Chapter

II Risk Perceptions in International Lending

Author(s):
John Lipsky, Peter Keller, Donald Mathieson, and Richard Williams
Published Date:
July 1983
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Issues Concerning the Markets

In general, banks in industrial countries appear to perceive the present situation as a time for a careful stocktaking and perhaps reassessment of their domestic and international growth and lending strategies. While this attitude of banks is not entirely a reflection of the emergence of international debt problems, this is certainly the most important factors on the international side. Banks and their supervisors have perceived a decline in the quality of banks’ international assets as a number of borrowing countries failed to make necessary or sufficient policy adjustments in the face of a deterioration in the international economic environment. But there is also concern that the economic problems of industrial countries and the yet uncertain prospects for a sustained recovery have impaired the quality of banks’ domestic assets as well. Indeed, in a number of countries, banks and their supervisors have felt a need for substantial write-offs and provisioning against domestic lending risks. Banks’ behavior in this regard is dependent on a number of factors, including the tax treatment such actions are afforded. Preliminary indications are that banks in a number of countries have added substantially to loan loss provisions against both domestic and international lending. Such provisioning was aided by the banks’ improved earnings.

Adding to the concern of banks and supervisors about the quality of assets is the relatively high concentration of sovereign and transfer risks among some of the large money center banks. For example, the individual exposure of some of the largest U.S. banks to one or more of the three largest sovereign borrowers currently engaged in debt restructuring is well in excess of 50 percent of each bank’s capital. Quite aside from the prudential concerns of banks’ managements and their shareholders there are indications that, in some countries, bank supervisors intend to press for an increase in the capital of banks with strong exposure concentration.

The rapid growth of bank assets over the past few years, and the need for increased provisioning against both domestic and international risks, have increased concern about capital adequacy among the banks themselves, even in countries where no formal supervisory capital-asset ratios exist. Moreover—as already mentioned—for banks with international assets largely denominated in dollars, but with capital denominated in the national currency of the bank’s domicile, the rise of the dollar in 1982 against many national currencies resulted in an increase in the balance sheet value of dollardenominated assets relative to banks’ capital funds. Despite some recent strengthening, the bank equity market has remained generally weak and this has made it difficult and expensive for banks to increase their capital base through share issues. At present few banks are formally constrained in their domestic and international lending activities by considerations of capital adequacy. However, the generally perceived decline in the quality of bank assets raises concern about capital adequacy and contributes to the banks’ current cautious attitude toward further asset growth, particularly of less profitable loans. This attitude is reinforced by concerns that new sources of bank capital will not become readily available during the next few years. Against this background, bank supervisors in many countries have encouraged banks to strengthen their capital-asset ratios by increasing retained earnings as bank profitability improves. In some countries, however, banks have been able to improve their capital positions by the issuance of subordinated debt.

The perceived funding risk has increased for many banks, primarily reflecting developments in the interbank market, which was seriously disturbed toward the end of 1982, partly because of domestic difficulties of some U.S. banks and partly because of debt rescheduling issues. Funding risk refers to the possibility that the market perception of the financial stability of a bank deteriorates to such an extent that it may no longer attract liabilities sufficient to match its assets, or that it may do so only at a loss. For major participants in the market, “tiering” and access questions appear to be largely resolved by now. However, growth of this market has slowed, as banks that have been net placers in the market are finding the margins no longer commensurate with the sovereign and transfer risk11 involved. It appears that banks from most developing countries will continue to find their access to this market limited, and even major nondollar banks remain concerned about possible future disturbances in the interbank market. Moreover, some of the banks’ international short-term assets were converted into medium-and longer-term loans as part of such rescheduling operations and they are trying to adjust their funding with a view to reducing the increased maturity mismatch.

Banks in some countries have proceeded—in part encouraged by their supervisors—to reduce their own funding risk, particularly in foreign currencies, by issuing medium-term floating rate debt. For instance, in 1982, some major banks were able to issue fixed rate obligations and swap the proceeds with a nonbank borrower that had issued floating rate debt. These so-called interest rate swap operations were also combined with currency swaps. However, in the first quarter of 1983, the volume of interest rate swaps declined as the yield on bank fixed rate debt instruments began to climb relative to other market yields and as financial markets in the United States became more receptive to corporate bond issues from lower-rated companies.

The sharply increased number of countries experiencing debt servicing difficulties since mid-1982 has forced banks to make difficult decisions regarding their participation in debt restructurings, often involving formal multilateral rescheduling of debt from official and/or private sources. Recent exercises that have been carried out in conjunction with the implementation of Fund-supported adjustment programs have often required the commitment of substantial flows of new lending and, thus, will increase the banks’ exposure to problem cases. Money center banks with very large exposure and with a long-standing involvement in the countries experiencing difficulties are particularly aware of the need for banks to support the adjustment efforts being undertaken. In most countries, supervisors as well perceive that continued net banking flows to countries with Fund-supported programs will improve the quality of existing bank assets. In general, supervisors see no contradiction in encouraging such flows, while at the same time requiring the establishment of special loan loss provisions for sovereign risks.

