Chapter

Annex I Major Capital Markets: Trends and Recent Developments

Author(s):
International Monetary Fund
Published Date:
September 1996
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During most of the period under review, a favorable inflation outlook and reductions in official interest rates generally supported an environment of rising bond and equity prices and record levels of fund-raising. Against this background, the major currencies experienced a temporary misalignment beginning in March 1995 and lasting through the summer. The associated currency movements created substantial volatility in the major currency and related money and financial markets, but this volatility subsided as the major currencies became more aligned with economic fundamentals. Overall, the sharp currency movements had no discernible lasting effect on interest rates in the major industrial countries in 1995.

In early 1996, the strength of the U.S. economy raised concerns about the possibility of a global bond market correction similar to the market turbulence experienced in early 1994. Although U.S. long-term interest rates have risen in 1996. the other major industrial countries have experienced somewhat smaller increases, reflecting the significant differences in cyclical positions and the absence of the kind of speculative position-taking by hedge funds that had characterized the widespread turbulence in 1994. European interest rates experienced a considerable degree of convergence in the second half of 1995, and forward yield curves suggest that market participants expect to see further convergence over the next three to five years, even though spreads over German interest rates are implicitly expected to remain high in some countries.

Equity markets in most of Europe and Japan moved ahead more slowly in 1995 than they did in Canada, the United States, and the United Kingdom, but in early 1996, equity prices in all of the major markets have trended higher. The steady rise in U.S. equity markets has periodically raised concerns about the possibility of a sharp correction that could spill over into other markets. Although a correction cannot be ruled out, most objective market indicators suggest that equity prices are not necessarily out of line with underlying fundamentals.

The nonsynchronous nature of business cycles can also be seen in the performances of the major banking systems. Banks in Canada, the United States, and the United Kingdom have experienced record profit levels after having labored to resolve asset-quality problems that developed in the early 1990s. The resulting liquidity in these banking systems has driven margins on domestic and international syndicated loans to historically low levels and raised loan volumes. The performance of the banking systems in France and Japan continue to be affected by nonperforming loans.

Foreign Exchange Markets

The major currencies experienced a temporary misalignment in early 1995 (Chart 13). The dollar depreciated from ¥101 in early January to ¥80 in mid-April, and from DM 1.56 to DM 1.35 during the same period. The deutsche mark’s appreciation against the dollar was associated with currency movements within European currency markets, reflecting several factors including uncertainty about prospects for Economic and Monetary Union (EMU), the “flight to quality” associated with the Mexican financial crisis, and political uncertainty in several countries. During the early part of the year, the deutsche mark appreciated against the French franc, the Italian lira, and the pound sterling, and reached record highs against several other European currencies (Chart 14). In addition, the Spanish peseta and the Portuguese escudo were both devalued in March 1995—the first realignment within the European exchange rate mechanism (ERM) since the widening of bands in 1993.

The temporary misalignment of the major currencies generated a significant but temporary increase in transactions volume and price volatility in currency markets and in related securities and derivative markets. Average daily turnover increased markedly in global currency markets during this period, and reached as high as $2 trillion in April.1 Associated with this sharp increase in activity was a sharp rise in price volatility in foreign exchange markets (see Chart 8).2

Chart 13.Major Industrial Countries: Exchange Rates

(Local currency/U.S. dollar)

Source: Bloomberg Financial Markets.

Volatility tripled both in the yen-dollar market (in March and rose further in April) and in the deutsche mark-dollar market (between mid-February and the end of March 1995), and it increased for dollar rates against the other major currencies and for most of all the other cross-rates between the major currencies.

A combination of macroeconomic factors were widely cited by market participants as having contributed to the temporary misalignment of the major currencies in early 1995. These include the effects of the Mexican crisis; diminished expectations of further U.S. interest rate increases in response to signs of a slowdown in U.S. economic growth: the persistence of the U.S. current account deficit and the Japanese current account surplus; an intensification of U.S. Japan trade tensions: and a shift by Japanese investors away from dollar-denominated assets.

Despite these macroeconomic explanations, some market participants nevertheless did not believe that the dollar’s decline against the yen in March and April 1995 was entirely consistent with existing fundamentals. Instead, short-term trading conditions and the impact of the use of derivatives were frequently cited as factors contributing to the appreciation of the yen against the dollar. One factor that was widely cited at the time as having contributed to volatility in the dollar-yen exchange rate is the role of so-called knock-out options—options (in this case European-style options) that are used to hedge against moderate fluctuations in exchange rates but not extraordinarily large movements, and that are canceled when spot rates reach a specified knock-out level.3 Such options have gained in popularity because the knock-out feature makes them relatively inexpensive. It is thought that under market conditions similar to those present in early March 1995. these options contracts can exert a disproportionate influence on the underlying exchange rate. Market participants confirmed that large volumes of knockout options were purchased, largely by Japanese corporations, during the previous 12 months to partially hedge the yen value of expected dollar receivables against the possibility of a further modest appreciation of the yen. In such a scenario, a corporation would pay a fee up front for the right to sell dollars against yen, at say ¥90. and also specify that in the unlikely event the yen appreciates all the way to say ¥85, the option would be knocked out: the option would then become useless to the corporation, while the options dealer would earn the full premium.

Chart 14.Major European Countries: Local Currency vis-à-vis Deutsche Mark, January 3, 1994-May 31, 1996

Source: Bloomberg Financial Markets.

Market reports suggested that by late February 1995, the major dealers had accumulated on their books a substantial quantity of options with knock-out values somewhere between ¥90 and ¥80.4 To the extent that dealers can have an influence on the market, as the yen was appreciating in early March they had an incentive to push the value of the yen up through the knock-out levels and thereby eliminate their obligations under the options contract.5 Additional downward pressure on the dollar would also have come from those dealers who had dynamically hedged these contracts, and who then would have had positions requiring the sale of dollars after the knock-out level had been reached.6 Further downward pressure would have been created by the original customers who became exposed to an appreciating yen as the knock-out level was approached and their currency-risk protection removed. They, too. would be inclined to purchase more dollar put options or to sell dollars. It is believed by market participants that under the circumstances prevailing at the lime—a bunching of limit orders, spot prices approaching the knock-out levels, and momentum from technical analysis—trading by major dealers can influence the spot exchange rate for a short period around a specific knock-out value. This, perhaps, provided additional pressure on the exchange rate to move to the next lower knock-out value, and so on.

Although there seems to be a consensus that something like the scenario just described actually occurred, there still is considerable uncertainty among market participants and observers about the quantitative impact of these options on the dollar-yen spot rate in March and April 1995. Nevertheless, and despite the fact that there is no way of measuring the precise impact, market participants generally believe that these instruments had some influence on currency options markets. For example, prices of options, expressed in terms of the implied spot price volatility associated with them, doubled within the four trading days from March 2 to March 7. 1995. What appears to be clear is that short-term trading conditions and other technical market factors can have some influence, albeit this is difficult to measure, on underlying asset prices. Thus, along with other macroeconomic factors, trading conditions may have helped to raise the value of the yen against the dollar in early 1995.

In the event, the dollar depreciation was reversed in August and September 1995, reflecting coordinated exchange market intervention by the major central banks, the easing of interest rates in Japan and Germany, and the release of economic indicators that suggested to market participants that a higher value of the dollar against the yen and deutsche mark was appropriate (Chart 15).7 According to market participants, the recovery of the dollar since September 1995 owes much to the resolve of the major central banks, especially the Bank of Japan, to reverse the appreciation of the dollar. Many observers have credited the stability of the yen-dollar rate since late 1995 to the Bank of Japan’s foreign exchange intervention operations, which are considered to have effectively put a floor under the dollar of about ¥105. These views are reflected, for example, in the yen-dollar yield curve arbitrage positions that U.S. hedge funds built up in late 1995.

The dollar’s recovery in August and September 1995 removed much of the volatility that was present in financial markets early in the year. Lower volatility, in turn, eliminated some of the motivations for speculative trading and for hedging, and this led to a reduction in trading volumes in foreign-exchange-related derivatives markets. Worldwide turnover of exchange-traded currency futures and options rose by almost 27 million contracts in the first half of 1995 (an increase of more than 78 percent), which then eased back to an increase of only 3.6 million contracts (or 6 percent) in the second half of the year.8

Chart 15.Major Industrial Countries: Official Interest Rate, January 3, 1994-May 31, 1996

Source: Bloomberg Financial Markets.

Against this background of reduced uncertainty and lower volatility, a number of country-specific factors affected selected currencies: examples include the sharp volatility associated with the Quebec referendum in late October in Canada and the “speculative attack” on the French franc by U.S. hedge funds in early October.9

By the end of the 1995, the dollar had regained all of its losses against the yen, reaching ¥104, hut only part of the loss against the deutsche mark, ending the year at DM 1.44. In early 1996, concerns that the yen could again rise against the dollar led to a temporary increase in price and volume volatility in the yen-dollar market, and turnover on the derivative exchanges increased again. On the Tokyo International Financial Futures Exchange (TIFFE). turnover rose by 46 percent in January 1996 and 28 percent in February; on the London International Financial Futures Exchange (LIFFE) trading increased 89 percent in January and a further 22 percent in February; and turnover on the two big U.S. exchanges rose 32 percent (on the Chicago Board of Trade (CBOT)) and 8 percent (on the Chicago Mercantile Exchange (CME) in January and a further 8 percent and 13 percent, respectively, in February.

Three factors were cited by market participants as possibly influencing the yen-dollar rate in 1996. First, the repatriation of foreign investments by Japanese investors before the end of the fiscal year in March 1996 tended to strengthen the yen. Second, the record low (and near zero) short-term interest rates in Japan might have increased the probability of interest rate increases, which was perceived as possibly strengthening the value of the yen. Third, many market participants believed that an increase in short-term interest rates, or a strengthening of the yen, would spark a large sell-off in U.S. government bond markets and raise capital inflows to Japan, and attributed these possibilities to pressures associated with some large hedge funds covering their short yen positions.10 In part as a result of this increase in pressure and volatility in the yen-dollar market, the Bank of Japan intervened heavily in the foreign exchange markets, for the third time since the start of 1995 non-gold foreign exchange reserves of the Bank of Japan rose by $17 billion in February 1996 and by a further $4.3 billion by the end of April, pushing non-gold reserves from $125.8 billion at the end of 1994 to almost $205 billion.

Overall, the dollar’s recovery against the other major currencies and the associated marked reduction in market volatility since late 1995 has been sustained through the end of May 1996, even though there was some temporary uncertainty and volatility in the early part of the year. Between January and the end of May 1996. the dollar has appreciated by a further 5 percent against the yen and the deutsche mark, and most of the major European currencies, with the notable exception of the pound sterling, had fully recovered and appreciated slightly against the deutsche mark.

Although it is difficult to discern from market data how market participants view the future course of the major currencies, futures and forward market data provide some information about expectations. For most of the major currencies, there are no significant discounts or premiums over the next six months in futures and forward markets (Chart 16). At the end of May 1996, dollars could be bought against the yen and the deutsche mark for end-May 1997 delivery at about 5 percent and 2 percent, respectively, below the spot rate. For yen-dollar contracts two to five years forward, the forward discount on dollars is 10 percent for the end of May 1998 delivery, and this discount rises steadily to 20 percent five years forward. The forward price of dollars against deutsche mark reaches a maximum discount of about 6 percent four years forward. The discount on dollars observed in the forward yen market is consistent with the predictions of traditional interest rate parity conditions. Specifically, dollar interest rates are about 4 to 5 percentage points higher (per annum) than yen interest rates for instruments with maturities between one and five years. This suggests that over a five-year holding period, dollar-denominated instruments would yield about 20 percentage points more than yen-denominated instruments in the absence of any significant changes in the yen-dollar exchange rate.

Bond Markets

Bond markets rallied during the period from the end of 1994 through January 1996 after one of the largest bond market corrections in recent history (see Table 3 and Box 1). U.S. Treasury bonds recorded gains of 24 percent, and long-term bonds in most of the major industrial countries recorded gains in the range of 15-25 percent. In many cases, returns on bonds were well above returns on equities.

Interest Rates

Yield curves generally shifted downward in the major industrial countries throughout the period under review, reflecting reductions in official interest rates, indications of a “soft landing” of the U.S. economy, optimism about the prospects for U.S. budget deficit reductions, and disappointing economic growth in Europe and Japan (see Chart 3). During 1995, ten-year government bond yields fell by 225 basis points in the United States; 207 basis points in Canada; about 160 basis points in France, Germany, and Italy; 140 basis points in the United Kingdom; and 130 basis points in Japan (see Chart 4). At their low points in January 1996. long-term interest rates in the United States were at their lowest levels in more than a decade. Short-term interest rates also declined in 1995, but with greater variation across countries than was the case for long-term rates (Chart 17). Since the beginning of 1996, although short-term interest rates have continued to decline, long-term rates have risen. Consequently, yield curves have steepened in most countries since early 1996 (Chart 18; see also Chart 3).

The general optimism over inflation and cyclical factors that lifted bond prices in 1995 began to fade in early 1996, particularly in the United States, as concerns surfaced that inflationary pressures were rising in the United States. Market participants focused more intensely on these concerns when Federal Reserve Chairman Alan Greenspan observed in his remarks to the House Banking

Committee on February 20, 1996 that the U.S. economy had strengthened beyond earlier expectations. Shortly after these remarks, ten-year U.S. Treasury bond yields increased by 25 basis points on top of the 25-basis-point rise that had accumulated since yields bottomed out in January 1996. Bond market volatility more that doubled in the United States and Canada between mid-February and mid-March, and increased sharply in all of the other major countries (Chart 19). Market participants generally perceived the March 8, 1996 release of U.S. nonfarm payroll data and the March employment report released on April 5, 1996 as confirming that the U.S. growth had increased, and this together with a general feeling of disappointment about the inability to achieve a U.S. budget deficit reduction added further momentum to the downward pressures on bond prices. Between March 7 and April 8. 1996. the ten-year Treasury bond yield increased by 53 basis points, and the Dow Jones Industrial Average dropped 171 points (about 3 percent) on March 8, 1996 alone. Bond and stock markets around the world recorded smaller but significant declines. In the first four months of 1996. the ten-year Treasury yield rose by 125 basis points, reversing more than half of the interest rate decline that occurred in 1995.

Chart 16.Spot and Forward Rates for Currencies of Major Industrial Countries Against the U.S. dollar, May 31, 1996

Source: Bloomberg Financial Markets.

Note: Data shown are bid rates. An increase means an appreciation of the U.S. dollar.

Chart 17.Major Industrial Countries: Short-Term Interest Rates 1

(In percent a year)

Sources: International Monetary Fund and Bloomberg Financial Markets.

1 Three-month certificate of deposit rates for the United States and Japan; three-month treasury bill rate for Italy; rate on three-month prime corporate paper for Canada; and three-month interbank deposit rates for other countries. Weekly averages of daily observations are plotted for all countries other than Italy and Canada. For Italy, results of fortnightly treasury bill auctions are shown. For Canada weekly observations are plotted.

2 1987 GDP weights.

The market conditions that led to the rise in interest rates in February 1996 raised concerns that global bond markets might experience another period of turbulence similar to that of early 1994.11

These concerns were related to perceptions that there were close parallels between the conditions in bond markets in 1993-94 and in 1995-96. First, market analysts noted that the rallies in U.S. bond markets (and other bond markets) in both periods were strong and that the rally was in fact greater in 1995 than in 1993: bond yields declined by more than 200 basis points in 1995, whereas they declined by about 150 basis points in 1993. Second, during both rallies, long-term interest rates declined below 6 percent. Third, the level of activity in derivatives markets rose sharply as the bond market rally in 1993 came to an end. in part because the demand for hedging instruments tends to be highly correlated with increased uncertainty, which often is associated with greater volatility. In the early months of 1996 there were near-record turnover volumes on the major derivatives exchanges, and swaps dealers reported near-record flows. These similarities led market observers to believe that the U.S. bond market was poised for a correction

Chart 18.Major Industrial Countries: Differentials Between Long- and Short-Term Interest Rates 1

(In percent a year)
(In percent a year)

Sources: Financial Times, Nihon Keizai Shimbun, International Monetary Fund, and Bloomberg Financial Markets.

1 The chart shows, for each country, the difference between the long-term rate shown in Chart 4 and the shortterm rate shown in Chart 17, except that for the United States three-month treasury bill rates are used as shortterm rates.

Chart 19.RiskMetrics Daily Price Volatility for Ten-Year Government Bonds, January 19, 1995-May 31, 1996

(In percent)

Source: J.P. Morgan.

Box 1.Causes of Recent Swings in Bond Yields

Recent years have seen sharp swings in bond yields, with yields on U.S. ten-year government bonds tailing to 5.2 percent in October 1993, then rising to a peak of 8.0 percent in November 1994, falling back down to 5.5 percent in January 1996. before rising again in recent months. Similar swings have been experienced in many other countries. By historical standards, recent volatility in bond yields—measured by the standard deviation of daily changes in bond yields—has been substantial, but not extraordinary. The chart shows that volatility in long-term U.S. dollar rates during several past episodes, most recently in 1987, exceeded that of recent years, and that these were most volatile in 1979. German interest rate volatility peaked in 1986, and volatility for other currencies peaked in 1987. around the time of the stock market crash, which also led to a period of increased stock market volatility (see Borio and McCauley (1995)).

Insight into the causes of bond market volatility can be obtained by decomposing bond yields in two different ways. The first decomposition makes use of the Fisher equation, which expresses changes in nominal interest rates as the sum of changes in real interest rates and changes in expected inflation. In general, neither real interest rates nor market inflation expectations can be directly observed.

