Chapter

IV Possible Sources of Banking Problems

Author(s):
G. Johnson, and Richard Abrams
Published Date:
March 1983
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As in all financial intermediation, risk is an inherent feature of international banking. This section describes the risks involved and discusses some of the threats these risks pose to the continuity of international bank lending.

Country Risk

The most obvious risk in international banking is that international loans of banks might not be serviced. Beyond whatever commercial risk may be involved in individual loans, international lending is subject to (1) sovereign risk—the possibility of default or repudiation by a government with respect to its external debt—and (2) transfer risk—the possibility that private borrowers who are able to generate the necessary repayments in local currency are prevented from converting the funds. Table 4 shows the exposure of the international banking system as a whole to the largest country borrowers. Table 5 presents the consolidated exposure of the banking systems of the United States and the United Kingdom to large borrowers. Data on consolidated exposure are not available for other banking systems.

Table 4.Country Exposure of International Banks at the End of 19811(In billions of U.S. dollars and per cent)
AmountPercentage of

Bank Capital2
Industrial countries outside BIS reporting area57.517.3
Australia9.93.0
Finland7.32.2
Norway10.73.2
Spain23.27.0
Oil exporting countries67.920.4
Algeria8.42.5
Indonesia7.22.2
Kuwait5.11.5
Nigeria6.01.8
Saudi Arabia5.61.7
Venezuela26.27.9
Non-oil developing countries3313.994.2
Argentina24.87.5
Brazil52.715.8
Chile10.53.2
Colombia5.41.6
Greece9.82.9
Hungary7.72.3
Israel6.01.8
Korea19.96.0
Mexico56.917.1
Philippines10.23.1
Portugal7.52.3
Romania5.11.5
South Africa11.23.4
Thailand5.11.5
Yugoslavia10.73.2
Offshore banking centers240.872.3
Bahamas71.021.3
Bahrain9.02.7
Cayman Islands46.614.0
Hong Kong31.39.4
Liberia6.92.1
Netherlands Antilles7.02.1
Panama26.98.1
Singapore36.611.0
Centrally planned economies450.215.1
German Democratic Republic10.73.2
Poland15.34.6
U.S.S.R.16.34.9
Sources: BIS, The Maturity Distribution of International Bank Lending; and Fund staff estimates.

Aggregate claims of BIS reporting banks on countries outside the BIS reporting area. All countries for which total bank claims exceed US$5 billion are listed separately.

Capital of banks in the BIS reporting area at the end of 1981 was on the general order of US$335 billion.

Excludes countries designated by the BIS as “offshore banking centers.”

Excludes Fund member countries.

Sources: BIS, The Maturity Distribution of International Bank Lending; and Fund staff estimates.

Aggregate claims of BIS reporting banks on countries outside the BIS reporting area. All countries for which total bank claims exceed US$5 billion are listed separately.

Capital of banks in the BIS reporting area at the end of 1981 was on the general order of US$335 billion.

Excludes countries designated by the BIS as “offshore banking centers.”

Excludes Fund member countries.

Table 5.Consolidated Country Exposures of U.S. and U.K. Registered Banks at the End of 19811(In billions of U.S. dollars and per cent)
Claims of U.S. BanksClaims of U.K. Banks
AmountPercentage

of bank

capital2
AmountPercentage

of bank

capital2
BIS reporting area156.9246.391.8253.5
Austria2.13.21.54.0
Belgium-Luxembourg9.014.26.618.3
Canada17.627.74.813.2
Denmark3.04.72.77.5
France18.429.013.737.7
Germany, Fed. Rep. of13.320.97.821.4
Ireland1.62.51.54.0
Italy10.216.05.916.4
Japan38.460.313.436.9
Netherlands4.67.33.610.1
Sweden4.36.72.77.5
Switzerland5.18.03.910.8
United Kingdom29.245.8
United States23.865.7
Other industrial countries16.826.311.431.5
Australia4.57.12.57.0
Finland1.93.01.95.1
Norway3.14.91.95.1
Spain6.09.54.111.3
Oil exporting countries20.131.68.623.8
Algeria1.21.90.61.7
Indonesia2.13.40.51.5
Kuwait1.32.01.12.9
Nigeria1.11.71.23.3
Saudi Arabia2.33.71.33.7
Venezuela10.115.93.18.6
Non-oil developing countries122.6192.549.8137.6
Argentina8.413.33.59.5
Brazil18.228.56.518.0
Chile5.79.01.54.2
Colombia3.04.80.61.7
Greece2.94.51.33.7
Hungary1.11.70.82.3
Israel2.53.90.61.6
Korea9.014.12.57.0
Mexico21.434.27.821.4
Philippines5.17.91.23.4
Portugal1.82.81.23.3
Romania0.30.50.61.7
South Africa2.74.22.57.0
Thailand1.82.90.61.6
Yugoslavia2.64.11.54.1
Offshore banking centers13.220.88.322.9
Centrally planned economies33.35.25.314.5
German Democratic Republic1.11.71.64.3
Poland1.21.90.92.4
U.S.S.R.0.60.91.85.0
International organizations and unallocated0.71.10.72.0
Total320.3503.0167.5462.8
Sources: Bank of England Quarterly Bulletin; and Federal Financial Institutions Examination Council, Country Exposure Lending Survey.

