Major Market Developments

Against the macroeconomic backdrop sketched above, international capital markets were generally characterized in 1990 by an increased cost of funds, as both interest rates and risk premiums rose and lending margins widened. Prices in most equity markets, both in industrial and developing countries (with the notable exceptions of Chile, Colombia, Mexico, and Venezuela) declined sharply and some earlier sources of low-cost funding dried up (e.g., bonds with equity warrants¹). In such an environment, there was a shift to shorter-term, more liquid, and relatively lower-risk instruments. Market participants characterized the process as a “flight to quality,” with lower-rated borrowers facing greater difficulty in raising needed financing, widening spreads between higher and lower quality instruments, and intensified concerns about a possible “credit crunch.”

During the year, major market segments witnessed a marked decline in activity. New issues on international bond markets fell by 11 percent, from $256 billion in 1989 to $229 billion in 1990. The decline was due largely to a sharp contraction in issues of equity warrant bonds by Japanese corporations, a reflection of weakness in the Tokyo stock market. In contrast, floating rate note issuance expanded in the face of increased interest rate uncertainty, as did that of ECU (European currency unit) bonds, sustained by an increasing range of actively traded bonds issued by European governments and agencies (Chart 2). Meanwhile, cross-border bank lending declined by 25 percent from $581 billion in the first three quarters of 1989 to $432 billion in the corresponding period of 1990, essentially reflecting a sharp slowdown in interbank business (Table 3).² In particular, interbank lending by U.S. and Japanese banks showed an increase of only $42 billion in the first three quarters of 1990, compared with an expansion of $127 billion in the corresponding period of 1989. This retrenchment reflects in part efforts by banks in these countries to restrain asset growth as they attempt to conform to internationally agreed capital adequacy standards. In contrast, as borrowers and lenders sought ways to manage increased risk and uncertainty in an unsettled environment, the markets for financial futures and options continued the strong expansion that was evident throughout the 1980s. Trading volumes, the range of contracts offered, and the degree of competition among organized futures and options exchanges around the world all increased markedly.

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International Bond Issues by Major Instruments, 1985–90

(In percent)

Source: Organization for Economic Cooperation and Development, Financial Market Trends.

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Table 3.

International Lending, 1983-Third Quarter 1990

(In billions of U.S. dollars)

Sources: Bank for International Settlements (BIS); Organization for Economic Cooperation and Development (OECD); International Monetary Fund, International Financial Statistics; and Fund staff estimates.

¹ IMF-based data on cross-border changes in bank claims are derived from the Fund’s international banking statistics (IBS) (cross-border interbank accounts by residence of borrowing bank plus international bank credits to nonbanks by residence of borrower), excluding changes attributed to exchange rate movements. BIS-based data are derived from quarterly statistics contained in the BIS’s International Banking Developments; the figures shown are adjusted for the effects of exchange rate movements. Differences between the IMF data and the BIS data are mainly accounted for by different coverages. The BIS data are derived from geographical analyses provided by banks in the BIS reporting area. The IMF data derive cross-border interbank positions from the regular money and banking data supplied by member countries, while the IMF analysis of transactions with nonbanks is based on data from geographical breakdowns provided by the BIS reporting countries and additional banking centers. Neither the IBS nor the BIS series are fully comparable over time because of expansion of coverage.

² Total changes in bank claims include offshore centers, international organizations, and other non-Fund members, as well as industrial and developing countries.

³ Estimates based on BIS and OECD data.

⁴ Net of redemption and repurchases, and of double counting, that is, bonds taken up by the reporting banks to the extent that they are included in the banking statistics as claims on nonresidents and bonds issued by the reporting banks mainly for underpinning their international lending activity.

⁵ Excludes the seven offshore centers (The Bahamas, Bahrain, the Cayman Islands, Hong Kong, the Netherlands Antilles, Panama, and Singapore).

Table 3.

International Lending, 1983-Third Quarter 1990

(In billions of U.S. dollars)

											1989	1990
				1983	1984	1985	1986	1987	1988	1989	First three quarters
International lending through banks and bond markets
	Total 1,2
		IMF-based		212	245	353	625	854	636	917	659	462
		BIS-based (gross)3		152	187	309	598	650	518	783	547	344
		BIS-based (net of redepositing)3		131	152	182	282	351	327	487	348	325
			Bond issues (net)4	46	62	77	87	51	77	97	78	30
	Change in bank claims1,2
		IMF-based		166	183	276	538	803	559	820	581	432
			Growth rate (in percent)	6	7	10	17	20	11	15	11	7
		BIS-based (gross)		106	125	232	511	599	441	686	469	314
			Growth rate (in percent)	7	6	11	20	18	10	15	11	6
		BIS-based (net of redepositing)		85	90	105	195	300	250	390	270	295
			Growth rate (in percent)	8	7	8	13	17	11	17	12	12
International lending to industrial countries
	Total
		IMF-based		156	183	271	490	592	538	645	481	411
		BIS-based (gross)3		106	148	249	473	482	427	608	435	281
		BIS-based (net)3		85	113	121	157	183	236	312	236	262
			Bond issues (net)4	36	51	63	77	44	67	81	68	25
	Change in bank claims1
		IMF-based		120	132	208	413	548	471	564	413	386
			Growth rate (in percent)	8	8	13	21	21	14	15	11	9
		BIS-based (gross)		70	97	186	396	438	360	527	367	256
			Growth rate (in percent)	4	5	9	15	13	9	12	8	5
		BIS-based (net)		49	62	58	80	139	169	231	168	237
			Growth rate (in percent)	5	5	5	5	8	8	10	7	9
International lending to developing countries 5
	Total
		IMF-based		32	14	8	5	23	−4	13	7	−12
		BIS-based3		28	10	17	4	−10	5	10	−12	−17
			Bond issues (net)3,4	2	3	4	2	1	2	2	1	1
	Change in bank claims1
		IMF-based		30	11	4	3	22	−6	11	6	−13
			Growth rate (in percent)	6	2	1	—	4	−1	2	1	−2
		BIS-based		26	7	13	2	9	3	−12	−13	−18
			Growth rate (in percent)	7	1	3	—	2	—	−2	−2	−3
Memorandum items
	Total gross bond issues			77	110	168	227	181	227	256	197	172
		Of which:
			Industrial countries	60	91	138	201	156	198	224	172	143
			Developing countries 5	3	4	8	4	4	6	5	3	4

Sources: Bank for International Settlements (BIS); Organization for Economic Cooperation and Development (OECD); International Monetary Fund, International Financial Statistics; and Fund staff estimates.

