound, may be more subject to variation. Capitalization characteristics, while still appropriate, may be more affected by external conditions. Ample alternate liquidity is maintained.


    Issuers rated Prime-3 (or supporting institutions) have an acceptable ability for repayment of senior short-term obligations. The effect of industry characteristics and market compositions may be more pronounced. Variability in earnings and profitability may result in changes in the level of debt protection measurements and may require relatively high financial leverage. Adequate alternate liquidity is maintained.

    Not Prime

    Issuers rated Not Prime do not fall within any of the Prime rating categories.

    Watchlist Definitions

    UPG on Review for Possible Upgrade

    DNG on Review for Possible Downgrade

    UNC Direction uncertain

    Source: Reproduced from www.moodys.comNote: Moody’s applies numerical modifiers 1, 2 and 3 in each generic rating category from Aa to Caa in the corporate finance sectors, and from Aa to B in the public finance sectors. The modifier 1 indicates that the issuer is in the higher end of its letter rating category; the modifier 2 indicates a mid-range ranking; the modifier 3 indicates that the issuer is m the lower end of the letter ranking category.

    Figure A5.1 provides a graphical analysis of the variables identified by the Cantor and Packer studies as well as by Juttner and McCarthy. The figure also analyzes a number of other economic determinants of ratings. It uses the average performance of emerging markets rated investment grade (the base group) as a metric to compare the macroeconomic fundamentals on the eve of the Mexican, Asian, and Russian crises. For each macroeconomic variable, the value of that variable for a particular country at any time is normalized using the mean and standard deviation of that variable for the base group. These normalized or standardized variables are then plotted in the figures with a movement away from the origin signifying a deterioration and a movement toward the origin signifying an improvement. For example, the value of 1 calculated for the current account for Mexico in 1994 implies that Mexico’s current account balance lay 1 standard deviation below the average for the base group in 1994.

    Figure A5.1.Emerging Markets: Sovereign Ratings and Fundamentals1

    Sources: Global Development Finance; IMF, International Financial Statistics, and World Economic Outlook.

    1 The figures plot a standardized value, lying between +3 and -3, for each macroeconomic variable. Note that for all variables a movement away from the origin signifies a deteriation. See text for full explanation.

    The analysis shows that the determinants of ratings were stable through 1997 and that ratings were generally consistent with economic fundamentals. This held for investment- and non-investment-grade countries on average, as well as for the countries involved in the recent financial crises.

    The first row traces the evolution of the fundamentals of investment-grade countries over time and shows that there is little difference over time (up to 1997) in their fundamentals, with the exception of investment, savings, the current account, and the government budget, which deteriorate somewhat for investment-grade countries between 1994 and 1996.

    The second row tracks the fundamentals of non-investment-grade countries relative to investment grade countries. It shows that there are marked differences in fundamentals, notably in the level of growth, inflation, debt, savings and investment, and macro-imbalances (current account, budget balance) between investment- and non-investment-grade countries. Over time, lending to the private sector also becomes a differentiating fundamental.

    The third row shows the fundamentals of the countries most affected in the recent financial crises. It shows that Mexico, which was rated as non-investment-grade at the time of its balance of payments crisis, had generally worse fundamentals than investment-grade countries; that the affected Asian countries, which were rated investment-grade, had fundamentals similar to the average for investment-grade, and that Russia, which was rated non-investment-grade, had generally worse fundamentals than investment-grade countries (with the exception—not surprisingly, given its early stage in transition—of lending to the private sector).

    Dynamics of Ratings Changes

    An interesting question is whether credit rating agencies can add to the dynamics of—i.e., either accentuate or attenuate—balance of payments crises. A necessary condition for this to occur is the existence of causality from ratings to spreads. A number of studies shed light on this issue using event studies and Granger causality studies.

    Cantor and Packer (1996) studied the effects of rating announcements (both outlooks (S&P’s term)/ watches (Moody’s term) and implemented ratings)1 on spreads (the differential between yields on sovereign dollar-denominated eurobonds and on comparable U.S. treasury bonds), using daily data covering the periods before and after the 79 announcements covered by their 35-country sample. They found that (1) positive announcements in the agencies’ ratings were followed by statistically significant bond yield movements in the expected direction, but that negative changes did not produce significant effects; and (2) the impact of rating announcements on spreads was much stronger for non-investment-grade than for investment-grade sovereigns.

    Reisen and von Maltzan (1999), using data on 29 sovereigns from 1989 to 1997 and 152 rating announcements (of which 97 were for emerging markets), conducted a two-part study. First, they examined the interaction between spreads on sovereign bonds (specifically, the differential between yields on U.S. dollar-denominated sovereign bonds and on 10-year U.S. treasury bonds) and implemented credit ratings, after allowing for the influence of macroeconomic country risk determinants. In particular, they considered whether credit ratings Granger-caused2 sovereign interest spreads after controlling for macro economic indicators available at a monthly frequency. These latter variables included the total stock market return, foreign exchange reserves, the real exchange rate, the terms of trade, and industrial production. The authors concluded that credit ratings Granger-cause yield spreads (and vice versa).

    The authors also undertook an event study similar to that undertaken by Cantor and Packer (1996). In this sample period, a significant change in the yield spread in the expected direction occurred during the announcement period only when a downgrade was implemented. These results are in sharp contrast with those of Cantor and Packer, who found significant effects only for positive announcements. However, one similarity between the two studies is that Reisen and von Maltzan find that the largest announcement effects are for emerging market sovereign spreads. As noted above, Cantor and Packer found the largest effects for non-investment-grade bonds, which correspond to those issued by emerging market sovereigns.

    Review of Ratings During the Crises

    Figures A5.2A5.12 summarize the ratings actions (changes both in outlooks and in long-term issuer ratings) taken by Moody’s and S&P’s for selected sovereigns in Asia, Latin America, emerging Europe, and Russia during the 1990s, as well as changes in yield spreads.3

    Figure A5.2.Ratings Actions by Moody’s and Standard & Poor’s and Changes in Yield Spreads: Argentina

    Sources: Moody’s; and Standard & Poor’s.

    Figure A5.3.Ratings Actions by Moody’s and Standard & Poor’s and Changes in Yield Spreads: Brazil

    Sources: Moody’s; and Standard & Poor’s.

    Figure A5.4.Ratings Actions by Moody’s and Standard & Poor’s and Changes in Yield Spreads: Hungary

    Sources: Moody’s; and Standard & Poor’s.

    Figure A5.5.Ratings Actions by Moody’s and Standard & Poor’s and Changes in Yield Spreads: Indonesia

    Sources: Moody’s; and Standard & Poor’s.

    Figure A5.6.Ratings Actions by Moody’s and Standard & Poor’s and Changes in Yield Spreads: Korea

    Sources: Moody’s; and Standard & Poor’s.

    Figure A5.7.Ratings Actions by Moody’s and Standard & Poor’s and Changes in Yield Spreads: Malaysia

    Sources: Moody’s; and Standard & Poor’s.

    Figure A5.8.Ratings Actions by Moody’s and Standard & Poor’s and Changes in Yield Spreads: Mexico

    Sources: Moody’s; and Standard & Poor’s.

    Figure A5.9.Ratings Actions by Moody’s and Standard & Poor’s and Changes in Yield Spreads: Poland

    Sources: Moody’s; and Standard & Poor’s.

    Figure A5.10.Ratings Actions by Moody’s and Standard & Poor’s and Changes in Yield Spreads: Russia

    Sources: Moody’s; and Standard & Poor’s.

    Figure A5.11.Ratings Actions by Moody’s and Standard & Poor’s and Changes in Yield Spreads: Thailand

    Sources: Moody’s; and Standard & Poor’s.

    Figure A5.12.Ratings Actions by Moody’s and Standard & Poor’s and Changes in Yield Spreads: Turkey

    Sources: Moody’s; and Standard & Poor’s.

    Asian Crises

    In the period leading up to the Thai crisis, the agencies began to express concern about weaknesses in the Thai financial system and the buildup of short-term debt in 1996. For example, Moody’s cited these concerns in both its May and September 1996 and February 1997 comments on the Thai situation. Its first rating action was to place Thailand’s short-term rating on review for a downgrade in May 1996, and it was subsequently lowered in September 1996 (to Prime 2—still investment-grade). In February 1997, Moody’s placed Thailand’s A2 long-term rating on review for a downgrade, which took place in April 1997 (to A3—still investment grade). Throughout this period, yield spreads on long-term Thai sovereign bonds remained essentially stable until July 1997. S&P’s made no ratings changes in the period between 1994 and July 1997. No further rating changes occurred during the severe speculative attacks on the baht in May and the subsequent floating of the baht in July 1997. Interest rate spreads began to rise in the third week of August prior to the downgrade of Thailand’s rating by S&P’s (to A- on September 3) and the placement of Moody’s rating on review for a downgrade on September 18 (with the rating subsequently lowered to Baal on October 1). In the midst of the speculative attacks on Hong Kong SAR in October, S&P’s lowered the long-term foreign currency rating for Thailand to BBB (on October 24); and Moody’s placed the Thai rating on review on October 23 and downgraded the rating to Baa3 (on November 27). The Moody’s rating was further reduced to Ba1 (non-investment-grade) on December 21, 1997. Subsequently, interest rate spreads declined from 500 basis points in early January 1998 to 300 basis points in late February without any ratings actions taking place.

