II. Financial Markets in Industrial Countries
Author: International Monetary Fund
Language:
English
Keywords:
WEFS; country classification; fixed interest rate bond; interest rate debt; U.S. dollar bond; market borrower; commercial paper; deutsche mark; zero coupon bond; forward rate; futures contract; International bonds; Securities markets; Foreign banks; Securities; Global
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Abstract

Total net lending through bank credit and bond markets during the first half of 1986 amounted to $146 billion (Table 2 and Chart 2) after having increased to $342 billion in 1985. Capital market activity reflected mainly developments in the industrial countries. There has also been a continuing shift toward reliance on bond markets to finance these flows. During 1985 and the first half of 1986, bond markets accounted for 43 percent of net bond and bank lending (net of interbank redepositing), compared with 13 percent in 1980–81.

Developments in Financial Flows and Instruments

Overview of Flows

Total net lending through bank credit and bond markets during the first half of 1986 amounted to $146 billion (Table 2 and Chart 2) after having increased to $342 billion in 1985. Capital market activity reflected mainly developments in the industrial countries. There has also been a continuing shift toward reliance on bond markets to finance these flows. During 1985 and the first half of 1986, bond markets accounted for 43 percent of net bond and bank lending (net of interbank redepositing), compared with 13 percent in 1980–81.

Lending to industrial countries through international bank credit and bond markets grew to $264 billion in 1985, contrasting with a decline in lending to developing countries to $15 billion in 1985. This trend was accentuated during the first half of 1986, as lending through bank credit and bond markets to industrial countries totaled $136 billion, while developing countries repaid $5 billion net. The growth in financing to borrowers in industrial countries reflected two key developments. The first was the widening current account imbalances among these countries. U.S. banks and nonbanks were the largest net takers of funds from the international banking system, while residents in Japan were net purchasers of foreign bonds on a very large scale. The second was the continuing trend toward the internationalization of bond and equity markets and portfolios and the integration of different segments of the international financial markets.

Bank lending to borrowers in industrial countries, continuing the upswing begun in 1984, rose to $202 billion in 1985 (a growth rate of 13 percent based on outstanding claims of $1.6 trillion at the end of 1984) and continued to increase to $96 billion during the first half of 1986 (Table 3). This growth was dominated by an expansion in interbank claims, which accounted for 83 percent of net bank lending during 1985 and the first half of 1986. The major destinations of interbank lending were the principal financial centers, where a high proportion of world securities market transactions took place. During 1985, Japan borrowed in the interbank market $42 billion, while such borrowing by the United States and the United Kingdom totaled $33 billion and $41 billion, respectively. In the first half of 1986, Japan remained the largest borrower in this market ($32 billion), while such borrowing by the United States and the United Kingdom amounted to $13 billion and $8 billion, respectively.

Table 3.

Bank Lending and Deposit Taking, Total Cross-Border Flows, 1982–First Half 19861

(In billions of U.S. dollars)

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Sources: International Monetary Fund, International Financial Statistics (IFS); and Fund staff estimates.

Data on lending and deposit taking are derived from stock data on the reporting countries’ liabilities and assets, excluding changes attributed to exchange rate movements.

As measured by differences in the outstanding liabilities of borrowing countries defined as cross-border interbank accounts by residence of borrowing bank plus international bank credits to nonbanks by residence of borrower.

Excluding offshore centers.

Consisting of The Bahamas, Bahrain, the Cayman Islands, Hong Kong, the Netherlands Antilles, Panama, and Singapore.

Transactors included in IFS measures for the world, to enhance global symmetry, but excluded from IFS measures for “All Countries.” The data comprise changes in identified cross-border bank accounts of centrally planned economies (excluding Fund members) and of international organizations.

Calculated as the difference between the amount that countries report as their banks’ positions with nonresident banks in their monetary statistics and the amounts that banks in major financial centers report as their positions with nonbanks in each country.

Consisting of all developing countries except the eight Middle Eastern oil exporters (the Islamic Republic of Iran, Iraq, Kuwait, the Libyan Arab Jamahiriya, Oman, Qatar, Saudi Arabia, and the United Arab Emirates) for which external debt statistics are not available or are small in relation to external assets.

Consisting of all developing countries except the eight Middle Eastern oil exporters (listed in footnote 7 above), Algeria, Indonesia, Nigeria, and Venezuela.

As measured by differences in the outstanding assets of depositing countries, defined as cross-border interbank accounts by residence of lending bank plus international bank deposits of nonbanks by residence of depositor.

Lending to, minus deposit taking from.

The United States was the largest recipient of net international capital flows in 1985 and the first half of 1986, as it borrowed abroad to finance its large current account deficit. On a net basis, international banks provided $30 billion to U.S. residents in 1985—the same as in the previous year—and $13 billion during the first half of 1986. In addition, foreigners purchased net $75 billion of securities in the United States in 1985. U.S. residents issued $40 billion (gross) in international bonds and notes in 1985, and also arranged another $4 billion of nonunderwritten facilities, mostly Eurocommercial paper. U.S. residents arranged $28 billion in international medium-term bank borrowing facilities in 1985, mainly in the form of other long-term international bank stand-by facilities ($25 billion). The U.S. share of total depositing by industrial countries in the international banking system has fallen sharply from 71 percent in 1982 to 12 percent in 1985 and 11 percent during the first half of 1986.

There was a large net balance of payments outflow from Japan on account of long-term securities transactions during 1985–86, while Japanese residents increased their net deposits with the international banking system both in 1985 and the first half of 1986. At least as striking as these net capital flows was the level of gross flows between residents and nonresidents of Japan. The gross flows were concentrated in interbank and securities transactions. International interbank lending to Japan nearly doubled to $42 billion in 1985, while interbank deposit taking from banks in Japan increased almost fourfold to $42 billion in 1985. Japanese residents purchased some $60 billion of long-term securities in 1985, while nonresidents acquired about $18 billion of bonds issued by residents of Japan on the international and domestic markets.

The much larger volume of gross flows is indicative of Japan’s emergence as a major international financial center and the growing importance of the yen in international markets. During the first three quarters of 1986, 15 percent of international bank loans were denominated in yen, compared with 14 percent in 1985 and 4 percent in 1982. The international activity of nonbanks in Japan appears to be directed mainly toward the securities markets. The preference by Japanese residents for international securities over bank deposits has been a significant factor in the shift in the relative international importance of securities versus banking markets in the last few years.

Interbank lending to the United Kingdom declined from $41 billion in 1985 to $8 billion in the first half of 1986, while interbank deposit taking from banks in the United Kingdom fell from $39 billion to $25 billion during the same period. Thus, on a net basis, international banks supplied $3 billion to banks in the United Kingdom in 1985 but obtained $17 billion in the first half of 1986. While holdings of securities by U.K. resident banks were not recorded in international banking statistics, the U.K. monetary sector acquired nearly $12 billion in overseas securities in 1985.

International bond issues by U.K. residents rose by $10 billion in 1985 to $15 billion. The U.K. Government issued a $2.5 billion floating rate note, the largest ever single issue of its kind. U.K. residents also arranged $10 billion in medium- and long-term international bank credit commitments (against $4 billion in 1984), of which half were other medium- and long-term bank credit facilities (note issuance facilities and multioption facilities and a further $6 billion in nonunderwritten facilities—mainly Eurocommercial paper).

During 1985–86, the Federal Republic of Germany replaced Switzerland as the largest net supplier of funds to the international banking markets as it supplied more than $13 billion net in 1985 and $21 billion net in the first half of 1986; in 1985, most of these funds were provided through the interbank market. In the last four years there has also been a steady expansion in transactions in German securities involving nonresidents. German residents’ net purchases of foreign securities rose to $11 billion in 1985 from $6 billion in 1984, while foreign investment in German securities increased to $14 billion in 1985 from $6 billion in 1984.

Developments in Banking Markets

Total international bank lending to industrial countries increased to $202 billion in 1985 and to $96 billion in the first half of 1986 (Table 3). Interbank lending rose to $175 billion in 1985 and to $76 billion during the first half of 1986; lending to nonbanks in industrial countries grew to $28 billion in 1985, but remained at only slightly more than half of the level in 1982 (Tables 16 and 17); and lending to nonbanks in industrial countries increased further to $20 billion during the first half of 1986. The greater interbank activity appears to be associated with a number of developments.

First, the further integration of banking activity in individual financial centers as markets have been liberalized has led to larger gross interbank flows, particularly with Japan, Belgium-Luxembourg, and the United Kingdom. Banks have dramatically increased their participation in the bond markets, as both issuers and holders—particularly of floating rate notes—and have greatly expanded their trading in, and underwriting of, various types of note issuance facilities. The increased links between the banking and securities markets may have increased interbank activity, as many banks have funded their portfolios of securities in this market. The large increase in cross-border interbank lending from banks in Japan appears to be related partly to the funding of their overseas branches’ holdings of securities where the tax and regulatory treatment is more favorable than in Japan. Banks in the United Kingdom were net absorbers of interbank funds, and this may partly reflect the funding of U.K. banks’ holdings of international bonds.

Second, the growth of interbank activity has been boosted by the need for larger forward covering by the banks to avoid open positions associated with the fluctuations in currency values, the shift in currency preferences of borrowers and depositors, and the growing use of the European Currency Unit (ECU) in the denomination of international loans and deposits as a way of hedging currency risks (Table 18).

Third, there has been a change in the importance of different nationalities of banks in international business with a shift toward banks that rely, to a greater extent, on the interbank market to fund their international business. By the end of September 1985, the international business1 of Japanese banks had expanded to account for the largest share of total international bank claims and liabilities (about 26 percent each, using the BIS data on international banking activity classified by the nationality of the banks; see Table 19). In the first three quarters of 1985, partly reflecting seasonal factors, international claims of Japanese banks grew by $121 billion, equivalent to an annual rate of 32 percent. By contrast, the international claims of U.S. banks fell by 3 percent at an annual rate in the period to account for only 23 percent of total claims by the end of September 1985. 2 On the one hand, Japanese banks, which hold a very large and increasing net creditor position vis-à-vis nonbanks ($125 billion at the end of September 1985), financed their international activity through a large net debtor position in the interbank market. U.S. banks, on the other hand, have traditionally drawn a much larger proportion of their funds used for on-lending directly from nonbanks.