¹ IMF-based data on cross-border changes in bank claims are derived from the Fund’s international banking statistics (IBS) (cross-border interbank accounts by residence of borrowing bank plus international bank credits to nonbanks by residence of borrower), excluding changes attributed to exchange rate movements. BIS-based data are derived from quarterly statistics contained in the BIS’s International Banking Developments; the figures shown are adjusted for the effects of exchange rate movements. Differences between the IMF data and the BIS data are mainly accounted for by different coverages. The BIS data are derived from geographical analyses provided by banks in the BIS reporting area. The IMF data derive cross-border interbank positions from the regular money and banking data supplied by member countries, while the IMF analysis of transactions with nonbanks is based on data from geographical breakdowns provided by the BIS reporting countries and additional banking centers. Neither the IBS nor the BIS series are fully comparable over time because of expansion of coverage.

² Total changes in bank claims include offshore centers, international organizations, and other non-Fund members, as well as industrial and developing countries.

³ Estimates based on BIS and OECD data.

⁴ Net of redemption and repurchases, and of double counting, that is, bonds taken up by the reporting banks to the extent that they are included in the banking statistics as claims on nonresidents and bonds issued by the reporting banks mainly for underpinning their international lending activity.

⁵ Excludes the seven offshore centers (The Bahamas, Bahrain, the Cayman Islands, Hong Kong, the Netherlands Antilles, Panama, and Singapore).

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Table 3.

International Lending, 1983-Third Quarter 1990

(In billions of U.S. dollars)

											1989	1990
				1983	1984	1985	1986	1987	1988	1989	First three quarters
International lending through banks and bond markets
	Total 1,2
		IMF-based		212	245	353	625	854	636	917	659	462
		BIS-based (gross)3		152	187	309	598	650	518	783	547	344
		BIS-based (net of redepositing)3		131	152	182	282	351	327	487	348	325
			Bond issues (net)4	46	62	77	87	51	77	97	78	30
	Change in bank claims1,2
		IMF-based		166	183	276	538	803	559	820	581	432
			Growth rate (in percent)	6	7	10	17	20	11	15	11	7
		BIS-based (gross)		106	125	232	511	599	441	686	469	314
			Growth rate (in percent)	7	6	11	20	18	10	15	11	6
		BIS-based (net of redepositing)		85	90	105	195	300	250	390	270	295
			Growth rate (in percent)	8	7	8	13	17	11	17	12	12
International lending to industrial countries
	Total
		IMF-based		156	183	271	490	592	538	645	481	411
		BIS-based (gross)3		106	148	249	473	482	427	608	435	281
		BIS-based (net)3		85	113	121	157	183	236	312	236	262
			Bond issues (net)4	36	51	63	77	44	67	81	68	25
	Change in bank claims1
		IMF-based		120	132	208	413	548	471	564	413	386
			Growth rate (in percent)	8	8	13	21	21	14	15	11	9
		BIS-based (gross)		70	97	186	396	438	360	527	367	256
			Growth rate (in percent)	4	5	9	15	13	9	12	8	5
		BIS-based (net)		49	62	58	80	139	169	231	168	237
			Growth rate (in percent)	5	5	5	5	8	8	10	7	9
International lending to developing countries 5
	Total
		IMF-based		32	14	8	5	23	−4	13	7	−12
		BIS-based3		28	10	17	4	−10	5	10	−12	−17
			Bond issues (net)3,4	2	3	4	2	1	2	2	1	1
	Change in bank claims1
		IMF-based		30	11	4	3	22	−6	11	6	−13
			Growth rate (in percent)	6	2	1	—	4	−1	2	1	−2
		BIS-based		26	7	13	2	9	3	−12	−13	−18
			Growth rate (in percent)	7	1	3	—	2	—	−2	−2	−3
Memorandum items
	Total gross bond issues			77	110	168	227	181	227	256	197	172
		Of which:
			Industrial countries	60	91	138	201	156	198	224	172	143
			Developing countries 5	3	4	8	4	4	6	5	3	4

Sources: Bank for International Settlements (BIS); Organization for Economic Cooperation and Development (OECD); International Monetary Fund, International Financial Statistics; and Fund staff estimates.

¹ IMF-based data on cross-border changes in bank claims are derived from the Fund’s international banking statistics (IBS) (cross-border interbank accounts by residence of borrowing bank plus international bank credits to nonbanks by residence of borrower), excluding changes attributed to exchange rate movements. BIS-based data are derived from quarterly statistics contained in the BIS’s International Banking Developments; the figures shown are adjusted for the effects of exchange rate movements. Differences between the IMF data and the BIS data are mainly accounted for by different coverages. The BIS data are derived from geographical analyses provided by banks in the BIS reporting area. The IMF data derive cross-border interbank positions from the regular money and banking data supplied by member countries, while the IMF analysis of transactions with nonbanks is based on data from geographical breakdowns provided by the BIS reporting countries and additional banking centers. Neither the IBS nor the BIS series are fully comparable over time because of expansion of coverage.

² Total changes in bank claims include offshore centers, international organizations, and other non-Fund members, as well as industrial and developing countries.

³ Estimates based on BIS and OECD data.

⁴ Net of redemption and repurchases, and of double counting, that is, bonds taken up by the reporting banks to the extent that they are included in the banking statistics as claims on nonresidents and bonds issued by the reporting banks mainly for underpinning their international lending activity.

⁵ Excludes the seven offshore centers (The Bahamas, Bahrain, the Cayman Islands, Hong Kong, the Netherlands Antilles, Panama, and Singapore).

The unwinding in 1990 of the asset price inflation associated with earlier sustained bank lending in a number of countries (real estate prices in the United Kingdom and the United States; equity, and possibly also property, prices in Japan) and the effects of high corporate debt leverage placed increasing strains on banks’ balance sheets. This was evidenced in deteriorating asset quality, higher provisioning against bad loans, and lower profitability. In some countries, the economic downturn that began during the year intensified these strains and brought to the fore concerns about “financial fragility.”

In addition, during 1990, net capital flows shifted among major industrial countries, the interpretation of which is complicated by a concomitant increase in quite large errors and omissions items. The main developments in this regard were as follows.

(1) A reversal of the traditional net portfolio and foreign direct investment inflows to the United States; net foreign purchases of U.S. Treasury bonds, in particular, declined sharply. The reduced external financing from these sources was associated with a lower current account deficit and an increase in the positive errors and omissions item.

(2) A sharp fall in net investment in foreign securities by Japanese institutions in 1990 (involving, inter alia, the first sustained net sales of U.S. securities since 1982), in the face of narrowing interest rate differentials and, in some cases, the need to cover losses stemming from the fall in the Japanese stock market. In contrast, the importance of net direct investment outflows as a counterpart to the current account surplus began increasing as from 1989.

