International financial markets

VIII. International financial markets

Highlights

Ample liquidity and subdued inflation provided a favourable climate for cross- border investment flows in 1997. Despite the Asian crisis, the international market-place remained a major channel through which banks and other investors pursued their search for higher returns, as illustrated by a growing willingness to consider new signatures and higher-risk instruments incorporating sophisticated payoff structures. The international financial markets also benefited from their competitive advantages relative to domestic markets, the underlying globalisation of finance and the growing demand for large and complex financing arrangements. The further lowering of regulatory barriers in some of the major centres and the forthcoming introduction of the single European currency gave additional impetus to the consolidation taking place within the financial industry, boosting cross-border flows. The turbulence in Asia led to an abrupt reassessment of lending and investment strategies, with a drying-up of securities flows to emerging market economies in the fourth quarter. While investors continued to shun Asian credits in the early part of 1998, the swift return to the market of other

Activity in international financial markets In billions of US dollars

Left-hand scale:

Right-hand scale: 3 1,200

Bank lending: 1

Exchange-traded derivatives

30,000 Net lending

OTC derivatives 4

1,000

Interbank redepositing Securities issues: 2

25,000

Non-financial sector 800

Financial sector

20,000

600

15,000

400

10,000

200

5,000

0 1993 1994 1995 1996 1997

1 Changes in amounts outstanding, excluding exchange rate valuation effects. 2 Net issues (exclud- ing exchange rate valuation effects) of international money market instruments, bonds and notes. 3 Notional amounts outstanding at end-year. 4 For 1997, end-June. Sources: Bank of England, Euroclear, Euromoney, Futures Industry Association, International Financing Review (IFR), International Swaps and Derivatives Association (ISDA), International Securities Market Association (ISMA), national data and BIS. Graph VIII.1

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developing countries suggests that, in spite of the greater focus on credit risk, the integration of emerging economies into the world financial system has not been fundamentally called into question.

Against this background, total net international financing through bank lending and securities issues again grew at a vigorous pace in 1997. The expansion of international bank claims was particularly striking given the rapid development of securitisation worldwide. Thus, banks sharply increased their interbank activity and stepped up their involvement in securities markets. Together with other intermediaries, banks accounted for about two-thirds of the expansion in the outstanding stock of international securities. While the greater importance of securities in banks’ balance sheets reflected their more active management of assets and liabilities, the large-scale recourse to the international capital market was a response to investors’ reduced interest in traditional forms of saving. In turn, this large overlap between international bank credit and securities financing, together with the strong inroads made by banks into other segments of the financial industry, shows that commercial banks continue to play a leading role in the intermediation process.

Meanwhile, changing perceptions concerning EMU, renewed volatility in foreign exchange and equity markets and the repercussions of the Asian crisis provided fertile ground for the trading of derivatives. Turnover on exchanges expanded after two consecutive years of decline, while business in over-the- counter products continued to thrive. Intense competition from OTC markets, the increasing popularity of electronic trading systems and the prospective introduction of the single European currency accentuated the forces driving

Estimated net financing in international markets1

Components of net international financing 1992 1993 1994 1995 1996 1997 Stocks at end- 1997 in billions of US dollars

Total cross-border bank claims2 185.5 316.4 274.9 680.1 532.7 1,156.7 9,038.3 Local claims in foreign currency – 39.8 –0.9 0.2 –36.0 71.4 65.1 1,344.4 minus: Interbank redepositing –19.4 115.5 85.1 314.1 184.1 721.8 5,097.7 A = Net international bank lending3 165.0 200.0 190.0 330.0 420.0 500.0 5,285.0 B = Net money market instruments 12.1 –6.3 3.3 17.4 41.1 19.8 183.8 Total completed bond and note issues .. .. 507.2 541.3 865.9 1,033.2 minus: Redemptions and repurchases .. .. 253.9 290.4 363.6 457.1 C = Net bond and note financing 137.9 195.2 253.3 250.9 502.3 576.0 3,358.3

D= A¤¤+¤¤B¤¤+¤¤C = Total international financing 314.9 389.0 446.5 598.2 963.4 1,095.9 8,827.2 minus: Double-counting4 69.9 114.0 41.5 53.2 213.4 230.9 1,242.2 E = Total net international financing 245.0 275.0 405.0 545.0 770.0 865.0 7,585.0