Considerable uncertainty exists in the market, however, about the behavior of smaller, regional banks or banks with relatively small international exposure and often limited international experience. In the aggregate, such banks already hold substantial international assets, so that any reduction in their exposure or even net lending to a country could seriously aggravate the balance of payments situation. To the extent that this occurs, the situation of banks with very large exposure to a particular country will become increasingly difficult as they are either forced to compensate for the withdrawal of other banks by further increasing their own exposure or else face a serious impairment of the quality of their assets.

As part of the rescheduling efforts in a number of major borrowing countries, a very large number of banks have linked their new lending decisions, often quite explicitly, to the existence of (and adherence to) a program supported by the Fund. This has brought Fund-supported programs under closer scrutiny by the financial community and, at the same time, has made the successful implementation of these programs of greater importance to both the lenders and the borrowing countries. Any perceived failure of programs with major borrowers could mean that net banking flows in 1983 to those countries, and in aggregate, may be substantially reduced.

The rescheduling operations already agreed or that are close to a conclusion generally have been welcomed by banks, as they have removed a degree of uncertainty from the market by regularizing the balance of payments and debt service situations of the countries involved. On the other hand, a number of banks are concerned that in many of these cases they may be approached repeatedly to further increase their exposure if countries are not able to make adequate progress in adjusting. In considering their future actions, banks are taking into account not only the likely course of events in the borrowing country but also the likely reaction of their own stockholders and their supervisors to continued lending to problem cases. Banks also are worried about the likely reaction of other banks to further requests for new lending, as a “breaking of ranks” will endanger the quality of their own assets and/or require even larger increases in their own exposure.

Uncertainties about behavior of other banks add a new layer of risk for the banks’ assessment of lending to countries that are not themselves affected by debt servicing problems but that would be vulnerable to any sharp curtailment of bank lending flows. Following the events in Eastern Europe and in the Western Hemisphere, the banks’ perception of regional risk in crises has sharpened. Increased awareness of sovereign risk and the possibility of the emergence of regional debt problems in other parts of the world make it unlikely that a revised lending strategy would involve an acceleration of flows to areas of the world not directly involved in present debt rescheduling exercises.

One effect of recent events was that, as part of the reschedulings for major countries, banks became much more aware of other banks’ lending strategies and exposure to various sovereign borrowers. Moreover, in some countries banks were also required to disclose their exposure to their shareholders. In addition, international debt issues have also gained the attention of the international press and even of national legislatures. All this has resulted in wide dissemination of information previously available only to supervisors. Moreover, supervisors in some countries have asked for more detailed submission of information on banks’ exposure, generally on a consolidated basis—i.e., including lending by branches and subsidiaries. It is difficult to assess what result increased reporting requirements and heightened public concern with issues of international lending will have on banks’ lending posture. Closer scrutiny of international bank lending by supervisors, shareholders, and policymakers will add a further note of caution to the international lending plans of banks, although this would surely not be as significant a factor as the banks’ own changed risk perceptions.

Interbank Markets

The international interbank market is a short-term market that operates in a rapid and informal manner, often through brokers, with a minimum of documentation.12 The customary role of international interbank markets has been to free individual banks from the need to match deposits and loans to nonbanks on their own balance sheets, as the market allowed rapid intermediation between banks with excess funds and those with unfunded lending opportunities. Banks also have been able to utilize the interbank market to adjust quickly the maturity structure and currency composition of their portfolios in response to market developments, even though customarily certain banks tended to be net takers of funds while others were net placers. Normally a bank utilizing the interbank market as a tool of liquidity management will participate on both sides of the market and will obtain a better rate as a result. Although differentiation between the perceived quality of participants has been expressed in terms of limits on credit lines more than through price discrimination, there is always a modest amount of “tiering” present. As the international operations of commercial banks expanded during recent years, more foreign branches and subsidiaries of banks domiciled in some non-oil developing countries began to participate in this market, joining the major banks from industrial countries.

Although data on interbank operations remain fragmentary, it is known that a substantial proportion of gross international bank claims, perhaps two thirds to three fourths of the total, are actually interbank credits. It is also known that a large percentage of these inter-bank credits, perhaps as high as 50 percent for banks in certain countries, are between different offices of the same bank. Although there is no necessary linkage between the aggregate volume of interbank operations and final lending, it appears that increased access to funding opportunities in the interbank market in recent years has greatly aided the entry of many banks—particularly nondollar-based banks13—into international operations and, especially, the syndicated credit market.