Total international bank commitments to industrial country borrowers in 1985 and the first three quarters of 1986 reached their highest level since 1982, a peak year (Table 20). Announcements of new long-term bank credit commitments rose slightly to $32 billion in 1985, as average spreads over reference rates on these loans to borrowers from industrial countries declined further to 41 basis points (Table 21), their lowest recorded level. During the first three quarters of 1986, these bank commitments continued at their 1985 pace. Spreads on these commitments declined further to 34 basis points. Other international long-term bank credit facilities, excluding merger-related facilities, surged in 1985 to $47 billion, a 62 percent increase. This growth of precautionary credit arrangements may have been stimulated partly by the general decline in fees and margins, which has reduced the cost of commitments, and partly by the decline in interest rates on deposits, which has led to the substitution of precautionary credit lines for liquid balances, the returns on which have been reduced.

Deposit taking from industrial countries increased to $205 billion in 1985 and expanded further during the first half of 1986 to $104 billion (Table 3). Interbank deposits accounted for most of this increase; deposit taking from nonbanks in industrial countries rose to $25 billion in 1985 and to $23 billion during the first six months of 1986. Depositing by nonbanks in industrial countries in 1985 reached only two thirds of its level in 1982, but exceeded that level (on an annualized basis) during the first half of 1986.

The Euronote, Eurocommercial Paper, and Medium-Term Note Markets

The international securities markets have been substantially broadened with the introduction of short-term notes. There are two categories of such note facilities. One type of short-term Euronote is underwritten by banks. These banks commit themselves to purchase Euronotes at predetermined rates if they cannot be placed in the market, for a period generally extending from five to seven years. A second variety of Euronotes is not underwritten (Eurocommercial paper), but is distributed through dealers on a best-efforts basis with flexible amounts and maturities.

The growth in underwritten Euronote facilities slowed to $16 billion (at an annualized rate) during the first three quarters of 1986, following a growth of $33 billion in 1985, whereas Eurocommercial paper grew from $0.6 billion in 1984 to $16 billion in 1985 and increased further during the first three quarters of 1986 to $52 billion (at an annualized rate) (Table 24). Approximately $20 billion in short-term promissory notes is currently outstanding.

As the market for Euro-facilities has evolved, financial packages have become increasingly complex and the range of participants has expanded. The volume of “multiple option facilities” increased from $8 billion in 1984 to $18 billion in 1985 and fell to $10 billion in the first three quarters of 1986 (Table 26). These facilities back the issuance of Euronotes or the use of short-term bank advances where the borrower has options to select the maturity, currency, and interest rate reference.

Borrowers have issued Euronotes and Eurocommercial paper as an alternative or supplement to floating rate notes, syndicated loans, and U.S. commercial paper. During 1985–86, nearly half of total facilities were arranged for borrowers domiciled in the United States, Australia, and the United Kingdom, for the most part nonbank corporations. U.S. corporations have been particularly active, accounting for nearly a third of the market. Australian borrowers more than doubled their issues to $8 billion in 1985; however, this dropped to $5 billion in the first three quarters of 1986 (annualized). Borrowers from the United Kingdom took in $4 billion in 1985 and $5 billion in 1986. The presence of sovereign borrowers in this market declined sharply in 1985, with a slight increase in 1986. The presence of industrial borrowers, on the other hand, increased in 1985 but declined again in 1986 (Table 27).

Euronotes have been underwritten largely by commercial banks, particularly those from the United States, France, Japan, Canada, Switzerland, and the United Kingdom. The absence of an active secondary market and the lack of a rating for most issues apparently deterred nonbank investors from holding a significant amount of notes. Principal nonbank investors reportedly include fund managers, corporate treasurers, insurance companies, and central banks.

The cost of tapping the Euronote market consists of the interest paid on the notes and the fees relating to the backup facility. Prime borrowers, such as Sweden and Australia, have been able to tap the note market at rates below the London interbank bid rate (LIBID), while others have paid rates somewhat above LIBOR, but below spreads on syndicated credits. Competition between investment and commercial banks has resulted in a significant reduction in the arrangement and stand-by fees. This development has induced many borrowers to substitute Euronotes for part of their traditional borrowings or stand-by facilities (such as lines of credit) used to back up their U.S. commercial paper program. Underwriting fees usually range from 5 to 15 basis points of principal. Customer relations and market share appear to be important elements in banks’ decision to underwrite facilities at fees that appear small in relation to the banks’ funding and credit risk, were they called upon to absorb the notes.

A further addition to the list of new instruments featured in the international market has been the medium-term note, which was introduced into the Eurodollar market in 1986. Medium-term notes are continuously offered unsecured notes with maturities ranging from nine months to ten years. They are not underwritten, but are sold instead on a best-effort basis through dealers. Medium-term note programs emerged in the early 1980s in the U.S. domestic market as a funding tool for high-quality financial companies. The emergence of a liquid secondary market and the flexibility afforded under the Securities and Exchange Commission’s (SEC) shelf registration procedures (Rule 415), which allows issuers to tap U.S. securities markets any time after satisfying SEC registration requirements rather than at a single predetermined issue date, gave additional impetus to this market. Strong demand by non-U.S. residents and the possibility of avoiding SEC registration requirements have resulted in actual and proposed Euro-programs of approximately $5 billion in 1986.

Developments in International Bond Markets

Issuing activity in the international bond market continued to rise sharply in 1985 and the first three quarters of 1986 (Table 4 and Chart 3). Gross international bond issues rose to $166 billion in 1985 and further to $231 billion in the first three quarters of 1986 (on an annualized basis). The bond markets’ expansion is in large part attributable to a substantial decline in long-term interest rates and associated capital gains for bondholders (Chart 1), to the access created by new instruments and issuing techniques (in particular interest rate and currency swaps), and to the liberalization of financial markets. The decline in interest rates has also motivated borrowers to prepay high-coupon debt by exercising call options. Early repayments of bonds, which amounted to $3 billion in 1984, rose to $19 billion in 1985 and reached $29 billion during the first three quarters of 1986 (Table 28). The issue of bonds (gross bond issues less scheduled and early redemptions) grew to $131 billion in 1985 and increased further to $170 billion in the first three quarters of 1986 (annualized). As a result of the decline in long-term interest rates, the maturity profile of international bonds has lengthened in most countries (Table 29).

Table 4.

International Bond Markets, 1980–86

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Sources: Organization for Economic Cooperation and Development, Financial Statistics Monthly and Financial Market Trends; International Monetary Fund, International Financial Statistics; and Fund staff estimates.

First three quarters of 1986 on an annualized basis.

Gross issues less scheduled repayments and early redemption.

Gross issues less scheduled repayments and early redemption and bond purchases by banks.

Three-month deposits.

Bonds with remaining maturity of 7–15 years.

The issue of straight bonds (i.e., fixed interest rate obligations without options to change its basic characteristic) rose to $93 billion in 1985 and further to $148 billion during the first three quarters of 1986 (annualized) (Table 31). The issue of floating rate notes declined from a peak of $58 billion in 1985 to $55 billion (on an annualized basis) during the first three quarters of 1986 (Table 32). The floating rate note market has benefited, however, from an increase in secondary market liquidity. The average size of transactions has increased from $1 million to $3-5 million. Bid and ask spreads have halved and now resemble those of other money market instruments. The increase in the relative importance of straight issues (Chart 7) was due in large part to the decline in long-term interest rates.

Chart 7.
Chart 7.

International Bond Issues by Major Instruments, 1983–86

(In billions of U.S. dollars)

Source: Organization for Economic Cooperation and Development, Financial Statistics Monthly.1First three quarters of 1986 on an annualized basis.

Floating rate note Eurodollar issues totaled 543 in number between January 1983 and December 1985, of which 50 percent were issued by banks, 35 percent by sovereign borrowers, and 15 percent by other borrowers. Floating rate notes have also been issued in nondollar currencies. At the end of 1985, according to market estimates, $6.5 billion of sterling floating rate notes were outstanding, $3.5 billion in deutsche mark floating rate notes, $1.6 billion in ECUs, $1.0 billion in Swiss francs, and $0.2 billion in Japanese yen. A decline in spreads has induced the early redemption of $9.8 billion of floating rate notes, compared with $6.6 billion for fixed rate bonds.

The currency composition of international bonds (Table 33 and Chart 8) has shifted away from the U.S. dollar and the Swiss franc toward the Japanese yen, the ECU, and other currencies. In particular, the share of the U.S. dollar fell from 61 percent in 1985 to 54 percent in the first three quarters of 1986, while the share of the Japanese yen rose to 10 percent from 8 percent during the same period, and the share of the ECU fell from 4.2 percent of total issues in 1985 to 3.1 percent in the first three quarters of 1986. In 1985, borrowers of ECUs included U.S. corporations (ECU 1.1 billion), Japanese issuers (ECU 0.9 billion), and international development organizations (ECU 0.6 billion), in addition to the traditional European Community (EC) borrowers (ECU 5.3 billion). While most of the ECU issues were fixed rate bonds, a market for ECU floating rate notes developed in 1985 with ECU 1.2 billion of new issues. Floating rate note issues are priced at narrow margins over ECU LIBOR.

Chart 8.
Chart 8.

International Bond Issues and Placements by Currency of Denomination, 1981–86

(In billions of U.S. dollars)

Source: Organization for Economic Cooperation and Development, Financial Statistics Monthly.1First three quarters of 1986 on an annualized basis.

The international bond markets have grown significantly faster than the domestic bond markets (i.e., bonds issued by residents in domestic markets) in the major currencies (Table 34). In particular, international U.S. dollar bond markets grew by 29 percent in 1985, while the domestic U.S. bond market (public and private) grew by 18 percent; in 1985, the dollar-equivalent volume in the international yen bond markets grew by 43 percent (Euro-yen 48 percent, foreign yen 24 percent), and the dollar-equivalent volume in the domestic yen bond market by 8 percent. The dollar-equivalent volume in the deregulated international deutsche mark bond market grew by 22 percent, while the domestic deutsche mark bond market grew by only 4 percent in U.S. dollar terms in 1985.

