Annex III Developments in International Financial Markets
- International Monetary Fund
- Published Date:
- January 1994
This annex discusses recent developments in international financial markets, beginning with the markets for fixed-income securities. The first section chronicles the decline in yields in 1993 and the remarkable growth in the market. The second section discusses developments in the international equity market, where activity reached record nominal levels. The third section discusses international banking activity in 1993, including the market for syndicated loans. The annex concludes with an update of developments in the banking sectors of some of the Nordic countries and of Japan.
International Bond Market Developments in 1993
A continued decline in long-term interest rates, exchange rate turmoil in Europe, and increased demand for official financing contributed to a record increase in bond issues in 1993. Yields on ten-year government bonds issued by the major industrial countries ended the year lower than their opening levels (Chart 5), as monetary authorities in each of these countries attempted to reverse a general slowdown in growth through declines in policy interest rates. In the United States, the federal funds rate did not decline further in 1993 but remained at a low level of 3.0 percent. Yields on U.S. bonds declined by 102 basis points from December 1992 to December 1993, while those on French Government bonds fell by 245 basis points and Italian yields fell by 504 basis points. These interest rate declines were reflected in the international bond markets. Yields on deutsche mark Eurobonds fell by 140 basis points from the end of 1992 to the end of 1993, while yields on dollar Eurobonds fell by 110 basis points (Table 11).
Chart 5.Long-Term Government Bond Yield for Seven Major Industrial Countries, January 1990–March 19941
Source: International Monetary Fund, World Economic Outlook.
1 United States: 10-year treasury bond. Japan: Before January 6, 1992, refers to over-the-counter 10-year government bonds with longest residual maturity; thereafter, refers to benchmark 10-year government bond. Germany: Government bonds with maturities of 9–10 years. France: Long-term (7–10 year) government bond (Emprunts d’Etat à long terme). Italy: Before June 1991, refers to government bonds with 2–4 years’ residual maturities; thereafter, refers to 10-year government bonds. United Kingdom: Medium-dated (10 year) government stock. Canada: Government bonds with residual maturities of over 10 years.
|(In billions of U.S. dollars)|
|Total gross international bonds||227.1||180.8||227.1||255.8||229.9||308.7||333.7||481.0|
|By residence of borrower|
|Countries in transition||0.3||0.6||1.4||2.2||1.7||1.5||1.3||5.8|
|Other, including international organizations||21.1||20.6||22.0||25.3||32.9||40.9||49.9||57.3|
|By category of borrower|
|By currency of denomination||(In percent)|
|Interest rates||(In percent a year)|
|Deutsche mark international bonds6||6.6||6.5||6.2||7.9||9.6||8.6||7.8||6.4|
|Memorandum items||(In billions of U.S. dollars)|
|Net issues of medium-term notes or Euronotes||…||23.3||19.5||6.9||32.0||32.5||37.5||72.7|
|Bonds purchased or issued by banks||76.0||53.0||67.0||78.1||80.1||40.4||74.7||121.5|
Overall, gross bond issues increased for the third consecutive year in 1993, reaching a record $481 billion, an increase of 44 percent over the previous record in 1992 (Table 11). Since redemptions and early repayments increased by only 27 percent over the 1992 level, net issues of bonds increased by 78 percent to $198 billion. Among total bond issues, straight (fixed rate) bonds accounted for a record $369 billion, a 77 percent share, compared with $265 billion in 1992, as borrowers took advantage of the low interest rates (Table 12). A sharp decline in amortization resulted in an increase of more than 200 percent in net issues of such bonds.
|(Gross issues in billions of U.S. dollars)|
|Floating rate bonds||13.0||22.3||17.8||37.1||18.3||43.6||69.8|
|Bonds with warrants attached||24.8||29.7||66.2||21.2||31.6||15.7||20.6|
|International equity offerings||20.2||9.0||16.9||14.0||23.8||25.3||36.6|
|Depository receipts (ADRs/GDRs/Rule 144A)||4.6||1.3||2.6||1.7||4.6||5.3||9.5|
|Cross-border equity trading1|
|Gross equity flows||1,377.8||1,166.7||1,562.6||1,390.9||1,322.5||1,400.0||2,000.0|
|Net equity flows||16.4||32.9||86.6||3.2||100.6||53.2||159.2|
|Cross-border mergers and acquisitions||70.8||109.6||117.5||128.4||81.1||80.9||…|
|(In percent of total)|
|Floating rate bonds||3.29||4.90||3.75||8.40||3.41||7.13||8.66|
|Bonds with warrants attached||6.28||6.53||13.93||4.80||5.89||2.57||2.55|
|International equity offerings||5.11||1.98||3.56||3.17||4.44||4.14||4.54|
|Depository receipts (ADRs/GDRs/Rule 144A)||1.16||0.28||0.55||0.39||0.86||0.86||1.18|
The floating rate note (FRN) sector saw even more impressive growth in 1993, with gross issues rising 60 percent to $70 billion and net issues increasing by approximately 270 percent. Particularly during the latter part of the year, the anticipation of an increase in official interest rates in the United States provided an incentive for lenders to avoid committing to fixed rates. The FRN sector also saw an increased use of structured issues such as “collars”—in which the lender is assured of receiving a minimum interest rate while the borrower is protected by a ceiling on the rate it would pay in the event of large increases in the reference rate. Other variants on the structured-note theme included “corridors” or “range floaters” and SURFs (step-up recovery floaters), in which the coupon is linked to the Constant Maturity Treasuries index rather than the shorter-term LIBOR. SURFs provide higher returns to investors as long as the yield curve is upward-sloping and getting steeper. As interest rate uncertainty increased, FRN issues grew in popularity at the expense of straight bonds. This development was particularly pronounced in the first quarter of 1994 as straight bond issues reportedly declined by 30 percent while FRN issues expanded by 130 percent.
The search for higher yields contributed to a modest recovery in the equity-related bond market. Such bonds were popular with Japanese borrowers in the mid- to late-1980s, but the decline in the Japanese stock market in 1990 and the ensuing recession in Japan resulted in a decline in activity in that segment of the bond market. The increase in equity returns in some of the industrial countries in 1993 provided an opportunity for this vehicle to expand (Chart 6). Gross issues of convertible bonds and bonds with warrants increased by 85 percent to $39 billion in 1993. However, a bunching of redemptions resulted in a net decline of $58 billion in outstanding issues.
