Chapter

III Recent Supervisory and Regulatory Initiatives

Author(s):
International Monetary Fund
Published Date:
January 1992
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Financial policies in the main industrial countries have generally been structured around their domestic banking and securities industries, reflecting the stage of development of financial markets when the regimes were first put in place. As a result, many of the policy issues confronting regulatory authorities today have arisen from recent innovations that have blurred the distinction between traditional banking and securities activities and from the relatively rapid growth in international financial activities. In general, these developments have promoted competition, which in turn has improved the pricing and delivery of services. At the same time, however, the innovations in and internationalization of financing activities have weakened the performance of some financial institutions and have exposed gaps in regulatory regimes.

The main emphasis of recent policy efforts to reduce systemic risk has been an internationally coordinated strengthening of the capital base of banks and securities firms. The Basle Committee on Banking Supervision, comprising the banking supervisors of the Group of Ten countries and Luxembourg, concluded an agreement in July 1988 on risk-weighted capital adequacy standards.16 The Basle capital standards have been an important instrument in forcing more discipline into the banking markets, inducing banks to give more careful attention to the appropriate pricing of risk for different activities. Moreover, efforts are under way to harmonize the capital requirements of banks and securities firms through negotiations between the Technical Committee of the International Organization of Securities Commissions (IOSCO) and the Basle Committee.

While the authorities’ efforts have alleviated some of the pressures on regulatory regimes, others remain, as evidenced by several recent developments. The closure of the Bank of Credit and Commerce International (BCCI) in July 1991 both exposed gaps in the supervision of banks’ foreign establishments and illustrated some of the shortcomings of the Basle Accord. These include the need to consider market risks and large credit exposures when evaluating the soundness of banks. In addition, authorities in some countries are contemplating the relaxation of legal restrictions on permissible banking activities, particularly those that separate banking from securities activities, since recent innovations have worked to undermine these barriers.

As banks have scaled back their lending to developing countries in the 1980s and early 1990s, and as cross-border banking activity fell sharply in 1991, it has become increasingly important to reduce impediments to international securities flows to enable these flows to compensate for disruptions in cross-border banking. For example, authorities have examined the scope for harmonizing disclosure requirements as a way of reducing the cost of marketing securities across borders. Moreover, there were several instances of security market manipulation in 1991 that, if left unchecked, would reduce the efficiency of these markets.

Recent events have also focused attention on the risks in payments, clearance, and settlement systems. First, the closure of BCCI exposed a Japanese bank to a significant loss through the operation of the dollar payment system, despite the relevant national authorities’ efforts to time the closure to avoid any such disruption. Second, the global collapse in equity prices in October 1987 was followed by several initiatives to strengthen the clearance and settlement systems in securities and derivatives markets. Many of these reforms are due to be implemented by the end of 1992.

International Capital Adequacy Standards for Banks

The weak capital positions of the major international banks in the early 1980s (Table 2) and concerns about international differences in capital requirements and in the definition of capital led the Basle Committee on Banking Supervision to conclude an agreement on risk-weighted capital adequacy standards. The Accord sought to strengthen banks against potential losses—mainly through a systematic treatment of credit (default) risk and the extension of capital requirements to some off-balance sheet exposures—while reducing competitive inequalities arising from differences in notional standards. The major features of the Basle Accord are summarized in Box 3.

Table 2.Capital/Asset Ratios of Banks in Selected Industrial Countries1(In percent)
1981198219831984198519861987198819891990
United States
Commercial banks5.835.876.006.146.206.196.026.286.216.46
Large commercial banks4.634.724.975.245.355.515.185.585.435.73
Japan
Commercial banks2.392.342.342.242.342.292.482.752.973.18
Large commercial banks1.911.871.901.801.951.912.182.492.702.93
Germany
Commercial banks3.984.044.023.934.244.584.764.584.875.05
Large commercial banks3.994.064.043.984.424.794.994.695.175.18
France
Commercial banks and credit cooperatives2.722.522.392.352.422.712.552.722.843.22
Large commercial banks2.211.991.861.721.912.201.912.162.192.56
Italy
Commercial banks5.285.646.257.056.866.356.91
Large commercial banks3.854.244.936.135.955.456.26
United Kingdom
Commercial banks4.004.525.235.435.784.894.67
Large commercial banks6.506.406.706.307.908.408.208.908.007.50
Canada
Commercial banks3.513.684.124.494.655.205.035.405.465.65
Netherlands
Commercial banks3.153.313.403.473.743.974.304.214.374.37
Sweden
Commercial loans1.481.371.321.381.361.291.381.421.531.66
Switzerland
All banks6.115.995.855.826.116.256.336.336.486.46
Large commercial banks5.785.585.445.385.906.016.096.136.506.34
Belgium
Commercial banks2.442.392.512.522.512.872.933.063.393.40
Luxembourg
Commercial banks2.943.023.203.293.473.483.373.293.203.21

Box 3Basle Accord

Background

International banks in the 1980s faced several challenges that jeopardized their profitability and accumulated capital, exposing governments to greater risks through their official safety nets for banks. Specifically, a number of institutions had significant loan exposures to heavily indebted developing countries that were experiencing debt-servicing difficulties, while differences among major industrial countries in the stringency of capital requirements created competitive inequalities among internationally active banks. More generally, banks operated in increasingly competitive markets for financial services fostered by the process of financial liberalization and innovation.

Against this background, the Basle Committee on Banking Supervision in 1986 proposed an initial plan to link common minimum capital requirements for international banks to their credit risk exposures, including both on- and off-balance sheet exposures. In March 1987, the United States and the United Kingdom reached agreement on the common definition of capital adequacy and, in June 1987, Japan joined them. The consensus was subsequently broadened after extensive discussions among the Group of Ten countries, culminating in the Basle Accord reached in July 1988.

Provisions

The Accord calls for a minimum 8 percent ratio of recognized capital to risk-weighted credit exposures by the end of 1992. At least half the recognized capital must be in the form of “core” (tier-1) capital, including common stock, noncumulative preferred stock,1 and disclosed reserves. The remainder, termed “supplementary” (tier-2) capital, includes such components as undisclosed reserves, general loan-loss provisions, asset revaluation reserves, hybrid capital instruments, and subordinated debt. The specific items recognized as tier-2 capital by individual national authorities varies, however subordinated debt is limited by the Accord to 50 percent of tier-2 capital. As an interim standard to be met by the end of 1990, the minimum ratios were set at 7.25 percent and 3.62 percent for total and tier-1 capital, respectively.

Assigned to five broad categories of relative riskiness, credit exposures are given weights ranging from zero to 100 percent. Loans to OECD/GAB official borrowers, for example, attract a zero risk weight, while claims on banks incorporated in OECD/GAB countries and interbank claims involving other countries and maturing in less than one year receive a 20 percent weight.2 Residential mortgages carry a 50 percent weight. Foreign currency loans to non-OECD/GAB governments and credits to commercial enterprises receive a 100 percent weight. Off-balance sheet items are first converted to on-balance sheet equivalents and then subjected to the standard risk weights.

Amendment to the Accord

An issue left outstanding by the Basle Accord was the precise definition of general and specific provisions and general loan-loss reserves. A November 1991 amendment to the Accord seeks to resolve this issue.3 The amendment is designed to prevent the inclusion of specific loan-loss reserves in general loan-loss provisions and thereby to make “earmarked” reserves ineligible for tier-2 capital.

