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Opportunities and constraints in international lending: Implications of increased bank lending for the international monetary system

Author(s):
International Monetary Fund. External Relations Dept.
Published Date:
March 1983
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David Williams

The growth of international banking, or the narrower but better known phenomenon, the Eurocurrency markets, has been extraordinary over the last 25 years. From virtually nothing in 1957, Eurocurrency deposits, measured on a gross basis, amounted in 1982 to approximately US$2 trillion—a compound annual rate of growth of over 20 per cent.

While the year-by-year fluctuations in the rate of growth of international lending have been marked, at no time—even during the worrisome days of 1974 when a number of commercial banks became overextended in their international operations—has there been a sustained contraction. The expansion of international lending into currencies other than the U.S. dollar—in particular, the Euro-sterling, Euro-deutsche mark, and Euro-Swiss franc markets—has been a very important steadying element in the growth of international banking when conditions in some markets—particularly the dollar market—were pointing to a slowdown in growth.

There has also been a phenomenal growth in the number of financial institutions that participate in international lending. At the end of 1981 some 600 banks, from about 85 countries, were operating in countries outside the legal domicile of their headquarters. These banks controlled about 450 subsidiaries, owned a network of about 5,000 foreign branches, and had well over 1,000 direct affiliations. It is striking that much of the expansion is in countries with well-established banking systems and money market centers, such as the more highly developed countries in Europe and North America and South and East Asia.

The physical expansion of international banking is to some extent a matter of the banks following the growth of overseas trade and international investment by domestic corporations. In addition, the emergence of the main centers of international banking reflect the influence of domestic regulatory and tax considerations and, perhaps more important, the absence of domestic controls and regulations—including the application of domestic interest rate ceilings, reserve requirements, and exchange controls—on the foreign operations of banks, as well as the presence of highly efficient international communications systems. In other words, the rapid expansion of international banking can be related to a considerable extent to the privileged position of banks in their non-domestic compared with their domestic operations.

The banks have responded to the stimulus of nonregulated banking, which has provided not only a high rate of profitability compared with domestic banking but also wide scope to experiment with new financial and credit instruments, new interest rate mechanisms, and new ways of meeting customer needs and tapping financial resources. The expansion of international banking has been a major phenomenon of the last quarter of a century; with its growth, however, have come problems for the working of the monetary system—both domestic and international—that are still to be tackled.

The rapid growth of international lending has not, of course, taken place in a vacuum. Over the entire postwar period, the scale of the world economy has grown at impressive nominal annual rates. Since the mid-1950s, world trade in goods, services, and private transfers has grown at a compound rate of almost 10 per cent expressed in U.S. dollar terms. Over much of the postwar period up to 1973, the period of the long boom, very impressive rates of growth in volume terms were also recorded. International financial transactions, for which no reliable data exist, have grown at substantially higher rates. In short, despite the slower real growth rates of the 1970s, and the marked deceleration of the early 1980s, the world economy has, by historical standards, been buoyant over most of the postwar period, and recessions have generally been short-lived and comparatively shallow.

This article is a shorter version of a paper delivered at the Colloquium of the Société Universitaire Européenne de Recherches Financières in Vienna, in April 1982.

New role for banks

The growth of the international banking system has reflected the rapid growth in the world economy, and indeed can take credit for a major role in facilitating the growth in international trade and payments that has contributed so much to the unprecedented international prosperity of the postwar years. International banking has also been an important part of the development process in the Third World as well as elsewhere over much of the period. However, the system performed a similar role in the last third of the nineteenth century and the early years of this century. No doubt an efficient international financial infrastructure is a necessary condition for furthering international economic development.

But over the last decade or so, the international banks have also been performing another major function—namely, the provision of balance of payments finance on a continuing basis and on a large scale to official borrowers. Formerly, resources to meet balance of payments deficits were exchanged mainly, though not exclusively, at an intergovernmental level and entailed balance of payments adjustment. (This involved essentially domestic deflation or, in the event countries had an effective choice, given their exchange rate arrangements, a floating exchange rate—”going off the gold standard”—with an accompanying deflation of domestic demand.) The possibility of financing a balance of payments deficit from the banking system over a prolonged period was not an option that was practically available to countries prior to the 1960s.

Over the last decade, the commercial banks have become the main providers of balance of payments financing and the suppliers of international reserves to official entities. In a very real sense, the international financial system is now a network of international banks whose scale of operations is outside the direct control of the central institutional authorities that are directly responsible for keeping the system on an even keel. The question is whether self-regulation by the banks represents a sufficient control and stabilizing influence in the international monetary system.