Chart 6.Major Industrial Countries: Changes in Stock Market Indices, January 1990–May 1994
Source: International Monetary Fund, World Economic Outlook.
With long-term interest rates falling sharply and yield curves in the United States and the United Kingdom flattening out during the second half of the year (Chart 7), borrowers sought to lock in the low interest rates for a longer period of time. Indeed, one of the notable achievements of the bond markets in 1993 was a lengthening of maturities. While, previously, Eurobond issues of longer than 10 years had been relatively uncommon, bonds with maturities as long as 30 years were very successfully issued in 1993. This development was most pronounced in the U.S. domestic market, which saw three issues of 100-year bonds. Long-term bonds benefited from strong demand from prudential institutions, which were keen to improve the maturity match between their assets and liabilities. Even narrow spreads above government securities were sufficient to attract this type of investor.
Chart 7.Major Industrial Countries: Yield Differentials, January 1990–April 19941
Sources: Organization for Economic Cooperation and Development, Financial Statistics Monthly; Nikkei Telecom; and IMF staff estimates.
1 Government bond yield minus three-month treasury bill rate, except for Germany and Japan.
2Government bond yield minus three-month Gensaki rate.
3Government bond yield minus three-month FIBOR rate.
The turmoil in European currency markets in September 1992 gave rise to a significant increase in sovereign borrowing on the international market as the countries that had defended their currencies attempted to replenish their foreign exchange reserves. To this source of demand was added a cyclical demand arising from weakening fiscal positions. Sovereign borrowers raised $104 billion in international bonds in 1993, up from $64 billion in 1992, and increased their share of gross bond issues to 22 percent from 19 percent (Table 11). Banks also increased their share of total issues by raising $110 billion in the bond markets in 1993, compared with $67 billion in 1992.
Another broad characteristic of the market in 1993 was the ease with which very large issues were marketed. Liquidity concerns have plagued the international bond market since its early days, and in 1993 some issuers took action to try to improve the liquidity of their bonds—and thereby capture the liquidity premium investors appear willing to pay—by issuing larger bonds and by offering to provide a secondary market. Much as governments have discovered that they can lower their borrowing costs in domestic markets by providing large benchmark issues rather than issuing a larger number of smaller-sized bonds with different characteristics, issuers in the international bond market have increasingly turned to “jumbo” bonds. Whereas only a couple of years ago most bonds were in the $50–100 million range, in 1993 bonds exceeding $1 billion were common in the international market, and there were some very large individual issues. For example, the World Bank issued a DM 3 billion global bond and Italy issued $5.5 billion in 10- and 30-year global bonds together. The World Bank deutsche mark global bond can be traded on both the German and U.S. markets despite their very different clearing systems. Some issuers deliberately created new benchmarks out of existing outstanding stocks—Italy, for example, offered to exchange all its outstanding straight bonds for new FRNs with a common maturity-while others attempted to provide a secondary market. The World Bank, for example, has required the seven underwriters of its $5 billion European medium-term notes (EMTNs) to post public bid prices.
Turnover on the secondary market increased significantly in 1993, exceeding the rate of increase in net bonds outstanding. Eurobond trading through Euro-clear and Cedel increased by 11 percent to $4,426 billion in 1993, while the net outstanding stock of bonds increased by 9 percent to $1,850 billion.
Another important development in 1993 was the globalization of the bond market both in terms of investor base and currency of denomination. The market for global bonds—bonds registered with the SEC and marketed and traded in North America, Europe, and Asia—grew markedly in 1993, with new issues raising $34 billion—including the first sovereign FRN global bond—compared with approximately $25 billion raised in 1992 and $15 billion in 1991.1 Formerly the preserve of industrial country governments and agencies and supranational borrowers, the global bond market opened up to private issuers and to issuers from developing countries—including Argentina and China—in 1993. The attraction for this vehicle has continued in 1994, with over $10 billion in new issues in the first two months alone. Somewhat paradoxically perhaps, 1993 also witnessed the coming of age of regional bond markets in which borrowers seek to tap a local rather than global market. The Dragon bond market in particular saw an increase in activity with issues totaling $3.2 billion.
With the emphasis on long-term issues both from issuers and investors, the shorter end of the market registered less impressive growth in 1993, with gross Euronote issues increasing by 18 percent to $159 billion.2 The most dynamic segment of this market continued to be the EMTN facilities, gross issues of which increased to a record $113 billion. Since 1991, the EMTN sector has rapidly overtaken the Euro-commercial paper (ECP) market. Since EMTNs are generally relatively short-term, small issues, they provide an attractive point of entry into the international bond market for new borrowers. The key to the success of the EMTN market is its highly flexible structure provided by the ability to register facilities without having to specify exactly how the issues will be structured. Thus, once the program is registered, it can be accessed very quickly in a wide range of currencies and maturities and with a seemingly unlimited range of credit enhancements. This flexibility has given rise to substantial “reverse enquiry” issues in which investors will communicate their preferences for maturity, currency of denomination, and embedded derivatives to issuers through their program managers. Thus, notes can be designed to fit precisely the requirements of particular investors and then placed directly with them. In 1993 between 50 percent and 60 percent of EMTN issues are believed to have included some kind of structure allowing investors to take positions in other markets. The use of structured issues—which link the return on the bond to prices of other assets such as equity or commodities—is used to provide more attractive returns to investors seeking to combine some minimum yield with a play on a particular market. At the same time, the increased use of underwriting methods to distribute EMTNs with sizes and maturities similar to those of Eurobonds means that the expansion of the EMTN market is increasingly at the expense of both the commercial paper and the bond markets.
