Chapter

II Structural Changes in the Financial Markets

Author(s):
Donald Mathieson, Eliot Kalter, Maxwell Watson, and G. Kincaid
Published Date:
February 1986
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In recent years, the structure of major international financial markets has been fundamentally altered by the development of new instruments, more intense competition, and significant changes in official regulations governing the banking and securities markets. While the principal instrument of medium-term international finance in the 1970s was the syndicated bank loan, alternative instruments such as floating rate notes, interest rate and exchange rate swaps, and international issuance facilities developed rapidly during the 1980s, substituting, in a number of cases, for syndicated lending.

Many of the new financial instruments initially were designed in response to tax or regulatory factors. However, the more enduring innovations have significantly altered the sharing of risks between borrowers and lenders, more closely integrated market conditions among the major countries, and strongly affected the roles of various financial intermediaries in channeling the flows of savings and investment between countries. The rapid pace of innovation represents a fundamental response to uncertainties in the international economy, experience of the debt crisis, and changes in official policies relating to bank supervision and financial markets. The changes in official policies relating to financial markets, in turn, have been undertaken in response to changes in economic conditions affecting domestic and foreign financial markets. These policy changes also reflect a desire to increase efficiency and competition in financial markets.

One factor that has contributed to the rapid pace of change has been the development of new computer and telecommunications technologies. While these technological changes would not, by themselves, have fundamentally altered the financial markets without accompanying changes in the economic environment and official regulations, new technology has increased the ability of financial institutions to manage more complex and sophisticated operations in an increasingly integrated global market.

This section examines some of the key sources of change that arise from macroeconomic conditions and from official policies aimed at liberalizing financial markets. It also discusses the nature of a number of new instruments in international markets. Finally, recent developments in market supervision are reviewed.

Factors Contributing to Change in Financial Markets

Inflation and Increased Uncertainty

The sharp acceleration of inflation during the 1970s in countries with major financial markets was a major factor leading to changes in financial instruments and regulations. The regulatory and institutional structures of major financial market countries in the 1960s and early 1970s reflected, to an important degree, a long experience of relatively low inflation rates and stable interest rates.10 Relatively low inflation contributed to interest rate stability and helped create a willingness on the part of savers to hold long-term, fixed interest rate assets. In addition, there emerged a number of financial institutions holding relatively illiquid, long-term, fixed interest rate loans that were financed by issuing relatively liquid, short-term, fixed interest rate liabilities.

Rising inflation resulted in low or negative real interest rates on many financial assets and reduced capital values of those assets. Although the acceleration in inflation was not uniform among major industrial countries, the average inflation rates in the 1970s were generally twice those observed in the 1960s.11 For holders of long-term, fixed interest rate securities during the 1960s, the higher levels of inflation and the accompanying increases in interest rates produced large capital losses and low (and often significantly negative) real returns on their portfolio holdings. This experience created a preference on the part of investors for instruments carrying variable interest rates or with relatively short maturities. While inflation slowed during the early 1980s, average inflation rates during 1980–84 were still higher than in the 1960s (except in the case of Japan).

Changes in financial markets were also stimulated by the emergence of more volatile macroeconomic conditions in the international economy during the 1970s and early 1980s. In addition to high and variable inflation rates and interest rates, this period witnessed the emergence of considerable exchange rate variability, sharp swings in economic activity, and substantial movements in relative prices of commodities. Moreover, macroeconomic policies generally placed less emphasis on stabilizing exchange rates or interest rates than in the past.

Sharp changes in economic conditions increased the uncertainty regarding real yields on financial instruments. As a result of increased uncertainty, lenders became reluctant to provide long-term, fixed interest rate funds, except in exchange for high real rates of return. To respond to changes in perceived risks, the issuers of securities and deposit liabilities attempted to alter the characteristics of financial instruments to enhance their liquidity and to make their future capital value more certain. This process has included the emergence of floating rate notes, interest rate and exchange rate swaps, and financial futures and option markets.

Changing Patterns of Payments Imbalances, Savings, and Investment Flows

The types of instruments used in international financial markets have been strongly influenced by the changing patterns of payments imbalances and the implied redistribution of savings and investment flows across countries and regions. During the 1970s, the need to finance the current account imbalances associated with the sharp movements in energy and commodity prices led to a significant expansion in international bank lending and the emergence of the syndicated bank loan as a principal vehicle of international finance.

For those developing countries which relied heavily on credit from commercial sources (the market borrowers), foreign capital inflows, measured relative to GDP, increased by nearly one half between 1967–72 and 1973–82. These inflows added the equivalent of 12 percent of domestic savings to total savings. Foreign capital inflows also represented an important component of total funds available to finance investment for those developing countries which have been heavily dependent on credits from official sources (official borrowers). During 1967–84, the inflows received by this group represented an average 6 percent of their GDP, and 51 percent of their domestic savings. In contrast, while individual industrial countries at times experienced large capital inflows or outflows during the 1960s and 1970s, the imbalances for the group as a whole varied between surpluses or deficits that were equivalent to less than 1 percent of their combined incomes or 3 percent of their domestic savings. Appendix III contains a more detailed discussion of the evolution of savings, investment, and foreign capital inflows during 1967–84.

In the period following the emergence of external payments difficulties for many developing countries in the early 1980s, there were sharp changes in the pattern of payments imbalances. Reflecting both the adjustment efforts of developing countries and a reluctance of commercial lenders to increase their exposure to countries with external payments difficulties, net capital flows and current account deficits declined sharply. The current account deficit of the developing countries in aggregate declined from $100 billion in 1982 to $42 billion in 1984.

At the same time, the current account position of the industrial countries switched from a small surplus in 1982 ($3 billion) to a sizable deficit ($35 billion) in 1984. Moreover, the current account imbalances of individual industrial countries increased significantly, with the U.S. current account deficit reaching $93 billion in 1984 and the Japanese surplus amounting to $36 billion. International capital movements thus increasingly represented flows between industrial countries, as opposed to flows between industrial and developing countries. At the same time, the issuance and purchase of securities (principally between entities in industrial countries) gradually displaced syndicated bank lending as a primary vehicle of international finance.

The decline of foreign capital flows to developing countries has sharply reduced the contribution of external savings to the financing of investment in these countries. For the market borrowers, the average ratio of foreign capital inflows to GDP during 1983–84 was below that experienced in the late 1960s and early 1970s. As a result, foreign capital inflows were equivalent to less than 7 percent of domestic savings during 1983 and 1984, whereas they had represented over 12 percent of the groups’ domestic savings in the late 1960s. In contrast, the capital inflows that have been received by the official borrowers have remained more stable and helped to sustain the level of investment for this group. Since the ratios of domestic savings to GDP in many developing countries remained unchanged over the period 1967–84, reduced capital inflows have been accompanied by generally lower ratios of investment to income.

Liberalization

While many recent changes in regulations governing financial markets have been undertaken in response to the pressures created by macroeconomic developments, there have also been efforts in some countries to introduce additional competition into domestic financial systems in order to promote efficiency and to increase international access to domestic financial markets. In addition, the growing scale of Eurocurrency operations has led to competitive pressures in both domestic and international financial markets, permitted certain restrictions on domestic financial transactions to be bypassed, and allowed arbitrage of financing conditions across major financial markets.