Where risk transfers are involved, exposure is recorded as being to the country of the guarantor. U.S. data cover 159 large banking organizations. U.K. data cover British-owned banks, consortium banks, and British subsidiaries of foreign banks. In both cases, claims of foreign subsidiaries and branches are included, except for local claims in local currencies. All countries for which total bank claims exceed US$5 billion (see Table 4) are listed separately, except for offshore banking centers. For most of the latter, claims of U.S. and U.K. banks, after risk transfers, are very small.

Bank capital, estimated on the basis of published data in the U.S. Federal Reserve Bulletin and the Bank of England Quarterly Bulletin, is US$63.7 billion for the United States and US$36.2 billion for the United Kingdom.

Excludes Fund member countries.

Sources: Bank of England Quarterly Bulletin; and Federal Financial Institutions Examination Council, Country Exposure Lending Survey.

Where risk transfers are involved, exposure is recorded as being to the country of the guarantor. U.S. data cover 159 large banking organizations. U.K. data cover British-owned banks, consortium banks, and British subsidiaries of foreign banks. In both cases, claims of foreign subsidiaries and branches are included, except for local claims in local currencies. All countries for which total bank claims exceed US$5 billion (see Table 4) are listed separately, except for offshore banking centers. For most of the latter, claims of U.S. and U.K. banks, after risk transfers, are very small.

Bank capital, estimated on the basis of published data in the U.S. Federal Reserve Bulletin and the Bank of England Quarterly Bulletin, is US$63.7 billion for the United States and US$36.2 billion for the United Kingdom.

Excludes Fund member countries.

The risk of loss to banks should be measured in relation to bank capital. At the broadest level of aggregation, the total capital of banks in the BIS reporting area at the end of 1981 was on the order of US$335 billion.9 The collective exposure of BIS reporting banks to each of the two largest borrowers among the developing countries thus exceeded 15 per cent of bank capital. The largest consolidated exposures to developing countries of banks based in the United Kingdom were of the same general order of magnitude, but for large banks based in the United States, consolidated exposure to individual developing countries was as much as 34 per cent of bank capital.10 The important consideration for banking stability is the situation of individual banks, for some of which exposure concentration is considerably higher than it is at the aggregate level.

But it is important to bear in mind that country crises in the servicing of debt to banks in recent years have resulted in reschedulings of debt on market terms. Given the nature of relations between banks and sovereign debtors, any significant degree of write-off may not occur even in the most serious cases, and the danger of total write-off that would seriously threaten a bank’s solvency seems remote. In any case, it would be unlikely to occur abruptly, giving banks time to adjust to the potential loss.

Other Risks in International Banking

Losses on foreign exchange operations were a major factor in most of the bank failures of 1974–75, but such losses can be controlled through placing limits on uncovered positions in foreign exchange operations. Supervisors have tightened their guidelines in this regard, and banks now generally appear to follow prudent practices.

Another risk arises from the fact that bank assets generally have longer maturities than bank liabilities, so that losses can occur if interest rates fluctuate. When operating in foreign currencies, moreover, banks lack the modest degree of protection offered by the ability to set “prime” rates or by the influence on the decisions of monetary authorities that they may have to some extent in their domestic currencies. On the other hand, the widespread use of floating interest rates internationally keeps interest rate risk small, though losses resulting from short-run fluctuations in interest rates can significantly affect bank profitability over short periods.

It is almost a truism that “the next banking crisis” will come from an aspect of risk that has not been foreseen, because if the problem is foreseen, precautions can be taken to forestall it. There is, moreover, always the risk of fraud, a factor in the bank failures in 1974 and again in 1982. Whatever the source of difficulty, however, with conditions of reasonable global economic stability, losses are unlikely to be so widespread as to threaten many banks with insolvency.

Bank Liquidity and Contagious Effects

The failure of even a few banks could lead to more widespread disruption through contagious effects on other banks. A banking crisis is, by definition, associated with requests by depositors for withdrawal of their funds from the banks in question. In attempting to meet such requests, banks need to substitute new liabilities for those being run off or to carry out a parallel runoff of assets. The cost of doing so rises sharply with the volume of funds that the banks attempt to acquire, severely constraining their ability to make new loans and, ultimately, threatening bank solvency.

