Chapter

II Recent Developments

Author(s):
G. Johnson, and Richard Abrams
Published Date:
March 1983
Share
  • ShareShare
Show Summary Details

The year 1982 was one of turmoil in financial markets. Banking problems, as measured, say, by the tiering of interest rates, were not as severe as in 1974–75, but it is nonetheless likely that substantial changes may ensue in the operation of the international banking system. This section presents a preliminary assessment of the significance of these events.

The major events of 1982 included two that had special implication for banks’ attitudes toward international lending. The conflict between Argentina and the United Kingdom included mutual imposition of financial sanctions—thus involving both the fourth largest bank debtor among the developing countries and the most important center for international banking. Mexico’s debt service crisis marked the first time a very large bank debtor—in this case, the largest among the developing countries—had encountered such difficulties; late in the year other major borrowers also encountered difficulties in servicing their debt. Two significant bank failures occurred—Penn Square National Bank in the United States and Banco Ambrosiano in Italy—the second of which involved complex international dealings, and both of which left some depositors uncertain about the extent to which they would be repaid. These developments occurred against a background of rising domestic loan losses and financial difficulties of major corporations in a number of countries that threatened banks with further losses.

Country Risk and Sovereign Lending

Until 1982 no very large borrower had encountered external debt servicing difficulties; even Poland had accounted for less than 4 per cent of bank loans outside the industrial countries. A growing number of relatively small borrowers had sought debt reschedulings, but they represented a very small proportion of banks’ international assets. Mexico’s debt service problems, however, involved a borrower that alone accounted for 13 per cent of bank loans outside the industrial countries. Despite the magnitude of Mexico’s debt to banks—perhaps not far short of bank capital for some large banks—expressions of concern about the effects on bank solvency have been muted. Presumably, this reflects continuing recognition that, while banks might not always emerge unscathed from country debt crises (although this has been the case up to now), the actual loss on account of any country is likely to be small relative to the total exposure to the country.

Confidence of Depositors

The confidence of large U.S. depositors was shaken by the failure of Penn Square National Bank, which was the first failure of a sizable U.S. bank in 50 years without immediate pay-off of depositors by the Federal Deposit Insurance Corporation. As a result, some banks suffered withdrawals, and some large depositors diversified their deposits to increase their effective insurance coverage, limited as it is to $100,000 per depositor at any individual bank. Rising loan losses led to doubts about even some major banks, which found themselves forced to pay more than the best market rates on their obligations. Beyond such tiering among financial institutions, there was also a movement from bank certificates of deposit into government obligations that led to increasing differentials between interest rates on certificates of deposit and those on treasury bills.5

More significant for international depositors was the failure of Banco Ambrosiano. While the Italian authorities and Italian commercial banks quickly took action to provide full backing for payment for depositors of the parent bank in Italy, including international depositors, no such backing applied to Banco Ambrosiano Holding in Luxembourg, with the result that its major bank creditors quickly declared default. Eventual recovery of most of the creditors’ funds seemed likely, but they faced, at the very least, protracted delays in recovery. Some tiering of Euromarket interest rates occurred, with some banks paying up to1/2per cent more than the lowest market rate for funds. Such tiering was much more modest than in 1974–75, when it approached 2 per cent for some banks, but it nonetheless indicated a more discriminating attitude on the part of other banks and nonbank depositors.

Interbank Relationships

Besides questions relating to interbank deposits, other aspects of interbank relationships have also come under scrutiny as a result of recent problems. On the positive side, the financial sanctions mutually imposed by Argentina and the United Kingdom do not seem to have led to interbank problems, in contrast to what occurred during the United States-Iran dispute in 1980.

It has sometimes been suggested that one area of vulnerability in international banking is that smaller banks often do not adequately analyze loans they participate in, but simply act on the advice of the large banks. A surprising aspect of the Penn Square National Bank’s failure was the extent to which the transmission mechanism worked the other way in domestic loans, with some very large banks apparently taking on loans arranged by Penn Square with a minimum of independent evaluation.

