This section reviews recent institutional changes in financial markets, looking in turn at developments relating to the regulation of the banking and securities industries and at the reform of market structures. Liberalization of financial markets has continued at a rapid pace and has involved reduced separation of functions between institutions, increased integration of markets, and a sustained rate of financial innovation. These developments have required the adaptation of regulatory structures, and in particular have spurred efforts at international harmonization of standards. Further impetus for reform has emerged in the wake of the market break of October 1987 and other events that have raised awareness of systemic risk, and this has led to attempts to improve market safeguards and establish more rigorous codes of conduct.

This section reviews recent institutional changes in financial markets, looking in turn at developments relating to the regulation of the banking and securities industries and at the reform of market structures. Liberalization of financial markets has continued at a rapid pace and has involved reduced separation of functions between institutions, increased integration of markets, and a sustained rate of financial innovation. These developments have required the adaptation of regulatory structures, and in particular have spurred efforts at international harmonization of standards. Further impetus for reform has emerged in the wake of the market break of October 1987 and other events that have raised awareness of systemic risk, and this has led to attempts to improve market safeguards and establish more rigorous codes of conduct.

Regulating the Banking and Securities Industries

During the past year, there has been significant progress toward the harmonization of international regulatory standards, including actions to bring national capital adequacy requirements for banks into line with the guidelines issued by the Basle Committee, substantial agreement on the modalities of establishing a single banking market in the EC, and first steps toward establishing international standards for the regulation of securities industries. In addition, in the United States there has been a major restructuring of the regulation of the thrift industry aimed at achieving a resolution of the severe difficulties experienced in this sector. Also, a number of countries have taken actions to reduce the functional barriers between the banking and securities industries.

Capital Adequacy


In July 1988, central bank governors of the Group of Ten countries endorsed a plan formulated by the Basle Committee of Bank Supervisors to establish uniform standards for capital adequacy for the major commercial banks under their jurisdiction. The basic requirement was established that banks should maintain a minimum capital base of 8 percent of risk-weighted assets by the end of 1992, with a transitional target of 7.25 percent being set for the end of 1990.43 At least half of the capital base would need to be core capital, consisting of ordinary paid-in share capital plus disclosed reserves less goodwill.

Since July 1988, many national authorities have taken actions to implement these guidelines. In the United States, in December 1988, the Federal Reserve Board issued implementation guidelines that applied to the bank holding companies and state-chartered members of the Federal Reserve System, and consistent guidelines for other depository institutions were issued by the Office of the Comptroller of the Currency and the Federal Deposit Insurance Corporation in early 1989.44 The guidelines followed the Basle Agreement in setting a capital adequacy standard of 8 percent of risk-weighted assets by the end of 1992, but attempted to ease the transition for bank holding companies by loosening requirements on the deduction of goodwill, broadening the types of preferred share issues qualifying as core capital, and by exempting subsidiaries primarily engaged in securities activities. Most U.S. banks are not expected to have major difficulty in achieving the new standards, although there has been concern over the position of some money center banks heavily exposed in the fields of sovereign lending and real estate (Table 12). In 1989, a number of these banks raised significant amounts of equity capital and took other actions, including asset sales, to bolster their capital positions.

Table 12.

Capital/Asset Ratios of Banks in Selected Industrial Countries, 1980–881

(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, owing 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, general provisions, and subordinated debentures to total assets. Data exclude cooperative and mutual banks. This ratio is different from the official ratio of risk coverage where assets are assigned different weights depending on the quality of each category.

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 1988 would show a ratio of 19.2 percent. Inclusion of current-year profits in banks' capital resources would result in a weighted average of 4.4 percent for 1988. Provisions for country risks, which are excluded from capital resources, have been moderately increased in the last year. The 1988 level of provision represents five times the level of 1982.

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 total assets (Swiss National Bank, Monthly Report).

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

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

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

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

In Japan, the Ministry of Finance issued capital adequacy guidelines in December 1988 that require the 35 Japanese banks with overseas branches or subsidiaries to observe the minimum capital standards of the Basle Agreement, while not falling short of the capital-asset ratio reached at the end of March 1987. Banks without overseas offices may keep to existing capital standards (which are tied to a 4 percent gearing ratio) or adopt the new guidelines by the end of 1992. Japanese banks already appear to be at or near the transitional level specified in the Basle Agreement. Two factors have made the capital situation of Japanese banks less difficult than supposed. One is that the larger Japanese banks typically possess significant undisclosed reserves—mainly arising from the practice of reporting such assets as long-term securities holdings and real estate at historic (and low) book values—a part of which may be counted toward the supplementary capital requirement. Additionally, Japanese banks have been able to raise large amounts of core capital through equity issues in 1988–89, a process facilitated by the strength of Japan's stock market. Indeed, Japanese financial markets have been a source of capital for banks from many other countries, particularly through private placements of subordinated debt.