However, reported inflation forecasts do not appear to have varied substantially in most countries since the beginning of 1993. Revisions in intlation forecasts in the World Eco-nomic Outlook, for example, have been quite small for most of the major industrial countries (see Table A). Recent bond market swings would therefore appear to be due primarily to fluctuations in real long-term interest rates, not to changes in inflation expectations. Borio and McCauley (1995) present evidence that the volatility of month to month revisions in inflation forecasts does not seem correlated with changes in bond yield volatility.

U.S. Long-Term Bond Yield Volatility

Source: IMF staff calculations from The WEFA Group data.

Note: Annualized standard deviation of daily percentage changes during calendar months of the yield on the ten-year constant maturity Treasury bond.

The other useful decomposition of long-term interest rates employs the concept of forward interest rates, which are the hypothetical future short-term interest rates that make a series of short-term fixed income investments yield the same return as a long-term bond. These forward interest rates can provide an indication of expected future short-term interest rates, with the caveat that this abstracts from possible risk premiums in long-term rates. For U.S. rates over the last four years, current short-term interest rates and near-term forward rates have been substantially more volatile than more distant forward rates (see Table B). This indicates that fluctuations in current and near-term expected short-term interest rates have been more responsible for swings in bond yields than have expected short-term rates further in the future.

Table A.World Economic Outlook Consumer Price Index Inflation Forecasts1(Annual fourth quarter to fourth quarter percent change)
19941995
United States
October 19933.0
May 19943.03.2
October 19943.03.4
May 19952.63.3
October 19952.63.1
Japan
October 19931.2
May 19941.11.1
October 19940.70.9
May 19950.90.1
October 19950.9-0.6
Germany (west)
October 19932.4
May 19942.32.0
October 19942.82.0
May 19952.81.7
Germany (united)
October 19952.61.9
October 19932.4
May 19942.12.0
October 19942.01.6
France
October 19932.4
May 19942.12.0
May 19951.42.2
October 19951.62.6
Italy
October 19934.0
May 19943.92.6
October 19943.52.9
May 19954.05.8
October 19953.95.9
United Kingdom
October 19934.0
May 19943.33.0
October 19942.43.2
May 19952.23.1
October 19952.23.2
Canada
October 19931.7
May 19940.41.8
October 19941.8
May 19952.3
October 19952.5
Source: International Monetary Fund. World Economic Outlook, various issues

The period under each country indicates the corresponding World Economic Outlook publication.

Source: International Monetary Fund. World Economic Outlook, various issues

The period under each country indicates the corresponding World Economic Outlook publication.

Taken together, these decompositions indicate that fluctuations in real short-term interest rates have been responsible for much of the fluctuations in bond yields in recent years. One scenario consistent with this story is the possibility that central banks in major industrial countries aim for low, stable rates of inflation. When there are signs of incipient increased or decreased inflationary pressures, central banks adjust short-term interest rates before these pressures affect inflation. Long-term rates also change, as current and expected near-term short rates change, in order to preserve relative expected returns. A proximate cause of the bond market turbulence in February and March 1994, analyzed in International Monetary Fund (1994), was revisions in prospects for short-term interest rates in major industrial countries. This interacted with the highly leveraged positions taken by some market participants to produce high volatility. The message of the discussion above is that the biggest component of these swings in bond yields seems to be changes in short-term real interest rates rather than revisions of inflation expectations or of future expected short-term interest rates. Furthermore, while the ability of market participants to take highly leveraged bond market positions has increased over recent years, the concurrent bond market volatility is not without historical precedent, indicating that new financial techniques and instruments are not themselves responsible for the recent swings in bond yields.

Table B.Changes in 12-Month Spot and Forward U.S. Dollar Interest Rates, 1993-95(Average absolute value of annual interest rate changes)
Constant Position on Forward
Yield CurveConstant Calendar Year
12.1719962.62
22.6319972.69
32.1719982.35
41.9819991.65
51.4620001.63
61.6720011.63
71.5120021.45
81.35
91.21
101.08
Source: IMF staff calculations based on data from Bloomberg Financial Markets.Note: Spot and forward interest rate data are based on swap yield curves. All data are based on three annual changes in percentage points (average absolute value of changes). Constant position on forward yield curve: year 2. for example, is the average of changes between 1994 forward at end-1992. 1995 forward at end-1993, 1996 forward at end-1994. and 1997 forward at end-1995. Constant calendar year uses forward for same calendar year (for example. 1996) for end-1992 through end-1995 yield curves.
Source: IMF staff calculations based on data from Bloomberg Financial Markets.Note: Spot and forward interest rate data are based on swap yield curves. All data are based on three annual changes in percentage points (average absolute value of changes). Constant position on forward yield curve: year 2. for example, is the average of changes between 1994 forward at end-1992. 1995 forward at end-1993, 1996 forward at end-1994. and 1997 forward at end-1995. Constant calendar year uses forward for same calendar year (for example. 1996) for end-1992 through end-1995 yield curves.

Despite the close parallels between these two episodes, there were other factors counterbalancing the concerns about a correction that apparently made a repeal of the 1994 experience unlikely, even in the event of another increase in U.S. rates. One such factor was the gradual increase in the slope of the U.S. yield curve in December 1995 and again since February 1996. which relieved market pressures. This reduced pressure was reflected in current and implied forward yield curves as constructed from interest rate swap data (Chart 20).12 These yield curves suggest that long rates contain little immediate upward momentum, an implication that is consistent with futures market quotes for the future delivery of long-term bonds. They also imply that markets anticipate further increases in short-term interest rates in 1997.

Another counterbalancing factor was that market volatility began to subside in March 1996. as the level of activity in derivatives markets declined sharply. Market turnover declined by 26 percent on TIFFE. 22 percent on LIFFE, and 13 percent on the CBOT, and it rose only modestly by 8 percent on the CME. A third factor was that, despite the rise in bond yields, there was in early 1996 a considerably smaller volume of proprietary trading and a lower degree of leveraging than was observed during the bond market rally in 1993. Because of the relatively steep U.S. yield curve in 1993, it had been common for investors to finance long Treasury positions with short-term dollar borrowing. When the Federal Reserve began to tighten monetary policy in February 1994. investors covered their short positions, and this exacerbated selling pressures in the long-bond market and magnified the correction in bond markets. En contrast, since early 1995, the U.S. yield curve has been much flatter than it was in early 1994 (see Chart 18). At the same time, hedge funds—which experienced losses from leveraged yield curve plays in 1994—have reportedly turned their attention since then toward arbitrage plays rather than leveraged directional plays.

Another possible reason why a major bond market correction did not occur is that macroeconomic conditions in many industrial countries—notably in Europe—are generally perceived to be inconsistent with substantial increases in interest rates. This might explain why there has been a “decoupling” of the other major bond markets from the U.S. bond market. More specifically, while the ten-year Treasury yield increased by 128 basis points in the first four months of 1996, interest rates on comparable government securities in the other major industrial countries have increased by considerably less. U.K. ten-year interest rates have displayed the highest correlation with U.S. interest rates in 1996, increasing by about 57 percent of the increase in U.S. rates. Canadian rates increased about 50 percent of U.S. rates, German long rates increased by 37 percent of U.S. rates, Japanese rates rose only 5 percent of U.S. rates, and French and Italian rates actually fell quite sharply during this period—by more than 100 basis points in the case of Italy. It is likely that a root cause of this decoupling is the decoupling of the business cycles in the United Stales. Canada, and the United Kingdom on the one hand, and continental Europe and Japan on the other hand.

These differences in macroeconomic conditions are reflected in forward yield curves (see Chart 20). According to these yield curves, short-term interest rates are expected to rise sharply in all the major industrial countries during the second half of 1996 and through 1997, with the notable exception of Italy, where a decline is expected. At the long end of the yield curves, the expectation is that there is more room for rates to rise in Germany and Japan than in the United States. With the Japanese economy appearing to have begun to recover from the 1991-95 recession, the markets might he anticipating Inline interest rate increases in 1996 and 1997. The strength of the yen in late April and May 1996 might have reflected such expectations of higher interest rates. However, the Japanese yield curve has shown little sensitivity to these expectations or to the recent increase in yields in the United States. One often-cited interpretation of the Japanese yield curve is that market participants perceive the possibility that a major rebalancing of portfolios may result from a decision to raise interest rates in Japan.

The German yield curve has also attracted considerable attention. The steepness of the German yield curve compared to other Group of Seven countries (see Charts 3 and 18) has been explained by market participants and authorities in various countries as being due in part to a so-called EMU premium of about 50-100 basis points in long-term rates.13 If this reasoning is valid, then there should also be “EMU discounts” in long-term bonds issued by those European Union countries that generally have “weaker” currencies and that may participate in EMU.

There does appear to have been some degree of convergence in interest rates in Europe after the first quarter of 1995, although in many cases spreads are wider than they were in early 1994 (see Chart 5). Since their peaks in 1995, spreads on ten-year bonds have narrowed in France from 101 basis points to 2 basis points by the end of May 1996; Belgian spreads have narrowed from 91 to 25 basis points; Spanish spreads fell from 528 to 267 basis points; Swedish spreads have narrowed from 444 basis points to 203 basis points; and Italian spreads narrowed from 602 to 292. In contrast, U.K. spreads have widened from 140 basis points to about 165 basis points over the same period. Market participants and officials in many countries attribute this convergence to expectations of EMU, to a reversal of the “flight to quality” following the Mexican crisis, and to country-specific factors. The narrowing of Italian spreads, for example, is due largely to a reversal of the increase that followed the Mexican crisis as well as to the announcement that the withholding tax on Italian government securities would be eliminated for most foreign investors.

Yield curves are also substantially steeper in those European Union countries that are generally considered to be able to meet the criteria to participate in EMU than they are in countries for which there is more uncertainty about their eligibility to participate. Specifically, the one- to ten-year spread along swap yield curves at the end of May 1996 for the French franc was about 275 basis points; more than 355 basis points for the deutsche mark, the Belgian franc, and the Netherlands guilder; about 195 basis points for the pound sterling; 95 basis points for the Italian lira; 195 basis points for the Spanish peseta; and 285 basis points for the Swedish krona (see Chart 6). Some have concluded that the countries with the steeper yield curves contain an EMU premium, while the others contain an EMU discount, and this therefore might help explain the convergence in yields that was discussed above.

If the market believes the Maastricht criteria will be enforced strictly, then with the introduction of a common currency in participant countries, the yields on these countries’ government bonds should converge—the Maastricht criteria would effectively ensure that the differences in default risk would be minimal. At the end of May 1996, the actual swap curve produces the following five-year yield spreads over deutsche mark five-year swaps: -15 basis points for the Netherlands guilder, about 5 basis points for the Belgian and French francs, 225 basis points for the Italian lira, 210 basis points for the pound sterling, 290 basis points for the Spanish peseta, and 246 basis points for the Swedish krona (see Chart 6). In January 1999, the implied forward yield curve spreads are roughly unchanged for the French and Belgian francs and the

Netherlands guilder, and they narrow by 60-85 basis points for the pound sterling, the krona, and the peseta, and by 20 basis points for the lira. Looking out an additional two years to January 2001, these spreads narrow again, by about 20 basis points for the pound sterling, the lira, the krona, and the peseta.

In sum, the evidence suggests that there has been some narrowing in yield spreads over German interest rates since early 1995. It is difficult, however, to identify precisely the component that can be attributed to EMU. Forward yield curves suggest that, even for those countries that currently have high interest rates relative to deutsche mark rates, the market anticipates spreads to continue to converge over the next three—five years.

Volume of New Issues

The year 1995 set a record for annual issues in international bond markets. Net issues by public and private sector entities totaled $313.2 billion, pushing the stock of international bonds up by 15 percent to $2.8 trillion (Tables 6 and 7).14 About one quarter of the stock of international debt securities at the end of 1995 were issued by public sector entities, and new issues by the public sector in 1995 accounted for 23 percent of all new issues. At the same time, the industrial country share of total international bonds issued increased from 81 percent in 1994 to 84 percent in 1995. More than 90 percent of the increase in issuance activity occurred in the second half of 1995. In the first half of the year, the fallout of the Mexican crisis limited the access of many developing countries to international bond markets. Similarly, the temporary misalignment of the major currencies increased exchange rate volatility and reduced swap spreads in the U.S. dollar sector, and thereby slowed the pace of industrial country net issues.

At least three factors appear to have supported the overall rise in issuance in 1995. First, sharp declines in interest rates throughout 1995 provided borrowers with the incentive to bring forward their funding schedules in order to lock in low fixed rates. Second, spreads on interest rate swaps encouraged high volumes of activity throughout the year, particularly in the five-year deutsche mark sector (Box 2). Third, there was strong demand for international bonds from retail investors in Japan and, to a lesser degree, in Belgium, Germany, Luxembourg, and Switzerland.

Tranches of several bond issues in the international markets were marketed in Japan to retail investors. International bond purchases (on the primary market) by Japanese retail investors are estimated to have been in the neighborhood of ¥4.0 trillion in 1995.15 Low interest rates in Japan on yen-denominated bank deposits and Japanese government bonds appears to be an important motivation for this strong demand. Early in the year, Japanese retail investors favored yen-denominated issues, but subsequently increased their demand for higher-yielding currencies, including the Australian dollar, the U.S. dollar, and the deutsche mark. The retail sector has also been attractive to issuers because yields are typically substantially lower on retail issues than on professionally targeted issues. For example, highly rated issues can often be brought to the retail market at a negative spread to sovereign issues, and many developing countries have been able to reduce their funding costs by more than 100 basis points with retail issues.16

Chart 20.Major Industrial Countries: Spot and Implied Forward Yield Curves, May 31, 1996, January 2, 1997, and January 2, 1998

(In percent)

Source: Bloomberg Financial Markets.

Note: Forward yield curves are calculated from the implied forward rates in the spot interest rate swap curves.

1 Except for Japan (January 6, 1997).

Table 6.Net Issues of International Debt Securities by Nationality(in billions of U.S. dollars)
19951996
199319941995Q1Q2Q3Q4Q1
All countries150.7285.7313.255.974.499.383.6112.1
industrial countries85.2232.3261.859.561.775.665.186.7
Of which:
United States-6.027.060.615 110.219.615.830.5
Japan-46.50.17.31.87.3-5.53.60.6
Germany32.558.174.115.116.619.622.824.3
France21.720.610.51.11.12.06.3-1.0
Italy9.411.97.1-2.17.03.0-0.8
United Kingdom16.616.813.74,02.04.53.37.4
Canada17.318.110.42.31.76.5-0.10.1
Developing countries34.635.231.3-5.68 117.011.516.1
Offshore centers15.18.24.3-1.21.63.95.3
Source: Bank For International Settlements

The Bahamas, Bahrain, Bermuda, the Cayman islands, Hong Kong, the Netherlands Antilles, and Singapore.

Source: Bank For International Settlements

The Bahamas, Bahrain, Bermuda, the Cayman islands, Hong Kong, the Netherlands Antilles, and Singapore.

Table 7.Outstanding Amounts of International Debt Securities(In billions of U.S. dollars)
19951996
19931994Mar.Jun.SepDec.Mar.
All countries2,037.82,441.72,638.62,735,92,750.32,803.32,873.5
Industrial countries1,650.31,976.42,150.62,229.02,238.12,277.82,330.8
Of which:
United States176.9209.3231.8243.2258.7272.8301.1
Japan340.1360.6388.6103.3371.9367.7360.9
Germany120.1189.4219.9237.8251.2271.6290.5
France153.1186.1201.3203.0202.0207.7202.7
Italy70.285.286.494.794.492.891.8
United Kingdom186.7211.9222.2223.2225 7226.4231.4
Canada146.9165.5171 7174.6179.5177.9176.9
Developing countries121.8162.1162.9173 1183.3192.9206.5
Offshore center111.319.618.718.720.123.829.0
Source: Bank For International Settlements

The Bahamas, Bahrain, Bermuda, the Cayman Islands, Hong Kong, the Netherlands Antilles, aad Singapore.

Source: Bank For International Settlements

The Bahamas, Bahrain, Bermuda, the Cayman Islands, Hong Kong, the Netherlands Antilles, aad Singapore.

Table 8.Outstanding Amounts and Net Issues of International Debt Securities by Currency of Issue(in billions of U.S. dollars)
Net issues
Amounts Outstanding199519951996
199319941995199319941995Q3Q4Q1
U.S. dollar836.4910.1984.931.573.774.925.325.445.3
Japanese yen272.3412.6496.833.8106.8108.337.522.815.5
Deutsche mark192.8244.0319.731.227.555.914.915.921.4
French franc92.7131.6139.034.527.05.2-0.30.86.2
Italian lira37.757.569.713.018.410.42.41 34.6
Pound sterling154.8178.2186.731.714.510.14.22.28.2
Canadian dollar81.783.583.720.56.7-2.1-0.4-0.30.3
Spanish peseta10.610.713.23.5-0.71.40.30.31.0
Netherlands guilder44.965.984.57 914.813.55.70.85.4
Swedish krona3.55.15.30,61.00.40.30.5
Swiss franc149.1161.21 88.9-2.3-6.41.51.13.52.1
Belgian franc2.22.34.3-0,4-0.32.00.90.60.2
Other159.1179.0226.7-8.02.729.57.710.71.4
Total2,037.82,441.72,803.4197.5285.7313.299.383.7112.1
Source: Bank For International Settlements.
Source: Bank For International Settlements.

In the first quarter of 1996, issuance activity increased 100 percent above the level of activity recorded in early 1995. This essentially confirms the views expressed in market commentaries that the continued strength of refunding programs (including funding associated with mergers and acquisitions) in tandem with low interest rates will work in 1996 to increase new issues to another record level.17 Issuance activity was particularly strong in January as interest rates in the major countries continued to ease. It then slowed somewhat in February owing to the increase in U.S. interest rates, and subsequently bounced back sharply in March as rises in interest rates in other industrial countries did not match the rise in U.S. interest rates.