The pressures for regulatory change affecting banking activity were often most evident when market interest rates rose relative to ceiling interest rates on bank deposit liabilities. Since interest rate ceilings on bank deposits were adjusted slowly to increases in market interest rates, there were at times significant outflows of funds from depository institutions subject to these interest rate ceilings into securities, including government paper, and deposits in nonbank institutions which were not subject to interest rate ceilings. Disintermediation was also encouraged by the need to finance large fiscal deficits in a number of countries with major financial markets. To finance these deficits, the authorities often issued debt with shorter average maturity, offered higher yields, and removed restrictions on the types of investors that could purchase short- and long-term government securities. Government debt carrying market-related yields provided attractive alternatives to banks’ deposits that had their interest rates fixed due to ceilings.

In most instances, changes in official policies have encompassed the relaxation of barriers separating the activities of different types of institutions, extensions of the geographical domain of existing institutions, the relaxation of interest rate ceilings, reductions in barriers to entry into the domestic financial system by both foreign and domestic institutions, the abolition or relaxation of exchange controls, and elimination of quantitative credit ceilings. Typically, new regulatory policies have been introduced gradually in order to allow the various sectors of the financial system sufficient time to adjust to the new financial market environment as well as to changing macroeconomic conditions.

Access to major financial markets has been improved by removal of capital controls, changes in regulations governing the taxation and issuance of bonds, the continuing expansion of the Eurocurrency markets, and changes in regulations governing access to both domestic and international markets. Table 2 provides some examples of the types of changes in regulations governing securities and banking markets that have occurred in recent years in Japan and the United States. Changes in Japanese regulations have broadened the array of instruments that can be used in securities markets and enlarged the access of both domestic and foreign borrowers to these markets, while increasing the role played by foreign financial institutions. In the United States, there has been a gradual removal of ceilings on domestic interest rates for bank deposits, a redefinition of the activities that various financial intermediaries can undertake, and a lessening of geographical restrictions on activities of banks.

Substantial changes have taken place in many other countries during the 1980s, In the United Kingdom, the authorities abolished exchange controls, removed restraints on the growth of bank liabilities (the Supplementary Special Deposit Scheme), and announced plans to liberalize the ownership of stock exchange firms with regard to both domestic and foreign institutions. In the Federal Republic of Germany, the authorities recently liberalized the types of securities that can be issued, allowing floating rate notes, zero coupon bonds, and swap-related issues. Also, it was recently announced that arrangements would be made to permit the issue of DM certificates of deposit by commercial banks. Foreign-owned institutions are now permitted to act as lead managers for foreign deutsche mark issues. In the Netherlands, a package of deregulation measures was announced in November 1985 that allows, among other things, the introduction of floating rate notes, certificates of deposit, and commercial paper. In addition, bond issues can now be brought to market without waiting in queue and foreignowned institutions are now permitted to act as lead managers in issuing securities.

In addition, withholding taxes on interest payments on domestic bonds held by foreigners have been removed in a number of countries including the United States, Japan, and the Federal Republic of Germany. There has been a removal of restrictions on the establishment of futures and options markets for financial assets, foreign exchange, and equities. Unlisted securities markets have been encouraged in several countries, to facilitate the raising of equity by small-and medium-sized enterprises.

The increasingly important role of foreign banks in the domestic markets of the major industrial countries is another aspect of growing integration—and competition—of financial markets. While foreign banks have traditionally provided financial services in the host country for exporters from their home countries, these banks are now attempting to establish positions in domestic retail banking markets by establishing branch networks or by purchasing domestic banks.

Table 2.Selected Changes in Regulations Governing Financial Markets in Japan and the United States
Japan
September 1982It was announced that the rules governing the issuance of yen-denominated obligations by nonresidents would be liberalized effective January 1983. The rule of one issue per quarter for a foreign corporate borrower was abolished, and private companies could compete for a place in the new issue queue on the same basis as supranational organizations and sovereign borrowers. All AAA-rated companies can issue on the market.
February 1983Ministry of Finance lifted its ban on the sale of zero coupon bonds in Japan but some conditions were placed on purchases of such bonds by Japanese investors.
December 1983Financial institutions were allowed to set up subsidiaries dealing exclusively in consumer lending.
January 1984The minimum size of CDs was reduced from ¥ 500 million to ¥ 300 million. Effective April 1, 1984 (i) the ceiling on overseas borrowing in the form of government-guaranteed bonds by public corporations and government-affiliated agencies was raised by one-half; (ii) the required credit rating for foreign governments and official agencies who wish to borrow for the first time in the domestic yen market was lowered from AAA to AA; and (iii) the waiting period between two offerings by the same borrower was abolished.
April 1984Guidelines on the issue of Euro-yen bonds issued by residents were eased, allowing some 120 Japanese firms to issue convertible Euro-yen bonds and some 30 firms to issue straight Euro-yen bonds. Guidelines on overseas lending by Japanese banks were discontinued.
May 1984The Ministry of Finance decontrolled exchange swaps in connection with the issuance of foreign currency bonds by residents, and of yen bonds by nonresidents. Nonresidents were excluded from the 20 percent withholding tax on interest paid on government bond issues in foreign currency. The final communique of the Working Group on Yen/Dollar Exchange Rates and the U.S. Secretary of the Treasury was published. It included a commitment by the Japanese authorities to create a framework for a yen-denominated bankers’ acceptance market and abolish, as of June 1, 1984, swap limits on spot foreign exchange position of banks. Furthermore, it authorized foreign companies to issue Euro-yen bonds under the criteria established for the use of samurai bonds. The criteria were to be relaxed further beginning in April 1985. The communique also contained a commitment from the Japanese Government to allow foreign financial entities to lead manage Euro-yen bond issues; to permit the issue of short-term Euro-yen denominated certificates of deposit; and to liberalize short-term Euro-yen loans to residents.
June 1984The Ministry of Finance relaxed “Gensaki” trading to include bonds denominated in foreign currencies which are listed on foreign stock exchanges. Banks were permitted to deal in secondary market issues of government and municipal bonds with maturities of up to two years. Short-term Euro-yen loans to Japanese residents were allowed.
September 1984Three foreign banks were invited to submit applications for licenses to deal in secondary market issues of public bonds under the same rules applying to Japanese banks.
December 1984Overseas branches of Japanese banks and foreign banks were allowed to issue abroad negotiable Euro-yen certificates of deposits with maturities of up to six months; nonresident borrowers were allowed to issue unsecured Euro-yen bonds under the same rules which govern foreign yen bond issues in Japan; and six additional foreign banks were authorized to sell Japanese government bonds over the counter. A concrete plan to create a yen-denominated Bankers’ Acceptance Market was announced.
March 1985The Ministry of Finance announced that from June 1985, banks and securities houses would be authorized to offer revolving loan facilities (up to ¥ 2 billion) by using public bonds as collateral, and that brokering licenses would be granted to banks for trading in the bond futures market which would begin operations in October 1985.
April 1985All banks were permitted to sell new types of large denomination deposit instruments with market-determined interest rates. Minimum size of CDs was lowered (to ¥ 100 million) and minimum maturity was shortened from three months to one month. Nonresident lenders and Japanese banks’ overseas branches were allowed to extend medium- and long-term Euro-yen loans, with a maturity of one year or more, to nonresidents and to overseas subsidiaries of Japanese corporations. The withholding tax on nonresidents’ earnings on Euro-yen bonds issued by Japanese residents was abolished.
June 1985It was confirmed that floating rate notes issued by nonresidents would be allowed on the Euro-yen market. The yen-denominated Bankers’ Acceptance Market became operative. Nine foreign banks were allowed to participate in trust banking business in Japan, thus permitting them to participate in the management of corporate pension funds.
July 1985It was also announced that foreign securities firms would be allowed membership on the Tokyo Stock Exchange before the end of the year.
October 1985Interest rates on large time deposits were liberalized.
United States
March 1980Depository Institution Deregulation and Monetary Control Act became law. It authorized negotiable orders of withdrawal (NOW) accounts on a nationwide basis from December 31, 1980 and extended reserve requirements to banks and other depository institutions that were not part of the Federal Reserve System. Furthermore, the law allowed savings and loan associations to invest 20 percent of their assets in consumer loans, commercial papers, and debt securities; allowed mutual savings banks to make business loans and accept business deposits; and created the Depository Institutions Deregulation Committee (DIDC), charging it with responsibility to eliminate gradually interest rate ceilings on deposit accounts.
December 1982Following instructions given by the Garn-St Germain Depository Institutions Act, the DIDC authorized money market deposit accounts (MMDA) with a minimum balance of $2,500 (subsequently changed to $1,000 after January 1, 1985, and zero after January 1, 1986) and with no interest rate ceiling. Depositors were allowed up to six transfers per month. Effective January 5, 1983, the DIDC allowed depository institutions to offer the Super-NOW account that had unregulated interest rates and unlimited transfers but with minimum balance requirements. Savings and loan associations were allowed to increase the proportion of their assets in the form of commercial loans.
June 1983The DIDC decided to eliminate all remaining interest rate ceilings on new time deposits of over $2,500 and longer maturity than 31 days opened after October 1, 1983. The Federal Reserve set a 5 percent capital/asset ratio requirement for larger banks.
October 1983The DIDC decided that the remaining requirement of a balance of $2,500 on deposit accounts should be phased out by January 1, 1986.
July 1984The Deficit Reduction Act repealed the 30 percent withholding tax on interest paid to foreign residents on qualified U.S. obligations issued after July 18, 1984.
September 1984The Department of Treasury banned direct or indirect sales to nonresidents of U.S. Government-backed security issues in bearer form.
November 1984About 9,300 state-chartered banks regulated by the Federal Deposit Insurance Corporation were permitted to enter the securities business.
January 1985The Department of Treasury announced that a separate trading of registered interest and principal of securities (STRIPS) programs would be available first for its long-term notes and bonds and later for all old and new eligible securities in circulation.
Source: Official data.
Source: Official data.