In Europe, the implementation of the guidelines has been complicated by the need to conform with efforts of the EC to create a single banking market. Nonetheless, in the United Kingdom the Bank of England issued guidelines in November 1988 requiring banks to reach the 8 percent capital adequacy target by the end of June 1989, while the main clearing banks had already satisfied these requirements a year earlier. In other EC member countries, regulators have waited for the formulation of directives at the EC level. In March 1989, the EC adopted the Own Funds Directive that harmonizes the definition of bank capital. In December 1989, at the same time as the adoption of the Second Banking Directive (see below), the EC adopted the Solvency Ratio Directive that sets out capital requirements for banks doing business in the EC. While the directive for the most part follows the Basle guidelines, there are some variations. For example, banks will not be allowed to include unrealized capital gains from their holdings of equities in their capital base; a lower risk weighting will be applied to mortgages in the transitional period; and discount houses in the United Kingdom are to be exempted. Most of the large internationally active banks are not anticipated to encounter substantial problems in meeting the new capital standards, although particular difficulties have been raised in France, as the capital bases of a number of banks are low, and the public ownership of several banks has limited options for building capital.

Securities Firms

During the past year, some initial steps have been taken toward achieving an international convergence of rules and regulations covering capital adequacy requirements for securities firms. In particular, at the September 1989 meeting of the International Organization of Securities Commissions (IOSCO), tentative agreement was reached on a report by a Technical Committee that concluded that there was a need for a common conceptual framework regarding the capital requirements for securities firms. The framework would include a risk-based measure of capital adequacy that would cover all risks to a firm, including position risk arising from both on- and off-balance sheet activities with allowance for risk-reduction measures, such as hedging, and would need to be supported by adequate accounting, reporting, and examination procedures. Such a regulatory system would be similar to those already used in the United Kingdom and the United States and to be adopted by Japan in early 1990. However, the proposals would be less readily applied in countries such as the Federal Republic of Germany with universal banking systems, in which a minimum capital base is required of a bank as a basis for all its operations, irrespective of scale.

In addition, the European Commission has prepared a draft directive on capital adequacy for securities firms, which is also now at the discussion stage. The draft directive is reported to have aroused some opposition, particularly from British regulators, because it does not contain adjustments to the measure of the position risk to allow for hedging and portfolio diversification. It also would apply a minimum capital requirement of about $25,000, which is quite high by U.K. standards.

Single European Banking Market

A key part of the plan to create a single internal market in goods, services, labor, and capital in the EC by the end of 1992 is the establishment of a Single Financial Area, which is to include community-wide competition in banking services. The legislative foundation for the establishment of such a unified banking market was set in 1977 by the First Banking Coordination Directive, which required that all member countries adhere to certain minimum capital and management standards for authorizing the establishment of banks and other credit institutions. In addition, the First Directive required that each country apply prescribed national treatment to banks from other EC countries: in other words, branches of these banks were subject to the same regulations as national banks in the host country. The provisions of the First Banking Directive were already more than satisfied by several member countries before the directive was adopted; its provisions are now in force in all EC countries.

Plans to establish community-wide competition in banking services are embodied in the Second Banking Coordination Directive, which was adopted in December 1989. This directive supercedes the First Banking Directive, and replaces the principle of national treatment with the principle of “mutual recognition of rules.” Thus, a bank licensed to do business in any EC member country will, in effect, be given a “passport” to do business in any other member country, subject only to the regulations in force in its home country, although for certain products host country rules will still apply, for example the codes of conduct for consumer or investor protection. The license will cover the normal banking services, such as deposit taking and lending, together with others, such as money transmission, securities trading, and provision of financial advice, provided that they are authorized by the home country regulator.