1 Changes in amounts outstanding, excluding exchange rate valuation effects, for banking data and euronote placements; flow data for bond financing. 2 Banks in the Group of Ten countries plus Luxembourg, Austria, Denmark, Finland, Ireland, Norway, Spain, the Bahamas, Bahrain, the Cayman Islands, Hong Kong, the Netherlands Antilles and Singapore, and the branches of US banks in Panama. 3 Excluding, on an estimated basis, redepositing between reporting banks. 4 International bonds purchased or issued by the reporting banks, to the extent that they are included in the banking statistics as claims on non- residents. Sources: Bank of England, Euroclear, Euromoney, IFR, ISMA and BIS. Table VIII.1

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the industry’s restructuring. Moreover, the growing importance of repurchase agreements, along with other techniques of risk management, points to a further integration of cash and derivatives markets. These developments, combined with the increasing intertwining of commercial banking, investment banking, insurance and asset management, and the rapid advances in information technology, are adding to the complexity of worldwide financial intermediation and to pressures to adjust the regulatory infrastructure.

The international banking market

A record volume of international syndicated loan facilities was announced last year. With the BIS data now incorporating refinancing transactions, announcements surged from $901 billion in 1996 (revised from $530 billion) to $1,136 billion. Margins for prime borrowers reached very low levels, leading banks to attach their loans to the provision of ancillary services and to focus on more profitable operations, such as mergers and acquisitions. They also turned to transition and emerging market countries, where lending was buoyed in the early part of the year by strong domestic demand and project financing and, subsequently, by the less receptive attitude of the international securities markets to lower-rated names. The Asian crisis led to a tightening of lending conditions

144

Record volume of syndicated loan facilities ...

Main features of international banking activity1

Uses and sources of international bank credit 1992 1993 1994 1995 1996 1997 Stocks at end- 1997 in billions of US dollars

A = Claims on outside-area countries 66.0 11.6 36.6 120.8 141.4 94.9 1,197.7 B = Claims on inside-area countries 80.4 251.4 228.3 506.5 446.2 1,115.7 8,935.0 (1) Claims on non-banks 90.0 122.7 –49.3 189.5 302.2 262.9 2,778.6 (2) International financing of domestic lending 9.8 13.3 192.5 2.9 –40.1 131.0 1,058.7 (3) Interbank redepositing –19.4 115.5 85.1 314.1 184.1 721.8 5,097.7 C = Unallocated –00.8 52.5 10.1 16.8 16.4 11.2 250.0 D= A¤¤+¤¤B¤¤+¤¤C = Gross international bank

lending 145.6 315.5 275.1 644.1 604.1 1,221.8 10,382.7

E = D¤¤–¤¤B(3) = Net¤¤international¤¤bank¤¤lending 165.0 200.0 190.0 330.0 420.0 500.0 5,285.0

A = Liabilities to outside-area countries 13.2 –14.8 74.6 96.4 101.8 75.7 1,043.1 B = Liabilities to inside-area countries 91.2 112.5 539.2 338.5 325.0 969.8 8,130.5 (1) Liabilities to non-banks 104.4 86.2 132.8 116.7 225.7 223.7 1,959.6 (2) Domestic funding of international lending 40.7 85.6 –64.4 18.9 –31.7 –5.8 1,292.2 (3) Interbank redepositing –53.9 –59.3 470.9 202.9 131.0 751.9 4,878.7 C = Unallocated 6.7 43.0 47.1 98.0 124.1 206.4 990.1 D= A¤¤+¤¤B¤¤+¤¤C = Gross international bank

borrowing 111.1 140.7 660.9 532.9 551.0 1,251.9 10,163.7

Memorandum item: Syndicated credits2 194.1 279.4 477.1 697.7 900.9 1,136.3

1 Changes in amounts outstanding, excluding exchange rate valuation effects. 2 Announced new facilities. Sources: Euromoney and BIS. Table VIII.2

Bank for International Settlements -- 68th Annual Report

Total international bank lending 1 In billions of US dollars

Total gross lending

1,200 Inside-area lending 2 Outside-area lending Unallocated

1988 1989 1990 1991 1992 1993 1994 1995 1996 1997

1 Changes in amounts outstanding of banks’ cross-border claims and local claims in foreign currency, excluding exchange rate valuation effects. 2 Net of interbank redepositing. Source: BIS. Graph VIII.2

1,000

800

600

400

200

for such borrowers, with wider spreads as well as stricter collateral and material adverse change clauses. Finally, banks continued to broaden the range of their risk management techniques through secondary market trading of loans, asset securitisation and credit derivatives.

