Quarterly Review, March 1999

8 March 1999

Introduction

The BIS is releasing today its regular quarterly review and statistics on recent international banking and financial market developments. Global financial markets suffered from extremely volatile conditions in the fourth quarter of 1998. The flight to safety and liquidity following the Russian debt moratorium in August reached a climax in October. Benchmark yields and equity prices retreated, while credit spreads widened markedly. Massive deleveraging added to price swings and further contributed to a drying-up of liquidity in a wide range of markets and instruments. In November, tensions eased somewhat following cuts in US official interest rates and the approval of an IMF-led support package for Brazil. However, concerns about market and counterparty risks remained pervasive. Indeed, credit spreads in bond markets widened again at the beginning of December on fears surrounding the financial situation in Brazil. This contrasted with the continuing euphoria in equity markets in Europe and the United States, despite repeated official statements of concern about a possible disconnection between price levels and fundamentals.

In the international securities market, gross issuance of bonds was of the same order of magnitude as that of the previous quarter, but a record volume of maturing debt meant that net financing fell to its lowest level in three years. International investment funds shifted further towards highly rated public sector entities and supranational borrowers, and there was an absolute decline in exposure to developing country entities. Financial institutions were also hard hit, with swap spreads over government bond yields remaining high throughout the period. Counterparty and liquidity risk issues were also very much to the fore in the derivatives industry, where the withdrawal of leveraged players and the paring-down of positions ahead of the introduction of the euro seem to have led to a sharp deceleration of activity in November and December. The less favourable environment faced by non-prime borrowers was equally apparent in the sector for syndicated loan facilities. The amount of syndications fell to well below total gross issuance of international securities, and pricing conditions tightened for most categories of borrowers.

At the same time, detailed international banking data now available for the third quarter of 1998 underline the depth and scope of the adjustments which took place during this episode of global turbulence. Although the international interbank market seems to have performed relatively well in its key function of redistributing liquidity worldwide, signs of strains were nevertheless apparent. Firstly, there was a sharp cutback in exposure to emerging market economies, with the turnaround vis-à-vis Brazil and Russia illustrating the abrupt reassessment of their creditworthiness. Secondly, more stringent collateral requirements meant that new lending to non-bank customers in major financial centres slowed to a trickle. In particular, credit lines to entities in the United States and certain Caribbean centres, where some major hedge funds are located, were not renewed. Thirdly, non-bank depositors displayed a strong preference for placing funds with banks perceived to be less exposed to the financial upheaval.

The fact that most major equity indices returned to near-peak levels in December suggests that the systemic repercussions of the upheaval were contained. Market participants themselves have been prompted to review previous assumptions concerning liquidity, credit risk and the correlation between markets, and to put greater emphasis on stress testing as well as on fundamental analysis. In addition, measures have been taken by the official sector to address immediate and longer-term weaknesses in the international financial system. However, recent events have also heightened the dilemma faced by the authorities in turbulent circumstances. On the one hand, it is recognised that private players should bear the cost of their own investment decisions. On the other hand, official action is sometimes needed to restore market confidence and preserve the stability of the system as a whole. The improved management of future crises will depend on the resolution of this dilemma.