In order to make mutual recognition acceptable, the Second Banking Directive provides minimum administrative, accounting, and control standards in addition to those prescribed in previous directives. Moreover, capital adequacy standards are to be harmonized within a framework similar to that suggested by the Basle Committee through two other accompanying directives, as described above. With regard to non-EC countries, the Directive provides for reciprocity of treatment, which would require that EC banks receive “national treatment” in the non-EC country, or licenses for banks from that country in the EC could be suspended or delayed. In addition, the directive allows the EC council to seek to negotiate “comparable access,” that is, to seek the same freedoms for EC banks in third countries as provided to third country banks in the EC.

Three other banking directives have recently been adopted by the EC member countries. The directive on Consolidated Supervision requires that any banking group be examined as a whole with respect to its accounts, exposure, and management, while the directive on Bank Accounts harmonizes the accounting rules for credit institutions. A related directive deals with Bank Branch Accounts, which states that banks with branches in more than one EC country must make available consolidated accounts for their EC-wide operations, which was adopted by the Council of Ministers in February 1989, and must be incorporated into the member countries' laws by the end of 1990.

The establishment of a Single Financial Area in the EC will also involve changes to promote community-wide competition in financial services outside banking. The Directive on Undertakings for Collective Investment on Transferable Securities (UCITS), which allows the sale throughout the European Community of unit trusts and mutual funds that have been licensed by home authorities as meeting agreed minimum standards, came into effect in October 1989. In addition, as mentioned above, a draft investment services directive is being prepared that would provide for investment firms that are not owned by banks to operate throughout the Community.

Restructuring the U.S. Thrift Industry

During the 1980s, the problems associated with insolvent savings and loan institutions in the United States reached a scale comparable to that experienced by deposit-taking institutions during the Great Depression in the 1930s. The Federal Savings and Loan Insurance Corporation (FSLIC), the agency that insures deposits in thrifts, was forced to deal with the insolvencies of more than 900 thrift institutions during the period 1980–88,45 including 205 institutions in 1988 alone. Despite these actions, at the end of 1988, 364 thrifts, with assets of around $114 billion, were technically insolvent, while a further 392 institutions with assets of $316 billion had capital-to-assets ratios of less than 3 percent. Thus, at year end, 25 percent of all thrift institutions with 32 percent of the industry's assets were insolvent or significantly capital impaired.

The problems of the thrift industry originated in part from the vulnerability of a fixed rate, long-term lender with relatively short-term liabilities to changes in interest rates. In particular, in the late 1970s and early 1980s, as ceilings on deposit rates were phased out and inflation and interest rates rose, fixed returns on mortgages and rising deposit costs contributed to substantial losses. These problems were exacerbated in the second half of the 1980s as expanded lending powers authorized in the early 1980s were combined with inadequate accounting standards, an easing of capital adequacy requirements, inexperienced or dishonest management, and the “moral hazard” arising from the presence of deposit insurance. A maturity mismatch problem was thus quickly transformed into an issue threatening the solvency of a major segment of the U.S. financial system.

In August 1989, the Financial Institutions Reform, Recovery and Enforcement Act (FIRREA) was passed into law to resolve the problems of the thrift industry. The reform consisted of five major elements.

1. The establishment of a new government agency, the Resolution Trust Corporation (RTC), which would be provided with $50 billion to resolve currently insolvent thrifts or thrifts that become insolvent in the next three years. The RTC will be authorized to borrow $20 billion from the Treasury Department and would obtain the remainder of its funding through the separate Resolution Funding Corporation (REFCORP), which would be authorized to issue $30 billion in 30-year bonds in private capital markets.

2. The Federal Home Loan (FHL) banks, the 12 regional banks of the Federal Home Loan Bank System, will be required to provide REFCORP with funds from retained earnings for the purchase of zero-coupon treasury securities that upon maturity will repay the principal of REFCORP borrowings and also meet part of the interest on those borrowings. Funding will also be obtained from the thrift industry by raising insurance premiums for savings and loan institutions.

3. The regulatory structure of the thrift industry would be overhauled. A single deposit insurance agency would be created by merging the FSLIC with the FDIC, although separate insurance funds would be maintained for commercial banks and savings and loan institutions. The existing thrift chartering and regulatory agency, the Federal Home Loan Bank Board (FHLBB) would be abolished, and the Office of Thrift Supervision (OTS) would be established as part of the Treasury Department to be responsible for supervising all savings and loans as well as chartering federal thrift institutions.