Implications of banks’ role

During the decade of the 1970s, official holdings of foreign exchange reserves quadrupled, which is an unparalleled rate of accumulation. During this period almost one half of net current account deficits and the reserve accumulation of the smaller industrial countries and the non-oil developing countries was financed by net borrowing from banks and from the international bond market. The international banking system, centered on the main industrial countries, essentially financed the payments deficits resulting from the sharp increases in the price of oil in 1973/74, which resulted in the major oil exporting countries becoming a major source of funds in the international banking system. A subsequent reduced flow of funds from the major oil exporting countries has tended to be compensated by a renewed outflow of banking funds from the industrial countries, mainly the reserve currency centers—the counterparts of the growth and currency diversification in the Eurocurrency market and the source of the multicurrency reserve standard, which is a distinguishing feature of the present phase in the evolution of the international monetary system.

The flow of banking resources to the non-oil developing countries was until mid-1982 remarkably steady in terms of their current account deficits. The complementarity of the sources of funds underscores the demand-determined nature of the international operations of commercial banks. It also underscores the relative instability of this system of reserve creation; a slowdown in international lending will affect the ability of countries to finance their balance of payments deficits and to accumulate their desired levels of international resources—that is, a generalized shortage of liquidity could arise, which could induce disorderly external adjustment by countries.

The international operations of the commercial banks must therefore be looked at not only from the point of view of their impact on the growth of world trade and income—their traditional commercial financing functions—but also from the point of view of their effects on the development of the international monetary system as a whole and, in particular, on the stability of that system, including the process of reserve creation. To some extent, the impact of these two main functions is indistinguishable. Countries that borrow for trade and development can, and do, use those resources as holdings of international liquidity—or reserves. Indeed, it is difficult to construct a comprehensive series of uses for the resources provided by the international banks over the last 25 years, although a great deal of data exist on the maturity distribution of international bank claims and on the country distribution of debt. A significant question that needs to be answered, however, is whether the large-scale borrowing has generated, or is generating, sufficient foreign exchange earnings over the medium term to pay the interest and repay the principal as well as to stimulate reasonable domestic economic growth in the debtor countries. This question arises in particular for that part of the debt incurred as balance of payments financing, because this “transfer problem” is, in view of the extraordinarily large volume of outstanding international indebtedness, an integral part of what is now usually referred to as the balance of payments adjustment process.

Limits to international banking

In view of the pervasive and fundamental role of international banking in the world economy as purveyor and creator of international credit, issues naturally arise regarding the limits to its growth and how the system can be controlled in the interests of monetary stability. Domestic banking systems are subject to the ultimate control of central banks, which, despite their residual obligation to finance net official deficits of the government, can impose a sufficient degree of restraint on the domestic activities of the banking system to achieve the broad aims of the authorities, at least over the short term. While no similar institutional arrangements exist at the international level—and it is for consideration whether that state of affairs is in the general good—the growth of international banking is constrained over the short run by developments in the international economy itself. The banks’ responses to these developments will help determine the course of the international economy in the 1980s.

Developments in the world economy are worrisome. The rate of growth of the world economy is exceptionally sluggish, particularly as measured by postwar standards. Rates of growth of output of 1 to 2 per cent and lower have been common over the last three years, and the immediate prospect is for little improvement. The low rates of growth in output and external trade, and accompanying high rates of unemployed resources in the labor and product markets, not only make it difficult to effect structural adjustment but also induce countries to borrow abroad to help finance domestic demand, which thereby delays the adjustment process and results in acute external financial difficulties.

In addition, the widespread reliance on monetary restraint to curb the endemic inflationary pressures of the last decade has resulted in extraordinarily volatile interest rates and, recently, in very high real levels of interest rates. Volatile interest rates have been associated with—indeed have helped to induce—very high short-run variability of exchange rates between some of the leading industrial countries—the group of countries in the European Monetary System being a particularly noteworthy exception. With these developments, a shift to shorter maturities on bank loans has become noticeable, and many new forms of borrowing have been introduced in the market as a means of reducing the high effective medium-term cost of borrowing and assuring the flow of resources. Floating rate note issues, for instance, are now almost the standard form of borrowing. In addition, however, potential buyers of medium-term bonds have been tempted with bonds convertible into equities, with issues incorporating a currency swap element, with zero coupon and deep discount issues, and—shades of the 1920s—with commodity-backed financings (of which one such issue was linked to the price of gold and another to the price of oil). The high variability of exchange rates and, more particularly high interest rate levels, has significantly increased the risks, and thereby the costs, of international banking.

