Banks and banking, International ; Debts, External ; Debt management

Hang-Sheng Cheng

English

Research Papers in Economics

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International DebtManagement
expansion ofinternational bankingactivities
over the last twenty years has increasingly
integrated the world's financial markets.
This change in international banking has
allowed banks to diversify risk on an inter-
national scale in normal times. However,
because integrated markets also transmit
economic disturbances-monetaryor real
-throughout the world, generalized shocks
result in systemized risks that quicklyturn
well-diversified asset portfolios into highly
risky ones. This is the same principle as in a
national economy: the risk ofageneralized
financial crisis is greater, the higher is the
degreeoffinancial integration ofthe various
regions in an economy.
Distinguishing rule
To choose between these twoapproaches, it
is necessary to examine their respective
underlying assumptions and compare their
empirical relevance. Finance involves risk-
taking, and prudence in financial manage-
ment means making sound judgments on
the basis ofreasonable assessments ofthe
likelihood offutureevents. In terms of
elementary statistical theory, this means
that individual bankers must project future
events with an implicit, subjective probabil-
itydistribution and choose a level ofrisk that
they are willing to accept in making loans.
The financial-integration view attributes the
international-debt problem to a series of
related, generalized shocks-theoil-price
increases in 1979-80,the subsequentworld
recession with falling world demand and
falling primary-commodity prices, and
unprecedentedlyhigh real interestrates. The
problem has been aggravated by the liquid-
ity crisis that has developed since mid-1982
due to the worldwide withdrawal ofbanks
from international lending. This view's
policy recommendation is to ensure ade-
quate supply ofinternational credit in the
short run and structural adjustments in
external payments in the longer run.
_._-_._-_._--
The choice ofsolution to the current
international debt problem depends criti-
cally on howone interprets the develop-
mentofinternational banking in the last
twenty years. Whetherone views the devel-
opmentas an extension ofdomestic banking
or as an irreversible process of international
financial integration leads to divergent
policy recommendations. In this Letter, we
shall propose a simple operating rule for
choosing between the two approaches, and
suggest that the policy measures adopted
thus far as being consistent with both.
Two polar views
The widespread difficulty non-OPEC, less-
developed countriesexperience in servicing
theirdebts has raised questions aboutbanks'
prudence in international lending. Particu-
larly disturbing have been reports ofbanks
competing to offer loans on exceedingly
favorable terms in disregard ofthe risks
involved. Some have maintained that the
banks' behavior was completely rational
because they had correctly counted on the
national and international authorities to bail
them out.
The alternative view focuses not on the
behavior of individual banks buton the
world environment for international
banking. It recognizes that the worldwide
This view suggests that banks must be made
to bear the consequences oftheir impru-
dence, and the public "bail-out" of impru-
dent banks is notonly unacceptable in a
free-enterprise economy, but also sows the
seed forfuture debtcrises. The policy
prescription, according to this view, is to let
the debtor countries default, and the banks
fail, so that the market will learn from past
mistakes. As long as there is adequate
deposit insurance (expandable by legisla-
tion) and monetarygrowth is kept stable, this
view holds that individual banks may col-
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Since the probabilitydistribution is based on
each individual banker's pastexperience, its
basis must Iie in the past even though the
projection is into the future.
Within this framework, there are three pos-
sibilities for a loan to go "bad." First, the
loan assessmentmayhavebeen madebyan
inexperienced bankerwhodid notknow his
business, that is, he did notmake an accu-
rate assessment ofeconomic reality.
Second, the probability distribution may
havebeen real istic, butthebankerchose too
high a level ofrisk. Third, the underlying
economic realitymayhavechanged sodras-
tically that pastexperiences are no longer
reliable for judging the probabilityoffuture
events. The banking-imprudence view con-
siders the international-debt problem as
the result of acombination ofthe first two
cases; the financial-integration view stresses
the third.
The choice between the two views might
appearto be necessarilyarbitrary. However,
most people would perhaps agree to a
"majority rule," which states that although
indiVidual bankers may be ignorantorreck-
less or both, it is unlikely that the majority
are. This rule does not presume a favorable
pre-disposition towards bankers' intelli-
2
gence or integrity, but itdoes presume a
beliefin the efficacyand stabilityofaprivate
banking system, buttressed by public super-
vision and regulation for helping insure
competition and sound banking, without
hampering private risk-taking. The fact that
over the past fifty years, this banking system
has been basically stable seems to indicate
thatthis proposition is more than ideology.
The rule breaks down, however, ifbanks
are neither ignorant nor reckless, butare
shrewdly conniving to take high risks for
high profits, counting on the authorities to
get them outoftrouble. Ifso, any policy
measures thatdirectly or indirectlyhelp
banks to get outoftrouble mightencourage
banks to become reckless and, hence, to
lead to greater financial instability. There is,
however, littleempirical evidence for this
attitude. First, in domestic banking, banks
have always known that central banks
would help out in the event ofany general-