A recent development in international bond and note markets is that banks and other financial institutions have accounted for an increasing share of new issues, totaling about 60 percent of new issues in 1995 and more than 70 percent in the first quarter of 1996. Even though these institutions are flush with capital, many large international banks have been shifting away from traditional sources of funding and toward debt securities.18 German financial institutions have been particularly active fund-raisers in international markets in the 1990s, accounting for about one fourth of all international debt securities issued by financial institutions. In contrast, nonfinancial issuers have continued to withdraw from the international markets. An example of this withdrawal is evident among Japanese corporations, which recently have been deleveraging.

In the dollar sector of international markets, narrow swap spreads and the temporary misalignment of the major currencies in the first half of 1995 resulted in a much smaller share of new dollar issues—only 10 percent. The reversal of these factors by midyear led the dollar sector to regain its historically dominant position as the year progressed. By the fourth quarter of the year, the dollar sector bad captured 31 percent of net issues. In the first quarter of 1996, the dollar sector’s share of new issues has increased further (Table 8).

Since the early 1990s, the dollar sector has experienced a gradual decline in market share, while the yen and deutsche mark sectors have increased market shares. In 1995, the deutsche mark sector roughly doubled its average share of new issues to about 18 percent, as the dollar sector share declined to an annual average of 25 percent. Much of the strength of the deutsche mark sector was in the five-year maturity range, owing in part to favorable swap rates. The market share of the yen sector declined from 37 percent in 1994 to 33 percent in 1995, reflecting a sharp decline in market share in the final quarter of 1995. The yen sector captured only 14 percent of the market in the first quarter of 1996. Unfavorable swap rates and strong demand by Japanese investors for foreign currency bonds are reported to be the key factors behind this drop in market share.

While the volume of new issuance on the international markets has been impressive, these markets are comparatively small next to domestic bond markets. The outstanding amount of debt securities in OECD countries is almost ten times as large, standing at just over $24 trillion at the end of 1995 (Table 9), and the level of new issues ($1.7 trillion) in 1995 was five times larger in the domestic markets than in the international markets. The United States accounted for about $10.7 trillion of the total outstanding amount, with Japan and Germany accounting for about $5 trillion and $1.9 trillion, respectively. The United States also accounted for more than 45 percent of new issues in domestic debt securities markets in 1995. Although the domestic debt markets are much larger than the international market, they have grown more slowly in recent years, reflecting fiscal consolidation efforts in the industrial countries, which has slowed the rate of public issues. Overall, outstanding amounts in domestic bond markets have grown at an average rate of 9 percent over the past five years, compared with 12 percent for the international markets.

Table 9.Domestic Debt Securities by Type, Sector, and Country of Issuer1
Net issues
Amounts Outstanding19951995
199319941995199319941995Q3Q4
Total issues19,714,522,171.424,110.01,604.41,474.41,680.3353.3348.1
Bonds15,878.017,978.219,530.41,444.31,275.21,336.9278.8383.9
Medium-term notes420.4490.8562.090.050.250.723.50.2
Commercial paper759.9813.4905.3-10.633.988.37.021.5
Treasury bills1,693.61,842.41,931.772.293.985.615.7-69.3
Other short-term notes962.61,046.61,180.78,521.1118.830.311.7
Private sector7,250.37,974.076.7440.3310.2639.5157.5162.6
United States3371.33,608.74,028.2226.5237.4419.41 14.189,7
Japan1,325.61,497.31,530.246.611.480.512.252.6
Germany738.1863.41,023.372.139.892.330.018.7
France541 2571.2601.41.0-25.3-21.8-5.4-14.3
Italy299.0324.9362.839.712.327.75.49.2
United Kingdom134.2169.8186.514.927.518.4-3.47.6
Canada47.046.552.13.52.34.31 61 4
Other793.9892.2992.236.04.818.73.0-2.3
Public sector12.464.214,197.515,333.41,164.51,164.21,040.9197.8185 4
United States5,968.96,354.46,697.8460.6385.5343.539.4119.6
Japan2,651.13,252.73,428.4157.9277.9312 449.935.2
Germany639.9805.0883.1136.889.913.84.4-0.2
France434.1549.7674.369.369.375.728.9-13.7
Italy887.71,074.01,169.594.8145.961.114.712.4
United Kingdom306.1354.8412.866.231.261.313.910.6
Canada422.6417,1451.223.418.722.67.8-1.5
Other1,153.81,389.81,616.3155.5145.8150.538.823.0
Source: Bank for International Settlements

Organization for Economic Cooperation and Development member countries only, excluding Iceland and Turkey.

Source: Bank for International Settlements

Organization for Economic Cooperation and Development member countries only, excluding Iceland and Turkey.

Across all OECD countries, public sector issuers accounted for 64 percent of outstanding domestic debt securities at the end of 1995, although this proportion varies widely across countries. In 1995. public sector issues accounted for 90 percent of all domestic debt securities in Canada, around 70 percent in Japan and the United Kingdom, 77 percent in Italy. 63 percent in the United States. 53 percent in France, and 47 percent in Germany. Public sector issuers accounted for a much smaller share of the international debt securities markets—24 percent at the end of 1995—than in domestic markets. Conversely, financial institutions account for 37 percent of debt on the international markets, but only 25 percent in domestic markets.

Equity Markets

Developments in the Major Markets

The same factors that boosted bond markets in 1995 and in early 1996—low inflationary pressures and continued easing of official interest rates—were instrumental in raising equity prices. Equity markets increased earlier in Canada, the United Kingdom, and the United States than in the oilier major industrial countries (see Chart 9) and the upward momentum in 1996 allowed these markets to post the largest gains in the period January 1995-May 31. 1996 (see Table 3). Mirroring the decoupling in global bond markets, this upward momentum faded in interest rates rose in February 1996. Equity prices to most of the other major equity markets have moved higher since the beginning of 1996: in the first five months of 1996. the French, German, and Italian markets all rose more than 10 percent, and the Japanese market about half as much.

The magnitude of the rise in U.S. equity prices has attracted attention. At the end of 1994. the market capitalization of the three largest stock exchanges in the United States was $5.1 trillion.19 The roughly 40 percent rise in the broad market indices between the end of 1994 and the end of May 1996 translates into the creation of about $2 trillion in equity wealth. In contrast, most equity markets in continental Europe and Japan gathered momentum only later in 1995. In Japan, a more stable exchange rate and improved prospects for economic recovery led the Nikkei 225 index to be the top performer in the second half of 1995 among the Group of Seven countries, rising 37 percent in six months and recovering more than its losses from the first half of the year. This renewed interest in Japanese equities has been maintained in 1996: on April 22, the Nikkei 225 index broke through the psychologically important level of 22,000 for the first time in four years, rising 50 percent above its low point in 1995. French and Italian equity prices were held back for much of the year owing to political and fiscal concerns, but both markets have recovered in 1996 as these concerns have eased.

Box 2.International Bond Issuance and the Swaps Market

A borrower that issues a bond assumes a particular currency and interest rate risk, which can be transformed into other currencies or interest rates through the use of interest rate and cross-currency swaps. A plain vanilla interest rate swap, in which the borrower agrees to pay a floating interest rate in return for receiving fixed interest payments, transforms a fixed-rate obligation into a floating-rate one. In a cross-currency swap, the original currency denomination can be redenominated into an exposure in another currency. Hence, swaps can be used to achieve a wide array of interest rate and currency exposures. Hence, a borrower with preference for a particular currency and interest rate risk can issue an obligation in almost any currency and interest rate market segment, and then use swaps to transform the risk according to these preferences. This allows borrowers to exploit markets that provide the lowest all-in cost of borrowing, factoring in the cash-flow on the swaps.

Consider, for example, a borrower faced with a choice between issuing floating-rate or fixed-rate obligations in the same currency, say dollars. Suppose this borrower prefers to end up with a floating-rate dollar liability. One option is to issue a floating-rate dollar liability paying a spread sL over the London interbank offered rate (LIBOR). Another option is to issue a fixed-rate bond paying rx and then enter into an interest rate swap in which the borrower receives a fixed-rate payment stream from, and pays a floating-rate payment stream to, a bank. Typically, the floating-rate side of the swap pays LIBOR, while the fixed-rate side is quoted at a spread, sx over the benchmark government bond yield, of the same currency and maturity, rG. The cost to the borrower of obtaining synthetic floating-rate financing is therefore the interest paid on the fixed-rate bond, minus the fixed-rate payment (sx + rG)received in the swap, plus LIBOR. If this is less than the rate the borrower can obtain directly on the floating rate market, that is, if rx-sx-rG<sL where the inequality compares spreads over LIBOR, then the borrower would prefer to issue the fixed-rate bond and swap into the floating-rate exposure. Alternatively stated, a borrower will issue fixed-rate bonds and swap into floating rates when the yield differential between its bonds and government bonds is less than the sum of the swap spread and the spread (over LIBOR) they would pay in the floating-rate market. In market parlance, this inequality indicates the existence of a “swap window.” The same inequality determines when a borrower who prefers a fixed-rate obligation will issue directly in the fixed-rate market rather than swap a floating-rate liability. Similar inequalities indicate when issuers would have a preference for issuing in different currencies and swapping into the preferred currency.

How do swap windows open? Rewriting the swap spread as the difference between the swap rate rs and the government bond rate rG and eliminating the government bond rate from the equation gives rx < rs + sL. While all three terms in this expression fluctuate, the term that probably varies the most is rx the interest rate on the fixed-rate bond issued by the borrower. This variation is due to simple supply and demand. As the supply of bonds in a particular currency and maturity range fluctuates, so does rx If the supply decreases, investors who have a preference for that currency and maturity bid up the price of the remaining bonds, driving down rx the yield on the bonds. The other terms in this equation, rs and sL tend to have more stable determinants. Since swaps can be hedged in the Eurocurrency futures market, at least imperfectly, and since swap dealers run swap books with many different contract maturities, the swap rate rs is more closely tied to swap rates for other maturities, and does not respond as much to fluctuations in the supply of bonds of a particular maturity. Instead the swap rate will likely be lied more closely to current and expected future short-term interest rates. The spread available to the borrower in the floating-rate market sL is a function primarily of the riskiness of that borrower’s credit, which also remains relatively stable over time.

A particular case illustrates the point. Chart A shows the deutsche mark swap and government bond yield curves on September i, 1995. The spread between the two rates widens discernibly at five years, creating a swap window at that maturity. This opportunity existed for most of 1995, and resulted in an increase in the issuance of deutsche mark bonds relative to bonds in other currencies. The swap window was created by a reduction in the issuance of five-year bonds from German issuers. In particular, the German federal agency Treuhandanstall went out of existence at the end of 1994: this agency had been a major issuer of five-year deutsche mark obligations.

Chart A.Deutsche Mark Swap and German Government Bond Yield Curves, September 1, 1995

Source: Bloomberg Financial Markets.

Chart B.Bond Issuance and Interest Rates

(Left scale in percent a year; right scale in billions of U.S. dollars)

Source: Bloomberg Financial Markets: International Monetary Fund, International Financial Statistics; Organization for Economic Cooperation and Development, International Capital Markets Statistics, 1950-1995; and The WEFA Group.

The foregoing describes a swap window opening in a particular segment of the international bond market. It is also sometimes asserted that swap conditions can be more favorable in the entire market than at other times, and that this drives issuance. In particular, when interest rates are expected to rise, swap rates tend to be driven up relative to other interest rates, perhaps because the for ward interest rates underlying swap rates reflect changes in expectations of future short-term interest rates. If bond yields are not tied as closely to short-term interest rate expectations as swap rates are, swap rates rise relative to other rates and it becomes more attractive to issue fixed rate bonds. This might he the case because changes in future short-term interest rates operate through changes in bank liquidity, and would be likely to show up most directly in interbank rates such as swap rates. On the other hand, as general market interest rates rise, the cost of borrowing (swapped or not) rises, and borrowers are likely to issue less debt. The time series of bond issuance and interest rate movements in Chart B suggests that this latter effect dominates. In years with rising interest rates (such as 1994), issuance volumes have tended to fall. The converse has also been true: between 1991 and 1993 interest rates fell, while bond issuance expanded. The swap spread has been relatively constant over this period. Furthermore, the growth of the swaps market since the mid 1980s has made it easier for borrowers to issue in currencies and interest rates different from their preferred habitat and then to use swaps to tailor their risk according to their preferences. This has allowed the range of currencies of denomination of international bonds to widen.

Low interest rates, low inflation, and improved earnings prospects have been the driving forces behind the recent buoyancy in industrial country equity markets. However, these factors alone probably do not explain the dramatic performance of the U.S. equity market. After the Mexican crisis, U.S. investors repatriated much of their foreign investments, and increased their focus on domestic markets.20 The associated increase in liquidity in U.S. markets appears to be an additional factor that pushed U.S. equity prices higher in 1995. Later in the year, and especially in early 1996. inflows into U.S. mutual funds helped to sustain this increased liquidity in U.S. equity markets. Over the past two and a half years, an average of $38 billion a month has been added to U.S. bond and equity mutual funds.21 Monthly inflows fell to below S30 billion by the end of 1994. but subsequently rose steadily. Inflows reached $42.5 billion in December 1995, and then increased to a record of more than $59 billion in January 1996, $52.9 billion in February, and $54.5 billion in Match. These inflows during December-March represent increases of 47, 86, 83, and 58 percent, respectively, over the same months a year earlier.22 More than half of the net inflows during this period have been directed toward equity mutual funds.

Inflows into U.S.-based mutual funds in late 1995 and early 1996 also boosted equity markets in other countries, particularly developing countries. Net sales of international equity mutual funds totaled about $11 billion in January-February 1996, well in excess of the total net inflows during all of 1995, and well on track to challenge the record-setting $27 billion in 1994. The magnitude of the portfolio flows from the United States to other equity and bond markets, in tandem with the infrastructure that has been assembled for exporting capital from the United Stales, has been shaping the behavior of bond and equity markets around the world.23

The concern most often expressed in market commentaries about global equity markets is that the U.S. market may be poised for a sharp correction. These concerns are predicated on several observations. First, the pessimism over inflation that has caused U.S. interest rates to rise has not had nearly the same impact on the equity market. The year-to-date value of transactions on the New York Stock Exchange (NYSE) reached $l trillion on March 26, 1996: in 1995 that volume of trading was not reached until May 12. Turnover has increased to 450 million shares a day in 1996, compared with 350 million shares a day in 1995 and 300 million shares a day in 1994. Second, the January-April period has in the past tended to see the greatest inflows into mutual funds, suggesting that the provision of liquidity from this source may decline in the rest of 1996. Third, equity price volatility in the United States has increased steadily since September 1995 (Chan 21). The unexpectedly high nonfarm payroll numbers released on March 8. for example, pushed the Dow Jones index to record its third largest one-day fall (3 percent) in its 67-year history, coming close to triggering the 250-point circuit breaker that would have shut down trading for the first time since the rule was implemented following the 1987 stock market crash.

Although most objective indicators of market direction and volatility suggest some mounting pressures on prices relative to fundamentals, these pressures do not appear to be unusually large. First, price-earnings ratios have increased from about 16 to 19 for the Standard and Poor’s 500 (S&P500) index since the end of 1994. In comparison, between January 1987 and October 1987, the price-earnings ratio for the S&.P 500 index increased from about 16 to 22—twice as large an increase as has occurred since the end of 1994. In addition, the level of the price-earnings ratio at the end of 1994 was a low point following its decline from about 26 in early 1992. Second, the earnings yield on U.S. stocks does not appear to have diverged from the yield on long-term bonds (see Chart 10 and Table 3).

The earnings yield has tracked the bond yield fairly closely over the past ten years, with abvious divergence occurring in mid-1987. The long-term bond yield in the United States has fallen sharply since the end of 1994. while earnings growth for U.S. equities has been strong. These two observations may be interpreted as suggesting that the dramatic stock market rally was necessary to align earnings yields with long-term bond yields in the United States. Third, implied volatility calculated from at-the-money futures call options indicate that volatility in the U.S. equity market may increase. However, when compared either to the other major countries or to historical levels, this increase is not particularly large (Chart 22).

Indicators of market sentiment also do not point to any significant departures between prices and fundamentals. In futures markets, December 1996 delivery Of the S&P 500 index was selling at the end of May for about 1 percent more than the current spot price. Furthermore, the ratio of put options to call options on the S&P 500 index—an indicator of short-to-long position taking—has shown little trend since the end of 1994. It has been widely reported that short interest in U.S. equities has risen to record levels in early 1996, which is often interpreted as an indicator of pessimism.24 These reports are difficult to interpret, however. First, the number of shares outstanding has a positive growth rate, and thus there is a natural tendency for short interest to rise. Indeed, the growth in short interest on the NYSE since the start of 1995—the start of the bull market—has been well below that in 1994, for example. Second, measured as a percentage of shares outstanding, the rise in short interest has not been dramatic, increasing to 1.4 percent in February 1996, from 1.3 percent during the previous three months.

Volume of New Issues

In sharp contrast to the international bond and syndicated credit markets, issuance activity in the international equity market declined by 9 percent in 1995, to $41 billion (Table 10). Privatizations historically have accounted for a significant portion of new issuance in the international equity market, in part because privatizations often are large issues relative to domestic equity markets, and the marketing and listing of these issues in more than one financial center can produce higher revenues and higher secondary market liquidity. The particularly weak investor sentiment for privatizations in 1995 and in early 1996 is the main reason for the sluggish primary market for international equities. For example, European countries’ privatizations in 1995, which have in recent years accounted for more than three quarters of all privatizations, amounted to only $24 billion, less than half of the estimated amount at the start of the year.25 Privatizations are reported to have slowed to a greater extent outside of Europe. For example, the $59 billion privatization of Indonesia’s PT Telkom was cut by half in the fall of 1995 because of weak demand from U.S. investors.