Regulatory Adaptations

As with the near crisis of 1974–75, the current surge in problems can be expected to bring about changes in bank regulation and supervision. Among domestic banking systems, a major strengthening of supervisory powers is under way in Italy, and Italian-owned holding companies abroad have been subjected to stronger reporting requirements. In the United States, since September 30, 1982 national banks have been required to file quarterly reports listing poor-performing loans, which previously were identified only in the context of bank examinations, and bank positions are to be subject to greater public disclosure. There is also a movement toward more conservative treatment of poor-performing sovereign loans, with banks increasingly making provisions against potential losses on such loans. In Canada, the large exposures of Canadian banks to individual corporations have led the Inspector-General of Banks to advise banks to limit such exposures to 50 per cent of capital, and a Parliamentary Inquiry has called for stringent legal lending limits. In the Federal Republic of Germany, the Deutsche Bundesbank has requested a number of banking institutions to give it notice of credits to foreign borrowers totaling DM 50 million or more.

Internationally, the problems of Banco Ambrosiano Holding raised questions about the sharing of responsibilities among lenders of last resort. Many of the calls on the Italian authorities to stand behind the subsidiary seem to reflect a belief that no depositor should be hurt by such a failure, a responsibility that presumably no lender of last resort would consider it appropriate to accept. Short of that, however, is the question of who has the responsibility to ensure an orderly and equitable resolution of the problems of failing banks. The authorities of Luxembourg and the United Kingdom, both of which have large numbers of subsidiaries of foreign banks within their jurisdictions, have made it clear that they regard the foreign parents as having full responsibility to support their subsidiaries. This could be taken to imply that the parent authorities have the responsibility of lender of last resort. The Italian authorities fully protected depositors with the parent bank. Along with some other parent authorities, however, they felt limited responsibility for foreign subsidiaries whose activities they were unable to supervise. The result may be firmer contractual understandings on financial support; Luxembourg has already required the Italian parents of Luxembourg holding companies to provide written guarantees of support.

The problems of Banco Ambrosiano Holding also pointed up gaps in bank supervision. Since it was a bank holding company and not a bank, under Luxembourg law the Luxembourg authorities did not have supervisory powers. Italy is now putting new controls on foreign subsidiaries of Italian banks to ensure better supervision of their activities.

Conclusions

In some ways, current financial events fit the model of speculative cycles developed by Minsky (as described in Kindleberger, 1978), in this instance with banks themselves as the major players. International bank lending has grown rapidly in recent years as a result of the emergence of highly profitable, seemingly riskless opportunities, while institutional changes in many domestic markets (particularly deregulation in the United States) have also generated new modes of financial intermediation. In the past, the end of such cycles was often accompanied by the financial collapse of the principal actors, in some cases accompanied by more general crises in the economies in which they operated. Viewed in this context, the events of 1982 to a large extent demonstrated the strength of the international banking system. The enormous financial strains associated with the maintenance of high real interest rates in the face of economic recession have placed many financial institutions in serious difficulties. As in 1974–75, some banks failed, mainly as a result of fraud or incompetence, but unlike the previous period these failures have not resulted in major disruption of international banking relationships, despite the fact that the underlying economic situation has been graver than it was then.

It is likely that in the short run there will be some negative impact on banks’ attitudes to international lending—particularly among smaller banks that may have less of a long-term commitment to their international customers. Over the medium term, the system should be strengthened by recent events. While some financial institutions, both those operating in domestic markets and those operating internationally, have been adversely and perhaps inappropriately affected by these events, a more discriminating approach by depositors should, in general, be salutary. The moral hazard pendulum had perhaps swung too far, with depositors—including interbank depositors—thinking they had no risk of loss and thus facilitating incompetent or fraudulent behavior in some institutions. A more cautious attitude on the part of depositors will make it more difficult for institutions with less than solid credentials to expand rapidly in risky or questionable areas of activity. While this may mean slower growth of bank credit, the credit that is not generated would probably be of marginal usefulness. At the same time, bank supervision is likely to be strengthened, and there is likely to be further clarification of international understandings in that area. There is also likely to be a better delineation of the relative responsibilities of the various national authorities for the orderly resolution of the problems of failing banks. Taken together, these developments should do much to reduce the extent to which banks can evade the intent of regulation and supervision of prudential behavior by locating in centers where monitoring is lax.

    Other Resources Citing This Publication