The geographical distribution of borrowers in the aggregate external bond markets has not changed much during the last several years, with borrowers from industrial countries accounting for about 87 percent in 1985 as well as during the first three quarters of 1986. Developing countries increased their access to the bond markets to $10 billion in 1985, but gross new issues declined to $6 billion (annualized) during the first three quarters of 1986 (Table 5 and Chart 9). International organizations borrowed $18 billion in 1985 and the same amount during the first three quarters of 1986 (annualized) in the international bond markets. Borrowing by U.S. residents rose to $41 billion in 1985. While most of this new borrowing ($29 billion in 1985) took place in the Eurodollar market, there also was a significant amount of new borrowing in the Euro-yen market, mainly in the form of dual currency issues. During the first half of 1986, U.S. residents remained the largest borrowers in the international dollar market, accounting for almost 30 percent ($33 billion) of the total, followed by Japanese borrowers ($17 billion).

Table 5.

Gross International Bond Issues and Placements by Groups of Borrowers, 1981-Third Quarter 19861

(In millions of U.S. dollars)

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Source: Organization for Economic Cooperation and Development, Financial Statistics Monthly.

The country classifications are those used by the Fund (see Appendix I). Excludes special issues by development institutions placed directly with governments or central banks and, from October 1984, issues targeted specifically to foreigners.

Chart 9.
Chart 9.

International Bond Issues and Placements by Groups of Borrowers, 1981–86

(In billions of U.S. dollars)

Source: Organization for Economic Cooperation and Development, Financial Statistics Monthly.1First three quarters of 1986 on an annualized basis.

Japanese residents borrowed about $21 billion on the international market in 1985, much in the form of equity-related issues that frequently are resold to Japanese institutional investors. Borrowing on the external yen bond market doubled in volume during 1985. Most of this increase was in the Euro-yen market, which experienced a fivefold increase to ¥ 1,525 billion, half of which was in the form of dual currency issues. The volume of new issues on the Euro-yen market surpassed for the first time the volume of samurai issues, that is, foreign yen-denominated issues in Japan. The expansion of the Euro-yen market continued in the first half of 1986 when the volume of new issues grew by ¥ 1,467 billion.

The Euro-yen market is largely made up of borrowers from industrial countries (who frequently swap their yen proceeds against domestic currency or U.S. dollars), while the samurai market is made up of borrowers from industrial countries (45 percent), international development organizations (35 percent), and developing countries (20 percent). The traditional samurai market was supplemented in 1985 by the so-called shogun market ($700 million), that is, a market for nonresident issues denominated in a non-yen currency.

Nonresident borrowing on the Swiss bond market grew by 18 percent to a historical high of Sw F 36 billion in 1985 and, during the first three quarters of 1986, it grew further by Sw F 24 billion (Swiss authorities do not permit an external Euro-Swiss franc market). Japanese borrowers accounted for 40 percent of total nonresident issues, with 60 percent of Japanese issues being equity-related.

The issue of external deutsche mark-denominated bonds in 1985–86 was greatly influenced by the implementation of liberalization measures, which resulted in a 65 percent increase in the volume of new issues to DM 32 billion in 1985 and to DM 21 billion in the first three quarters of 1986. Among the newly authorized instruments, floating rate notes were the most successful, with 27 percent of total issues occurring in this market in 1985. The volume of zero coupon bonds issued, on the other hand, remained modest (DM 1.7 billion). The group of major borrowers consisted of international organizations (DM 4.8 billion), U.S. borrowers (DM 3.1 billion), Japanese borrowers (DM 2.2 billion), and Swedish borrowers (DM 2.0 billion). Three developing countries (China, Korea, and Malaysia) issued a total of DM 1.8 billion.

The international bond markets have experienced considerable innovations in instruments and issuing techniques. The volume of zero coupon bond issues rose from $1.7 billion during 1984 to $3.6 billion during the first three quarters of 1986. Innovation in the coupon reset mechanism led to the introduction of the mismatched floating rate notes in 1984. A mismatched floating rate note has multiple dates for resetting interest rate dates within a single interest payment period; thus, the interest payment may be made semiannually, whereas the interest rate is reset at shorter intervals, for example, monthly. Approximately 20 percent of all floating rate note issues were mismatched during 1985. The floating rate note market also saw the introduction of perpetuals, which accounted for 12 percent of new issues in 1984 and 16 percent during the first three quarters of 1986. In 1985 almost 80 percent of perpetual floating rate notes were issued by U.K. banks in an attempt to increase their capital for supervisory purposes, while during the first three quarters of 1986, the issuance of perpetual floating rate notes declined.

Asset-backed finance in the form of securities backed by mortgages, receivables, or export proceeds has recently emerged as an innovation in international capital markets, after having taken root in the U.S. financial markets. Instead of funding by raising debt or equity, corporations have resorted to the sale of instruments collateralized by their assets. Typically, the assets are put into a trust and used as collateral against floating rate notes. This structure has permitted borrowers to reduce their borrowing costs by enhancing the creditworthiness of their bonds. Similarly, certificates of receivables have been issued by corporations. Such techniques have generally been successfully employed when some of the assets of the firm command a higher credit rating than the company itself.

Developments in International Equity Markets

An important development in international financial markets during 1985 and 1986 has been the growth in international equities and equity-related issues. The definition of international equities is less straightforward than the definition of international bonds because equities are normally categorized by method of issue rather than by type of instrument issued. Euro-equities—issues floated outside domestic markets by way of a Eurobond type of syndication and distribution—are issued in bearer form (bearer participation certificates) and are outside national equity listing regulations. The currency denomination is chosen by the issuer. All other types of international equity issues fall within the category of foreign equities, such as equity issues floated simultaneously in several established and regulated domestic markets. Although individual tranches are issued in the individual markets to satisfy national regulations, the equity stock is normally fully fungible among the various markets.

International equities may also be created by transforming registered stock into a form that can be traded in a foreign market as a domestic instrument. The most popular method is the creation of American Depository Receipts (ADRs). Shares are issued by the depository, usually a U.S. bank, against a stated number of foreign securities held by the depository. The SEC requires the registration of ADRs and, in some cases, of the underlying shares. Firms wishing to raise additional equity capital in the United States are required to issue sponsored ADRs. In this case, the depository enters into a contract—the deposit agreement—under which the depository issues new ADRs listed on a national exchange.

Unsponsored ADRs resemble a secondary market transfer within the fixed volume of outstanding equity. The issue of unsponsored ADRs is frequently driven by investors’ desire to avoid domestic stock exchange turnover taxes. In addition, the ADR format circumvents national provisions prohibiting local companies from establishing a share registry outside their national jurisdiction, as does the U.K. Companies Act; the advantage of the ADR format to investors is their status as local instruments to which restrictions on purchase of foreign registered securities do not apply. Thus, the issuance of international equity has been motivated by the possibility of broadening the market for the issue, of obtaining a lower issuing cost by avoiding regulatory or fiscal requirements, and of exploiting differences in price-earning ratios across various markets.

The volume of new issues of Euro and foreign equities (excluding ADRs and equity-related bonds) has grown rapidly in recent years to $2.8 billion in 1985 and $1.2 billion in the first quarter of 1986. Of this amount, about $1.0 billion of Euro-equity was issued in 1985. Swiss corporations accounted for 99 percent of new Euro-equity issues in 1985. These issues generally found their way back into the portfolios of domestic investors. The total number of ADR issues is estimated at about 600, covering 20 different countries, but data on the volume of ADRs are not yet available as the amount of equity held in this form has fluctuated widely over time due to its fungibility. U.S. corporations were the largest borrowers in the foreign equity market with $615 million of new issues, followed by German and Dutch borrowers with $290 million and $200 million, respectively.

Among various types of equity-related issues are convertible Eurobond issues that allow for the conversion of bonds to equity that is fully fungible with the original equity stock. Similarly, equity warrants give the bondholder the right to subscribe at a predetermined price within a fixed period, with the new equity being again fully fungible; this method of issuing new equity has been employed to avoid local restrictions in the form of pre-emption rights. The market for equity-related issues (convertibles and bonds with warrants) grew to $11.5 billion in 1985 and accelerated to $17.2 billion in the first three quarters of 1986 (Table 36). Japanese borrowers accounted for 54 percent of all equity-related issues during the first half of 1986, and 63 percent of equity-related issues was denominated in U.S. dollars. Such equity-related bonds are frequently resold to Japanese institutional investors.

Hedging Instruments

A recent deepening of the market for financial futures and financial options has significantly increased the scope for financial and nonfinancial firms to hedge risk associated with open financial positions. A financial futures contract conveys the right and the obligation to purchase an underlying financial instrument at an agreed price on a specified date. A financial option conveys the right but not the obligation to buy (call option) or sell (put option) an underlying financial instrument at a predetermined price on (European option) or before (U.S. option) a specified date. The development of interest rate futures and options has been complemented by the introduction of currency options and futures. Interest rate and currency futures and options are traded at exchanges in most of the major financial centers (Table 38). In addition to the standardized options traded on organized exchanges, there is over-the-counter trade in options in most financial centers.

The number of different contracts and the volume of contracts traded on the exchanges have expanded significantly. The total open-interest positions in all interest rate futures contracts at the Chicago exchanges grew from $66 billion at the end of 1981 to $192 billion at the end of 1985, with most of the growth being accounted for by futures contracts in Eurodollar deposits, which grew from $1.5 billion to $121.0 billion over the same period (Table 39). Similarly, the total face value of open positions in interest rate futures on Eurodollar deposits traded on the London International Financial Futures Exchange (LIFFE) grew from $5.2 billion at the end of 1983 to $21.2 billion at the end of 1985 (Table 40).

The total face value of outstanding interest rate options (on three-month Eurodollar deposits) stood at $60 billion on the Chicago Mercantile Exchange and at $4 billion on the LIFFE at the end of January 1986 (Table 41). The outstanding value of options traded over the counter is estimated by industry sources to be of the same order of magnitude as the volume of options traded on the exchanges. The average maturity of options outstanding lies between two and six months. Options have enjoyed greater popularity than futures since the potential loss incurred by the holder from adverse movements in the price of the underlying instrument is limited to the purchase price of the option.