    S&P’s initially downgraded Indonesia’s rating in early October 1997 (to BBB−) with only limited increases in yield spreads. Spreads rose sharply in late October, though there were no rating actions, and again in mid-December 1997 prior to the downgrades by both Moody’s (to Bal) and S&P’s (to BB+) in late December to below-investment-grade. The subsequent simultaneous downgrades on January 9, 1998 (to BB by S&P’s and to B2 by Moody’s) coincided with the peak in spreads. Indonesia was further downgraded in March and May 1998, and downgraded to “selective default” in March 1999.

    In Korea, despite the growing awareness of financial sector vulnerabilities following the collapse of Hanbo Steel in January 1997, there were no actions by the ratings agencies until Moody’s placed it on a negative outlook in June 1997. The downgrade on October 24 by S&P’s (from AA- to A+) was accompanied by a sharp rise in yield spreads. Similarly, there were sharp increases in bond spreads as Korea was downgraded repeatedly in November and December by Moody’s (to A3 on November 27, to Baa2 on December 10, and to Bal on December 21) and S&P’s (to Al on November 25, to BBB- on December 1, and to B+ on December 22). As was the case in Thailand and Indonesia, Korea was not downgraded to non-investment-grade until late December. A number of market observers have argued that the Korean downgrade was perhaps the largest and sharpest in the history of sovereign ratings.

    Russian Crisis

    A year ahead of Russia’s August 1998 financial crisis, rating agencies viewed the sovereign as being of below investment grade. Moody’s rated Russia Ba2 and S&P’s BB- in August 1997. In the wake of the Asian crisis, during which Russia lost a sizable amount of reserves and spreads roughly doubled, S&P’s changed its outlook to negative in December 1997, whereas Moody’s downgraded the sovereign to Ba3 in March 1998. When concerns about debt sustainability led to pressures on the exchange rate and reserves in May, to which the Russian central bank reacted by tripling key interest rates to 150 percent. Moody’s downgraded the sovereign to B l (along with several large banks) on May 29, and on June 9, S&P’s followed suit with a downgrade to B+.

    A financial crisis was narrowly avoided during May–July, as it became clear that additional financing, including from the IMF, would be mobilized. However, pressures built up again in August over concerns about the government’s ability to roll over its maturing debt and the decision by the state-owned Savings Bank not to roll over its maturing treasury bills. Russia lost over $5.5 billion in reserves while spreads reached as high as 2,500 basis points.4 Financier George Soros’ call in his August 13 Financial Times article for a 25 percent devaluation, which included a warning about financial sector weaknesses, also unsettled the markets. During this period, there was a rapid succession of downgrades—characteristic also of the Korean crisis. On August 13, S&P’s downgraded the sovereign to B- with a negative outlook, and downgraded domestic debt from a B to a C. The same day, Moody’s downgraded Russia to B2. Moody’s cited “concerns about the potential systemic effects of the financial crisis,” while S&P’s referred to liquidity problems “compounded by the banking crisis and the likelihood that further sharp declines in output and living standards will weaken domestic support for the Yeltsin administration’s economic reform program.”

    Further downgrades followed after the ruble was effectively devalued when the upper band for the ruble was raised by 50 percent and a conversion of GKOs to longer-term paper was announced along with a 90-day moratorium on external debt payments, leading to fears of generalized default. S&P’s downgraded the sovereign on August 17 to CCC with negative outlook, and to CCC- with negative outlook on September 16, 1998. Moody’s downgraded the sovereign on August 21 to B3. S&P’s assigned a rating of selective default for both foreign and local currency debt on January 27, 1999; spreads reached a record that day.

    Brazilian Crisis

    In January 1998, a year ahead of the onset of its financial crisis, Brazilian sovereign issues were perceived as relatively risky by the rating agencies (Moody’s B1/S&P’s BB-). Subsequently, Moody’s lowered its rating to B2 on September 3, 1998, in response to concerns that the Russian crisis might spread to Brazil. Spreads mirrored this concern, rising to 1,500 basis points in end-August. Throughout October and November, spreads declined following President Cardoso’s reelection and the negotiation of the US$41.5 billion international package, but then rose rapidly again in December in response to capital outflows as markets worried about the fiscal situation and political wrangling with the states. Pressures mounted for a devaluation in the hope that this would arrest reserve losses and help reduce interest rates. After the real was devalued by 8 percent on January 13, S&P’s downgraded Brazil to B+. Over the next two weeks, the real lost an additional 30 percent of its value—and did not stabilize until after the appointment of Arminio Fraga as Governor of the central bank and the resumption of the IMF-supported program in March. No further downgrades were implemented during this period.

    Evaluating Rating Agencies: By What Criteria?

    The expanding role of rating agencies in global capital markets, particularly with the steep rise of emerging market borrowing in the 1990s, has propelled the agencies to the spotlight and earned them much criticism for their performance. Criticism has been most intense during the Mexican and Asian crises, where the agencies have been blamed for failing to signal to investors the risks present in the Mexican and Asian economies prior to their eruption.

    The failure to predict the Mexican and Asian crises has been attributed to a number of factors. First, rating agencies are said to be influenced by the compensation they receive from rated issuers.5 According to this argument, the agencies would hesitate to downgrade issuers from fear of spoiling business relationships that underpin their income stream. Second, the agencies purportedly are reluctant to downgrade sovereigns for fear of precipitating self-fulfilling crises. Indeed, it is not uncommon for downgraded sovereigns to blame the rating agencies, among others, for their troubles.6 Finally, some argue that the rating agencies are inadequately staffed and therefore not up to the task. Critics contend that the agencies are unable to match the salaries offered by Wall Street firms to attract highly skilled analysts.7 As such, the issue of inadequate staffing deserves scrutiny, and is analyzed in greater depth in the “Survey of Credit Rating Agencies” section below.

    However, a strong case can be made that disincentives to downgrade are outweighed by the incentive for rating agencies to build and maintain their reputation and credibility in the eyes of investors. Absent credibility, which is the pillar of their franchise value, demand for ratings would fall, and along with it, the raison d’être of the agencies. Rating agencies, therefore, are unlikely to trade off their credibility in return for short-term revenue gains.

    Regardless of the merits of various criticisms of ratings agencies, the debate has progressed without proper context, namely, a set of explicitly defined criteria and standards by which the performance of agencies should be evaluated. Absent a predetermined set of criteria, the criticisms themselves have lacked credibility and utility.

    We propose the following set of interrelated criteria for evaluating rating agencies.

    Track Record

    The starting point of evaluating ratings is their track record in capturing default risk.8 Lower-rated issuers would be expected to have defaulted more frequently than higher-rated ones. Ultimately, ratings are probabilistic statements of the likelihood of default, and default alone. They are not meant to predict financial crises per se.

    In this context, it is important to address the misconception that highly rated countries are not suppose to experience financial crises. Surely, highly rated countries can be expected to have fewer crises, but more importantly, more creditworthy sovereigns are thought to have stronger political, economic, and social capacities to manage a crisis than are less creditworthy issuers. Similarly, to the extent that market risks, liquidity risks, currency risks, and transfer risks affect default risk, ratings necessarily should reflect such risks as well.

    The record on ratings and actual defaults for corporates in the past shows a high correlation between credit quality and default remoteness: the higher the rating, the lower the probability of default, and vice versa. On this score, ratings, on average, are a good indicator of relative creditworthiness. (See Figure A5.13.)

    Figure A5.13.Average Cumulative 15-Year Default Rates for Corporate Issuers

    (In percent)

    Sources: S&P’s (1999b); and S&P’s Sovereign Ratings.

    Evaluating the performance of ratings in the sovereign sector is more problematic than for corporates, however. To date, among rated sovereigns, only Russia has defaulted (as defined by the rating agencies) on rated foreign currency debt, and only three, Indonesia, Pakistan, and Russia, have defaulted on unrated foreign currency debt. Moreover, the small sample size of rated sovereigns, at 80–100, would preclude a meaningful statistical analysis of default rates when they occur. However, given the equivalence of default risks across issuers, where in principle a AAA-rated sovereign has the same probability of default as a AAA-rated corporation, one can infer from Figure A5.13 the implied default probabilities for sovereigns. For example, sovereigns rated investment grade (BBB and higher) are supposed to have very low (1–5 percent) chances of default, even over 15 years.

    In the context of the recent financial crises, several observations can be made. First, Thailand, Korea, and Indonesia’s investment-grade ratings before the crisis failed to capture the risks of both their intense financial crises and initial crisis mismanagement, which subsequently were reflected in sharp downgrades. Hong Kong SAR and Malaysia’s investment-grade ratings, by contrast, arguably better reflected their stronger crisis management capacities and vulnerability to crisis (i.e., modest external debt), respectively. Second, Brazil and Russia’s initially low ratings in the non-investment-grade category adequately reflected the relatively high possibility of crisis and/or crisis mismanagement, which have since been validated.


    Another criterion by which to evaluate ratings is their durability. Presumably, the stronger the predictive value of ratings, the more durable they are and the less frequently they will change. Although ratings are inevitably influenced by cyclical factors, rating agency officials point out that long-term ratings, where possible, try to see through cycles. Admittedly, the durability criterion can falsely imply that a stable rating is “correct,” even where the lack of a rating change reflects a gross error in analytical judgment or belated recognition of growing risks.

    On this score, ratings are fairly stable. According to rating transition data from S&P’s for all issuers, two facts emerge. First, higher ratings are longer lived. Second, issuers rated investment grade have a 60–70 percent chance of still being rated in the same category five years later. Sovereign ratings also exhibit stability, with sovereigns rated investment grade having a 60–90 percent chance of still being rated in the same category three years later (Figure A5.14).