As in previous years, the U.S. dollar was the most frequent currency of denomination for bonds in 1993. However, with the expansion of currency swap markets, the importance of this statistic is less clear, since many dollar issues are swapped into other currencies. With the virtual collapse of the ECU bond market in the last quarter of 1992 following the first ERM crisis, issues of bonds denominated in ECU declined from 6.4 percent of total gross issues in 1992 to only 1.5 percent in 1993. The share of issues in deutsche mark increased as European governments restored their foreign exchange reserves and German regional governments increased their use of international bond markets. The share of bonds issued in pounds sterling also rose as U.K. interest rates fell after sterling’s suspension from the ERM. The main development in terms of currency distribution of new issues, however, was the increased use of currencies other than the dollar, the yen, the deutsche mark, and the pound sterling. The expansion of issues into a broader range of currencies was facilitated by deregulation in a number of markets. For example, the French Government approved the use of the franc in the EMTN market; the Italian Government eliminated the stamp tax on government bond trading on regulated exchanges and introduced a more efficient system of withholding tax reimbursements for investors from countries with double taxation agreements with Italy; and Portugal abolished withholding taxes on foreign investors in government bonds. The most significant liberalization, however, was implemented in Japan, where financial deregulation has proceeded rapidly in recent years. The Japanese Government eliminated the 90-day “lockup” on Euro-yen bonds issued by governments and international institutions and reduced the credit rating requirements for corporate issuers in the domestic and foreign markets.
International Equity Market Developments
Reflecting the greater recourse to securities markets as an alternative to bank financing—and benefiting from price rises on most exchanges—cross-border equity issues increased by 45 percent in 1993 to $37 billion (Table 12). Of this total, the United States alone accounted for approximately $10 billion in 1993, while the developing countries issued $11 billion in new equity, up from about $7 billion in 1992. An increasingly important segment of the international equity market is the market for depository receipts. Total net issues of these instruments by all countries reached $9.5 billion in 1993, an increase of 81 percent over $5.3 billion in 1992 (Table 12).
Privatization has played an important role in expanding the international primary market for equity. In 1993, an estimated $8.9 billion in privatized equity was sold to foreign investors. The central governments of OECD countries alone have announced approximately $196 billion in privatizations to be completed by the end of the century.
More important perhaps than the expansion in the international primary market, the significant price increases on stock exchanges worldwide—particularly those of the emerging market economies-increased the attractiveness of international portfolio investment.3 For a U.S.-based investor, for example, investment in foreign markets proved highly lucrative in 1993. All of the emerging stock markets tracked by the International Finance Corporation (IFC), except for China, Nigeria, and Venezuela, outperformed the Standard and Poor’s (S&P) 500 index in dollar terms. In addition, many of the European markets performed relatively well; however, the highest returns were found in the emerging markets. As discussed in Annex IV, the proliferation of country funds has greatly facilitated access by retail investors in industrial countries to foreign markets, especially the emerging markets.
In the United States in particular, the search for higher returns on savings than have been offered by banks led individuals increasingly to invest in mutual funds and, among them, country funds.
Net international equity trading reached an estimated $159 billion in 1993, up sharply from $53 billion in 1992, and by far the highest volume of cross-border trading estimated since 1986 (Table 13). U.S. investors once again provided most of the demand, investing an unprecedented $66 billion in foreign equity while benefiting from inward investment of only $21 billion. Although European investors showed the largest annual increase in investment outflows, from $7.6 billion in 1992 to $45.2 billion in 1993, the European markets again benefited the most from international portfolio flows, with sales to foreign investors rising from $25 billion in 1992 to $56 billion in 1993.
|Rest of world||7.35||-1.95||10.07||8.48||-14.22||2.62||-0.62||6.30|
|Rest of world||1.20||3.46||3.51||8.63||3.90||5.06||0.87||2.50|
It was, however, the scale of investment in the emerging markets that attracted the most attention in 1993. Sales of equity to nonresidents more than doubled in 1993 to $52 billion. The increase was greatest among the Asian markets, which recorded net equity sales of $30 billion, up from $11 billion in 1992. Latin American markets also more than doubled their sales of equity to foreign investors. Emerging market investors ventured abroad on a greater scale in 1993 than they had previously. Investors in these markets spent $21 billion on equities listed on the exchanges of the more developed markets.
International Banking Activity
Banks’ cross-border activities continued to expand slowly in 1993—as they did in 1992—after having contracted sharply in 1991.4 The aggregate figures, however, conceal markedly different experiences between different types of counterparties in 1993. Lending to nonbank borrowers increased by the second largest margin since 1982, while interbank lending rose by the smallest amount in any year other than 1991 (when the interbank market contracted sharply). A feature common to both market segments since 1990 is the slowdown in deposit growth relative to the experience of the mid- to late-1980s. This difference between lending to banks and nonbanks was observed for industrial countries, but not for developing countries, where lending to nonbanks rose by a much smaller amount than in 1992. Reporting banks continued to reduce their net exposure to all counterparties in the countries in transition.
Aggregate cross-border bank lending increased by $257 billion in 1993, down slightly from an increase of $262 billion in 1992 and well below the increases achieved in the years since 1985 (Table 14). Lending to industrial country counterparties increased by $190 billion, more than in 1992 but still considerably lower than the increases observed in the late 1980s, while claims on developing country borrowers increased by $38 billion, which was $7 billion less than in 1992. With cross-border liabilities increasing by $195 billion in 1993, net claims actually increased by $63 billion, compared with an increase of $95 billion a year earlier.
|Total changes in claims on2||531||799||565||833||732||-70||262||257|
|Countries in transition||4||1||5||7||-5||3||4||-4|
|Unidentified nonbank borrowers5||44||52||-6||44||53||-22||-20||25|
|Total changes in liabilities to6||588||764||518||823||668||-100||168||195|
|Countries in transition||-1||-1||4||4||-5||1||11||5|
|Unidentified nonbank depositors5||47||61||6||14||64||35||25||19|
|Total changes in net claims on7||-57||35||47||11||64||31||95||63|
|Countries in transition||5||2||1||3||-1||2||-7||-9|
|Inidentified nonbank borrowers5||-2||-9||-12||31||-10||-58||-45||6|
While the overall figures suggest a declining importance for international bank lending, in fact lending to nonbank borrowers has been fairly robust during the 1990s. Net international claims on non-banks rose by $147 billion in 1993, almost twice the increase in 1992 and the largest increase since data became available in 1983 (Table A8). This expansion in net claims was due both to a rapid rise in gross claims and a slowdown in liabilities. Total lending rose by $191 billion, more than in any year since 1982 except 1990. The increase in lending was most visible in the U.S., German, and U.K. banks. Cross-border lending by Japanese banks, on the other hand, fell in the second half of the year as these institutions continued their retrenchment from international lending in response to domestic balance sheet difficulties.