Chart 21.RiskMetrics Daily Volatility for Stock Price Indices, January 19, 1995-May 31, 1996

(In percent)

Source: J.P. Morgan.

Chart 22.Implied Volatility: S&P 500, Nikkei 225, and DAX Indices

Source: Bloomberg Financial Markets.

Note: Implied volatility is a measure of the expected future volatility of the index based on market prices of the call options on futures on the index. The annualized percent rate of change plotted in the chart is a weighted average of the estimates of the implied volatility of call option futures.

Issuance activity in domestic equity markets in the major industrial countries has been mixed (Table 11). The sharp rise in U.S. equity prices helped to boost new issues in the U.S. markets by about 10 percent in 1995. but they remained below their levels in the early 1990s. Since early 1995, the most active segment of the U.S. market for new equity issues has been the market for initial public offerings from high-technology firms. More than 200 such firms went public in 1995. just under the record of 223 initial public offerings by high-technology companies in 1983.26 The sluggishness of the equity markets in the other major industrial countries is consistent with the less active new issue markets in these countries. In Japan, issuance activity by smaller companies on the over-the-counter (OTC) market—which is not included in the data in (see Chart 10 and Table 3).

Issuance activity in domestic equity markets in the major industrial countries has been mixed (Table 11—is reported to have been strong in 1995 and a substantial number of new issues in this market are expected in 1996. In Germany, equity issuance fell slightly in 1995, although 1994 was a strong year for new issues. The increased “equity habit” of investors and the shift by firms toward other sources of finance in Germany are important factors driving issuance activity. These same factors also figure prominently in explaining the high levels of new equity issues in Italy.

Table 10.International Equity Placements1(in millions of U.S. dollars)
19911992199319941995
United States5.06.99.94.66.2
Germany0.70.20.22.73.0
France1.71.73.73.83.2
Italy0.50.50.52.32.5
United Kingdom6.43.34.41.02.3
Canada0.30.20.50.62.1
Other8.810.721.529.921.7
Total23.423.540.744.941.0
Source: Organization For Economic Cooperation and Development, Financial Market Trends, February 1996

Euro-equities plus other international share placements.

Source: Organization For Economic Cooperation and Development, Financial Market Trends, February 1996

Euro-equities plus other international share placements.

Regulatory and Structural Developments in Securities Markets

Perhaps the most noteworthy structural developments in securities markets in the past year have taken place in the United Kingdom. The Alternative Investment Market (AIM) was established on June 19. 1995 by the London Stock Exchange (LSE) to encourage initial public offerings by small and developing firms.27 This market has a lower level of regulation than the “first-tier” market and is targeted at professional investors. By the end of 1995, there were 121 companies listed on the AIM. over two thirds of which were simply transferred from the LSE’s so-called Rule 4.2 market, which has been a trading facility for unlisted shares.

Table 11.Major Industrial Countries: Domestic Equity Issues1

(In millions of U.S. dollars)2

1986198719881989199019911992199319941995
United States61,80053,40039,90032,70026,00070,60084,500116,20066,30073,200
Japan314,88342,48665,891108,79643,11010,6454,57211,45713,9135,360
Germany7,5506,6154,28610,30017,3437,99311,03111,80217,96916,467
France419,89926,75626,28938,18340,97942,57446,55642,43248,19521,213
United Kingdom11,21725,91710,28711,3146,67118,77410,35024,42621,54811,211
Canada3, 512,43214,2266,31713,5066,62411,63612,04017,25912,9734,142
Total6127,779169,398152,969214,799140,727162,223169,1148223,576180,897131,592
Sources: Bank of Canada. Bank of Canada Review, various issues: International Monetary Fund. International Financial Statistics IIFS). and Organization for Economic Cooperation and Development. Financial Statistics Monthly, various issues.

Italy is not shown as consistent data for all years are not available

Local currency data are convened into U.S. dollars by using period average exchange rates from IFS (line rf).

First three quarters of data for 1995.

First two quarters of data for 1995

Contains both domestic and foreign equities.

The 1995 total is not comparable with totals for earlier years, since data are not available for the entire year for Canada, France, and Japan.

Sources: Bank of Canada. Bank of Canada Review, various issues: International Monetary Fund. International Financial Statistics IIFS). and Organization for Economic Cooperation and Development. Financial Statistics Monthly, various issues.

Italy is not shown as consistent data for all years are not available

Local currency data are convened into U.S. dollars by using period average exchange rates from IFS (line rf).

First three quarters of data for 1995.

First two quarters of data for 1995

Contains both domestic and foreign equities.

The 1995 total is not comparable with totals for earlier years, since data are not available for the entire year for Canada, France, and Japan.

A second development in the United Kingdom is the implementation of the new trading service, Tradepoint, which began operations on September 21, 1995. Tradepoint is in direct competition with the LSE. but is itself not an exchange. The important difference, however, is that Tradepoint, unlike the LSE, is not a market-maker system, but rather is an automated, screen-based, order-matching trading system for 400 stocks—400 more are planned to be added in 199ft—that are listed on the LSE and is available to institutional investors to trade directly with each other. To date, trading on Tradepoint has been negligible.

There has also been much discussion recently of reforming the trading mechanism on the LSE. which appears to be related in part to competitive pressures associated with single market initiatives in the European Union (for example, the Investment Services Directive). The discussion has involved the trade-off between transparency and liquidity, the way in which private information is reflected in market prices, and whether the market-making trading system on the LSE is less efficient than an automated order-matching system, which has been adopted in virtually all competing European centers. It was announced in March 1996 that an order-driven electronic system will be introduced by May 1997 for a subset of equities listed on the LSE.

Developments in the U.K. government bond market—the “gills market”—have possibly been more substantial than in the equity market. The reform package for the gilts market has three elements. The first reform to be implemented was the introduction in 1995 of a preannounced auction calendar and maturity schedule. The second reform, implemented on January 2. 1996. is open gilt repo trading, referred to as the “most significant liberalisation in the gilt market since Big Bang.28 This liberalization means that “there will be no official restrictions on anyone repoing, lending or borrowing gills for any purpose, either directly or indirectly through an intermediary.”29 Previously, gilt repos were available only to Gilt Edged Market Makers (GEMMs), the authorized dealers of U.K. government bonds. The objective of this reform is to facilitate the financing of gilt holdings, thus increasing the liquidity and efficiency of the gilt market and lowering the government’s cost of funds. The third element of the gill market reform is that all returns on gilts will be taxable—formerly, only interest was taxed. This reform is designed to open the door to the introduction of a strips market in early 1997, which will further enhance the efficiency of the U.K. government bond market.30

The United Kingdom’s efforts at developing an equity market that smaller firms can tap for financing is a reflection of a Europe-wide initiative to develop equity markets similar to the NASDAQ market in the United States. In early 1996, the Nouveau Marche began operating in France as a subsidiary of the Paris Bourse and targeted at smaller firms throughout Europe.31 In Italy, preliminary approval from regulatory bodies has recently been granted for Metim, a stock exchange for smaller Italian firms.

In Japan, a number of important steps have been taken in recent months following up on the pledges contained in the financial services agreement reached with the United States in January 1995. First, The domestic bond market has been further deregulated, which has eased considerably issuance criteria for Japanese firms and for foreign entities (in the Samurai market). On January 1, 1996, the Japanese Ministry of Finance lifted the last important restrictions on the domestic bond market, removing the restrictions that the issuer had to have an investment grade rating and also removing stringent covenant requirements. Issuers now need not have ratings to issue in the domestic bond market. These liberalization measures are expected to lead to a flood of issuance in the domestic market by emerging market borrowers.

A second major development in Japan was the announcement in January 1996 of the introduction of an asset-backed securities (ABS) market before the end of the fiscal year (the end of March 1996). ABS markets have been particularly successful in the United States in transferring assets from balance sheets of financial institutions and corporations to securities markets. Some market participants in Japan believe that an ABS market may facilitate the resolution of the banks’ bad loan problems, by allowing banks to repackage non-performing loans as asset-backed issues.32

On August 2, 1995, the Ministry of Finance announced measures to encourage overseas investments and loans by institutional investors as part of its efforts to stabilize the value of the yen. First, insurance companies were permitted to make foreign-currency-denominated loans.33 Second, the so-called 50 percent rule limiting the share that insurance companies could hold in yen-denominated syndicated loans was abolished. Third, the 90-day “lock-up” period before Japanese residents could purchase Euroyen bonds issued by nonresidents was removed. Fourth, the valuation methods for foreign bonds held by institutional investors was revised. U.S. Treasury bonds, which previously had to be valued at cost, can now be valued at either market value or cost—the same treatment accorded to Japanese government bonds. In addition, the so-called 15 percent rule, which previously required companies to mark to market their foreign currency assets when exchange rates moved by over 15 percent, was lifted and can now be applied at the discretion of individual companies. Finally, the regulation on foreign exchange positions imposed on authorized foreign exchange banks was eased to promote their investment in foreign-currency-denominated bonds.

It is not clear to what extent these restrictions were binding and what impact their liberalization has had on capital flows. Press reports, however, suggest that Japanese banks and other investors have stepped up their investment in Eurobonds following the casing of restrictions on bond purchases, but this may also reflect declines in Japanese interest rates. The removal of the 15 percent rule will likely imply smaller capital inflows to japan prior to the end of the fiscal year than has been the case in other years in which the exchange rate has moved by more than 15 percent.

An over-the-counter equity market for special rule issues was established in July 1995 in Japan to ease firms’ ability to raise capital. Companies reduced their minimum trading lots to make their stocks more attractive to retail investors. The ban on issuing commercial paper with maturities of two weeks or less was lifted in October 1995 to help firms procure short-term funds. As of January 1996. foreign companies that are more than three years old were able to apply for listings on the foreign section of the Tokyo Stock Exchange (previously, companies had to have been established for at least five years). In addition, nonrated issuers were permitted to issue unsecured straight bonds, convertible bonds, and bonds with equity warrants from January 1996; the lifting of this restriction expands the range of potential Samurai issuers, allowing borrowers such as Argentina. Brazil, Mexico, and Turkey to tap the Tokyo bond market.

In Germany the asset-backed market has also recently captured considerable attention. The market for pfandbriefe—bonds collateralized by mortgages or public sector loans—attracted international attention in 1995-96, Traditionally, the market has been domestically focused, but the increased appetite for deutsche mark-denominated securities along with efforts by German financial institutions to improve and internationalize the pfandbriefe market have resulted in a considerable increase in issuance activity in the market, and significant marketing to foreign investors. Issuance of pfandbriefe in 1995 reached a record DM 240 billion. About 70 percent of outstanding issues are backed by public sector loans, and the remaining 30 percent by mortgages. In early 1996, the first global pfandbriefe issue came to the market, with much of the issue sold to Asian and American investors.34

In May 1996, the United States Treasury announced plans to offer in flat ion-indexed bonds for the first time. Although the amounts and structure were not announced, the bonds are expected to have maturities between 10 and 30 years and to offer real returns of about 3 percent. Currently, the main issuers of inflation-indexed bonds are the United Kingdom ($57 billion, outstanding) and Israel ($25 billion, outstanding). Canada, Sweden, and Australia also issue indexed bonds. The appeal of indexed bonds is their potential to lower government borrowing costs, as they reduce the incentive of the government to levy an inflation tax. Indexed bonds are particularly attractive to risk-averse investors, such as pension funds, that are committed to making inflation-indexed payments. Furthermore, a secondary market for indexed-Iinked bonds can provide a reliable indicator of market expectations for inflation.

Derivatives Markets

Between the end of 1986 and the end of 1994, the total notional principal of outstanding exchange-traded derivative contracts—including interest rate futures and options, currency futures and options, and stock market index futures and options—grew at an annual average rate of 40 percent, from $0.6 trillion to $8.9 trillion (Table 12). In the same period, annual turnover rose from 3 15 million contracts to 1,142 million contracts (Table 13),

In 1995, the growth in exchange-traded derivatives markets slowed considerably, and there was a shift in product types toward simpler plain vanilla structures and away from more exotic option-related structures. The notional principal outstanding rose by less than 4 percent in 1995, and total global contract turnover on exchanges increased by only 6 percent over 1994. Contract turnover overstates the slowing of the growth of these markets, because of the high volume of activity on a newly reporting Brazilian exchange in which the notional amounts of contracts is substantially smaller than in the developed markets: measured in dollars of notional principal, turnover actually fell by more than 4 percent in 1995.

The reasons for these changes in the growth rate and product types are related. First, several major losses associated with highly leveraged derivative products—including those of Orange County, Proctor and Gamble, and Barings—caused many participants to shy away from derivatives, particularly from exotic, highly leveraged structures. The structured note market in the United States, for example, virtually collapsed in 1995, with most of the activity in this market accounted for by “simple” step-up notes with short maturities.35 Second, declining interest rates in several major industrial countries reduced the demand for interest rate hedging products, by far the largest segment of the derivative markets. The small rise in turnover of exchange-traded derivative contracts in 1995 was held back by a sharp drop in trading in interest rate futures and options, with a 12 percent contraction in turnover in this market segment in the fourth quarter alone. In fact, activity in interest rate derivatives was buoyed in Europe by political and economic uncertainty, but the slackening demand in the United States and elsewhere offset this.

Turnover data for early 1996 indicate that volumes have rebounded considerably in the major markets due to increased uncertainty surrounding EMU and interest rates. For example, in London, volumes on LIFFE increased by 89 percent in January 1996, by 22 percent in February, and then dropped back in March to the levels seen in January, Peak volumes on most of the major exchanges approached levels in February seen at their high in March 1994, following the global bond market correction.

Table 12.Markets for Selected Derivative Financial Instruments: Notional Principal Amounts Outstanding(In billions of U.S. dollars, end-year data)
1986198719881989199019911992199319941995
Interest rate futures370.0487.7895.41.200.81,454.52,156.72.913.04.942 65.757.45,863.3
Futures on short-term interest rate instruments274.3338.9721.71,002.61,271.11,906,32,663.74,632.85,422.35,475,2
Three-month Eurodollar 1229.5307.8588.8671.9662.61,100.51,389.62,178.72,468.62,451.7
Three-month Euroyen2109.5243.5254.5431.81.080.11,467.41.400.7
Three-month Euro-deutsche mark314.447.7110.0229.2421.9425.7654.6
Futures on long-term interest rate instruments95.7148.8173.7198.2183.4250.4249.3325.9355.3388.1
U.S. Treasury bond423.026.539.933.223.029.831.332.636.139.9
Notional French government bond52.17.67.06.17.011.421.012.612.712.4
Ten-year Japanese government bond663.5104.8106.7129.5112.9122.1106.1135.9164.3178.8
German government bond71.44.213.720.227.833.341.756.7
Interest rate options8146.5122.6279.2387.9399.51,072.61,385.42,362.52,623.52,741.6
Currency futures10.214.612.116.017.018.326.534.740.137.9
Currency options839.259.548.050.256.562.971.175.655.643.2
Stock market index futures14.517.827.141.369.176.079.8110.0127.3172.2
Stock market index options837.827.742.970.793.7132.8158.6229.7238.3326.9
Total618.3729.91,304.81,766.92.290.43,519.34,634.47,771.18,862.59,185.3
North America518.1578.1951.71,155.81,268.52,151.72,694.74,358.64,819.54,847.2
Europe13.113.3177.7251.0461.2710.11.114.31,777.91,831.72,241,3
Asia-Pacific87.0138.5175.4360.0560.5657.0823.51,606.02,171.81,990 1
Other0.10.20.51.828.739.5106.7
Source: Bank for International Settlements

Traded on the Chicago Mercantile Exchange-International Monetary Market (CME-lMM; Singapore International Monetary Exchange (S1MFX). London International Financial Futures Exchange (LIFFE). Tokyo International Financial Futures Exchange (TIFFE). and Sydney Futures Exchange (SFE).

Traded on the TIFFE and S1MEX.

Traded on the Marche a Terme International de France (MATIF) and LIFFE.

Traded on the Chicago Board of Trade (CBOT). LIFFE, Mid-America Commodity Exchange (MIDAM), New York Futures Exchange (NYFF) and Tokyo Stock Exchange (TSE),

Traded on the MATIF.

Traded on the TSE, LIFFE, and CBOT.

Traded on the LIFFE and the Deutsche Terminborse (DTB).

Calls plus puts.

Source: Bank for International Settlements

Traded on the Chicago Mercantile Exchange-International Monetary Market (CME-lMM; Singapore International Monetary Exchange (S1MFX). London International Financial Futures Exchange (LIFFE). Tokyo International Financial Futures Exchange (TIFFE). and Sydney Futures Exchange (SFE).

Traded on the TIFFE and S1MEX.

Traded on the Marche a Terme International de France (MATIF) and LIFFE.

Traded on the Chicago Board of Trade (CBOT). LIFFE, Mid-America Commodity Exchange (MIDAM), New York Futures Exchange (NYFF) and Tokyo Stock Exchange (TSE),

Traded on the MATIF.

Traded on the TSE, LIFFE, and CBOT.

Traded on the LIFFE and the Deutsche Terminborse (DTB).

Calls plus puts.