General provisions or reserves can qualify as tier-2 capital only if they do not reflect a known deterioration in the value of assets. Provisions or reserves created against a specific loss or known deterioration in asset values are ineligible. The definitional problem arose because the laws in a number of countries party to the agreement prohibit making provisions against unidentified, future losses. In addition, the amendment reduced the transitional ceiling on general provisions and reserves to 1.5 percent of risk-weighted assets from 2 percent. The final ceiling of 1.25 percent was unaltered.

The Banker’s Perspective

Among banks recently surveyed by Price Water-house,4 several expressed dissatisfaction with the broad categorizations of credit risk employed in the Accord. Particularly troublesome was the differential treatment between OECD/GAB and non-OECD/GAB countries regarding the risk weights applied to credit exposures to central governments, public sector entities, and banks—a concern shared by authorities in some non-OECD/ GAB countries. Other problem areas were the 100 percent weight applied to all commercial loans, some of which have higher credit ratings than bank debt carrying only a 20 percent risk weight, and the intercountry differences regarding the discretionary elements of tier-2 capital.

1Undeclared dividends on noncumulative preferred stock cannot be accumulated and paid at a later date, as with cumulative preferred stock.2The OECD/GAB classification refers to countries either that are full members of the Organization for Economic Cooperation and Development (OECD) or that have concluded special lending arrangements with the International Monetary Fund associated with the General Arrangements to Borrow (GAB).3Basle Committee on Banking Supervision (1991b).4Price Waterhouse World Regulatory Advisory Practice (1991).

Implementation of the Accord

Implementation of the Accord through legislative changes or binding guidelines issued by regulatory authorities is now complete within the Group of Ten countries.17 Other countries and regions to implement the Accord include Australia, Austria, Denmark, Finland, Hong Kong, Indonesia, Ireland, Israel, Malawi, Malaysia, Morocco, New Zealand, Nigeria, Norway, Portugal, Saudi Arabia, Thailand, and Turkey.18 Greece, Luxembourg, and Spain are in the process of implementing the EC directives on bank capital adequacy—the Own Funds Directive and the Solvency Ratio Directive—which generally conform to the standards of the Accord.19

Spurred by market pressures, most large international banks have responded by meeting the final capital standards well before their entry into effect under the Accord.20 This strengthening of capital positions has occurred despite the decline in bank earnings and in asset quality in several countries, particularly the United States, Japan, and the United Kingdom. To meet the minimum standards, however, banks in several countries have needed to raise additional capital or to change their asset portfolios, or both. While curbing new lending to businesses and households, U.S. banks in 1990-91 have raised significant amounts of tier-1 and tier-2 capital through equity and, to a lesser extent, bond issues.21 At the same time, large U.K. banks shifted the composition of their assets to those with lower risk weights so as to maintain their risk-adjusted capital ratios despite a small reduction in capital.

Japanese banks have long enjoyed substantial revaluation reserves in the form of unrealized capital gains on their long-term equity investments. Under the Accord, banks are permitted to count 45 percent of such unrealized capital gains on securities (but not on real estate) as tier-2 capital. However, a decline in the Nikkei stock index in excess of 50 percent over the past two years has significantly eroded such capital, and Japanese banks have been forced to issue subordinated debt. Despite this effort, several major Japanese banks have been pushed near the 8 percent target of the Accord, while one bank has yet to attain the prescribed ratio. Furthermore, some institutions are now constrained by the requirement that subordinated debt not exceed 50 percent of tier-1 capital. Hence, for these institutions, options are to raise equity (tier-1 capital), or upper tier-2 capital, or to reduce risk-adjusted assets by selling securities, reducing interbank exposure, and disposing of assets carrying 100 percent risk weights. In fact, the unprecedented decline in cross-border banking activity in 1991 can largely be accounted for by a retrenchment of Japanese banks in the interbank market, presumably reflecting efforts to preserve capital.

Policy Issues Relating to the Accord

The Accord has received much attention over the past year mainly because in certain countries, most notably the United States, Japan, and the United Kingdom, the strengthening of capital positions has coincided with concern about a tightening of bank credit conditions. This has naturally raised the issue of whether it would be advisable to relax the Basle standards to give a boost to bank lending.

In considering the issue, four factors must be taken into account. First, evidence on the existence of a “credit crunch” is not clear cut.22 It has proved difficult to isolate the effects of shifts in the supply of credit from shifts in demand; the demand for credit in these countries will have been depressed by the recession or growth slowdown, as well as by the recognition by businesses and households that existing levels of indebtedness require correction.23 Second, focusing on bank credit can lead to an inaccurate indication of overall credit availability given the substitutes that exist for some types of bank loans; commercial paper and bonds are prime examples of such substitutes. Even for businesses with no access to money and securities markets and for households, an alternative to bank credit often exists in the form of lending by finance companies.24 Third, a decline in bank lending may also partially reflect a secular trend of borrowers’ drifting into securities markets. Finally, and most important, even if the Basle standards are acting at the margin to decrease the supply and to increase the cost of bank credit, this would need to be weighed against the more substantial longer-term benefits of increased soundness of banking practice and of reduced competitive inequities. For these reasons, authorities in industrial countries argue that weakness in economic activity, together with a deceleration in bank lending, should not be taken as a justification for relaxing or fine-tuning the Basle capital standards. The evidence seems to indicate that the Accord has been inducing banks to give more careful attention both to the pricing of risks associated with different kinds of lending activity and to the need to hold adequate capital against these risks. It is therefore doing what it was intended to do. As the industrial economies rebound and as more sustainable balance-sheet positions are restored, prospects for making good-quality bank loans should improve.

This being said, one related issue merits both close attention and further investigation: the role of the capital standards, combined with the steep decline in Japanese equity prices and real estate values, in the large reported contraction in the cross-border interbank market.25 Volume in this market fell by an unprecedented $154 billion in 1991 (apparently largely reflecting the retrenchment of Japanese banks). This decline raises some concern because it could compromise liquidity in the international banking system and cause difficulty for banks facing short-term liquidity needs.

As mentioned above, the closure of BCCI in July 1991 has also focused attention on some gaps in coverage of the Accord. A June 1991 Price Water-house report commissioned by the Bank of England revealed large scale fraud at BCCI going back several years and highlighted two specific developments that precipitated the troubles at BCCI.26 First, the bank’s treasury operations from 1977 to 1985 sustained dealing losses totaling an estimated $600 million to $700 million (excluding interest) and, second, the bank had an exposure of more than $700 million to a single borrower with close ties to the bank’s management.27 Neither the “market risks” undertaken by the bank’s treasury nor the large credit exposure is covered by the Accord.

Since the Accord focused mainly on credit risk, the Basle Committee has been seeking to broaden its coverage to include various types of “market risks”—foreign exchange risk, interest rate risk, and position risk in traded equity securities.28 Banks’ exposure to such risk has increased in recent years as interest rates and capital controls have been liberalized and permissible banking activities expanded. Of the three types of risk, proposals for dealing with foreign exchange risk are the most advanced. The aim is to set capital requirements on banks’ open foreign currency positions. One of the main difficulties in this area is measuring foreign exchange risk in a portfolio of foreign currency positions, which requires some allowance for correlation among currency movements.