Some of the more imaginative scenarios for an international banking crisis postulate withdrawals of funds by a few large depositors as a trigger for a crisis. In such scenarios, the original withdrawals occur not because of fears about the security of deposits but for, say, political reasons. Through contagion, such actions generate the fears that lead to a crisis. Safeguards for bank liquidity seem strong enough to prevent such actions by a small number of depositors from provoking a major crisis. In the past, moreover, governments have shown a readiness to block the withdrawal of deposits when security matters were involved, and there is no reason to think that they would not do so quickly if a banking crisis threatened to occur.

More plausible, depositors might ask to withdraw their funds from certain banks because of a real or imagined danger of insolvency. In the absence of complete information about the affairs of banks in which they deposit their funds, depositors are naturally prone to become doubtful of banks in general when even a few banks are thought to be in serious trouble. Contagion is likely to be a more serious problem with respect to international than domestic deposits, because of the difficulties that some depositors have in obtaining information, the large size of individual deposits (which implies minimal coverage by any available deposit insurance), and uncertainty about the ability and willingness of national authorities to protect foreign depositors against loss in the event of a bank failure.

Interbank Relationships

A particular feature of international banking is the extent to which banks rely on funds “purchased” from holders of large balances. Even in domestic banking, many institutions have, over time, become more dependent on such wholesale funding, as opposed to their traditional retail deposit base. But in international banking, at least for operations in foreign currency, funding is almost purely a wholesale business. A relatively small number of large banks, moreover, are favored by nonbanks as outlets for their funds. The fact that most of the other banks involved rely to a large extent on funds onlent by the big banks facilitates the transmission of bank difficulties.

In a banking crisis, banks would have difficulty collecting funds due them from a failing bank, while the failing bank or its liquidators would insist on collecting funds due it from other banks. While the exposure of a bank to any other single bank is not likely to be large relative to bank capital (unlike the exposure that some banks may have to individual countries), its collective exposure to banks in difficulty could be substantial. As with country exposure, data on the interbank exposures of individual banks are generally not available. The scale of interbank credit by various measures is in the range of 65–75 per cent of total international bank liabilities (Ellis, 1981). Much of this credit, however, is really intrabank credit, because it represents positions vis-à-vis foreign affiliates. Individual banks, moreover, are normally active on both sides of the market—that is, whether they are net takers or placers of funds, they normally take gross positions both as takers and placers.

Besides the obvious problems posed for banks by loss of funds loaned to failing banks or by difficulties in finding new sources of funds to replace funds previously borrowed from failing banks, banks that rely heavily on other banks for net funding might face further difficulties. Banks placing funds, like other depositors, would become more wary of redepositing, except with banks they felt were in a strong position. Beyond that, however, banks might feel a need to protect themselves against runs on their own deposit base by shifting their assets out of interbank deposits and into cash or liquid government obligations. For net placers of interbank funds, such a shift would be relatively easy to carry out, but the result would be a liquidity drain for banks that were net takers. These latter banks would include most of the small banks operating in the international money market. In the near crisis of 1974, for example, the large money-center banks drastically reduced the number of other banks with which they were prepared to place funds.

The continuity of international bank lending is dependent on another interbank relationship as well. The large loans that characterize much of medium-term international bank lending are typically put together by a club or syndicate of banks. Anything that affects interbank confidence could jeopardize the syndication process. The actions of certain U.S. banks in connection with the Iranian crisis of 1980, for example, led to accusations of bad faith from other banks and may have temporarily hampered loan syndications.11 One response to such problems has been to include much more detailed legal specifications in loan agreements.

Changes in Risk Perceptions

The rest of this paper examines the various safeguards against disruptions of international banking—that is, the elements of an international safety net. It is important to bear in mind, however, that even if banks were not forced to withdraw from international banking through actual bank failures or official action, they could still withdraw from it because of changes in their perceptions of its riskiness. While gradual changes in risk perceptions could be accommodated by gradual shifts in lending spreads, so that the international economy would have time to adjust to a gradual shift in financing flows, a sharp change in perceptions could lead to abrupt shifts in flows that could not be accommodated by a moderate hardening of terms. In that case, many countries could find themselves losing access to international bank credit.

Changes in risk perceptions may have a regional impact. As a result of the Polish debt crisis, Hungary experienced major difficulties in obtaining bank finance, despite the general perception that its economy was basically sound. Bank behavior, moreover, often displays a destabilizing pattern. At the aggregate level, small banks generally remained rather aloof from international lending in the mid-1970s, even after the tiering associated with the 1974 bank failures had dissipated and international lending had once again become highly profitable. The subsequent rise in international lending toward the end of the decade, paralleling the rush at its beginning, suggests the presence of “bandwagon” effects.

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