OTC derivative markets continued to expand at a brisk pace in 1995 in comparison to the exchanges (Tables 14 and 15). The members of the International Swaps and Derivatives Association (ISDA) report that the notional principal of outstanding interest rate and currency swaps increased from $1.0 trillion at the end of 1987 to $15.2 trillion by the end of 1995. In addition, the total notional principal of OTC interest rate options—caps, collars, floors, and swaptions—-increased from $0.6 trillion at the end of 1990 to $3.7 trillion by the end of 1995. In total, the notional principal of outstanding OTC derivatives (as measured by the reports of the members of ISDA) at the end of 1995 was $18,9 trillion.

Because OTC markets are highly decentralized, the available information on the size of the global OTC derivative markets is limited. The information reported by the members of ISDA, for example, does not include transactions by nonmembers of ISDA, and it includes only interest rate and currency swaps as well as interest rate options, and so only provides a limited picture of the global OTC derivatives market.

In April 1995. the BIS coordinated the first ever survey by central banks in 26 countries of OTC and exchange-traded derivatives markets. This survey provides the most comprehensive accounting of the markets to date, capturing about 90 percent of the intermediaries active in the derivatives markets.36 The survey includes swaps, forwards, and options for currencies, interest rates, equities, and commodities. Moreover, the BIS survey includes many derivative positions that are not recorded in the ISDA survey, not only because the BIS survey captures more market participants and instruments but also because it reports many arm’s-length derivative contracts that are netted out in the ISDA sur-vey.37 The motivation for including these contracts in the BIS survey is that the survey is intended to measure the market size in contrast to the ISDA survey, which is concerned primarily with net risk exposures. The BIS survey is, therefore, a much better indicator of market size.

Table 13.Annual Turnover in Derivative Financial Instruments Traded on Organized Exchanges Worldwide(In millions of contracts traded)
1986198719881989199019911992199319941995
Interest rate futures91.0145.7156.3201.0219.1230.9330.1427.1627.8561.0
Futures on short-term interest rate instruments16.329.433.770.276.087 3144.9180.0282.4266.5
Three-month Eurodollar112.423.725.246.839.441.766.970.2113.6104.2
Three-month Euroyen24.715.216.217.426.944.242.9
Three month Euro-deutsche mark31.63.14.812.221.429.525.7
Futures on long-term interest rate instruments74.7116.3122.6130.8143.1143.6185.2247.1140.1294.5
U.S. Treasury bond454.669.473.872.878.269.971.780.7101.587.8
Notional French government bond51.111.912.415.016.021.131.136.850.233.6
Ten-year Japanese government bond69.418.418.919.116.412.912.115.614.115.2
German government bond70.35.39.612.418.927.751.244 8
Interest rate options822.329.330.539.552.050.864.882.9116.7225.5
Currency futures19.921.222.528.229.730.031.339.069.798.3
Currency options813.018.318.220.718.922.923.423.821.323.2
Stock market index futures28.436.129.630.139.454.652.071.2108.8114.8
Stock market index options8140.4139.179.1101.7119.1121.4133.9144.1197.3187.3
Total315.0389.6336.2421.2478.3510.5635.6788.111,142.21,210.1
North America288.7318.3252.2287.9312.3302.7341.4382.3513.5455.0
Europe10.335.940.764.483.0110.5185.0263.5397.3353.3
Asia-Pacific14.430.034.463.679.185.882.898.4131.9126.5
Other1.65.58.95.33.911.626.343.799.4275.4
Source: Bank for International Settlements

Traded on the Chicago Mercantile Exchange-International Monetary Market (CME-IMM) Singapore International Monetary Exchange (S1MFX). London International Financial Futures Exchange (LIFFE). Tokyo International Financial Futures Exchange (TIFFE). and Sydney Futures Exchange (SFE).

Traded on the TIFFE and S1MEX.

Traded on the Marche a Terme International de France (MATIF) and LIFFE.

Traded on the Chicago Board of Trade (CBOT). LIFFE, Mid-America Commodity Exchange (MIDAM), New York Futures Exchange (NYFF) and Tokyo Stock Exchange (TSE),

Traded on the MATIF.

Traded on the TSE, LIFFE, and CBOT.

Traded on the LIFFE and the Deutsche Terminborse (DTB).

Calls plus puts.

Source: Bank for International Settlements

Traded on the Chicago Mercantile Exchange-International Monetary Market (CME-IMM) Singapore International Monetary Exchange (S1MFX). London International Financial Futures Exchange (LIFFE). Tokyo International Financial Futures Exchange (TIFFE). and Sydney Futures Exchange (SFE).

Traded on the TIFFE and S1MEX.

Traded on the Marche a Terme International de France (MATIF) and LIFFE.

Traded on the Chicago Board of Trade (CBOT). LIFFE, Mid-America Commodity Exchange (MIDAM), New York Futures Exchange (NYFF) and Tokyo Stock Exchange (TSE),

Traded on the MATIF.

Traded on the TSE, LIFFE, and CBOT.

Traded on the LIFFE and the Deutsche Terminborse (DTB).

Calls plus puts.

The findings of the survey are striking. The estimated notional value of outstanding OTC foreign exchange, interest rate, equity, and commodity derivative contracts totaled $47.5 trillion (after adjusting for double counting and including estimated gaps in reporting) at the end of March 1995 (Table 16). About 98 percent of this total is accounted for by interest rate ($28.85 trillion) and currency derivatives ($17.7 trillion). The outstanding interest rate and currency swaps and options reported by ISDA dealers was $13.9 trillion in mid-1995, which captures just over a quarter of the global OTC derivative market.38

Table 14.Notional Principal Value of Outstanding Interest Rate and Currency Swaps1(In billions of U.S. dollars)
198719881989199019911992199319941995
Interest rate swaps
All counterparties682.91,010.21,502 62,311.53,065.13,850.86,177.38,815.612,810.7
Interbank (ISDA member)206.6341.3547. 1909.51,342.31,880.82,967.94,533.9
Other (end-user and brokered)476.2668.9955.51.402.01,722.81.970.13,209.44,281.7
End-user476.2668.9955.51.402.01,722.81.970.13.209.44.281.7
Financial institutions300.0421.3579.2817.1985.71,061.11.715.72,144.4
Governments247.663.276.21,36.9165.5242.8327.1307.6
Corporations 3128.6168.9295.2447.9571.7666.21,166.61,829.8
Unallocated15.54.9
Brokered
Currency swaps
All counterparties365.6639.1898.21,155.11,614.31,720.71,799.21,829.72,394.8
(Adjusted for reporting of both sides)(182.8)(319.6)(449.1)(577.5)(807.2)(860.4)(899.6)(914.8)(1,197.4)
Interbank (ISDA member)71.0165.2230.1310.1449.8477.7437.0422.5
Other (end-user and brokered)294.6473.9668.1844.91,164.61.243.11.362.21.407.2
End-user4147.3237.0334.1422.5582.3621.5681.1703.6
Financial institutions61.9102.7141.7148.2246.7228.7221.9227.1
Governments233.954.065.683.296.9110.6135.8122.1
Corporations351.676.5116.5191.1238.7282.2323.4354.4
Unallocated3.810.3
Brokered
Total (interest rate and currency swaps for all counterparties)1,048.51,649.32,4011.83,466.64,679.45,571.57,976.510,645.315,2115.5
Sources: Bank for International Settlements and International Swaps and Derivatives Association, Inc. (ISDA)

As of end of December.

Including international institutions.

Including others.

Adjusted for double counting as each currency swap involves two currencies

Sources: Bank for International Settlements and International Swaps and Derivatives Association, Inc. (ISDA)

As of end of December.

Including international institutions.

Including others.

Adjusted for double counting as each currency swap involves two currencies

The replacement value of the estimated $47.5 trillion in contracts was about $2.2 trillion, or 5 percent, which provides a better perspective of the actual credit exposure of dealers in these markets. The credit exposure is even lower than these numbers suggest because of netting arrangements between dealers and the value of collateral.39 For example, for ISDA members, at the end of 1994 netting reduced the replacement value by 55 percent, and collateral reduced it by about another 4 percent of the original replacement costs.

After eliminating double counting, the BIS estimates total average daily turnover of interest rate and currency contracts at $880 billion in April 1995. about three quarters of which was accounted for by foreign exchange forward and swap transactions. About two thirds of transactions involved counterparties in different countries, which points to the globalization of the derivative markets.

In addition to OTC derivatives, intermediaries that were involved in the survey coordinated by the BIS reported that they held a further $16.6 trillion in notional principal of exchange-traded derivatives. This suggests a large scale of involvement by intermediaries in both OTC and exchange-traded derivatives markets, related to the motives that dealers in OTC markets have to lay off their net risk in exchange-traded markets. In aggregate, therefore, respondents to this survey revealed that they were involved in transactions representing more than twice the world GDP.

Underlying this rapid growth in derivative markets has been the increasing trend toward the globalization of derivative activities. It has been found that 55 percent of all outstanding OTC interest rate and currency derivatives has involved counterparties in different countries.40 At the end of 1987, interest rate swaps denominated in currencies other than the U.S. dollar represented about 21 percent of all interest rate swaps; by mid-1992, this share had expanded to more than 60 percent, and has been above 50 percent since then (Table 17). Associated with the volatility in the yen-dollar market in early 1995, yen-denominated interest rate and currency swaps outstanding increased by almost 50 percent in the first half of 1995.

The globalization of derivative markets is reflected also in the increasing interconnection among derivatives markets around the world. The proliferation of after-hours trading and cross-listing of products has moved the markets closer to becoming a 24-hour, global derivatives market.41 Derivatives products listed in a variety of other industrial countries (for example, Italy and Germany) are becoming directly tradable from the United Stales. Similarly, the Investment Services Directive, which came into force on January I, 1996 in the 15 European Union member countries, increases the scope for cross-border securities trading by, for example, requiring regulators to allow trading screens for one member country’s market to be placed in any other European Union country. This legislation is likely to have profound effects on the trading of all securities in the European Union, possibly leading to a single electronic trading system for all products offered in the member states.

Table 15.New Interest Rate and Currency Swaps1(In billions of U.S. dollars)
19871988198919901991199219931994
1st2nd1st2nd1st2nd1st2nd1st2nd1st2ndlst2nd1st2nd
halfhalfhalfhalfhalfhalfhalfhalfhalfhalfhalfhalfhalfhalfhalfhalf
Interest rate swaps
All counterparties181.5206.3250.5317,6389.2444.4561.5702.8762.1859.71,318.31,504.31,938.52,166.33,182.93,058.0
Interbank (ISDA member)58.967.086.6106.5140.4177.6223.2261.3335.4426.4617.7718.7959.21,044.81,622.21,577.3
Other (end-user and brokered)122.0139.3163.9211.1248.7266.8338.2441.5426.8433.3700,6785.6979.31,121.51,560.71,480.7
End-user121.0136.0162.3209.1242.8260.6334.5370.8419.2425.5681.0755.7922.91,077.71,481.71,480.7
Financial institutions82.386.4102.8135.3152.9165.0200.2219.9229.3263.1404.6449.3518.1597.7780.0852.5
Governments210.910.815.717.223.016.633.741.043.435.564.984.0107.790.8114.564.3
Corporations327.814.843.954.360.579.0100.6110.0116.4126.9211.5222.4288.8389.2587.0563.9
Unallocated4.12.36.58.30.1
Brokered1.63.31.61.95 96.23.770.77.67.719.629.956.543.879.0
Currency swaps
All counterparties87.185.7122.3126.2166.7189.6189.3236.2322.6334 1312.1291.6113.6276.7362.1396,6
(Adjusted for reporting of both sides)(43.5)(42.8)(61.1)(63.1)(83.4)(94.8)(94.6)1118.1)(161.3)(167.1)(156.1)(145.8)(156.8)(138.4)(181.0)(198.3)
Interbank (ISDA member)1 7 518.325.433.350.850.553.069.6105.9102.068.364.261.349.679.882.4
Other (end-user and brokered)69.567.496.992.9115.9139.1136.3166.6216.7232.1243.9227.4252.3227.2282.2314.1
End-user434.333.547.546.457.569.667.783.0103 1116.0121.6113.1126.0112.9139.6157.1
Financial institutions18.913.023.320.222.429.822.828.641.157.440.938.039.337.949.358.3
Governments27.66.310.68.713.29.812.510.913.717.123.618.530.821.827.626.7
Corporations37.913.612.910.218.527.732.443.548.241.557.156.655.953.162.672.1
Unallocated0.60.71.33.52.20.10.1
Brokered0.90.31.90.21.00.90.710.70.10.71.20.31.33.0
Total (interest rate and
currency swaps for all
counter parties)268.6292.0372.8443.8555.9633.9750.8939.01,084.71,193.81,630.41,795.92,252.12,443.03,545.03,454.6
Sources: Bank for International Settlements and Internalional Swaps and Derivatives Association, inc. (ISDA)

During the respective half of the year.

Including international institutions.

Including others.

Adjusted for double counting as each currency swap involves two currencies.

Sources: Bank for International Settlements and Internalional Swaps and Derivatives Association, inc. (ISDA)

During the respective half of the year.

Including international institutions.

Including others.

Adjusted for double counting as each currency swap involves two currencies.

Table 16.Global Notional Amounts of Derivative Contracts Outstanding by Underlying Market Risk Factor, End-March 1995(In millions of U.S. dollars)
Over-the-Counter Contracts1Exchange-Traded Contracts2
Market Risk FactorNotional amountsPercent shareNotional amountsPercent share
Foreign exchange313,095100120100
U.S. dollar-deutsche mark2.102164941
U.S. dollar-Japanese yen3.565273731
U.S. dollar-currencies other than deutsche mark and Japanese yen5,072392924
Deutsche mark-Japanese yen2232
Deutsche mark-currencies other than U.S. dollar and Japanese yen972732
Japanese yen-currencies other than U.S. dollar and deutsche mark4243
All other pairs of currencies737611
Single currency interest rates26,64510015,669100
U.S. dollar9,307357,70249
Deutsche mark3,376131,54810
Japanese yen5,562213,74824
Other8,400312,67117
Equity and stock indices579100442100
U.S.1232113130
Japanese1001716638
European2784810524
Other7413399
Commodities318100142100
Of which:
Gold4147463424
Memorandum items:
Estimated gaps in reporting5
Foreign exchange4,605
Interest rates2,205
Equity and stock indices51
Commodities32
Estimated global amounts outstanding
Foreign exchange17,700
Interest rates28,850
Equity and stock indices630
Commodities350
Sources: Bank for International Settlements, “Central Bank Survey of Derivatives Market Activity: Release of Preliminary Global Totals.” Press Communique, December 18. 1995; Bank For International Settlements. Central Bank Survey of Foreign Exchange and Derivatives Market Activity. 1995 [Basle: Bank for International Settlements, May 1996); and IMF staff estimates

Adjusted for local and cross-border double counting, except data for gold commodities, which are available only on an unadjusted basis.

The data refer to exchange-traded transactions reported by survey participants in the reporting countries, and not to the notional amounts outstanding of all contracts traded on exchanges in the reporting countries. The data are not adjusted for double counting and are not directly comparable with outstandings reported by exchange-traded market organizations.

Data on notional amounts outstanding of over-the-counter contracts are incomplete because they do not include outstanding forwards and foreign exchange swaps positions of market participants in the United Kingdom. The percentage shares have been calculated on data that exclude figures for currency swaps and options reported by dealers in the United Kingdom.

The percentage share of gold has been calculated on a comparable basis, that is, without adjustment for double counting.

Estimates have been prepared for less than full coverage of derivatives market activity in the reporting countries. They include estimates for missing data on outright forwards and foreign exchange swaps, which were not collected from survey participants in the United Kingdom.

Sources: Bank for International Settlements, “Central Bank Survey of Derivatives Market Activity: Release of Preliminary Global Totals.” Press Communique, December 18. 1995; Bank For International Settlements. Central Bank Survey of Foreign Exchange and Derivatives Market Activity. 1995 [Basle: Bank for International Settlements, May 1996); and IMF staff estimates

Adjusted for local and cross-border double counting, except data for gold commodities, which are available only on an unadjusted basis.

The data refer to exchange-traded transactions reported by survey participants in the reporting countries, and not to the notional amounts outstanding of all contracts traded on exchanges in the reporting countries. The data are not adjusted for double counting and are not directly comparable with outstandings reported by exchange-traded market organizations.

Data on notional amounts outstanding of over-the-counter contracts are incomplete because they do not include outstanding forwards and foreign exchange swaps positions of market participants in the United Kingdom. The percentage shares have been calculated on data that exclude figures for currency swaps and options reported by dealers in the United Kingdom.

The percentage share of gold has been calculated on a comparable basis, that is, without adjustment for double counting.

Estimates have been prepared for less than full coverage of derivatives market activity in the reporting countries. They include estimates for missing data on outright forwards and foreign exchange swaps, which were not collected from survey participants in the United Kingdom.