During 1982, the interbank market was disturbed by several developments. Continued economic weakness adversely affected the general quality of the domestic assets held by banks in major industrial countries. By mid-1982, there reportedly was some shortening of maturities in interbank markets, and some of the banks in major industrial countries with problematic domestic assets found it more difficult and expensive to raise funds in the market. At about the same time, it became apparent in the course of debt restructuring negotiations that foreign branches and subsidiaries of certain banks headquartered in non-oil developing countries had been utilizing short-term funds obtained in inter-bank markets to fund medium-term domestic lending in the country of domicile. Moreover, it became evident that many of the traditional participants in the international interbank market had not been fully aware of the degree of maturity mismatching engaged in by some of the more recent participants, nor of the concentration of sovereign and transfer risk the loan portfolios of these banks contained. The failures of two major banking operations as a result of mismanagement also caused many banks to reevaluate their interbank credit lines on a case-by-case basis.

It also seems that many banks had not adequately monitored their actual interbank exposure to other participants in the market once their internal lending limits were established. Moreover, in some instances banks did not include interbank exposure under their overall country lending limits, as they did not consider such operations as subject to sovereign risk. There were some instances where, as payments difficulties emerged, banks headquartered in that country rapidly increased their international interbank borrowing. Although the rapid utilization of lending limits should have provided a danger signal to banks from other countries participating in the interbank market, relevant information often was either not readily available or not regularly scrutinized. As the true dimensions of this problem became apparent during 1982, banks from these developing countries found their access to increased interbank borrowing severely curtailed or eliminated and banks from some other developing countries faced limitations on access. Except in certain specific cases, it appears that many traditional market participants were cutting back unused portions of their lending limits, rather than reducing their actual interbank exposure, thus precluding further rapid increases in such exposure without explicit review of lending limits.

In a number of countries, however, most notably in Brazil, difficulties in maintaining interbank exposure were an important factor contributing to the emergence of external payments difficulties during 1982. Moreover, access to interbank markets proved to be a central element in the negotiations of various debt rescheduling arrangements in late 1982 and early 1983. Also, the turbulence in interbank markets during mid-1982 to late 1982 probably added to the widely noted reluctance of smaller dollar-based banks and many nondollarbased banks to continue to increase their international exposure, due to a heightened perception of funding risk. The absence of these banks in lending was particularly felt in the syndicated credit market, where it made the task of selling down new credits considerably more difficult for the lead banks.

Bank Debt Restructuring

The prolonged global stagnation of recent years, together with high real interest rates in international markets, aggravated the external payments situation, particularly of the non-oil developing countries, and an unprecedented number of countries experienced severe external debt servicing difficulties. More recently, declining oil prices also weakened the balance of payments situation of some of the oil producing countries. As a result of these factors and delays in formulating adequate policy adjustments, there was a sharp increase in the number of countries that have approached commercial banks either for a formal debt rescheduling or for other forms of debt relief. In some cases the deterioration of the perceived creditworthiness of a country was, in large part, due to the “contagion” effect of the debt servicing difficulties of other countries in the same region. The generally observed shortening of the average maturity of outstanding bank debt over recent years made a number of borrowers more susceptible to confidence problems. During 1982 and early 1983, some 28 developing countries completed or were engaged in negotiations for some form of multilateral commercial bank debt restructuring. As of mid-1982, this group included the largest borrowers in international capital markets (Table 7). By the end of 1982, the total external claims of banks in the BIS reporting area on these 27 countries (excluding Liberia, which is an offshore financial center) totaled $209 billion, fully 20 percent of the total external claims of these banks (net of inter-bank redepositing). For those major borrowers engaged in negotiating restructuring arrangements during the second half of 1982, new lending generally appears to have ceased, or bank exposure has even declined, at least until the conclusion of negotiations and the implementation of the restructuring arrangement.

