Increasing borrowing flexibility and reducing costs
Thomas Hoopengardner and Ines Garcia-Thoumi
The World Bank Group (which includes the International Bank for Reconstruction and Development, the International Development Association, and the International Finance Corporation) made commitments of over $15,300 million to its developing country members in fiscal year 1983 (which ended on June 30, 1983). Of this total, over $11,100 million came from the Bank itself. In sharp contrast to bilateral and some multilateral development institutions, the Bank receives only about 5 percent of its funds from the governments of high-income countries. The balance must be borrowed on competitive terms in world financial markets. In fiscal year 1983, for example, it borrowed the equivalent of nearly $10,300 million.
The fact that the Bank borrows the bulk of its funds means that its financial position is under close and constant scrutiny. Since 1981, the Bank has made several notable changes in its financial structure and operations to assure its continuing financial strength in changing circumstances. In January 1982, it began to levy a front-end fee on loans, in addition to the commitment charge and lending rate arrangements already in effect; in July 1982, it made a fundamental change in the way the interest rate on loans was set; and finally, in September 1982, its Executive Directors authorized selling short-term securities to provide an additional source of funds. (It has also instituted currency swaps; these are discussed in the accompanying article by Christine Wallich.)
There were three reasons for these changes. First, the financial markets on which the Bank depends have been much more volatile in recent years than they had been during the first 30 years of its existence. Second, at the same time, the Bank’s vulnerability to this volatility was increasing because of greater exposure to changing interest rates. Finally, its borrowing requirements were growing, and it needed additional flexibility to secure funds at terms favorable to its own borrowers.
Long-term interest rates tended to rise in the 1970s, but changes were rather gradual (Chart 1). Between 1972 and 1978, year-to-year changes of 1 percentage point or more in the long-term U.S. Treasury bond rate were unusual, and over the entire seven-year period the rate stayed within about a 3 percentage point band. Since 1979, long-term rates have been higher, much more volatile, and less predictable as monetary policies of the major industrial countries tightened and uncertainties developed about the future course of inflation. Changes of 1 percentage point in one month have not been unusual and changes of 3–4 percentage points have occurred several times within 12-month periods. Long-term interest rates have recently seemed somewhat less volatile, but there is no assurance that this indicates a return to the earlier stable rates. The impact of the changed financial environment is that the Bank’s borrowing costs are now perceived to be much more volatile and less predictable than they had been previously.
Meanwhile, the Bank’s ability to withstand rapid changes in interest rates was deteriorating, as a result of two interrelated factors: the simultaneous rapid growth in its commitments created greater risks from lags, while the declining maturity of borrowings and the decreasing importance of paid-in capital both created greater risks from maturity mismatching.
When the Bank makes a loan, the funds do not change hands immediately, but are disbursed as a project is implemented. Under the old lending rate system, the Bank made a firm commitment at the time the loan was agreed to make these funds available to borrowers at a fixed interest rate. However, most funds were not borrowed by the Bank until just before they were needed. If market interest rates rose between the time the lending rate on a loan was agreed and the time disbursements were made, the Bank could incur a loss—resulting from lag risk. (Conversely, it could gain should the interest rate fall over the relevant period, but this did not happen since rates were rising steadily over the 1970s.) If losses from such lag risks were incurred on many loans, net income could fall and borrowing costs would rise even further in response to market perceptions of the Bank’s financial health. The ultimate losers would be the Bank’s borrowers.
Maturity mismatch risk arose because the Bank tended to “borrow medium” but “invest short” and “lend long.” It borrowed primarily four currencies—deutsche mark, Japanese yen, Swiss francs, and U.S. dollars—medium-term, from five to ten years. Its loan disbursements tended to be in deutsche mark, yen, and Swiss francs, generally at longer maturities than the borrowings underlying them. Meanwhile, the Bank tended to rely on its dollar borrowings as a source of funds for its pool of liquid cash and securities, which have much shorter maturities than the borrowings underlying them.
This pattern of exposure meant that if interest rates rose, the average gains on short-term dollar investments increased faster than the average cost of the existing underlying medium-term borrowings. Thus, in the short run, net income would tend to rise. In the medium term, the cost of borrowings would catch up with the higher return on investments, but at the same time this cost would rise faster than the return on the longer-gestating loans, so net income would fall in the medium term. In the very long term the old fixed-rate loans would be repaid, new loans at higher fixed interest rates would be disbursed, and net income would be restored.
Lag risk and maturity mismatch risk and their evolution over time are summarized in the “gap curve” graphs in Chart 2, which measure the extent to which interest rate “fixity” disappears from one side of the balance sheet before it disappears from the other. Note the pattern: first interest rate fixity vanishes from the assets side as the Bank’s short-term securities mature, then from the liabilities side as its medium-term borrowings are retired, and finally from the asset side once again as loans are eventually repaid. This pattern of exposure is a direct and inevitable consequence of “borrowing medium” while “investing short” and “lending long.” A rough idea of the impact on future net income of a 1 percent change in interest rates may be obtained simply by multiplying the exposure shown on a gap curve by 1 percent. A 1 percent interest rate increase at the end of fiscal year 1981 could reduce fiscal year 1987 income by about $180 million, or by about 25 percent. Larger changes in interest rates would have had a proportionately greater impact on income.