outlook for the world financial system: a banker's perspective

OUTLOOK FOR THE WORLD FINANCIAL SYSTEM: A BANKER’S PERSPECTIVE

LELAND S. PRUSSIA’

The international financial environment has changed radically over the last decade. Commercial banks have played an increasing international role-providing trade credit for the world economy’s increased integration; longer-term capital-investment financing; and balance-of- payments financing, which expanded substantially wi th “‘recycling” OPEC deposits.

Debt-service strategies based on continued export-market vitality, inflationary expectations, and low or negative real interest rates ran afoul as the world economy experienced an unusually severe recession. Developing nations suffered three blows: 1) Higher interest rates increased their debt service. 2) Dollar appreciation increased indebtedness burdens. 3) A drop in export earnings and a rise in the cost of key imports crippled trade balances. Rising protectionism and volatile foreign-exchange rates have further discouraged trade.

Although domestic banking recently has been somewhat deregulated, Congress now is considering legislation which would seriously impair American banks’international operations and therefore their capacity to help finance the economic recovery. New capital-asset regulations tend to discourage American banks f rom keeping very safe, but low-yielding foreign loans. “Special reserves” provisions of the International Mone- tary Fund (IMF) quota bill would impose standards that not m e n the U.S. government could meet. Other provisions are highly ambiguous. Legislation before the House calls for “economic impact studies” and excessively stringent foreign-loan requirements. These regulations would severely handicap the competitiveness of American banks and adversely affect the economic recovery both here and abroad.

Despite the current difficulties in the international financial system, I believe that its future can be managed appropriately if we pursue a prudent course of action in a sustainable environment of growth. But I am concerned that pending events in the legislative arena here at home could add serious complications.

Rapid changes have occurred in the international financial system in the last few years. The role of commercial banks within that system has also undergone rapid change, and the pace is accelerating. BankAmerica’s recent acquisition of Seafirst Corporation attests to the fact that traditional barriers to banking are coming down, and the shape of the financial landscape is being permanently altered.

Let me begin by discussing the market environment for banks, and the impor- tance of recent and likely future changes in it. Then we will examine the regulatory framework for banking. With this as background, I will draw conclusions about how the international banking system is likely to evolve in the next few years.

‘Chairman, BankAmerica Corporation.

Contemporary Policy Issues Number 4, January 1984 64

PRUSSIA: A BANKERS PERSPECTIVE 65

I. THE MARKET ENVIRONMENT

International banking embodies a host of financial activities, but three broad categories of lending activity stand out: namely, trade credit, capital investment project finance, and balance-of-payments accommodations.

Trade is financed in concert with overall movements in markets. In this regard, during most of the '60s and ' ~ O S , the nominal value of world trade grew at 15 percent a year. This rapid growth reflects, in large part, the increasing integration of the world economy due to lowering of trade barriers, creation of free-trade zones like the European Economic Community, the abolishing of many exchange restrictions, and, of course, inflation.

International bank lending expanded at about the same rapid rate. The close correlation between the volume of world trade and the foreign assets of depository banks is truly astounding. Between 1963 and 1982, the correlation coefficient between these two variables is highly significant: .98 in fact.

Narrowing the focus a bit to this country, U.S. exports also grew very rapidly, increasing from $25 billion in 1965 to $220 billion in 1980. U.S. banks financed the bulk of that trade, and as a result, foreign assets of U.S. banks increased sharply. The correlation between the value of U.S. exports and the foreign assets of U.S. banks is also very high.

Indeed, it is clear that international trade and finance are so closely intertwined that one cannot exist without the other. Obstacles to international finance are obstacles to international trade.

The second traditional area of international lending is for investment capital or project finance. While multinational development banks such as the World Bank make long-term development credits available, commercial banks are quite active in providing longer-term financing for manufacturing, mining, and processing projects.

Typically, these projects require imports of capital equipment. While this assures that the project benefits from the use of modern technology, it also creates a need for foreign borrowing to finance it.

There's no easy rule about what portion of an international investment should be financed from foreign sources. Of course, every investment should yield a rate of return above the cost of borrowing, after appropriate risk adjustment.

But foreign borrowing must also satisfy a second criterion: namely that the project should generate enough additional foreign exchange to service the external indebtedness. If this is not the case, the burden of earning the necessary foreign exchange will be shifted to other projects, for which the private and social costs of the foreign borrowing may no longer coincide.

On the other hand, countries not able to finance their imports of capital goods in international capital markets will find their development efforts severely impaired.

To force developing countries to earn first the foreign exchange needed for productivity-enhancing investments implies the application of a much stricter standard than is customary for domestic investment projects in the industrialized countries. To avoid such inequities, which can only lead to relative impoverishment of the developing countries, access of developing countries to international capital markets should be encouraged in a stable growth environment.