(3) Sustained net portfolio outflows from Germany through most of 1990, possibly reflecting the increased uncertainty associated with the unification process, with nonresident interest in the substantial amounts of government bonds issued appearing only toward the end of the year. Direct investment outflows from Germany also increased significantly, with European Community (EC) countries being the main recipients, while the share taken by the United States fell sharply.

For developing countries, access to spontaneous credit on international capital markets continued to be limited in 1989–90, with few exceptions. A significant development was the incipient return to the capital markets—and particularly the bond markets—of some Latin American borrowers. The countries of Eastern Europe, for their part, saw their recourse to the bond and syndicated credit markets curtailed, as, among other factors, the difficulties inherent in the transition to market economies came increasingly to the forefront. The feared diversion of private sector funds to Eastern Europe at the expense of other developing countries did not occur in 1990. In general, at a time of unsettled market conditions, creditors appeared to be particularly mindful of the importance of the sustained and credible implementation of sound macro-economic policies and structural reforms by developing countries, not only by those attempting to re-enter the international capital markets, but also by those that had managed to retain their access to those markets.

The response of global financial markets to the outbreak of the Middle East crisis in August 1990 provides an indication of how the effects of large, unanticipated real sector shocks are transmitted rapidly across both industrial and developing countries.³ Asset price movements following the emergence of the Middle East crisis, and the associated sharp rise in oil prices (Chart 3), indicate that market participants anticipated a deterioration in economic fundamentals (e.g., growth and inflation), and an increase in the range of potentially adverse outcomes for other parameters (e.g., interest rates). The term structure of interest rates in both the spot and futures markets in the major industrial countries steepened (or became less inverted) during the first two weeks following the invasion of Kuwait. In the futures market for U.S. Treasury securities, the term structure of anticipated interest rates steepened also in relation to that prevailing in the spot market, an indication of a general expectation that long-term interest rates would rise further relative to short-term rates. At the same time, uncertainty about the financial outlook increased. Anticipated near-term asset price variability—as reflected in options prices—increased sharply on most markets. Not surprisingly, the sharpest increase in anticipated volatility, by a factor of close to three, was for the price of oil. The anticipated volatility of U.S. equity market prices more than doubled, while the implicit volatilities in the markets for U.S. Treasury bonds and Eurodollar deposits also rose sharply. In contrast, the implied volatility in foreign exchange options did not increase significantly.

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Oil and Gold Prices, July 6, 1990–January 25, 1991¹

(In U.S. dollars)

Sources: Data Resources Inc.; and Fund staff estimates.¹ The average petroleum spot price (APSP) is the unweighted spot market price per barrel of U.K. Brent (light), Dubai (medium), and Alaskan North Slope (heavy). For gold, the price is London afternoon fixing, U.S. dollars per ounce.

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The crisis in the Middle East resulted in a further tightening of market conditions, especially for less creditworthy borrowers. A general preference for safer and more liquid financial instruments was reflected in increased spreads between corporate and government securities on national markets and between private sector Eurobonds and government securities denominated in the same currency on international markets. Despite large asset price movements, however, there were no market disruptions, closures, or significant backlogs. The effects on financial institutions were limited primarily to a number of banks located in the Middle East, which suffered severe liquidity strains that were met, inter alia, through sales of developing country debt holdings, temporarily widening the secondary market discounts on such debt. Elsewhere, the influence was indirect, affecting those banks and securities houses in industrial countries that incorporate unrealized capital gains on asset holdings into their capital positions (notably in terms of the lending behavior of Japanese institutions), or whose loan portfolio (particularly corporate and real estate) was adversely affected by the worsened outlook for economic fundamentals in major industrial countries.

In contrast to market reaction to the onset of the crisis, the response of asset prices to the outbreak of hostilities in January 1991 was less pronounced, apart from a substantial decline in oil prices. Equity prices rose and long-term interest rates declined on both spot and futures markets; the anticipated volatility of prices for oil, bonds, and equities also fell. The difference in the adjustments of asset prices in August 1990 and in January 1991 appears to reflect the fact that the earlier event was largely unanticipated; market participants responded more abruptly and with less information. In such a situation, asset price adjustments are likely to be sharper and more extensive. The events of January 1991, in turn, were anticipated to a comparatively larger extent and elicited more moderate adjustments in portfolios.

Spontaneous Financing for Developing Countries

Developing countries’ access to spontaneous credit on international capital markets has, with the exception of a few countries, been severely curtailed since 1982. Against this background, it is noteworthy that some developing countries with recent debt-servicing problems succeeded during 1989–90 to gradually restore a degree of access to spontaneous capital flows, most notably through bond issues and flows into their domestic equity markets; to date, however, the amounts have been modest and the phenomenon limited to a narrow range of countries. In addition, several developing countries that have maintained access faced a tightening of market conditions in 1990.

Spontaneous medium- and long-term bank credit commitments to capital importing developing countries amounted to $16.5 billion in 1990–11 percent above the level attained in 1989. This increase was largely attributable to the sustained growth of bank credit commitments (to $10.7 billion, a 20 percent rise) to traditional Asian borrowers and a strong increase in commitments to the Soviet Union (in large part guaranteed by Organization for Economic Cooperation and Development (OECD) governments). At the same time, although small in overall terms, there was a resumption in spontaneous bank credit commitments, mainly project related, to several borrowers in the Western Hemisphere (Chile, Mexico, and Venezuela). In contrast, there were no new spontaneous bank commitments to Eastern European countries, reflecting not only political uncertainty but also fear of contagion effects following the suspension of payments by Bulgaria in March 1990.

A limited return to spontaneous access by countries with recent debt-servicing problems was also evident in securities markets, which have in fact constituted the main point of market re-entry for countries with recent debt-servicing difficulties. This possibly reflects factors such as the still modest overall amount of developing country bond debt outstanding and the relatively good servicing record on such instruments. International publicized bond issues by developing countries in 1990 amounted to $5.1 billion, compared with $4.5 billion in 1989. In addition, partial information on private placements and other unpublished bond issues by developing countries indicates that they amounted to some $1.5 billion in 1990. Together with substantial issues by traditional Asian borrowers (India, Indonesia, Korea, and Malaysia), the higher volume of bond issuance included an estimated $2.4 billion of public issues and private placements by entities in two Western Hemisphere countries with recent debt-servicing problems (Mexico and Venezuela).⁴ Bond issues by three traditional Eastern European borrowers (Bulgaria, Czechoslovakia, and Hungary) were broadly stable between 1989 and 1990 (about $1.3 billion), but the composition of new issues changed sharply (no issues by Bulgaria, and an increase from $74 million to $377 million in Czechoslovak issues). Bond issues by the Soviet Union (at $298 million) equaled only about one third of their 1989 level.