At the same time, gross credit flows intermediated by the international

... and of interbank

banking market soared from $604 billion in 1996 to an all-time high of $1,222 transactions ...

billion. The upsurge was almost entirely accounted for by interbank business

Currency and nationality structure of international bank lending * Percentage shares, at end of quarter

By currency By nationality of reporting banks

United States

50 Japan

US dollar Yen Deutsche mark

Germany France

United Kingdom

French franc Sterling

0 1993 1994 1995 1996 1997

1993 1994 1995 1996 1997

* Cross-border claims and local claims in foreign currency of banks located in industrial reporting countries. Source: BIS. Graph VIII.3

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under the combined influence of a number of forces. First, although banks retreated massively from Asia in the fourth quarter, the need to fund or hedge existing positions and accommodate the abrupt change in the behaviour of investors and borrowers involved a major redistribution of liquidity worldwide. Secondly, the funding difficulties experienced by Japanese banks, especially towards the year-end, required a large supply of fresh capital from the head offices to their branches abroad. Thirdly, consolidation within the industry, especially among European groups, may have created temporary funding requirements. Finally, greater reliance on collateralised lending brought a broader spectrum of participants to the interbank market. In contrast to the buoyancy of interbank business, direct lending to non-bank entities moderated from the record level of 1996, possibly as a result of a cutback in leveraged transactions.

Business with countries inside the reporting area

Among the various reporting centres, the United States and the United Kingdom were the main beneficiaries of the reshuffling of interbank transactions last year. A large volume of interbank funds was also channelled to the Caribbean centres, where many hedge funds and other investment companies are located. In addition, banks stepped up their acquisitions of debt securities, using government paper denominated in the major trading currencies to raise cash on a collateralised basis for the purchase of high-yielding instruments. The abrupt reversal in banks’ holdings of securities issued by offshore and emerging market entities in the fourth quarter, from an increase of about $30 billion in the first nine months of the year to a fall of $9 billion, suggests a significant amount of proprietary trading by banks. Excluding securities business, direct credit to the non-bank sector located inside the reporting area showed some weakening from

146

... but slightly reduced borrowing by non-banks ...

Banks’ external claims on countries outside the reporting area*

Country groups

1995 1996 1997 Stocks and countries

Year Year Year Q1 Q2 Q3 Q4

at end- 1997 in billions of US dollars

Total outside area 120.8 141.4 94.9 41.6 31.0 25.1 –12.8 1,197.7 Developed countries 24.6 22.8 24.8 4.1 8.8 7.9 4.1 211.5 Eastern Europe 3.3 10.8 18.3 4.3 3.2 8.2 2.4 105.2 Developing countries 93.0 107.9 51.8 33.2 19.0 9.1 –19.4 880.9 Latin America 16.4 28.5 33.1 7.4 3.7 11.1 11.0 304.4 Argentina 1.9 5.4 7.0 1.0 0.1 2.8 3.1 46.3 Brazil 12.0 16.7 11.5 3.2 2.7 4.8 0.8 101.2 Mexico –4.2 0.1 1.7 0.8 –0.2 –21.3 2.4 73.9 Middle East –7.5 –0.1 10.0 3.6 –0.6 0.3 6.7 80.1 Africa –2.2 –0.4 2.6 0.8 0.9 0.7 0.2 50.7 Asia 86.3 79.8 6.1 21.4 15.0 – 23.0 –27.3 445.8 Indonesia 6.9 9.4 5.6 1.8 2.8 3.2 –12.2 62.7 Korea 22.5 26.6 –14.2 4.3 4.0 –22.2 –10.2 104.1 Thailand 38.8 9.5 –17.5 0.5 –0.3 –10.5 –17.3 79.6

* Changes in amounts outstanding, excluding exchange rate valuation effects. Source: BIS. Table VIII.3

Bank for International Settlements -- 68th Annual Report

the record level of 1996, especially in the fourth quarter. The flight to quality resulting from the spillover of the Asian turbulence seems to have temporarily dampened the enthusiasm for leveraged investment strategies.