    Figure A5.14.Rating Stability

    (In percent of ratings in the same category)

    Sources: S&P’s (1999b); and S&P’s Sovereign Ratings.

    Notwithstanding the overall stability of ratings for all issuers, including sovereigns, a number of sovereigns experienced sharp downgrades during the recent financial turmoil. “Ratings crises” (defined as in Juttner and McCarty (1998) as a downgrade of three notches or more in long-term foreign currency debt within a six-month period) were observed in Asia (Indonesia, Thailand, South Korea, and Malaysia), and later in Romania, Russia, and Venezuela. In Brazil, only one agency downgraded after the initial devaluation, and there were no further downgrades thereafter.

    Market Comparison

    Another important factor is the track record and durability of ratings compared to the market. Although ratings are imperfect forecasts of default risks, to the extent that they are less volatile and more accurate than the market, ratings still enhance the efficiency of capital markets.

    Ratings are clearly more stable than market spreads, which fluctuate daily and sometimes by substantial amounts. An analysis of a sample9 of crisis and non-crisis countries shows that the variances of spreads (adjusted for the mean) were several times that of ratings. The key question then is whether ratings or spreads have greater foresight.

    One year ahead of the crises in Thailand, Indonesia, and Korea, sovereign spreads were quite low (Figures A5.2A5.12), on the order of 100–150 basis points. In Russia and Brazil, they were somewhat higher, about 300 basis points. Thus, in relative terms, the markets agreed with rating agencies, placing the probability of default in Russia and Brazil higher than in the Asian countries.10 Spreads did not widen much in the Asian countries by the time of the onset of their crises; as with ratings, the bulk of the deterioration came afterward. In the case of Russia and Brazil, spreads also mirrored developments in ratings, growing sizably before the onset of the crises, worsening thereafter in the case of Russia, and hardly deteriorating in the case of Brazil. The same appears to have been true for the opinions of market analysts, as we discuss further below.

    The above discussion suggests that in Asia markets failed to foresee the recent financial crises and the corresponding rise in default risks, along with rating agencies. It also appears, however, that the agencies discriminated more effectively between crisis and noncrisis countries compared to the market, which almost indiscriminately priced the debt of all issuers much higher. For noncrisis countries, the average downgrade was less than one notch, yet spreads trebled between mid-1997 and end-1998 and still stand at about double what they were before the crisis (see Table A5.2).

    Table A5.2.Rating and Spread Trends
    Rating Changes1Average Spreads2
    (number of notches)(basis points)
    6/97–6/986/97–12/986/97–5/99June 1997June 1998December 1998May 1999
    Noncrisis Countries3−0.1−0.6−0.6162307478267
    Crisis Countries4−3.8−4.6−4.61426151,4701,049
    Sources: Moody’s, S&P’s, various issues; and Bloomberg.

    Average of Moody’s and S&P’s.

    The average spreads for “crisis” countries and the total sample are distorted by the extremely high level of Russia’s spreads.

    Noncrisis countries include Argentina, China, Colombia, Hong Kong SAR, Mexico, the Philippines, Poland, South Africa, Turkey, and Venezuela.

    Crisis countries include Brazil, Indonesia, Korea, Russia, and Thailand.

    Market analysts’ views can be gauged in a summary fashion through Institutional Investor and Euromoney ratings. These institutions compile the views of economists in leading international banks and money management firms, among others, and thus can serve as a proxy for market analyst’s views. Ratings are available semiannually (in March and September). Notwithstanding some reduction in its ratings of Asian countries during 1996, Institutional Investor continued to assign relatively high ratings to Thailand and Korea (63 and 72 out of 100) in the year before their crises, in September 1996, and a somewhat lower rating to Indonesia (52). Ratings were reduced substantially after the crises (Table A5.3). For Russia and Brazil, precrisis ratings were quite a bit lower (28 and 40 in September 1997, respectively). As was the case for credit ratings and spreads, after the crises, the Institutional Investor rating was reduced for Russia, but hardly for Brazil. Similar scores were assigned by economists participating in the Euromoney survey. Korea received the highest score among the Asian crisis countries (a score of 88 out of 100 for economic performance) in September 1996. Scores were subsequently lowered substantially. Russia and Brazil scored poorly ahead of their crises and also showed large declines over time (between September 1997 and March 1999). In the case of Brazil, most of the decline occurred as early as September 1998, in the wake of the Russian crisis, rather than after Brazil’s devaluation.

    Table A5.3.Market Ratings of Crisis Countries(Scores out of 100)
    Institutional InvestorEuromoney
    Sources: Institutional Investor and Euromoney, various issues.

    September 1996 for Asian countries; and September 1997 for Russia and Brazil.

    September 1998 for Asian countries; and March 1999 for Russia and Brazil.

    To conclude, it appears that spreads as well as market analysts—as represented in Institutional Investor and Euromoney ratings—provided signals similar to those of the credit rating agencies. They failed to signal the Asian crises in advance; they down-rated these countries after their crises; they assigned a higher risk to Russian and Brazilian issues from the start; and they did not revise their views in a major way for Brazil.

    Academic Research

    Similar mixed results characterize the performance of “leading indicators” of currency crises developed in the academic literature. This empirical literature, which continues to evolve, suggests that high growth in credit to the private sector, an overvalued real exchange rate compared to trend, a high current account deficit, and low reserves relative to either broad money or short-term debt are associated with a higher probability of crisis (see, e.g., Sachs, Tornell, and Velasco, 1996). An initial systematic review of empirical work on currency crises (Berg and Pattillo, 1999) concludes, however, that the out-of-sample predictive power of models of currency crises is poor. In the Asian crisis, the approach that appears to have the best out-of-sample predictive ability is the “signals” approach of Kaminsky, Lizondo, and Reinhart (1998), in which monthly indicators signal a crisis whenever they cross a certain threshold. Even using this approach, only a small fraction of Asian crises were called.11 The Thai crisis was foreseeable using these models, but the Indonesian was not; Brazil was seen as vulnerable to a crisis in 1997, even though it showed resilience at the time (Berg and Pattillo, 1999).

    Proposed Use of Credit Ratings in the Basel Accord

    External credit ratings are increasingly being adopted in regulations worldwide. The most common form of regulation involves limits on exposure to non-investment-grade securities. A recent Basel Committee consultative paper proposes to expand the use of external credit ratings, by integrating external ratings in the Basel Committee risk weighting scheme.12 Specifically, risk weights based on sovereign credit ratings would replace the current distinction between OECD and non-OECD countries.13Box A5.3 lays out the criteria that the Basel Committee proposes to use in selecting institutions eligible to produce ratings for use in the new risk weighting scheme. These selection criteria aim to determine which agencies’ ratings will be eligible for regulatory purposes. As such, they are separate and distinct from the criteria for evaluating the performance of rating agencies outlined earlier.

    Box A5.3.Criteria for Eligible External Credit Assessment Institutions

    The minimum criteria that the Basel Committee sees as essential for recognition are as follows.

    Objectivity. The methodology for assigning credit assessments must be rigorous, systematic, continuous, and subject to some form of validation based on historical experience. Moreover, assessments must be subject to ongoing review and responsive to changes in financial condition. Before being recognized by supervisors, the Committee proposes that an assessment methodology for each market segment, including rigorous backtesting, must have been established for at least one year, while recognizing that a three-year period would be preferable.

    Independence. The methodology should be as free as possible from any external political influence or constraints, or economic pressure from assessed entities.

    Transparency. For validation purposes, the individual assessments should be publicly available.

    Credibility. To some extent, credibility will be derived from the criteria above. This criterion should not be used as a barrier to the entry of new institutions, but, at the same time, any new institution that emerges following this change in the supervisory framework would need to be carefully evaluated. The credibility of an institution would also be underpinned by the existence of internal procedures to prevent the misuse of confidential information.

    International Access. The institution is not required to assess firms in more than one country, but its results should be available to nondomestic parties with legitimate interest on the same basis as to equivalent domestic parties.

    Resources. The institution should have sufficient resources to allow substantial ongoing contact with senior and operational levels of assessed entities.

    Recognition. National supervisory authorities will be responsible for recognition of institutions based on the above criteria. It is proposed that the Secretariat to the Committee will serve as a clearing house of information on the institutions recognized by national supervisory authorities.

    Source: Reproduced from Basel Committee on Banking Supervision, 1999, pp. 33–34.

    Survey of Credit Rating Agencies

    Earlier in this annex, we emphasized the need to concentrate on analytical methodologies and resources of rating agencies as potential areas for improvement. To this end, a survey of the leading international ratings agencies was conducted,14 involving several questions on information sources and access, analytical approaches and methods, and resources devoted to the analytical process. The results of the survey are reported in Table A5.4.

    Table A5.4.Survey of Credit Rating Agencies1
    Analytical Methodogy
    MethodologyScenario Analysis or Stress Testing?Coping with Uncertainty: Probabilistic Approach?Changes Post-Asian Crisis (for all agencies)
    For all rating agenciesGenerally no model; only criteria. Qualitative approach using quantitative indicators and qualitative factors.Generally yes, but informal and selective.Generally no. Only two of the agencies assign probabilities to risk factors for some dynamic emerging market countries.Greater emphasis on external debt and liquidity, banking soundness, corporate leverage, and policy response capability.
    Resources Devoted to Analysis
    Sovereigns Rated (A)Country Analysts2 (B)Research Assistants (C)Sovereigns Per Analyst and Research Assistant
    Analyst Education and Experience
    Ph.D.M.A.B.A.Work Experience3
    Information, Resources, and the IMF
    Enough Information for Risk Analysis?Enough Resources?What Can the IMF Do?
    (for all agencies)
    For all rating agenciesYesYesPublish Article IV reports, facilitate the provision and standardization of data. Efforts to establish framework for debt restructuring and involve the private sector in preventing and resolving financial crises viewed as very positive.