Table 17.Currency Composition of Notional Principal Value of Outstanding Interest Rate and Currency Swaps(In billions of U.S. dollars)
198719881989199019911992199319941995
Interest rate swaps
All counterparties682.91,010.21,502.62,311.53,065.13,850.86.177.38,815.612,810.7
U.S. dollar541.5728.2993.71.272.71,506.01,760.22,457.03,230.14,371.7
Japanese yen40.578.5128.0231.9478.9706.01,247.41,987.42.895,9
Deutsche mark31.656.584.6193.4263.4344.4629.7911.71,436.9
Pound sterling29.752.3100.4242.1253.5294.8437.1674.0853.9
Other39.594.8195.8371.5563.3745.41,406.12,012.43,252.3
Interbank (ISDA member)206.6341.3547.1909.51,342.31,880.82,967.94,533.9
U.S. dollar161.6243.9371.1192.8675.0853,91,008.41,459.8
Japanese yen19.543.061.1126.1264.9441,3820.81,344.8
Deutsche mark7.917.232.678.4111.2175.6356.1514.5
Pound sterling10.417.640.0100.1106.3137.2215.2315.4
Other7.119.642.2112.1184,9272.8567.4899.4
End-user476.2668.9955.51.402.01.722.81,970.13,209.44,281.7
U.S. dollar379.9484.3622.6779.9831.0906.31.448.61,770.3
Japanese yen21.035.566.9105.8214.0264.7426.7642.5
Deutsche mark23.729.352.0115.0152.2168.8273.7397.1
Pound sterling19.334.760.4142.0147.3157.6222.0358.7
Other32.475.2153.6259.4378.3472.7838.41,113.1
Currency swaps1
All counterparties182.8319.6449.1577.5807.2860.4899.6914.81,187.4
U.S. dollar81.3134.7177.1214.2292.2309.0320 1321.6418.9
Japanese yen29 965.5100.6122.4180.1154.3158.8170.0200.0
Deutsche mark10.71 7.026.936.247.653.469.777,0119.0
Pound sterling5.38.916.724.537.440.144.243.045.7
Other55.793.5127.8180.3250.0303.7306.9303.4403.8
Interbank (ISDA member)35.582.6115.1155.1224.9238.9218.5211.3
U.S. dollar16.734.148.259.786.890.982.380.4
Japanese yen7.218.628.337.460.953.953.349.3
Deutsche mark1,63.05.47.69.412.612.912.0
Pound sterling1.11.64.36.28.410.47.16.5
Other9.025.428.844.159.571.163.063.1
End-user147.3237.0334.1422.5582.3621.6681.1703.6
U.S. dollar64.6100.7128.9154.5205.3218.2237.7241.2
Japanese yen22.747.072.285.0119.2100.4105.6120.6
Deutsche mark9.114.021.528.538.240.856.965.0
Pound sterling4.27.312.418.329.129 737.036.6
Other46.768.199.0136.2190.6232.6244.0240.4
Sources: Bank for International Settlements and International Swaps and Derivatives Association. Inc. (ISDA)

Adjusted for double counting as each currency swap involves two currencies.

Sources: Bank for International Settlements and International Swaps and Derivatives Association. Inc. (ISDA)

Adjusted for double counting as each currency swap involves two currencies.

Further, market participants report that the largest future growth area for derivatives is in the emerging markets, particularly. Southeast Asia, as government restrictions on foreign exchange transactions and stock ownership are eased. This emphasis on the emerging markets has resulted in a number of cooperative agreements. Examples include the listing of currency options from the Philadelphia Exchange on the Hong Kong Futures Exchange; agreements for cross-listing of products by LIFFE in London with derivatives exchanges in Singapore in addition to Tokyo and Chicago; and recently announced plans by the CBOT to set up derivatives exchanges in Poland, Brazil, and Argentina. In addition, in some countries where derivatives markets have not yet developed, it is becoming increasingly possible to find derivative contracts for these countries in other markets. For example, the CME introduced futures and options on the Mexican peso in April 1995, on the Brazilian real in November 1995, and on Brady bonds in March 1996, as part of a larger venture to launch a new division devoted to emerging markets. This division plans to trade futures and options on Mexican, Brazilian, and Argentine stock indices, currencies, and

Brady bonds. The Chicago Board Options Exchange (CBOE) introduced in 1995 a cash-setlled European style option on the Latin 15 index, which provides exposure to the stocks of Argeniine, Brazilian. Chilean, and Mexican companies.

Banking Systems and Loan Markets

Loan Activity in the International Markets

Announced syndicated loans in the international markets jumped to a record level of S320 billion in 1995 (Table 18). an increase of 27 percent over 1994 and 45 percent over 1993. Data for the first quarter of 1996 indicate that syndicated lending has continued to rise even further. The activity in 1995 was stimulated in large measure by the rush to lock in funding rates that were in some cases at their lowest since the mid-1980s. Moreover, syndicated lending expanded much more rapidly than international bond issues, reflecting the very slim margins and high degree of liquidity of the international banking market, as well as the narrow level of interest rate swap spreads, which caused a shift from fixed-rate funding—bond markets—toward floating rate funding—chiefly bank loans. In addition, in some important respects syndicated loans are a more flexible source of funds than bonds: they can often be repaid prior to maturity without penalty and can usually be arranged more quickly. A large proportion of the funding requirements in the international syndicated credit market are refinancings, backup facilities, and financing related to mergers and acquisitions. The share of lending allocated to borrowers in industrial countries remained essentially unchanged at around 79 percent of lending in 1995.

Table 18.Announced International Syndicated Credit Facilities by Nationality of Borrower(In billions of U.S. dollars)
19951996
1992199319941995Q1Q2Q3Q4Q1
All countries221.4220.9252.0320.282.876.472.388.898.9
Industrial countries165.2168.3199.4251.670.951.256.972.679.6
Of which:
United States91.388.172.177.712.15.435.125.149.3
Japan1.51.51.30.70.50.2
Germany2.12.91.413.00.1124.57.33.5
France5.56.06.212.73.83.03.32.60.7
Italy5.42.83.715.210.32.90.91.10.8
United Kingdom25,517.034.258.812.913.18.224.610.2
Canada3.59.416.011.99.12.30.50.4
Developing countries48.241,638.250.99.019.110.812.014.4
Offshore centers16.19.814.317.42.95.94.54.15.0
Source: Bank for International Settlements

The Bahamas, Bahrain, Bermuda, the Cayman Islands, Hong Kong, the Netherlands Antilles, and Singapore.

Source: Bank for International Settlements

The Bahamas, Bahrain, Bermuda, the Cayman Islands, Hong Kong, the Netherlands Antilles, and Singapore.

Table 19.Spreads on Eurocredits1(in basis points)
1995
19911992199319941995Q1Q2Q3Q4
OECD countries808678594335374849
Non-OECD countries788510110710711111810498
Average spread798581645046455654
Source: Organization for Economic Cooperation and Development (OECD)

Weighted average of spreads applied to Eurocredits signed during the period. Tax-sparing loans as well as facilities classified under “other debt facilities” are excluded.

Source: Organization for Economic Cooperation and Development (OECD)

Weighted average of spreads applied to Eurocredits signed during the period. Tax-sparing loans as well as facilities classified under “other debt facilities” are excluded.

Table 20.Profitability of Banks in Selected Industrial Countries(Pretax profits as percent of overtime assets)
1985198919901991199219931994
United States0.910.770.700.771.331.751.74
Large banks6.840.450.540.541.241.741.65
Japan0.430.46160.320.260.180.11
Large banks0.430.460.330.300.210.130.02
Germany0.830.700.630.580.470.550.54
Large banks1.050.920.830.750.700.570.58
France0.260.210.250.06-0.03-0.18
Large banks0.540.380.350.210.130.05
Italy1.171.161.160.910.970.47
United Kingdom1,090.180.700.400.310.761.15
Canada0.780.701.221.170.530.771.85
Spain0.721.581.531.561.110.01`0.68
Netherlands10.740.640.500.510.530.600.61
Switzerland
Large banks0.730.680.530.610.600.720,55
Sweden0.340.470.222.840.250.150.98
Denmark23.720.28-0.27-0.01-1.200.620.00
Norway0.540.17-1.03-4.56-1.260.521,29
Finland0.540.340.47-1.081-1.73-1.17
Source: Organization for Economic Cooperation and Development (1996)

All banks.

Commercial and savings banks.

Source: Organization for Economic Cooperation and Development (1996)

All banks.

Commercial and savings banks.

Concern about the narrow level of interest rate spreads in the international syndicated loan market continues. The available data on loan spreads seem to suggest some rebounding in spreads since the third quarter of 1995 (Table 19). However, the funding of a number of large mergers and acquisitions, which normally carry higher spreads, may have inflated the average spreads. Other data suggest that spreads may have continued to narrow as recently as December 1995. Moreover, continued intense competition in the U.S. domestic market, which has created new price points in the past year or more, continues to spill over into the international markets, and many high-quality borrowers are obtaining funds at razor-thin spreads. Regardless of the pattern of margins, however, competitive pressures in the international syndicated loan market have resulted in a marked weakening of covenants, so the information content of average spreads may be limited. Indeed, competition through relaxing loan covenants could potentially be much more dangerous than price competition.42

Recent Developments in Industrial Country Banking

The condition of banking systems in the major industrial countries in 1995 differed greatly between those countries that had emerged strongly and early from the recession of the early 1990s (Canada, the United Kingdom, and the United States) and those countries in which growth had remained relatively weak (France, Italy, Germany, and Japan). The deterioration in credit quality during the cyclical downturn earlier in the decade, and the asset-price detlation that was associated with it, continued to be reflected in bank balance sheets, in the decline in profits (Table 20), and in the rising provisions (Table 21) in this second group of countries. These differences in performance are reflected in bank ratings (Table 22 and Box 3). Since the beginning of 1995, long-term credit ratings for banks in the United Kingdom and the United States have improved markedly, while those of banks in France, Italy, and Japan have deteriorated, and those of banks in Canada and Germany have remained stable.

The collapse in commercial real estate prices has played a key role in recent banking difficulties in industrial countries. Chart 23 shows the evolution of price indices for property-related equities in Europe and North America since the middle of 1995, These data indicate that property markets came under pressure in Europe in August 1995 and, despite a temporary resurgence in January 1996, have remained subdued, while in North America, prospects for real estate have improved steadily since late November 1995. In Tokyo, while occupancy rates have improved since mid-1994, rental rates have continued to decline (Chart 24).

For the banks in the United Kingdom, Canada, and the United States, the improvement in asset quality has allowed them to reduce their provisioning out of current income, providing the main source of net income growth. Coincident with the declining provisions, however, has been the continued narrowing of net interest margins in recent years in these countries. 43 An alternative, but not necessarily superior, measure of the return to lending is the spread between a typical interest rate on loans and a typical deposit rate. In 1995. Canadian banks’ intermediation spreads, already relatively low, declined further, while those of the U.K. and U.S. markets widened slightly (Chart 25).44 For the banks in France, Italy, and Japan, the continuing weakness in the economy and in property values resulted in an increase in non-performing loans and therefore in provisioning. As elsewhere, net interest margins in these three countries have been declining steadily since 1992. Moreover, the intermediation spreads in Chart 25 show how severe the decline has been in spreads in France since mid-1993.

Table 21.Provisions of Banks in Selected Industrial Countries1(Net provisions as percent of net operating income)
1985198919901991199219931994
United States43.1556.1857.9757.4037.0721.2214.06
Large banks44.7474.2366.3269.1242.7723.8115.15
Japan3.998.717.2818.3933.9843.0962.21
Large banks3.119.878.3823.0743.9353.4793.19
Germany36.2037.4145.5044.4959.3155.9248.68
Large banks23.7318.8036.7033.3547.5559.1648.83
France66.0468.0265.9890.47105.67177.68
Large banks49.7058.2363.0276.4084.2791.11
Italy27.8230.6425.4334.8141.0566.12
United Kingdom33.7289.7757.3776.6280.2053.5222.51
Canada44.0762.3822.7831.4467.3850.5221.54
Spain53.8526.5627.9430.5837.2999.5252.95
Netherlands232.8936.8138.2535.8735.9033.4731.44
Switzerland
Large banks41.3041.9745.4157.5162.9963.4260.31
Sweden70.5064.8664.79594.28114.75125.8827.84
Denmark320.7275.91129.03100.63305.2373.2199.54
Norway54.1790.31209.816,712.0181.4276.569.43
Finland51.8541.1629.060.950.60-0.224.10
Source: Organization for Economic Cooperation and Development (1996)

Net provisions generally include, in part or in full, charges for value adjustment in respect of loans, credits, and securities. book gains from such adjustments, losses on loans, and transfers to and from reserves for possible losses on such assets. Consequently, net provisions can be negative. as was the case in Finland (1991. 1992. and 19941 and Sweden (1991-94). The ratio to operating profit was, nevertheless, positive in all of these cases but one because operating profit was also negative in those years.

All banks.

Commercial and savings banks.

Source: Organization for Economic Cooperation and Development (1996)

Net provisions generally include, in part or in full, charges for value adjustment in respect of loans, credits, and securities. book gains from such adjustments, losses on loans, and transfers to and from reserves for possible losses on such assets. Consequently, net provisions can be negative. as was the case in Finland (1991. 1992. and 19941 and Sweden (1991-94). The ratio to operating profit was, nevertheless, positive in all of these cases but one because operating profit was also negative in those years.

All banks.

Commercial and savings banks.

Canada, United Kingdom, and United States

Net profits in the Canadian banking industry increased by 18 percent in the fiscal year ended October 1995, mainly because of lower loan loss provisions.45 Slow loan growth, combined with narrower intermediation spreads, resulted in a decline in net income from lending, but income from securities activities rose 35 percent to compensate for this decline in traditional banking income. Continuing a six-year trend, net interest margins narrowed to 2.7 percent, from 3.0 percent during the previous fiscal year. Asset quality continued to improve, with the ratio of gross nonaccrual loans to total loans falling to 1.1 percent at the end of the fiscal year, from 1.6 percent in 1994 and the peak of 3.2 percent in 1992. Banks have steadily reduced their exposure to commercial real estate, but the remaining exposure is an important source of concern; as a result, some of the banks have accelerated workouts or sales of real estate loans. With improving asset quality, banks reduced their provisions by 27 percent over the previous fiscal year, which provided the main source of income growth. Tier 1 capital rose from 6.8 percent at the end of 1994 to 7.0 percent of risk-weighted assets at the end of 1995 owing to the improving profit situation.46

Table 22.Major Industrial Countries: Bank Rating Changes, 1995-961
IBCAMoody’s
UpDownBanks ratedUpDownBanks rated
Canada1060012
France110301825
Germany01130127
Italy18270310
Japan012191821
United Kingdom21209033
United States207100248289
Sources: IBCA Ltd.: Moody’s Investors Service: and IMF staff calculations.

Net changes in long-term credit ratings between January 1, 1995 and April 30, 1996 (IBCA) or March 31. 1996 (Moody’s). For IBCA. only commercial banks (including cooperative institutions, but not investment banks or building societies) without government guarantees are included. For Moody’s, the set of institutions included are those described as banks or bank holding companies.

Sources: IBCA Ltd.: Moody’s Investors Service: and IMF staff calculations.

Net changes in long-term credit ratings between January 1, 1995 and April 30, 1996 (IBCA) or March 31. 1996 (Moody’s). For IBCA. only commercial banks (including cooperative institutions, but not investment banks or building societies) without government guarantees are included. For Moody’s, the set of institutions included are those described as banks or bank holding companies.

Box 3.Moody’s Bank Financial Strength Ratings

In 1995, Moody’s Investors Service introduced a new rating system for financial institutions, called the Bank Financial Strength Rating (BFSR). Whereas an institution’s long-term debt rating indicates the rating agency’s assessment of the likelihood of default, the BFSR represents an opinion of a bank’s intrinsic strength, or alternatively, the likelihood that the institution will require financial assistance from third parties such as its owners or the government. The BFSR does not incorporate the probability that such support will be forthcoming, only the probability that it will be needed. Hence, a bank may have a relatively low BFSR. but a higher long-term credit rating, reflecting the opinion that third-party support would be forthcoming to prevent a default. BFSRs for selected industrial countries are given in the table. In arriving at the BFSR, Moody’s takes into consideration factors such as the bank’s financial fundamentals, its franchise value, its main risk factors, the macroeconomic environment, and the quality of banking regulation and supervision. Differences in average BFSRs across contries, therefore, can be interpreted as indicating relative weaknesses in the overall soundness of the banking system, either due to poor bank performance or to inadequacies in the regulatory infrastructure.

Moody’s Bank Financial Strength Ratings for Selected Countries and Regions, May 1996
AB+BC+CD+DE+ETotal
Australia00344100012
Austria0012220007
Belgium0222100007
Canada01540000010
Denmark0011100003
Finland0000030014
France12545540127
Germany32486300026
Hong Kong0020500007
Italy00364201218
Japan0030109177349
Luxembourg0030000003
Netherlands3101000005
Norway0000310004
Singapore0301200006
Spain13512000012
Sweden0001400005
Switzerland1211110007
United Kingdom1955110027
United States3216811380800011296
Total1342115154135392287535
Source: Moody’s Investors Service.
Source: Moody’s Investors Service.

Some Canadian banks have responded to the increase in capital by buying back their stocks, while others have acquired other domestic and foreign banks and nonbank financial institutions.47 The diversification of Canadian banks into nontraditional financial services is one of the key developments of the past eight years. Banks were allowed into the securities industry in 1987, and the revision of the Bank Act in 1991 gave them full securities and trust banking powers through subsidiaries. All of the major banks have since developed or acquired securities firms and trust bank subsidiaries. The greater importance of these nontraditional activities has also contributed to the gradual decline in banks’ net interest margins, because trust and securities businesses tend to operate on lower margins than bank lending. Banks have also expanded their insurance activities, and in some eases have entered into partnerships with insurance companies to facilitate cross-selling of each others’ products.

The major commercial banks in the United Kingdom reported record profits in 1994 and 1995, due mostly to reduced loan loss provisions.48 Despite a slight narrowing of interest margins, strong loan growth—after two years of decline—enabled net interest income to edge upward by 2 percent.49 The proportion of nonperforming loans in the loan portfolio has declined sharply since its peak of 18 percent in 1993. allowing provisions to remain at the same level in terms of pre-provision income as in 1994.50 The improved capital levels among U.K. banks has resulted in a stiffening of competition in the loans markets—particularly residential mortgages and high-quality corporate loans—-which caused the Bank of England to caution against overly aggressive pricing practices in the syndicated loans market in early 1995.

