II. Global Financial Markets: Moving Up the Learning Curve

International Monetary Fund
Published Date:
September 1996
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During the last ten years, global financial markets and intermediaries have faced several costly and contagious financial crises. There have been abrupt declines in asset prices (for example, global equity markets in 1987, real estate values in the late 1980s and early 1990s, and global bond markets in 1994); major bouts of volatility in the foreign exchange markets (for example, the European exchange rate mechanism (ERM) crises in 1992-93, the dollar-yen market in early 1995); an exchange rate crisis together with a debt crisis in the emerging markets in early 1995; and a number of costly banking problems in several industrial and some key emerging market countries. In addition, there has been a string of serious, albeit nonsystemic problems in individual institutions around the world (Barings, Bank of Credit and Commerce International, Daiwa Bank, Metallgesellschaft, Orange County, and Sumitomo Corporation). Although many factors have contributed, including macroeeonomic policies and management control failures, these events appeal to have been a by-product of the transformation and restructuring of international finance that has taken place during the last ten years, including the increase in competition that accompanied the liberalization of the financial sector in most of the major industrial countries: the integration of capital markets; the increasing dominance of institutional investors: the development of new financial techniques and instruments, particularly in the derivatives area; and the growth of the emerging markets.

Both the private and the official sector were forced to learn to manage the new risks generated by the evolving financial environment. The efforts, on the part of the official sector, are clearly evident in the strengthening of the regulatory and supervisory environment in response to the significant losses sustained by many of the industrial country banking systems in the 1980s and early 1990s.1 These losses were due in large part to the increased competitive pressure that arose with the liberalization of the financial sector, which also led to rapid growth in lending, frequently in an environment of rising asset prices. The role of supervisors had been limited in the highly regulated environment, and they often lacked the experience, expertise, and authority to exert sufficient oversight and restraint as banking expanded into new products and services. The subsequent cyclical monetary contraction then produced a sharp downward revaluation in asset prices and a corresponding increase in non-performing loans.

Spurred by the cost of these crises, banking supervisors in most industrial countries made significant efforts to improve their regulatory and supervisory capability. These included allocating increased staff resources to on-site inspection, developing rigorous and early systems of classifying nonperforming credits, and obtaining greater authority to close failing institutions. The most important structural policy initiative was the 1988 Basle Accord, which raised and harmonized risk-weighted regulatory capital ratios among the Group of Ten major industrial countries. However, even before the Basle Accord was fully implemented, it became clear that the growth of the global over-the-counter (OTC) derivative business within the major banking systems was posing another challenge to bank supervisors (see Tables 13 and 15 in Annex I). The ability of international banks and securities houses to use financial engineering to alter the risk characteristics of financial instruments and to shift risk positions off their balance sheets, combined with the growing possibility to move financial activity from one jurisdiction to another, gave international banks the tools to blunt the full impact of prudential restrictions. The traditional financial policy paradigm, which sought to balance the benefits of the official financial safety net provided by the central bank with a binding regulatory structure and supervisory over-sight, had become unbalanced: the private financial sector bad retained the benefits of the safety net. but had managed to lessen the impact of prudential oversight.

A supervisory approach based on forcing compliance with a prescribed set of balance-sheet ratios no longer presented a necessary or sufficient condition for risk management of international financial intermediaries, however refined the definitions and calculations were. Instead, the members of the Basle Committee on Banking Supervision changed the focus of surveillance to ensure that banks in the Group of Ten countries had the ability to control and manage financial risk adequately. To this end. internationally active banks will be allowed to use their own internal risk-management models to estimate and control the total net loss that they could sustain during a specified number of trading days (the so-called value-at-risk methodology), with the regulatory minimum capital requirement for market risk then being determined as a multiple of the bank’s value at risk. The new methodology is creating powerful incentives for encouraging banks to improve their risk management—for the first time, successful efforts by banks to control their market risk will be directly rewarded with a lower regulatory capital ratio.