On the other side of the balance sheet, nonbanks’ cross-border deposits grew by only $43 billion in 1993, compared with an increase of $65 billion in 1992. Liabilities of nonbanks in Japan and the United States, in particular, declined for the third consecutive year. Banks in France also saw a decline in cross-border nonbank liabilities. The decline in cross-border deposits by nonbanks parallels the recent trend toward weaker deposit bases for banks in their domestic markets. In the United States, for example, there has been a tendency for nonbanks, including households, to look for higher returns on their savings in nonbank financial institutions such as mutual funds (see Box 2). Part of the explanation for the coexistence of a slowdown in deposits and an expansion in credit lies in the significant increase in banks’ purchases of international corporate bonds. Hence, banks are increasingly extending credit not through loans but through the securities markets.5
In sharp contrast to the experience of the nonbank sector, gross interbank claims rose by a modest $67 billion in 1993. Industrial countries accounted for most of the slowdown, with cross-border lending growing by only $31 billion, less than one tenth of the increases observed during 1986–90 (Table A9). Lending to developing country banks actually picked up slightly, increasing by $34 billion compared with $22 billion in 1992. A sharp rise in interbank liabilities—particularly to industrial countries—resulted in a strong contraction in net cross-border interbank claims of $85 billion in 1993 after a $20 billion increase in 1992. This reversal was due mostly to a decline of $73 billion in net lending to industrial country banks, although net claims on developing country banks fell by $10 billion, continuing the series of annual decreases dating back to 1987.
Developments in the interbank market in 1993 reflected a number of influences. The large buildup of cross-border interbank claims within Europe during the attack on the European ERM in September 1992—which saw intra-European interbank claims rise by $146 billion—was partially reversed during the subsequent three quarters. The unwinding of such positions in the first quarter also resulted in a large fall in net claims of U.S. banks. However, renewed tensions in the foreign exchange market led to a further accumulation of cross-border claims within Europe in the third quarter of 1993. Interbank activity within Europe was also buoyed by an increase in securities transactions and large currency transfers in the fourth quarter. For example, German banks’ net claims on other, mostly European, banks increased strongly in the fourth quarter, as a result of the decision to apply withholding tax to interest earned on foreign mutual funds. German residents responded by liquidating investments in offshore funds. The Japanese banking industry continued its retrenchment from the international interbank market, with the third consecutive year-on-year decline in total claims. Finally, the favorable borrowing conditions available on international securities markets caused banks to rely less on the interbank market. Bond issues by banks reached record levels in 1993, increasing by 64 percent to $110 billion (Table 11).
Reflecting the weakening of overall international bank lending, the syndicated loan market continued a trend of declining net issues that began in 1991. Although the total value of syndicated loans signed in 1993 rose by 10 percent to $130 billion, an increase in redemptions resulted in a 20 percent decline in net new lending to $70 billion. This development is attributable to the reduction in long-term bond rates, which made such issues more attractive and increased concern for credit quality among lending banks. New lending in the first quarter of 1994 reportedly declined by 25 percent over the same period in 1993, owing in part to increased uncertainty over interest rates.
Banking Developments in Three Nordic Countries and in Japan
As discussed in last year’s report, International Capital Markets: Part II, rapid financial liberalization in some industrial countries had led banks in the 1980s to enter into new activities, as well as to increase their exposure to real estate. A decline in asset prices at the end of the decade and in the early 1990s reduced both borrowers’ ability to repay loans and the value of loan collateral, resulting in significant losses on bank balance sheets. This section provides a brief update on efforts undertaken since the first quarter of 1993 to resolve these difficulties in the banking sectors in three Nordic countries and in Japan. This year, Venezuelan banks have encountered severe difficulties, while some individual large banks in France and Spain have also registered large losses (Box 4 discusses these events).
Box 4New Episodes of Stress in Banking Systems
A banking crisis emerged in Venezuela in early 1994. The liberalization of interest rates in 1989 led to intense competition among banks for market share in deposits. In the anticipation of further reforms that would introduce universal banking and open up the sector to foreign competition, many banks attempted to increase their share of the deposit and loan markets. The most aggressive competitor was Banco Latino, which had become the second-largest bank in Venezuela by the end of 1993. By offering higher interest rates than the other banks, Banco Latino nearly doubled its deposits in 1991 alone. This strategy contributed to operating losses in 1992, since it resulted in narrower interest margins. On the other side of the balance sheet, the rapid expansion of lending—including to other members of the same financial group and to bank insiders—led to increasing loan losses. By the end of 1992, 7 percent of the bank’s loans were nonperforming, a much higher ratio than for other banks. Liquidity problems emerged in December 1993, which led to a run on deposits. On January 13, 1994, the central bank announced that Banco Latino had a deficit of Bs 26.5 billion in the check-clearing system. The bank was placed under receivership by the Superintendent of Banks and Other Financial Institutions.
Problems at eight smaller Venezuelan banks developed in the ensuing weeks as a result of a flight to quality by depositors. The deposit guarantee agency, Fogade, responded by providing Bs 446 billion in low-interest loans in exchange for at least 51 percent of the capital of these banks. This amount is in addition to the Bs 313 billion lent to Banco Latino prior to its reopening on April 4, 1994.1 The Bs 759 billion ($6.4 billion) total represents approximately 14 percent of Venezuela’s 1993 GDR To try to limit the political, monetary, and fiscal impacts of this rescue operation, the Government has increased deposit insurance coverage to Bs 4 million (effectively covering almost all of Banco Latino’s deposits), issued zero-coupon bonds to soak up the extra liquidity, and imposed a 0.75 percent tax on bank withdrawals. The authorities have proposed that the eight banks, which are now effectively state owned, will be liquidated or merged with stronger banks.