As in Canada, banks in the United Kingdom have also responded to high capital levels and expanded banking powers by acquiring firms in competing sectors. All of the major banks purchased one or more securities trading firms in the post-“Big Bang” years, often with poor results. Recently, some of the major banks have increased their participation substantially in investment banking activities. In addition, banks have acquired, or entered into, cross-selling agreements with insurance companies. Building societies have been the latest targets of bank acquisitions. Very narrow margins in residential mortgages, and growing competition from banks, have forced some building societies to convert to bank status, others to merge, and still others to seek acquisition by commercial banks. This consolidation process is expected to continue in 1996.51

In the UnitedStates commercial banks insured by the Federal Deposit Insurance Corporation {FDIC} earned a record $48.8 billion in net income in 1995. 9 percent higher than in 1994. This performance was due in part to strong loan growth—the highest annual growth rate since 1984—which more than offset a slight decline in net interest margins. In addition, pastdue and noncurrent assets remained steady al 2.5 percent of gross loans at the end of 1995, which allowed provisions and charge-offs to remain at historically low levels.52 Finally, noninterest income rose 8 percent over 1994 levels.

The rapid expansion in loans, coupled with shrinking margins, raised concerns in 1995 about the possibility of a return to the lax credit quality practices of the 1980s and of an increase in nonperforming loans. Syndicated lending rose by 23 percent in 1995, after a 65 percent increase in 1994. and this record level of activity was accompanied by a narrowing of margins and a relaxation of covenants as banks competed aggressively for market shares.53 These developments provoked a reaction from the regulatory agencies in the United States. However, surveys of banks’ lending practices carried out by the FDIC and the Federal Reserve in early 1996 have found that most banks have not relaxed credit standards over the past year. In response to the rising personal debt-income ratio and rising credit card default rates, banks have tightened consumer lending conditions and increased their loan loss provisions against consumer loans. Exposures to traditionally risks sectors such as commercial real estate have generally declined, while the outlook for the commercial and residential real estate markets in the United States is relatively positive. The high asset quality levels in 1995 are reflected in industry-wide indicators of risk. At the end of 1995. there were 144 banks on the FDlC’s “problem bank” list, with total assets of $17 billion, compared with 1,016 banks with assets of $528 billion at the end of 1991.54

Banks’ derivatives activities leveled off in the second hall of 1995 after increasing modestly in the beginning of the year. At the end of 1995. The total notional principal value of OTC and exchange-traded derivatives held by commercial banks was $17.1 trillion, up from $15.8 trillion at the end of 1994. but down from $18.2 trillion at the end of September 1995.55 As in previous years, approximately 66 percent of the total notional principal was accounted for by interest rate derivatives, with 32 percent consisting of exchange rate contracts; 86 percent of the end-1995 total represented OTC contracts. The derivatives market is highly concentrated, with the top nine banks accounting for 94 percent of the total notional principal, up from 86 percent in 1991. In addition, total credit exposure (measured by the gross positive fair value) of these nine banks’ positions was only $228 billion—25(1 percent of their total capital, down from 336 percent at the end of the first quarter.56 This decline in credit risk was due in part to the decline in U.S. interest rates and to the greater use of netting agreements.

Chart 23.Indices of Property-Related Stocks in Europe and North America

(First week of July 1995 = 100)

Source: Salomon Brothers Inc.

Chart 24.Tokyo Commercial Real Estate Occupancy and Rental Rates

(First quarter 1992 = 100)

Source: Ikoma Data Service System.

U.S. commercial banks have seen their deposit insurance premiums greatly reduced. With the Bank Insurance Fund (BIF) having returned to full capitalization in May 1995, the FDIC voted in November 1995 to reduce deposit insurance premiums to their lowest-ever levels. As of January I. 1996, well-capitalized banks pay no insurance premium above the $2,000 minimum—since September 29, 1995 they had paid 4 basis points—and other banks pay premiums of up to 27 basis points, depending upon their capitalization rates.57 In contrast, the insurance fund for savings and loans institutions, the Savings Association Insurance Fund (SAIF), has reserve coverage of only 0.4 percent of insured deposits, and savings and loans will continue to pay premiums of between 23 and 31 basis points.

At the same time that a number of countries—including Japan and Mexico—are considering establishing institutions modeled on the Resolution Trust Corporation (RTC) to assist in resolving problems of nonperforming loans in their countries, the RTC has been closed. Established in 1989 to manage the liquidation of failed savings and loans, the RTC liquidated 747 savings institutions with a total book value of $452 billion, realizing revenues of $400 billion. Combined with direct fiscal expenditures to fund the RTC and earlier efforts at resolving the crisis, the total public cost of the savings and loans crisis has been estimated at approximately $140 billion, or 1.9 percent of 1995 GDP.

A major development in the U.S. banking industry in 1995 was the increased pace of consolidation and repositioning. Mergers and acquisitions among banks and thrifts surged in 1995, involving a record $542 billion in assets.58 There were 420 mergers with aggregate deal size of $73.1 billion in 1995, compared with 564 deals for $22.4 billion in 1994. The pace slowed somewhat in the first quarter of 1996. with only 75 deals for $4 billion.59 The key development in 1995-96, however, has been that more of the activity involved very large banks, reversing a trend since 1991 in which mergers and acquisitions have tended to be concentrated in the smaller, regional banks as they sought to increase their market strength through greater size. The merger of the Chase Manhattan Bank with Chemical Bank, valued at $10) billion, created the largest bank in the country with total assets of $297 billion. The Wells Fargo-First Interstate merger created a much smaller bank, with combined assets of $108 billion, but cost $12.3 billion. A number of factors motivated this consolidation activity (Box 4). including the desire to exploit perceived economies of scale and scope, to economize on information technology expenses that are increasingly critical to the maintenance of market share in a wider range of banking activities, and by being able to provide services across a wider geographical area. In addition to mergers, there were some notable divestitures, including the decision of J.P. Morgan to pull out of the securities custody business and Citibank’s decision to withdraw somewhat from the U.S. corporate banking sector. Banks appear more determined in withdraw from relalively unprofitable activities and to concentrate on only those activities where they have a comparative advantage, rather than trying to provide the full range of services to all customers. The improved earnings in 1994—95 gave banks the resources to acquire the needed expertise to expand into new activities rather than to build it up from within.

Chart 25.Major Industrial Countries: Intermediation Spreads

(Average lending rate minus deposit rate, in percent)

Sources: International Monetary Fund, International Financial Statistics; and Organization for Economic Cooperation and Development.

Unlike developments in Canada and Europe, merger and acquisition activity in the United Stales did not involve banks acquiring nonbanks, because Glass-Steagall restrictions make many such purchases difficult, if not impossible. However, despite the Glass-Steagall Act, U.S. banks have engaged in nontraditional activities. For example, banks acquired limited securities trading powers in 1987 through the use of Section 20 subsidiaries, and national banks’ ability to sell insurance was recently greatly enhanced by a Supreme Court decision overruling state rules limiting such activity. Similarly, constraints on bank branching introduced by the McFadden Act of 1927. while gradually weakened during the 1980s, have been nearly eliminated by the Riegle-Neal Interstate Banking and Branching Efficiency Act that came into effect in September 1995. This act lifted state restrictions on interstate mergers and acquisitions of bank holding companies, and lifted similar restrictions imposed on nonholding company banks, unless a state chose to “opt out.” By the end of 1995, only one state had chosen to opt out.

France, Italy, ami Japan

Commercial banks in France have continued to feel the effects of the collapse of the domestic real estate market and weak demand for loans.60 Net interest income declined in 1995 owing to shrinking interest margins and falling corporate loan volumes.61 In addition, income from capital markets activities, which fell sharply in 1994 as rising interest rates cut into bond trading and derivatives activities, did not recover appreciably in 1995. Loan loss provisions declined by 39 percent in 1995, providing the only upward momentum to net income. Despite this, nonperforming loans remained at about 6.4 percent of gross loans although the trend appears to be downward. Commercial real estate remains the key source of potential problems. After some delay, banks have recently moved to shore up their loan loss reserves in this sector, and some banks have taken extraordinary measures to rid themselves of real estate exposures—Indosuez sold a large portion of its portfolio to its parent company, while Compagnie Financiere de Paribas reported a loss in 1995 mostly because of write downs and provisions against properly loans of F 2.2 billion.62

Box 4.Consolidation in the Financial Services Industry

Flush with capital as a result of strong earnings performance over the past two years, banks embarked on a mergers and acquisitions spree in the past year or two to better position themselves for future challenges. The motivation for each deal is, of course, to a great extent unique, but some general trends can be identified. In general, mergers or acquisitions are struck in order to allow banks to (1) increase size to take advantage of economies of scale; (2) broaden their product base to exploit economies of scope; or (3) provide services across a broader geographical area.

In the United States, consolidation has been motivated in large measure by the increasing competition from non-bank financial institutions. Nonbanks attract ever larger shares of household savings (into mutual funds, insurance policies, and securities investments, for example) and provide an increasing share of consumer lending (particularly in auto and mortgage finance and credit cards). Increased reliance by banks on fee income and a need to better serve their customer base with a broader range of services are the driving force behind the recent wave of mergers and acquisitions. Technology plays a key role in this process. The investments in technology that are needed to provide these services, and to better target products to customers, are costly, and mergers allow these costs to be spread across a wider customer base. However, this may be a less important factor in the future, as technology costs are declining rapidly. The use of technology allows banks to exploit returns to scale that were formerly unavailable—they can provide a broader range of services to a larger customer base, with less use of costly branches (for example, through phone banking and automated teller machines), and with better product targeting through improved analysis of customer databases.

Consolidation has also been encouraged in the past year by the elimination of most constraints on interstate branching and banking, and by the high stock prices of acquiring banks that lowered merger costs. Greater geographical diversity and product diversity, both of which may result from mergers, may also provide risk-reduction benefits to the banks.

In Japan, consolidation has been driven by the need to control the pace at which the industry contracts under the weight of the deterioration in overall asset quality rather than by considerations of market share or cost cutting. Indeed, in Japan, as with countries such as France, Italy, and Germany, cost cutting through downsizing is very difficult due to regulations and union strength. One important exception to this trend is the merger of Mitsubishi Bank with the Bank of Tokyo, since both banks were comparatively healthy and in no danger of failing. In this case, the merger seems to have been motivated by a desire to combine two highly complementary institutions.

In Europe, in particular, recent merger activity appears most often to have been motivated by a desire to expand into new lines of business. Some commercial banks in the United Kingdom have acquired building societies, and the major Canadian banks have entered into the securities and trust businesses through acquisition since their powers were broadened in the 1992 Bank Act amendment. One development that attracted considerable attention in 1995 was the spate of acquisitions of U.K. merchant banks by foreign institutions. In some of these cases especially, there appears to have been a recognition that “Anglo-Saxon” investment banks have important skills that are necessary for establishing a global presence in capital markets.

The desire to broaden their geographical presence also explains much of banks’ recent merger activity. Two of the largest Canadian banks made significant investments in Mexican banks in 1995, and an important motive behind some of the European banks’ acquisitions has been to be better able to serve the European and, more broadly, the global market. Hence, complementarities of geographical experience were important considerations in banks’ choices of targets. Industry representatives speak of the need to be a “global player,” which means both being able to provide the same services to one’s clients throughout the world (Citibank is the best example of this philosophy), and being able to lap the investor bases in the United States, Europe (mostly the United Kingdom), and Asia (mostly Hong Kong and Japan) in placing securities.

Crédit Lyonnais, after losses totaling F 19 billion during 1993-94. and two government support packages, earned a small profit of F 33 million in 1995, However, problems emerged in late 1995 at Credit Foncier, a privately owned specialized financial institution whose franchise was virtually eliminated by the cancellation of a government housing finance subsidy program that had been implemented through the bank.63 Credit Foncier lost F 10.8 billion in 1995, after setting aside F 13.1 billion in provisions against loans to developers of commercial real estate and other real estate loans, wiping out its capital.64 A 14-month credit line of F 20 billion from the Caisse des Dépôts et Consignations was arranged in January 1996, but a permanent solution—involving the sale of the bank—was expected by the end of July 1996. Credit Foncier is the largest borrower in the domestic bond market, with approximately F 260 billion in outstanding debt.

The enactment of the 1984 Banking Law and the subsequent lifting of credit restrictions expanded the range of permissible activities for French banks, which resulted both in a rapid expansion in lending and in greater competition on interest rates and fees and commissions. In addition, the development of short-term debt securities markets in the mid-1980s and the tax benefits accorded to mutual fund investments sparked the disintermediation of (largely interest-free) retail deposits away from banks into mutual funds. Although the banks control the largest investment funds, the result has been a gradual decline in bank margins and greater competition across the range of Financial services. These developments have contributed importantly to the current situation of relatively weak core banking earnings and asset quality problems in the French banking system. So far, however, there has not been as much consolidation among the major French banks as there has been in other countries that have similarly liberalized their financial sectors. This has been due in part to the large ownership stake held by the state in the banking system, and the ability of specialized banks to continue to exercise their sectoral monopoly power to help finance operations in new markets. With the privatization of eight banks since 1987, the stage may be set for a more fundamental restructuring of the banking sector, of which the proposed merger of Crédit National and Banque Francaise de Commerce Extérieur may be the first step.

Bank performance in Italy suffered badly from the rise in interest rates in 1994—because banks have extensive holdings of government securities—and flat loan growth. The eight largest commercial banks experienced combined losses totaling Lit 203 billion in 1994, after earning profits of Lit 2,207 billion in 1993.65 A key source of the decline in income was a 53 percent fall in income from trading in securities and foreign exchange. Loan loss provisions declined as a proportion of net interest income, despite a steep increase in nonperforming loans. For the eight largest banks, nonperforming loans increased by 51 percent in 1994, rising to 6 percent of total loans, up from 4 percent at the end of 1993.66 For the banking system as a whole, the incidence of nonperforming loans is significantly higher.

Banco di Napoli, a partially government-owned commercial bank, reported a loss of Lit 3,155 billion in 1995, surpassing its own record loss of Lit 1,147 billion in 1994, and wiping out most of its capital.67 The increase in losses was due mostly to a second year of increased loan loss provisions equal to 145 percent of net interest income after a review of the bank’s portfolio was conducted by new management installed in early 1995. The bank’s poor asset quality stems from the relatively high concentration of the bank’s lending in the southern part of Italy, which was severely affected by the recent recession and by cutbacks in government subsidies.68 In November 1995. the Bank of Italy arranged a temporary loan of Lit 2,500 billion—-at 25 basis points above the interbank rate—from a group of 11 banks and the Cassa Depositi e Prestiti. The bank also announced a restructuring plan involving the sale of some assets, closure of unprofitable branches, and cuts in operating expenses. A March 1996 decree authorized the Treasury to inject up to Lit 2.000 billion in capital into the bank. The Treasury intends to privatize the bank some time in 1997.

The difficulties at Banco di Napoli echo earlier problems at Banco di Sicilia—also partially owned by the Treasury—which, during 1992-95, received capital injections from the Treasury totaling Lit 350 billion. Senior management was replaced in 1994, and a restructuring plan was initiated that involved the devolution of noncore activities and cost-cutting. In March 1996, the Bank of Italy appointed an administrator for Siciicassa, the second largest bank in Sicily after Banco di Sicilia. Siciicassa, is also a public law bank majority owned by a public foundation. The decision to intervene came after an inspection by the central bank found that doubtful loans amounted to almost half of the bank’s loan book.

Banks in Japan experienced losses from the burden of the large stock of nonperforming loans on their balance sheets, despite the recent improvement in the economy.69 The 21 major banks reported an aggregate net loss of ¥3,565 billion in March 1996, up from an aggregate loss of ¥120 billion in 199495.70 These losses are due entirely to extraordinarily high loan loss provisions and write-offs, which increased to more than ¥10,707 from ¥4,694 billion in 199495. Operating income surged to ¥4,770 billion, more than 70 percent higher than in the previous year. Wider interest margins, made possible by record low official interest rates, contributed to much of this improvement in income, but the largest part of the increase was derived from gains on investment bond portfolios and income from previously unrealized capital gains on the banks’ equity portfolios (hidden reserves).

At the end of March 1996, the 21 major banks reported ¥13,112 billion in nonperforming loans (3.3 percent of total loans) and ¥8.757 billion in restructured loans.71 By comparison, at the end of September 1995, the banks held ¥13,014 billion in non-performing loans, and ¥10,815 billion in restructured loans.72 In addition, banks reported for the first time loans to clients to which they had provided financial support—for example, by forgiving loans.

A key development in 1995 was the agreement on a plan (approved by the Cabinet on December 19. 1995) to liquidate the seven insolvent housing loan companies (jusen) The seven jusen had total assets of ¥13.190 billion, of which ¥6.410 billion were unrecoverable, ¥ 1.240 billion were possible losses,73 and the remaining ¥5,540 billion were recoverable or performing. The agreed plan specified that the relevant financial institutions would share most of the initial loss of ¥6,410 billion and that any further losses would be disposed of at a later stage. In the first stage, the banks that founded the jusen, and in many cases provided their management and recommended customers, would write off their entire exposure to the jusen—amounting to ¥3.5 trillion. The agricultural cooperatives will get back all of the ¥5.5 trillion that they loaned to jusen, and will provide a grant of ¥530 billion to the Jusen Resolution Corporation (JRC)74 other financial institutions would accept losses of ¥1.7 trillion. In addition, ¥680 billion was earmarked in the 199697 budget to cover the balance of the initial losses.