    The survey comprised questions on analytical sources, processes, and methodologies; human resources devoted to sovereign analysis; rating agencies’ views on the adequacy of information and resources at their disposal and on the role of the IMF. The rating agencies surveyed include Moody’s, S&P’s, Fitch IBCA, and DCR.

    Includes sovereign rating group heads and deputy heads.

    Includes country analysts only and experience in country risk analysis alone.

    The average work experience figure is a weighted average of years of work experience based on the number of country analysts in each rating agency.

    Information Sources

    The principal source of information for all rating agencies is country visits, which generally occur once a year for each rated sovereign. Dynamic emerging market and crisis economies are visited more frequently, as much as two or three times a year, which complements continuous correspondence and contacts throughout the year, including when government authorities visit agency headquarters during investor road shows. During on-site visits, which usually last two to four days, the agencies interview a wide range of individuals, including finance ministry and central bank officials, private sector representatives, and political actors and observers. The agencies also gather the views of World Bank and IMF resident and desk economists, and use the publications and statistical resources of multilateral agencies, the BIS, the IIF, and the OECD.

    Information Access and Sufficiency

    The rating agencies have broad access to policymakers and independent observers and to available information on the sovereigns they rate. More important, the agencies unanimously report that they have enough information to assign and monitor sovereign ratings, especially after recent and ongoing improvements in the frequency and accuracy of foreign reserve data, and in the compilation of external debt statistics. As such, the high-profile cases of Mexico, Thailand, and Korea, where highly relevant foreign reserve figures were withheld, are exceptions rather than the rule. In this context, the agencies support the IMF’s data transparency and standardization efforts. Moreover, the agencies were unanimous in calling for the publication of IMF Article IV consultation reports.

    Analytical Methods

    The rating agencies do not use specific models (probabilistic or otherwise) to assign sovereign ratings. Instead, their analytical approaches are qualitative and aim to assess a multiplicity of qualitative factors and quantitative indicators that affect sovereign default risk. Some highlights on analytical methods include the following.

    • Political factors, such as government stability and unity, and consensus in favor of reform and austerity have always been emphasized along with economic and financial factors, particularly in emerging market economies.

    • The track record of economic policy management has also been heavily emphasized, and underpinned the (false) expectation that Asian economies would respond more quickly and forcefully to impending signs of distress.

    • The prospect of an IMF-supported reform program, and the associated financing, is assessed and generally viewed positively, though only on occasion has it had a material impact on the rating decision. The prospect of IMF support had the greatest initial impact on the ratings of Russia, and moderated the magnitude of deterioration in the creditworthiness of Mexico, Thailand, and Brazil during their crises.

    • The agencies do not conduct rigorous scenario analysis and stress testing, and rarely assign probabilities to specific risk factors and scenarios when assigning and monitoring ratings.

    • Following the Asian crisis, the agencies are placing greater emphasis on external debt and liquidity, banking soundness, corporate leverage, and policy response capacities.15

    Analytical Resources

    Among the more revealing aspects of the survey is the amount of resources devoted to sovereign analysis. On average, each rating agency analyst is responsible for seven sovereigns. In terms of educational and work background, most sovereign analysts have a master’s degree, and on average they have 10-12 years of work experience in country risk analysis. The average level of experience, in the case of most agencies, reflects a mix of some analysts with very high levels of experience (15–20 years) and others with much less (1–3 years). Rating agencies are unanimous in their assessment that they have adequate human resources to perform their tasks.

    In light of the survey findings, the following observations can be made:

    • The agencies’ unanimous position that they have enough information suggests that the real challenge of improving the predictive value of ratings and enhancing market efficiency rests more on improving the analysis of available information and less on generating more information. The agencies’ call for the publication of IMF Article IV consultation reports arguably reflects their need for more sources of analysis.

    • Given the importance of political factors in shaping policy decisions, policy implementation, and economic performance, the emphasis on political factors as much as economic ones seems appropriate, and a qualitative analytical approach is almost inevitable. Evaluating political factors, however, is inherently difficult, given the wide margin surrounding possible political outcomes in most developing countries. Even when they are accurately assessed, political factors may be less influential in rating outcomes because they are less tangible than economic and financial risks. It may not be coincidental that Indonesia and Russia have been among the most dynamic credit stories over the last year, driven mainly by their unstable politics.

    • Similarly, the emphasis on economic management track record and the growing importance of policy responses is well placed. However, anticipating the policy responses of governments under stress is also analytically very challenging. Having managed their economies successfully for decades, Korea and Thailand were rated highly and were expected to manage their financial stresses successfully without depleting their usable reserves to the extent that they did. The subsequent rating downgrades reflected both the large scale of the crisis, but also the inadequate initial responses.

    • Given the uncertainties inherent to political factors and government behavior under stress, the almost complete lack of a probabilistic approach to risk analysis is somewhat surprising, especially because ratings themselves are probabilistic statements of default risk. In the absence of a more probabilistic approach, the danger is that less tangible, but potentially important, risks may not be accorded the appropriate weight in rating decisions.

    • The number of countries followed by agency analysts is excessive in light of the challenges associated with analyzing sovereigns. Global financial integration and liberalization have strengthened interdependencies to a degree that requires increasingly sophisticated risk assessment techniques, including systemic risk analysis, scenario analysis, and stress testing. The role of common lenders (commercial banks, investment banks, and hedge funds) in transmitting crises means that an intimate knowledge of lender and market behavior is also important. The excessive number of countries followed by agency analysts heightens the challenge of broadening the scope of country risk analysis and applying time-intensive techniques. As such, adequate staffing is clearly an issue to be contended with by the agencies.

    • A key dimension of the resource issue is how the agencies compare to the market. To the extent that the agencies are better staffed than most market institutions, then the agencies clearly can add value, even if they are resource-cons trained by some analytical or objective criteria. This issue cannot be assessed at present with the available data.

    • Finally, the frequent criticism that the agencies cannot attract high-caliber analysts is not supported by the survey. Virtually all agency sovereign analysts have graduate degrees, and on average, many years of experience in country risk analysis. The issue is that more of them are needed.

    Annex VI: Use of Ratings in the Regulatory Process

    The 1990s have witnessed an increased reliance on credit ratings by regulators in both mature and emerging markets. Indeed, the ratings are used in rather similar fashions in all countries. Perhaps the most extensive use of ratings has been to place investment restrictions on regulated institutions (Tables A6.1 and A6.2). Another common regulatory use of ratings relates to establishing capital requirements for financial institutions.1 Various countries impose lower capital ratios for banks and haircuts on securities houses when they hold highly rated securities. A third area of use relates to disclosure and issuance requirements. Initially, disclosure requirements for issuers of investment-grade securities were reduced. Subsequently, regulators specified that certain types of securities could only be issued if rated, and they often imposed a minimum rating requirement on these issues. Most regulators in emerging markets in Asia and Latin America currently impose a rating requirement on issues of nongovernment bonds and commercial paper. Self-regulatory bodies such as stock exchanges in the United States and Europe also impose rating requirements that issuers have to fulfill in order to be listed.