Options have generally been written by commercial and investment banks in response to demand by their commercial customers, who seek to hedge an open position in the underlying security. Branches of foreign banks in international financial centers usually write options against the currency of their home countries. The market for over-the-counter currency options is partly retail, consisting of nonbank customers purchasing options contracts to insure themselves against adverse exchange movements, and partly wholesale, consisting of commercial and investment banks’ trading options to bridge or reinsure the risk incurred in writing options for their customers.

In addition to options and futures contracts, bond issues frequently have contingent features such as interest rate caps or floors on floating rate notes, prepayment or extension provisions, warrants, and equity-related features such as convertible bonds and equity warrants. A currency option bond allows the bondholder to change the currency denomination of the face value of the bond. The advantage of issuing bonds with contingent features is that such features can be securitized by detaching them from the bond and selling them separately. For example, while the borrower pays a higher coupon on capped floating rate notes, the proceeds from the sale of the cap in isolation more than compensate the borrower for the higher coupon rate. In 1985, about 10 percent of all floating rate notes issued were capped, and bonds with equity-related contingent features accounted for 7 percent of total bond issues. In the first half of 1986, bonds with equity-related features rose to 10 percent of total bond issues.

A variant on the financial futures contract is the forward rate agreement specifying the interest rate to be paid on a deposit of specified maturity at a fixed future settlement date. On settlement day, the difference between the agreed interest rate on the floating rate note and the reference rate, usually LIBOR, applied to the principal determines the value of the contract. About 90 percent of forward rate agreements are denominated in U.S. dollars. The principal dealers are large banks seeking to hedge loan commitments. The forward rate agreement market is largely an interbank market with a turnover volume approaching $10 billion a month.

The introduction of longer-term interest rate and currency swaps has recently complemented the set of short-term hedging and arbitrage instruments (see Appendix III for a more detailed description of currency and interest rate swaps). The basic interest swap is an exchange between two counterparties of a fixed interest rate cash flow for floating interest rate cash, flows in the same currency; the principal amount remains with the original parties, only the interest payments are swapped. A currency swap is an exchange of interest payments in one currency for interest payments in another currency. In this transaction, the parties also exchange the principal amounts at a negotiated exchange rate. The currency coupon swap combines the interest rate swap with a currency swap.

Currency swaps allow borrowers to hedge exchange risk over maturities extending beyond those available in the currency options or futures markets. Swaps of both types allow for the arbitrage across debt instruments having differing relative scarcity in different markets. Investors in fixed rate instruments generally demand greater creditworthiness of borrowers than investors in floating rate instruments. Hence, two borrowers of differing creditworthiness will be able to reduce their respective borrowing costs by accessing the market in which they enjoy an advantage and then swapping the interest payments. As a result of such cost advantages, many high-quality borrowers have issued fixed rate Eurobonds and used swap transactions to acquire floating interest rate funding at a cost below LIBOR.

The growth in currency swaps is partly due to the increased opportunities created by financial deregulation and liberalization in the Federal Republic of Germany, Japan, and Switzerland. The volume of primary issues arising from currency swaps expanded to $20 billion in 1985, or triple the volume in 1984. Interest rate swaps rose to $170 billion in 1985. The portion of new nondollar issues that were associated with a swap (i.e., swap driven) rose from 1 percent in 1981 to 25 percent in 1985. This development was particularly evident in the growth of yen-denominated issues, which accounted for 28 percent of total swap-driven new issues in 1985, compared with 5 percent in 1984. The U.S. dollar accounted for 19 percent of swap-driven issues in 1985. Borrowers (of U.S. dollars and yen) represented nearly half of the swap market in 1985. In some smaller countries, the volume of swap-driven transactions has grown to represent a significant portion of the domestic market. In particular, the growth in the Australian and New Zealand markets in 1985 was largely swap driven; about 60 percent of Australian and 85 percent of New Zealand dollar bonds were swapped.

Sources and Implications of Recent Changes

Liberalization

Liberalization measures in major financial markets have been concentrated in three main areas—interest rate liberalization, relaxation of exchange controls, and permission to introduce new instruments. The removal of interest rate ceilings on deposit liabilities was effected for a variety of reasons. In some countries, market interest rates rose relative to regulated interest rates, causing disintermediation from the banking sector into the securities markets, in particular into money market and bond market mutual funds. Similarly, the need to finance large fiscal deficits created secondary markets in government bonds in some countries, placing pressure on regulated interest rates. In addition, concerns about the efficient allocation of loanable funds in financial systems relying in part on regulated rates has contributed to the willingness of the authorities to abandon administered interest rates in favor of market-determined rates.

Relaxation of barriers to international competition in financial intermediation in several industrial countries has significantly reduced or eliminated the financial distinction between foreign and domestic borrowers and investors. Measures taken include removing withholding taxes on interest income accruing to nonresidents, extending the availability of domestic financial instruments to nonresident borrowers, and allowing domestic borrowers to access the international financial markets. Foreign ownership of domestic financial institutions has been liberalized, and foreign institutions are increasingly allowed to lead-manage securities issues, as well as to acquire membership on stock exchanges. Such liberalization has been undertaken to increase the efficiency of domestic financial markets by exposing them to competition from international markets. A further motivation for liberalizing cross-border activities has stemmed largely from the desire of major industrial countries to retain or regain a role in international financial markets in line with the importance of their economies in the world economy.

The introduction of new types of financial instruments and issuance techniques has been authorized in order to allow borrowers, investors, and financial intermediaries to reallocate risk among themselves. Examples of such instruments are floating rate instruments, stand-by facilities, and hedging instruments (forward, futures, and options contracts). Other instruments have been introduced to permit the domestic banking sector to fund itself competitively (e.g., certificates of deposit), or to ensure that domestic markets are not at a disadvantage vis-à-vis international markets (e.g., swap-driven bond issues, equity-related issues, zero coupon issues). In addition, a concern to foster competition and reduce intermediation costs has led to the introduction of additional money market instruments (commercial paper, mutual funds, and repurchase agreements) and has stimulated reforms of commission structures and stock exchanges. As a result, the regulatory environment has had to be adjusted increasingly frequently in order to prevent the competitive advantages or disadvantages associated with the different regulatory environments from leading to imbalances in market shares among the various financial sectors, that is, to re-establish stability.

Financial liberalization has taken place in many of the major financial centers; specific liberalization measures have taken a variety of forms, reflecting differences in institutional structure. Knowledge of the nature of regulatory changes is crucial to an understanding of the influence that liberalization measures have had on financial flows. Thus, a brief review of recent liberalization measures in selected financial centers is provided below.

France

The French authorities have undertaken extensive financial liberalization during the past two years. There has been a substantial deepening and broadening of domestic capital markets through the introduction of new financial instruments and borrowing techniques. Implementation of a new banking law in 1984 brought diverse credit institutions under a single supervisory structure. The authorities have also acted to relax exchange controls. French investors in non-French franc securities are no longer required to pass through the devise titre to buy and sell foreign currency for investment purposes. French authorities have announced their intention to abandon quantitative controls on credit (encadrement du credit) by 1987, in favor of interest rate management in their conduct of monetary policy.

In 1985, French authorities reopened the Euro-French franc bond market. Euro-French franc bonds can now be issued by nonresidents and be purchased freely by French residents (though they may not be offered to French investors at the time of issue or listed on the Paris Stock Exchange). Euro-French franc bond issuers have been exempted from the 10 percent withholding tax applied in the domestic market. Foreign banks are allowed to act as co-lead underwriters, and currency swaps and convertible issues are possible in this market. The number and volume of new Euro-French franc issues have been restrained by a monthly ceiling, which is gradually being raised.

The range of financial instruments available in domestic securities markets has broadened since 1982 as the regulations governing the management, portfolio composition, and fiscal status of mutual funds have been relaxed. Mutual fund assets quadrupled from 1982 to the end of 1985, when they reached F 644 billion, about half of which were concentrated in money market mutual funds. The money market Société d’Investissement a Capital Variable (SICAVs), whose proceeds are invested in floating rate and short-term bonds and short-term treasury issues, accounted for about 70 percent of all money market mutual fund assets, the remaining 30 percent being accounted for by the smaller and more specialized Fonds Communs de Placements (FCP).

In addition, French banks began issuing negotiable certificates of deposit in March 1985, the first such issue to be launched in continental Europe. The maturity on these securities ranges from three months to two years and they are mostly held by banks. In December 1985, commercial paper (billets de trésorerie) with maturities ranging from ten days to two years was introduced with the requirement that such paper must be backed by a stand-by line of credit with a bank. The commercial paper market, which reached F 25 billion in July 1986, permits French corporations to manage their liquidity with a marketable short-term instrument. The rate of return on these securities is set in relation to the Paris interbank market.

Short-term treasury securities (bons du Trésor négociables) were made available in 1986 to nonbanks and banks. These securities have fixed coupons and range in maturity from ten days to seven years. Among the instruments and issuance techniques introduced in the longer-term bond market are a series of zero coupon bonds issued by the Treasury in 1986, perpetual floating rate securities, and extendable bonds. The Treasury has employed the auction technique to raise funds in the long-term bond market. Short-term treasury securities, combined with conventional government bonds, provide a complete maturity spectrum of government obligations, thus allowing for the hedging of trading strategies in this market.

The rapid growth of the domestic bond market made possible the opening of a financial futures market (marché à terme d’instruments financiers or Matif) in March 1986, providing forward hedging contracts on the basis of a notional long-term government security. A domestic 13-week treasury bill futures contract was introduced on the Matif in June 1986.

The Paris Stock Exchange partly replaced a fixed commission schedule with negotiated brokerage commissions in July 1985 and has introduced continuous trading in listed stocks and bonds. Negotiated brokerage commissions have replaced a fixed commission schedule since July 1985. The liberalization of the Stock Exchange was in part due to the growth in international trading of European depository receipts in major French stocks and in part to the increased need of banks and corporations to raise capital in anticipation of their denationalization, which is scheduled to begin by early 1987.