In principle, the risk can be measured, by reference to portfolio theory, using historical exchange rate volatilities and correlations between exchange rate pairs. However, to ease the computational burdens of the scheme, the Committee has developed a proxy measure that tracks the foreign exchange risk of international banks. Using sample data provided by banks, the Committee then gauged the appropriate capital charges for that risk measure.

The treatment of overall exposure to interest rate risk raises complex measurement issues that the Committee has not fully resolved. Nevertheless, it has summarized the broad elements of an adequate measurement system that reflect current market practices. The aim is to derive a single-number indicator of interest rate risk that is simple to calculate. However, there is as yet no consensus regarding the specifics. Finally, with respect to the treatment of interest-bearing securities in banks’ trading portfolios, the Committee is aiming for convergence with securities regulators, while maintaining consistency with the international system for bank capital adequacy.

The Committee is also working on strengthening the current capital framework with regard to position risk in traded equities. The Accord currently does not distinguish between the risk in a single equity and the risk of a broad market movement, and it is not entirely consistent with capital requirements currently applied to securities activities. The Committee’s basic approach is a two-tier calculation that would replace the current capital charges for equities. In principle, the scheme attempts to capture both the risk in a specific equity and the risk of a broad market move. The Committee proposed 50 percent risk weights for the gross portfolio positions (long and short) and a 100 percent weight for the net position of a diversified book of highly liquid equities. These weights correspond to minimum capital requirements of 4 percent and 8 percent, respectively.29 This two-tier approach was recently accepted by the Technical Committee of the IOSCO (see the discussion below). Many issues remain unresolved, however, including the appropriate risk weights for gross and net positions.

Recognizing that diversification is a key principle in banking, the Basle Committee issued a paper in January 1991 intended as a guide to “best practices” for bank supervisors in the monitoring and control of large credit exposures.30 The paper suggests that a sound supervisory system would consist of the following key elements: (1) a definition of a credit exposure that encompasses both standard forms of lending, and on- and off-balance sheet positions that may be subject to counterparty defaults; (2) a definition of a counterparty that is sufficiently broad to include entities related to the borrower in such a way that failure of one is likely to involve failure of the others;31 and (3) a limit of not more than 25 percent of a banking group’s capital on the group’s exposure to a consolidated private sector counterparty, together with a lower threshold of not more than 10 percent of capital for reporting large exposures.

Effectiveness of the Accord in Reducing Systemic Risk

Although efforts to strengthen the capital base of banks have undoubtedly curbed their on-balance sheet lending, the overall reduction in systemic risk has been attenuated by the increasing risks associated with an expansion in off-balance sheet activity in derivatives and in other transactions that result in contingent claims on the banking system and, in particular, wholesale institutions. Capital requirements act as a constraint on specific activities of banks; as such, it is perhaps not surprising that they have induced banks to move into activities that are less constrained. Recent attempts to apply capital requirements to off-balance sheet activities have elicited another response: the growing use of “netting” of off-balance sheet positions—most prominently in the banks’ swap books—so as to reduce the base against which capital requirements are figured.

In the end, it is difficult to map out the desired evolution of capital standards without taking a view on both the acceptable exposure to systemic risk and the appropriate scope of the wholesale banking activities. For example, rigorous application of capital standards to the off-balance sheet activities of wholesale banks, particularly to netting arrangements, may well cause such business to migrate to the organized futures exchanges, depriving banks of what is easily their most important source of fee income and accelerating the transition to a smaller wholesale banking system. But it would also reduce systemic risk because the organized futures exchanges have in place strong mechanisms for internalizing risk (namely, margin requirements, day-to-day marking to market of net positions, and guarantees of net positions by the exchange itself based on its own capital) that have no direct counterpart in bank operations, and because (in the absence of an outside party who guarantees net positions) it is gross rather than net exposure of banks in the swap market that is the relevant indicator of risk. The ability of the Accord to produce a level playing field is limited by the differences that still exist in national financial safety nets and in accounting procedures. Differences across countries in deposit insurance and in implicit liquidity and solvency guarantees imply that the cost of capital to banks remains unequal among countries. Differences in accounting procedures make it more difficult to determine true (as opposed to measured) differences in capital across countries.

Other Issues on the Supervision and Regulation of Banks

Supervision of Banks’ Foreign Establishments

The internationalization of financial markets is posing a particularly serious challenge for supervisors since it undermines the ability of domestic jurisdictions to enforce domestic regulations in domestic markets. The event that has served most to focus attention on gaps in the supervision of banks’ foreign establishment was the closure of BCCI in July 1991. It is worth noting at the outset that, although the bank was active in 70 countries, BCCI’s closure had a minimal systemic impact on the international banking system.32

An important factor in the demise of BCCI was the lack of consolidated home-country supervision.33 The parent holding company was chartered and nominally headquartered in Luxembourg, but its London offices served as operational headquarters. Much of its activities were channeled through its two largest banking subsidiaries—chartered in Luxembourg and the Cayman Islands. Since under Luxembourg law, holding companies are not subject to supervision, BCCI was able to avoid being responsible to a single supervisory authority because of its complex corporate structure.

An early agreement among Group of Ten authorities, working through the Basle Committee on Banking Supervision, was the Basle Concordat of 1975 that had assigned responsibility for supervising the solvency of foreign branches to the home country, while the host country would supervise foreign subsidiaries and joint ventures. In addition, parent authorities were to take account of the exposure of domestic banks to their foreign subsidiaries and joint ventures.34 To clarify the somewhat ambiguous phrasing of the Concordat with respect to foreign subsidiaries and joint ventures, the BIS Governors in 1978 endorsed the Basle Committee’s proposal that banks’ capital adequacy should be subject to consolidated supervision, inclusive of foreign branches and subsidiaries. Nevertheless, events such as the problems of Banco Ambrosiano Holding in 1982 indicated that significant gaps in supervision remained.35

The Concordat was revised in 1983 to include the principle of consolidated supervision and to identify ways of avoiding gaps that may arise as a result of inadequately supervised holding companies. The revised Concordat emphasized the importance of ongoing contact and collaboration between supervisors in bridging gaps in supervision. Despite the efforts of the Committee, however, there remained relatively little flow of information between supervisors, apart from initial contacts when foreign establishments were formed.

Recognizing the importance of practical collaboration, the Committee, in conjunction with the Offshore Group of Banking Supervisors, developed a series of recommendations to encourage more regular and structured contacts between supervisors. These guidelines, published as a supplement to the Concordat in April 1990, aimed to implement those aspects of the 1983 Concordat that require information flows between supervisory authorities and, in particular, to strengthen consolidated supervision.36 The supplement outlined the information needs of both parent and host authorities and urged the authorities to use contacts when authorization is given to open a foreign establishment to create a basis for future collaboration between them. It also recommended the removal of certain secrecy constraints that would enable national supervisors to exchange information, subject to strict confidentiality conditions, and emphasized the importance of sound international standards for external audits.

Despite the Committee’s work to ensure that no foreign banking establishment escapes supervision and that such supervision is adequate, the BCCI closure focused attention on the issue of how to strengthen supervision of banks’ foreign operations when home-country supervision is not adequate. While the importance given in the Concordat to comprehensive consolidation techniques and to adequate exchange of information between home and host regulatory authorities remains beyond dispute, the limited effectiveness in the BCCI case has induced deliberations and policy adaptations to strengthen the supervision and regulation of international banks.

