Massive retreat by banks from emerging markets
According to the Bank for International Settlements' quarterly review, banks "retreated massively" from emerging market economies in the volatile third quarter of 1998. Besides pointing to emerging markets being confronted with an international credit squeeze, the BIS report also commented on the risk evaluation and management structures of banks, which have been found wanting even as the latter have expanded their range of activites.
by Chakravarthi Raghavan
GENEVA: Banks "retreated massively" from emerging market economies, and sharply cut back new loans to non-bank customers in the industrialized world, according to detailed data for the third quarter of 1998, the Basle-based Bank for International Settlements reported in its quarterly review of international banking and financial market developments.
The available data provide evidence of an international credit squeeze for most emerging market borrowers, the BIS said.
The cutback on lending to non-bank customers inside the BIS area is probably indicative of the unwinding of leveraged positions, and net repayments by non-banks in the Caribbean and other offshore centres, where many of the highly leveraged hedge funds are technically located. Borrowers appear to be reducing their gearing since 1997, and the data reported by the BIS show a repayment of about $4.7 billion in the third quarter. Repayments are also indicated in the data from the Cayman Islands.
The claims of reporting banks (from the BIS area) on Asian countries declined for the fifth consecutive quarter by $23 billion, bringing the outstanding exposure of banks to the region back to its end-1995 level.
At the same time, the banks have begun to retreat from Eastern Europe and Latin America, with credit flows to Russia and Brazil being particularly affected.
The decline in banks' outstanding claims on developing countries and eastern Europe, following the Russian debt moratorium of 17 August, the BIS said, amounted to $35 billion.
At the same time, there was stagnation in lending to non- bank customers inside the reporting area (industrialized countries) and this was "consistent with reports of significant deleveraging towards the end of the third quarter, entailing substantial repayments of bank credit," the BIS added.
While detailed data for the fourth quarter will only come in the next quarterly review, the BIS reports that global financial markets suffered from extremely volatile conditions in the fourth quarter of 1998.
The flight to safety and liquidity, in the aftermath of the Russian debt moratorium in August, reached a climax in October. Benchmark yields and equity prices retreated, while credit spreads widened markedly.
Massive deleveraging and, in the process, the near collapse of a major hedge fund (the US-based LTCM) added to price swings and further contributed to a drying up of liquidity in a wide range of markets and instruments.
While in November tensions eased somewhat, following the cuts in US official interest rates and approval of an IMF-led support package for Brazil, and improved economic and financial prospects in Asia, there continued to be high volatility in most market segments, suggesting that concerns about market and counter-party risks remained pervasive.
In the bond market, credit spreads widened again in December due to fears surrounding the situation in Brazil, in contrast to what the BIS calls "continuing euphoria" in equity markets in Europe and the USA.
[The latest IMF agreement announced with Brazil would however suggest a conditionality, requiring a turnaround in Brazil's trade deficit by a massive $15-20 billion, that is difficult to comprehend except in the context of a major recession.]
The various proposals put forward (in the aftermath of the Asian crisis) for ensuring an orderly and cooperative resolution of future crises, in particular to involve the private sector, are now of more immediate concern, the BIS notes.
Events in Russia have reversed the bias towards excessive risk-taking, but by causing a massive unwinding of positions in a broad range of markets and instruments, they created the risk of a systemic failure, prompting official action aimed at restoring market confidence.
Authorities in the major industrial centres are now faced with the heightened dilemma of letting private players bear the cost of their own investment decisions, while having to look at preserving the stability of the system as a whole.
"The improved management of future crises will depend on the resolution of this dilemma."
In international financial markets, data for the fourth quarter clearly indicate strains. Despite a recovery in deals related to mergers and acquisitions in Europe and the USA, total announcements were at $190 billion, 16% below those of the third quarter.
There has been a near halving of facilities arranged for emerging market names. The average maturity of loans has fallen to less than four years, while pricing conditions have tightened for virtually all non-prime borrowers, pushing the weighted average spread charged to emerging market signatures to a new peak.
The international inter-bank market, the BIS says, performed relatively well during this period of upheaval, its natural role of accommodating the changing behaviour of investors offsetting the continuous pullback of Japanese banks and the indirect impact of the turmoil on banks with actual or perceived links to the countries most affected by the turbulence - such as German banks to Russia. In view of the abrupt turnaround in credit flows to Brazil and Russia, internationally active commercial banks "seem to have been caught by surprise by the drying up of market liquidity in a wide range of currencies and debt instruments."
"While banks in recent years have considerably broadened the range of their activities, becoming for instance increasingly active in securities trading, their systems for evaluating and managing credit risk have generally lagged developments in the area of market risk," comments the BIS.
"Even when this has not been the case, internal models have often failed to cope with the abrupt swings which took place in correlation, volatility and liquidity," adds the BIS.
"The deterioration in the value of collateral assets, coming as it did on top of the weakening in the quality of counter- parties, may have acted as a further incentive to retreat, in both cash and derivative markets. Indeed, while collateralization may have initially contributed to delaying the drying up of liquidity, it may have amplified the subsequent turnaround and the associated reduction in credit exposure of banks."
But the global financial crisis helped support activity in the over-the-counter (OTC) derivatives market in the fourth quarter of 1998.
[The OTC derivatives market, as distinct from exchange- traded derivatives, which are very profitable to the banks (by way of commissions and fees, but without risks), is non- transparent, and often even the parties to such derivative instruments are not fully aware of the range of risks they bear, some of the studies since the Asian crisis have brought out. The Basle Committee on Banking Supervision and other institutions dealing with various segments of the markets, are grappling (so far not very successfully) with ways to make the OTCs and their trades more transparent for countries and regulators.]
Faced with heavy losses, proprietary traders and hedge funds unwound their positions and attempted to shift exposures through the creation of structured securities, the BIS said. However, this boost to business was temporary as downgrades and defaults intensified risk aversion and led to a sharp cutback in credit lines to non-bank intermediaries. Market participants reconsidered their dependence on value-at-risk calculations, giving greater weight to potential future exposure and liquidity risk factors. A similar reassessment took place in the repurchase market. Intermediaries had granted highly favourable financing terms to leveraged investors and relied heavily on collateral at the expense of credit analysis. A number of financial institutions have since announced changes to their risk management structures that will result in a better integration of market and credit risks, the BIS says.
In the interest rate swap market, spreads on major benchmark rates reached an eight-year high in October owing to concerns about credit risk. Although margins narrowed somewhat in November, the prevailing climate of uncertainty hampered underlying sources of business. One of the notable features of the quarter was the unusual evolution of interest rates in the Japanese interbank market. Western-based banks began offering negative rates on yen-denominated deposits, while Japanese banks faced new upward cost pressures on their interbank liabilities. These developments prompted Western banks to reverse outstanding yen-denominated interest rate swaps and led some intermediaries to offer yen interest rate floors.
In the area of cross-currency products, market volatility reached unprecedented highs in the early part of the fourth quarter. In particular, the sharp appreciation of the yen in October, which was exacerbated by the reversal of short yen positions held by leveraged investors, was associated with record volatility in yen-related options. Its persistence thereafter suggested ongoing fears of a further unwinding of outstanding yen carry trades. (Third World Economics No. 205, 16-31 March 1999)
The above article was originally published in the South-North Development Monitor (SUNS) of which Chakravarthi Raghavan is the Chief Editor.