Portfolio equity flows to developing countries increased in 1989–90, mainly through country specific and multicountry funds (an estimated $1 billion a year) but also, more recently, through equity issues by developing country corporations on industrial country stock exchanges. Foreign portfolio investors have also acquired equity participation in developing country corporations in the context of privatization programs. New issues of country funds came to a virtual halt in the latter half of 1990, following a period of rapid expansion and consequent market saturation, as well as a slower-than-anticipated deployment of funds in Eastern European countries.

Recent Structural Changes in Financial Markets

Previous reports in this series have described the structural changes in financial markets arising from liberalization, market integration, and the spread of innovative financing instruments and techniques. These trends continued, and in some cases intensified, in 1989–90, increasing competition among major financial centers and institutions and diminishing segmentation between various sectors of domestic and international markets. Although these phenomena are frequently depicted as global in scope, it should be noted that few developing countries are directly involved in them and important structural differences persist across the main industrial countries. Distinctions remain, for example, in the extent and nature of links between banking and commerce, the degree of financial concentration, the role of securitized money markets, the organization of national stock exchanges, and the taxation of financial activities.

The process of deregulation of financial sector prices (such as interest rates, fees, and commissions), which began in earnest in the 1980s, is now largely complete in most industrial countries. During the past two years, direct controls on interest rates have disappeared or been reduced to the point of insignificance, with, in particular, further deregulation (or the erosion of longstanding cartel-like arrangements) in Austria, France, Japan, and Switzerland. In Japan, where interest rate controls have long been a prominent feature of the financial system, deregulation proceeded more decisively in the past year; in July 1990, the authorities announced a three-year timetable for the complete liberalization of rates on time deposits, and an advisory council is currently deliberating moves to deregulate rates on demand deposits. This process significantly raised the average cost of funds for Japanese banks and probably contributed to their retrenchment from low-margin cross-border activity. Similarly, the process of replacing fixed fees and commissions for financial services with freely negotiable ones continued in most of the countries where it had not yet been completed, and most notably in Switzerland.

Restrictions on the range of financial institutions’ activities also continued to erode, either through market practice or through legislative and regulatory action. In addition to the blurring of distinctions between banking and the securities business, a more recent development has been a deepening of linkages between banking and insurance. In an increasing number of countries, the policy consensus has been shifting away from legally imposed specialization of financial services toward allowing market participants to decide for themselves the degree of functional diversification they wish to pursue, within appropriate regulatory and supervisory safeguards. In all of the three major economies with traditionally segmented systems-Canada, Japan, and the United States—there have been moves toward a relaxation of functional barriers. Policy movement is most advanced in Canada, where reform proposals presented by the federal government in September 1990 would eliminate many of the remaining restrictions between the “four pillars” of banking, securities, trust, and insurance companies. In Japan, a revision of the policy separating banks and securities houses is under consideration. In the United States, a detailed set of proposals concerning deposit insurance and financial regulatory reform was released by the Treasury Department in February 1991; the proposals included significant changes in laws that have long restricted the conjunction of banking and securities functions under one corporate charter and the expansion of banks across state lines.

As increased linkages across a range of financial services become more widespread, there appears to be a general trend toward the emergence of financial conglomerates.⁵ Contrasting trends, however, are also in evidence. Diversification strategies have been developed mainly by large institutions as a means of consolidating positions in their home markets, while domestic or foreign newcomers to these markets have often adopted a specialized “niche” approach to establishing initial footholds. Furthermore, some amount of “re-specialization” is taking place in some large institutions themselves, as they retrench from highly competitive market sectors characterized by overcapacity (e.g., securities trading in some major financial centers). This is especially evident in the restructuring programs announced in 1990 by a number of major internationally active banks. Nevertheless, the underlying trend toward the formation of financial conglomerates appears to be deeply rooted, raising difficult challenges for supervisory authorities.

Movement toward the geographic integration of financial markets has been especially pronounced within the European Community. As part of the 1992 single market program, major directives affecting the banking market were adopted in 1989 and the transposition of these directives into national legislation is under way.⁶ Meanwhile, discussions on directives for a single market in the securities field are continuing. In addition, the directive on the liberalization of capital movements within the EC came into effect in July 1990, by which time most EC members had already fully implemented it. Complementing these measures were the negotiations on economic and monetary union (EMU), which culminated during the period under review with the initiation of the intergovernmental conference in December 1990.

The overall process of European integration is viewed by many market participants in Europe, both in EC member and nonmember countries, as constituting the single most important influence on their activities and strategies for the 1990s. Views differ, however, as to the ultimate direction of structural change, in banking as well as in other financial markets. With regard to banking, the single market is seen by some as likely to entail a gradual convergence toward a multipurpose or universal banking model, as universal banks authorized to conduct, for example, securities underwriting in their home country will, by virtue of the single license, be able to do so in other member countries, even those that at present restrict their own banks from such activity. An alternative view is that specialized institutions might prove more adaptable and efficient in taking advantage of the larger and more competitive European market than universal banks. In practice, the prospect of the 1992 single market has not yet led to substantial or widespread cross-border organizational mergers, and most European banks appear to have opted to strengthen their domestic bases, thus far limiting their cross-border ambitions to wholesale or niche activities.

Progress within the EC on a single market in the securities field has been slower.⁷ There are two main outstanding issues in this regard. The first concerns the organization of national exchanges; among other things, at issue is the extent to which securities business should pass through recognized national exchanges or be allowed to take place outside those exchanges. Distinctive national approaches to such questions reflect differences in the established practices of member country exchanges, as well as competitive considerations and different ways of reconciling the objectives of market efficiency and investor protection. The second issue involves capital adequacy standards for securities firms, including banks engaged in securities activities. The directive currently in draft form allows supervisors in member countries with non-segregated (universal) systems to choose between applying existing bank capital adequacy requirements to a universal bank’s aggregate activities and “carving out” a bank’s securities trading book for application of the securities’ standards. By early 1991, this approach had not fully satisfied some member countries’ concerns that requirements imposed on banks and nonbank securities firms be broadly equivalent to avoid creating competitive distortions.