Table 7.Developing Countries Ranked by Debt to Banks, December 19821(In millions of U.S. dollars)
1. Mexico262,888
2. Brazil260,453
3. Venezuela227,474
4. Argentina225,681
5. South Korea23,245
6. South Africa14,338
7. Philippines12,554
8. Chile211,610
9. Portugal10,004
10. Greece9,988
11. Indonesia9,948
12. Yugoslavia29,821
13. Nigeria28,527
14. Algeria7,685
15. Hungary6,757
16. Israel6,669
17. Malaysia6,627
18. Colombia6,312
19. Kuwait6,188
20. Saudi Arabia5,515
21. Peru25,353
22. Egypt4,932
23. Thailand4,921
24. United Arab Emirates4,814
25. Ecuador24,488
26. Romania24,243
27. Turkey23,971
28. Morocco3,882
29. Ivory Coast3,387
30. India2,603
31. Iran, Islamic Republic of2,263
32. Uruguay21,531
33. China1,344
34. Costa Rica21,261
35. Sudan21,119
36. Tunisia1,059
37. Cameroon1,046
38. Libya1,004
39. Bolivia2940
40. Zimbabwe914
41. Zaire2873
42. Dominican Republic2866
43. Pakistan837
44. Trinidad and Tobago824
45. Nicaragua2814
46. Congo805
47. Kenya770
48. Jordan767
49. Gabon701
50. Sri Lanka654
51. Zambia2590
52. Paraguay575
53. Papua New Guinea547
54. Syrian Arab Republic540
55. Jamaica2521
56. Honduras2469
57. Oman455
58. Iraq453
59. Haiti445
60. Qatar434
61. Senegal2410
62. Viet Nam376
63. Guatemala373
64. Niger334
65. El Salvador3317
66. Madagascar2299
67. Togo2253
68. Tanzania241
69. Ghana239
70. Burma208
71. Malawi2202
72. Bangladesh172
73. Mauritius148
74. Guinea138
75. Guyana2129
76. Yemen Arab Republic129
77. Benin120
Sources: Bank for International Settlements, The Maturity Distribution of International Bank Lending; and Fund staff estimates.

Besides the Fund member countries listed in this table, some 48 other developing countries are either classified as offshore banking centers or their outstanding debts to BIS reporting banks amount to less than US$100 million.

Currently in the process of formal multilateral debt restructuring with commercial banks or has completed such a process since January 1982. Liberia also completed such a renegotiation in 1982; however, it is not included in the above table because of its status as an offshore financial center.

Currently in the process of a formal bilateral debt renegotiation.

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

Besides the Fund member countries listed in this table, some 48 other developing countries are either classified as offshore banking centers or their outstanding debts to BIS reporting banks amount to less than US$100 million.

Currently in the process of formal multilateral debt restructuring with commercial banks or has completed such a process since January 1982. Liberia also completed such a renegotiation in 1982; however, it is not included in the above table because of its status as an offshore financial center.

Currently in the process of a formal bilateral debt renegotiation.

The number of bank debt restructuring arrangements either under negotiation or completed since the end of 1981 is unprecedented; as is the amount of debt subject to these arrangements. In many ways the negotiations resemble earlier cases of commercial bank debt restructuring. Banks remain generally unwilling to reschedule payments—particularly interest—in arrears, to reschedule future interest payments, or to restructure principal maturities at less than market-related interest rates. However, some of the recent reschedulings differ from previous cases in that banks have been willing to commit themselves to increase their net lending as part of a restructuring arrangement. Typically this new lending was closely linked to a program supported by the Fund. At present the total of such commitments is estimated to amount to over $12 billion. In certain cases, commitments were also made by the banks to maintain a given amount of short-term exposure (including inter-bank operations) to a country in the context of a restructuring agreement.

Supervisory Issues

Overview

With the widespread emergence of debt servicing difficulties in the past year, involving some of the largest borrower countries, issues of sovereign and transfer risk increasingly became the focal point of official attention. Supervisory authorities have become concerned about the extent to which the apparent deterioration in the quality of banks’ international assets has affected the strength of their major banks and also, to some extent, the stability of the international financial system. Efforts are under way to improve the assessment of the riskiness of international loans and the evaluation of banks’ true capital position in light of changes in the quality of international claims. Supervisors in several financial market countries are pressing banks to reflect in their balance sheets the deterioration in their inter-national assets by the formation of specific loan loss provisions or even write-offs. These supervisors are, however, also aware of the need for significant net bank lending flows to developing countries that continue to put in place adjustment programs, often with the Fund’s support and frequently involving bank debt rescheduling arrangements.

The banks’ willingness to continue international lending on a significant scale to these countries will be affected not only by steps taken by the supervisory authorities per se. Other official actions, such as the tax treatment that special provisioning or write-offs for sovereign risks receive, will be of importance for banks’ future attitudes toward increases in their international exposure in certain countries. Moreover, the management of banks has become increasingly subject to pressures from shareholders since the bank debt situation has attracted the attention of the press and since increased public disclosure of banks’ international lending has been mandated in some countries.

The supervisory response to the international debt situation has differed considerably among countries, but important similarities can also be found in the emphasis placed on improved risk assessment and in questions of loan loss provisioning. Some supervisory agencies are currently waiting to see how the banks and their external auditors are responding on the latter issue in their own balance sheet preparation and so far have only stated some general principles to assist banks in forming judgments. In some instances the attention of the national legislature is also currently focusing on the question of international lending and other supervisory issues. The supervisory response in various countries also reflects sharply increased potential or actual losses on domestic loans, which have affected the financial position of the banks headquartered therein.