Serious problems also surfaced at two of the largest banks in Europe. On December 28, 1993, the Bank of Spain announced that it was intervening to support Banco Español de Credito (Banesto), the fourth largest bank in Spain. After two years of very rapid expansion, the bank’s problem loans grew too large to be covered by investment income; at the end of 1993, approximately 20 percent of the bank’s loans were nonperforming. This news came only six months after the bank had successfully raised in June 1993 Ptas 95 billion in capital, at which time nonperforming loans were an estimated 9 percent of total loans. The interim management of Banesto, installed in December 1993, estimated that provisions and write-offs totaling Ptas 605 billion (approximately $4.3 billion) were needed. Under an agreement with the Bank of Spain, Banesto assumed Ptas 320 billion of the loss, wiping out its reserves and almost half its share capital. The Bank of Spain and the other commercial banks shared equally in Ptas 285 billion in losses. In addition, Ptas 600 billion in problem loans with an estimated market value of Ptas 315 billion was transferred to the Deposit Guarantee Fund. On April 25, 1994, Banesto was sold at auction to Banco Santander for Ptas 313 billion, making the latter the largest Spanish bank with total assets of Ptas 17.1 trillion.
Difficulties at Crédit Lyonnais, the largest banking group in Europe, became more widely known in February 1994, although the replacement of its executive chairman in November 1993 had signaled that the bank was in trouble. Here again, the problem appears to have stemmed from a rapid expansion of lending in the late 1980s and early 1990s, a downturn in the economy, and a decline in prices for commercial property used as collateral for loans. In early 1994, the bank reported a loss of F 6.9 billion for 1993 and a significant shortfall in capital was recognized. In March 1994, an agreement was reached that called for a capital injection of F 4.9 billion ($850 million) from the French Government and two state-owned companies, the transfer of F 40 billion in doubtful real estate loans—partially guaranteed by the Government—to the Treasury, and asset sales of over F 35 billion over two years. Once again, problems appear to have come to a head relatively quickly. At the end of June 1993, problem loans were reported to be only F 24 billion.1 Banco Latino also benefited from Bs 48 billion in loans from other banks to resolve its liquidity problems in January 1994.
Developments in Nordic Banking
In three Nordic countries—Finland, Norway, and Sweden—a rapid increase in credit and the expansion of bank activities into riskier, less familiar markets—such as real estate lending—was accompanied by the liberalization of the financial sectors in the early to mid-1980s.6 There, as in Japan, a decline in real estate prices, combined with other country-specific factors, triggered the emergence of substantial stocks of nonperforming loans. In these three countries, the Governments declared their willingness to provide the necessary support for the banking system. In Finland and Sweden, unlike in Norway and Japan, the Governments responded with explicit guarantees of the banks’ liabilities and, in many cases, with equity injections, which have resulted in governments becoming majority shareholders in a number of institutions.
The crises that afflicted the banking industries in Finland, Norway, and Sweden appeared to have eased significantly in 1993, as declining interest rates and exchange rate depreciation contributed to increased profits, which allowed many banks to raise capital on domestic and international markets.7 These crises have been costly. The Governments of Finland, Norway, and Sweden have together committed about $20 billion in capital injections and guarantees in support of their banks since the onset of the crisis.8 The individual country amounts represent 8.2 percent of 1992 GDP in Finland, 4.0 percent in Norway, and 6.4 percent in Sweden; in each case, the commitments have exceeded the value of equity in the banking system when the crisis emerged.
In late 1992 and into early 1993, interest rates in these three Nordic countries fell sharply, in part following a global trend, but partly also because of a change in policy away from defending fixed exchange rates. The lower rates resulted in a widening of interest margins, which directly led to an improvement in operating profits. In addition, lower interest rates translated into capital gains on banks’ bond and equity portfolios, which in turn provided additional income. Finally, securities trading commissions in some banks were favorably affected both by the European exchange rate turmoil in late 1992 and early 1993, and by a general increase in securities trading activity (as bond and share prices rose).
Table 15 shows the improvement in Nordic banks’ income statements in 1993. With one exception, all of the major banks in these countries recorded increases in operating profits—or declines in losses—in 1993. In most instances, the most important source of increased income was the securities trading account. For example, in Norway, securities trading earned profits of NKr 1.4 billion in 1993, after a NKr 600 million loss in 1992—accompanied by modest increases in net interest income. The turnaround in profits is most noticeable in Norway where net income increased by NKr 9 billion. The 1993 results for Sweden are not directly comparable to the 1992 results because of the substantial restructuring of the banking system in that country. Both Nordbanken and Gota Bank had most of their nonperforming loans removed from their balance sheets and received large capital injections from the Bank Support Authority (BSA). With the exception of Gota Bank, all of the major Swedish banks enjoyed improved profits in 1993. In Finland, although only one of the major banks, Okobank, was profitable, losses at the other institutions declined considerably—by more than 40 percent at Postipankki and Skopbank.
|Net interest income||…||6.89||7.66||9.01|
|Net operating revenue||…||0.98||2.06||4.56|
|Net nonperforming loans||…||21.40||28.67||26.33|
|Net interest income||12.24||11.15||11.48||12.74|
|Net operating revenue||4.28||-0.42||4.77||9.92|
|Net nonperforming loans||…||22.73||23.29||19.14|
|Net interest income||…||41.80||39.04||40.88|
|Net operating revenue||…||25.26||20.44||33.68|
|Net nonperforming loans||…||…||107.07||53.11|
In Finland, the increase in profits made it unnecessary for some banks to seek government assistance. The largest Finnish bank, Kansallis-Osake-Pankki (KOP), announced in February 1993 a Fmk 3 billion capital restructuring proposal. This involved cutting the nominal value of existing shares in half, and then issuing bonus shares and a rights issue with a combined value equal to the new value of old equity. In October 1993, after the parliament’s decision to adopt the “good bank/bad bank” model, KOP announced that its investment banking operations were to be spun off into a new unit, called Prospectus. KOP raised a total of Fmk 4.5 billion in new equity in 1993—38 percent of its end-1992 capital—through sales of shares to the Government, rights issues, and international offerings. The Union Bank of Finland also announced an ambitious capital raising campaign in August 1993 that involved a Fmk 1.158 billion rights issue, a Fmk 300 million direct offering, and finally the sale of Fmk 1 billion in new shares.
