BIS Quarterly Review December 2002 - International banking and financial market developments
9 December 2002
The BIS Quarterly Review released today is divided into two parts. The first part analyses recent developments in financial markets, financing flows in banking and debt securities markets, and activity in derivatives markets. The second part presents articles on topics of special interest. This issue offers four articles, with the following topics: predicting banking crises; dealing with settlement risk in currency markets; the effects of interest rate movements on bank interest margins; and the integration of credit markets in East Asia.
International banking and financial market developments
Expectant markets stage a recovery
A revival of confidence ended six months of deepening pessimism in financial markets. The period from May to September 2002 had been marked by a series of blows to investors' expectations. As a consequence, stock prices had tumbled and long-term interest rates had steadily declined. In October, a few favourable corporate earnings reports seemed sufficient to turn investor sentiment around. Over seven weeks in October and November, stock prices began to recover and long rates to rise. However, negative profit warnings continued to outnumber positive ones and macroeconomic data initially tended to be weak. Whether the market recovery is sustained remains to be seen.
Investors in the corporate bond markets shared some of the new optimism prevailing in stock markets. Corporate spreads narrowed significantly in October and November, reversing part of the widening that had taken place as equity markets were falling. However, perceived credit risks in some sectors remained high. In particular, underfunded pension liabilities in the automobile and airline industries led to credit rating downgrades for some companies, including the finance company subsidiaries of US car manufacturers. During the third quarter, when corporate spreads were especially wide, net international issuance of fixed rate securities fell by two fifths, a decline not seen since the immediate aftermath of the Russian crisis in 1998.
Political developments overshadowed the emerging markets. In Brazil, it became clear in October that the next president would be a candidate whose previous views had been a source of concern to market participants. As the election approached, his reassurances about pursuing a sound economic policy seemed to restore a degree of confidence to the sovereign debt market. In Asia, the terrorist attack in Bali in October depressed the Jakarta stock market for a few weeks and had momentary effects on the Bangkok and Kuala Lumpur markets. There were no discernible effects elsewhere. While financial inflows remained sluggish for emerging economies as a group, stronger credits maintained access to capital markets.
The international debt securities market
The slowdown in the international debt securities market that had begun in June continued into the third quarter of 2002. The net amount of funds raised in this market came to only $183 billion, 47% below that of the previous quarter and the lowest level since the fourth quarter of 1998, the period following the Russian financial crisis and the near collapse of LTCM. The decline in issuance affected advanced as well as emerging economies, with a particularly sharp fall in net issuance by entities based in the United States.
The decline in net issuance coincided with a widening of credit spreads. This suggests that fund-raising fell in part because investors were less willing to supply funds, a situation that had already become apparent by the end of the second quarter. European and US financial institutions in particular sharply reduced their borrowing activity in the international debt securities market. Net issuance by large US finance companies, for example, fell by two thirds.
Trading activity on derivatives exchanges remained intense in the third quarter of 2002. The aggregate turnover of exchange-traded contracts monitored by the BIS amounted to $192 trillion, a 14% increase over the second quarter. While the strongest expansion took place in government bond contracts, activity in money market instruments and stock index contracts was also buoyant. In a departure from the seasonal slowdown usually observed in July, the aggregate volume of transactions in that month nearly matched the record observed in November 2001. This high volume of business may have reflected a new round of hedging and repositioning as investors responded to a series of events that weakened their confidence in the strength of the global economy.
The global over-the-counter (OTC) derivatives market also saw increased activity in the first half of 2002. The latest BIS semiannual data on aggregate positions placed the size of this market by end-June at almost $128 trillion in notional amounts outstanding, a 15% increase over end-December 2001. Much of the expansion took place in the interest rate segment, the largest of the broad market risk categories covered by the semiannual survey. These numbers also suggest that OTC activity grew faster than that on exchanges.
The international banking market
Following several quarters of decelerating growth, international banking activity began to stabilise in the second quarter of 2002. Cross-border lending by Japanese and German banks showed signs of levelling out, as did the growth of claims on Europe and the United States. Cross-border credit to governments and other non-bank borrowers continued to outpace credit extended to other banks, contributing to a shift in the sectoral composition of banks' international balance sheets towards non-banks.
In emerging markets, withdrawals of funds placed with banks in the reporting area contributed to the third consecutive quarter of net inflows. Latin America was the only region to see an outflow of funds, as cutbacks in credit more than offset a repatriation of deposits. Faced with volatile financing conditions, residents of Brazil met their need for dollar liquidity by withdrawing funds from abroad.
Assessing the risk of banking crises
Noting the increased frequency and severity of banking crises across the globe in the last two decades, Claudio Borio of the BIS and Philip Lowe of the Reserve Bank of Australia propose a new set of early warning indicators for such crises. Compared with a number of previous proposals, these indicators have some particular advantages. They draw exclusively on information available to policymakers at the time. They take explicit account of the important interaction between factors. And they emphasise the cumulative nature of the processes that give rise to system-wide distress. Borio and Lowe construct their indicators from only three core variables: private credit, equity prices and exchange rates. The resulting indicators show that it may be possible to identify, with some confidence, the build-up of vulnerabilities that leads to crises, although predicting the exact timing of the crises is not feasible.
Settlement risk in foreign exchange markets and CLS Bank
In the first and most dramatic case of settlement risk in the foreign exchange market, the closure of Bankhaus Herstatt in Germany in June 1974 set off a chain of events that disrupted payment systems and brought the market to a halt. Gabriele Galati of the BIS explains how settlement risk arises in currency markets and describes the initiatives to deal with it taken by central banks and market participants over the last two decades. In September 2002, CLS Bank, a financial institution set up to reduce such risk, began to operate. Galati discusses the formation of the new bank and its likely effect on Herstatt risk.
Interest rate risk and bank net interest margins
Banks' interest rate risk reflects the extent to which their financial condition is affected by changes in market interest rates. Bill English of the BIS examines the component of interest rate risk arising from possible effects of market rates on bank interest margins in 10 industrial countries. He finds that banks have generally managed their exposures to volatility in the yield curve in ways that have largely protected their net interest margins. He acknowledges that changes in net interest margins could be an important source of uncertainty in bank profitability and could have adverse effects for particular institutions. Nonetheless, he concludes that fluctuations in market interest rates "seem unlikely to undermine sharply the health of the banking sector through their effects on net interest income".
Integrating the finances of East Asia
Robert McCauley and Blaise Gadanecz of the BIS and San-Sau Fung of University College London provide evidence that overturns the widely held view that East Asia suffers from a significant lack of financial integration. The impression has been that capital is largely channelled between East Asia, on the one hand, and London or New York, on the other, rather than between East Asian economies themselves. Given the memory of the abrupt withdrawal of funds from the region five years ago, the perception of such a pattern of capital flows contributes to a sense of financial vulnerability. McCauley, Fung and Gadanecz assemble evidence from the international bond market and international syndicated loan market showing that "East Asia's finances are more integrated than is often appreciated". While they find that firms from outside the region are prominent in the roles of bookrunners and loan arrangers, they also find that regional funds and banks are quite well represented among the underlying investors in bonds and among the syndicate members in loans.