BIS Quarterly Review June 2001 - International banking and financial market developments
18 June 2001
Swings in market sentiment were particularly pronounced in the early months of 2001. While it was clear that the US economy had begun to slow substantially, market participants vacillated in their views about the likely length and depth of the slowdown, the extent to which it would spread to Europe and elsewhere, and its ramifications for corporate earnings and credit quality. Inter-meeting policy rate cuts by the US Federal Reserve buoyed the markets in general, while company profit warnings tended to depress the equity markets. By April, investors seemed to be looking beyond a brief slowdown in corporate earnings to a robust recovery.
Compared to equity investors, participants in fixed income markets seemed to be less prone to change their views. As short-term interest rates fell against a background of confidence in an imminent recovery, yield curves in both US dollars and euros tended to become progressively steeper and credit spreads narrower.
The international debt securities market
The decline of interest rates and narrowing of credit spreads brought borrowers with low and medium ratings back in force. Net issuance of straight fixed rate bonds and notes in the international market surged to an all-time high of $204 billion during the first quarter of 2001. Nevertheless, aggregate net issuance declined because of a sharp contraction in money market borrowing. Gross announced issuance of bonds and notes rose by $140 billion over the previous quarter, while repayments increased by $72 billion.
The shift from short-term to long-term funds represented a return to more normal patterns after the previous quarter's unusually high volume of money market issuance. Credit rating downgrades and a reluctance of banks to provide backup liquidity facilities made it more difficult for some firms to borrow in the commercial paper market, and they turned to a newly receptive bond market.
Emerging economies also returned to the bond market, albeit in a modest way. Net issuance by these borrowers amounted to $6 billion in the first quarter, after a quarter of net repayments. As a group, countries in Latin America and non-industrial Europe raised funds, while those in Asia made repayments.
The dollar value of turnover on derivatives exchanges rose by a record amount in the first quarter of 2001, driven by a 55% increase in turnover in exchange-traded interest rate contracts. Activity in short-term contracts was especially strong, surging by 61%. The impetus for all of this activity was apparently the surprise cut in US policy rates in early January.
In contrast to exchange-traded activity, the expansion of the notional amount of outstanding over-the-counter (OTC) contracts slowed down considerably in the second half of 2000. This represents a significant departure from previous patterns since in recent years the growth of OTC market activity had consistently outpaced that on exchanges. The most notable feature of the moderation in OTC market activity was a decline in inter-dealer transactions, particularly in euro-denominated interest rate swaps.
The international banking market
The fourth quarter of 2000 saw a remarkable surge of interbank activity. The latest BIS locational banking statistics show an increase of cross-border claims by $400 billion, $302 billion of which comprised interbank lending. Much of this interbank activity was driven by efforts to recycle large inflows from oil-exporting countries and emerging economies in East Asia to borrowers in the United States and other industrial countries.
The surge in fourth quarter activity brought the rise in cross-border claims for the year to $1.2 trillion, a quadrupling over 1999 levels. As in the case of the quarterly increase, the annual rise was dominated by interbank activity, which is typically inflated by a multiplier in the recycling process. Lending to non-bank borrowers actually slowed to $55 billion in 2000, about half of what it was in 1999. Cross-border purchases of securities continued their upward trend, driven by a sixfold increase in purchases of securities issued by US residents.
Banks' cross-border claims on emerging economies continued to contract in the fourth quarter of 2000, by $6 billion. A rise in claims on Brazil and Turkey was more than offset by a decline in claims on Korea and other Asian economies. Considering changes in banks' claims as well as emerging economies' cross-border deposits, net outflows from emerging economies to international banks during 2000 even exceeded average annual outflows during the financial crises of 1997-99.
Stress testing in practice
A feature article presents the results of a survey of stress testing practices conducted in May 2000. Forty-three major commercial and investment banks from 10 countries responded to questions about the material risks they faced. The survey suggests that stress testing has become an integral part of the institutions' risk management. In responding to the tests, risk managers seem to take into account their position in the market and the strategic aspects of risk management. In particular, there are no strict mechanical rules for responding to instances in which risk limits are breached. Decisions are taken on a case by case basis.
Do macro announcements still drive the US bond market?
A second feature article explores the extent to which various macroeconomic announcements still lead to sharp changes in the price of the five-year US Treasury note. The article compares announcement effects in 1999 to those in 1993-94, relying on a previous study that looked at the earlier period. The article reports five basic results. First, the largest short-term price movements in the Treasury market were still associated with macroeconomic announcements, but the market seemed to react to more announcements than before. Second, announcements continued to trigger higher than average price volatility. Third, the surprise content of announcements in 1999 was smaller than before. Fourth, the price response to surprises in non-farm payrolls, the single most important announcement, was no longer consistent in sign although the price response to inflation surprises was similar to that previously found. Finally, there is no evidence that large equity price changes drove bond price movements in 1999.
Is there a "Nasdaq effect" in emerging equity markets?
A third special feature investigates whether there is a "Nasdaq effect" in emerging equity markets. The article asks specifically whether changes in this index lead to movements in the equity markets even after accounting for common global and sectoral components. The analysis suggests that changes in the Nasdaq Composite have little additional explanatory power beyond these components, although a "Nasdaq effect" may be part of the global factor. However, the analysis also points to the possible instability in the examined relationships, particularly during 2000.
Read the publication: BIS Quarterly Review June 2001