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Changing International Financial Markets

Author(s):
International Monetary Fund. External Relations Dept.
Published Date:
January 1989
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A look at the forces currently reshaping the world’s financial markets and the consequences for banking in both industrial and developing nations

A variety of factors are changing contemporary financial markets and raising fresh challenges for market participants and regulatory authorities. Widespread programs of financial liberalization and major technological innovations, particularly in the fields of data processing and telecommunications, are tightening links between markets once essentially bounded by national borders. Massive capital flows triggered by a lowering of exchange restrictions, changing international investment patterns, and macroeconomic imbalances are having a marked impact on market scale and volatility. Variable exchange rates and fluctuating interest rates are providing market participants with incentives to develop novel financing instruments and techniques. All these factors have induced major competitive and structural changes in the environment in which financial institutions operate.

The consequent restructuring is particularly evident in the banking sector. As regulatory authorities allow the scope and character of the operations of financial institutions to change, they themselves face enormous pressures to strike an appropriate balance between policies fostering competition, protecting investors and depositors, and safeguarding systemic stability. In response to these pressures, governments in nearly all advanced industrial countries have tightened prudential (i.e., supervisory and capital adequacy) standards for banks, reduced domestic financial repression, and taken further steps to liberalize the banking environment, especially through the relaxation of geographic and functional restrictions on banking activities. In the wake of widespread deregulatory movements and the stock market crisis of October 1987 (when prices on the world’s seven largest stock exchanges fell by an average of 16 percent in two hectic days of trading), similar cross-cutting influences are at work in the securities sector.

This article is based principally on International Capital Markets: Developments and Prospects, 1989, by a staff team from the Exchange and Trade Relations and Research Departments of the Fund. Available from Publication Services, IMF, Washington, DC 20431 USA. $15.

New capital adequacy standards

In an attempt to control the risks inherent in more competitive international banking markets, bank supervisors have sought, since the early 1970s, to raise safety standards and coordinate associated national policies. In 1975, common interests in this regard led 10 leading industrial countries to establish the Committee on Banking Regulation and Supervisory Practices (once commonly referred to as the Cooke Committee, after its former chairman) under the auspices of the Bank for International Settlements (BIS). The initial work of the Committee paved the way for an international understanding (the so-called “Basle Concordat”) on a division of supervisory responsibilities between the home country of a bank and the countries hosting its foreign affiliates. In 1986, the Basle Committee proposed a plan to harmonize capital adequacy standards for major banks across member countries (see table). In March 1987, the United States and the United Kingdom reached agreement on common capital requirements for their own banks (expressed as a proportion of total assets adjusted for credit risk). By July 1988, all the countries represented in the Basle Committee reached a consensus on a similar basis and began applying new capital adequacy standards to all internationally active commercial banks under their jurisdictions.

The new standards do not replace existing national approaches to bank regulation, but simply harmonize certain basic rules, including those affecting the treatment of capital and risk weighting. Since the financial structures of banks generally reflect unique national histories, tax policies, accounting practices, and other country-specific customs, the ultimate impact of the standards is expected to vary somewhat by country. The common requirement, however, is that by 1992, banks must maintain minimum capital bases equivalent to 8 percent of their risk-adjusted assets. This is, however, a minimum requirement and national authorities are left with the flexibility to impose more stringent rules. In addition, the new standards, which cover assets as well as items not carried directly on balance sheets (such as guarantees and lines of credit), assign specific risk-weightings to various categories of assets, thereby encouraging more careful assessments of credit risk by banks.

To give three examples, claims on governments of OECD countries carry a risk- weighting of 0 percent, and no regulatory capital is therefore required to back them, although treatment under national regulations may require it. Housing loans secured by mortgages carry a weighting of 50 percent, so banks are effectively required to maintain the 8 percent capital ratio on half the total value of such loans. Finally, standard commercial loans and sovereign loans to non- OECD countries carry a weighting of 100 percent, and banks must therefore meet the 8 percent standard with respect to their full value. Banks are generally attempting to adjust to the new requirements in three ways: by raising new capital directly in stock and bond markets, by shedding or restructuring assets, and by generating more capital internally through improved profit margins.

Market integration

The general increase in bank capital requirements is occurring simultaneously with the continuing erosion of restrictions on cross-border banking and on the establishment of banks and other financial institutions outside their home countries. In the United States, for example, a growing movement toward interstate banking is widely expected to lead by 1992 to the creation of a truly national market. In 1989, Canada and the United States began implementing a bilateral Free Trade Agreement, which, among other things, facilitates the expansion of financial institutions on both sides of the border.