“Financial Fragility”

A number of interrelated factors have placed downward pressure on profit margins of banks in all industrial countries, albeit to differing degrees. The loss of banks’ traditional advantages in extending credit to prime corporate borrowers and in providing other financial services has undercut the once considerable value of a banking franchise. The effects of intensified competition and erosion of market share have, in many cases, been compounded by an element of greater risk taking, with an excessive concentration of exposure to certain categories of borrowers. In a number of countries, such exposures may be traced to the way the most recent credit cycle unfolded, with an extended period of rising real estate and equity prices paving the way for a sharp expansion in borrowers’ leverage ratios, and an associated miscalculation of risks by commercial bank lenders. As those prices began falling, the deteriorating quality of bank portfolios has required increasing provisions against nonperforming loans, in some cases eroding banks’ capital bases. Exposure to commercial real estate lending is now the main source of deteriorating asset quality for banks in a number of countries, following a strong expansion of such lending during the 1980s. U.S. commercial banks’ domestic property loans increased from 29 percent of assets in 1980 to 37 percent by 1989; for the United Kingdom, the share doubled to 23 percent over the same period; and it is estimated at around 17 percent (10 percent excluding the construction industry) for Japanese city banks, many of which have also engaged in substantial property lending abroad.⁹

Market response to banks’ deteriorating asset quality and low profitability has been reflected in downgraded credit ratings, a sharp fall in many banks’ stock prices, and a marked increase in their cost of tapping confidence-sensitive sources of funds. Credit downgradings were numerous in 1990, particularly in the United States and Japan. Downgradings in Europe were more limited, although there too greater competition and disintermediation—both likely to be intensified by the EC 1992 program—have affected the quality of bank assets and eroded profitability, especially in the United Kingdom. Market participants have also noted the potential risks involved in German banks’ ventures in the former German Democratic Republic; although by the end of the period under review those banks remained strong even if profit growth had decelerated.

With regard to banks’ stock prices, during 1990 shares of some major U.S. banks fell by as much as two thirds and those of Japanese banks by between 40 percent and 50 percent. Exacerbating the effects of such declines, yields on confidence-sensitive sources of bank funding, such as subordinated debt and preferred stock issues, rose significantly, particularly for major money center banks in the United States. In some cases, record premiums of up to 500 basis points over U.S. Treasury securities of comparable maturity were recorded. Partly in consequence of such developments, traditional pressures from banks’ end-of-year balance sheet window-dressing operations emerged at an unusually early stage during 1990. These actions and reactions would suggest that, despite the existence of official safety nets, there are still important elements of market discipline imposed on financial institutions.

These developments reflected a growing sense of the fragility of financial institutions during 1990, with increasing concerns that market resilience would be severely tested in the period ahead, especially if the slowdown in economic activity were to be deep, broad, and prolonged. There are also concerns that the weakness of financial institutions might limit the ability of governmental authorities to pursue preferred macroeconomic and regulatory policies, and might also render the necessary processes of restructuring less orderly. Finally, there are concerns that calls on official safety nets and potential claims on public treasuries might be significant. A clear manifestation of these concerns in the United States is given by the actual and projected deterioration in the capitalization of the deposit insurance fund of the Federal Deposit Insurance Corporation (FDIC), owing to the high number of bank failures and increase in related losses.

It is possible, of course, that observers may have exaggerated such concerns. Many major banks are now more adequately capitalized, already meeting the minimum international capital adequacy standards set for the end of 1992 (with the exception of a few U.S. and most Japanese institutions which, nonetheless, met year-end 1990 transitional requirements). Most banks now are also well provisioned against developing country exposure, and there are signs of better risk-based pricing and greater selectivity in lending. Moreover, many banks have undertaken or announced wide-ranging restructuring programs to reduce costs. While acknowledging the need for financial institutions and the regulatory framework to adapt to the new conditions, authorities in most industrial countries have tended to take the view that such adaptation would not be advanced by an easing of regulatory and supervisory standards, a position endorsed by the Basle Committee on Banking Supervision. On the contrary, there has been generally an increased emphasis on enhancing supervisory oversight, strengthening payments systems, and reassessing the role of official safety net provisions. Such an approach was, for example, evident in the February 1991 regulatory reform proposals of the U.S. Treasury Department.

Global Credit Pressures

Various pressures on both the demand and supply sides of the international capital markets have reawakened concerns about the level and allocation of world savings. Such concerns became especially prominent as international interest rates climbed over most of the past year, and as the availability of credit became constrained, even to the point where certain borrowers appeared to be subjected to non-price rationing. Fears about the deleterious consequences of a severe credit tightening were most obvious in certain domestic economies, prompted by concerns that reductions in bank lending could adversely affect economic activity if otherwise creditworthy firms could not obtain the financing needed for their current operations and if such retrenchment exacerbated declines in asset prices. Such fears, for example, underlay moves by the U.S. Federal Reserve in the latter part of 1990 to lower interest rates and reduce banks’ reserve requirements, with these measures being accompanied by official calls on banks to avoid “unwarranted” credit stringency.

Several key factors are seen to sustain the worldwide demand for funds. They are not easy to quantify, as some factors represent actual demands in the short term and have immediate effect, while others represent potential or pent-up longer-term investment requirements for broad public purposes and their effective impact is accordingly different. Undoubtedly, one major factor influencing the demand side is German unification, which, by virtue of its fiscal impact, will sharply cut into net saving in Germany. There are also the potentially significant financing demands associated with restructuring in Eastern Europe and with postwar reconstruction in the Middle East. These demands augment the continued needs of developing countries for additional resources. Large-scale privatization programs in these and other countries are also perceived to bring further pressures to bear on scarce global savings, as are environmental programs in several countries. Investment demand in some industrial countries is expected in the longer term to reflect pent-up needs to improve and replace outmoded public infrastructure and to enhance productivity in the context of changing demographic profiles.

Against these sources of present and future demand, various factors are widely perceived to be restraining the global supply of saving. While a secular decline in private saving rates appears to have halted or even reversed in some countries, demographic factors are expected to prevent any significant rebound, and public sector dissaving remains high in many countries. Compounding such factors may be constraints on bank intermediation, arising from the response by commercial banks to tighter regulatory and supervisory regimes, and in particular to more stringent capital requirements. In many cases, responses to those requirements have entailed substantial new capital-raising efforts (e.g., the large international issues of subordinated bonds by Japanese banks) and, given a rising cost of capital, contractions in assets, either in relative or absolute terms. Cross-border activity has been the prime area for such contraction, as most banks have given priority to maintaining their domestic client bases. In this context, the question has arisen of whether there is in actuality, or is bound to be, a shortfall in financing of otherwise deserving undertakings, and consequently a less-than-optimum rate of investment and output growth, because of the need (or preference) of banks to scale down asset growth.