Business with countries outside the reporting area

The drop in banking flows to emerging economies in Asia last year (from $80 billion in 1996 to $6 billion) provides an imperfect picture of the extent of the turnaround which took place in the course of the year. The quarterly BIS data show that banking flows were well sustained until the onset of the crisis. Flows to Thailand began to change direction in the second quarter, and in the case of Korea the reconsideration of exposure only became evident in the third quarter. ... and sudden

The withdrawal of funds turned into a stampede in the fourth quarter, affecting retreat of banks from Asia

most Asian countries and leading to a $27 billion reduction in outstanding claims on the region. Interestingly, the over-reliance on short-term banking debt had been recognised well before the first major assault on the Thai baht in February 1997. The national authorities themselves had made unsuccessful attempts to stem such inflows. But the ample availability of liquidity worldwide, together with strong competitive pressures among a broadening range of lenders to what was regarded as a high-growth and profitable region, appears to have made participants oblivious to the weakness of the financial infrastructure and deteriorating economic fundamentals. A notable factor in this process has been the strong increase in the Asian exposure of European banks in recent years, in the face of low returns in traditional markets and limited opportunities for expansion in North America. The resulting lending spree made the reversal all the more abrupt.

Contagion elsewhere is

In Latin America, ongoing structural reforms and some tightening of monetary conditions were fairly successful in stemming contagion in the fourth limited

quarter. Indeed, nearly one-third of reporting banks’ lending to the region last

International bank lending to various regions *

Left-hand scale (in percentages):

Right-hand scale (in US$ billions): Share of short-term

Claims on: claims in total claims

Banks Public sector Non-banks

Asia Latin America Eastern Europe

400

300

200

100

0 93 94 95 96 97 93 94 95 96 97

93 94 95 96 97

* Amounts outstanding at end-year. For 1997, end-June data, which include major breaks in series affecting inter alia the maturity distribution of claims. Source: BIS. Graph VIII.4

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year was recorded in this period. The major exception was Brazil, where banking inflows dropped from an average of $3.6 billion in the first three quarters to $0.8 billion in the fourth. Although the country was one of the main victims of the crisis outside Asia, policy resolve did much to rapidly restore market confidence (see Chapter III). At the same time, the slowdown in lending to Eastern Europe towards year-end did not prevent a record volume of credit to the region for the year as a whole ($18 billion). The Asian crisis had an uneven impact there in the fourth quarter. The Czech Republic and Hungary saw further sizable imports of banking funds, but the tightening of interest rates failed to maintain flows into Poland and Slovakia. In the case of Russia, the loss of momentum of inflows (from an average of $4.2 billion in the preceding two quarters to $0.9 billion) reflected some repayment of interbank credit, possibly as a result of the debt rescheduling agreement reached in October. The withdrawal of non-resident investors from the Russian Treasury bill market in the wake of the Asian crisis was more than offset by new lines of credit to the public sector.

The events of 1997 raise questions regarding the lessons that have been drawn by market participants. Admittedly, these developments are likely to have prompted changes in risk management practices and to have led to a reconsideration of the narrow reliance on ratings in the pricing of credit. They also seem to have brought a recognition that, with the growing complexity of financial linkages, official actions to preserve systemic stability should not insulate creditors and debtors from the adverse consequences of poor investment and policy decisions. Nevertheless, the renewed decline of risk premia for non-Asian

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International bank and debt securities financing in Asia and Latin America In billions of US dollars

Asia 1 Latin America

10- - 10- - Bank borrowing 2 Securities issuance 3

20- - 20- - 30- - 30- - 1993 1994 1995 1996 1997

1993 1994 1995 1996 1997

1 Excluding Hong Kong, Japan and Singapore. 2 Exchange-rate-adjusted changes in BIS reporting banks’ claims vis-à-vis Asian and Latin American countries. 3 Net issues of international money market instruments, bonds and notes. Sources: Bank of England, Euroclear, Euromoney, IFR, ISMA, national data and BIS. Graph VIII.5