4. The safety and soundness standards for savings and loan institutions would be brought in line with those of commercial banks. In particular, risk-based capital adequacy standards for savings and loan institutions will be established that are no less stringent in the aggregate than those for national banks. Moreover, goodwill will be phased out of capital over a period of five years.

5. To preserve a specialized housing finance system, thrift institutions will be required to invest an increased proportion of their assets in residential mortgages and related assets to qualify for advances from FHL banks, which will themselves be reorganized under a newly created Federal Housing Finance Board. Investments in high-yield noninvestment grade (“junk”) bonds and equities will be significantly restricted.

While the precise costs of this reform plan are naturally uncertain, estimates of the present value cost of the past resolution cases and those likely to arise over the next three years range from $76 billion to $111 billion. On a cash-flow basis, total outlays over the next 11 years are estimated at $240 billion. Roughly three fourths of these outlays would be borne by taxpayers.

Separation of Functions

A number of actions were taken in different countries to reduce the restrictions on banks operating in security-type transactions, thus continuing to erode the separation of functions traditional in some countries between the banking and securities industries. In the United States, the Federal Reserve Board approved the applications of five major banks to underwrite corporate debt, subject to the condition that such underwriting be conducted by a separately capitalized subsidiary unit. It also authorized state member banks, in line with national banks, to own shares in certain investment companies and money-market mutual funds. In addition, in September 1989, a court ruling affirmed banks' powers to underwrite securities backed by their own assets. In France, the Finance Ministry proposed changes in the mutual fund law permitting the securitization of bank credits, which will allow the creation of “fonds communs de créances” and the pooling of mortgage credit. In the United Kingdom, the Bank of England amended its banking regulations affecting the securitization of mortgages, covering situations where banks trade loans among each other or package them into securities for resale to investors. In addition, the Bank invited interested financial institutions to join the current eight discount houses that act as intermediaries between the central bank and the rest of the banking system. In Japan, the Ministry of Finance allowed mutual (or sogo) banks to be converted into commercial banks, and eased banks' branching restrictions. Furthermore, in exchange for allowing securities houses to deal in currency futures, the Ministry of Finance permitted banks to broker government bond futures for the first time.

Reforming Market Structures

Financial Instruments

Regulatory authorities continued to take measures to facilitate the broadening of the range and variety of financial instruments available to investors and borrowers, both resident and nonresident. To some extent, this involved the liberalization of exchange controls and other measures to provide access to instruments denominated in foreign currency or derivative instruments based on foreign markets. In addition, a number of entirely new instruments were introduced on existing options and futures exchanges, while several countries that had lacked such markets acted to establish them.

Progress toward the liberalization of exchange and capital controls was particularly marked in EC member countries, where most restrictions on capital movements are to be phased out by the end of 1992. Already all capital controls have been virtually eliminated by Denmark, the Federal Republic of Germany, the Netherlands, and the United Kingdom. Belgium, France, and Italy took important steps toward liberalization in 1988 and 1989 and are to have eliminated controls by mid-1990. The remaining countries are to follow suit by the end of 1992, except Greece and Portugal, which have until the end of 1995 to comply.

Steps were also taken in countries outside the EC to reduce exchange and capital controls. In Switzerland, the National Bank lifted most capital export restrictions for banks and quasi-banks. Individual and syndicated Swiss franc credits (which now include currency swaps) for SwF 10 million or more and with a maturity of one year or more to nonresidents will only have to be reported and no longer require approval (foreign currency credits had already been partly exempt). In Japan, the Ministry of Finance eased restrictions on use of the Tokyo offshore market with effect from April 1, 1989. In particular, the ceiling on the daily net inflow of funds from offshore accounts was raised and a 5 percent ceiling on the daily net outflow was removed. In addition, in June 1989 regulations governing the issuance of yen-denominated bonds in the Euro-yen market by foreign borrowers were relaxed to allow maturities of less than four years. Moreover, the standard of a single A, or better, credit rating by a leading credit rating agency of Japan or the United States has been relaxed to allow any credit rating by a leading agency. Finally, in the United States, the Federal Reserve Board allowed U.S. banks to accept foreign currency deposits. The move mainly benefited retail customers, as large investors could already trade in foreign currencies through securities firms and overseas banks.