It is this combination of large anticipated investment needs, relatively low saving, and bank lending restraint that has fueled credit crunch concerns and associated worries that optimum rates of investment and growth would not be achieved over the near term. It is possible, however, that expectations along these lines are exaggerated. The aggregate impact of privatization schemes on global capital markets, for example, is likely to be less than sometimes suggested. Experience indicates that countries with ambitious privatization programs will often still need to put into place the necessary macroeconomic, legal, and institutional preconditions for achieving programmed levels of asset sales, and that the operations which eventually do take place are likely to be less than those preannounced and will be spread over an extended period of time.¹⁰ Furthermore, privatization schemes, even when implemented, need not affect the net demand for loanable funds when they serve as a substitute for the net issuance of government debt or, as was the case with recent debt-equity conversions in Argentina, when they involve the retirement of outstanding liabilities. On the issue of bank lending restraint, some observers take further comfort in the view that disintermediation has, in fact, reduced corporate reliance on bank credit to a considerable extent. Moreover, some observers have welcomed a correction in what was generally judged to have been a disturbing earlier propensity on the part of banks to pursue asset growth for its own sake. Finally, the economic slowdown in a number of countries is in itself seen as dampening investment demands.

Despite the above qualifiers, on balance, the behavior of international interest rates over the past year, particularly at the long end of the maturity spectrum, appears to suggest that the worldwide demand for saving relative to supply remains strong. This would underscore the importance and urgency of increasing world saving, both through an acceleration of the process of fiscal consolidation, particularly in countries where fiscal deficits remain high, and through measures to encourage—or, in some cases, to remove disincentives—for greater private saving. For developing countries, the environment of tougher international competition for investment capital, together with the investor flight to quality, highlights the crucial importance of sound policies to maintain or restore creditworthiness.

Market Re-Entry of Developing Countries

Developing country borrowers attempting to regain access to spontaneous private financing in international markets clearly confront difficult obstacles. Negative market perceptions are not easy to overcome given concern about past debt-servicing performance (reflected, for example, in substantial secondary market discounts on bank claims (Chart 4)), the complexities creditors face in evaluating sovereign risk, and the absence of well-established and enforceable seniority arrangements to protect new private flows or segregate them from old claims. Nonetheless, a few highly indebted middle-income developing countries, particularly in Latin America, have in the past two years initiated a modest return to spontaneous market access, following a long period of exclusion. While limited in scope, their initial experiences raise important policy issues and provide insight into the possible features that a more general process of market reentry could take.

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Secondary Market Prices for Developing Country Loans¹

(In percent of face value)

Source: Salomon Brothers.¹ Weighted average for 15 heavily indebted countries.

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A precondition for restoring market access is the sustained implementation of appropriate adjustment policies, reinforced by structural reform efforts. For countries perceived by the market to be excessively indebted—reflected in relatively high risk-related yields on domestic and external debt instruments—such efforts can be assisted by comprehensive restructuring of the existing commercial bank debt stock, as well as by debt relief granted by official creditors. The combination of good policies and, where necessary, lower contractual debt-service burdens, can help reduce risk premiums to levels that investors do not consider so high as to denote severe and insurmountable financial weakness, and that developing country borrowers—especially private sector corporate entities—are willing and able to pay.

The perception of the risks involved in holding claims on developing country borrowers has also been reduced for certain classes of debt by a differentiation in payment policies, that is, by giving certain instruments a de facto (or expected) priority in payment and excluding them from rescheduling exercises. Thus, for example, developing countries experiencing payments difficulties on private sector debt have sought to protect flows vital to their economies, such as trade and interbank credit, by giving them priority in servicing. Some major developing country debtors have, for similar reasons, during the past two decades, continued to discharge their international bond obligations on a timely basis, despite general payments difficulties; it should be noted that such obligations typically represent a relatively small share of total debt service due.

The secondary market for developing country debt appears to have incorporated perceptions of payments priorities on different types of debt by the same sovereign borrower, with these debts trading at significantly different implicit yields. This tiering in pricing, which reflects perceptions of de facto seniority, has helped make room for new issues by private sector developing country borrowers at yields that compare favorably with (i.e., are somewhat lower than) yields implicit in secondary market prices for the old bank debt—now securitized—of their respective governments. It should be noted, however, that well-established enforceable seniority arrangements do not exist for international contracts involving sovereign risk. Prioritizing debt service on certain types of claims, either at the initiative of the debtor or by voluntary agreement with creditors, is thus essentially an informal exercise not likely to prove fully credible to all market participants.

New developing country borrowings have also been facilitated by the expanded use of specific financing techniques that seek to reduce direct country risks incurred by lenders. Careful customizing of debt issues to the needs of particular markets (timing, pricing, maturity, choice of currency, redemption clauses, etc.) is considered essential, especially when overall market conditions are tight. One technique that has been used to a significant extent by borrowers from countries with recent debt problems is collateralization. This technique provides lenders with the right to take possession of certain specified assets in the event of default; to this end, lenders usually require that taking possession and disposing of the collateral are free of operational complications and uncertainties. Collateralization has been used predominantly by developing country corporate borrowers or public sector corporations raising debt without explicit guarantees from their central governments. Various kinds of assets have been pledged as collateral, including foreign exchange receivables generated abroad, claims to assets located abroad, and commodity swaps.¹¹

Collateralization may play an important role in overcoming credit rationing and, in particular, it can serve a useful purpose for nonsovereign borrowers that are new entrants to markets and are establishing their reputations. At the same time, however, the technique does have some limitations. Potential reductions in the seniority of creditors with unsecured claims can be problematic. Difficulty can arise, for example, when newly pledged assets, such as accounts receivable, could be used to service general obligations. By earmarking such assets, the debtor in effect loses flexibility—particularly should short-term liquidity problems arise—and raises the risk of loss for other claim holders. These risks of subordination could be of particular concern to international financial institutions who hold preferred creditor status. In view of such considerations, creditors have often included negative pledge clauses in their loan contracts that may block any pledge of collateral on new contracts. A related limitation of collateralization is that its excessive use could impair, rather than improve, a borrower’s prospects for future market access on an unsecured basis. By unduly encumbering its assets through liens, a borrower may thereby significantly raise its future financing costs. The benefits of obtaining liquidity now through the pledge of collateral must thus be weighed against such future costs.