Federal Republic of Germany

In Germany several measures were taken to extend the range of available instruments, notably in the securities market, and to facilitate international competition. The 25 percent withholding tax on interest payments on domestic bonds to nonresidents was removed in August 1984. New financing instruments and issuing techniques were introduced in May 1985. German authorities have also agreed to permit foreign banks with subsidiaries in Germany to lead-manage bond issues when the authorities of the foreign bank extend such privileges to German banks. (This requirement has had the effect of excluding Japanese banks, among others, from lead-managing deutsche mark issues.) Furthermore, since June 1986, domestic subsidiaries of foreign banks have been allowed to join the German Government’s bond-issuing syndicate (Bundesanleihekonsortium).

In May 1985, the German authorities permitted the issuance of new instruments such as floating rate notes, zero coupon bonds, bonds with debt warrants, dual currency bonds, and currency swaps. Convertible bonds and bonds with equity warrants had already been issued. Among the new instruments, the floating rate note has flourished most, as evidenced by the rapid growth in its issuing volume, which amounted to $3.2 billion by the end of 1985 and $2 billion in the first three quarters of 1986 (annualized). Issues of zero coupon bonds have been somewhat limited, in contrast, due to the tax treatment of interest accruing to corporate investors. The possibility of tapping German debt markets and swapping the proceeds into other currencies has enlarged the range of financing sources to both German and foreign borrowers; it is estimated that more than half of all international bond issues in Germany are swapped.

Access to the German capital markets has also been facilitated by the liberalization of the calendar system. Under this system, a committee of representatives of major German issuing banks and a representative of the Bundesbank, as a nonvoting observer, had full authority to determine the volume and schedule of issues. In May 1985, the calendar system was replaced by a simple monthly notification system, whereby lead managers had to notify the Bundesbank. As of July 1986, banks need only inform the Bundesbank of their intentions two business days before the onset of a semimonthly period.

Traditional money market instruments in Germany have included primarily central bank balances (Zentralbankguthaben), and discountable treasury notes, with less emphasis being placed on treasury bills and bankers’ acceptances. The newly introduced floating rate notes provide investors with a tradable short-term instrument, thereby serving to deepen the money market. In addition, the German authorities have permitted the issuance of negotiable certificates of deposit as of May 1, 1986, thus further enlarging the range of available money market instruments. The existing stock exchange turnover tax has so far severely limited the volume of certificates of deposit that have been issued.

Japan

During the past decade, the Japanese authorities have undertaken extensive efforts to liberalize their domestic financial markets and cross-border financial activities. At the core of the liberalization of domestic financial markets has been the creation of money market instruments. The introduction in 1979 of negotiable certificates of deposit (subject to a competitive floating interest rate structure), the removal of restrictions on the interbank call and bill discount markets, and the growth in the bond and certificate of deposit repurchasing (gensaki) markets have significantly deepened and broadened the domestic money markets. This development has been hastened by the growth of primary and secondary markets for government securities, a consequence of large and persistent fiscal deficits since 1975. By March 1986, the four money market instruments had reached a total of ¥ 36 trillion. Outstanding bill discounts increased 83 percent in 1985 to ¥ 14.6 trillion, while certificates of deposit rose 14 percent (to ¥ 9.6 trillion), call money increased 1 percent (to ¥ 5.1 trillion), and gensaki balances rose 30 percent (to ¥ 4.6 trillion).

The spectrum of domestic money market instruments was broadened with the introduction of money market certificates in March 1985, bankers’ acceptances in June 1985, and publicly auctioned discount short-term government refinancing bonds in February 1986. Among these, the money market certificates, a large-denomination deposit instrument, had grown within a year to an outstanding amount of ¥ 5.6 trillion in March 1986. The bankers’ acceptance, in contrast, totaled only ¥ 30 billion by the end of 1985 because the regulated short-term prime lending rate remained below the money market rates; in addition, the bankers’ acceptance is subject to a stamp duty. In October 1985, a bond futures market was opened, based on a notional ten-year Japanese Government bond contract.

In March 1986, the Bank of Japan began lending funds for money market brokers (tanshi) to purchase certificates of deposit in a market that is open to participation by financial institutions, corporations, regional governments, and institutional investors. This move was intended to extend monetary policy to the unregulated money market sector.

The institutional separation of banking and securities market activities is becoming less clear cut. Since June 1984, 136 major banks have been authorized to deal in government bonds in the domestic market, previously the domain of the securities houses. Bank affiliates and insurance company affiliates have been permitted to set up investment advisory firms, whose entrusted funds totaled ¥ 3.3 trillion in September 1985, compared with ¥ 4.4 trillion for securities house affiliates. Nine foreign banks have been permitted to set up trust banks whose managed pension funds were formerly reserved for trust banks and insurance companies. In addition, securities houses have increasingly competed with banks through investment trusts, which are mutual funds usually administered by related companies of securities houses; the total assets of investment trusts grew from ¥7.2 trillion in 1981 to ¥ 20 trillion in mid-1985.

The liberalization of domestic financial markets and of cross-border markets has been occurring simultaneously. The internationalization of the yen has helped to promote arbitrage between the existing regulated interest rate structure in Japan and the unregulated yen interest rate structures existing in Europe and growing in Japan. Arbitrage opportunities have been exploited through the use of currency swaps and short-term loans whereby Japanese companies borrow foreign currency for general capital purposes.

In 1984, the Euro-yen bond market was opened to foreign and Japanese corporations. In June 1986, access to this market was extended to foreign banks (Japanese banks remain excluded) which previously had been restricted to Euro-yen certificates of deposit and swaps for accessing yen-denominated funds abroad. The volume of new issues in the Euro-yen bond market soared to ¥ 1,525 billion in 1985 (mainly accounted for by dual currency bonds), against ¥ 1,273 billion in the much older and established samurai market (domestic market for nonresident issuers). In the first three quarters of 1986, new issues in the Euro-yen market totaled ¥ 3,181 billion (annualized), while new issues in the samurai market reached ¥ 869 billion. In addition, the maximum maturity of Euro-yen certificates of deposit was extended from six months to one year in April 1986. The Euro-yen bond market remains somewhat insulated from the domestic yen markets, due to a seasoning provision which prevents Japanese residents from acquiring Euro-yen securities for 90 days (reduced from 180 days in April 1986) after issuance. Euro-yen dual currency bonds may not be sold in Japan within 180 days after issuance. In 1985, the first yen-denominated obligations were issued in the United States (Yankee yen bonds).

During 1985–86, the Ministry of Finance authorized the issuance of Euro-yen floating rate notes, dual currency bonds, currency conversion notes, zero coupon bonds, and deep discount bonds. These were initially made available exclusively to foreign issuers; although the latter two instruments remain restricted to foreign issuers, the others were later authorized for Japanese issuers as well. Dual currency bonds were authorized for issuance in Japan by foreign borrowers in April 1986. Much of the new activity in the Euro-yen market has been swap driven, with Japanese issuers providing floating rate dollar bonds against the fixed rate yen obligations incurred by foreigners.

In Japan, foreign currency denominated bonds have been issued by non-Japanese residents (shogun bonds) since August 1985. Foreign currency denominated bonds issued by Japanese residents in foreign markets (sushi bonds) have been available since 1985. Sushi bonds are counted as non-yen securities for regulatory purposes and are subject to the 25 percent limit on investment in foreign currency denominated assets by insurance companies; however, sushi bonds, residents’ foreign currency deposits, and loans in foreign currencies are excluded from the rule that insurance companies invest no more than 25 percent of their assets in securities (yen and non-yen) of nonresidents. In March 1986, these two 25 percent ceilings replaced a 10 percent ceiling on investments by insurance companies in nonresident securities (yen and non-yen), and in August 1986 these two 25 percent ceilings were increased to 30 percent.

In early 1986, a tax measure was passed into law to facilitate the opening of an offshore banking market in Tokyo. Both Japanese and foreign banks will be admitted to the offshore market, provided their domestic and offshore operations are strictly separated. This market will be free of withholding tax.

United Kingdom

The U.K. authorities are undertaking a major regulatory reform and liberalization of financial markets. The new reform measures are intended to create broader and more efficient markets for the securities and investment industries and include plans to restructure the Stock Exchange, to reorganize the gilt-edged market, and to further extend the range of domestic money market instruments. These initiatives were prompted by a combination of increasing competition and the need to adapt U.K. domestic markets to changing international conditions. Many of the traditional distinctions among U.K. financial institutions are likely to disappear with the emergence of conglomerates offering a wide range of financial services. These structural reforms also raise prudential and investor protection considerations. The U.K. authorities are thus in the process of a comprehensive regulatory overhaul in the financial services area. This will create a regulatory structure which will be largely run by practitioners, but which will be firmly based on statute.

Under the proposed financial services legislation, which should become law by the end of 1986, the Secretary for Trade and Industry will be empowered to authorize businesses to provide financial services and to regulate their activities. These powers are expected to be delegated to the Securities and Investments Board, which will be able to recognize several self-regulatory organizations covering activities in the securities and investment area. Financial institutions undertaking a range of financial market activities may require authorization from several self-regulatory organizations. Foreign financial firms in banking, insurance, or investment business may be subject to a reciprocity requirement. The gilt-edged market will be supervised by the Bank of England and the Stock Exchange.

Simultaneously, the structure of the Stock Exchange has been changed. Following an agreement made in 1983 between the Stock Exchange and the Secretary for Trade and Industry, fixed commissions were abolished in October 1986, and the Exchange’s operations have been liberalized through the introduction of new trading practices and systems. Since March 1, 1986, nonmembers have been allowed to form new member firms, as well as acquire 100 percent ownership of Stock Exchange members. Hence, commercial and merchant banks are permitted to enter directly or indirectly into securities brokering and dealing business. In addition, as of October 1986, all Stock Exchange members can deal directly with investors, that is, buy and sell securities either as agents or principals.

In line with the changes to the structure of the Stock Exchange, the gilt-edged market has been reorganized. The new structure resembles the market for U.S. Government securities, although there are some significant differences. There are a large number of competitive primary dealers (market-makers) able to act both as principals and agents. The primary dealers are served by a number of interdealer brokers which can facilitate anonymous direct dealing between them, and Stock Exchange brokers which (as at present) can arrange stock borrowing and assist in the financing of their positions. All these institutions are required to have dedicated pound sterling capital and to be members of the Stock Exchange, although prudential supervision is carried out by the Bank of England.