Development of Market Instruments

Parallel with the changes in official regulations, a variety of new instruments has developed in response to macroeconomic changes as well as existing and new regulations. Most of these instruments both redistribute risk in the markets and foster greater integration, whether by blurring the distinctions between banking activity and the securities markets, or by allowing borrowers to access markets in new ways.

Securitization

Floating rate notes have become an important instrument because they have been able to satisfy certain needs of both lenders and borrowers during periods of high and variable interest rates, unstable macroeconomic conditions, and uncertainty about the future trends in interest rates and inflation. In particular, floating rate notes fundamentally alter the sharing of the risks associated with interest rate variability between the borrower and the lender. With floating rate notes the borrower bears the costs of higher interest rates or obtains the benefit of lower yields. Borrowers have been willing to bear this additional risk in order to obtain longer maturities than are typically available through the issuance of fixed interest rate bonds.

Although the first Eurocurrency floating rate notes were issued in the early 1970s, it was not until recently, when banks began to use floating rate notes for liquidity management and as a means of adding to their capital, that the volume of these instruments expanded to a significant level. During 1979–81, for example, Eurodollar floating rate notes represented 12 percent of all new international bond issues, but this proportion grew to 34 percent in 1984, Commercial banks have been both major purchasers and issuers of floating rate notes. Many non-U.S. banks often found Eurodollar floating rate notes the least expensive means of securing medium-term U.S. dollar funding for their medium-term floating interest rate syndicated loans in U.S. dollars. In addition, subordinated floating rate notes were at times used as a source of bank capital. where this was permitted by the authorities.

Many corporate and sovereign borrowers found it less expensive to issue floating rate notes (or fixed interest rate bonds) than to obtain syndicated bank loans. This change in the relative cost of borrowing through bank loans and securities reflected, in part, the perception that the creditworthiness of many banks had declined in view of the difficulties that many of their borrowers were having in servicing their bank loans. As a result, the ratings of a number of leading banks were reduced relative to some of their sovereign and corporate clients. This factor, in addition to the costs of loan intermediation, helped keep the cost of syndicated loans for many creditworthy borrowers above the costs they experienced by directly issuing notes or other securities. In many cases, banks were able to hold floating rate notes without incurring the full liquidity and capital costs associated with direct loans, owing to privileged regulatory treatment of securities.

Floating rate notes typify a more general tendency, called “securitization,” to increase the marketability of banks’ assets which traditionally have been held to maturity. Also, a large number of recent syndicated loans have incorporated contractual features allowing them to be transferred, usually in the form of transferable loan certificates. Of course, regulators and many banks point out that the negotiability of an asset does not ensure that it is salable at close to par value. Ease and value of resale can be affected by the evolving creditworthiness of the borrower, as well as by interest and exchange rate fluctuations.

From the point of view of the borrower, syndicated loans are more flexible than the issuance of floating rate notes in a number of respects. The borrower can draw on the funds available through a syndicated loan at any time during the loan period, can often change the interest rate basis (e.g., from the three- to the six-month LIBOR), can prepay the loan, and can sometimes even select the currency in which to receive the loan. In contrast, with a floating rate note, the borrower receives all funds at the time of issuance, the interest rate basis is typically fixed for the life of the note, which can generally not be prepaid, and these notes are denominated in a single currency. However, lenders find floating rate notes much more attractive since they typically have greater liquidity than participations in a syndicated loan.

In a number of respects, note issuance facilities (NIFs) and other backup credit facilities that have recently developed are an attempt to combine some of the characteristics of the traditional syndicated loan with those of a floating rate note. The note issuance facility consists of an arrangement whereby an underwriting syndicate commits itself for several years (sometimes as long as ten years) to purchase the borrower’s notes of one- to twelve-month maturity with a fixed spread (the “cap rate”) above a benchmark interest rate. When the borrower activates the facility, notes are sold through bidding by tender or through negotiation to banks and other institutions that then place the notes with investors or add them to their investment portfolios. The cost to the borrower of such sales is usually below the “cap rate.”

The underwriting banks are required to take up only those notes that cannot be sold below the “cap rate,” although the underwriters can—and do—acquire the notes voluntarily also. About 25 percent of all note issuance facilities are not underwritten or are only partially underwritten. Approximately three quarters of the underwritten note issuance facilities operate with a tender panel while the rest are placed by a single bank. The average maturity of the facility is seven to ten years, whereas the notes that are issued typically have maturities of one, three, or six months.

The development of such facilities is characteristic of the type of innovation that arises through the application in a new setting of a financing technique well-established in one financial market. The short-term “committed” bank credit line or stand-by credit has been a common feature of domestic financial markets in many industrial countries. The type of international issuance facility that has recently grown so rapidly differs from domestic stand-by arrangements primarily in being explicitly medium-term. It seeks to protect the underwriters by covenants analogous to those used in medium-term syndicated credits rather than by periodic renewal, as in domestic stand-bys.