Although clearly less important than debtors’ policies and initiatives, it should be noted that, on the creditor side, regulations in industrial countries may also play a role in debtors’ return to market access. Loan-loss provisioning requirements, for example, can affect the willingness of banks to hold new debt instruments issued by countries with recent debt-servicing problems. Banks have, in fact, in recent years increased their average provisions against losses on developing country credits in response to both regulatory requirements and market pressures. While specific provisioning regulations vary from country to country, average provisioning levels against developing country exposure exceed 50 percent in all of the main creditor countries except Japan. In general, provisioning requirements are to a large extent set and determined by backward-looking factors (particularly, past debt-servicing problems), and they tend to respond with a lag to recovery in debtors’ prospects. In some countries, for example, provisioning regulations specify that loan-loss reserves must be maintained at least five years after the most recent rescheduling agreement. Consequently, while some developing countries have succeeded in restoring limited spontaneous market access, bank claims on them are, in most cases, subject to unchanged provisioning requirements. Only a few regulatory systems explicitly provide for flexibility in “graduating” a country from mandatory provisioning lists following evidence of an improvement in prospects. To the extent that the process of market re-entry progresses, increased attention will likely need to be devoted to assuring an appropriate degree of flexibility in provisioning requirements, while maintaining prudent banking practices.

A final consideration that arises from the primary role played by portfolio flows, rather than syndicated bank lending, in the process of developing countries’ market re-entry as witnessed to date concerns the catalytic role of the Fund. While syndicated bank lending packages could in some cases be mobilized as part of the overall support of the international financial community for a country’s adjustment efforts, private sector portfolio flows will usually only respond to clear changes in economic prospects of indebted countries brought about by the pursuit of appropriate financial and structural policies, that is, to circumstances that enhance the risk-adjusted yield of debt instruments relative to those available elsewhere. In this context, the catalytic role of Fund-supported adjustment programs vis-à-vis private sources of financing essentially takes the form of helping members to adopt and sustain policies that promise to restore investor confidence and establish an environment conducive to capital reflows. Flight capital, in particular, perhaps being associated with investors with a more intimate knowledge of a debtor country’s circumstances, appears to be highly responsive to confidence-building changes in policy. In Mexico, for example, the sustained implementation of adjustment efforts, including specific policy actions to remove obstacles to capital flows, together with the finalization of a commercial bank financing package, was associated with significant inflows of private capital, especially in the form of foreign direct and portfolio investment as well as capital repatriation. Among other reforms, the setting of realistic exchange rate and interest rate policies from the outset of adjustment and, as conditions permit, the lifting of capital controls can turn around investor sentiment and rebuild confidence in a country’s economic and financial prospects.

During the period under review, the importance of complementing such reforms with the liberalization of domestic financial markets has been particularly highlighted in Eastern Europe. Recent experience in Poland and elsewhere has demonstrated that a solvent and effectively supervised banking system, connected through an interbank market and supplemented by a money market and a market for claims on real assets, is a prerequisite not only for effective monetary control but also for successful privatization. Fostering such reforms is an extensive program of technical assistance being provided by the Fund to Eastern European countries, both directly and through coordinating assistance provided by various industrial country central banks.

Reassessing Official Safety Nets

The financial fragility concerns noted above have focused increasing attention on the role of official safety nets, created in all major industrial countries to promote financial stability and prevent financial disturbances from spilling over into the real economy. Safety nets, whether in the form of explicit guarantees or implicit commitments, essentially manifest recognition of the unique elements of systemic risk inherent in banking and finance and of the “public good” provided by fundamental market soundness. Official safety nets typically encompass the provision of emergency liquidity assistance by central banks and some form of depositor protection through private or official insurance. While these safety nets have undoubtedly helped to contain the broader effects of financial disturbances at times of stress, they also by their nature expose the authorities to credit risk from various sources. To contain such risk, official safety nets are increasingly viewed as constituting integrated systems, in which official guarantees extended to the system are balanced by minimum capital adequacy standards and other prudential requirements.

Recent financial problems in some major industrial countries, notably the United States, along with the increased integration of national markets and expansion of cross-border financial activities, have heightened concerns about the credit risks to which governments are exposed through official safety nets and the potential budgetary implications arising from the associated contingent liabilities. A first set of concerns, and the one currently receiving most attention in the United States, emanates essentially from the “moral hazard” dilemma. In essence, while official assistance during a financial crisis can limit adverse effects on real activity and income, the expectation that such assistance will be available may alter the behavior of economic agents in such a way as to make a future crisis more likely, for example, by encouraging excessive risk taking.¹² A second set of concerns, less evident in current public policy debates, but having important systemic implications, including within the process of economic and monetary union in the EC, arises from the fact that, despite the increased cross-national financial integration, official safety nets remain principally organized along national lines. This risks leaving inadequately addressed important questions concerning the prudential supervision of domestic institutions in foreign markets and of foreign firms in domestic markets, the participation of foreign institutions in national deposit insurance arrangements, the extension of deposit insurance to the foreign operations of domestic financial institutions, and the responsibility for providing emergency liquidity assistance to offshore markets.

On many of these questions, and most specifically on the precise conditions and circumstances under which some types of official financial assistance will be made available, the authorities in major industrial countries have remained purposely vague and ambiguous in an attempt to counter the moral hazard problem. Nevertheless, despite important differences in the explicit or de jure scope and definition of official safety nets in the major countries, their de facto application, in the relatively rare instances in which they have been called upon, has not substantially differed. Thus, for example, while deposit insurance systems in major countries vary widely (in terms of the amount of insurance provided, the institutions allowed or obliged to participate in the system, and the relative roles of private and official insurance), the authorities concerned have almost invariably taken steps vis-à-vis troubled banks to protect all depositors from loss. Notwithstanding formal limits everywhere on the size and number of deposits insured, instances in which either small or large depositors have incurred actual losses have been rare. Similarly, although the details of intervention have varied across cases, especially in regard to the extent of any joint effort between public and private entities, governmental authorities have almost never been prepared to allow the sudden failure of an important banking institution; the 1974 collapse of the Herstatt Bank in Germany is the main significant exception.

Given this similarity in the de facto extension and operation of safety nets across major industrial countries, the moral hazard and related market discipline issues, so intensely discussed over the past year in the United States, appear to be present to some extent in all systems, even where safety net provisions have not recently been called upon. No system has in practice been fully immune from a propensity by banks to misprice their credits or become overexposed to certain high-risk borrowers, hence the broader importance of efforts to ensure the cost-effectiveness of safety nets and enhance the scope of market discipline. In addition to the renewed emphasis on capital adequacy discussed below, proposals have also included tighter limits on large or concentrated credit exposures, the use of risk-based deposit insurance premiums, depositor or other private sector co-insurance plans, prompt closure rules for troubled institutions, and restrictions on banks’ asset choices. The increasingly global nature of financial markets and the resulting speed with which shocks can spread across major domestic and offshore financial centers highlights the importance of international coordination of the support efforts of major central banks.