A number of actions were taken that furthered the trend toward the international trading of financial instruments. In the United States, the Securities and Exchange Commission (SEC) added a number of countries to the six countries whose government debt is eligible for futures trading in the United States. In Switzerland, the Admissions Board has allowed the official listing of foreign junk bonds, although only in special market segments, as long as those meet the formal listing requirements. In the United Kingdom, the International Stock Exchange (ISE) relaxed listing requirements for foreign companies, in line with EC directives. In the Federal Republic of Germany, the Finance Ministry permitted nonresident individuals to purchase listed five-year federal bonds at issue. Such bonds account for about one fifth of total federal debt outstanding.

A wide range of new instruments has been introduced in the past year. In the United States, the Commodity Future Trading Commission approved a number of new stock index futures and options contracts based on baskets of foreign stocks, including a futures contract to be traded on the Chicago Mercantile Exchange (CME) based on an index of equities traded in different countries, a futures contract based on an index of 50 foreign stocks traded in the United States, and contracts based on the Nikkei 225 and Topix indices. Trading was also approved for Euro-rate differential futures and options contracts (DIFFs), based on the spread between three-month Euro-dollar rates and the corresponding Euro-deutsche mark, Euro-sterling and Euro-yen rates. The Chicago Board of Trade (CBOT) has recently introduced interest rate options on both short-term (13-week treasury bills) and long-term (7 to 10-year treasury notes and 30-year bonds) rates; these contracts differ from most previous interest rate options in that they are settled for cash rather than by delivery of a security, are “yield-driven” (i.e., their price is based on the underlying asset's yield rather than its price), and are for “European” exercise (i.e., the options can only be exercised at their expiration date, rather than at any time up until that date). Also, the New York Stock Exchange introduced “sponsored” FADRs, that is, American Depository Receipts representing French Treasury bonds with the fiduciary responsibility shared by the French Treasury and the issuing bank, which will enable U.S. investors to purchase French Government bonds denominated in U.S. dollars while avoiding French taxation.

In the United Kingdom, the London International Financial Futures Exchange (LIFFE) introduced in September 1988 the first futures contract denominated in deutsche mark on a ten-year German Federal Government bond (the “Bund”), and a similar contract was subsequently introduced on the MATIF in France. In April 1989, both LIFFE and MATIF introduced three-month Euro-deutsche mark interest rate futures contracts, and in October 1989 LIFFE launched a three-month ECU interest rate futures contract. In France, leading financial institutions have started an interbank market in stock index futures (OMF), while the Paris Financial Instruments Clearing House (CCIFP) opened over-the-counter dealing in a futures contract based on an index of French shares.

Several new financial futures contracts were introduced in Japanese markets. New stock index futures contracts were simultaneously launched on the Tokyo Stock Exchange (based on the Topix index of 1,117 Japanese stocks) and the Osaka Stock Exchange (based on the Nikkei index). Trading also started in June 1989 on the Tokyo International Financial Futures Exchange (TIFFE) in futures contracts on three month Euro-yen and Euro-dollar deposits and yen/dollar currency futures.

Foreign Participation

The general trend toward reducing barriers to entry to foreign participants in domestic financial markets continued, during the past year, although typically liberalization measures included requirements for reciprocal treatment. The most important developments in this area were the steps taken toward creating a single banking market in the EC, as described above. In addition, there were moves in a number of countries to increase foreign participation in securities markets. In particular, in Japan, the Ministry of Finance announced steps to open up the primary market for ten-year Japanese Government bonds (which accounts for some 80 percent of the Japanese Government bond market), including an increase in the underwriting share of foreign banks and securities firms and providing access for 4 foreign firms to the syndicate of 33 domestic underwriting managers. In the United Kingdom, a subsidiary of the Industrial Bank of Japan won London Stock Exchange membership and became the first subsidiary of a Japanese bank to engage in market making of Japanese stocks traded abroad. Also, futures industry regulators in the United States and the United Kingdom reached a new, precedent-setting memorandum of understanding that exempts U.K. firms in the United States and U.S. firms in the United Kingdom from domestic capital requirements and speeds up information sharing during emergencies. In Switzerland, the three large Swiss banks announced that the Swiss subsidiaries of three major German banks will join the permanent underwriting syndicate for Swiss franc foreign bond issues as the first foreign-owned member banks.