Another adverse factor in the current economic environment is that although the massive payments imbalances of the past few years have diminished to a considerable extent, the aggregate deficit of the non-oil developing countries (approximately $86 billion in 1980 and about $99 billion in 1981) has fallen only slightly. Massive financing will again be needed, of which, on recent past experience, about one half can be expected to come from the international banks. Without such assistance these countries would need to contract their imports on a major scale and severely curb their already inadequate rates of growth.

However, further large-scale deficits, partly financed by borrowing, will add to an already burdensome load of international debt. Total foreign indebtedness of the non-oil developing countries amounted to approximately $550 billion in 1981, which represents a compound annual rate of growth of almost 21 per cent since 1971. The ratio of debt service payments to exports of the non-oil developing countries in 1981 was approximately 23 per cent, in contrast to a ratio of approximately 17 per cent in 1978. High interest rates compound the burden of large absolute amounts of debt and worsen the current account problems of servicing it. A 1 percentage point change in interest rates in the Eurodollar market is equivalent to $2 billion in debt service to the non-oil developing countries based on their current debt. Furthermore, the conditions are spawning increasing demands for debt reschedulings on a widespread scale and thereby spread all debt over relatively long periods of time. Finally, and perhaps not unexpectedly, the general quality of debt, both official and corporate, in both the industrial countries and the developing countries, is deteriorating under the pressure of low growth, high inflation, and high real interest rates.

In short, the international banking system is facing an increasingly difficult economic environment over the short-term. The creditworthiness of some countries, and corporations, has fallen dramatically. The banking system itself is having to adapt to a new environment of considerable instability of interest rates and exchange rates, declining adequacy of capital to loan ratios, and increasing demands for debt rescheduling with consequential reductions in creditworthiness. In the light of the deterioration in the world economy and the decline in the former high rates of profitability on international lending, and taking into account the rise in bad or nonperforming assets, there is a risk that the flow of bank credit will dry up, particularly from the smaller institutions.

There are then, from a number of viewpoints, grounds for the banks to become more cautious in extending new loans. However, there is no reason for the generalized indiscriminate slowdown in international lending by the banks that has emerged during late 1982. Indeed, in the present darkening economic circumstances, it is clearly in the general interest to maintain an adequate flow of funds through the international banking system and in particular to the non-oil developing countries.

The banks and adjustment

At the same time, there is need for further balance of payments adjustment in many countries, both developed and developing. Clearly, the financing and adjustment mechanisms need to be reconciled. However, the present institutional arrangements do not assure proper reconciliation between adjustment and financing. The next phase in the evolution of the international monetary system may well be concerned with this dichotomy between the reserve-creating institutions and the reserve-controlling institutions. In the meantime, the banks themselves can take more steps to help reduce the risks of international lending and maintain some of the financial discipline associated with balance of payments adjustment.

The orderly evolution of international banking would seem to call for commercial banks to adopt formal measures of self-control. A greater collaborative effort by the leading international commercial banks would be an important stabilizing element in international banking. This effort could take a number of different forms. A system could be established to provide for a continuous exchange of information between banks in areas critical to their operations—such as the extent of the reporting bank’s involvement in each country, the maturity structure, and the amounts of credit outstanding in individual countries both in aggregate and by key sectors. The new initiatives by a number of commercial banks to establish an institute of international banking (a product of the recent Ditchley II conference) marks an important advance in international commercial bank collaboration. A comprehensive approach could be developed for the management of external financial risks, including the establishment of a country risk assessment or ratings bureau. The major commercial banks could also arrange publicly outstanding lines of credit with each other. A financial pooling arrangement through the creation of credit lines could provide the banks with an automatic short-term source of liquidity and could also encourage banks to provide stand-by facilities to their overseas branches and to smaller international banks. A further development could be the creation of an international deposit insurance, or credit guarantee fund, which would increase the confidence of depositors and reduce the risks of international lending. These are some measures that the banks themselves could initiate and put into operation.

The role of official institutions

The current overall scale of operations by the international banks attracts official concern, particularly in view of the lack of central control over the international banking system. The present decentralized system of prudential control, which rests essentially with the commercial banks themselves and secondarily with individual central banks, needs further improvement in order to safeguard the stability of the banking system and the international monetary system.