    Table A6.1.U.S. Regulations Making Use of Credit Ratings
    1.The Office of the Comptroller of the Currency (OCC) and the Federal Reserve Board (FRB) have, since 1936, restricted banks to investing in investment-grade debt securities.
    2.The Federal Deposit Insurance Commission (FDIC) does not allow insured banks that are not members of the Federal Reserve System (FRS) to acquire or establish subsidiaries that trade in securities, but there are a few exceptions, such as if the securities are investment grade. The FDIC also imposes on state-chartered banks that are not members of the FRS to mark to market non-investment-grade securities in capital valuations.
    3.The National Association of Insurance Commissioners (NAIC) established in 1951 capital requirements for insurance companies that give the lowest requirement ratio to investment-grade debt securities.
    4.A 1975 amendment to rule 15c3-1 of the Securities and Exchange Commission (SEC) specifies the percentage haircut deductions that apply to broker-dealers’ investment-grade bonds depending on their type. The securities that receive the lowest haircuts include commercial paper rated in one of the three highest rating categories by at least two NRSROs and nonconvertible debt securities rated in one of the four highest rating categories by at least two NRSROs.
    5.Since 1982, the SEC has simplified information disclosure for issuers of investment-grade securities who are allowed to register their securities using form S-3. Also, foreign issuers are automatically eligible to use the simple form F-2 to register investment-grade securities. An even simpler form, F-3, is also available for use under specific conditions, some of which are relaxed, however, if the security to be registered is investment grade.
    6.Since 1989, the Department of Labor has permitted pension funds to invest in asset-backed pass-through certificates if, among other conditions, these certificates are rated in one of the three highest categories by one of the four largest rating agencies.
    7.Under the Financial Institutions Recovery and Reform Act of 1989, savings and loans are prohibited from investing in n on-investment-grade securities.
    8.Under the 1991 amendement to rule 2a-7 of the 1940 Investment Company Act (ICA), money market funds are required to limit investments to securities that are rated in one of the two highest rankings by at least two NRSROs (and only up to 5 percent of investments should be in securities rated in the second rating, while only up to 1 percent of assets can be second-rating securities of a single issuer).
    9.Under rule 3a-7 of the 1940 ICA, adopted by the SEC in 1992, certain issuers of asset-backed securities are exempt from registration and regulation if, among other factors, their issues receive investment-grade ratings by at least one NRSRO.
    10.Underwriting of nonconvertible debt or nonconvertible preferred stock is allowed under rule 10b-6of the SEC 1934 Act when the securities involved have an investment-grade rating from at least one NRSRO.
    11.Under rule 10f-3 of the 1940 ICA, registered investment companies cannot engage in underwriting activities if the underwriter is an affiliate or an affiliate of an affiliate. One exception to that rule, however, is if the company is acquiring investment-grade municipal bonds.
    12.Under rule 12d3-1 of the 1940 ICA, the rules under which an investment company can acquire securities of parties deriving more than 15 percent of their gross revenues from securities-related activities include a rating requirement: the acquired securities have to be investment grade.
    13.Some rules imposed on savings associations registered with the Office of Thrift Supervision make use of ratings. These associations, for example, cannot trade in corporate debt securities that are not investment grade, nor in commercial paper rated below the first two highest ratings by an NRSRO, and both types of assets can qualify as liquid to meet liquidity requirements.
    14.Foreign banks that want to insure their deposits with the FDIC are required to pledge a specific percentage of high-quality assets such as securities rated in one of the two highest ratings by an NRSRO.
    15.Several states use credit ratings in security valuations and in ruling on the type of investments eligible for various state-regulated funds and financial institutions. In California, county treasurers can only invest in money market funds that are rated by two NRSROs, and municipalities can invest up to 30 percent of their portfolio in medium-term corporate bonds if they have a minimum A rating by two NRSROs. In Vermont, domestic issuers can invest a maximum of 50 percent of their assets in investment-grade fixed-rate corporate securities; banks can invest in investment-grade interest paying corporate securities and in revenue bonds issued by out-of-state parties if they are rated investment grade.
    16.The New York Stock Exchange and Philadelphia Stock Exchange set margin requirements based on the type of security pledged to secure the loan. The most favorable treatment is accorded to U.S. government obligations and to mortgage-backed debt securities rated in one of the two highest rating categories by at least one NRSRO (NYSE rule 431 and PHLX rule 722).
    Sources: Baron and Murch (1993); Cantor and Packer (1994); Dale and Thomas (1991); and conversations with representatives of the SEC and various credit rating agencies.
    Table A6.2.Regulatory Use of Credit Ratings in Selected Countries
    Industrial Countries
    AustraliaAlthough there are no nationwide regulations making use of ratings, the provinces of New South Wales and Victoria restrict fiduciaries to invest only in securities that have a stipulated rating (AA or higher in the first province, varying depending on the rating agency in Victoria).
    CanadaMore simple filing procedures apply when issuing nonconvertible debt or preferred stock in the case of companies that already have investment-grade outstanding debt.
    A credit rating is required from banks when their financial condition is being examined.
    JapanThe ministry of finance stipulates that any listed company can issue commercial paper provided it has an investment-grade rating from two recognized agencies.
    Securities purchased, bonds borrowed, and financial instruments serving as collateral in repos undertaken by money reserve funds must be rated either long-term in the three highest rating classes or short-term in the two highest rating classes by at least two designated agencies.
    Investment in Class 1 securities (rated in the two highest long-term ratings or in the highest short-term rating) cannot exceed 5 percent of net assets per issuer (except for Japanese government and government-guaranteed issues) while investment in Class 2 securities cannot exceed 5 percent of total net assets, with a single issuer limit of 1 percent of net assets.
    The ministry of finance imposes on Japanese companies that want to issue nonconvertible (convertible) euroyen debt to either be rated AA (A) or above, or be rated A (BBB) and have net assets of 55 billion yen. Nonresidents can issue euroyen bonds provided they possess a rating.
    SwitzerlandTo be listed for trading on the Zurich stock exchange, debt securities must be investment grade (or designed by the underwriter as equivalent).
    E.C.The Capital Adequacy Directive (CAD) was adopted in 1993, whereby a higher capital requirement was recommended for investment firms and credit institutions that hold low-grade securities.
    FranceThe European CAD was adopted in 1996: the banking rule 95-02 allows for lower capital provisions for securities given at least two accepted minimum ratings by separate agencies.
    The rule specifies 13 acceptable agencies and a benchmark minimum rating for each.
    Commercial paper issues with maturities exceeding two years, asset-backed securities, and all bank certificates of deposits must be rated.
    The Stock Exchange can request a rating from any issuer that seeks a listing, and usually does so for first-time foreign issuers.
    ItalyThe European CAD directive was adopted in 1997: banks can reduce capital provisions for qualified securities, which are securities that have two approved ratings by two separate accepted agencies.
    The methodology followed by banks to determine the percentage deduction of own funds in the prudential provision for country risk takes into account ratings in addition to spreads.
    A securitization law, currently with the parliament, states that securitized assets of banks have to be rated.
    Money market funds cannot invest in paper rated below investment grade.
    The European CAD directive was adopted in 1996. Banks and securities firms are permitted lower capital provisions for investment-grade securities.
    Emerging Markets
    IndiaThe Reserve Bank of India requires that loan and investment companies have minimum investment grade rating in order to accept public deposits. Also, the amount of such deposits that equipment leasing and hire purchase companies can accept is 2.4 times greater if they have such a rating.
    Nonbank financial corporations that are either unrated or rated below investment grade must disclose their rating to potential depositors before getting their deposits.

    Ratings are compulsory on all public issues of debentures with maturity exceeding 18 months. Hence, there is a rating requirement for nongovernment bonds, commercial paper, nonbank and bank deposits, and investment schemes of plantation companies. There are two requirements for large issues (exceeding the equivalent of $25 million).
    Pension funds can only invest in securities that have two ratings.
    IndonesiaThere is a minimum rating requirement on commercial paper issues (A4, the local minimum investment grade rating) and a rating requirement on nongovernment bond issues.
    The insurance council “urges” companies to invest in investment-grade paper, and is currently proposing to use ratings as part of a system of risk-based capital provisioning for insurance companies.
    KoreaThere is a requirement of two ratings for the issuance of nongovernment bonds and commercial paper but under discussion is the possibility to remove this requirement.
    The ministry of finance and economy looks at the ratings of bonds of security companies in determining net capital rules.
    MalaysiaThere is a minimum rating requirement (BBB, which is the local equivalent of investment grade) on nongovernment bonds and commercial paper.
    PhilippinesThere is a rating requirement for nongovernment bond issues, and the security and exchange commission there has the discretion to mandate a rating for commercial paper issues.
    The social security, retirement, and separation benefits systems can only invest in commercial paper rated investment grade.
    The national health insurance corporation can only invest in the stock of companies with debt rating of investment grade.
    Taiwan Province of ChinaThere is a rating requirement on nongovernment bonds.
    Financial institutions that guarantee commercial paper programs must be rated.
    Any issuers of warrants or guarantors of warrants must be rated investment grade.
    Corporate bonds can be deposited with the central bank (as collateral, for example) by investment trust companies only if these bonds have been rated in the lowest A level.
    Issuers of bonds and stocks are allowed accelerated procedures if within the past 12 months they issued debt rated investment grade.
    The central bank gives credit in banks’ risk-adjusted capital calculations to holdings of debt securities rated above investment grade.
    ThailandThe limit imposed by the Bank of Thailand on bank lending to a single borrower (25 percent of the bank’s Tier 1 capital) does not apply in case the bank is acting as an underwriter of securities issued by a company with a AA or higher credit rating.
    There is a rating requirement on nongovernment bonds and commercial paper publicly sold.
    Latin America
    ArgentinaBanks must be rated by two separate agencies and have to disclose these ratings to counterparties in a transaction upon demand. In addition to banks, most types of financial institutions are subject to a rating requirement as well—except for insurance companies.
    Banks capital adequacy requirements are lower for loans granted to clients with ratings above the sovereign as well as for OECD government bonds rated investment grade.
    Liquidity requirements of banks can be met with holdings of various securities issued by A-rated firms or financial institutions.
    Banks cannot purchase bonds issued by (or extend credit to) related clients if these bonds are rated below BB.
    Banks are required to issue bonds for 2 percent of deposits, to be held by a foreign bank with an A rating or higher.
    ChileThe issue abroad of American Depository Receipts by residents is subject to two minimum international risk-rating requirements (BBB—for banks; BB- for other firms).
    The sale or issue abroad of bonds or other debt securities by resident banks and firms registered with the Superintendency of Securities and Insurance is subject to a minimum rating requirement of BB- for nonfinancial institutions (BB if the bonds have less than 4-year maturity) and of A+ (BBB- in the case of subordinated bonds) for banks and financial institutions.
    Investment by commercial banks and other credit institutions abroad is restricted to bills and bonds issued or guaranteed by foreign governments or central banks and private enterprises with a minimum long-term international debt-risk rating (and its equivalent for short-term debt) of BBB.
    Pension funds and insurance companies may hold only foreign instruments of a minimum rating of A−.
    A credit rating is required from banks when their financial condition is being reviewed.
    MexicoPrivate pension funds can only invest in securities rated at least AA.
    Firms must have an investment-grade standing when they issue debt.
    There is one rating requirement on all debt (commercial paper, medium-term notes, and bonds) issued by companies in the public market.
    Debt funds have to be rated.
    The Superintendency of pension funds requires pension funds to be rated, but the ratings are private (only disclosed to the regulators and to the funds themselves), although there is a possibility that they will be made public soon.
    Sources: Banco Central de Argentina (1998); Baron and Murch (1993); Callen and others (1998): Dale and Thomas (1991); Laurens and Cardoso (1998); IADB (1998); World Bank (1998); and conversations with central bank and ministry of finance officials and with representatives of various credit rating agencies.