Several approaches are under consideration, including measures by host countries to impose sanctions on home countries that do not adequately supervise their banks. For example, the EC is considering a scheme that would give a stronger incentive for home countries in the EC to supervise their banks’ foreign operations, by requiring that any insured EC deposit losses, including those incurred in foreign branches, be paid by the home country. Similarly, in the United States, new legislation—passed by the U.S. Congress in November 1991—bars any bank from operating in the United States that is not subject to firm, consolidated home-country supervision, including foreign banks that have already obtained U.S. charters. The new law also gives the Federal Reserve Board broad powers to supervise both state and federally chartered foreign banks and requires that foreign banks conduct retail operations through separately capitalized subsidiaries rather than branches.37 While the U.S. measures will tend to reduce the value of bank charters in lightly regulated jurisdictions, they represent a step away from the home-country principle of the Basle Concordat toward a host-country rule. This, in turn, has raised legitimate concerns that reversion to a host-country orientation for bank supervision, if widely adopted, might prove ultimately to be inconsistent with maintaining progress toward liberalization in financial services.

Permissible Banking Activities

The range of permissible banking activities varies considerably across countries. Those that permit the widest range of activities are the universal banking systems in Germany, the Netherlands, and Switzerland where banks can engage in not only traditional banking activities, such as deposit taking and lending, but also securities and insurance activities. There are no holding companies and separate subsidiaries are used at the convenience of banks or when required by foreign regulatory authorities. The more restrictive systems are those that erect legal barriers between traditional banking activities and other types of financial services as in the United States and Japan.

Countries with more restrictive systems have been examining ways to liberalize the permissible activities of banks or bank-holding companies in recent years. In Japan, two Ministry of Finance advisory councils recently considered proposals for modifying the legal separation of commercial and investment banking. The Securities and Exchange Council and Financial Systems Research Council (FSRC) have considered several alternative structures for the Japanese financial system, including those used in Canada and Germany.38 While the two councils examined different aspects of reform, they both envisioned that commercial banks would be allowed to underwrite private securities but not to retail securities to the public. The entry of banks into the securities industry would be made only through separately capitalized subsidiaries and with thick firewalls between the securities subsidiaries and parent banks. These barriers would be designed to restrict the exchange of information and personnel and thus to limit conflicts of interest. The Diet passed this reform package in June 1992.

In the United States, the administration proposed a comprehensive overhaul of the U.S. banking system that, inter alia, would have allowed banks to affiliate with securities firms and insurance companies within a financial-service holding company and permitted banks to branch nationwide. These measures were intended to improve the competitiveness and long-term profitability of the U.S. banking industry. The proposal also would have expanded the borrowing authority of the Federal Deposit Insurance Corporation (FDIC), required banking regulators to implement prompt corrective actions for undercapitalized banks, and rolled back the too-big-to-fail doctrine by limiting the circumstances under which uninsured deposits are protected.39 In the event, the Congress did not pass the administration’s bill. In its place was passed a measure that replenished the deposit insurance fund, strengthened banking regulations, and curbed deposit insurance coverage (see below).

Deposit Insurance Schemes

Deposit insurance schemes generally aim to protect the investments of retail depositors who are less able than wholesale depositors to judge the creditworthiness of banks. All countries with such schemes, for example, place limits on the value of deposits covered by their guarantees. These ceilings in industrial countries range from about $15,000 in Belgium to over $650,000 in Italy. However, despite these formal limits, the banking authorities in most industrial countries have at times taken steps to protect all depositors from losses due to bank failures. As a result, the number of instances in which either retail or wholesale depositors have actually incurred losses is few.40

As mentioned above, the U.S. Congress in November 1991 passed a “narrow” banking bill that replenished the insolvent Bank Insurance Fund and, at the same time, implemented measures to strengthen banking supervision and to roll back the too-big-to-fail doctrine.41 The bill authorizes the FDIC to borrow up to $70 billion from the U.S. Treasury, $25 billion to absorb losses and the remainder in working capital secured by assets seized from failed banks. The $25 billion is to be repaid over 15 years from higher insurance premiums charged to banks. Recourse to taxpayer funds is not expected at present.

To strengthen banking supervision, the bill mandates a sequence of prompt corrective action to be undertaken by bank supervisors and triggered by diminishing levels of bank capital. This sequence includes suspension of dividend payments, restrictions on asset growth, and limits on management compensation. Bank supervisors are also required to initiate the closure of a failing bank if its capital drops below 2 percent of risk-adjusted capital.

In addition to the above measures, the bill stipulates that beginning in 1994 the FDIC must undertake the least costly resolution of a failed bank with one exception: the Treasury Secretary could determine—in consultation with the Federal Reserve Board and the FDIC—that the failure of a particular bank posed a “systemic risk.” In such cases, the FDIC could protect all deposits, including those not explicitly covered by the insurance scheme. This measure aims to roll back the too-big-to-fail doctrine by placing such decisions in the political arena.

Regulation and Supervision of Securities Activities

Similar to banks, securities firms are subject to capital regulations that seek to ensure that these institutions can withstand periods of extreme market volatility or failure of a large institution. However, because of differences in the main sources of risk, credit versus market risk, the setting of capital standards for banks and securities firms has differed fundamentally. In addition, and in contrast to banks, securities activities are subject to extensive public disclosure requirements to protect investors from fraud and to ensure an efficient allocation of capital. Disclosure standards are also supplemented by other regulations aimed at preventing specific market abuses.

International Capital Adequacy Standards

Capital adequacy standards for securities firms have generally stipulated that recognized capital must exceed a given percentage of their indebtedness. For example, in the United States, the basic standard is 6⅔ percent of senior obligations or, under an alternative, 2 percent of total debt. Recognized capital typically included not only shareholder equity and subordinated debt of sufficient maturity, but also short-term subordinated debt used to fund underwriting and other extraordinary activities and certain accrued liabilities payable at the discretion of the firm.

The standards often required, however, deductions from capital to reflect the liquidity or market risk of securities. An illiquid asset, for example, may have required a 100 percent capital charge, while marketable assets that were not hedged were generally subject to fractional charges or “haircuts” that reflected the historical price volatilities of bonds, equities, and other securities. In the United States, the haircuts range from zero percent for treasury bills to 30 percent for corporate equities under the basic standard or 15 percent under the alternative.

In September 1991, the Technical Committee of the IOSCO forwarded to the Basle Committee a memorandum summarizing its members’ positions on establishing common, minimum capital standards for internationally active securities firms and banks. The memorandum states the Technical Committee’s willingness to conclude an agreement with the Basle Committee that would establish an international standard for position risk requirements and a definition of permitted regulatory capital.

Departing from the traditional capital adequacy standards for securities firms that capture both credit and market risk in a single, comprehensive weight, the Technical Committee backed the Basle Committee’s “building-block” approach that separates credit risk from market risk. With respect to position risk for debt securities, all members of the Technical Committee were prepared to accept and implement the building-block methodology, albeit with some changes to the Basle Committee proposals.