These facilities have generally been arranged for highly regarded borrowers from the major industrial countries, including large banks and international institutions. They can potentially be used for a variety of purposes. While a fully drawn facility could be used in place of a syndicated loan to raise cash, very few facilities have been arranged in this manner. During 1984 and the first half of 1985, only a relatively modest proportion of the notes that could be issued under the existing facilities have actually been issued, especially in the case of facilities for corporations. Note issuance facilities arranged for corporations have thus far been used primarily as a replacement for a bank stand-by. Note issuance facilities may, however, serve as the basis for the issuance of Eurocurrency commercial paper. Note issuance facilities are still undergoing rapid evolution. This is evident most recently in the development of multiple-option funding facilities (MOFFs) which allow the borrower either to sell Eurocurrency notes in different currencies or to obtain short-term bank advances.

The yields on the notes issued under these facilities have typically been below LIBOR but above the yields on alternative money market instruments (e.g., Eurocurrency deposits of comparable maturity). Notwithstanding this favorable interest rate differential. nonbanks’ holdings of Euronotes are believed to remain very modest at this time. The principal nonbank purchasers have been corporations, insurance companies, investment trusts, and central banks.

Thus, the development of a true Eurocommercial paper market for corporate and sovereign borrowers is still at an embryonic stage. The future development of note issuance facilities will be crucially dependent on the willingness of nonbank investors to purchase the short-term notes which are issued under these facilities. One element necessary for many nonbank corporations to invest in such paper on a large scale may be widespread rating of such paper by established credit-rating agencies.

Swaps, Options, and Futures

Another new instrument, which emerged in significant volume only in the early 1980s, has been the medium-term swap. Swap transactions have been used both to arbitrage differences in borrowing costs across major financial markets and to reallocate the interest and exchange rate risks implicit in medium-term financial transactions.12 Given the extensive interest rate and exchange rate movements that have occurred since 1973, institutions have sought means to impose control over and to minimize their borrowing costs; to cover long-term commitments in foreign currencies; and to be able to use fully worldwide intracompany liquidity, both in convertible and blocked currencies. The thinness or absence of forward foreign exchange markets for cross-currency financial transactions with maturities beyond one or two years has meant that medium-term transactions could not be fully hedged using traditional foreign exchange markets. However, the existence of the medium-term swap market has itself now stimulated and facilitated development of the forward exchange markets at similar maturities.

Both securities houses and commercial banks have expanded their swap activities at a rapid pace. Since 1981, interest rate and exchange rate swap transactions have grown at a rapid rate, reaching an estimated $80 billion in 1984. Over the last few years, swap markets have undergone extensive change. During the initial development of the swap markets, swaps typically had a value of between $10 million and $150 million, with a maturity from three lo ten years. By 1984, in contrast, maturities were generally between one and twelve years, with amounts ranging from $5 million to $500 million. Swaps are now also being used by corporations, banks, insurance companies, savings and loan associations, governments, and multilateral agencies. Currently, a very substantial proportion of new bond issuance in international markets is undertaken as part of a swap transaction. There are approximately three times as many interest rate swaps as currency swaps.

In swap transactions, financial intermediaries may play the role of a broker, bringing together two parties that undertake the actual swap, or may stand between the parties. In the latter instance, the financial intermediary assumes the credit risk that either of the parties may fail to perform, which could result in unintended losses or profits, depending on intervening currency and interest rate movements. Estimates by market participants ranged widely as to the proportion of face value of a swap which might be considered as representing the credit risk. These estimates varied in particular in the case of medium-term interest rate and currency swaps, where the currencies concerned have varied materially in the past (e.g., interest and currency swaps involving U.S. dollars against deutsche marks or Swiss francs). The very fine margins obtained through swaps reflect the fact that some institutions view their swap transactions as having relatively low credit risk.

As the outstanding volume of swaps increased, a so-called secondary market developed. Existing swaps are said to be “traded” when the swap is terminated, with payment of a negotiated fee by one original counterparty to the other original counterparty; when it is reversed through an offsetting swap with a new counterparty; or when one side of the swap is assigned by an original participant to a third party. In the second and third of these cases, the credit risk is not extinguished and may be increased because new counterparties are introduced in the chain of transactions. Swaps have thus not yet reached the status of finely tradable instruments. Moreover, it is not clear that actual trading of swaps is completely risk-free. To reduce such risks, many corporations refuse to deal with counterparties whose credit ratings are inferior to their own rating.

For corporate borrowers, swaps have also been a means of obtaining medium-term fixed interest rate credits. Among other factors, the financing of large fiscal imbalances in a number of major countries has to some degree stimulated corporate borrowers with less than the very best credit ratings to seek access to medium- and long-term capital market funds outside the traditional fixed-rate market. Swap transactions have allowed these corporations to issue floating rate debt in markets where their name has a scarcity value, and then to enter into a swap transaction in which they agree lo service the fixed interest rate debt of another entity (often a bank). The other entity agrees to service the corporation’s floating rate debt. These swaps allow the corporation to obtain the equivalent of fixed interest rate debt at a cost that is lower than could often be obtained through direct fixed interest rate bond issues. (Appendix IV provides an example of this type of transaction.)

Early in the development of the market, some non U.S. dollar-based banks were able to obtain indirectly medium-term, floating interest rate U.S. dollar finance at rates substantially below LIBOR, by issuing fixed interest rate, non-U.S. dollar foreign and Eurobonds, and by swapping the proceeds for U.S. dollars. As the market has developed, the initial large savings in borrowing costs that could be obtained through these swaps were eroded by competitive pressures.

A further area of innovation has been the rapid expansion of currency and interest rate options and futures. These markets permit banks and corporations to hedge their exposure to financial risks. The expansion of such activity may involve banks both as an agent for other parties and as principals—and if as principals, they may be trading on their own account, or taking positions to limit the interest and exchange rate exposure arising through other assets and liabilities.

The use of financial futures by banks for their own account has increased sharply. Interest rate futures, for example, offer banks an alternative route to hedge mismatches between interest rates applicable to their assets and liabilities. This avoids an increase in interbank positions to match such exposure, thus economizing on the capital required for the banks’ business.

Changes in the Supervision of Financial Markets

The growth in banks’ off-balance sheet business, the “securitization” of loan claims, and the growing integration of different financial markets and market segments have raised new and complex issues for supervisory agencies. These changes have occurred at a time when the quality of many banks’ assets was still affected by the external payments problems of certain developing countries, and in some cases by debt-servicing difficulties of borrowers in the energy, agricultural, shipping, and real estate sectors of industrial countries.

These developments have posed substantial challenges to supervisors. They have also demonstrated the importance of steps taken over the past ten years to develop international coordination of bank supervision under the auspices of the Cooke Committee13 and of regional supervisory groups. With the growing integration of different types of financial markets, the need for close coordination between banking supervisors and regulators of other financial intermediaries has also been demonstrated.

There has been a continuing need to strike a balance between the common concern of bank managements and supervisors to strengthen individual institutions rapidly and a concern that such actions could—by their cumulative effect in restricting flows of new funds to debtor countries—jeopardize the immediate stability of the financial system and thus prove self-defeating. Supervisors’ sensitivity to this dilemma is illustrated by their acceptance of increases in banks’ exposure to countries experiencing payments difficulties that have occurred under internationally concerted “new money” packages. Some current issues of relevance in this area are touched on in the discussion below of banks’ reserves for loan losses.

