This paper discusses systematic issues in international finance explained in the International Capital Markets report. The paper describes that the nature and extent of recent banking problems in several industrial countries along with the policy responses to those problems. It is observed that balance sheet problems in banking are widespread among the major industrial countries. The paper also analyses recent activity in the European currency unit bond and exchange markets, and reviews developments in the private financing of developing countries and discusses several issues raised by the recent experience, including the broadening of the investor base for developing country securities, the special role played by regional financial centers in East and Southeast Asia, and the systemic implications of the evolving pattern of developing country financing. A key influence on international capital movements in recent years was the rising international diversification of investment portfolios, which is generally believed to have increased in response to the liberalization of exchange and capital controls in many industrial countries in the 1970s and 1980s.
This year’s capital markets report has been divided into two parts. Part I, Exchange Rate Management and International Capital Flows, examined the implications of the growth and international integration of national capital markets for the management of exchange rates, with particular attention paid to the currency turmoil that enveloped the European Monetary System last year. Part II of the report focuses on several systemic issues in international finance, including recent experience with loan losses—especially in real estate—of banking systems in a number of industrial countries; sources of systemic risk in the rapid growth of off-balance-sheet financial transactions—particularly in the bank-driven, over-the-counter derivative markets; supervisory and regulatory developments; and some capital market issues pertaining to developing countries.
Although banking cannot lay uncontested claim to being the world’s oldest profession, it is clear that the principles that have helped to define sound banking behavior have a long history. At least five of those principles—namely, avoid an undue concentration of loans to single activities, individuals, or groups; expand cautiously into unfamiliar activities; know your counterparty; control mismatches between assets and liabilities; and beware that your collateral is not vulnerable to the same shocks that weaken the borrower—remain as relevant today as in earlier times. Indeed, behind all of the banking or financial sector crises that have emerged in industrial countries over the past decade—ranging from the developing country debt crisis of the early 1980s, to the saving and loan crisis in the United States, to the bank solvency crisis in Finland, Norway, and Sweden, to the spate of banking strains elsewhere—at least one of those principles has been violated.
The markets for over-the-counter and exchange-traded derivative instruments have exhibited explosive growth in the late 1980s and early 1990s.52 In their continuing search for profitable new activities, the banking sectors in the major industrial countries have become extensively involved in these markets both by acting as dealers in the OTC market and as users of exchange-traded instruments. Indeed, the most notable development in the major financial markets during the past five years has been the growth in volume and in diversity of OTC financial derivative instruments. Exchange-traded derivative contracts have likewise grown at a dizzying pace, stimulated in large part by the OTC business of the banking sector. The notional value of outstanding exchange-traded and OTC contracts has grown from $1.6 trillion in 1987 to $8 trillion in 1991, or from about 35 percent to 140 percent of U.S. GDP (Table 6 and Chart 18).
The shifting financial terrain over the past two decades has placed considerable stress not only on banks and other financial institutions, but also on the regulatory regimes in many industrial countries. International efforts to strengthen the regulatory framework for banks have focused on two main areas—the formulation of capital adequacy standards and the consolidated supervision of banks’ foreign establishments. The internationalization of financial markets has meant that a coordinated policy response among authorities was essential in preventing the shifting of financial activity to avoid regulation.
January 1, 1993 was the target date for the completion of the single internal market in the EC. The creation of a single financial market is an essential element of this project. It entails first the abolition of capital controls—thus allowing funds to be allocated to their most productive uses within the EC. It also entails the removal of all barriers to cross-border provision of financial services. This measure was intended to bring to financial services the efficiency-enhancing international competition and specialization that the establishment of the Common Market had previously brought to markets for goods. Many barriers to trade in financial services had remained, motivated by national governments’ concerns for the important issues of public protection that are involved. Of this agenda, much has been accomplished, although some important steps also remain to be completed. The formation of the European single financial market must be viewed in the context of developments in the world more generally, including the proposed liberalization of trade in financial services in connection with the Uruguay Round negotiations of the General Agreement on Tariffs and Trade (GATT), and initiatives in the Basle Committee and IOSCO to harmonize capital requirements and establish home-country supervision for banks and securities firms.
The Maastricht agreement of December 1991 generated a surge of activity in the ECU securities market. This market had become symbolic of confidence in convergence to monetary union and the creation of a European central bank (ECB), and the ECU was viewed as more likely to have a stable real value as it would become the unit of account in a monetary union.96 At the end of 1991, the market included ECU 193 billion of banking liabilities, ECU 124 billion of bonds, and ECU 17 billion of Euro-notes and treasury bills; in the first half of 1992, ECU primary bond issues totaling ECU 26 billion (compared with ECU 33 billion in the whole of 1991) were brought to the market (Bank for International Settlements, 1993, p. 62).
The resurgence of private market financing to developing countries continued in 1992. As in previous years, the volume and form of private flows varied markedly across groups of countries. Capital flows to developing countries that had experienced debt-servicing difficulties during the 1980s were mainly through securities markets, whereas financing to countries that had maintained market access consisted of both banking and—increasingly—securitized flows. The growth in scale of portfolio flows has been paralleled by increasing market maturity, by a broadening range of instruments, by rising market liquidity, and by growing availability of information. Nevertheless, developments in this market were far from smooth, with several important sectors experiencing setbacks. Most notably, Latin American entities experienced a significant tightening of their market access during the second half of 1992.