The Technical Committee’s members, however, differed on the acceptability of the building-block approach for traded equities. The Japan Securities Bureau indicated that it preferred to retain its newly introduced capital adequacy rules based on the traditional, comprehensive approach. Meanwhile, the U.S. Securities and Exchange Commission (SEC), while supporting the building-block approach as a means of expressing a minimum standard, said it would retain its current set of rules for traded equities.

Despite the differences, the Technical Committee’s members agreed that there should be an internationally agreed minimum capital standard for traded equities. A majority of the Committee agreed that this standard, expressed in terms of the building-block methodology, should be 4 percent for gross positions (both long and short) and 8 percent for the net position (for diversified portfolios of highly liquid equities), although some countries preferred higher and others lower figures. Regarding the standard’s implementation, the Committee recommended that all securities regulators agree either (1) to adopt minimum haircuts for equities, if using the building-block methodology or (2) if not implementing that methodology, to adopt haircut requirements that, in the aggregate, are no less stringent than those required by the building-block approach.

The Technical Committee and the Basle Committee for the first time held a joint meeting in January 1992 to examine proposed minimum capital standards covering the securities activities of internationally active banks and securities firms.42 The meeting resulted in preliminary understandings on several of the key issues.43 First, the building-block methodology would be used to establish capital standards for traded debt securities. Second, the building-block methodology would also be used for traded equity securities. Those securities supervisors that have long successfully applied the comprehensive methodology, however, could continue to do so. Any supervisors using the comprehensive approach would undertake to show that its application yielded capital requirements that were consistently equal to or greater than the capital that would be required under the building-block approach. Third, progress was made in reaching mutually acceptable definitions of capital, particularly with regard to subordinated debt.

Multilateral Disclosures and International Security Offers

In view of the growing importance of international security offers, IOSCO has established a Working Party to identify the major impediments to such offers. This group in a 1989 report identified several key obstacles, placing particular emphasis on the need to harmonize public disclosure requirements and accounting standards.44 One consequence of the lack of harmonization is recourse to private placements in international security offers. While less costly than public offers, private placements do not benefit from the fuller disclosures associated with public offers and may be feasible only for corporations with exceptionally strong financial positions.

Most industrial countries require firms with widely held securities to make certain public disclosures using generally accepted accounting principles, as a means of protecting investors from fraud and ensuring efficient pricing in primary and secondary markets. When a public offer is made, an issuer must generally file a prospectus with the relevant supervisory or listing authority, or both, detailing its financial history and prospects. In addition, a public offer generally entails a continuing obligation to make periodic financial disclosures; however, disclosure regimes and accounting standards differ significantly across countries.45

Progress in harmonizing disclosure requirements has been achieved within the EC. The EC directives in this area—the Listing Particulars Directive and Public Offers Directive—stipulate the general contents of public disclosures that must be made when securities are admitted to official listing on a stock exchange or are offered to the public.46 These directives as currently amended also provide for the mutual recognition of public disclosures, provided that they are approved by the competent authorities in the other EC country in which the securities are being officially listed or publicly offered.47

The International Accounting Standards Committee (IASC), in cooperation with national standard setting bodies and the European Commission, is also working to achieve greater comparability of financial statements across countries through the harmonization of accounting standards.48 IASC has issued 31 standards dealing with most of the topics that affect the financial statements of corporations that issue securities on international capital markets. The committee aims by the end of 1992, to eliminate most of the choices of accounting treatment for like transactions and events that are currently permitted by International Accounting Standards.

Ensuring the Integrity of Securities Markets

Whatever the advances in technology and in the range of services available to participants, financial markets cannot be said to have evolved to a higher plane unless the integrity of those markets—that is, the protection afforded to investors—is maintained.49 Unfortunately, 1991 was marked by a number of disturbing developments in financial markets. In addition to the closure in July 1991 of BCCI, discussed above, there were a number of problems in securities markets, including the admission in June 1991 that several Japanese securities firms had paid loss compensation to favored investors (primarily large institutions); the allegations in June and August 1991 of insider trading on the Frankfurt Stock Exchange by traders at two large German banks; and the admission by Salomon Brothers in August 1991 of violating rules governing auctions of U.S. Treasury securities. This section analyzes these recent problems and discusses the policy issues raised by the difficulties. Moreover, this section also investigates whether there is a common thread running through the problems and summarizes the policy actions taken in their wake to minimize the chances of a recurrence.

Box 4Market-Based Financial Discipline

Most discussions of financial crises, failures, and misbehavior emphasize the authorities’ responsibility in regulating financial markets and institutions. What role can market forces play in this regard? Financial markets allow economic units to maintain temporary imbalances between their receipts and payments but need discipline to keep some units from following unsustainable paths—such as borrowing without the means or even the intention of repaying.

Market discipline works in two stages: as a borrower begins to incur debts that can only be serviced with difficulty, the lender’s response is first to require a higher interest rate to compensate for the increased risk of default and eventually to exclude the borrower from further borrowing, thereby depriving the borrower of the benefits of access to the markets.1

Failures of market discipline often provide the rationale for regulatory action, but policies intended to regulate financial institutions or to protect their customers may either strengthen or weaken the discipline imposed by financial markets. It is important that such intervention be carried out in a way that does not weaken market discipline further.

Market discipline requires that financial markets provide appropriate signals and constraints to induce borrowers to behave in a manner consistent with solvency. If a borrower starts on a path of borrowing that may turn out to be unsustainable, lenders must respond first by requiring a higher interest rate spread to compensate them for the increased default risk that this path entails.2 The higher interest rate, however, itself increases the debt burden on the borrower, so that beyond a certain point no increased spread can compensate the lenders for the increased default risk; beyond this point, the borrower is simply excluded from the market and prevented from borrowing any more.

Market discipline may fail by being too lax—that is, by failing to penalize a borrower for behavior that entails an increased risk of default. There is also the possibility that discipline may fail by being too harsh—that is, by excluding borrowers that are actually creditworthy—and this would also distort the allocation of credit. This may happen, for example, as a result of contagion effects, whereby all borrowers in a particular category—for example, developing countries in a particular region—regardless of their performance, are excluded from the market or subjected to a high interest rate spread.

Effective market discipline requires four general conditions:

Open Markets. Free and open financial markets are required so that a borrower who continues unsustainable borrowing will face increased interest rate spreads. This means that the borrower must not face a captive market, in which lenders have no alternative but to lend to a particular borrower. In the case of borrowing by a sovereign government, for instance, capital controls may impair market discipline by limiting domestic residents’ ability to seek alternative assets abroad, enabling a government to increase its debt without driving up interest rates. Access to privileged sources of financing—such as pension funds—have a similar effect.

Information. The second condition for effective market discipline is that lenders have access to the relevant information so that they can respond in a timely manner to the borrower’s behavior. The practice—prevalent among financial institutions as well as governments—of incurring off-balance-sheet liabilities, such as loan guarantees and other contingent claims, often makes it difficult to determine how these liabilities should be regarded in assessing a borrower’s total indebtedness.

No Bailout. The third condition for effective market discipline is that there be no anticipation of a bailout in case of (actual or impending) default. This condition is the Achilles’ heel of market discipline; what makes it so hard to achieve is the need for credibility. It is not enough that the authorities promise not to carry out a bailout; market participants must also believe that they will not bail out a delinquent borrower when the chips are down. For example, if the borrower is perceived as too big to fail, lenders may believe that, regardless of what the outside authorities say, a bailout would occur.