The major responsibility for virtually all the prudential aspects of international banking continues to fall on the individual commercial banks. However, since December 1974, a great deal of work has been done under the aegis of the Bank for International Settlements (BIS) in the form of the Committee on Banking Regulation and Supervisory Practices and on the surveillance of banking practices, the clarification of the relationships between local central banks, head offices and branches and affiliates of the international banks, and the systematic monitoring of international banking. Improvements to the monitoring process have included strengthening prudential control over the international banks by supervising banks’ international business on a consolidated basis and by assessing country risks better.

The formal arrangements for the supervision and surveillance of international banking are comprehensive, and the rules are reasonably fully articulated. Cooperation—if not already operational—is increasing, though it is an essentially untried method of self-control. The exchange of information between the major central banks, the inspection by central banks of—and their control over—the international operations of commercial banks is at present at a level that should, at least in theory, if not in practice, provide the central banks with an early warning system, if not the ability to avoid a crisis from developing with the inevitable need for more direct official intervention.

However, the growing scale of the foreign operations of commercial banks, which include both borrowing as well as lending, could result in circumstances in which the local central bank could not adeqately cushion all adverse strains. Under these circumstances, coordinated central bank action may be necessary to help halt a crisis or to prevent one from developing. An important example of coordinated central bank action at a time of incipient crisis was the announcement made in September 1974 by the governors of the central banks of the Group of Ten and Switzerland that they would be prepared to supply liquidity to the markets if the need arose. The significance of this action was that the major central banks created a precedent to commit liquidity to the international banking system if needed and thus acted as a major stabilizing element.

Uncertainty regarding the capacity of national central banks to stabilize the system in turn raises the question of the role of official international financial institutions, in particular the Fund. The Fund is a main source of conditional liquidity for a member in need of balance of payments financing. A Fund member has access at any time to its various facilities, provided it accepts the policies attached to their use, and the member is encouraged to use those resources earlier rather than later in its external financial difficulties. The conditional resources of the Fund can be made available only on the basis of an agreed stabilization program with the member. However, the policies relating to the implementation of a stabilization program over a period of some years are not intended, nor are they designed, to meet a sudden or emergency situation in a member’s balance of payments and reserve position. Nevertheless, there is a need to relate in some systematic fashion the processes of reserve creation, which are determined largely by the commercial banks, with policies to ensure balance of payments adjustment over reasonable periods of time, without members resorting to policies destructive of the growth of trade and payments.

The Fund and the commercial banks have an essentially complementary relationship. However, the Fund’s legal and practical responsibilities are solely to its membership, and the membership regards its relations with the Fund as sensitive and confidential. For example, these relationships would not be enhanced in the event the Fund decided to publish its reports and evaluations of members’ economic policies and prospects; there is also a limit to the amount of information that the Fund, at its initiative, could publish or otherwise make available that bears on the economic and financial performance of a member. It also follows that the Fund cannot in normal circumstances advise banks regularly on their lending activities with individual countries.

There are, of course, ways in which the Fund can and does help its members in their relations with the commercial banks. For example, there has been concern that excessive lending by commercial banks can lead to debt service problems for borrowing countries, which in turn could threaten the stability of the international banking system. In response to this concern, the Fund can play a useful role in helping to resolve crises that might arise in the servicing of bank debt, especially as they bear on the balance of payments position of members. The Fund has also, at the request of its members, advised on members’ relations with the commercial banks, including assisting in obtaining adequate information on their external financial situation. Furthermore, banks have been lending to some countries on a net basis only because the country had concluded a stabilization agreement with the Fund. In this latter respect, the commercial banks lend conditional resources to support the balance of payments adjustment effort of the borrower. The Fund itself also closely monitors developments in international banking, which includes ongoing discussions with the commercial banks, central banks, and international agencies such as the BIS and the Organization for Economic Cooperation and Development.

Under present arrangements, the Fund’s role vis-à-vis the private banks is limited. Its impact on the financial markets and the institutions that compose those markets is felt mainly, though not entirely, indirectly, through its influence on—and ability to persuade—its members. This points up a gap in the present international monetary system: namely, an absence of central control over lending by commercial banks for balance of payments purposes, which results in the creation of international reserves, and the overwhelming need to link that financing with policies for balance of payments adjustment, which the banks cannot themselves provide. This is a major challenge in the improved working of the monetary system—to make reserve creation serve the purposes of balance of payments adjustment. It is a challenge not only for the commercial banking system but also for those official international institutions charged with safeguarding the stability of the international monetary system.

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