Emphasizing Capital Strength

Previous reports in this series have provided details on the agreement on the international convergence of capital measurement and capital adequacy standards elaborated by the Basle Committee on Banking Supervision and endorsed by the Group of Ten central bank governors in July 1988. In essence, that agreement seeks to bring the recognized capital base of internationally active banks to a common minimum ratio of 8 percent of risk-weighted credit exposure by the end of 1992, with transitional arrangements and an interim standard of 7.25 percent by the end of 1990. Since its adoption, the capital adequacy accord has effectively attracted a widening group of participants. It is being implemented not only by all parties to the initial agreement (Group of Ten countries and Luxembourg) but also by virtually all countries with large international banks. For its part, the EC, in the context of its single market program, adopted directives in 1989 on bank solvency ratios and own funds that closely resemble the Basle capital accord.

The rationale for this emphasis on adequate capital has essentially been threefold. First, raising capital standards increases the proportion of a bank’s risk borne by shareholders and therefore reduces the potential benefit from high-risk, high-margin investments; that is, it reduces the moral hazard problem noted above. With more of their own money at risk, bank owners and managers are likely to evaluate more prudently the risks and benefits of portfolio choices, and a higher cushion is created between potential miscalculations and the eventual need for recourse to public safety nets. Second, higher capital requirements impose an additional market test, requiring investors to be convinced that expected returns justify the commitment of risk capital. In this sense, they can also serve to promote a shrinkage of the banking sector when this test is not deemed to be met. Third, the establishment of internationally agreed capital standards aims to promote greater competitive equality across institutions from different countries (a “leveling of the playing field”).

Experience to date in the application of the Basle capital accord provides the initial basis for assessing developments against these broad objectives. In practice, since the accord was announced, markets have, to a large extent, exercised their own discipline, putting pressure on major banks to achieve at least the 8 percent risk-weighted capital adequacy standard well before the end of the transitional period. Furthermore, as raising capital has become increasingly difficult and costly, banks facing capital strains have placed greater emphasis on curtailing asset growth, including outright asset sales and retrenchment from noncore activities, especially abroad. In addition, as the new capital requirements have become effective, banks have been induced to accord greater attention to their appropriate return on assets, engaging in more careful pricing for their new lending. This is perceived to be particularly the case for those institutions that were previously in a position to take advantage of relatively less binding domestic capital requirements.

All of these reactions, while seen by some as contributing to a slower expansion of credit by commercial banks, are generally considered to be salutary. The current consolidation appears to be part of a necessary slimming process that a world banking industry suffering from overcapacity needs to undergo. Market reactions to date are considered to be in line with the underlying objectives of the capital accord and are not generally viewed as warranting relaxation or delay in the application of the standards.¹³ The Basle Committee has for its part made it clear that it does not propose to introduce any amendments to the accord at the present juncture, and that it considers any relaxation of capital standards inappropriate.

In sum, there is a strong view among participants and officials that the domestic and international markets should and do increasingly focus on, and reward, capital strength, and that the competitive positions of internationally active financial institutions in the 1990s will hinge importantly on their comparative capital positions. Well-capitalized institutions are considered to be the best placed to establish long-term relationships, to be attractive counterparties in various financial transactions, and to expand their businesses as new market opportunities emerge.

Supervising Financial Conglomerates

Increased competitive pressures, partly attributable to official policies of financial deregulation, have in recent years intensified the trend toward concentration, diversification, and the formation of financial conglomerates. This process raises several supervisory and regulatory challenges, including practical and technical problems relating to the identification and assessment of financial risks and to the prevention of conflicts of interest. From a more general perspective, a critical problem posed by this process is the potential extension of public safety nets to a very wide range of financial, and perhaps commercial, activity. This could result from difficulties in containing financial “contagion” across the component parts of a conglomerate. Losses in one component could reduce the prudential capital underpinning other components, or erode market confidence in the conglomerate as a whole, as occurred recently in the cases of British and Commonwealth in the United Kingdom and Drexel Burnham Lambert in the United States. If, in consequence, safety nets were perceived to extend very widely across financial markets, the efficient allocation of resources across the economy could be quite significantly affected and potential calls on budgetary resources could be substantial.

Although effective supervision and regulation can serve to limit such risks, authorities have found it difficult to isolate banking from other financial services and to abstain from intervention where sizable institutions are in difficulty. There are still in practice many unanswered questions with respect to the supervision of conglomerates. In this light, the October 1990 international conference of banking supervisors concluded that, because of the variety of structures, there is no single or simple way in which the supervision of financial conglomerates can be best carried out and that some combination of approaches is therefore necessary.¹⁴ Hence, it is through the pragmatic and flexible implementation of various supervisory tools—rather than in attempts to define a broadly valid supervisory model—that the issue of the supervision of financial conglomerates will most likely be addressed in practice. These complementary approaches, despite notable limitations, include specific supervisory techniques, such as consolidated supervision and supervision based on functional (rather than institutional) criteria, the isolation of particular components of groups through administrative barriers such as “firewalls” (which restrict business relations and the movement of funds within the group) and effective cooperation and information exchanges between the supervisory authorities of a group’s component parts.

The difficulty of supervising effectively diversified financial conglomerates has contributed to interest in alternative policy approaches, including that of restricting tightly the assets in which deposit-taking entities may invest, that is, removing the depository function from conglomerate activity. An extreme version of this approach would create insured “narrow” banks, investing only in high-quality, short-term, liquid investments, and providing fee-based checking accounts and other payments services. Moving in such a direction would entail a significant change in current financial structures in all industrial countries. Experience over the past decade suggests that adaptive behavior in markets may, in practice, circumvent the intent of such tight balance sheet restrictions. Moreover, if narrow deposit-taking institutions were owned by a wider group, obvious questions would arise about their links to nonbank affiliates with uninsured liabilities.

As efforts continue to make supervision more effective in all of the areas discussed above, the main challenges will be to achieve greater safety without compromising competitiveness and innovativeness and without diverting financial activity to unregulated sectors. It may be necessary to accept substantial adjustment costs as excessive credit concentrations are unwound, longstanding franchises in banking are dismantled, and more rigorous pricing of credit and other risks become pervasive. Where possible, such costs should be allowed to fall on the private sector, and the changes in funding costs discussed earlier in this report illustrate the working of some market sanctions and disciplines. A critical consideration for policymakers, however, is that the current phase of transition in the national and international financial markets will be more smoothly effected if sound fiscal and monetary policies promote stable market conditions and financial confidence, and provide assurance that the budgetary underpinning of safety nets—when these are needed—is undoubted.