In addition to the Financial Services Bill, the provisions of the recently passed Building Securities Act will come into effect in January 1987. This Act redefines the boundaries separating the activities of building societies and commercial banks which had eroded during the past decade. Ceilings are to be set on the proportion of assets of building societies that can be placed in investments other than mortgages and on the proportion of funds that can be raised in wholesale markets.

The removal of exchange controls in 1979 effectively unified the Euro and foreign sterling markets. Foreign institutions based in the United Kingdom are authorized to lead-manage foreign sterling issues as long as comparable U.K.-owned institutions enjoy reciprocal rights. The application of the new regulatory environment to activities in pounds sterling, as well as non-sterling markets in the United Kingdom, means that the previously unregulated Euromarkets in London will, for the first time, operate within a national regulatory framework.

The already extensive range of domestic money market instruments, that is, treasury bills, negotiable sterling certificates of deposit, short-term floating rate gilt instruments, bankers’ acceptances, and commercial bills, was supplemented with sterling commercial paper in May 1986. Parliament amended the Banking Act so that the issuance of commercial paper is no longer classified as deposit taking. Commercial paper is exempted from stamp duty and withholding tax, and its issue does not require timing consent from the Bank of England. However, commercial paper may have maturities only from seven days to one year and must have a minimum denomination of £500,000.

United States

The U.S. financial system was significantly deregulated during the 1980s through the removal of interest rate ceilings on deposit liabilities, the gradual weakening of barriers separating securities and banking markets, and the geographic expansion of banking institutions. Financial markets in the United States have traditionally been free to introduce financial instruments and issuing techniques, as long as these comply with disclosure and fiscal rules. As a result, U.S. financial institutions have been a major source of financial innovation.

The most significant liberalization measure has been the virtual removal of the interest ceiling on deposit accounts, which occurred in response to the development of the negotiable order of withdrawal (NOW) accounts and the growth of money market mutual funds. In 1980, the Depository Institutions and Monetary Control Act provided for the phasing out and eventual elimination of limitations on maximum rates of interest and dividends payable on savings deposits and accounts by depository institutions. In addition, the Garn-St. Germain Act of 1982 authorized depository institutions to offer money market deposit accounts, which had no restrictions on interest rates. As of mid-1986, interest rate ceilings have substantially been eliminated.

A weakening of restrictions on underwriting and mutual fund activities of commercial banks under the Glass-Steagall Act occurred in 1982, when the Comptroller of the Currency permitted national banks to conduct brokerage business. Furthermore, the Glass-Steagall Act was widely interpreted as not prohibiting subsidiary relationships between state-chartered banks that are not members of the Federal Reserve System and investment banking firms, thus allowing mutual fund organizations to set up bank or trust companies. In 1983, the Comptroller of the Currency authorized mutual fund organizations to acquire national banks that are members of the Federal Reserve System.

In order to avoid the constraints of the Bank Holding Company Act, some of the bank subsidiaries’ business was shed to keep the bank from meeting the definition of a bank pursuant to the Bank Holding Company Act. The Comptroller of the Currency has generally allowed securities firms to acquire such “nonbank” banks despite the Federal Reserve Board’s objections. While statutory revision will eventually have to resolve such interagency disputes, there has been a considerable reduction in the barriers imposed by the Glass-Steagall Act between the securities and the commercial banking industries.

Geographic constraints on bank expansion have also been significantly modified. Bank holding companies have been able to establish interstate networks of “nonbank” banks, that is, consumer finance companies, mortgage companies, etc., that do not both accept deposits and make commercial loans. The acquisition across state lines of failing institutions was authorized in 1982. Several states recently adopted laws that provide for entry of banks from neighboring states under regional reciprocity, resulting in a substantial increase in the level of interstate banking.

In a major initiative in 1982, the SEC streamlined access to the primary markets for well-established issuers by implementing so-called shelf registration procedures that significantly reduced the time required to bring issues to market. The resolution of jurisdictional disputes between the SEC and the Commodity Eutures Trading Commission in the regulation of financial futures and options has now created an environment conducive to the rapid growth of trading in these instruments, which have gained virtually universal acceptance as vehicles for management of interest rate and stock market risk.

In general, the regulatory response to new financing techniques has been of a direct and limited nature, apart from proposals, discussed below, to use risk-asset ratios for evaluating capital adequacy. For example, the financing of takeovers with subordinated debt including junk bonds was curtailed with a margin requirement promulgated by the Federal Reserve Board. The U.S. authorities have traditionally allowed foreign financial institutions to participate in U.S. financial markets on an essentially equal footing with U.S. institutions. A withholding tax levied on nonresident holders of bonds issued by U.S. residents in the domestic or Euromarkets was abolished in 1984.

Other Industrial Countries

Several other industrial countries, that is, Australia, Denmark, Italy, the Netherlands, New Zealand, Sweden, and Switzerland, have undertaken a partial liberalization of financial markets. The advances in this field achieved by the Netherlands and Switzerland are discussed below.

The financial authorities of the Netherlands announced an extensive package of liberalization measures effective January 1, 1986, in order to liberalize their capital markets in line with changes in neighboring countries, such as the Federal Republic of Germany. These principally affect issuing techniques, the characteristics of new issues, and new instruments. The authorities replaced the calendar system for new issues with a system of notification of at least two days and not more than one month before the launching date. As a result, delays experienced in bringing new issues to the market have declined significantly, and the opportunities to swap liabilities have been enhanced.

Restrictions have been removed from the maturity, denomination, and volume of domestic guilder bonds issued. Euroguilder issues may now be underwritten and listed, as well as have a prospectus. Foreign banks also are permitted to lead-manage Euro and domestic guilder issues and underwrite up to one third of offerings if the banks have a capital market presence in the Netherlands and reciprocity exists between their countries of origin and the Netherlands. As a result, the distinction between a domestic and the Euro-guilder market has become inconsequential. Generally, the financial authorities treat foreign and domestic banks alike.

New instruments authorized as part of the liberalization package include floating rate notes, for which the Netherlands Bank publishes daily the Amsterdam interbank offered rate. Zero coupon bonds remain prohibited for fiscal reasons, but bullet maturities have been introduced, and debt and equity warrants are now authorized. Index-linked loans continue to be prohibited for counterinflation policy reasons. Guilder commercial paper may now be issued, distributed through brokers, and continuously offered to investors. The Netherlands Bank has offered to act as a clearing house for commercial paper. The stock exchange tax has been abolished for certificates of deposit and commercial paper. Futures and options have for some time actively traded (including in ECU) on the Amsterdam exchange. The Netherlands financial markets are free of interest rate, credit, and exchange controls.

The financial markets in Switzerland have traditionally been international markets and have remained open to foreign borrowers since 1963. There has not been a calendar for new issues since 1984. However, the Eurobond Swiss franc market has been required to remain within Swiss jurisdiction, as capital export transactions denominated in Swiss francs can only be carried out by banks domiciled in Switzerland. The maximum admissible size of public issues was recently doubled to Sw F 200 million, and there has been some liberalization of the rules governing the issue of, and investment in, private placements denominated in Swiss francs, thereby blurring the financial distinction between public issues and private placements. However, there remains a stamp duty totaling 0.615 percent on newly issued securities.

In principle, the method and form of raising capital have not been restricted, but Swiss markets have been selective in adopting new issuance techniques and instruments. Swiss markets have adopted convertible and option bonds, dual currency bonds, perpetual bonds, zero coupon bonds, and bonds with swap clauses. Note issuance facilities and floating rate notes have been hampered by the start-up duties and minimum maturity requirements.

Innovations

Market incentives for innovative instruments and techniques may be attributed in part to opportunities to avoid or reduce the costs of regulatory restrictions and the taxes on financial activity through the use of new instruments or issuing techniques. Another market factor motivating innovation has been the intensification of competition among financial firms. In this connection, technological advances have promoted competition by making it increasingly feasible to separate the location of financial activity from the location of the underlying real economic activity, as well as to separate the location of final investor from final borrower.

A further motivation for innovation has been the opportunity for investors to improve their risk-return trade-off possibilities through instruments targeted to new sources of funds or instruments designed to hedge, arbitrage, or reallocate market and credit risk. Finally, a general tightening of balance sheet capital requirements has increased the incentives for banks in many industrial countries to employ new techniques to conduct off-balance sheet financing activities.

Innovations can generally be classified as risk transferring, liquidity enhancing, or credit or debt creating. Risk-transferring innovations have occurred in the area of hedging instruments, such as options, swaps, and various other contingent contracts that transfer risk at a market price. Floating rate instruments transfer interest rate risk from the lender to the borrower. Similarly, stand-by facilities for short-term paper shift funding risk from the issuer to the provider of the facility for a fee. New types of insurance contracts, for example, on swaps, have been employed to shift credit risk. Such voluntary reallocation of risk among market participants may have resulted in a more efficient allocation of risk. Finally, innovations including the multiple option Euronote facility, Euro-equity issues, and swaps have facilitated arbitrage of yields and perceptions of creditworthiness between markets.

Liquidity-enhancing innovations in financial markets have come in the form of new marketable securities, principally in short-term markets. In addition, the growth of stand-by facilities has underpinned the liquidity of short-term debt paper, and the increased volume of organized exchanges for contingent contracts has rendered such contracts more liquid. The collateralization of new liquid instruments with existing nontradable assets has de facto made such assets tradable. Furthermore, the introduction of new instruments and the growth in short-term government debt markets have greatly enhanced liquidity.

Credit-creating innovations have motivated the mobilization of dormant assets and tapped new sources of credit (for example, asset-backed instruments, junk bonds, and equity participations), thereby generating new financial flows in debt and equity markets. In addition, innovative instruments have expanded credit markets geographically, as in the case of swap-driven transactions.

The liberalization and innovation that have taken place in financial markets during the past two years have induced significant structural changes in the form of securitization of credit flows and the desegmentation and globalization of financial markets. The securitization of international credit flows occurred with the disintermediation of lending from the banking sector to the marketable debt sector. In the first half of the 1980s, the share of marketable debt in total new international credit grew from 31 percent in 1980 to 70 percent in 1985.