On the other hand, the first bank taken over by the Finnish Government, Skopbank, continued to require government support in 1993. In May 1993 the Government Guarantee Fund (GGF) injected Fmk 700 million in preference capital into the bank. Skopbank went to the international capital markets in July and September 1993 to borrow a total of $150 million (by issuing a three-year bond), but in December it announced that it needed a further capital injection of Fmk 350 million in order to meet its capital requirements. This brought the total amount of GGF funds invested in this bank to Fmk 3.7 billion, and the GGF now owns 53 percent of Skop-bank’s equity and 63 percent of its voting shares. The Bank of Finland had provided Fmk 11.1 billion in assistance to Skopbank by the end of 1993.
In October 1993, the Government announced that the GGF had negotiated the takeover of the Savings Bank of Finland by KOP, Unitas, Postipankki, and the Okobank group.9 Each of these four groups would acquire a quarter of the Savings Bank for a price of Fmk 1.4 billion; each will receive about Fmk 12 billion of assets. All of the Savings Bank’s bad loans will be transferred to a separate company to be wholly owned by the GGF.
Following on favorable midyear results and the success of KOP’s equity issues, the Norwegian banks have also raised additional equity, which has in some cases reduced the Government’s equity share to 70 percent. Swedish commercial banks reported significantly improved results in the first half of 1993—particularly Nordbanken which, as a result of the divestiture of most of its nonperforming loans, recorded a SKr 12.6 billion turnaround in pretax profits to SKr 2.5 billion. Nordbanken’s improved position provided the necessary support for the issue of a $30 million bond. Following the announcement of an increase in net profit to SKr 837 million from SKr 658 million during the first half of 1992, Svenska Handelsbanken, the largest commercial bank, announced a SKr 2.5 billion rights offering. Most significantly, the improved operating environment reduced net losses at Skandinaviska Enskilda Banken (SEB) to SKr 298 million from SKr 2.5 billion in the first half of 1993. As a result, in August 1993 SEB withdrew its application for government support and announced plans for a SKr 5.3 billion rights issue. SEB had also employed the “good bank/bad bank” model in 1993, by transferring 513 real estate properties, worth SKr 12.4 billion, to its real estate unit, Diligentia Fastigheter.
Likewise, the remaining two Swedish applicants for government assistance withdrew their requests after posting improved results for the first half of 1993. Foreningsbanken, a former rural cooperative institution, successfully launched a SKr 3.5 billion initial public offering in December 1993, which was followed early in 1994 by a $100 million bond issue.10 Swedbank followed suit with the announcement of a proposed SKr 8 billion restructuring plan in December 1993, which will include a SKr 2.1 billion stock issue.
The situation at Gota Bank took somewhat longer to be resolved. It was taken over by the Government in December 1992 after its parent company, Gota AB, declared bankruptcy. As a result of the government guarantee, Gota was able to issue $200 million in two equal tranches of five- and eight-year bonds. In the fall of 1993, the Government announced its intention to sell Gota Bank and began approaching other banks, domestic and foreign. Eventually all of the banks that expressed interest, except Nordbanken, declined to bid. Consequently, in December 1993, these two banks were merged. Prior to the merger, however, SKr 38 billion of Gota Bank’s bad assets—all bad loans greater than SKr 5 million—were transferred to a new company, called Retriva, which was capitalized by the Government to the amount of SKr 3.8 billion and received loan guarantees of SKr 3.5 billion. As a result of this operation, Gota Bank’s stock of nonperforming loans was reduced to 4 percent of total loans, from 36 percent. In addition, the BSA provided a capital injection of SKr 20 billion to Gota Bank in order to cover remaining loan losses.
Balance Sheet Difficulties in Japan
Steep declines in equity and real estate prices after 1990 were the key factors that precipitated banking difficulties in Japan. Since a significant proportion of bank loans were secured directly or indirectly by real estate collateral or extended to real estate companies and developers, the decline in land prices soon resulted in the accumulation of increasing stocks of nonperforming loans on the balance sheets of the major banks. These difficulties were compounded since 1991 by a general slowdown in the real economy, which led to further additions to the stock of bad loans.
As discussed in Part II of last year’s International Capital Markets report, the banks’ ability to strengthen their balance sheets depends to a considerable extent on external factors such as developments in the equity and real estate markets and in the real economy more generally. While equity prices have recovered from cyclical lows and a bottoming out of real estate prices may be in sight, banks must rely on improved revenue—in particular, an increase in interest earnings—in order to be able to increase their reserves against bad loans.
With economic growth slowing sharply from mid-1991 on, monetary and fiscal actions were taken to support activity. The official discount rate was reduced from 6 percent in mid-1991 to a historic low of 1.75 percent in September 1993, and fiscal expenditure was increased in a series of four supplementary budgets announced since August 1992, the latest of which was announced in February 1994.11 Banks’ interest rate margins, which had, if anything, narrowed slightly in the early part of 1993, widened appreciably in the fourth quarter. The spread between the average long-term loan rate and the interest rate paid on large (in excess of ¥ 10 million) one- to two-year term deposits fluctuated between a high of 211 basis points and a low of 185 basis points during the first eight months, but it jumped to 256 basis points in September and finished the calendar year at 286 basis points. A similar, although less dramatic, increase is observed in spreads between short-term lending and deposit rates, and in spreads over many other sources of funding.
While these wider spreads improved banks’ operating revenue—particularly in the second half of the fiscal year—commercial property values continued to decline in 1993 and in the first quarter of 1994. Commercial real estate prices fell by 18.3 percent in Tokyo and by 19.1 percent in Osaka in 1993; further declines of 4 percent and 3.9 percent, respectively, were registered in the first quarter of 1994. Prices for commercial real estate in these cities have fallen by approximately 40 percent and 60 percent, respectively, from the peak level in 1990.