Capital Adequacy

Bank supervisors have continued their coordinated efforts to halt and reverse the decline in capital adequacy levels that had been evident in the late 1970s in many national groups of banks. Published capital ratios in a number of industrial countries have risen as a result of supervisory and market pressures (Table 3). The need to persist in this endeavor has been underscored by recent experience of some supervisors. This experience has indicated that adequate capital is essential to allow banks to withstand significant losses arising from their lending and other activities, and to limit the potential liabilities of public agencies in the event of the failure of an institution.

In the United States, strong impetus for the strengthening of capital asset ratios was given by the passage of the International Lending Supervision Act of 1983. Recently, Federal agencies adopted new capital adequacy standards involving a minimum ratio of 5.5 percent for primary capital and 6 percent for total capital to banks’ assets, increasing the minimum capital requirements for larger banks. At a hearing before the Senate Banking Committee in September 1985, the Chairman of the Federal Reserve Board indicated that, in his view, an increase to 9 percent in the ratio of total capital to assets for commercial banks was “attractive in concept and worthy of study.” The possibility of a 9 percent total capital ratio had been raised previously by the Chairman of the Federal Deposit Insurance Corporation. Market estimates indicate that the total (as opposed to primary) capital ratio of the holding companies for the U.S. money center banks was equivalent to 8.5 percent in June 1985, up from 7.8 percent at end-1984. The comparable picture for a wider group of 35 banks gives very similar results.

The internationally coordinated effort to strengthen capital asset ratios has itself influenced the forms in which banks are taking on business. In particular, the application of a simple capital asset ratio may give banks incentives both to conduct business “off-balance sheet” and to invest less on low-yielding, high quality assets. Thus pressure has developed in favor of the more sophisticated risk-weighted capital ratios typically applied in many European countries. The interaction between capital adequacy regulation and innovative market responses is discussed in more detail in the following subsection.

A further area of change is increased vigilance by supervisors over the quality of banks’ capital. Authorities have expressed concern about the role subordinated debt can play in bank capital. In particular, they have questioned the ability of such debt capital to absorb recurrent losses, and to back assets except in the event of liquidation. In the Federal Republic of Germany, for example, subordinated debt has not been included in the capital base. In many other countries, such debt has been viewed as only “secondary” capital, subject to limitations on the degree to which it can be included in prudential capital measures. Supervisory concern about the role of subordinated debt as capital has increased, as many banks have become holders, as well as issuers of substantial quantities of such debt. Thus, capital available to the banking system is to some degree being double-counted, and the capacity of such instruments to serve as capital may be perceived differently by issuers and holders.

Limits on the ability of banks to issue straight equity capital, particularly in cases where a bank’s stock is poorly regarded by the market or where the bank is under government ownership, have thus led banks to issue instruments that fall between the traditional categories of loan and stock. These securities—with titles such as “participation certificates”—typically offer investors a somewhat higher return than bonds, but can (directly or by concession) bear part of the burden of lower profits or eventual losses.

As regards the international coordination of supervision, the consensus among bank supervisors on the need to supervise the international activities of banks on a worldwide consolidated basis has been implemented more fully. The authorities in Japan have moved to a consolidated monitoring procedure and, in the Federal Republic of Germany, legislation mandating consolidated supervision of banks has come into force. Considerable progress has also been made in agreeing on common techniques to monitor the capital adequacy of banks in different countries, based on alternative definitions of banks’ capital and assets, including risk-weighted capital ratios. Work on coordinated monitoring of capital ratios has been pursued by the Cooke Committee. Moreover, the European Commission (EC) has proposed to the representative organizations of the banking industry in each member state the harmonization of capital adequacy monitoring. The EC is currently engaged in trial calculations of capital ratios, or “observation ratios.”

Table 3.Capital-Asset Ratios of Banks in Selected Industrial Countries, 1977–841(In percent)
19771978197919801981198219831984
Canada23.403.273.162.983.4633.654.064.43
France42.292.622.402.202.071.961.94
Germany, Federal Republic of53.413.323.313.273.263.313.343.38
Japan65.285.125.135.285.255.035.225.15
Luxembourg73.523.453.503.593.83
Netherlands84.413.864.294.204.334.604.684.72
Switzerland9
Largest 5 banks6.096.206.116.185.785.585.445.29
All banks5.595.685.635.665.365.255.165.05
United Kingdom
Largest 4 banks107.147.537.186.856.396.286.596.20
All banks115,205.205.105.004.474.144.354.47
United States
Nine money center banks124.954.734.514.524.624.935.416.22
Next 15 banks125.725.425.375.515.215.345.696.63
All reporting banks12,135.705.535.295.355.385.605.946.53
Sources: Fund staff calculations based on data from official sources, as indicated in footnotes.

Aggregate figures such as the ones in this table must be interpreted with caution. Differences across national groups of banks (share of the interbanking activities in the total assets, provisioning practices, definition of the capital) make cross-country comparisons less appropriate than developments over time within a single country, which however can be affected by changes in regulations or practices year after year.

Ratio of equity plus accumulated appropriations for losses (beginning with 1981. appropriations for contingencies) to total assets (Bank of Canada Review).

The changeover to consolidated reporting from November 1, 1981 had the statistical effect of Increasing the aggregate capital-asset ratio by about 7 percent.

Ratio of capital, reserves, and general provisions, to total assets. Data exclude cooperative and mutual banks. This ratio is not the official one (ratio of risk coverage), which includes loan capital and subordinate loans in the numerator and balances the denominator with regard to the quality of the assets, and which provides the groundwork for the control of the banking activities by the Commission Bancaire. (Commission de Contrôle des Banques, Rapport).

Ratio of capital including published reserves to total assets (Deutsche Bundesbank. Monthly Report).

Ratio of reserves for possible loan losses, specified reserves, share capital, legal reserves plus surplus and profits and losses for the term to total assets (Bank of Japan, Economics Statistics Monthly).

Ratio of capital resources (share capital, reserves excluding current year profits, general provisions, and eligible subordinated loans) to total payables. Eligible subordinated loans are subject to prior authorization by the Institut Monèlaire Luxembourgeois and may not exceed 50 percent of a bank’s share capital and reserves. Data in the table are compiled on a nonconsolidated basis, and as a weighted average of all banks (excluding foreign bank branches). An arithmetic mean for 1984 would show a ratio of 6.98 percent. Inclusion of current year profits in banks’ capital resources would result in a weighted average of 4.03 percent for 1984. Provisions for country risks, which are excluded from capital resources, have been considerably increased in the last four years, with a tripling of the level of provisions between 1982 and 1984.

Ratio of capital, disclosed free reserves, and subordinated loans to total assets. Eligible liabilities of business members of the agricultural credit institutions are not included (Dc Nederlandsche Bank N.V., Annual Report).

Ratio of capital plus reserves to total assets (Swiss National Bank, Monthly Report).

Ratio of share capital and reserves, plus minority interests and loan capital, to total assets (Bank of England).

Ratio of capital and other funds (sterling and other currency liabilities) to total assets (Bank of England), Note that these figures include U.K. branches of foreign banks, which normally have little capital in the United Kingdom.

Ratio of total capital (includes equity, subordinated debentures, and reserves for loan losses) to total assets.

Reporting banks are all banks which report their country exposure for publication in the Country Exposure Lending Survey. Federal Financial Institutions Examination Council.

