BIS Quarterly Review, June 1997

The BIS is releasing today its regular quarterly commentary and statistics on recent "International Banking and Financial Market Developments". The report notes that ample liquidity continued to support activity in international securities markets in the first quarter of 1997, with a 18% annualised rate of expansion in the total stock outstanding. Some uncertainty concerning European economic and monetary union (EMU) and growing expectations of a tightening of monetary policy in the United States did not fundamentally call into question the ongoing search for yields and the related process of international portfolio diversification. While trading strategies and instruments were quickly adapted to take into account new market conditions, interest rate differentials created sustained demand for dollar and sterling assets, and the structural convergence of European debt markets supported issuance in European currencies and ECUs. At the same time, less favourable borrowing conditions for high-yielding paper had a somewhat negative impact on issuance and pricing in the latter part of the quarter. However, these developments were short-lived and were due as much to local factors as to a general reassessment by international investors of the risk profile of their portfolio in the wake of US monetary tightening.

In the main, changes in market conditions were much less pronounced than in 1994, with the rise in US official rates largely anticipated and the initial monetary stance less accommodating. In addition, as shown by detailed international banking data available up to the end of 1996, deeper underlying changes may have contributed to enhancing the resilience of the world financial system to disturbances. Firstly, the more systematic use of collateralisation in wholesale cash transactions has helped to reduce credit risk. Secondly, consolidation and restructuring within the global financial industry, together with an increasingly market-oriented regulatory approach, have led to a greater awareness of market and credit risks and, therefore, more efficient asset and liability management. Finally, efforts by recipient countries to reduce dependence on short-term capital are beginning to bear fruit, with the growing recognition that changes in economic policies are more effective in achieving this objective than ad hoc restrictive measures on capital inflows. At the same time, however, cross-border investment flows continue to be driven by wide interest rate differentials between assets in US dollars and in other major currencies, still leaving markets exposed to any unexpected turnaround in underlying conditions. Moreover, the unusually long economic expansion in the United States raises the question of whether the pricing of some transactions has given sufficient consideration to credit risk over the full business cycle. Issues related to the practical implementation of EMU and to the possible existence of large open positions are the source of additional uncertainty. All of these factors should put a premium on prudent behaviour by market participants.