Developments in the equity and property markets are relevant for a number of reasons. As regards equity prices, banks are allowed to claim 45 percent of the unrealized gains on their equity portfolios as tier 2 capital. Thus, a decline in equity prices results in a direct decline in capital. This factor has been considerably alleviated by the permission banks received in July 1992 to include perpetual subordinated debt in tier 2 capital. Between March 1992 and March 1994, the major banks increased their subordinated debt by ¥ 2.9 trillion. The accounting for unrealized gains or losses on equity holdings, however, exposes banks to a potential problem. Since banks must report the value of their holdings at the lesser of the market value and the book value, a decline in the price of these shares must be recorded as a loss on their income statement. Land prices affect the banks’ balance sheets by changing the value of their loans. A significant proportion of banks’ lending has been extended to real estate developers, to construction firms, or to housing loan companies; real estate serves as the collateral for such loans.
Equity prices fluctuated widely in 1993. The key Nikkei 225 index rose from ¥ 16,925 at the end of 1992 to a peak of ¥ 21,148 in mid-September 1993 before falling to a low of ¥ 16,079 at the end of November. Since early January 1994, the index has fluctuated within a relatively narrower band of ¥ 19,000 to ¥ 21,000.
The continued slowdown in economic activity, combined with declines in land prices, contributed to an increase in nonperforming loans in the fiscal year 1993/94. At the end of March 1994, the 21 major banks reported nonperforming loans of ¥ 13,573 billion, up from ¥ 12,775 billion at the end of March 1993 (Table 16).12 Most of the problem assets are on the books of the city banks, whose reported nonperforming loans increased by 6.1 percent to ¥ 8,974 billion. The problems are most pronounced, however, at the trust banks, whose ¥ 2,712 billion in nonperforming loans represent almost 4 percent of their lending.
|Mar. 1992||Sept. 1992||Mar. 1993||Sept. 1993||Mar. 1994|
|Net interest income||5,213.10||3,032.30||5,908.70||2,687.10||5,580.60|
|Net operating income1||2,610.30||1,613.30||3,091.80||1,317.40||2,724.90|
|Provisions and charge-offs2||550.30||434.90||1,321.40||1,058.30||3,538.70|
|Risk-weighted capital ratio (in percent)||8.27||8.78||9.32||9.82||9.73|
|Net interest income||4,145.80||2,372.80||4,657.80||2,159.70||4,439.60|
|Net operating income1||2,167.90||1,295.40||2,512.40||1,094.50||2,179.70|
|Provisions and charge-offs2||437.30||356.70||1,011.60||850.30||2,490.00|
|Risk-weighted capital ratio (in percent)||8.19||8.69||9.62||9.75||9.69|
|Long-term credit banks|
|Net interest income||470.70||321.20||526.20||182.70||341.20|
|Net operating income1||270.90||223.60||336.40||96.40||175.60|
|Provisions and charge-offs2||49.00||39.90||197.30||122.30||546.90|
|Risk-weighted capital ratio (in percent)||8.31||9.12||9.14||9.23||9.25|
|Net interest income||596.60||338.30||724.70||344.70||799.80|
|Net operating income1||171.50||94.30||243.00||126.50||369.60|
|Provisions and charge-offs2||64.00||38.30||112.50||85.70||501.80|
|Risk-weighted capital ratio (in percent)||8.66||8.92||10.01||10.90||10.46|
|Nikkei 225 index||19,345.95||17,399.08||18,591.45||20,105.71||19,111.92|
The banks’ first line of defense against balance sheet weakness is an increase in loan-loss reserves. There are two kinds of reserves: (i) general reserves, additions to which are exempt from tax up to the legal maximum of 0.3 percent of the value of loans made; and (ii) specific reserves held against individual loans. Until recently, banks could only create specific reserves with the approval of the Ministry of Finance’s Banking Bureau. This could be a time-consuming process because the bank would have to submit each loan for consideration individually to a Banking Bureau examiner. The tax liability of these provisions was determined by the Tax Bureau, which generally required proof of legal bankruptcy before exempting specific reserves from taxation. The February 1994 stimulus package eased these constraints somewhat by allowing banks more discretion in creating specific reserves: banks were freed of the need to present each loan for consideration and could make provisions against loans that they decided were nonperforming or doubtful.
Banks are permitted to write off losses equal to the difference between the book value and the market value of a loan when it is sold. In addition, when losses arise from loans against which sufficient provisions have not been made, they must be charged against current income; interest accrued but not paid in two years must also be charged off. However, while banks’ foreign subsidiaries have begun to make use of the secondary market for loans elsewhere, there is no such market in Japan as of yet. In the absence of a market for loans, the major Japanese banks, together with many regional banks, insurance companies, and cooperative credit institutions, set up the Cooperative Credit Purchasing Company (CCPC) in early 1993. This essentially serves as a vehicle through which banks can realize the losses on their nonperforming loans and thereby make them eligible for tax deductibility. In the 1993/94 fiscal year, ¥ 3,838 billion in loans were sold to the CCPC; the discount on these loans averaged 54 percent (Table 17).13 The 21 major banks claimed tax deductions of ¥ 1,775 billion. During the same period, banks made specific provisions of ¥ 1,378 billion and charged off ¥ 385 billion against nondeveloping-country loans.
|(In billions of yen)||(In percent)|
|Total for 1993 and 1994||2,120||4,519.9||2,231.0||50.6|
Loans sold to the CCPC are evaluated by a pricing committee that determines an approximate market value for the collateral. The loans are then purchased by the CCPC at this price, with the financing provided by a loan from the selling bank. Interest and principal payments on these loans commence only after the collateral is sold. Hence the bank essentially exchanges a nonperforming loan for a performing loan to the CCPC and obtains a tax deduction for the difference. However, since the bank remains responsible for losses incurred by the CCPC if it is unable to sell the collateral (at its new estimated value), the bank is not as clear of the problem as it would be if it had sold the loan on a secondary market.
The Ministry of Finance has recently encouraged banks to make more aggressive use of the CCPC and has permitted banks to set up similar units to purchase restructured loans of nonbank affiliates-loans that often are not already included in the estimate of nonperforming loans. Reportedly, the first such entity has been proposed by a group of banks to purchase the restructured loans due to ten non-bank affiliates of Hyogo Bank.