The trend in supervisory actions affecting the formation of prudential reserves against sovereign and transfer risks and their link to the adequacy of banks’ capital positions are discussed below. Other similar issues relate to the need for better collection and dissemination of information to supervisors and the public, the further strengthening of international supervisory cooperation, and banks’ country risk assessment.

Provisioning and Capital Adequacy

The deterioration in the quality of banks’ (international and domestic) assets has heightened the concern of supervisors, and also of bank management, about capital adequacy. Quite apart from any movements in formal capital-assets ratios, banks’ capital strength deteriorates pari passu with the quality of their assets. In many financial market countries, the supervisory response to the widespread emergence of international debt servicing problems has, therefore, focused to a large extent on banks provisioning against specific country risk to correct the banks’ capital position for changes in the quality of such claims.

Until recently, banks headquartered in most of these countries were not permitted to specifically make tax deductible provisions for sovereign lending and transfer risks. In response to recent events, however, there was an important change in supervisory attitudes. Banks are now generally permitted, encouraged, or even required to set aside provisions for cross-border risk. To the extent that retained earnings or capital are redesignated as specific provisions, the measured capital-asset ratio generally will be reduced, reflecting that the deterioration in the quality of banks’ assets has weakened the banks. However, the creation of write-offs or specific provisions once such deterioration has occurred does not imply that banks are in a weaker position than if they had continued to carry their quality impaired loans at full value. The ability and willingness of banks to set aside loan loss reserves will depend on both their earning position and the tax treatment such provisions receive.

There are important accounting differences in the treatment of specific provisions against sovereign risk. These differences appear both across countries and also among published accounts, tax accounts, and supervisory accounts. In some cases assets are written down, i.e., shown at less than face value. In other instances an offset is provided on the liability side while the assets continue to be shown at full value. In some countries the authorities have encouraged the banks to consider “earmarking” part of the general or “hidden” reserves as provisions against country risk.

Insofar as bank supervisors are suggesting or mandating specific provisionings, their judgment does not appear to reflect primarily whether or not a country has engaged in a debt rescheduling exercise but is based on a judgment as to whether its debts are, for all practical purposes, irrecoverable.

In most cases, specific guidelines for provisioning against country risk have not yet been issued, although in a number of countries these are under consideration by regulatory agencies, legislators, and tax authorities. The tax treatment such provisioning receives will be of great importance for banks’ attitudes toward further international lending, particularly to developing countries. Aside from some of the less recent reschedulings, regulators generally feel that the uncertain balance of payments prospects in many borrowing countries preclude at this stage the issuance of clear-cut recommendations or requirements. On the other hand, particularly in countries where the earnings of banks strengthened significantly in 1982, regulators have generally encouraged banks, often strongly, to make adequate provisions against country risk rather than to increase their dividends. Nonetheless, only in exceptional cases have quantitative guidelines regarding provisioning for specific sovereign risk been issued so far.

In general, supervisory agencies do not expect uniformity in the approach taken by their banks to specific country risk provisioning, in part because of the different composition of debt of the individual banks and also because of differences in banks’ earning positions. In the absence of specific legislative or administrative requirements, most supervisory authorities appear prepared to judge the adequacy of specific provisioning in light of a bank’s overall situation, including its capital position, general reserves, and hidden reserves. The latter are not shown in the published accounts, but generally are known to the auditors and supervisory authorities.

The overall response of banks to these recommendations by the supervisory agencies still remains uncertain, as the 1982 balance sheets for some banks are just being finalized or are not yet available, and as the question of tax treatment of specific provisions against country risk remains unresolved in several countries. There are, however, indications of a large increase in provisioning against domestic risks in some of the 1982 balance sheets already published. Moreover, in many countries banks have set aside significant provisioning against country risk, often for the first time. Although these provisions are generally large relative to bank earnings, so far they appear to involve bank loans extended to a fairly limited number of countries. There are important differences in the extent of provisioning, depending on the nationality of the bank. Even within a country, banks’ provisions against risk for identical sovereign borrowers are far from uniform. As a result, provisions taken by major international banks against the poorest sovereign risks are currently ranging from zero to 100 percent, although provisions in excess of 50 percent appear to be relatively scarce. Sharply improved gross earnings and strong supervisory encouragement, combined perhaps with generally favorable tax treatment of specific provisions, appear to have led major continental European banks to make relatively larger country risk provision against a somewhat wider range of countries than banks headquartered in other parts of the world. Apart from the important aspect of tax treatment, these banks generally face less pressures from shareholders to pay large dividends. Indeed, despite improved earnings, some continental European banks are forgoing increases in dividends altogether to strengthen country risk provisions and shelter profits from taxation. In Japan, however, banks are being asked to set aside provisions against sovereign risks out of after-tax profits.