ized loan defaults. But, in spite ofthis
knowledge, therehave been cases of indi-
vidual recklessness leading to bank failures,
but no recurrent financial crises in major
industrial countries overthe last fifty years.
Second, even ifbanks have differentexpec-
tations in international bankingthan in
domestic banking (there is neither reason
norevidence forthis), according to this
view, the massive amounts of international
aid to the debtor nations since mid-1982
should have vindicated their earlier risk
assessment; hence, there should be no
ground for them to withdraw from inter-
national lending. In fact, international bank
lendinghas declined precipitously, thus
lendingcredence to the opposite view that
the banks were indeed surprised by the
severityof the international-debt problem.
Policy measures
The proposed "majority rule" and the
empirical evidence validate the financial-
integration approach to the international
debt problem. Practical considerations of
minimizing risk in policymaking lead to thesame conclusion. The world is facing the
serious threat ofa financial crisis oflarge
dimensions. To follow the policy recom-
mendationsofthe bank-imprudence view
and be wrong could lead to disasterforthe
world economy, includingour own. But to
follow those ofthe financial-integration
view and be wrong would only mean that
we have helped some banks that we should
not have. A strategy ofrisk minimization
wouId, therefore, call forextending aid to
the debtor nations in order to ensure ade-
quate supply of international liquidityand,
at the same time, tightening supervision and
regulation overinternational lendingso as to
guard against banks' laxity in vigilance in
expectation ofinternational aid tothedebtor
nations.
This interpretation appears to be consistent
with the policy measures that have been
taken thus far. In the world economy,
without aworld monetary authority, the
central banks ofmajor industrial nations
havebanded togetherthrough theirmonthly
meetings atthe Bankfor International Settle-
ments to monitorcurrent developments and
to pursue acoordinated strategy forensuring
the supply ofinternational liquidity. To-
gether with the national treasuries, they
have provided temporary funds to help out
cash-strapped debtor nations inordertogive
them time to negotiate for medium-term
loansfrom the International MonetaryFund.
The mainstay ofthe strategy, however, lies
in the IMF credits, in conjunction with loan
packages from banks, which are granted
uponthe condition thatthe debtorcountries
adopt austerity programs to reduce their
payments deficits; thai is, to adoptappro-
priate policy measures for structural adjust-
ments to make their payment positions
viable in the longer run. The IMF member
nations have agreed to a47.5 percent
increase in IMF fundingto carry out this
important task.
In addilion, the three Federal banking
agencies---'the Federal Reserve, the Comp-
3
troller ofthe Currency, and the Federal
Deposit Insurance Corporation-have
jointly proposed a program to improve
information about international banking
and to tighten its regulation. The proposed
measures include quarterly reports and
promptdisclosure to individual banks'
exposures to country risks, a requirement
ofa special reserve for protracted non-
performingloans, and newaccounting rules
forspreading loan fees overthe lifeofa loan.
In addition, the U.s. has strengthened its
coordinationwith foreign bank regulatorsto
ensure regulatory equity among countries.
All ofthese may be regarded as appropriate
supplements to the principal strategy of
ensuring an adequate supply of interna-
tionalliquidity.
With these policy measures, much has been
accomplished since the tensions started
sixteen months ago. In this turbulent world,
sheer survival is victory. The international
debt problem is not resolved yet.However,
with the revival ofthe world economy and
the recovery ofworld trade there is ground
foroptimism thatthe world will achieve sus-
tained economic recovery without a crip-
pling financial crisis-provided that banks
stop the back-sliding outofinternational
lending that had continued through the first
halfofthis year. Hang-Sheng Cheng
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BANKING DATA-TWELFTH FEDERAL RESERVE DISTRICT
(Dollaramounts in millions)
Selected Assets and Liabilities
Large Commercial Banks
Amount
Outstanding
12/7/83
change
from
11/30/83
Change from
year ago
Dollar Percent
p
year-ago period 11/30/83 12/7/83
y g
of Daily Figures
Loans' (gross, adjusted) and investments'" 164,796 1,335 2,368 1.5
Loans (gross, adjusted) - total# 144,704 1,228 2,993 2,1
Commercial and industrial 44,196 215 - 727 - 1.6
Real estate 57,610 99 405 0.7
loansto individuals 25,371 121 1,740 7.4
Securities loans 3,395 672 H89 35,5
U.S. Treasury securities* 7,783 104 824 11.8
Other securities'" 12,309 2 - 1,449 - 10.5
Demand deposits - total# 45,437 1,414 3,583 8.6
Demand deposits ....... adjusted 31,148 1,617 1,881 6.4
Savings deposits - totalt 66,669 547 33,650 101.9
Timedeposits - total# 70,340 165 - 26,965 - 27.7
Individuals, part. & corp. 64,476 - 2 - 22,932 - 26,2
(Large negotiable CD's) 17,414 42 - 16,102 - 48,0
Weeki' Avera es Weekended Weekended Com arable
Member Bank Reserve Position
Excess Reserves (+l/Deficiency(-)
Borrowings
Net free reserves (+l/Net borrowed(-)
80
5
75
92
17
75
94
2
92
'" Excludes tradmg account secunttes,
# In~ludes items notshown separately.
t Includes MoneyMarket Deposit Accountsj Super-NOW accounts, and NOWaccounts.
Editorial commentsmay beaddressed totheeditor(Gregory Tong) ortotheauthor.••.Free copiesof
this and other Federal Reserve publications can be obtained by calling orwriting the Public
Information Section, Federal Reserve Bank ofSan Francisco, P.O. Box 7702, San francisco 94120.
Phone (415) 974-2246.

International debt management

http://www.frbsf.org/publications/economics/letter/1983/el83-51.pdf

International debt management

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Research Papers in Economics