BIS Quarterly Review September 2001 - International banking and financial market developments
10 September 2001
The BIS Quarterly Review has two parts. The first provides a review of recent developments in international financial and banking markets. The second part of this Review features three articles on topics of special interest: one on the policy dilemma of bank provisioning, one on the growth of foreign currency deposits in Taiwan, China, and the third on the use of collateral in wholesale financial markets.
The recovery keeps investors waiting
The onset of summer 2001 was marked by fading hopes for an early global economic recovery. As discussed in the June 2001 issue of the BIS Quarterly Review, spring had been a time of cautious optimism in financial markets, with participants generally convinced that monetary easing by the principal central banks in the developed countries would quickly turn the global economy around. However, in June and early July, disappointing macroeconomic data from Japan, Europe and the United States accompanied by profit warnings from European and North American companies indicated that the slowdown was not only continuing but also spreading. Stock markets fell sharply, giving back their recent gains and extending the correction that had begun a year before.
The general deterioration in stock markets was compounded in July by strains in emerging markets. Economic stress in Argentina, Turkey and Poland spilled over onto the currencies of a number of emerging economies, although there were also many countries that were unaffected. The contagion, however, was short-lived, starting to abate within two weeks as market participants again began to differentiate carefully between countries.
In spite of the gloom in equity markets, there was little sign of a credit crunch in international fixed income markets. Yield curves in the major swap markets retained their steep slopes, indicating a degree of confidence in a near-term economic recovery. Rising losses from defaults did not prevent credit spreads from narrowing further, as investors sought to add corporate bonds to their portfolios. Even spreads in the troubled telecoms sector narrowed. In the international market, firms continued to take advantage of favourable conditions by floating long-term debt securities in the second quarter, albeit at a slower pace than before. At the same time, with banks providing ready financing, announcements of new international syndicated credit facilities surged, reversing a two-quarter decline. Many corporate borrowers, however, used the funds raised to pay off other obligations, especially maturing long-term debt and commercial paper, rather than to invest in new equipment and acquisitions.
The international debt securities market
The second quarter saw a contrast between strong gross issuance and declining net issuance in the international debt securities market. Behind the strength of gross issuance was a continued reliance by large corporate borrowers on a receptive market to raise funds for refinancing other debt. The fact that net issuance fell even with favourable credit spreads suggested that the global economic slowdown was beginning to dampen the demand for funds related to new investment as well as acquisitions.
Gross announced issuance of international bonds and notes reached $543 billion during the second quarter of 2001, and indeed such issuance in the first six months of the year was at an all-time high. By turning to long-term debt, some borrowers locked in relatively low financing costs at a time when access to commercial paper markets was difficult for low-quality issuers.
The net amount of funds raised during the second quarter of 2001 was $260 billion, down 15% from the previous quarter. The slowdown in net issuance started with money market instruments in the first quarter and widened to include longer-term securities in the second. Financial institutions accounted for much of the decline in fund-raising, indicating a lack of financing demand from their own borrowers. The main exception to the pattern of retrenchment was developing countries as a group, whose net issuance continued to recover during the second quarter of 2001 from an unusually depressed final quarter of 2000.
Aggregate turnover on exchange-traded derivatives markets reached a new high in the second quarter of 2001. The dollar value of contracts monitored by the BIS rose to $140 trillion, a 3% increase. Although the markets' rate of expansion moderated relative to the record increase seen in the previous quarter, business in fixed income instruments, particularly those based on US money market rates, remained exceptionally buoyant. While hedging induced by monetary policy easing appears to have been an important element in the high turnover of interest rate instruments, changes in risk management practices may have also played a role. In Japan, by contrast, turnover in most fixed income products remained on a downward trend.
The international banking market
The first quarter of 2001 saw record activity in the international banking market. According to the BIS locational banking statistics, cross-border claims of banks in the reporting area increased by $704 billion, substantially higher than the previous peak of activity in the first quarter of 2000. These flows were bloated by interbank activity in a recycling process that supported a revival of cross-border lending to non-bank borrowers, to an unprecedented $183 billion. The bulk of this lending went to non-banks in the United States. In Europe, cross-border flows to non-banks were boosted by purchases of government securities, and in offshore centres by hedge fund activity.
Emerging economies as a group did not share in the expansion of international banking activity. New lending to Mexico, Korea, Brazil and emerging Europe in the first quarter was more than offset by cutbacks in claims on Argentina, Turkey and economies in East Asia and the Middle East. Coupled with continuing deposit inflows from Asian and oil-exporting countries, this contraction resulted in the eighth consecutive quarter of net outflows from emerging economies to banks in the reporting area.
The provisioning dilemma
A feature article discusses a number of recent policy initiatives related to bank provisioning and proposes an analytical framework for evaluating them. Provisioning practices have come under increased scrutiny over recent years from accounting and taxation authorities as well as financial supervisors. This heightened scrutiny reflects not only the role that provisioning plays in the transparency of bank balance sheets and the behaviour of bank profits, but also the attention the proposed New Basel Capital Accord has drawn to ways of protecting a bank from credit losses. The article points to important differences of views regarding criteria for identifying a deterioration in credit quality, the role of loan pricing, the relevant horizon for credit assessment and the appropriate discount rate. The tensions seem to arise from a difference in perspective: while financial supervisors focus on the soundness of the banking system, accounting authorities emphasise fair and objective loan valuations.
The growth of Taiwanese foreign currency deposits
A second article notes that a surge of Taiwanese foreign currency deposits in recent years is at odds with the generally positive relationship between inflation and the scale of foreign currency deposits. The article then proceeds by considering four alternative explanations: country risk, credit risk, interest rate differentials and exchange rate expectations. Analysis of the evidence suggests that country risk, credit risk and interest differentials are not the likely explanations, while an expected depreciation of the local currency seems to be the most convincing one, especially when yields favour foreign currency.
Collateral in wholesale financial markets
A third feature article presents some of the main findings of a report on changing collateral practices in financial markets. Over the past few decades, counterparty risks in wholesale transactions have increasingly been covered by bilateral collateral agreements. In 1999, a report by the Committee on the Global Financial System (CGFS) had pointed to inadequacies in collateral practices as creating problems in the functioning of markets in autumn 1998. The CGFS followed up by establishing the Working Group on Collateral to review developments in collateral use, and the group published its report in March 2001. Drawing on the report, the article describes the increasing number of assets that are accepted as collateral and identifies possible systemic implications of the way collateral may be used during times of stress.