As of March 31, 1994, the 21 major banks reported adjusted operating earnings, defined as net interest revenue plus noninterest revenue less non-interest expenses, of ¥ 2,725 billion, 12 percent less than for 1992/93.14 Among the three groups of banks, the adjusted operating earnings of long-term credit banks suffered the largest decline, falling by 48 percent. Contrary to the experience of the other two groups, the earnings of the trust banks increased by 52 percent. Changes in net interest revenues were the driving force for changes in adjusted operating income: city banks’ net interest revenues declined by ¥218 billion and long-term credit banks’ net interest revenue declined by ¥ 185 billion. For the trust banks, in contrast, net interest revenues increased by some ¥ 75 billion.
Net operating income is an important element of banks’ efforts to resolve the bad loans problem, because higher operating income allows for faster provisioning and write-offs. Assuming an average discount of 50 percent on the value of the nonperforming loans remaining at end-March 1994, the noncollateralized portion of these bad loans was approximately ¥ 6.8 trillion;15 the combined specific reserves of the major banks at that time was ¥ 3 trillion. In 1993/94, banks’ provisions and charge-offs, including losses on CCPC loans, amounted to ¥ 3.5 trillion—130 percent of net operating income. With similar levels of provisioning, banks could increase reserves by the additional ¥ 3.8 trillion needed to fully cover the decline in portfolio value in just over a year.
However, the banks were only able to make such large provisions and write-offs by drawing on their unrealized gains on securities holdings—particularly equities. In 1993/94, the 21 major banks recorded ¥ 1.8 trillion in net profits on their equity holdings. As of March 31, 1994, the major banks had unrealized gains on equities of ¥ 19.6 trillion. While these gains can be realized by some institutions and used as a means to increase provisions, it would be difficult for all banks to do so since they hold a significant share of Japanese equities. At the end of September 1993, the 21 major banks’ equity portfolios were valued at an estimated ¥ 36 trillion, or 10 percent of the market capitalization of the first two sections of the Tokyo Stock Exchange.16
For further discussion on global bonds, see Annex I.
The Euronote category comprises Euro-commercial paper and EMTN in addition to note-issuance facilities and other short- and medium-term borrowing facilities.
For further discussion on emerging markets, see Annex IV.
The following centers report activity for the international banking statistics: Australia, Austria, The Bahamas, Bahrain, Belgium, Canada, the Cayman Islands, Chile, Denmark, Finland, France, Germany, Hong Kong, Ireland, Italy, Japan, Korea, Luxembourg, the Netherlands, the Netherlands Antilles, Norway, Panama, Portugal, Saudi Arabia, Singapore, Spain, Sweden, Switzerland, the United Arab Emirates, the United Kingdom, and the United States.
The Danish banking industry, while also suffering from high loan losses, has not required government support on anything like the scale of the other Nordic countries. The four major Danish banks—Den Danske Bank, Unibank, Sparekassen Bikuben, and Jyske Bank—reported operating results in 1992 not unlike those in Finland, Norway, or Sweden. High loan-loss provisions and large valuation losses on securities holdings contributed to a combined pretax loss of DKr 8.2 billion in 1992 (compared with DKr 338 million in 1991). Despite continued high loan-loss provisions, the banks’ pretax profits turned sharply upward in 1993, owing in large part to gains on bond holdings (which are carried at market value). At year-end, the banks’ combined pretax profit was DKr 5.5 billion.
While all of the Danish banks have incurred substantial loan losses in recent years, problems at the eighth largest bank, Varde Bank, had grown so serious in November 1992 that the central bank arranged a consortium of the seven larger banks to provide a DKr 750 million guarantee fund. Despite some balance sheet restructuring, the central bank determined in 1993 that the bank was about to fail. Consequently, it was decided in December 1993 to transfer the DKr 7 billion in performing assets to Sydbank Sonderjylland and to retain the DKr 4 billion in nonperforming assets in Varde Bank, which will be wound down over the next few years by the central bank with the support of a government guarantee. This is another example of the “good bank/bad bank” model for resolving banking difficulties.
However, the Danish banking situation differed in at least two important respects from those in the other three Nordic countries. First, Danish banks have always been well capitalized. Even at the end of 1992, the major banks had capital/ asset ratios in excess of 11 percent. Second, banks are required to report the current market value of their securities holdings and must set aside loan-loss provisions at the first hint of problems rather than waiting for arrears to accumulate. As a result, bank profitability will be affected by a downturn in the economy earlier than otherwise, but banks will be better equipped to deal with any problems that emerge.
Earlier exchange rate depreciation had actually contributed to problems in the Finnish banking sector. The corporate sector had relied heavily on foreign-currency-denominated bank loans and many of these became nonperforming in 1991–92 when the depreciation of the markka led to significantly higher debt-service costs.
The estimated gross amounts committed, with attribution, are SKr 92 billion in Sweden (Bank Support Authority), Fmk 39 billion in Finland (IBCA Limited), and NKr 28.2 billion in Norway (IBCA Limited).
The Savings Bank of Finland was itself formed in 1992 by the merger of 41 small savings banks.
The BSA provided a SKr 2.5 billion capital-adequacy guarantee for the initial public offering. This guarantee can be utilized if the bank’s capital falls below 9 percent of its risk-weighted assets. If fully utilized, this facility would result in a 54 percent BSA share in Foreningsbanken equity (86 percent of the votes).
The official definition of nonperforming loans includes loans to borrowers that have legally been declared bankrupt (¥ 2.3 trillion) and loans on which interest has not been paid for 180 days (¥ 11.3 trillion). These figures on nonperforming loans do not include restructured loans. The Japan Center for International Finance estimates the stock of restructured loans at ¥ 13–14 trillion. The increase in nonperforming loans between March and September 1993 is a net number: nonperforming loans that have been sold to the Cooperative Credit Purchasing Company or charged off are removed from the non-performing category, as well as from the balance sheets of banks.
As the data in Table 17 show, most loan sales to the CCPC have been arranged immediately prior to the end-September and end-March reporting dates.
This measure differs from the Japanese definition of operating earnings, which includes unrealized gains and losses on the investment bond portfolio. These are removed to approximate banks’ cash flow.
In 1993/94, loans were sold to the CCPC at an average discount of 51 percent.
Based on data provided by IBCA Limited.