    Most regulators stipulate a list of recognized agencies whose ratings can be used to satisfy ratings requirements. In Japan, for example, the ministry of finance has maintained a list of designated Japanese and American ratings agencies since 1986.2 In the United States, such agencies are referred to as Nationally Recognized Statistical Rating Organizations (NRSROs), a term introduced by the SEC in 1975.3 To resolve the ambiguity created by multiple and, at times, different ratings, most regulations accept the highest or second-highest rating. Most countries that assign a list of recognized agencies accept the ratings of the major international institutions (such as S&P’s and Moody’s) and those of some local agencies.4

    The United States pioneered the regulatory use of ratings some seven decades ago. In 1931, the OCC first used the distinction between investment- and non-investment-grade securities when it ruled that, while bonds rated BBB or better were to be carried at book values by banks, lower-rated bonds had to be written down to market value and 50 percent of the resulting losses were to be charged against capital. In 1936, the OCC and the Federal Reserve Board prohibited banks from holding bonds not rated investment grade by at least two agencies.5 The use of the investment- and non-investment-grade distinction to constrain institutional portfolio choices subsequently spread, particularly in the late 1980s and the early 1990s, to pension funds, savings and loans, and money market funds (see items (6), (7), (8), and (13) in Table A6.1).

    The use of ratings soon expanded to areas other than investment restrictions. In the early 1950s, insurance company regulators were using ratings to help determine the capital to be set aside when certain types of securities were held. In 1975, the SEC started imposing higher haircuts on broker-dealers holding commercial paper not rated in the three highest rating categories and for nonconvertible debt securities that were not investment grade.6 In 1982, the SEC eased disclosure requirements for issuers of investment-grade securities, hence expanding the use of ratings to yet another new regulatory facet. This type of regulatory use was extended with the adoption of rule 3a-7 by the SEC in 1992, whereby an investment-grade rating for an asset-backed security allowed the issuer to use simplified registration requirements. The use of ratings subsequently expanded to use in regulation on underwriting activities (see items (10) and (11) in Table A6.1) and on restrictions related to the counterparts in security trading (see items (11) and (12) in Table A6.1).

    The expanding use of ratings in regulation was also marked by a shift from the reliance on the investment-grade rating as a cut-off in rules. Alternative benchmarks became the A rating (adopted by the Department of Labor in restricting pension funds’ investments as well as by the SEC in setting haircuts on commercial paper) or the AA rating (adopted by the Federal Deposit Insurance Commission in the con-ditionality attached to providing insurance to foreign banks’ deposits as well as by the Office of Thrift Supervision in regulating the use of commercial paper both in trading and liquidity provisions by savings associations). Moreover, some regulations, instead of introducing a cut-off rating requirement, stipulated a schedule whereby various rating levels would correspond to different restrictions or charges. Hence, the SEC established different quantitative restrictions on the investments of money market funds depending on whether the securities are AAA or AA rated (see item (8) in Table A6.1).

    Credit ratings were first introduced in Japan in 1974.7 The first Japanese credit rating agency (Japanese Bond Research Institute) was established in 1979, and regulators began using its ratings as eligibility standards for bond issues in the early 1980s. By the 1990s, ratings completely replaced the previous standards for bond issuance based on net asset value and other firm data. Most of these extensive rating-based standards were in turn abolished in 1996, however, in a move to further liberalize financial markets. Nevertheless, the ministry of finance still relies on ratings in various ways, mainly in the prudential regulation of money reserve funds. These funds are not allowed to trade in securities rated below A (long-term) or AA (short-term). Issues of euroyen debt by domestic and foreign parties are subject to rating requirements as well (see Table A6.2 on previous page).

    In the mid-1980s, the regulatory use of ratings began to spread to countries other than Japan and the United States (see Table A6.2). In Europe, this trend was primarily promoted by the 1993 Capital Adequacy Directive, which specifies capital requirements designed to ensure the safety and soundness of banks and security houses in the European Community. The 1993 Capital Adequacy Directive stipulates that these institutions should set aside more capital against their holdings of non-investment-grade securities. By 1997, most EC member countries had amended their legislations to incorporate the 1993 Capital Adequacy Directive in their surveillance of financial companies. The traditional use of ratings in investment prohibitions recurred in Italy, where money market funds are not allowed to invest in low-grade paper. In France, rating requirements were imposed on the issuance of various types of securities, such as commercial paper, asset-backed securities, and bank certificates of deposits. The use of ratings in Europe, while still limited, is rapidly expanding. The recently proposed amendment to the Basel Capital Adequacy requirements, which links risk weights with ratings (see Box 4.2 in Chapter IV), is expected to lead to greater use of ratings in the regulatory process in all countries with internationally active banks.

    The regulatory use of ratings in emerging markets, particularly in Latin America, has been fostered by the process of deregulation and liberalization. In some of these markets, capital requirements have been linked to the use of ratings. In Argentina, for example, bank capital requirements are lower for loans granted to clients with ratings above the sovereign, as well as for OECD government bonds rated investment grade. However, ratings are most widely used as benchmarks in restricting portfolio investment and security issuance. Rating-based investment restrictions are imposed on pension funds in Chile and Mexico, and on the social security and worker compensation systems in the Philippines. India, Indonesia, Korea, Malaysia, the Philippines, Taiwan Province of China, and Thailand figure among the countries that impose rating requirements on security issues. In Latin America, all countries except for Brazil either have already adopted rating-based restrictions on security issuance or are considering their use. Argentina, Chile, and Mexico have implemented rules requiring banks, financial companies, and debtors to be rated for a variety of reasons, including specifying conditions under which deposits can be accepted or debt can be issued (see Table A6.2).


    The only additional remaining step is the introduction of notes and coins, which will take place by 2002. The “Eurosystem,” which comprises the ECB and the 11 national central banks of the participating member states, has responsibility for monetary policy for the entire euro area. The Governing Council of the ECB (formed by the governors of the 11 participating national central banks and the six members of the ECB’s Executive Board) has responsibility for formulating monetary policy. The main institutional features of EMU and implications for financial markets are discussed in International Monetary Fund (1997), pp. 169–213, and International Monetary Fund (1998), pp. 104–110.

    These procedures are described in European Central Bank (1998).

    The fixed amount of liquidity to be allotted is not announced before the ECB has received all the bids. In principle, this would allow the ECB to vary the quantity of liquidity supplied on the basis of banks’ bidding behavior. In practice, however, the very low allotment ratios (see below) suggest that the ECB’s policy is far from giving banks all the liquidity they demand.

    The list of assets eligible for the Eurosystem’s monetary policy operations is updated monthly on the ECB website. Both public and private assets are eligible. Initial margins and valuation haircuts serve as risk control measures.

    At the beginning of February, the ECB clarified that banks did not actually need to have collateral covering the full value of their bids, but only enough collateral to cover the allotted amount. Nevertheless, the variability of allotment ratios, ranging from 6.1 to 33 percent in the first six months, and reaching 100 percent on one occasion (April 6), makes it unlikely that banks bid greatly in excess of their available collateral.

    According to market participants, in this respect, the structure of the euro money market is not much different from the structure of domestic money markets prior to EMU. In domestic markets, large banks tended to collect most of the liquidity and could squeeze smaller banks in the unsecured market.

    Some observers have noted that because the overnight rate is an unsecured rate (unlike the MRO rate), the overnight rate should normally trade slightly above the MRO rate.

    The first maintenance period of the euro era ran from January 1 to February 23. Subsequent maintenance periods run from the 24th of the month to the 23rd of the following month.

    Prior to EMU, “American” flexible-rate tenders (in which allotments are made at the individual rates bid by participants) were mainly used in Austria, Italy, Portugal, and Spain; “Dutch” flexible-rate tenders (in which allotments are made at a common rate) were used in Ireland; fixed-rate tenders, with either fixed or variable quantities, were mainly used in Finland, France, Germany, and the Netherlands. (See Aspets berger, 1996, Table 3). The choice between fixed-rate and flexible-rate tenders mainly reflects the central bank desire of providing clear interest rate signals, while the choice between “American” and “Dutch” flexible-rate tenders depends on their impact on central bank revenues.

    See Box 3 in European Central Bank (1999b), p. 42.

    In Italy, for example, whose electronic interbank market is generally perceived as one of the most efficient in EMU, banks’ recourse to the marginal lending and deposit faci lities in the first four months of EMU accounted only for 1.7 percent and 7 percent of the total respectively, while the funds intermediated by the Italian banking system were more than 10 percent of those of the entire EMU area (see Banca d’Italia, 1999, p. 183).

    For a description of the TARGET payment system, see International Monetary Fund (1997, 1998).

    The main competitor of TARGET for cross-border payments is the net clearing system of the European Bankers’ Association (EBA). In addition, cross-border payments can be processed also by the net clearing system owned by the Landeszentral bank in Hessen (Germany) called Euro Access Frankfurt (EAF), and the French Paris Net Settlement (PNS), formerly called Systeme Net Protégé. Whereas EBA payments can all be classified as cross-border and TARGET cross-border payments are clearly identified in the ECB’s statistics, it is not possible to know the cross-border share of EAF and PNS payments, part of which are domestic.