Market Liberalization

In the past year, actions have been taken in a number of countries to encourage the development of competitive financial markets. Most noteworthy in this regard has been the reform of short-term money markets in Japan. Until recently, the principal money-market instrument for the Bank of Japan was the discount bill, with maturities of one to six months. In November 1988, however, this market was expanded by allowing the use of discount bills with maturities of one, two, and three weeks. In addition, the longest maturity in the uncollateralized call market was lengthened from three weeks to six months (and further to one year in April 1989). Also, the authorities continued to deregulate the banking system, taking measures that included an increase in banks' permissible overnight dollar/yen positions and a reduction in the minimum size of large-lot time deposits not subject to interest regulation.

In a number of countries, actions were taken to improve the functioning of stock exchanges, including measures to introduce competitive price setting, to reduce barriers to entry, and to computerize prices and transactions. Specifically, in France, brokers' commissions on the Paris Bourse were freed from controls in July 1989, stock exchange firms continued to open capital to participation by outsiders, and the computerization of trading was completed. In Spain, continuous trading was introduced in April 1989 and ownership of stock-exchange companies was opened to outside partners in July 1989. In Belgium, the Brussels Stock Exchange launched a Continuous Computer Assisted Trading System (CATS) in January 1989, and a commission has proposed further reforms that would end the brokers' monopoly on equity transactions. In the Netherlands, fixed commissions are to be eliminated on the Amsterdam Stock Exchange from July 1990. In Greece, Parliament passed legislation to reform the Athens Stock Exchange, including the setting up of computerized trading, and the admission of domestic and foreign financial institutions. In Portugal, the two stock exchanges have introduced continuous computerized trading at uniform prices, initially for five stocks.

In the Federal Republic of Germany, the Federal Government passed a revision to the stock-exchange law to permit the establishment of a futures and options market. Inter alia, the changes make futures and options contracts legally enforceable,46 extend the range of participants and instruments in the stock exchange, incorporate new guidelines on mutual recognition of listing prospectuses (thereby including nonissuers), admit listing of securities in foreign and composite currencies, improve market supervision, and raise prudential requirements. Subject to the approval of the Federal Banking Supervisory Office, 17 German banks formed the Deutsche TerminBörse (DTB) GmbH, which launched trading in German Government bond futures, stock options, and stock index futures in January 1990.

Changes have also been introduced to improve practices in bond markets. In particular, a number of governments have taken measures to revise procedures in markets for government paper to improve debt management. In the Federal Republic of Germany, the Bundesbank engaged in securities repurchase agreements under a new variable rate tender method, under which banks have to pay the interest rate they bid on all accepted bids instead of having the lowest accepted rate applied to all bids, as was the case with traditional tenders. In the United Kingdom, the Bank of England undertook its first auction of ECU treasury bills, and also successfully introduced “reverse auctions” to buy U.K. Government debt at prices close to market levels, in response to the emergence of a net public sector financial surplus. In Italy, the Treasury has reintroduced treasury certificates with extendable maturities, as well as inflation-linked paper, and plans to issue ECU treasury bills (BTEs) with maturities of less than 12 months (in addition to BTEs with longer maturities).

Market Safeguards

In a number of markets, procedures have been changed to reduce the degree of risk stemming from erratic market fluctuations in the wake of experience in October 1987. In particular, in the United States, the SEC and the CFTC approved coordinated “circuit breakers” to interrupt all stock-related trading in the event of sharp market swings. The NYSE, the CBOE, and the CME introduced the possibility of trading halts when the Dow Jones Industrial Average and related stock index futures fall by a specific number of points, as well as procedures for reopening the markets (Table 13). In a similar vein, the SEC endorsed the New York Stock Exchange's proposal to route stock transactions underlying program trading in the Standard & Poor's (S&P) 500 futures contract (traded on the Chicago Mercantile Exchange) into a “side file” once the S&P 500 drops by 12 points and, in the event of order imbalances and insufficient trading interest, to halt trading in the stock.

Table 13.

Circuit Breakers in Major U.S. Markets

(Effective on October 13, 1989)

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Note: DJIA = Dow Jones Industrial Average; NYSE = New York Stock Exchange; S&P = Standard & Poor's.