Bailouts can take a number of forms. One example is the role of deposit insurance in recent failures of banks and savings-and-loan associations (S&Ls) in the United States. If deposits are fully insured, depositors do not need to assess a bank’s solvency, since they will receive the full value of their deposits even if the bank fails. Thus, many banks and S&Ls that were close to failure have nonetheless been able to attract deposit funds which in many cases were used for very risky investments, exacerbating their losses once they did fail. Limiting deposit insurance coverage is the obvious solution, but it is not always a credible one: in many failures, uninsured depositors have been compensated regardless.

Borrower Response. Market discipline has two stages: initially, the borrower faces a rising interest rate spread, and eventually is denied access to credit. The second stage, while dictated by the logic of the situation, is often harsh. The smooth operation of market discipline requires that borrowers respond to market signals before reaching such a crisis.

A rational agent faced with a higher interest rate would respond by reducing borrowing (or refrain from unsustainable borrowing in the first place). Borrowers may not act this way either because they do not make rational decisions—as for example the decision-making processes of governments or other large organizations may not generate rational collective choices—or because they do not intend to repay the debt anyway, in which case a rising interest rate is immaterial. The latter problem of adverse selection—meaning that some borrowers do not plan to repay their debts, and the lender may not be able to identify these borrowers—creates a need for credit rationing.3 One example of this principle is financial institutions that are at or near the point of insolvency: even if they must pay high interest rates to attract deposits, this does not affect their behavior much, as they do not expect to survive to pay these rates anyway.

The recent trend toward securitization of lending and the declining role of banks and other financial intermediaries may impinge on financial markets’ ability to discipline borrowers. To the extent that these developments are associated with financial market liberalization, market discipline may be strengthened. A counterargument is that intermediaries may specialize in gathering information about borrowers; however, even more specialized agencies, such as credit-rating agencies, may be doing much to fill the gap. Bailouts are less likely in a securitized financial system, as the risks associated with particular borrowers are more widely dispersed, reducing the pressure for a bailout and making it harder to implement. This may enhance the role of market forces in disciplining financial activity.

1Market discipline is discussed more fully in Lane (1992).2There has been some empirical evidence on the responsiveness of the cost of borrowing to borrowers’ behavior: Goldstein and Woglom (1991, 1992) examined interest rate spreads on state and municipal bonds; Edwards (1986) interest rate spreads on sovereign debt; and Stone (1990) secondary market prices of sovereign debt.3See Stiglitz and Weiss (1981).

In Japan, the four large securities firms and 13 second-tier firms acknowledged paying compensation for trading losses to 608 corporations and nine individual investors, totaling about ¥172 billion during 1987-90.50 The payments, which were not illegal under Japanese law, were justified by market participants as an important part of the long-run relationship between the securities firms and their clients given the fixed brokerage commission system.51 The loss compensation episode in Japan has increased pressure both to introduce greater competition into the securities market, and thereby reduce the dominance of the four largest securities houses, and to give greater weight to consumer (as opposed to producer) interests. As noted earlier, reforms to ease market entry into the securities business for banking institutions (and for foreign securities firms) are seen by the authorities as facilitating these objectives.

In September 1991, the Provisional Council for the Promotion of Administrative Reform, a blue-ribbon commission, recommended to the Prime Minister the establishment of a semi-independent agency to oversee Japan’s financial markets. In May 1992, the Diet passed legislation that established the Securities and Exchange Supervision Committee, which has the power to investigate alleged securities market abuses and to bring legal charges against violators. The imposition of any disciplinary measures would be, however, at the discretion of the Ministry of Finance. In addition, the Ministry of Finance intends to strengthen the transparency of financial regulations by seeking to have the Diet amend the Securities and Exchange Law to prohibit loss compensation and discretionary-account contracts, by converting administrative guidance into laws or rules of self-regulatory organizations, and by making penalties for rule violations more stringent.

Allegations of insider trading on the Frankfurt Stock Exchange by traders at two large German banks emerged in June and August 1991.52 Insider trading, while not illegal under German law, does breach voluntary market codes. To comply with an EC Directive, the German authorities anticipate enacting legislation making insider trading illegal by the middle of 1993.53 An unresolved issue, however, is what authority will be responsible for enforcing the law and for oversight of the securities markets more generally. At present, the Länder oversee the fragmented system of regional stock exchanges in Germany. As in Japan, the German Ministry of Finance is considering the creation of a centralized securities market regulator akin to the SEC. The relative success of the SEC in policing the securities market would appear to make it a good model for the supervision of the securities markets in both Japan and Germany.

In August 1991, Salomon Brothers admitted to violating on three separate occasions rules governing U.S. Treasury securities auctions that prohibit individual bidders from purchasing more than 35 percent of the treasury securities in a single auction. Salomon Brothers took these large positions with the intent of implementing a “corner” and “short squeeze.”54

As a preliminary response, the U.S. Treasury Department in November 1991 implemented new rules aimed at creating fairer auctions. First, all broker dealers may bid without posting a deposit or guarantee, a privilege which primary dealers alone enjoyed before. Second, investors may purchase up to $5 million of each auction through “noncompetitive” bids, which do not vie directly with those of large dealers. Previously, these bids were limited to $1 million.

In January 1992, the Treasury Department, the SEC, and the Board of Governors of the Federal Reserve System completed a joint study of reforms in the auction of government securities.55 The report addressed a broad range of government securities market issues, including measures to combat short squeezes and changes in U.S. Treasury auction procedures. The report recommended that the U.S. Treasury be prepared to provide the market with additional supply of any security that is the subject of an acute, protracted shortage, regardless of the reason for the shortage. The possible reopening of issues would greatly reduce the potential for short squeezes. The reopenings could occur either through standard auctions, through a “tap” issue whereby the U.S. Treasury offers the securities to the market on a continuous basis, or through securities sales with the Federal Reserve acting as the agent.56

The desire to strengthen the integrity of markets also underlies the discussion of transparency and concentration versus liquidity in markets taking place in the context of the proposed EC Investment Services Directive. Transparency means that information on security trades and prices is made available as soon as technologically feasible. One view (held by the so-called Club Med group, which comprises France, Spain, Italy, and Belgium) is that trading in securities should be conducted on recognized exchanges, subject to the aforementioned transparency and concentration requirements. Its adherents are concerned about the significant share of trading taking place off-exchange in London (on Stock Exchange Automated Quotations (SEAQ) International), where transparency and concentration are not required. They argue that lack of transparency damages the integrity of markets and leads to an inferior price discovery process. The opposing view (held by the so-called North Sea group, comprising the United Kingdom, Germany, and the Netherlands) emphasizes that transparency requirements reduce liquidity in the market because market makers will be unwilling to trade large blocks of securities in open view of their competitors. They also argue that restricting trading to recognized exchanges is more costly because it would split European securities markets into small local exchanges. Moreover, this group argues that it would be undesirable to burden securities firms with establishing a locally capitalized subsidiary in every market. Germany, in particular, insists that its universal banks be granted access to security markets on the same terms as security subsidiaries from countries with bank-holding companies. There are signs that a compromise is in the offing. This might take the form of an “opting-out clause” that would permit an investor to choose not to have his trade conducted on a recognized exchange, thus leaving open the possibility that wholesale trades continue to be conducted off-exchange.