The third major activity, balance-of-payments financing by commercial banks, is a fairly new activity. Although it has been a familiar form of financing, it was substantially expanded with the oil crisis of 1973. The massive external payments

66 CONTEMPORARY POLICY ISSUES

imbalances that resulted from the first and second round of oil price increases gave rise to the familiar “recycling” of OPEC deposits.

Banks in the key industrialized countries experienced a sharp rise in their deposits from OPEC countries, and were, therefore, in a position to make these additional funds available to the non-oil developing countries in the form of general purpose balance-of-payments loans. Without commercial bank recycling, the non-oil developing countries would have had to curtail their own imports sharply, and the reces- sions of 1975 and 1980 would have been much deeper than they actually were.

A key to the growth and debt-service strategies of many developing countries was ambitious capital-investments programs. Countries such as Brazil and Mexico con- sistently committed more than 20 percent of their GNP to investment projects. This strategy, however, had its price. By assuming longer-term debt of unprecedented proportions, non-oil developing countries also incurred significant debt-service obli- gations for an extended period of time.

Clearly, accelerated development strategies required the continued health and vitality of export markets-as well as a continuing expectation of an inflationary bias. Only strong exports in this environment could earn these countries the financial wherewithal to service their external indebtedness.

But this strategy fell afoul of the unusually protracted and severe recession which the world economy experienced in the early 1980s. Rapid expansion of trade in an inflationary environment accompanied by low and even negative real rates of interest turned into a nightmare of contracting trade with deflation and very high real rates of interest.

The practice of financing longer-term borrowing on the basis of floating interest- rate notes also came to haunt international financial markets. Banks reasoned that they avoided interest-rate risk on the mismatch of their short-term liabilities and medium-to-long-term assets by lending on a floating-rate basis. Under these arrangements, interest rates to be paid on the outstanding debt are adjusted periodi- cally,to the London Interbank Offer Rate (LIBOR). Borrowers, on the other hand, were not overly concerned. They reasoned that nominal interest rates would generally reflect inflation rates and therefore merely index the indebtedness.

What both parties neglected to recognize was that the floating interest-rate fea- ture embodied in international loan agreements forced borrowers to compensate lenders in the form of higher real debt-service payments for the inflationary erosion of principal.

The consequence was a shifting forward in time of the real burden of debt service. This happened at a time when the borrowers were not in a position to assume this additional burden.

Falling commodity prices also contributed to the cash-flow problems of developing countries. The IMF index of commodity prices stood 38 percent higher at the end of 1980 than it was at the end of 1982. The brunt of that deterioration in commodity prices had to be borne by the commodity-exporting developing countries.

At the same time, the recession in the industrialized countries caused them to curtail imports sharply. The leading industrialized countries of the Group of Ten decreased their import volume in real terms by more than 7 percent between 1980 and 1982. This drop in import volume, along with the drop in commodity prices, devastated the earning power of most developing countries.

If this were not enough, the real effective exchange rate of the U.S. dollar has risen by 20 percent since 1980. The dollar’s appreciation was a double blow to the


non-oil producing Less-Developed Countries (LDCs) . First, it increased the burden of their debt, most of which is dollar-denominated. Furthermore, dollar appreciation meant that key import commodities, such as oil, became more expensive.

In essence, the developing countries were dealt three blows simultaneously: debt service was up due to higher interest rates; the burden of indebtedness also increased due to dollar appreciation, and trade balances were crippled by a decrease in export earnings due both to declining terms and volumes of trade, while the cost of key imports was increased substantially. Caught in the crossfire, developing countries have experienced severe liquidity problems. The most heavily indebted countries have been the ones that were most seriously affected.

The outlook for international banking in the '80s has to remain extremely cau- tious. Trade finance will not be the growth area in the 1980s that it was in the '70s. Protectionist barriers will hold down the growth in trade volume to approximately the rate of growth in world GNP, and economic growth itself will be at aslower pace.

In addition, volatile foreign exchange rates are likely to discourage trade further because of the added uncertainty and high cost of hedging. Less trade means, of course, less trade finance. Trade financing activities of commercial banks are likely to show only moderate growth compared with the rapid expansion of the 1970s.

If the trade outlook is not too robust, neither is the forecast for international investment. Large idle capacity in most key industries around the globe-mining, steel, automobiles, and agriculture-will keep investment in new capacity rather modest in the immediate years to come. Hence, a strong demand for new capital investments in project financing is not likely.

Finally, balance-of-payments deficits have been reduced considerably by unfold- ing events, and it is likely that the demand for this type of credit facility will continue to be subdued. The adjustment programs now being undertaken by many developing countries are beginning to bite. For example, the current-account deficits of the developing countries in 1983 will be one-third lower than in 1981. Of course, much of this is necessary, but this also means that the demand for balance-of-payments financing should remain moderate.