Capital/asset ratios of banks in selected industrial countries, 1980—88(In percent)
198019811982198319841985198619871988
Canada3.03.53.74.14.44.65.04.85.1
France2.12.02.22.42.73.74.54.95.4
Germany, Federal
Republic of3.33.33.33.33.43.53.63.73.7
Japan5.35.35.05.25.24.84.84.84.9
Luxembourg3.53.53.53.63.84.04.14.14.1
Netherlands4.24.34.64.74.85.05.25.65.5
Switzerland7.67.57.57.37.47.87.98.08.0
United Kingdom5.04.54.14.44.55.55.46.06.4
United States5.45.45.65.96.56.97.27.98.1
Sources: Data provided by official sources; and Fund staff estimates.Note: These aggregate figures 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.
Sources: Data provided by official sources; and Fund staff estimates.Note: These aggregate figures 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.

Among the countries of the European Community, efforts are underway to create a unified financial services market by the end of 1992. The Community’s new banking coordination directive, completed in 1989, entitles banks licensed in any member country to offer a wide range of financial services, including leasing, securities underwriting and trading, and funds management, throughout the Community, subject only to the supervision of authorities in their home countries. Similar plans are being advanced for other types of intermediaries. In anticipation of 1992, banks in Community countries are considering various competitive strategies. As they maneuver for position, they face a complex set of decisions involving the scale and type of future European operations, the entrance of new competitors, and the redeployment of resources outside of Europe. Non-European banks are confronting similar decisions as they assess the risks of being left out of a potentially promising market. Although Community officials have signalled their intention not to restrict access to the unified European market, the plans of nonresident institutions are complicated by uncertainty as to the emerging regulatory structure.

Complementing the trend toward geographic integration, a general movement toward functional integration between financial markets is also underway across advanced industrialized countries. Perhaps the most obvious development has been the gradual spread of universal banking-type structures (financial conglomerates), once limited to certain continental European countries, to various parts of the world. In many cases, governmental authorities have been willing to relax functional constraints in order to stimulate competition and promote greater market efficiency. At the same time, financial innovations and the changing needs of clients have encouraged commercial banks and securities firms to expand into one another’s established markets. For similar reasons, many banks have ventured into related fields, such as trust and mortgage banking, insurance, and investment management. In the United Kingdom, Canada, and Australia, for example, recent measures have permitted commercial banks to purchase or establish securities houses and related businesses. Even in Japan and the United States, two countries that have long enforced strict separation between such activities, commercial banks are gradually being allowed to expand their involvement in the underwriting of corporate stocks and bonds.

All of these deregulatory moves have refocused the attention of bank managements on profitability—the key to raising new capital, defending established market positions, and supporting new competitive strategies. The resulting drive to open up new profit opportunities has set in motion a restructuring of the industry on an international scale. This continues to be reflected in a proliferation of mergers, substantial cuts in staffing, the conversion of portions of loan portfolios into marketable securities (securitization) in order to make more efficient use of existing capital resources, and the outright discounting and sale of problem loans.

Impact on developing countries

The responses of banks to the new challenges posed by changing international markets have important consequences for developing countries, which once relied on those markets for substantial amounts of financing. In light of recent loan servicing difficulties in a number of highly indebted countries, and a simultaneous increase in banks’ provisions against possible loan losses, it is perhaps not surprising that international banks have failed to maintain the high levels of lending recorded a few years ago. In effect, bank credits to developing countries in all regions of the world except Europe have, in fact, fallen dramatically since 1982. (See Ishrat Husain, “Recent Experience with the Debt Strategy,” Finance & Development, September 1989.) But the precipitous nature of the banks’ retreat has also been profoundly influenced by the cross-cutting pressures of deregulation and enhanced supervisory requirements.

Secondary market prices for developing country loans1

Source: Salomon Brothers.

1 Weighted average for 15 heavily indebted countries.

Institutions needing to raise capital in order to comply with the new Basle standards have noted that bank share prices, especially in North America, have responded positively to indications that individual banks have significantly reduced or eliminated their loans to developing countries. Indeed, the discounting and selling of such loans has given rise to a burgeoning secondary market. Gross transactions in this market are estimated by brokers to have grown from less than $5 billion a year in 1985 to over $15 billion in 1987, and perhaps as much as $50 billion in 1988. The declining prices generally witnessed in the market during the same period (see chart) reflect the efforts of some bank managements to strengthen capital/asset ratios and restructure balance sheets simply by shedding problem loans, even at significant immediate cost. In the United States, for example, such efforts have contributed to an overall decline of external claims on developing countries from 11.7 percent of total banking assets in 1982 to 5.7 percent in 1988.

