I Introduction

G. Johnson, and Richard Abrams
Published Date:
March 1983
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During the 1970s, international lending by banks came to play a dominant role in the flow of international finance. In the early 1980s, banks have continued to play a major role, but the recent evidence of strains in international banking has raised questions about the prospects for continuity of international intermediation by banks.

This paper focuses on one aspect of banks’ willingness and ability to continue international intermediation.1 Banking history up to the 1930s was replete with crises that entailed a disruption of banking activity, drastically altering the volume, direction, and terms of the flow of funds within and among national economies. Could such a disruption occur today? The paper provides a qualitative assessment of the strengths and weaknesses of the existing safeguards for the continuity of international intermediation by banks. As background to that discussion, it also presents, in general terms, some conceivable origins of banking problems and some of the possible consequences of such problems for the international economy.

Safety Nets in Domestic Banking

The history of the development of market economies has been characterized by a growing dependence on financial intermediaries to provide the money and credit that facilitate economic activity, so that the consequences of a collapse of financial institutions have become progressively more serious.2 The Great Depression of the 1930s could almost be defined in terms of financial collapse. In the United States, for example, the stock of money contracted by more than one third between August 1929 and March 1933. In the same period, more than one fifth of the commercial banks in the United States suspended operations. Others were merged or voluntarily liquidated, so that the number of commercial banks in operation declined by a third (Friedman and Schwartz, 1963). Although authorities in most European countries intervened more actively to shore up their banking systems, major bank failures or payments moratoriums were common. Withdrawals of bank loans and deposits played a major role in the balance of payments crises of the period, particularly in Central and Eastern Europe.

Since the crisis of the 1930s, the financial authorities of most countries have changed their policies in order to avoid a recurrence. While economic fluctuations and failures of individual institutions have inevitably continued, the fact that these have not resulted in generalized financial panics bears witness to the success of banking “safety nets.”

The purpose of such safety nets is to keep financial systems functioning in the face of economic shocks.3 They can be thought of as consisting of a series of defenses: (1) prudential measures to protect bank solvency; (2) prudential measures to protect bank liquidity; (3) official assurances (such as deposit insurance) to depositors that their deposits are safe, even with troubled institutions; (4) orderly resolution of the problems of failing banks; and (5) in the last resort, official provision of liquidity to permit solvent institutions to keep functioning in the face of a loss of depositor confidence. In setting up these defenses, however, financial authorities face the problem of “moral hazard.”4 That is, any measure that reduces the extent to which the market penalizes imprudent behavior (or rewards prudent behavior) may well encourage institutions to behave imprudently. For example, full insurance for all liabilities of financial institutions, adequately funded, would guard against system-wide drains of liquidity resulting from a loss of depositor confidence but, at the same time, would remove the market mechanism that forces individual institutions to act so as to preserve that confidence. The multiple layers of partial protection that make up each country’s safety net and the diversity of safety nets from country to country reflect, to a large extent, attempts to require banks to accept responsibility for their actions, while preserving the stability of the system.

With effective safety nets, the effects of banking problems will be limited to an increase in the price of intermediation. If banks’ capital positions look weaker, whether because they have been reduced by loan losses or because banking is perceived to be a riskier business, the need to strengthen those positions (either through retaining earnings or through tapping the capital markets) will force up the spread between deposit and lending rates. While this would raise the cost of credit to borrowers, there should be no question of credit availability, although if the other circumstances of the economy are unfavorable there might be problems of creditworthiness of otherwise bankable customers.

This last point gets back to the ultimate requirement for banking stability—that policies be carried out in such a way as to maintain a reasonable degree of economic stability. One further caveat should be noted. The degree to which any banking safety net can stretch without breaking depends on the flexibility of bank supervisors and monetary authorities. If there were limits on the amount of liquidity that a central bank could supply, for example, or if banks were forced to adhere to strict quantitative standards for bank capital in the face of large loan losses, the ability of the banking system to continue intermediating could be seriously impaired.

Scope of the Study

Following this introductory section, Section II reviews some recent events in international banking as background to the discussion of the issues covered in the paper. Section III then presents some of the dimensions of the world’s dependence on financial intermediation by international banks, with particular emphasis on the flow of capital to the non-oil developing countries. It also notes the extent to which the external accounts of industrial countries could be affected by problems in their international banking sectors. These problems could be the result of spillovers from difficulties in domestic banking or of particular features of international banking itself. Section IV briefly looks at possible sources of instability and at ways in which initial problems could escalate.

The remainder of the paper examines the safeguards built into the present international banking system and points out the gaps that remain. Section V focuses on prudential standards for the protection of bank solvency. A fundamental prudential standard involves a bank’s maintaining sufficient capital in relation to its assets to permit the bank to absorb significant losses. Standards are also established to limit particular sorts of risk. In the international area, the standards that have received the most attention relate to the management of foreign exchange exposure, concentration of country exposure, and maturity transformation. The section concludes with a review of the development of international coordination of supervisory standards, a subject that is examined in greater detail in Appendix I.

Public fears of bank failure, whether justified or not, may lead to abrupt withdrawal of deposits from particular banks or from groups of banks. Banks attempt to protect themselves against such problems by maintaining liquid assets, by limiting the degree of mismatch between the maturities of assets and of liabilities, and by arranging lines of credit with other banks. Section VI describes precautions taken by international banks in this area.

The final line of defense against bank crises is the willingness of banking authorities to provide support for banks. The support provided by deposit insurance is less significant in international banking than in domestic systems. With international banks, moreover, special problems are posed for banking authorities in their role of ensuring an orderly resolution of the affairs of failing banks, and for some banks the locus of lender of last resort responsibility is not clearly defined. Questions may also be raised about the ability and willingness of lenders of last resort to provide general liquidity to their banking systems to meet their international obligations. Section VII discusses policies of lenders of last resort with respect to international banks. Appendix II provides a brief systematic review of the role of national lenders of last resort in international banking.

In the event of a major disruption of the international banking system, there could be a need for special international financial arrangements to help countries deal with the consequences of the disruption for the capital accounts of their payments balances. Assistance might be needed both by countries that were dependent on borrowing from banks and by countries whose banking systems were under pressure. Besides temporary financial assistance to deal with the immediate consequences of the disruption, there might also be a need for new channels for longer-term international capital flows if banks’ withdrawal from international banking turned out to be substantial and sustained. Questions about the nature of such financial assistance are beyond the scope of this paper.

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