Is there a common thread in the recent problems? The short answer is “no.” No common factor seems to explain the problems that surfaced last year. Some market participants feel that the greater competitive pressures in the industry, along with the prospect of a further shakeout, had increased the incentives for “double or nothing” behavior, and even for illegal activity. It is difficult, however, to explain why such pressures would have produced these particular cases and not others, as well as to separate the influence of these broader factors from that of plain, idiosyncratic fraud; moreover, some of the scandals represented longer-standing practices that had, perhaps by coincidence, been publicized simultaneously in several countries. None of this alters the conclusion that ensuring integrity in financial markets is a first order objective that calls for clear regulations, for strong codes of conduct, and for continuously monitoring the observance of those laws and codes.

Regulation of Payments, Clearance, and Settlement Systems

At the center of current international monetary arrangements lies a network of national and international payments, clearance, and settlement systems that permit the exchange of funds associated with most international trade and facilitate financial transactions. These systems have gone largely unnoticed because, in the main, they have functioned smoothly and efficiently. During the past two decades, however, the growing size and integration of major financial markets have sharply increased the volume of transactions both within and across national systems. As a result, both market participants and national authorities have pursued measures to strengthen the major payments, clearance, and settlement systems so that they can efficiently process the larger volume of transactions and effectively manage the risks associated with the possibility of counterparty failures and liquidity crises.

“Offshore” Netting Schemes

BCCI’s closure revealed that “Herstatt” type risk is present in the new “offshore” netting systems.57 These systems have emerged primarily to facilitate settlement of foreign exchange transactions by bridging the significant time zone differences among Asia, Europe, and North America.

One such system is operated by Chase Manhattan Bank in Tokyo.58 During the Tokyo business day, correspondent customers of Chase make dollar payments by sending and receiving payment orders that result in credits and debits to their accounts at Chase’s Tokyo branch. Some customers are allowed to overdraw their dollar accounts at the Chase-Tokyo branch within specified limits, with the understanding that such overdrafts will be settled in New York during the U.S. business day. In addition, U.S. dollar balances held at Chase-Tokyo at the end of the Japanese business day can be moved in whole or part by instructing Chase-Tokyo to transfer funds in New York during the U.S. business day beginning six hours later. These funds are typically transferred by Chase and their Tokyo customers through their U.S. branches or through U.S. correspondent banks over Clearing-House Interbank Payment System (CHIPS).

Prior to the closure of BCCI, however, a large Japanese bank had made a yen payment to the Tokyo branch of BCCI as part of a foreign exchange transaction and was awaiting the dollar payment to its Chase-New York account when BCCI was shut down. Since the BCCI branch had not delivered the dollars to the New York account, the Japanese bank was left with a loss. Nevertheless, losses in the interbank market stemming from BCCI’s failure were relatively small, given the scale of its operations, because, before its closure, most institutions would only undertake fully collateralized transactions with the bank.

Policy issues surrounding offshore netting schemes were recently addressed by an ad hoc committee organized under the auspices of the Bank for International Settlements (BIS).59 As a first step toward ensuring the adequacy of the risk-management practices in private interbank netting arrangements, the committee agreed upon minimum standards for the design and operation of offshore netting schemes. Two standards stress the importance of clarifying the legal standing of the netting scheme and ensuring that the participants understand the associated credit and liquidity risks.

Some netting schemes, for example, are simply informal arrangements between banks to make one net payment between themselves, for each currency and date for which several amounts are due. Alternatively, two banks can enter into a formal agreement under which one running net amount will be due between them for each future date and each currency they trade. This is achieved by formally netting the second, and each subsequent, deal with the first for that particular date and currency, and thereby effecting a new contract for the net amounts.60 Under normal circumstances, both types of netting arrangement reduce liquidity risks by lowering the amounts due. In the event of a counterparty default, though, the gross amounts would be due under the first scheme, leading to an unwinding of payments, while only the net position would be legally due under the second. To manage their exposures to risk, counterparties must have a precise understanding of the legal standing of their netting arrangements and the associated liquidity and credit risks.

Additional standards address risk management in multilateral netting or clearinghouse arrangements. Multilateral schemes involve a relationship between each participant and the central counterparty or clearinghouse, which may serve to shift risk from bilateral counterparties to other participants in the system. The central counterparty in some schemes, for example, provides payments finality and bears the risk of default by one or more participants. Any losses may be allocated among the remaining participants according to a predetermined rule. Alternatively, a central counterparty may bear no risk by allocating any losses arising from a default on the basis of the bilateral dealings with the defaulting party. Since alternative schemes create different incentives for the participants and central counterparty to manage their credit exposures, it is critical that there be a strong link between the ability to contain risks and the incentives to do so.

Even if fully implemented, the proposals of the committee could not eliminate risks that arise in settlement of foreign exchange contracts due to differences in timing of currency payments that typically must be made in the country of issue of each currency. If the hours of operation of national payments systems do not overlap, then one of the counterparties to the contract must pay out one currency prior to receiving payment of the other. During the interval between settlement of each leg, the party that has made the first payment would risk losing the full value of the second if the counterparty were to default. Cross-currency settlement risks are particularly significant for foreign exchange transactions that require settlement in both Tokyo and New York, as evidenced during the closure of BCCI. A party that sells yen in exchange for U.S. dollars must irrevocably pay out the yen at least 6 (and as many as 14) hours before it receives payment in U.S. dollars. In order to reduce this risk, the Bank of Japan is contemplating extending the hours of its financial network system, and there are discussions with the Federal Reserve to open the Fedwire system earlier.

Harmonization of Clearance and Settlement Systems

Spurred by the global collapse of equity prices in October 1987 and the relatively rapid growth in securities activities, market participants and authorities have focused on ways to strengthen market structures and, in particular, to ensure reliable and efficient clearance and settlement systems. At the end of the 1980s, clearance and settlement procedures in various markets were of uneven quality and largely reflected local traditions and practices. These differences not only impeded cross-border securities transactions but, under adverse circumstances, were a potential source of financial instability.61 Consequently, several initiatives were undertaken to harmonize clearance and settlement systems in industrial countries and some developing countries.

In one initiative, a committee, sponsored by the Group of Thirty, of market participants from several countries has sought to identify the key features of clearance and settlement systems that promote efficiency and reduce risks to market participants. In 1989, this group made nine recommendations to be implemented by the end of 1992.62 In summary, the recommendations were designed to achieve the following objectives: match trades by the day after the trade date;63 settle trades on a continuous rolling basis, by the third day after the trade; insist on delivery of securities to purchasers as a condition for collecting payments; and improve efficiency by using depositories and netting mechanisms. Similar recommendations were also made by studies sponsored by the International Society of Securities Administrators, the European Community, and the Federation Internationale des Bourses de Valeurs.

Since the publication of the nine recommendations, the committees sponsored by the Group of Thirty have monitored their implementation in individual countries.64 In several major industrial countries, a number of the recommendations are already in place, but clearance and settlement systems lack some key elements. For example, Japan is in the process of creating a central securities depository to replace the partial depository now operating. In France, the central securities depository has been established for some time, but the movement to a rolling settlement has only just started. The U.S. clearance and settlement systems are seeking to reduce the settlement period from five to three days after the trade date; this requires many procedural changes, due to the number and geographic dispersion of market participants.