In response to the growth in cross-border exposure and the expanding participation of foreign institutions in domestic wholesale finance, authorities with responsibility for financial surveillance in the major countries also strengthened existing cooperative arrangements. The Basle Concordat, which allocates supervisory responsibilities between home and host country supervisors, has been extended to allow the host country to deny access to banking institutions from countries whose oversight over the consolidated activities of the institutions is not in keeping with the agreed minimum standards. In addition, efforts are under way in a joint forum, consisting of banking, securities, and insurance supervisors from the Group of Ten countries, to consider the issues relating to the supervision of international financial conglomerates. Furthermore, in the aftermath of the Mexican crisis concerns about the orderly resolution of sovereign debt-servicing difficulties arose, and the central hanks of the Group of Ten countries have begun to consider more orderly procedures to prevent and resolve sovereign liquidity crises. A number of private and official studies and consultative papers have served to clarify the issues concerning the modalities of orderly workout procedures for sovereign debtors.

The stability of the international banking sector was further strengthened by improvements in financial market infrastructures in the major industrial countries. Foremost among these have been the risk-reduction initiatives in the wholesale payment systems in the major industrial countries. Central banks in many of the European Union countries have initiated efforts to reduce intraday payments-related credit in net settlement systems by restructuring payment systems into real lime gross settlement (RTGS) systems with collateralized overdrafts.2 Furthermore, in the U.S. RTGS system, the risk-abatement initiatives currently in effect have taken the form of placing caps on the size of uncollateralized daylight credit and of levying charges on such overdrafts. A reduction in the intraday exposure of unsettled payments means that the failure of a single financial institution will have less of an impact on the ability of its counterparties to make good on their payments. Hence, payment system reform is viewed by the major central banks as an important component of the efforts to strengthen the market mechanism in banking and finance and as a way of achieving a reduction in the cost of the financial safety net.

Consultations with international banks in the major financial centers, with bank rating agencies, supervisors, and some of the larger corporate borrowers indicate that the international banking sector has also made progress in managing the risks it faces in the new financial environment. First, a more cautious attitude toward risk on the part of international banks can be seen in their efforts to reduce their credit risk exposures—the traditional source of banking problems and the most difficult exposure to hedge. Banks have reduced their unsecured credit exposures to other banks and financial institutions, in favor of collateralized lending through repurchase agreements. Although detailed balance sheet data are not readily available, bank rating agencies confirm that the international banking sector has become more diversified, in part because the increased securitization of bank loans has allowed banks to achieve a better geographic and sectoral distribution of their credit exposure. The management and control of the credit risk associated with their off-balance-sheet derivative positions have also been improved. It has become commonplace to mark positions to market regularly, and if necessary to ask for collateral. Moreover, major banks now undertake extensive bilateral netting of exposures with their major counterparties, which is estimated to reduce gross exposures by more than half. Most important, there also appear to be greater efforts to guard against unlikely but costly events; for example, stress-testing and simulations of the impact of a loss of liquidity in individual markets are now routine risk-management tools. All such developments represent an improvement over the situation only 18 months ago, as well as a significant change in attitude toward risk and risk management on the part of the international banking community.

Second, market participants indicated that the investment activities of the high-risk/high-return pools of institutional investment funds (macro-hedge funds, proprietary trading by the major financial houses, risk-tolerant mutual funds) have become more cautious and less aggressive. The high leveraging and rapid positioning—with the extensive use of derivatives—across international markets and currencies by this new group of market participants added considerable pressure and momentum to market movements, such as during the ERM crises in 1992-93, the 1994 bond market turbulence, and the dollar-yen market in early 1995.3 During the period 1990-94, hedge funds scored major gains and saw their capital under management grow from less than $10 billion to more than S100 billion; there are now more than 3,200 such funds. However, during the last two years, these gains have been offset by large losses. Several of the larger hedge funds and proprietary traders have curtailed, for now, their activities and re-examined their strategies; indeed, several of the more prominent funds have returned capital to their investors. What is more important, the international banking sector, which provides the credit That allows the funds to leverage their capital, also has become more conservative in managing their exposure to this sector, raising margins and collateral requirements. Their proprietary trading activity has likewise seen a retrenchment since the end of 1994.4 These changes in investment strategies appear to be reflecting both improvements in risk assessment and changes in preferences for risk taking.