Over the last decade, banks’ international assets have grown much faster than domestic assets or capital, and these assets are largely concentrated on a few major borrower countries experiencing debt servicing difficulties. Furthermore, the majority of these claims are held by a relatively small number of major international banks. For some of these banks it is known that claims on the largest borrower countries experiencing debt servicing difficulties amount to a high proportion of the capital of these banks. Consolidated reporting suggests that for some banking systems a significant part of inter-national lending has taken place through subsidiaries which, in some instances, were not constrained by the prudential ratios applying to the parent banks. In addition, for banks with international assets largely denominated in dollars but with capital denominated in the national currency of the bank’s domicile, the strengthening of the dollar in 1982 against many national currencies resulted in an increase in the balance sheet value of dollar-denominated assets relative to the bank’s capital funds. At the same time, the generally weak bank equity market of the past two years has made it difficult and expensive for banks to increase their capital base through share issues, although this may have changed in recent months as the price of bank stocks rose sharply in some countries.

The redesignation of bank capital or retained earnings as special reserves or provisions against increased commercial and sovereign risk tends to slow the growth of bank capital or limits the banks’ ability to increase dividends—and thus to have access to the equity markets—or both.14 Although at present few banks are actually seriously constrained in their lending activities by formal capital-asset ratios (or other supervisory limits), concern about capital adequacy contributes to the banks’ current cautious attitude toward the rate of further asset growth—particularly of less profitable loans. Bank supervisors in many countries have increasingly encouraged banks to strengthen their capital position by increasing retained earnings as bank profitability improves. At the international level there has been an increasing consensus among supervisory authorities around the world that the erosion of capital ratios should be resisted on prudential grounds and that the capital of major banks should not be permitted to deteriorate from present levels. In several countries, however, banks were able to improve their capital-asset ratios through the issuance of subordinated debt. In other countries, subordinated debt is not considered to be part of bank capital for the fulfillment of solvency ratios.

Funding Risk

As previously mentioned, banks in some countries have been encouraged by their supervisors to reduce their funding risk, particularly in foreign currencies, by issuing medium-term floating rate debt. As interest rates began to decline in 1982, some banks were able to obtain medium-term floating rate funding by issuing fixed rate obligations and swapping the proceeds with a nonbank borrower that had issued floating rate debt. Many of these so-called interest rate swap operations were also combined with currency swap operations. Until recently, banks whose fixed rate debt instruments were well accepted in the market have been able to use this technique to obtain floating rate funding at favorable rates. While these operations are innovative, and have assumed some importance as a source of medium-term finance for a number of international banks, it is expected that their role will be limited in amount and duration. This expectation partly reflects that these swap operations require the matching of maturity and currency needs of various borrowers and creditors, as well as the persistence of a better reception of banks’ fixed rate issues in the bond markets than that for corporate borrowers. The development of these techniques not only reflects changes in capital market conditions but also increases concerns of funding risks in the inter-bank market by some nondollar-based banks and smaller banks in general. Such concerns were heightened by the recent disturbance in the interbank market which resulted in significant tiering and the market’s reevaluation of prudent limits on interbank lines. The supervisory authorities in several countries have given more attention to maturity mismatch in international lending, and in a few cases where there are administrative guidelines these have been tightened.

Dissemination of Information

The emergence of payments difficulties in major market borrowing developing countries, and their resolving by debt restructuring operations, have served to under-score the need for more complete disclosure to bank supervisors of the sovereign risk, and other risks associated with international operations, borne by individual banks. In addition, the considerable public attention focused on international debt difficulties has heightened awareness of sovereign risks on the part of share-holders and depositors. The issue of consolidated reporting of banks’ exposure, i.e., including operations of branches and subsidiaries, remains of primary importance to bank supervisors. As a result of changes introduced in recent years, banks in many countries already are required to provide consolidated balance sheets to their supervisors and in some others these provisions were strengthened during 1982. In the Federal Republic of Germany, banks are currently reporting consolidated data on the basis of a “gentleman’s agreement” with the bank supervisors, based on the expectation that such reporting will soon be mandated under an amendment to the Banking Law. In 1982 banks in some countries were required to report their individual country exposure to bank supervisors or to increase the frequency and comprehensiveness of such reporting. In a few countries, banks must also report the unutilized portion of their country limits.

There is even less uniformity among countries with regard to approaches for increasing the transparency of international lending to bank shareholders and depositors. For example, during the past year, banks in the United States have been required to increase public disclosure of some of their international exposure, and additional steps in this direction may be taken in the near future. In Canada banks were advised to disclose publicly some geographical distributions of international claims. However, supervisors in some other countries feel that increased market transparency will not be helpful. They believe that it will not be possible for banks to disclose sufficiently detailed information for an adequate evaluation of the riskiness of a specific bank’s portfolio. In their view responsibility for such an evaluation must ultimately rest with the bank supervisors and banks’ own auditors.