    Some payments recorded in TARGET are actually transactions within the same banking group. An example are the €13–14 billion of TARGET payments between U.K. banks and their branches on the continent that are exchanged at the beginning and end of each day.

    Late payments in TARGET are also said to be partly related to (1) the repatriation of intraday liquidity, which the out-NCBs have to raise; (2) the concentration of end-of-day liquidity positions of banks and their branches at one location (to centralize overnight liquidity management); (3) the fact that many banks have not yet implemented tools allowing dynamic intraday liquidity management; and last but not least, (4) the fact that other large-value systems close at 4:00 p.m., whereas TARGET closes at 6:00 p.m. This last has a twofold effect: (1) the balances of those systems are settled via TARGET and therefore induce cross-border TARGET payments between 4:00 p.m. and 4:45 p.m.; and (2) between 4:00 p.m. and 6:00 p.m., TARGET has a monopoly position.

    The ECB itself has acknowledged remaining problems in European Central Bank (1999c), p. 48*: “The present lack of market conventions has resulted in imbalances between payment systems and makes it difficult for banks to manage their payment flows efficiently. Therefore, the ECB is urging the industry to make a considerable improvement in this field very soon.”

    The coverage of the national indices used in Figure A1.3 is likely to differ from that of the EONIA panel. The ECB does not publish interest rates for the national components of the EONIA, but it has indicated that the dispersion among the average national interest rates reported by the credit institutions in the panel is minimal. After the first week of EMU, their weighted standard deviation fell below 2 basis points and stabilized around that level thereafter (see Box 2 in European Central Bank, 1999b, p. 35).

    The bid-ask spreads in Table A1.2 need to be interpreted with caution as they may not always reflect actual deals and may depend on the sampling techniques used by each data provider (Reuters and Bloomberg). For instance, many indications show that Paris is playing a major role in money market arbitrage within the euro area, but this does not seem to be reflected in lower bid-ask spreads, as one could expect.

    There are already several means—such as becoming a member of a foreign securities settlement system or engaging the services of a private sector custodian—by which a counterparty in one country might hold a security in a securities settlement system in another country, even without any cross-border links or system consolidation, but these methods are not available (or attractive) to all investors (see Bank of England, 1999).

    In May 1999, the two large European international depositories, Euroclear and Cedel, proposed two competing systems of links and alliances between national securities settlement systems. In the same month, the ECB published a list of 26 links eligible for cross-border use of collateral in Eurosystem monetary policy and ESCB intraday credit operations on a free delivery basis.

    The project “Euromaster Agreement” has been designed to overcome legal problems.

    Additional links are currently under assessment.

    Despite these obstacles, there are some reports of increased cross-border trading, especially in the repo markets, and reports that market participants have set up new or increased existing bilateral limits to spur trading in the unsecured interbank market.

    When ministers of finance or economic affairs meet as the EU Council of Ministers on issues in the domain of fiscal or macro-economic affairs, the Council is referred to as the ECOFIN Council.

    There is notably the case of Broker Tec, an electronic platform for trading of European and U.S. bonds developed by a group of large investment banks, whose introduction has been postponed to early 2000 to avoid overlap with Y2K preparations.

    The exceptions to this trend are the Scandinavian and Benelux countries, where some cross-border mergers have occurred, and, to some extent, Italy, where foreign participation is substantial. Italian banks with a significant participation of foreign investors account for close to half of the domestic deposits. However, apart from one holding of 22 percent (by France’s Credit Agricole), this mainly reflects a substantial number of holdings of just under 5 percent, the level at which Banca d’Italia approval must be sought. The role of foreign partners is still modest in France and negligible in Germany. In the case of France, however, the core shareholder group of the privatized Credit Lyonnais, which controls 33 percent of the capital and voting rights, comprises three foreign banks and the French arm of a German insurance company, together with three French institutions. Some banks from Spain and Scandinavia have instead expanded cross-border into non-EMU (and, indeed, non-EU) countries with the objective of preserving profitability and increasing their size and market value as a possible defense in the ongoing process of consolidation.

    In a related context, it has been suggested that the recent large Spanish merger (Banco Santander and BCH) may have acted as a trigger for the subsequent domestic merger activity in France and Italy discussed below.

    See also Fazio (1999).

    The members of FESCO are Austria, Belgium, Denmark, Finland. Ranee, Germany, Greece, Iceland, Ireland, Italy, Luxembourg, the Netherlands, Norway, Portugal, Spain, Sweden, and the United Kingdom.

    See also Padoa-Schioppa (1999), p. 6.

    Major banks refer to city banks, long-term credit banks, and trust banks. Data on these banks were obtained from Fitch IBCA unless otherwise stated.

    Data obtained from Fitch IBCA.

    These figures are based on a Bank of Japan study of historical write-off rates for a sample of 18 banks during 1995–97. Future write-off rates may be different from historical write-off rates, owing to recent policy measures and changes in the Japanese economic situation.

    Banks were allowed to adopt the deferred tax accounting method for their unconsolidated accounts for their FY1998 financial statements (this method was already used for consolidated accounts).

    The adoption of this method increased parent banks’ equity capital (this year only) by the amount of deferred tax receivables that they carried. There was no effect on capital adequacy ratios, because these were already calculated on a consolidated basis.

    In the United States, all provisions are aggregated and banks are allowed to include an amount up to 1.25 percent of risk assets as Tier 2 capital.

    For example, Bank of Tokyo-Mitsubishi has twice the assets of Citibank, but produces only one-third of the revenues.

    IMF staff estimates based on data provided by Fitch IBCA.

    For example, Sanwa Bank as a whole reportedly spends less on information technology than does the Tokyo office of Goldman Sachs.

    In addition, during FY1998, banks raised about ¥2.8 trillion in Tier 1 capital from private sources, mostly related companies: about ¥1.4 trillion in common shares and about the same amount in higher-yielding preferred securities.

    For details of the PCA framework, see International Monetary Fund (1998).

    Hitherto, nonbanks were allowed to use funds raised through bonds for capital investment, but had to raise loanable funds through bank borrowing or equity financing. The right to issue bonds to raise loanable funds will be limited to nonbanks capitalized at over ¥ 1 billion (these nonbanks also have to meet the same standards for bad loan disclosure as banks). This change is expected to benefit large nonbanks engaged in mortgage lending, consumer lending, and leasing.

    Improved supervision is especially important in light of the Big Bang financial reforms that expand banks’ range of activities.

    The recent tax change that allows banks to deduct debt forgiveness did not address the deductibility of provisions. Currently, provisions are automatically deductible only under certain narrow circumstances; otherwise tax deductibility depends on rulings by the tax authorities.

    Several changes in accounting rules are scheduled to take effect in 1999–2002. At the end of FY1999 the publication of consolidated accounts will become mandatory. The new rules will require the consolidation of the accounts of all firms over which a company exercises effective control, including through minority participation. Starting with FY2000, firms will have to mark to market all their financial assets (except for cross shareholdings, marking to market of which will become mandatory at the end of FY2001). The disclosure of corporate pension liabilities will also become mandatory at the end of FY2001.

    In the case of nonfinancial firms listed in the TSE1 First Section of the Tokyo Stock Exchange, for example, their liabilities are estimated at ¥50–80 trillion, while current profits earned by those firms were less than ¥ 10 trillion in 1998, and after-tax profits were about ¥1 trillion.

    Direct comparisons across countries are difficult because of differences in definitions and reporting procedures. The aggregate debt-equity ratio of Japanese corporations is close to 450 percent, while the ratio of liabilities to net worth of U.S. corporates is about 200 percent, and the ratio of debt to own funds of firms in western Germany is somewhat above 300 percent. By contrast, the average debt-equity ratio of TSE1 companies (350 percent) is actually lower than that of the U.S. firms included in the S&P Industrial Index (450 percent) or of large German nonfinancial firms (460 percent)

    The net debt-equity ratios for the nonmanufacturing and manufacturing sectors are, respectively, 250 percent and 60 percent.

    By comparison, return on equity in the United States is on the order of 20 percent.

    Recurrent profits of nonfinancial listed corporations fell 26 percent and total profits dropped by 70 percent in 1998 compared with 1997.

    Mergers and acquisitions by foreign companies in Japan are still few in absolute terms (75 in 1998) but their number has doubled from 1996 to 1998. They have increasingly involved large financial and industrial companies in which the foreign partner is expected to play a major role.

    Rehabilitation procedures using bankruptcy laws aimed at small and midsized firms focus on protecting secured debtors. Other procedures aimed at large firms entail the transfer of corporate control to a court-appointed trustee and can be relatively complex.

    This change is expected to aid corporate reorganization. The experience in the United States may be illustrative. James (1995, 1996) shows that U.S. banks were willing to participate in debt-equity swaps of severely impaired claims and take advantage of exemptions to the U.S. law banning banks from holding corporate equity when the going-concern value of a distressed debtor was higher than its liquidation value. Banks usually agreed to swaps when other creditors also participated in the workout.

    See IMF (1998) for the importance of securities in emerging market banks’ portfolios and for related innovations in market risk regulation.

    Aside from closing 16 out of 30 merchant banks, the authorities closed several insolvent insurance companies, securities firms, and investment trust companies, and some forty credit unions. Many others were placed under rehabilitation plans monitored by the Financial Supervisory Commission, but the restructuring of the non-bank financial system remains incomplete.