Third, developments in the emerging markets in late 1995 to early 1996 represent a further example of a return to a more stable environment. Most developing countries appear to have become more cautious about relying on highly volatile short-term portfolio capital flows, and investors seem to be paying more attention to economic fundamentals when evaluating the risks of investing in emerging markets. Significant flows of capital had surged, at relatively low spreads, into many of the emerging markets during the first half of the 1990s, as a result of optimistic assessments of the borrowers’ economic prospects and yields that were relatively attractive vis-à-vis yields in industrial country markets (Table 1). Flows began to level off in 1994 with the increase in interest rates in some of the major industrial countries. The devaluation of the Mexican peso in December 1994, and the financial contagion that followed during the first quarter of 1995, produced a sharp across-the-board decline in flows to emerging markets, combined with significant market pressures on the exchange rates of several countries. Most of the emerging market countries, regardless of economic performance, felt at least some temporary effects from the changes in investor sentiment and the rebalancing of international portfolios that followed.

Table 1.Capital Flows to Developing Countries and Countries in Transition(In billions of U.S. dollars)
All developing countries
Total net capital inflows143.5154.9130.1172.9151.6193.7
Net foreign direct investment18.628.431.648.961.371.7
Net portfolio investment18.336.947.289.650.437.0
Other 26.689.651.334.539.885.3
Of which:
Net credit and loans from IMF-
Total net capital inflows123.149.832.170.581.1104.1
Net foreign direct investment9.414.314.432.741.952.4
Net portfolio investment-
Of which:
Net credit and loans from IMF-
Latin America
Total net capital inflows118.523.053.163.447.261.8
Net foreign direct investment6.611.212.813.917.717.1
Net portfolio investment17.411.417.851.617.410.0
Other 2-5.50.522.5-
Of which:
Net credit and loans from IMF1.2-1.0-1.6-0.9-1.312.9
Countries in transition
Total net capital inflows111.9-
Net foreign direct investment2.
Net portfolio investment0.8-
Of which:
Net credit and loans from IMF3.
Source: International Monetary fund, World Economic Outlook database

Not including reserve assets.

Short- and long-term trade credits; loans (including use of IMF credit); currency and deposits: and other accounts receivable and payable.

Source: International Monetary fund, World Economic Outlook database

Not including reserve assets.

Short- and long-term trade credits; loans (including use of IMF credit); currency and deposits: and other accounts receivable and payable.

After the initial overreaction to the Mexican crisis, investors began to discriminate more carefully between regions and then between countries within regions, and investment increasingly took the form of more stable, longer-term direct investment, rather than portfolio flows. For example, while net foreign direct investment in developing countries increased by 17 percent in 1995, net portfolio flows declined by 27 percent. The regional pattern and composition of flows suggest that investors have become more sensitive to economic fundamentals in host countries—the size of current account deficits in relation to foreign exchange reserves, external debt, and domestic saving: growth potential; and the soundness of the banking system. Furthermore, those segments of the international investment community—mostly institutional investors—that invested heavily in the emerging markets appear to have become more knowledgeable; the quality of country research and the availability of financial data all have improved compared to what existed in 1994. Although continued volatility in emerging market asset prices and capital flows cannot he ruled out. discussions with market participants and country authorities suggest that the risk of contagion from a disturbance in one of the major recipient countries is now thought to be lower than in 1995.

Market participants in the major industrial countries appear to be heeding the lessons from their earlier mistakes and excesses. For now. investment behavior is viewed as having become more conservative, with leveraged position-taking in the global financial system having been reduced to the levels of the late 1980s, and with banks having become more conservative in financing leverage. The developments in international financial markets discussed in the next section also offer some support for this conclusion. Furthermore, it appears that the official sector has been able to restructure financial regulations and oversight in response to changes in the environment. Finally, cooperation in the surveillance of international banking markets has been strengthened. All in all, it appears that international financial markets are now better placed to support global macroeconomic developments.


For details see International Monetary Fund (1993 and 1994) and Lindgren, Garcia, and Saal (1996).


An RTGS system is a gross settlement system in which processing and settlement take place continuously.


See International Monetary Fund (1993).


Informal estimates by market participants in late 1993 placed the size of leveraged resources of hedge funds at around $400 billion, of proprietary trading positions (that is, trading on the institution’s own account) at around $200 billion, and of the more speculative mutual funds at around $300 billion. Although there do not exist precise estimates of the volume of resources now available to these investors, industry sources suggest that their total investment resources may have declined by as much as one third.

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