In some other major industrial countries, clearance and settlement systems required more extensive upgrading to meet the Group of Thirty recommendations. For example, the United Kingdom started the reform process with a paper-based system that had no central securities depository, no rolling settlement, and no delivery versus payment requirement. Significant reforms to the U.K. clearance and settlement systems are under way and many of the recommendations are due to be implemented by the end of 1992.

Countries represented on the Committee are Belgium, Canada, France, Germany, Italy, Japan, Luxembourg, Netherlands, Sweden, Switzerland, United Kingdom, and United States.

Implementation of the Accord has been chronicled in International Monetary Fund, International Capital Markets (April 1990 and May 1991).

In Indonesia, the Accord will not become fully effective until the end of 1993; while, in Saudi Arabia, the standards were modified to reflect differences in banking practices between the Group of Ten and the Gulf Cooperation Council.

Council Directive 89/298/EEC (Official Journal of the European Communities, May 5, 1989) and Council Directive 89/647/EEC (Official Journal of the European Communities, December 20, 1989), respectively. With regard to the definition of capital, the EC directives exclude from tier-1 capital current year profits unless verified by auditors and from tier-2 capital asset revaluation reserves. The EC directives also create a special 10 percent risk weight for claims on institutions specializing in the interbank and public debt markets.

Tier-1 capital consists of common stock, disclosed reserves, and noncumulative preferred stock. Tier-2 capital consists of undisclosed reserves, general loan-loss provisions, asset revaluation reserves, hybrid capital instruments, and subordinated debt.

The evidence is surveyed in the International Monetary Fund, World Economic Outlook (May 1991). See also Bank of England (May 1991), Board of Governors of the Federal Reserve System (April 1992), Bernanke and Lown, (1991), and O’Brien and Browne (1992).

This is not to deny that there will be costs involved when a bank closes or cuts back sharply on its commitments and a middle-market firm has to establish a relationship with a new lender. The point is not that banks have no comparative advantage in gathering information about borrowers but rather that this advantage is much smaller today and applies to a much narrower class of borrowers than in years past.

It is worth noting that much of the decline in Japanese equity prices and real estate values represents a return to more normal, historical relationships.

A version of the Price Waterhouse report was presented to the U.K. High Court, a summary of which is provided by Timewell (September 1991).

BCCI had $20 billion in assets at book value when it was closed.

The Basle Committee circulated an interim report on the supervisory treatment of market risks in October 1990.

As an example, consider a bank that was long in a highly diversified portfolio of equities. This portfolio would attract a 12 percent capital charge (4 percent of the gross position plus 8 percent of the net position). However, for a fully balanced position of long and shorts, the capital requirement would amount to only 8 percent (4 percent for each of the two gross positions, with no additional requirement for the zero net position).

The Committee cites as an example of such a definition the one used in the EC Commission’s Recommendation to its member countries.

BCCI’s credit rating and general reputation among wholesale banks was such that it was essentially excluded from the interbank market.

Home country generally refers to that country in which an international bank is headquartered or incorporated, while the host country is that country in which the bank’s foreign branch, subsidiary or joint venture is located.

A later supplement to the Concordat stressed the need to exchange information between home and host regulatory authority when authorization is given to open a foreign establishment. However, the adequate exchange of information proved to be difficult to implement, in part because of bank secrecy laws.

Since Banco Ambrosiano Holding was a bank-holding company and not a bank, the Luxembourg authorities did not have supervisory powers under Luxembourg Law.

Existing retail branches of foreign banks were grandfathered by the law.

United States, Department of the Treasury (1991). International Monetary Fund, International Capital Markets (1991), provides a summary of the administration’s proposal.

Corrigan (1990) examines the scope of de facto deposit protection in several large industrial countries.

Federal Deposit Insurance Corporation Improvement Act of 1991 (Pub. L. 102-242). International Monetary Fund, International Capital Markets (1991) and (1991) examine the financial troubles recently encountered by U.S. thrift institutions and commercial banks.

The Committees expect to be in a position to issue publicly consultative papers in the summer of 1992.

Technical Committee of the International Organization of Securities Commissions (1989). The report noted that many of the obstacles confronting international equity offers were also present for international debt offers.

Council Directive 80/390/EEC (Official Journal of the European Communities, April 17, 1980) and Council Directive 89/298/EEC (Official Journal of the European Communities, May 5, 1989), respectively.

Council Directive 87/345/EEC (Official Journal of the European Communities, July 4, 1987) amends the Listing Particulars Directive to provide for the mutual recognition of these public disclosures.

International Accounting Standards Committee (1991) discusses recent efforts to improve the comparability of financial statements across countries.

Ultimately, doubts about the integrity of markets translate into a lower demand for securities and a higher cost of capital for investment. An important, broader issue running through many of the policy questions taken up in this report is how the responsibility for bringing “discipline” to financial markets and to governments and firms ought to be allocated between the markets on the one hand and official regulations and intervention on the other. An analysis of the conditions necessary for “market discipline” to be effective is contained in Box 4.

However, the Ministry of Finance had issued an administrative guideline prohibiting the compensation of trading losses. Legislation is pending that would make loss compensation illegal.

The questionable transactions appear also to have been motivated in part by tax considerations.

A market corner is a situation in which a single party or allied group has contracts obliging others to deliver a substantial amount of a specific commodity, security, or cash, while controlling the available, deliverable supply. A short squeeze is a situation in which short sellers of a commodity or security scramble to obtain a small deliverable supply when their position is called, thereby driving prices above the level justified by fundamentals. By controlling the bulk of an auction and by gradually reversing that position in either the cash or repurchase market, the securities firms could induce investors that were short in the when-issued market to bid up the secondary market price of the new securities to meet their maturing obligations. Salomon Brothers would then sell or lend the new securities at advantageous yields.

Department of the Treasury, Securities and Exchange Commission, and the Board of Governors of the Federal Reserve System (1992).

Though such discretionary action should go a long way toward preventing negative-sum games of price manipulation, they do have at least one shortcoming. Intervention will be triggered by upward price jumps—whether or not these jumps are attributable to corner attempts. Since the policy will inevitably cut out some of the upside, competitively generated bond price movements, auction participants may well have an incentive to bid low (since bearish players now need have less fear of either a squeeze or other yield-lowering events).

Herstatt risk refers to cross-currency settlement risk in foreign exchange transactions, after the market disruptions surrounding the failure of Bankhaus I.D. Herstatt in 1974. Foreign exchange transactions typically involve two separate payments (one in each of the currencies involved), the timing of which is influenced by the hours of operation of the respective national payments systems. The gap between operating times between major financial centers (e.g., Tokyo and New York) can be as long as 14 hours.

The Chase-Tokyo dollar clearing system is described in Juncker, Summers, and Young (1991).

BIS (1990). This report examines the policy issues raised in a preliminary document by The Group of Experts on Payments Systems of the Central Banks of the Group of Ten Countries: “Report on Netting Schemes,” BIS (1989). This earlier report is discussed in Folkerts-Landau (1991).

This is often referred to as netting by novation.

For an analysis of problems in U.S. clearance and settlements systems during the October 1987 collapse in equity prices, see The Working Group on Financial Markets (1988), and Bernanke (1990a).

A matching system compares trades and ensures that both sides of the trade correspond.

See, for example, Group of Thirty (1991).

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