Questions were raised on the lessons drawn

Bank for International Settlements -- 68th Annual Report

borrowers in 1998, despite the absence of marked improvements in external financial indicators and lingering uncertainty as to the actual impact of the Asian crisis, suggests a return to loose lending standards. It is at least to be hoped that current commitments by authorities in borrowing countries to more rigorous macroeconomic policies and financial market restructuring will be pursued, as well as efforts by intermediaries to develop better systems and strategies for managing credit exposures.

The international securities market

Impact of market

In spite of the record volume of announced new international debt securities in turbulence offset by strong expansionary forces ...

1997, the sharp increase in repayments meant that growth in net issuance moderated substantially. Nevertheless, it remained significantly higher than that in domestic securities markets. The high volume of issues and their growing diversity suggest that expansionary factors were sufficiently powerful to offset

... such as the

the impact of recurring market turbulence. The search for higher returns search for yields ...

remained a driving force, drawing new classes of investors and issuers to the

Main features of international debt securities issues1

By instrument, residence,

1992 1993 1994 1995 1996 1997 Stocks currency and type of issuer

at end- 1997 in billions of US dollars

Total net issues 149.9 189.0 256.5 268.2 543.4 595.9 3,542.2 Money market instruments2 12.1 –66.3 3.3 17.4 41.1 19.8 183.8 Bonds and notes2 137.9 195.2 253.3 250.9 502.3 576.0 3,358.3 Developed countries 114.0 123.0 184.7 198.7 363.3 394.1 2,604.4 Europe3 92.6 137.9 151.9 148.2 212.0 223.7 1,531.5 Japan –3.4 –45.8 –27.7 –29.4 –17.6 –32.7 156.5 United States 16.9 10.2 37.2 62.2 144.9 185.4 614.2 Canada 10.5 19.0 16.8 9.1 9.8 9.1 187.9 Offshore centres 0.0 5.2 35.3 33.8 74.6 91.6 323.7 Other countries 12.7 24.7 27.9 24.0 80.4 79.7 297.8 International institutions 23.1 36.1 8.6 11.7 25.0 30.4 316.4 US dollar 58.1 28.9 67.3 70.2 262.8 336.5 1,569.3 EU currencies 84.1 111.2 96.8 98.0 175.3 199.0 1,191.8 Yen 9.1 29.3 87.5 83.6 85.1 34.2 462.0 Other currencies –1.4 19.6 4.9 16.4 20.2 26.2 319.1 Financial institutions4 42.9 51.8 138.5 170.7 351.0 368.2 1,605.5 Public sector5 82.7 130.8 103.3 74.0 121.4 101.8 1,067.0 Corporate issuers 24.4 6.5 14.7 23.6 71.0 125.9 869.7 Memorandum items: Stand-alone international bonds 109.5 116.8 116.3 75.8 278.3 292.8 2,469.0 Bonds issued under EMTN programmes 11.0 38.4 86.9 104.4 195.9 215.8 604.9

1 Flow data for international bonds; for money market instruments and notes, changes in amounts outstanding, excluding exchange rate valuation effects. 2 Excluding notes issued by non-residents in the domestic market. 3 Excluding Eastern Europe. 4 Commercial banks and other financial institutions. 5 Governments, state agencies and international institutions. Sources: Bank of England, Euroclear, Euromoney, IFR, ISMA and BIS. Table VIII.4

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market. Tolerance for risk was illustrated by the positive reception given to first- time sovereign borrowers and the widening spectrum of issuing currencies. Investors were also more willing to consider high-yielding instruments incorporating features such as junior capital status, derivatives-related payoffs or complex securitisation mechanisms.