Sources: Fund staff calculations based on data from official sources, as indicated in footnotes.

Aggregate figures such as the ones in this table must be interpreted with caution. Differences across national groups of banks (share of the interbanking activities in the total assets, provisioning practices, definition of the capital) make cross-country comparisons less appropriate than developments over time within a single country, which however can be affected by changes in regulations or practices year after year.

Ratio of equity plus accumulated appropriations for losses (beginning with 1981. appropriations for contingencies) to total assets (Bank of Canada Review).

The changeover to consolidated reporting from November 1, 1981 had the statistical effect of Increasing the aggregate capital-asset ratio by about 7 percent.

Ratio of capital, reserves, and general provisions, to total assets. Data exclude cooperative and mutual banks. This ratio is not the official one (ratio of risk coverage), which includes loan capital and subordinate loans in the numerator and balances the denominator with regard to the quality of the assets, and which provides the groundwork for the control of the banking activities by the Commission Bancaire. (Commission de Contrôle des Banques, Rapport).

Ratio of capital including published reserves to total assets (Deutsche Bundesbank. Monthly Report).

Ratio of reserves for possible loan losses, specified reserves, share capital, legal reserves plus surplus and profits and losses for the term to total assets (Bank of Japan, Economics Statistics Monthly).

Ratio of capital resources (share capital, reserves excluding current year profits, general provisions, and eligible subordinated loans) to total payables. Eligible subordinated loans are subject to prior authorization by the Institut Monèlaire Luxembourgeois and may not exceed 50 percent of a bank’s share capital and reserves. Data in the table are compiled on a nonconsolidated basis, and as a weighted average of all banks (excluding foreign bank branches). An arithmetic mean for 1984 would show a ratio of 6.98 percent. Inclusion of current year profits in banks’ capital resources would result in a weighted average of 4.03 percent for 1984. Provisions for country risks, which are excluded from capital resources, have been considerably increased in the last four years, with a tripling of the level of provisions between 1982 and 1984.

Ratio of capital, disclosed free reserves, and subordinated loans to total assets. Eligible liabilities of business members of the agricultural credit institutions are not included (Dc Nederlandsche Bank N.V., Annual Report).

Ratio of capital plus reserves to total assets (Swiss National Bank, Monthly Report).

Ratio of share capital and reserves, plus minority interests and loan capital, to total assets (Bank of England).

Ratio of capital and other funds (sterling and other currency liabilities) to total assets (Bank of England), Note that these figures include U.K. branches of foreign banks, which normally have little capital in the United Kingdom.

Ratio of total capital (includes equity, subordinated debentures, and reserves for loan losses) to total assets.

Reporting banks are all banks which report their country exposure for publication in the Country Exposure Lending Survey. Federal Financial Institutions Examination Council.

The treatment of country risk in observation ratios of the kinds used by the Cooke Committee and the EC, respectively, was discussed in a recent speech by H.J. Mueller, Executive Director of the Netherlands Bank.14 “Both systems apply relatively simple weighting, which essentially distinguishes between four broad categories of assets: claims on (a) governments, (b) banks, (c) private sector, and (d) contingent items. Apart from some minor differences with respect to the relative weighting of the various assets, a more fundamental problem needs, however, to be resolved: how to reflect cross-border risk in risk-weighted capital ratios. In the EC calculation, claims on governments and banks are split into two groups, namely, industrialized and nonindustrialized countries (based on IMF definitions) in order to reflect, through a different weighting, the element of country risk. It is to be hoped that the Basle Supervisors Committee will recommend the same kind of approach of incorporating a country-risk factor into its capital adequacy ratio. Although the inclusion of an element of country risk may raise conceptual and political difficulties, this aspect cannot be overlooked nowadays.”

Interaction of Capital Adequacy Regulation and Market Innovation

Given the competitive and innovative nature of financial markets, official actions to increase the capital cover of bank-intermediated flows inevitably have met with responses from financial market participants to minimize the incidence of these costs. Thus, a key aspect of financial market activity in 1984–85 has been the remolding of capital market business to reduce or eliminate the costs of intermediation. Supervisory actions were not, however, the only factor influencing this trend. Another important factor was the deterioration in the credit rating of some banks that has taken place in recent years. This deterioration has been indicated by a downgrading of bank liabilities by rating agencies and, on occasion, by widening differentials in short-term funding rates at times of market concern. Consequently, in the longer run, the improvement in banks’ financial positions sought by supervisors would help enhance banks’ abilities to raise funds cheaply and to intermediate domestic and international credit flows effectively.

A few examples may illustrate how banks have restructured their business in response to supervisory influences on capital adequacy and related market pressures. First, there has been a very rapid growth in types of banking business that—in many countries—are not recorded on banks’ balance sheets or are not captured in capital adequacy requirements. Thus, bank stand-by arrangements which back issues of negotiable securities by nonbanks have expanded substantially. Activity in financial futures markets has presented an important alternative to “on-balance sheet” interbank activity for matching interest rate positions. Credits have been granted in the form of negotiable instruments (such as floating rate notes), in part, because in some supervisory schemes listed securities receive privileged treatment in measurement of capital or liquidity adequacy.

In the United States, revisions to guidelines regarding capital adequacy issued in 1985 included reference to off-balance sheet banking: “The Federal Reserve will also take into account the sale of loans or other assets with recourse and the volume and nature of all off-balance sheet risk. Particularly close attention will be directed to risks associated with stand-by letters of credit and participation in joint venture activities. The Federal Reserve will review the relationship of all on-and off-balance sheet risks to capital and will require those institutions with high or inordinate levels of risk to hold additional primary capital. In addition, the Federal Reserve will continue to review the need for more explicit procedures for factoring on- and off-balance sheet risks into the assessment of capital adequacy.” One estimate of the effect of incorporating stand-by letters of credit indicates that the primary capital ratio for 12 money center banks would decrease from 6.3 percent to 5.6 percent.15

In April 1985, the Bank of England instituted a comprehensive review of off-balance sheet risks for banks in the United Kingdom, although without a presumption that all types of such business would necessarily be included in prudential ratios. The first stage of this review was essentially fact-finding, involving consultation with banks, banking associations, and licensed deposit takers, as well as other interested parties, including auditors. The second stage will be a set of recommendations on the treatment of off-balance sheet risks for the purposes of assessing capital adequacy and liquidity management and control.

Pending completion of this study, and in response to the increase in banks’ contingent commitments from revolving underwriting facilities and other note issuance facilities, the Bank of England has announced that such commitments must be given a 0.5 weighting in U.K. banks’ capital adequacy ratios. This weighting also applies to guarantees and a number of other contingent liabilities. It is anticipated that the Japanese authorities will take action along similar lines, involving a weight of 0.3 for underwriting commitments. Similar measures are being studied or implemented in other countries also.

Therefore, market developments have led to an evolution in supervisory approaches to capital adequacy, perhaps especially in countries where a simple gearing ratio (capital to total assets) has traditionally been applied. The need for capital adequacy measures to capture differing degrees of risk attached to various instruments has heightened interest in the more flexible “risk assets” ratio approach to assessing capital adequacy. Under the risk assets approach, which is prevalent in European countries, different capital weightings are applied to various types of claims and reflect broadly the degree of bank risk. Both in the United States and Japan, supervisory agencies have indicated that the risk asset approach is under active study.