Securitization of international financial markets has been spurred largely by a relative reduction in the cost of funding through security markets, compared with the cost of funding through bank credits. Bank lenders have also increasingly participated in the international securities markets by buying and selling securities and by increasing the negotiability of their loan assets. For example, the total holding by banks of international bonds and other long-term securities rose from $47 billion in 1981 to $158 billion in 1985. At the same time, the volume of securities issued by banks in international credit markets rose from $5 billion in 1981 to $45 billion in 1985 (excluding certificates of deposit).

Domestic financial markets have become less segmented, owing to deregulation, increased competition, and the introduction of new products. In particular, the barriers between banking and securities markets have been blurred through regulatory changes, the securitization of bank assets, and increased bank participation in capital markets. The increased tradability of instruments and the availability of options have diminished the segmentation of markets arising from differences in maturity of instruments, while the use of dual currency bonds, currency option bonds, and swaps has diminished segmentation arising from differences in the currency of denomination. The distinction between debt and equity instruments has also been weakened by the use of equity-related instruments and the issue of debt of indefinite maturity.

The pace of change has not been uniform across countries, reflecting to a large extent the existing differences in institutional structures. Countries in which the banking sector has been regulatorily separated from the securities sector are generally witnessing more competition among financial sectors and more pressure for removing restrictions. Nonetheless, the liberalization of financial markets and the innovation in these markets have proceeded simultaneously and to a considerable extent in reaction to each other. Financial markets have become more globalized with the liberalization of cross-border financial activities and the expansion of foreign institutions inside domestic markets. This trend has been confirmed by the growth in international equity issues and the beginning of continuous global trading.

The Cross Report and the Implications of Recent Changes

In response to the growth in new financial instruments and to concerns over their effect on financial policy, central banks of the Group of Ten set up a study group in early 1985, chaired by Sam Y. Cross, Senior Vice President of the Federal Reserve Bank of New York. 3 The Cross Report identified three potential areas of concern resulting from the securitization of credit flows and globalization and desegmentation of financial markets: (1) diminished transparency with regard to financial conditions; (2) increased uncertainties associated with the use of monetary policy; and (3) increased difficulties in achieving effective supervision of financial markets.

Recent structural changes in international financial markets have reduced both the coverage and the usefulness of currently available international and domestic financial statistics. The securitization of credit flows has meant that a growing proportion of financial flows bypasses the banking sector, which has been the traditional source of data in the current reporting system. While the nationality, currency of denomination, and other characteristics of gross new international bond issues have recently become more readily available, information on the characteristics of the outstanding stock of international bonds remains incomplete. In addition, it is not possible to obtain information on the ownership of new or outstanding international bonds. This problem has been made worse by the increasing marketability of bank loans, for example, through the introduction of transferable loan certificates.

The growth in off-balance sheet activities in the banking sector has made measurement of financial exposure particularly difficult in this sector. The displacement of syndicated lending by the issuance of short-term paper under Euronote or Eurocommercial paper programs has further eroded the share of international financial transactions covered by current reporting systems, except when such paper is purchased by banks. These developments have tended to obscure data on credit flows to various sectors of the economy and have made it difficult to ascertain the financial exposure of these sectors.

The increased use of swaps, hedging instruments, and various stand-by agreements has tended to make assessment of financial exposure of various sectors of an economy less reliable. The use of such instruments has variously altered the currency composition and the credit and market risk associated with reported financial positions. Thus, the information content of the available financial statistics has been reduced, and its usefulness to monetary authorities responsible for the conduct of financial policy has been impaired.

While desegmentation and globalization of financial markets have contributed greatly to competition in financial markets worldwide and thus have increased the allocative efficiency of financial markets, these two trends are posing a significant challenge to authorities responsible for the conduct of monetary policy. The process of financial innovation has generally reduced the information content of money and credit aggregates in some countries. The introduction of new transaction-type instruments with market-related interest rates has made it necessary from time to time to redefine targeted monetary aggregates in order to maintain a stable statistical relationship between targeted aggregates and nominal spending variables. In addition, the growth in off-balance sheet activities by banks and the expansion in the use of international financial instruments have weakened the statistical link between domestic credit aggregates and nominal spending aggregates.

A second effect of the structural changes in financial markets on monetary policy has been the increased importance of interest rates relative to direct allocation of credit as a mechanism for transmitting the effects of monetary policy to the economy. In particular, the deregulation of interest rates, the increased use of floating rate instruments, the securitization of banks’ assets, and the development of secondary markets have meant that changes in monetary policy have been transmitted more readily through changes in interest rates rather than through availability of credit to specific sectors of the economy. Thus, the effects of monetary policy have become more evenly spread, and the monetary authorities have lost some of their ability to influence the availability of credit to selected sectors of the economy.

A third effect of the structural changes in financial markets on monetary policy has been the increased mobility of capital arising from the globalization of financial markets. The gradual liberalization of cross-border financial transactions has increased the interest sensitivity of capital flows. The introduction of new instruments such as currency swaps, multicomponent note issuance facilities, and Euro-equity issues has facilitated arbitrage between international markets and thus furthered the transmission of disturbances from one national market to another. It is also likely that the increased mobility of capital has—for many countries—increased the magnitude of changes in the exchange rate relative to the changes in interest rates that arise with changes in monetary policy. The consequence of such changes in the exchange rate may limit the role of discretionary monetary policy in obtaining domestic policy objectives.

While, on the one hand, desegmentation and globalization may have reduced the information content of monetary aggregates, increased the role of interest rates as a transmission mechanism, and increased the interest sensitivity of capital flows, it has, on the other hand, facilitated the implementation of monetary policy through market measures. In particular, the broadening and deepening of domestic money markets have allowed monetary authorities in some countries (e.g., France and Japan) to rely more on open market or discount operations rather than on credit controls. In addition, the growth in domestic money markets has made it possible for some monetary authorities (e.g., the Federal Republic of Germany) to supplement discount operations with open market operations in the form of repurchase agreements.

The Cross Report notes that while financial innovation has in many respects improved the efficiency of international financial markets, changes in the activities of banks and other financial institutions that have both driven and resulted from innovation may have heightened financial market vulnerability and complicated the task of financial market supervision.

Banks have moved increasingly to capital market activities, many of which have been conducted off-balance sheet and have not been subject to capital requirements. The Cross Report cautions that the rapid growth in financial institutions’ ability to transform risk may have led to an underestimation of total risk in the system and an underpricing of new instruments. Systematic underpricing of financial transactions would mean that the earnings generated by such transactions were insufficient to protect participants from the risks of the transactions, as they provided insufficient resources with which capital could be increased against risk of loss.

A common feature of many innovations is that they allow creditors to “unbundle” risk—that is, to separate market and credit risk—and to adjust risk profiles more finely than was possible before. For well-informed and well-managed institutions, such increased flexibility may be beneficial, while for the financial system as a whole it may be seen as increasing allocative efficiency. However, the move toward tradable assets may also obscure the underlying level of liquidity risk in the banking system. Banks that hold securities rather than loans may believe that they will be readily able to liquefy such assets. However, the ability to sell securities could be seriously impaired at just the time when holders are likely to want to sell them—when there is doubt about the underlying creditworthiness of the debtor, but when other holders are also trying to sell their securities. Moreover, the quality of banks’ portfolios would deteriorate if high-grade loans are securitized and sold.

To the extent that credit flows are channeled increasingly through capital markets rather than banks, the international banking system could become less responsive to sudden increases in liquidity demand and less able to withstand shocks to the systems. The Cross Report notes that central banks may find themselves increasingly expected to assume some form of residual responsibility for nonbank financial conglomerates, whose international operations often straddle the boundaries of responsibility of different regulatory and supervisory bodies within and across countries.

Supervision in Adaptive Markets

The recent changes in capital markets pose a challenge for supervisors in assessing banks’ capital adequacy and liquidity; in judging the overall impact on risk concentration in the system of new instruments—including the impact on nonbanks whose activities have been interlinked with banks; and in defining the boundaries for supervision and associated lender-of-last-resort facilities.

Supervisors have noted that their attempts to regulate one part of the market may often create incentives for banks to expand in less regulated areas, or for nonbank financial institutions to bid successfully for business traditionally carried out by banks. The adaptiveness of today’s markets means that supervisory actions may create a market response more quickly than in the past—perhaps in the form of the development of a new instrument—that may reduce the impact of the initial ruling. In particular, stronger capital requirements in recent years have led banks to search for ways of repackaging risk and building up earnings from off-balance sheet items, which in the past have not been subject to capital requirements.

As regulators have reacted to the recent changes, some have noted that a greater emphasis on supervision, rather than rigid regulation alone, can enable supervisory authorities to respond more suitably and appropriately to financial innovation. In the United States, there appears to have been, over time, some movement away from regulation toward a more supervisory approach. In the United Kingdom, the trend appears to have been in the direction of complementing a supervisory approach with statutory backup.

In response to the challenges posed by market changes, banking supervisors have extended their international coordination and have indicated the importance of coordination between supervisors of different types of financial institutions and financial markets. In the past year, bank regulators have collaborated in the Basle Supervisors’ Committee in studying how they should respond to financial market changes. A key set of issues addressed by supervisors concern the means to extend the progress in raising banks’ capital ratios by relating capital adequacy measurements to different types of risk undertaken by banks, both on- and off-balance sheet.

A major development over the past year has been the collaboration between supervisors to improve their knowledge and understanding of the implications of banks’ off-balance sheet activities. The Basle Supervisors’ Committee has published a report4 analyzing the nature of the risks involved in the instruments and techniques. The paper has been circulated to supervisory authorities, as well as being available more generally to commercial banks, their auditors, and the general public. It aims to encourage a broadly coordinated supervisory response to the development of off-balance sheet business that would reduce competitive inequalities between countries. It includes a basic framework for supervisory reporting systems as well as a set of common definitions. In discussions with the authors, banks indicated that they found these concepts helpful in analyzing their own risk exposure.

The main conclusion of the report is that the risks associated with most off-balance sheet activities—broadly, market risk, credit risk, and management risk—are no different in principle from those arising from on-balance sheet business. Rather than being treated separately, or excluded altogether from consideration, these risks should be incorporated into banks’ overall management of their risk exposure and taken into account by supervisors. Such an integrated approach would also allow banks and others to evaluate more accurately the beneficial impact of off-balance sheet transactions that hedge on-balance sheet exposures.