International Cooperation

Although international cooperation in the area of bank supervision has progressed greatly over the past decade, developments in international capital markets over the past year have posed new challenges for the international coordination of bank supervision. The collapse of Banco Ambrosiano in Italy and its complex group of affiliates around the world—including Banco Ambrosiano Holding in Luxembourg—highlighted the need to define the responsibility of bank supervisors regarding new forms of organization of banking activities, such as bank holding companies.

In June 1983 “Principles for the supervision of banks’ foreign establishments”15 was published, which had been prepared by the Basle Committee of Supervisors and endorsed by the Governors of the Group of Ten countries and Switzerland. It represents a revision of the 1975 concordat16 in order to take account of changes in supervisory techniques and practices and developments in the market place. The essential principles of the 1975 concordat remain the same: that no foreign banking establishment should escape supervision and that the supervision should be adequate. The division of responsibility for supervising the solvency and liquidity of banks’ foreign branches, subsidiaries, and joint ventures remains essentially as before, although with increased emphasis on the shared responsibilities of parent and host authorities in the supervision of liquidity. The principal revision was made in order to incorporate the principle of consolidated supervision that had been agreed by the Committee and endorsed by the Governors subsequent to the 1975 concordat. The new document also examines further ways of avoiding gaps in supervison that may arise as a result of inadequately supervised centers or the existence of intermediate holding companies within banking groups. Like the 1975 concordat, the new document refers only to supervisory responsibilities not to responsibilities for lender-of-last-resort support.

There has been additional progress in enlarging the number of countries whose banking supervisors are in mutual contact and who are working toward harmonization of supervisory practices. Institutionally there were further meetings in 1982 of the group of offshore banking supervisors that was founded in 1980. The most tangible result of international cooperation in recent years was the general acceptance and widespread implementation of the Basle Committee’s recommendations that bank solvency be evaluated on a consolidated basis. Steps are being taken in a number of countries to permit a greater exchange of information among supervisors and improved reporting by branches and subsidiaries to their parent banks. Another important issue currently under study by the Basle Committee relates to the question of capital adequacy.

The European Community is also developing observation ratios for banks and calculations have been carried out in order to increase the understanding of banks’ solvency, liquidity, and profitability in member countries of the Community.

A new Directive on supervision of credit institutions on a consolidated basis was adopted by the Council of Ministers of the European Community (EC) on June 13, 1983 and notified to Member States on June 21, 1983. This document is reproduced as Annex II to this paper. The thrust of the Directive, which will apply to all community members, is to establish the principle of supervision on a consolidated basis and to require its application wherever a “credit institution,” i.e., a bank, in one EC Member State has a controlling interest in another credit institution, or in another “financial institution” in the same or another Member State.17 The Directive does not apply where the parent is not a credit institution, for example, where the parent is a nonbank holding company. Supervision on a consolidated basis is “to enable the supervisory authorities in the Member States to make a more soundly based judgment of the financial situation of a parent credit institution and the institutions partly or wholly owned by it.”18 The initiative for consolidation will rest with the author of the parent country, but host country authorities will be expected to cooperate if the parent institution’s participation is 25 percent or more of the subsidiary’s capital. Recognizing the importance of credit and financial institutions with links outside the Community, the Directive recommends that EC Member States extend the scope of supervision on a consolidated basis through bilateral agreements with nonmember states.

Community members have two years—until July 1, 1985—in which to bring their own regulations and procedures into line with the requirements of the Directive. However, Member States may defer, for up to five years, the application of the Directive for the supervision of certain institutions, provided notification is made (to the Commission) within six months of June 21, 1983 (see Directive, Article 2, paragraph 3). More generally, the dictates of the Directive will not come into play at all in those instances where the individual Member States judge that consolidation would be “inappropriate or misleading.” Except for the two kinds of cases mentioned immediately above, supervision on a consolidated basis will be mandatory where parent participation is greater than 50 percent, and the authorities in the host country will be required to remove all legal obstacles that could hinder the flow of information from the subsidiary to the parent institution for the purposes of consolidation. In specific cases, the host authorities could be required either to verify information concerning a particular institution or to allow the parent authorities, or an independent auditor or other expert, to carry out the verification (see Directive, Article 5, paragraphs 1 and 4).

For participations of over 25 percent but no more than 50 percent, the parent authorities must supervise on a consolidated basis if they judge that the parent holds effective control of the subsidiary, and in this case the host authorities for the subsidiary would be obliged to cooperate in the same manner as the first alternative. If parent participation is less than 50 percent and the parent bank’s authorities judge there is no effective control they may choose not to consolidate, but if they do wish to consolidate the host authorities would then have to cooperate in the same way as under the first two alternatives. Although the Directive stipulates the principle of compulsory consolidation, it does not lay down detailed rules for such consolidation for the purposes of supervision.