As indicated above in connection with cross-border risk, defining risk weightings for capital adequacy purposes and modifying them over time to reflect market developments is not a simple task. A coordinated study among supervisors in the Cooke Committee is currently under way to assess the regulatory implications of different types of off-balance sheet business, including notably their treatment for capital adequacy purposes. Meanwhile, supervisors in the key financial market countries have strongly warned banks that supervision is in the process of being extended to off-balance sheet activities, and that these activities may be included formally in capital adequacy requirements.

Reserves for Loan Losses

Closely linked with the assessment of banks’ capital adequacy is the valuation of banks’ assets. While current profits are a first protection against losses, banks also need adequate reserves to withstand potential losses, including those arising from cross-border exposure. Pressure on banks to establish adequate reserves is clearly manifest in market reactions as well as supervisory responses.

Provisioning practices on cross-border exposure are complex and—notwithstanding the pursuit of common supervisory objectives—the detail of practices in different countries differs to a very considerable degree. While increasing their general capital and reserves, banks in many countries have also reserved (or “provisioned”) against exposure to individual debtor countries. Alternatively, in a number of countries, banks have taken a “basket” approach to constitution of reserves, setting aside reserves against a portion of their exposure to a group of countries—typically those that have recently experienced payments difficulties. Variants on this latter technique are applied, for example, in Canada, France, Japan, and Switzerland. This approach reflects a view that transfer risk is inherent in all such loans, but that it is inappropriately captured by specific provisioning against individual debtor countries.

The degree of supervisors’ involvement in the process of establishing reserves against transfer risks varies considerably from country to country. In some countries (for example, Canada, Switzerland, and the United States), supervisors are involved in setting mandatory provisioning levels, although these are, in effect, minimum provisioning levels, and some banks build up their loan loss reserves beyond such levels. In many other countries, supervisors’ involvement is primarily based on assessment of individual banks’ actions, as reviewed by external auditors, when measured against prudent valuations made by other institutions. A further variation is that the scale of reserves held available to meet losses (and transfers to or from such reserves) need not be disclosed in some countries.

The degree of provisioning differs widely from country to country and from bank to bank. While minimum provisioning standards are mandatory in some countries, these countries are not necessarily those where provisioning is most sizable. Key factors influencing provisions are the scale of a bank’s exposure, the availability of current profits, and the possibility of securing tax deductibility. In general terms, banks in continental Europe can offset provisions for unrealized losses against current taxes to a considerable degree. At the other end of the spectrum are banks in Japan and the United States where, beyond certain specified levels, banks can only reduce their tax burden when actual loan losses are experienced. Tax deductibility, however, is not within bank supervisors’ direct control.

As a broad generalization, it is not uncommon for banks in continental European countries to have earmarked reserves against exposure to countries that have experienced payments difficulties, on a scale that could absorb losses equivalent to one fifth or more of their exposure to such countries. Banks in industrial countries elsewhere may generally have a lower level of reserves earmarked against such potential losses. However, such a comparison is of limited usefulness. Banks’ ultimate ability to absorb losses is not mainly a function of average national provisioning percentages. It depends on the relationship between a variety of factors. These include the scale and distribution of any bank’s exposure, after allowing for reserves earmarked against such exposure; the underlying earnings stream of the bank from other, unrelated activities; the concurrent loss experience on other types of lending or off-balance sheet activity; the total capital and available resources of the bank (including resources represented by assets carried below market value); and the liquidity available to the bank to withstand sudden market reactions. The diversity of such factors—within, as well as between, countries—is considerable.

The difference in banks’ exposure and ability to absorb losses is one element that has weakened cohesion among banks providing financial support for countries in payments difficulties. However, there is no immediate prospect of convergence in key factors influencing such ability, whether technical factors, such as the tax deductibility of reserves, or the longerrun relationship between individual banks’ available profits and the scale of their exposure. Moreover, banks’ attitudes to such financing may be strongly influenced by their longer-term business interests in individual countries.

A subject of particular interest at the present time is the influence of provisioning practices on banks’ willingness to resume spontaneous lending to countries that have restructured their external debt. In this regard, the distinction between mandatory and non-mandatory provisioning is relevant, but the impact of either system on individual institutions can vary. For example, under either system a bank which has high provisions relative to other banks, or relative to mandatory levels, might feel comfortable with a modest increase in exposure to a country whose external position is improving. The bank might feel that the type and scale of exposure strengthened its existing claims. In addition, it might judge that adequate reserves were already established, or alternatively desire additional tax savings gained from new reserves, if its profits and tax regime permitted. At the other extreme, a bank with sizable exposure, low provisioning, weak profitability, and limited tax advantages on further provisions would likely seek to avoid any increase in exposure—even through instruments that were serviced regularly such as trade financing. Under such circumstances, mandatory minimum provisioning levels, if they existed, would be only one aspect of its concern.

However, one identifiable concern relates to the impact at the margin of mandatory provisions on exposure to a group (“basket”) of countries. Specifically, any increase in exposure to one country in the basket results in a need to increase provisions. The dynamics of this process imply that, for example, a spontaneous increase in trade financing, which has been regularly serviced, to a country whose economic prospects have improved, would result in the same provisioning requirement as a new medium-term loan to a country whose economic policies and prospects have worsened sharply. Supervisors in those countries where a basket approach is adopted are sensitive to the possibility that such arrangements have the potential to operate in a counterproductive manner, and in several cases are reviewing this problem.

As indicated above, banks and supervisors suggest that supervisory rules, like immediate tax considerations, are only one factor influencing banks’ willingness to lend. In general, these regulatory factors may well be subordinate to banks’ perceptions of their longer run business interests. While attention to potential regulatory obstacles is an important concern, neither banks nor regulators believe that growth in spontaneous lending can be stimulated primarily by fine-tuning of microprudential instruments.

Liquidity

A substantive reappraisal of liquidity management in banks’ international business has been under way in recent years. Four main factors have caused this reappraisal: problems in the interbank market encountered with banks from certain developing countries; funding difficulties experienced by a number of industrial country banks, and the official response to these difficulties; a decline in the interbank business of some major banks as part of an effort to restrain their balance sheet growth relative to capital; and the rapid growth in certain instruments (notably, floating rate notes and stand-by credits) whose liquidity characteristics have yet to be fully tested. Banks and supervisors have begun to subject liquidity adequacy to a fundamental review of the kind undertaken for capital adequacy since 1977.

Problems encountered by developing countries in the interbank market since 1982 were a factor leading to reappraisal of the role of interbank placements in banks’ liquidity management. A main reaction to these problems was a more critical appraisal of the purposes for which banks were tapping the interbank market. Concern developed, and has persisted, that banks should not use short-term interbank funding as a principal source of medium-term lending to their home countries. From 1982, spontaneous access to the international interbank market has been curtailed for banks from developing countries that have restructured their debt. A substantial proportion of these banks’ interbank borrowings has been consolidated under “maintenance of exposure” facilities. In Brazil and Mexico, in particular, interbank facilities amounting $11 billion have been consolidated since 1982. Trade-related and interbank borrowings often other countries have also been consolidated, and the total short-term bank debt rolled over or converted into medium-term loans since 1982 stood at $38 billion at the end of 1985. Over time, a natural increase in trade-related lending may allow such maintenance of exposure arrangements to be dispensed with.