First, the report discusses market or position risk, which arises when an institution’s open position, or exposure, would lead to losses if the market moved adversely. Liquidity or funding risk—the risk that a bank will be unable to obtain the necessary funds to meet its obligations as they fall due—is analyzed under this heading, as well as foreign exchange and interest rate risk. A brief discussion of the particularly complex measurement of risk involved in options is also included. As far as interest and exchange rate risk is concerned, the report recommends that banks should extend their established procedures for assessing and controlling such risk to off-balance sheet items carrying similar risks.

The report argues that the recent buildup in total commitments—typically carried off-balance sheet—as banks have moved away from traditional lending toward providing underwriting and other backup facilities represents a significant additional risk to banks’ funding strategies. This, together with uncertainties about the liquidity of the newer markets—for example, for options, forward rate agreements, and swaps—should lead banks to take a cautious approach to their liquidity management.

The second type of risk, which is dealt with at greater length, is credit risk, which arises when a borrower or a counterparty may be unable to meet its obligations. The report classifies the various types of off-balance instruments by their relative credit risk, using as a yardstick the credit risk involved in a traditional on-balance sheet exposure, such as a loan. When analyzing the new instruments, the report distinguishes between four categories for the purpose of credit risk—(1) guarantees and similar contingent liabilities; (2) commitments; (3) market-related transactions; and (4) advisory, management, and underwriting functions.

Within each functional category, qualitative credit risk weightings—full, medium, or low—are assigned to the different instruments. Thus, for example, both guarantees and performance bonds are analyzed under the category of contingent liabilities but, whereas guarantees are classified as “full” risk, or equivalent to a direct credit substitute, it is suggested that performance bonds should be seen as carrying a “medium” credit risk. The classification system may provide a possible guide to supervisors when determining quantitative weightings to be given to the different instruments in national standards for capital adequacy.

Finally, the report considers management or control risks that arise when banks fail to apply adequate control and accounting systems to monitor and limit total risk exposure. While risk management is a problem in all banking operations, it may raise particular difficulties in the case of off-balance sheet activities because of the complexity of many of the instruments and the absence of the accounting discipline of on-balance sheet exposure.

The Basle Committee noted that the introduction of reporting requirements would be an urgent first step toward the integration of off-balance sheet exposures into overall risk management and capital adequacy standards. Some work is already under way and some of the complex new instruments—such as guarantees—are already being included in supervisory reporting guidelines, but supervisors have said that it may take a number of years before adequate reporting standards are reached.

Partly because of a concern to capture off-balance sheet risks, the use of risk-asset ratios for determining capital adequacy is continuing to become more widespread. Such a measure, which assigns different capital weights to categories of assets on the basis of their riskiness, is particularly well suited for the incorporation of off-balance sheet business into capital requirements.

Federal regulators in the United States have circulated a proposal for a risk-asset ratio, based on broad categories of borrower (government, commercial, or bank), on the residence of the borrower (for example, industrial or developing country government, or U.S. or foreign bank), and on the type of instrument. Note issuance facilities would carry a weighting of 30 percent of that of industrial loans. In Japan, the authorities have recently developed a risk-asset weighting for banks’ international business, which would classify assets mainly by category of borrower and by type of instrument. A weighting of 30 percent would be applied to borrowing guarantees and medium-term commitments such as note issuance facilities. In Germany and the United Kingdom, where risk-asset ratios were already in effect, a weighting of 50 percent has been assigned to note issuance facilities, while in France a weight of 25 percent has been set. The Bank of England has also issued a consultative paper on the credit risks arising from off-balance sheet business that closely follows the analysis of the Basle Committee paper.

Supervisors have commented that the risk-asset ratio should provide a complementary guide to capital adequacy, and thus yield better information than a gearing ratio alone. However, it should not be viewed as a precise tool for judging assets on a loan-by-loan basis, and still less as a means of integrating into one statistic the totality of supervisors’ monitoring requirements.

While pursuing this work in the areas of risk-asset ratios and off-balance sheet business, bank supervisors have continued to press for a strengthening of banks’ capital positions (Table 6). In the Federal Republic of Germany, many banks have already reached the target for consolidated capital ratios set for 1991. In Japan, an overall capital ratio of 4 percent of assets has been set to be reached by banks with domestic operations only by 1990. A 6 percent ratio is to be reached in 1987 by banks with foreign branches, and for this ratio they may include in capital a substantial proportion of hidden reserves. The risk-asset ratio for international business (discussed above) complements these straight gearing ratios. In the United Kingdom and the United States, banks’ capital ratios increased further in 1985, although a substantial proportion of the capital raised by major banks in these countries during the past two years has been in the form of loan capital rather than equity.

Table 6.

Capital-Asset Ratios of Banks in Selected Industrial Countries, 1978–851

(In percent)

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Sources: Data provided by official sources; and Fund staff estimates.

Aggregate figures such as the ones in this table must be interpreted with caution, due to differences across national groups of banks and over time in the accounting of bank assets and capital. In particular, provisioning practices vary considerably across these countries as do the definitions of capital. Therefore, cross-country comparisons may be less appropriate than developments over time within a single country.

Ratio of equity plus accumulated appropriations for contingencies (before 1981, accumulated appropriations for losses) 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. From December 1985, the Bundesbank data incorporate credit cooperatives (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, Economic 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 Monétaire 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 1985 would show a ratio of 9.3 percent. Inclusion of current year profits in banks’ capital resources would result in a weighted average of 4.3 percent for 1985. Provisions for country risks, which are excluded from capital resources, have been considerably increased in the last few years, with a quadrupling of the level of provisions between 1982 and 1985.

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 (De Nederlandsche Bank, N.V., Annual Report).

Ratio of capital plus published reserves, a part of hidden reserves, and certain subordinated loans to assets (Swiss National Bank).

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 (including 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 of the Federal Financial Institutions Examination Council.

Supervisors from different countries have also been reviewing the definition of capital and the components of capital applied to international banks. Various main layers of capital have been distinguished, ranging from shareholders’ equity to subordinated term debt. The “layering” allows for a common analysis between countries despite the considerable national diversity of legal, accounting, and regulatory practices and definitions.

Market pressures and an extension of capital adequacy monitoring to many banks’ off-balance sheet business may induce “regulatory arbitrage” whereby business shifts to types of institutions or locations enjoying regulations that apply the least stringent capital weight or other “costs” to particular transactions. For example, securities companies can engage directly or indirectly in many activities that are conducted by banks. Widespread liberalization and deregulation have contributed to the integration of financial markets within and across national boundaries, making these considerations more important for bank supervisors.

Supervisors are concerned to provide something rather closer to a “level playing field” for the institutions channeling savings within and among countries, to reduce competitive inequities, and to allocate savings more efficiently, in response to underlying economic conditions. One concern is the different standards applied to nonbank activities. The Bank of England has proposed detailed guidelines for capital adequacy in the gilt-edged market and has insisted on separate, dedicated capitalization for all participants in the market, whatever their ultimate ownership.

The overlap between banks and nonbanks has raised, more generally, the issue of supervising financial market participants by function, rather than by institution. Some supervisors noted, however, that the overall soundness of an individual institution may not be clearly analyzed if—under the functional approach—the capital adequacy and the asset quality of various aspects of the institution are judged separately by different regulators, unless possibly a “lead supervisor” were appointed for each institution.

The potential for coordinated supervision of securities and commodities markets was increased significantly in September 1986 with the announced accord between securities regulators in the United Kingdom and the United States. With this accord, the U.K. Department of Trade and Industry, the U.S. Securities and Exchange Commission, and the U.S. Commodity Futures Trading Commission have agreed to increase systematic cooperation in areas of investor protection and in regulating market participants. Previously, cooperation had been on a case-by-case basis. In addition, efforts are under way to extend cooperation agreements with regulators in other major financial centers. One objective of this effort is to provide a regulatory foundation for worldwide continuous trading in a proliferating variety of investment instruments.

1

“International” business is defined as the cross-border positions of parent banks, their branches, and subsidiaries in 16 reporting countries—Austria, Belgium, Canada, Denmark, France, the Federal Republic of Germany, Iceland, Italy, Japan, Luxembourg, the Netherlands, Spain, Sweden, Switzerland, the United Kingdom, and the United States—plus the local foreign currency positions with nonbank residents and nonaffiliated banks in these countries, and is thus not on a strict residency basis. In addition to the international activities of banks in the 16 reporting countries, the data include the cross-border operations of branches of U.S. banks in The Bahamas, the Cayman Islands, Hong Kong, Panama, and Singapore.

2

These figures, however, are distorted, since the data are not adjusted for the effects of exchange rate movements, and the decline in the value of the dollar might be expected to have a greater effect on boosting the dollar value of the claims of Japanese banks than U.S. banks. However, the figures also include the offshore branches of U.S. banks but not of Japanese banks in the totals, leading to an overestimate of the share of claims held by U.S. banks.

3

Recent Innovations in International Banking (Basle: Bank for International Settlements, 1986).

4

The Management of Banks’ Off-Balance Sheet Exposures: A Supervisory Perspective, Committee on Banking Regulations and Supervisory Practices (Basle, March 1986).

Within Same Series

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Cover International Capital Markets, 1986
International Capital Markets, 1986
Author: International Monetary Fund
ISBN:
9781451941692
ISSN:
0258-7440
Publication Date:
01 Jan 1986
Publisher:
International Monetary Fund
DOI:
https://doi.org/10.5089/9781451941692.083
Pages:
164
  • View in gallery

    International Bond Issues by Major Instruments, 1983–86

    (In billions of U.S. dollars)

  • View in gallery

    International Bond Issues and Placements by Currency of Denomination, 1981–86

    (In billions of U.S. dollars)

  • View in gallery

    International Bond Issues and Placements by Groups of Borrowers, 1981–86

    (In billions of U.S. dollars)

International Bond Issues by Major Instruments, 1983–86

(In billions of U.S. dollars)

International Bond Issues and Placements by Currency of Denomination, 1981–86

(In billions of U.S. dollars)

International Bond Issues and Placements by Groups of Borrowers, 1981–86

(In billions of U.S. dollars)