    As of end-February 1999, KAMCO had purchased W 44 trillion of loans for W 20 trillion, a 55 percent discount. Total disposals and collections were just W 1.7 trillion, but the agency has so far recovered more than it had paid on the most desirable properties.

    The discount is 61 percent if one large loan bought for a nominal amount is included.

    Thailand has made substantial progress in cleaning up the finance companies, and asset sales are well advanced.

    Private investors were given warrants that allow them to buy shares from the government in three years at a prespecified price.

    While the People’s Bank of China estimates nonperforming loans to be 20 percent of total loans, most analysts believe the actual figure is significantly higher. To better gauge the banks’ asset quality, this year the People’s Bank of China will require them to re-classify their loans into the standard five categories, but officials have not made public the results of banks that experimented with the plan last year in Guangdong province. Also, RMB 270 billion of Special Treasury Bonds have been issued to recapitalize the four state-owned commercial banks.

    See IMF (1998) for a description of the main aspects of Argentina’s BASIC (bonds, auditing, supervision, information, and credit rating) approach to banking oversight, which combines aspects of the conventional approach to regulation and supervision with the monitoring and discipline imposed by the market (including the use of credit rating agencies).

    The top 10 banks accounted for 69 percent of total deposits at end-1998, compared with 50 on the eve of the Mexican crisis, and foreign banks hold about 40 percent of total deposits.

    Net of provisions, nonperforming loans increased from 3.2 percent of total loans to 3.5 percent, over the same period. Moreover, banks continue to be well capitalized, with the capital adequacy ratio (calculated according to Basel rules) steady at 19.8 percent—well above international standards and the requirements of local legislation.

    Total BIS reporting banks’ exposure to Brazilian banks was reduced by $5.6 billion in 1998, with $5.2 billion of that reduction happening during the second half of the year.

    Two wholesale banks suffered significant losses due to large short-dollar positions on the futures exchange. One failed after the devaluation, and the other is undergoing voluntary liquidation. Also, some highly leveraged (domestic) hedge funds suffered severe losses in January, but this had a marginal effect over the banking system, in part owing to the implementation of Chinese walls after March 1998; in the case of one large bank, management decided to reimburse investors after several lawsuits were filed against the bank’s asset management company.

    By end-August 1998, the concept of Tier 2 capital was introduced and could be counted toward meeting the capital adequacy requirement of 11 percent of risk-weighted assets. The authorities are committed under the IMF-supported program to adopt capital requirements for market risk and to implement a forward-looking loan classification system.

    Under the law passed in December 1998, the Fondo Bancario de Protectión al Ahorro (FOBAPROA) liabilities were transferred to the Instituto de Protectión del Ahorro Bancario (IPAB), which will have two units: one charged with liquidating the assets currently in the hands of FOBAPROA and another that will be responsible for deposit insurance.

    Moody’s estimates of economic capital in the Mexican banking system make a series of adjustments to reported capital, including (1) a more realistic view of certain impaired assets; (2) adding the unreserved portion of past-due loans; and (3) adjusting assets downward for intangibles and deferred tax credits. The agency believes that the estimates are conservative, and the exclusion of franchise values in the calculations is based on the severity of the legacy of impaired assets and the very weak capital-producing earnings after the 1994–95 crisis (see Moody’s, 1999c).

    Borrowers that are current or bring their accounts current by end-September 1999 will qualify for discounts of 45 percent for small business loans, 50 percent for mortgages, and 60 percent for farm and fisheries loan balances up to specified ceilings.

    The deterioration in asset quality continued in the first quarter of 1999, with nonperforming loans increasing to almost 7.3 percent of total loans by end-March 1999, while provisioning fell to 102 percent.

    Unlike Mexico, the Venezuelan banking system recovered rapidly from the systemic crisis of 1994–95, mainly as a result of increased foreign ownership and the fact that local banks were able to recapitalize themselves due to foreign exchange gains and high margins in a negative real interest rate environment (see Moody’s, 1999d).

    Prior to the summer of 1998, retail investors made substantial profits through carry trades conducted through the currency futures markets, which allowed them to profit from the interest differential (adjusted for exchange rate changes) with very low margins. The Russian crisis and its spillovers to Hungarian money and capital markets led to the failure of six brokerage houses.

    Turkish banks are the treasury’s largest creditors as they hold an estimated three-fourths of the lira-denominated government debt. Because of the importance of government securities in the banks’ portfolios, any disturbance to the domestic treasuries market entails serious liquidity risks for the banks.

    The real level of problem loans is estimated to be a multiple of the banks’ reported ratio of 2 percent of total loans, once restructured credits and bad loans to state enterprises are included.

    See Box 4.2 in Chapter IV for a summary of the proposed revisions to the Basel Accord on Capital Adequacy.

    In addition, representatives from Australia, Hong Kong SAR, the Netherlands, and Singapore have been invited to participate in the Forum’s meeting on September 15, 1999.

    These recommendations complement the annual survey of disclosures about trading and derivatives activities of banks and securities firms (see, e.g., Basel Committee on Banking Supervision and IOSCO, 1998b).

    Hedge funds are exempt in the United States from SEC reporting requirements and from regulatory restrictions on leverage or trading strategies. Hedge funds that trade on organized exchanges are, however, required to register with the Commodity Futures Trading Commission as “commodity pool operators” and are subject to reporting requirements on their exchange-traded options and futures positions.

    The recent Basel Committee paper on revisions to the Basel Accord (Basel Committee on Banking Supervision, 1999c) suggests abolishing the 50 percent cap on the risk weights of OTC derivative exposures and introducing a new 150 percent risk weight category for poor-quality corporate claims (see Box 4.2 in Chapter IV).

    The Joint Forum on Financial Conglomerates, which comprises representatives of the Basel Committee on Banking Supervision, IOSCO, and the International Association of Insurance Supervisors, as well as national supervisors, was established in 1996.

    See Box A5.2 for definitions.

    A variable x is said to Granger-cause another variable y if prediction of the current value of y is enhanced by using the past values of x. This definition is usually implemented by regressing y on past values of x and y and possibly a number of control variables. If past values of x help explain y (as measured by an F-test), x is said to Granger-cause y (Kennedy, 1985).

    Yield spreads refer to the difference between sovereign yields and U.S. treasury bill yields of the same maturity. In Malaysia, sovereign yields are not available and the yield on a public enterprise issue (Petronas) is used.

    For a detailed account of developments during this period, see the World Economic Outlook (IMF, 1998), pp. 49–53.

    Prime Minister Mohamed Mahathir’s public condemnation of the agencies following Malaysia’s downgrade is a prime example of this during the Asian crisis.

    A default occurs when an issuer does not make full and timely payment of interest or principal on a rated debt instrument.

    The sample included the debt instruments of Argentina (10/6/06), Brazil (11/5/01), China (11/03), Colombia (6/14/01), Hong Kong SAR (MTRC, 10/01/05), Indonesia (8/1/06), Korea (KDB, 11/21/03), Malaysia (Petronas, 10/18/06), Mexico (1/15/07), the Philippines (10/16), Poland (7/1/04), Russia (11/27/01), South Africa (10/17/06), Thailand (4/15/97), Turkey (05/02), and Venezuela (6/18/07).

    While in general market views on default can be inferred from spreads on foreign-currency-denominated instruments (see Cline and Barnes, 1997), and compared with rating agencies’ views, such inferences need to bear in mind that liquidity is also an important determinant of spreads.

    Of course, it is always possible to call every crisis, simply by “crying wolf” on every occasion, implying a large number of false alarms. For acceptable rates of false alarm, empirical models miss most crises. Berg and Pattillo show that the Kaminsky-Lizondo-Reinhart model correctly calls 25 percent of precrisis months when the rate of false alarm is 63 percent, and 4 percent of precrisis months when the rate of false alarm is 17 percent.

    Underthe proposal, the more sophisticated banks would be able to rely on their own internal rating systems rather than using external ratings. See Basel Committee on Banking Supervision (1999).

    For banks, a second option is under consideration: risk weights based on banks’ own ratings rather than the rating of their sovereign.

    The four rating agencies surveyed include Moody’s, S&P’s, Fitch IBCA, and DCR.

    For example, see Fitch IBCA (1998) and S&P’s (1998).

    The recent proposal on capital adequacy requirements by the Basel Committee on Bank Supervision to use credit rating to determine risk weight is reviewed in Box 4.2, Chapter IV.

    The list today consists of the following agencies: Japan Rating and Investment Information, Japan Credit Rating Agency, Moody’s Investors Service, S&P’s, Fitch IBCA, DCR, and Thomson Bank Watch.

    The list of NRSROs in the United States includes the major agencies (Moody’s, S&P’s, Fitch IBCA, DCR, Thomson Bank Watch) as well as some smaller ones (McCarthy, Crisanti). Several foreign rating agencies have applications pending with the SEC to acquire NRSRO status.

    The adoption of rating-based regulations was the main force leading to the creation of rating agencies in emerging markets in Latin America and Asia; there are on average three to four such agencies per country in Latin America. In cases where the establishment and operation of a rating agency are subject to a set of rules, as is the case in Argentina, Chile, and Mexico, once such an agency is allowed to be established, its ratings are automatically recognized by regulators.

    This investment-grade distinction was also adopted by the National Association of Insurance Commissioners in 1951.

    The SEC introduced at that time the concept of an NRSRO by referring to Moody’s, S&P’s, and Fitch as agencies whose ratings it recognized for the purpose of this legislation.

    In 1974, Mitsui & Co. was the first Japanese firm to obtain a rating (BBB) from an American agency prior to launching an international bond offering.

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