Community members are also required to remove legal obstacles that could hinder the flow of information from the subsidiary to the parent institution for the purposes of consolidation.

Country Risk Assessment

Various aspects of prudential bank supervision were discussed at length in a recent paper.19 Another issue touched upon was country risk and sovereign lending. The issue is how and to what extent can or should the evaluation of the quality (and changes therein) of banks’ international assets be brought directly under the purview of the supervisory authorities. By and large the national authorities have wished to avoid norms or guidelines, formal or informal, that would affect banks’ decisions on lending to specific countries and the scale and direction of amounts thus committed. The generally accepted precept is that banks should make their own lending judgments—taking into account risk-adjusted rates of return—and must be responsible for them. Nevertheless, the supervisors are responsible, inter alia, for assessing the quality of banks’ total assets, including loans with cross-border risk. Until now, the majority of supervisory authorities have viewed the problem as one of ensuring that their banks have adequate internal procedures to manage such risk and sufficient information on which to base their lending decisions. This general approach was endorsed by the Basle Committee.

Some further initiatives in this general area have been taken in recent years. In the United States, countries borrowing (over minimum amounts) from U.S. banks were placed in categories with differing notional guide-lines on what could be considered “excessive” exposure in relation to capital/reserves for each category. Exposures that exceeded these norms were listed on examination reports and thus brought to the attention of bank management. In various circumstances, these reports also included a note on the economic circumstances of particular countries where exposure concentrations were indicated. This, in turn, required that senior supervisors be given country briefings by an interagency review committee. It does not appear that this system, which is unique, greatly affected the inter-national lending decisions of the major U.S. banks or the degree of any concentration of exposure.

In another country, informal guidance indicated that outstanding medium-and long-term loans to any country should not exceed a (flat) proportion of banks’ capital. In others, there are legal lending limits to any one borrower, but these mainly extend limits on domestic lending operations rather than focusing specifically on cross-border risk. In some countries, including a few with formal capital-asset ratios, there are weighting procedures for risk assets under which some cross-border claims are given higher weights. And in several countries (almost all of the above), the contact between the banks and the responsible authorities provides at least some basis for an informal exchange of views on specific cross-border lending risks.

Undoubtedly, ideas will evolve in this area over time, particularly in light of events of the past year as regards the emergence of serious payments difficulties by a number of borrowing countries; but it is likely that any change will be gradual. One area that could be strengthened is the provision of information to examiners (auditors, etc.) of individual borrowing country situations by the national authorities; over time this could provide the basis for such an exchange of views by supervisory agencies at the international level.

Banks themselves have reacted to recent developments by strengthening their own internal analytical capabilities and management procedures for sovereign risks. Moreover, toward the end of 1982 major international banks began to organize an international institute to provide its members with improved economic and financial information concerning major borrower countries in international markets. In early 1983, this “Institute of International Finance” was established in Washington, D.C., and a large number of banks were invited to join. The declared purpose of the Institute will be to gather country economic information; to discuss with borrower countries their economic plans and financing needs; and to serve as a forum for dialogue between the international banking community and multilateral institutions, central banks, and supervisory agencies. The founding of this Institute is symbolic of banks’ increased awareness and concern with questions of cross-border risks and of the initiatives they are taking to improve risk management in view of recent experience.

11Transfer risk refers to the possibility that an otherwise solvent nonsovereign debtor will be prevented from meeting international obligations because of denial of access to foreign exchange.
12Transactions are agreed over the telephone and confirmed by telex.
13This refers to banks with headquarters outside the United States, whose capital is denominated in currencies other than the U.S. dollar.
14In some countries certain types of loan loss provisions are treated as part of capital—e.g., general loan loss provisions in the United States. In a strictly accounting sense additions to such accounts may tend to rise, as dividends may be decreased below what they would otherwise be. However, when loan losses are taken by the writing down or writing off of the asset, banks’ capital-asset ratio’s tend to fall.
15This document is reproduced as Annex I to this paper.
16For a description of the original concordat, see International Monetary Fund, International Capital Markets: Developments and Prospects, 1982, Occasional Paper No. 14 (July 1982). A summary and discussion are contained in International Monetary Fund, Aspects of the International Banking Safety Net, Occasional Paper No. 17
17A “credit institution” is defined as a deposit-taking institution that extends credits for its own account. A “financial institution” means an entity other than a credit institution, whose principal activity is to extend credit facilities (including guarantees), to acquire participations, or to make investments.
18Press Release of the Council of the European Communities General Secretariat, No. 7624/83, June 13, 1983.
19International Monetary Fund, Aspects of the International Banking Safety Net, Occasional Paper No. 17 (March 1983).

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