Difficulty may arise with circuit breakers, however, when such mechanisms are not coordinated to halt trading simultaneously on all markets. This point is illustrated by the events of October 13, 1989, in the United States, where the NYSE stayed open the entire day as its first circuit breaker was never triggered while trading in the S&P 500 stock index futures contract on the CME was halted on two occasions and the CBOE also halted trading in its S&P 100 stock index option. These uncoordinated trading halts may have created additional uncertainty about the extent of the decline in equity prices and generated cross-market selling pressures. When the options market closed in the early afternoon, many writers of put options (i.e., those that agree to put a floor under the price of a given stock or stock index) apparently still had open positions that they had not succeeded in closing during the morning of October 13. As a result, when the futures market reopened (and the option market remained closed), these put writers attempted to hedge their position by selling stock index futures, and this put sharp downward pressure on futures prices. Moreover, in the period when both the option and futures markets were closed, efforts were made (both by option writers and program traders) to create “synthetic puts” by purchasing bonds and selling stocks short. Such short selling naturally put downward pressure on equity market prices. Thus, while it is still unclear whether coordinated circuit breakers can play a useful role in helping stock and derivative equity markets cope with greater price volatility, it is now evident that uncoordinated trading halts can make the situation worse.

Another type of safeguard has involved limits on the use of certain computer-driven trading strategies. In the United States, it has been argued that computer-driven program trading contributed to the fall in equity prices in October 1987 and October 1989 either directly, by generating sales of futures contracts in a declining market, or indirectly, by creating a negative market psychology. While portfolio insurance (or dynamic hedging) activities were cited by some as an important source of price variability in 1987, recent attention has focused more on the role of stock index arbitrage. The response to these criticisms in the United States has involved limitations on the use of NYSE facilities by program traders.

However, some market observers have argued that these steps are insufficient and that the real answer is to raise margin requirements on stock index futures from their current level of 7 percent to the same as those that apply to stock purchases (50 percent). The proponents of stock index arbitrage have responded that raising stock index futures margins could make the stock market even more volatile by reducing the amount of speculative activity, which would allow prices to move even further away from their fundamental values. It has also been noted that, if stock index arbitrage was a factor in producing the fall in equity prices, then those markets without such program trading should have been more stable. In fact, the one market where such activity was clearly absent was in the Federal Republic of Germany, where there is no futures market; and it suffered the largest price decline among the ten major equity markets on October 16, 1989.

Investor Protection

In response to concerns about the need to increase transparency in complex financial markets and heightened awareness of the possibilities for insider trading, the authorities in a number of countries have taken steps to bolster investor protection and to reduce the scope for illegal transactions. In particular, in the United Kingdom, as part of the continuing implementation of the Financial Service Act (FSA), the Securities and Investments Board (SIB) promulgated guidelines to ensure compensation to investors for losses as a result of default by an authorized investment company. The U.K. Securities Association (TSA) and the SIB adopted a joint policy stance toward the home country regulators of foreign banks' branches in the United Kingdom, which allowed the SIB to authorize nearly 200 branches of foreign firms to operate in London. More generally, the Companies Act of 1989 contains a series of amendments to the FSA aimed at making investor protection less cumbersome. These amendments include the abandonment of the requirement for SRO (self-regulating organizations) rule books to provide equivalent protection to that offered by the SIB (which had been blamed for much of the unwieldy detail of rule books).

In Japan, the pricing of new issues was made more transparent by the Tokyo Stock Exchange by requiring applicants to sell up to half of an issue at a preflotation auction (where bids are limited), barring connected persons from bidding, and setting a floor price near the price of shares in a similar company. The Government also implemented a new law against insider stock trading, which provided for stricter penalties, required companies to register material information with the stock exchanges, and restricted company insiders from trading shares. Investor protection was improved further through implementation of revisions in securities law, which strengthened the right of the Ministry of Finance to investigate listed companies (and not only securities firms and stock exchanges as hitherto) for insider trading.

Further steps to act against insider trading should stem from the agreement by the finance ministers of the European Community to issue a directive requiring countries to pass legislation outlawing insider trading by June 1992. Currently, the Federal Republic of Germany, Italy, Belgium, and Ireland do not have national laws to ban insider trading.


For more details, see International Monetary Fund, International Capital Markets: Developments and Prospects, April 1989, World Economic and Financial Surveys (Washington, 1989).


Banks will also continue to have to satisfy a minimum ratio of core capital to total assets (not risk-weighted). In September 1989, the Comptroller of the Currency indicated that regulations would be issued to set a 3 percent core capital standard for national banks, effective the end of 1990.


This was typically done through an assisted merger with a healthy institution although in extreme cases the FSLIC was forced to liquidate the troubled institution or take it under conservatorship.


Such contracts were previously not enforceable because of an antigambling law.