Funding difficulties experienced by a number of banks in industrial countries have also influenced liquidity management substantially. One conclusion drawn by market participants from recent experiences in the United States, the United Kingdom, and Canada is that monetary authorities remain highly sensitive to the dangers of contagion that could arise if an institution of significant size were unable to meet its commitments in the wholesale money markets. Taken alone, this conclusion would certainly raise serious concerns about the “moral hazard” posed by national authorities’ willingness to provide liquidity support, especially while uninsured deposits are being withdrawn.

Other responses to these incidents may run counter to that concern. Funding problems or serious losses in commercial banks have prompted authorities in different countries to tighten supervisory procedures significantly during the past ten years. In a number of instances, this has involved closer collaboration with bank auditors and increased coordination with supervisors in other countries. Banks have also been influenced directly by events in the interbank market, and have sought to strengthen and safeguard their own liquidity positions. Several techniques have been employed to lengthen the “survival period” during which a bank could withstand strains in international wholesale markets. On the funding side, banks have raised medium-term funds through interest rate swaps, diversified wholesale funding sources, increased the proportion of “relationship” deposits, and—in the case of U.S. banks—broadened their retail deposit base.

On the asset side, banks have focused on the liquidity of various categories of assets. Interbank placements with other banks have been examined much more closely to assess their true liquidity in times of stress. More conservative institutions indicate that they see merit also in holding some prime quality, short-term negotiable paper, including government debt, in currencies that match their wholesale liabilities. The desire for greater asset liquidity has also been one of the factors leading to the “securitization” of bank assets. Certainly, in a legal sense, or for some regulatory ratios, an increase in liquidity results from “securitization.” However, supervisors have indicated a concern that the effective liquidity of these instruments may be overestimated in some cases. On the other hand, banks’ liquidity position may deteriorate quickly if they are required to provide funds to borrowers under standbys or international issuance facilities.

For some banks, including notably U.S. banks, the effort to improve liquidity has had to be weighed against a desire to restrain balance sheet growth due to market and regulatory pressures for higher capital ratios. Indeed, one of the factors leading supervisors to favor risk-asset ratios for capital adequacy purposes has been the desire to ensure that capital adequacy requirements were not met by measures that could weaken a bank’s liquidity position. The interaction of capital and liquidity supervision has attracted increased attention recently and is likely to be a key area of interest in the period ahead.

Functional Versus Institutional Supervision

The lowering of barriers in financial markets has advanced to varying degrees in different countries, but there is a clear tendency for financial institutions to develop a full spectrum of financial products. Thus, in some markets, banks now compete directly with securities houses, mortgage institutions, insurance companies, and even “nonfinancial” companies in different markets for financial products. A striking development of the past two years has been the recognition that supervision practices should be adopted to suit the more integrated financial markets.

Traditional forms of regulation of the financial services industry in many industrial countries have been based on restrictions to entry into various types of business, and limitations on product competition between different sectors of the industry. In many ways, this practice has facilitated the supervision of institutions, and allowed supervisors to have detailed knowledge of the management and activities of individual institutions whose business was, to a degree, homogeneous. Such compartmentalization persists to a degree in some countries, such as the United States and Japan, where deposit taking and securities underwriting are separated. Nonetheless, even in these countries, commercial banks and securities houses have considerably greater freedom for competition in their respective business areas outside the national territory.

In the United Kingdom there was a clear demarcation between stock exchange members and other financial institutions. The past year has seen the formation of links between banks and stock exchange members with the intention of combining the roles of issuing house, agent broker, market maker, and investment manager in a single institution. Investment business will be subject to common standards for entry, with much emphasis on disclosure and transparency. A key task of the new securities authority will be to devise rules to control conflicts of interest. The issue of avoiding conflict of interest in an evolving financial structure has also been addressed in Canada, where a discussion paper on the future structure of parts of the financial services industry was issued early in 1985.

Efforts are under way in a number of countries to study and enhance the coordination between supervisors of different types of financial intermediaries. While this issue has arisen with regard to various aspects of supervision, it has been clearest in the areas of capital adequacy. For example, both banks and securities companies carry inventories of securities and enter into medium-term currency and interest rate swaps. To raise the capital costs associated with banks’ involvement in such activities may simply displace business to other financial institutions.

In countries where integration of the financial services sector is proceeding rapidly, regulatory authorities have been studying the merits of supervising financial companies on a “functional,” rather than an “institutional” basis. Under a functional approach, a given activity would be subject to the same supervisory regime regardless of the type of financial institution undertaking the activity. For example, the same prudential rules would apply to both banks’ and to securities houses’ inventories of marketable securities (including frequent marking to market, full disclosure, and regular turnover of portfolio holdings). To facilitate supervision, different market activities might be confined within identified departments of a company, or companies within a group.

In this connection, supervisory attention has come to focus also on safeguards to contain any problems of confidence within single parts of a financial company, avoiding contagion to the remainder of the company or group and to the rest of the system. Component parts of financial conglomerates can be separately capitalized, and the Bank of England’s discussion document relating to primary dealers in the gilt-edged market proposed that these should be backed by dedicated capital. The Canadian discussion paper emphasizes the barriers within a financial conglomerate. These are not simple issues, however, as was noted in a speech by the Deputy Governor of the Bank of England in November 1984: “There is, however, a potential tension between the desire to isolate market-making risks, and the well-established principle that parent banks have a moral obligation to stand behind their subsidiaries to cover losses, even when they exceed their limited liability in law. The involvement of a bank in a group which contains a market-maker is therefore likely to have implications for the assessment of its own capital adequacy.”16

The functional approach to supervision has attracted attention because it creates a regulatory “level playing field,” but it does not offer a simple solution. In practice, it may prove unrealistic to supervise one segment of the business of a financial company—or even of a group of companies—without knowledge about other parts. Experience has demonstrated that, in an industry where confidence plays a crucial role, problems in one part of a financial business can spread quickly to affect the position of other units. Thus, close coordination between regulatory authorities—domestically and internationally—is likely to remain of paramount importance.

For example, inflation (as measured by the consumer price index) in the United States averaged only slightly more than 2 percent per annum during the 19S0s and 1960s; and, in the United Kingdom, inflation was typically between 3 percent and 4 percent during this period. In the Federal Republic of Germany, the rate of inflation rose only slightly from an average annual rate of 2 percent in the 1950s to 2.5 percent in the 1960s: whereas in Japan, inflation was usually between 4 percent and 5.5 percent during this period.

In the United Stales, inflation during the 1970s averaged nearly 8 percent per annum versus 3 percent in the 1960s, In the United Kingdom, the annual average rate of inflation in the 1970s was nearly 14 percent in comparison with an average of 4 percent in the 1960s. In the Federal Republic of Germany, the rate of inflation equaled 5 percent in the 1970s versus 2.5 percent in the 1960s. In Japan, inflation during the 1970s averaged 9 percent per annum versus less than 6 percent in the 1960s.

Appendix IV explains the mechanics of an interest rate and currency swap.

The Cooke Committee is formally known as The Group of Ten Committee on Banking Regulations and Supervisory Practices. It meets under the auspices of the Bank for International Settlements.

The speech was given at the Conference on Banking Control and Supervision, hosted by the Arab Bankers Association in London May 7–8, 1985.

“Implications of the Federal Reserve’s Proposed Capital Guidelines,” a Bond Market Research publication by Salomon Brothers, Inc., September 12, 1985.

Speech by C.W. McMahon, Deputy Governor. Bank of England, to the Euromoney Conference in Sydney, Australia, November 27, 1984.

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