Impact on industrialized countries

As banks adjust their balance sheets and adapt their operating strategies to more competitive market conditions, they are taking on new risks. Indeed, the pace of change in recent years has led many market participants to conclude that the general level of risk in the entire international banking system is increasing too quickly, and without adequate control by the banks themselves or by their governmental supervisors. The shocks that coursed through the system in the wake of the stock market crisis in 1987, the exorbitant costs associated with the recent collapse of numerous savings institutions in the United States, and a rising volume of highly leveraged corporate acquisitions have contributed to such concerns.

Banks perform their traditional intermediary function by assuming, at a price, various normal business risks, related to credit, liquidity, interest rate, and exchange rate considerations. By diversifying their portfolios, limiting their exposures to individual borrowers, maintaining adequate reserves, and using various hedging techniques, they seek to manage such risks, while at the same time profiting from them. With the currently heightened drive for profitability, many banks are turning to innovative products in the hope of generating fee income, often by avoiding immediate credit commitments and creating contingent obligations. The complexity of such financial products, the highly sophisticated technology upon which they depend, and the difficulties bank managers face in fully assessing associated risks have made the task of supervisory authorities more difficult. The effects of market restructuring on payments’ clearing systems, through which banks settle accounts with one another, and the sheer volume of transactions, have added to their task. The concerns of supervisors in this latter area were well exemplified in November 1985 when computer problems at the Bank of New York, a major clearing bank, led to massive overdrafts that could have triggered a chain reaction of institutional defaults in the absence of substantial intervention by the Federal Reserve.

The disquiet engendered by these new risks has promoted extensive international collaboration among banking supervisors during the past decade. Indeed, it was such collaboration that led, for example, to the negotiation of the Basle capital adequacy standards, including their coverage of offbalance sheet items. Moreover, in various bilateral and multilateral forums, similar intergovernmental consultations have been initiated on issues arising from integrated securities markets. Although there are few signs of a general retreat from the deregulatory trend so evident across the advanced industrialized world in recent years, governmental supervisors are clearly now seeking a new equilibrium between competition and control in markets where banks and nonbank intermediaries now compete more directly and more intensely. One of the most challenging aspects of their task involves attempting to limit the liability of public treasuries for financial failures. Since the potential collapse of a bank or major securities house in one country can now quickly threaten the stability of markets in other countries, governments are at pains to limit the scope of explicit or implicit guarantees connected with their traditional roles as lenders of last resort. Individually, as well as jointly, they are therefore seeking ways to manage such systemic risks by encouraging greater self- discipline within financial institutions, despite more competitive market conditions. At the same time, they are recognizing the importance of stable macroeconomic conditions to reduce the likelihood that official guarantees might be activated.

Conclusion

In order to survive and prosper in changing international markets, banking intermediaries themselves have had to restructure, necessitating significant changes in their balance sheet strategies. Such restructuring has been supported by modifications in regulatory and accounting practices, several of which have been formulated in a multilateral framework. The implications of that restructuring for governments of both industrial and developing countries are profound. The governments of industrial countries have confronted subtle challenges as they have sought to establish a level of financial regulation that maximizes competitive efficiency without jeopardizing market safety and stability. At the same time, governments of developing countries have encountered institutions less willing or able to meet their needs for fresh credit. Consequently, these governments have had to make arduous internal policy adjustments and strengthen their efforts to attract other forms of sustainable foreign capital inflows. The process of adjustment is likely to continue, raising new and interconnected challenges for private market participants and policymakers in both industrial and developing nations.

Macroeconomic Policies in an Interdependent World

Now available from the International Monetary Fund

Co-published with The Brookings Institution and the Centre for Economic Policy Research

Edited by Ralph C. Bryant David A. Currie, Jacob A. Frenkel, Paul R. Masson, and Richard Portes

Available in English. 1989.

US$17.50 (paper) vi + 420 pp.

ISBN 1-55775-111-0

International economic interdependence is attracting growing interest from policymakers and economists. This volume, a collection of papers delivered at a conference in Washington, D.C., considers economic interdependence among developed countries as well as between them and the less developed regions of the world. The authors assess domestic fiscal and monetary policies in light of global interdependence and the advantages involved in coordinating macroeconomic policies.

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