The resilience of international financial activity also resulted from longer- term changes on the borrowing side. First, financial liberalisation in the principal economies has encouraged borrowers to obtain lower costs by tapping new pockets of investment demand elsewhere. Secondly, restructuring in the industrial and financial sectors has been accompanied by increasingly large and complex structures whose technical requirements are more often than not met more easily in the international market-place. Thirdly, innovation has facilitated market access by enabling intermediaries to unbundle and repackage underlying risks, as illustrated by the rapid development of asset-backed securities and credit-linked notes. Fourthly, the shift by investors away from traditional saving instruments has fuelled recourse by intermediaries to the market, while the improvement in the credit quality of North American and certain European banks has facilitated the marketing of their issues. Fifthly, the gradual integration of emerging market and transition economies into the global economy has seen a growing proportion of international business accounted for by borrowers from such countries. Lastly, the scheduled introduction of the single European currency has acted as a catalyst for cross-border European borrowing and investment.

Type and nationality of issuers

Issuance by financial institutions accounted for nearly two-thirds of the growth of the international securities market in 1997, illustrating the importance of cross- border capital in the active management of assets and liabilities. While European

150

... financial restructuring ...

... market innovation ...

... and the advent of the euro

Borrowing by financial institutions predominates

International interest rates Monthly averages, in percentages and percentage points

Long-term rates 1 Term structure 2

US dollar

French franc Yen

Sterling 8

Deutsche mark

2- - 0

4- - 1993 1994 1995 1996 1997 1998

1993 1994 1995 1996 1997 1998

1 Yields in annual terms on five-year interest rate swaps. 2 Five-year rates minus three-month euro- market interest rates. Sources: DRI and BIS. Graph VIII.6

Bank for International Settlements -- 68th Annual Report

banks often issued subordinated debt to capitalise their trading books or to finance acquisitions, many US-based institutions exploited existing discrepancies in the regulatory and tax treatment of such debt. The issuance of asset-backed securities through special-purpose vehicles accounted for a significant share of activity by financial institutions. At the same time, budget consolidation dampened sovereign issuance from industrial countries, providing room for new entrants, including recently privatised entities, semi-public financing agencies and local authorities. Meanwhile, borrowing by the corporate sector remained higher than in the early part of the decade. Sizable issuance

An analysis by nationality of borrower reveals that entities from the United by US as well as emerging market entities

States continued the return to the international market that had begun in 1995, accounting for 30% of the increase in the stock of issues. In spite of the Asian crisis, gross issuance from Eastern Europe and Latin America exceeded the record level of 1996. Sovereign borrowers, from Latin America in particular, conducted substantial refinancing operations to lengthen the maturity of their external debt. Argentina, Brazil, Panama and Venezuela brought to market large issues of 30-year uncollateralised global bonds in exchange for part of their outstanding Brady bonds. In addition to reducing financing costs, these transactions were aimed at creating long-term benchmarks to facilitate market access by the private sector. They also illustrated the perceived improvement in the creditworthiness of these countries, which was only briefly interrupted by the Asian crisis.

Types of instrument

The emphasis on

Money market instruments (euro-commercial paper and other short-term liquidity ...

euronotes) expanded at a slower pace in 1997. Investors’ abrupt reassessment of liquidity and credit risks in the wake of the Asian crisis led to a drying-up of net issuance in the fourth quarter. This accentuated the contrast with the US commercial paper market, where expansion proceeded at a brisk rate. Differences in underlying economic conditions between Europe and the United ... hampers the

States, and the more fragmented nature and smaller size of European money growth of the ECP market

market funds, continued to hamper the growth of the ECP market. However, further liberalisation and the prospect of a unified pan-European CP market are likely to render ECP more competitive.

In the longer-term segments of the international securities market, fixed rate paper again accounted for the bulk of gross issuance. Although emerging market borrowers and securitisation vehicles launched some very large bond issues, the growing importance of smaller issues under euro-medium-term note facilities Search for higher

meant that the average size of transactions declined. In their search for higher yields ...

yields, investors purchased longer-dated securities (including a few 100-year Yankee issues), bringing the average maturity back to the near-record length of 1993. While the fixed rate market continued to play a central role in the broadening of market access, announcements of floating rate notes reached a historical high. Investment demand for such defensive instruments was ... but strong demand for defensive

encouraged by anticipations of interest rate increases in the major currencies and the strong liquidity position of financial intermediaries. Meanwhile, investors instruments

showed renewed interest in equity-related issues, as uncertainty about the health

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