Under the plan, the remaining jusen assets, amounting to about ¥6.8 trillion, will be transferred to the JRC, which will be set up to collect on these assets. The founding banks, agricultural cooperatives, and other lender banks will extend low-interest loans to the JRC to finance the cost of the assets acquired from the jusen. Public funds will be used to cover half of the ¥1.2 trillion in future losses, if they occur after claim collections, while the private financial institutions concerned are expected to cover the remaining losses. The initial capital of the JRC is to be provided by the Jusen Account of the Deposit Insurance Corporation (D1C). The private financial institutions concerned will contribute about ¥1 trillion to the Special Fund for Stabilization of Financial System of this account, the government will provide ¥5 billion to this account, and the Bank of Japan will provide ¥100 billion. The investment income generated from the Special Fund will be used to cover the half of the JRC’s possible future losses mentioned above.

The Financial System Stabilization Committee (FSSC), set up in July 1995 to formulate a strategy for resolving the nonperforming loans problem, issued its final report at the end of December 1995. The report recommended the establishment of the Resolution and Collection Bank—an institution similar to the U.S Resolution Trust Corporation—to handle the disposal of failed credit cooperatives, pay off depositors, and collect loans. Financial institutions are to pay a special levy during the next five years equal to three times the current D1C insurance premium (0.012 percent of insured deposits) to establish “special accounts” at the DIC to assist in financing the disposal of failed institutions. If these accounts are exhausted after five years, public funds will be used to complete the resolution of the failed cooperatives. In addition, the FSSC recommended that regular deposit insurance premiums should be raised fourfold to build the reserves of the DIC.

The FSSC also recommended measures to improve banking inspection and supervision, which were recommended by the Ministry of Finance in December. To strengthen internal management controls, financial institutions will be expected to follow guidelines on inhouse inspections and risk management: appropriate vacation policy is to be applied; and internal auditors will be expected to report directly to headquarters. To ensure sound management of financial institutions, a system of prompt corrective action is to be introduced whereby the Ministry of Finance will take actions, including issuing directives to improve management, if financial institutions fail to meet specified objective criteria (such as capital adequacy ratios). In addition, the Ministry will strengthen its monitoring (of weaker institutions, in particular), making use of external auditors to verify compliance with regulations. Overseas branches also will be subject to more frequent scrutiny by the ministry and the Bank of Japan. In addition, the authorities plan to strengthen the exchange of information with foreign supervisory authorities, in accordance with the Basle Concordat. Finally, there is to be greater coordination between the local and national supervisory authorities to strengthen the supervision of credit cooperatives.

Germany

Because German property values have not declined to the extent that they did in other Group of Seven countries, the banking system has avoided the wide swings in profitability that banks elsewhere have experienced. However, German economic growth has been relatively slow since the 1992 recession, and this has been reflected in relatively stable but low operating profits—net interest income plus noninterest income—for the banking system.75 Operating profit for the major commercial banks rose by only 4 percent in 1995 after falling by 5 percent in 1994. While trading income rebounded from a poor year in 1994, net interest income declined by 7 percent in 1995. reflecting the continuing contraction of net interest margins.76 Margins have been shrinking as a result of increased competition in the loan market, a greater share of mortgages in total lending, and higher funding costs as banks increasingly have to compete with nonbank institutions, such as money market funds, for deposits.77 However, because of large revaluation gains on securities held for liquidity purposes, the banks reported a 39 percent increase in net profits for 1995.78

A key feature of the banks’ reports in 1995 was the increase in transparency and use of international accounting standards (IAS). Deutsche Bank reported its earnings according to both German accounting standards and IAS, and there were some important differences. Under IAS, Deutsche Bank’s net income rose from DM 1.7 billion in 1994 to DM 2.1 billion in 1995. Under German standards, the increase was from DM 1.4 billion to DM 2.2 billion. Moreover, to conform to IAS. Deutsche Bank for the first lime disclosed the size of its hidden reserves—DM 1.4 billion at the end of 1995. The bank’s two main rivals in Germany, while not going as far as Deutsche Bank to restate their results according to IAS, did increase their disclosure levels, particularly in breaking down the change in net loan loss provisions between net provisions and revaluation gains on liquid securities. These two banks also disclosed for the first lime the level of their loan loss reserves—DM 8.7 billion for Dresdner Bank and DM 7.9 billion for Commerzbank.

While consolidation or repositioning of the domestic banking industry has not been significant in recent years. German banks have embarked on a highly visible campaign of foreign acquisitions. In 1995. Dresdner Bank acquired the U.K. investment bank Kleinwort Benson and U.S.-based RCM Capital Management. Also in 1995, Commerzbank acquired the U.K. asset management concern Jupiter Tyndall. and WestLB acquired U.K. stockbroker Panmure Gordon. While dating from an earlier period, Deutsche Bank completed the integration of Morgan Grenfel), which it had acquired in 1989. Through these investments, these banks have expanded their range of capital markets expertise that are important elements of a strategy of being able to provide the full range of financial services in the international markets.

1The Bank for International Settlements conducted its fourth triennial survey of foreign exchange market trading activity in April 1995. The results of this survey are reviewed in Annex III.
2Chart 8 shows the J.P. Morgan RiskMetrics measure of daily price volatility, calculated as 1.65 times the standard deviation of daily changes in spot prices using an exponential 10-day moving average with a decay factor of 0.94, which attaches the greatest importance to recent observations. These numbers are interpreted as the range—that is, plus or minus the volatility number in the chart—within which prices will fluctuate in one day in percentage terms, 90 percent of the time. For example, a volatility number equal to 1 means that the exchange rate is expected to fluctuate within 1 percent of its current level each day; if this number were to increase to 2, then the exchange rate may change by up to 2 percent a day.
4Malz (1995) notes that “transactions in knockouts had increased to between 2 and 12 percent of all currency option trading by early 1995 from a negligible share just two or three years ago.”
5To the extent that dealers themselves had built up short dollar positions in order to influence the price, they would have to repurchase dollars after the knock-out level was breached.
6Although knock-outs are difficult to hedge and many dealers rely on a diversified portfolio of these options for protection, some dealers hedge by selling more put options close to the knock-out level together with buying a put at the strike price. As the spot rate attains the level at which the puts were written, these puts need to be bought back, and new ones, at lower strikes, need to be sold. If the spot rate goes through the knock-out level and the option is canceled, the dealer is exposed to losses from further declines in the spot rate on the sold puts used as the hedge. Either the dealer needs to buy back the put options sold for the hedge or sell dollars in the spot market. Often dealers establish stop-loss orders at these levels to facilitate the unwinding of these positions. These actions drive up the price of put options with strikes at the knock-out level, as well as contribute to pressure for a further dollar spot rate decline.
7See the May 1995 World Economic Outlook for a detailed discussion of the macroeconomic environment surrounding these developments.
8Bank for International Settlements (1996c).
9Selling pressure on the French franc in early October 1995, allegedly by some large U.S. hedge funds, prompted the Bank of France on October 9 to suspend the five—ten day lending window and then to lift its 24-hour lending rate to 7.25 percent, from 6.15 percent. These measures were clearly successful in stemming the attack.
10Large positions were reported to have been constructed by U.S.-based hedge funds to arbitrage the yield spread between Japan and the United States by borrowing short-term yen and investing the proceeds in U.S. Treasury securities to earn a 4-5 percentage point spread.
11This question had been raised a great deal in the financial press; see, for example, Irving (1996). See International Monetary Fund (1994) for a discussion of the 1994 bond market turbulence.
12The future yield curves are calculated from the current swaps yield curve by calculating the implied future interest rates. For instance, using the current one- and two-year interest rates, one can easily calculate the implied annual interest rate one year from now. This rate would then be the one-year rate for the projected yield curve one year from now.
13The EMU premium refers to a higher than normal yield on German long-term bonds because of the possibility that investors will be paid in a currency that is weaker than the deutsche mark. PaulChoudhury (1996), for example, discusses this hypothesis.
14The average annual growth rate of the outstanding amount of international debt securities (bonds and notes) over the past five years has been 12 percent (Bank for International Settlements (1996a)).
15“Japan’s Foreign Bond Fever Fades,” International Financing Review, Issue 1128 (April 13, 1996), p. 12.
16For instance, a $2 billion sovereign issue from Sweden was marketed to Japanese retail investors at a negative spread to U.S. Treasury securities; see Irvine (1995).
17The high growth rate should be interpreted with caution as issuance activity in early 1995 was subdued because of the Mexican crisis and currency market turbulence.
18See Bank for International Settlements (1996a and 1996c).
19These three markets are the New York Stock Exchange (NYSE), the National Association of Securities Dealers Automated Quotation (NASDAQ) system, and the American Stock Exchange.
20The response of U.S. portfolio investors to the Mexican crisis is discussed in more detail in Annex II.
21According to the Investment Company Institute.
22In October 1993, just before the global bond market turbulence, U.S. mutual funds had net assets of $2 trillion; in February 1996, they broke through the $3 trillion mark.
23Cross-border dealing in securities—as measured by clearing and settlement through the two international clearing systems, Euroclear and Cedel—climbed to $35 trillion in 1995, up 20 percent over 1994 and 550 percent over five years ago. While these clearing systems were originally designed for the Eurobond market, they have become a “hub” that domestic securities markets around the world have plugged into.
24Short positions entail the borrowing and simultaneous sale of the security in the hopes of being able to buy the security back later at a lower price to return it to the lender. Short positions can also arise from tax strategies as well as positions in derivatives markets. For example, an equity option can be replicated by a position in the equity combined with a fixed-income position. Thus, arbitrage between options and spot market can result in short positions in equity markets without there being any widespread bearish sentiment on equity markets in general. Nonetheless, many commentators and practitioners widely use it as such an indicator. Short interest increased to 2.13 billion shares on the NYSE and 954 million shares on the NASDAQ by mid-February.
25For details see J.P. Morgan (1996).
26“U.S. Equities: Index Rally Sparks Issues,” Financial Times: Capital Sources, Year End Review, January 16, 1996.
27See Bank of England (1995b and 1996).
29Bank of England (1995a, p. 325).
30“Stripping” a bond allows the principal and the coupons to be traded separately, thus resulting in a series of zero-coupon bonds rather than a single coupon bond. Strips are particularly useful to pension funds and insurance companies who wish to better match their asset-liability structure.
31The Nouveau Marche is recognized as a regulated market under the Investment Services Directive, and thus can solicit listings from firms domiciled in all 15 member states of the European Union.
32In Europe, the ABS market has developed further with two recent issues: Volkswagen issued a DM 500 million receivablesbacked floating rate note (FRN) that is the first significant ABS issue in the deutsche mark sector and is considered to be a “trailblazer” for the market; and Birmingham Midshires Building Society brought £1 billion of mortgage-backed FRNs to the market, the largest ABS transaction seen in the European markets.
33Life insurance companies have about ¥150 trillion in total assets. The share of foreign-currency-denominated securities in their portfolios declined from 15 percent in 1990 to 7 percent by end-1994.
34Global bonds are marketed simultaneously to three geographical regions—Europe, the United States, and Asia—and can be traded around the clock as they are linked with clearance and settlement systems in the major time zones.
35Falloon (1996).
36See Bank for International Settlements (1996d).
37In addition, it has been suggested by market participants that the BIS survey may contain some double counting associated with national authorities reporting the same position when a firm initiated a derivatives position in one country and booked it in another.
38Restricting attention to currency and interest rate swaps and options, the ISDA survey captures about three quarters of the global market as measured by the BIS survey.
39ISDA reported (for the first time) replacement costs at the end of 1994 to be 2 percent of notional principal for participants in their survey.
40Bank for International Settlements (1995b).
41See, for example, Heron (1996).
42“Safety First,” International Financing Review, Issue 1116 (January 20, 1996), p. 1.
43The net interest margin is defined as net interest revenue divided by average earning assets. Comparisons across countries of net interest margins are not advisable, owing to differing definitions of net interest income.
44Problems may arise too with this indicator of the profitability of banks’ operations. First, the interest rates used may not be the most relevant rates. In this chart, the loan rate is in most cases the benchmark “prime” rate; most nonrestructured loan rates exceed this rate and by amounts that vary over time. Moreover, the deposit rates used may not apply to the largest portion of deposits, or may not reflect the true return on deposits in cases where banks routinely compensate depositors through reduced costs for services or through bonus interest rates.
45This description of developments in 1995-96 for Canadian banks is based on the financial reports of the six largest commercial banks as compiled by IBCA Ltd.
46The high profitability of Canadian banks continued in the first quarter of 1995 96, with aggregate net income of the six major banks rising 12 percent over the previous quarter, again due in large measure to lower loan loss provisions. Net interest margins were slightly narrower again, but net interest income rose 4.6 percent regardless. Asset quality continued to improve, with aggregate nonperforming loans declining 15 percent, and reserve coverage increased to 80 percent of nonperforming loans.
47The Bank of Montreal acquired Harris Bank in Chicago in 1984 and took a 16 percent stake in Grupo Financiero Bancomer, Mexico’s third largest bank, in the first quarter of 1996. The Bank of Nova Scotia similarly acquired 16 percent of Grupo Financiero Inverlat in 1995.
48This description of developments in 1995 for U.K. banks is based on the financial reports of the six largest commercial banks, as compiled by IBCA Ltd.
49The net interest margin declined to 2.1 percent in 1995, from 2.3 percent in 1994.
50There is no standardized definition of “impaired” or “nonperforming” loans in the United Kingdom. In general, this category includes nonaccrual loans, performing but doubtful loans, and, where disclosed, potential problem loans.
51See for example, Moody’s Investors Service (1995).
52Past-due loans are those that are 30-89 days in arrears; noncurrent assets are those that are 90 days or more in arrears.
53However, in the first quarter of 1996, syndicated lending volumes declined 24 percent over the same period in 1995.
54“Problem banks” are institutions “with financial, operational or managerial weaknesses that threaten their continued financial viability.” Only 6 commercial banks failed in 1995, out of 10,451 banks at the end of 1994.
55These totals include foreign exchange spot contracts, which totaled $305 billion at the end of 1995.
56The concentration of the market shows up also in the fact that the aggregate credit exposure of all banks represented only 6.8 percent of capital at end-1995. Another measure of credit risk is provided by the statistic that the notional principal value of contracts 30 days or more past due at end-1995 was only $18 million (0.0001 percent of the total).
57A “well-capitalized” bank has total capital in excess of 10 percent of risk-weighted assets, a tier 1 capital ratio in excess of 6 percent, and a tier 1 leverage ratio in excess of 5 percent. The FDIC is required to ensure that the BIF has reserves roughly equal to 1.25 percent of insured deposits, and the fund was estimated to have reached that level in May 1995, leading the FDIC to refund premium overpayments and to lower the premiums in September 1995. These refunds and the reduced premiums together saved the commercial banks an estimated $2.6 billion in the second half of 1995.
59Kaplan (1996b).
60This discussion of the French banking system is based in part on financial reports of the following banks: Crédit Lyonnais, Société Géneralé, Banque National de Paris, Compagnie Financière de Paribas, and Compagnie Financière de CIC et de l’Union Européene, as reported by IBCA Ltd.
61Margins have declined steadily since 1989, reaching 1.7 percent in 1995 from 2.7 percent in 1989.
62Since 1993 banks have taken exceptional measures to rid themselves of problem real estate exposure. By late 1994, about F 100 billion in bad loans had been transferred to "defeasance" structures (40 percent on account of Credit Lyonnais, 15 percent on account of Groupe GAN, and another 20 percent on account of the Comptoire des Entrepreneurs). This process has cost the banking sector about F 250 billion (3.5 percent of GDP).
63Credit Foncier is privately owned but the government has the right to appoint the management of the bank.
64Losses in 1994 had totaled F 2 billion.
65This discussion of developments in the Italian banking system is based, in part, on the financial statements of the eight largest commercial banks, as reported by IBCA Ltd.
66Nonperforming loans are defined here as doubtful debts (sofferenze), plus overdue installments and interest payments.
67Banco di Napoli is majority owned by a public foundation, Fondazione Banco di Napoli.
68At end-1995, 16 percent of loans in banks based in central and northern Italy were nonperforming, but the ratio among banks in the south was 23 percent.
69In March 1996, Taiheiyo Bank, the one hundred and fourth largest bank in Japan, failed with ¥170 billion in irrecoverable loans against only ¥37 billion in equity. Newly created Midori Bank took over the operations of the failed Hyogo Bank on January 29, 1996. Capital of close to ¥80 billion was raised from most of the 21 major banks, second-tier regional banks, insurance companies, securities firms, and some nonfinancial firms. Midori Bank also obtained a ¥110 billion subordinated loan from the Bank of Japan.
70Only four banks reported a net profit for the recent fiscal year.
71Nonperforming loans are defined as loans to bankrupt borrowers plus loans 180 days or more past due. Restructured loans include those that were restructured at rates below the prevailing official discount rate.
72The figure for nonperforming loans was reported by the banks in their midyear financial statements, while the figure of restructured loans at end-September 1995 was reported in November 1995 by the Ministry of Finance. Recapitalized loans and loans restructured at rates above the discount rate were also excluded from the official definition.
73The amount ¥1,240 billion was estimated in August 1995, with an assumption that collateral would incur losses amounting to 30 percent of the assessed land value (known as Rosen-ka). In the plan of December 1995, an extra effort was envisioned to reduce these losses.
74The organization commonly known as Jusen Resolution Corporation is formally translated as Housing Loan Administration Corporation.
75This discussion of recent developments in the German banking system is based in part on the financial reports of the five largest commercial banks as reported by IBCA Ltd.
76The net interest margin for the major German banks declined in 1995 for the fourth consecutive year to 1.55 percent. The inclusion of trading income in the definition of net interest income in German bank accounts obscures the link between net interest margins and intermediation spreads.
77By the end of 1995, money market funds, introduced only in 1994, had attracted a total of DM 37 billion.
78Under German bank accounting rules, these marked-to-market revaluation gains (or losses) are netted against loan loss provisions. In 1995, the major banks reported a 50 percent decline in provisions.

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