II. THE REGULATORY FRAMEWORK

Banking is clearly a highly regulated industry. The McFadden Act and Douglas Amendment tell banks where they can do business; the Glass-Steagall Act tells them what they can do; and Regulation Q tells them what they can pay their depositors in some cases.

Contrast this constrained posture in the U.S. with the freedom American banks found when they went offshore. No wonder so many small and medium-sized Amer- ican banks got involved in international banking during the 1970s. It is somewhat ironic that the very same banks that were not allowed to offer merchant or investment banking services to their customers through their home offices were free to do so at their foreign offices.

Regulators certainly have shown a much more conciliatory attitude in recent years. Witness the actions taken by the Depository Institutions Degregulation Com- mittee in recent months toward phasing out remaining interest-rate ceilings on deposits. This is certainly welcome news.

Be this as it may, the regulatory outlook is still not all that pleasant. While some of the unreasonable restrictions on banks within this country are being phased out or reduced, we find that new restrictions are now threatened to be imposed on the international activities of American banks.


The Congress is now considering legislation that would make it much more difficult for American banks to compete in the international arena. The regulations are also taking a tougher stand on risk management. These actions, in sum, could have undesirable consequences for the capacity of American banks to finance the economic recovery now under way.

These actions comprise new capital-adequacy regulations and pending legislation regarding special reserves and economic impact studies in connection with foreign lending.

Legislation authorizing an $8.4 billion increase in the U.S. IMF quota and Gen- eral Arrangements to Borrow is before Congress. Some observers have construed this as a bail-out for commercial banks. Nothing could be further from the truth. As a matter of fact, the IMF has been very active in encouraging additional bank lending in support of IMF standby agreements.

In some countries, such as Brazil and Mexico, banks have been required to com- mit explicitly 7 percent in additional financing. This is to provide badly needed funding for the balance of payments of these countries to supplement the IMF support program.

As a result of the Congressional call for further capital-adequacy regulation, Fed- eral regulators have recently instituted a mandatory 5-percent ratio of primary capital to assets for all large American banks. Meeting this standard is manageable for the banks affected, because all of them are already within or quite close to that ratio.

Other things being equal, more capital is better than less, but of course, other things seldom remain constant. In the case at hand, the new mandatory capital-asset requirements will make it difficult for banks to keep very safe but low-yielding assets on their books: interbank credits, government securities such as Treasury Bills, and loans to the very best borrowers. Instead, banks may reduce low-yield commitments in favor of better returns elsewhere, and simultaneously, they may also simply con- tract their asset base to achieve the new, higher capital ratio.

Let me illustrate by an example. Assume that a bank lends $100 million to a prime borrower, such as the Kingdom of Sweden. If the market rate for such loans is represented by a spread of 112 percent over the marginal cost of funds as represented by LIBOR, this loan will add some $500,000 to the bank's annual earnings.

The bank will have assumed little additional risk as a result of this transaction, but will still have to add about $1 million to loan-loss reserves reflecting this transaction to keep this ratio relatively constant. The bank also has to raise $4 million in capital to preserve its primary capital-to-asset ratio. On a combined basis it will incur additional costs of approximately $750,000 if one calculates the cost of bank capital plus reserves at a current rate of 15 percent per annum. Consequently, the bank will not show a profit on this transaction.

While this example is somewhat oversimplified and neglects some additional costs and revenues, the point is clear that an American bank is unlikely to be able to engage in this type of transaction. Instead, a foreign-based government-owned bank with an equity-to-asset ratio of perhaps less than 2 percent will pick up this additional business, since nobody worries much about the capital adequacy of a nation- alized bank.

Low, risk-adjusted, small-spread transactions will be adversely affected by these across-the-board capital requirements. This pertains also to interbank lines of credit that many large American banks have traditionally granted to foreign banks to assure them of dollar liquidity in times of need.


The IMF quota bill now before Congress also contains provisions for “special reserves” to be established against foreign loans that are currently in arrears, where the country breaches any provision of an IMF standby arrangement or cannot service its current debt without additional borrowing or rescheduling. Not even the U.S. government would be able to service its debt without additional borrowing. Yet, this stringent standard is to be applied to the outstanding debt of any foreign borrower.

Also, there is considerable ambiguity in the concept of full compliance with any IMF adjustment program. Many IMF adjustment programs contain a large number of specific performance objectives.

With this in mind: Is the breaching of any one of these objectives sufficient to trigger the “special-reserve” provision? Does it matter whether the breach is of a minor technical nature or whether it is a major provision? Who is to make these determinations?

There are clearly more questions than answers. The most onerous part of the “special-reserve” provision is that these funds are to

be set aside out of current earnings, and are not to be considered as part of a bank‘.. capital. Yet, it is the very purpose of capital to provide asafety cushion for contingen- cies such as loan losses.

In short, the special-reserve provision means that banks will have to have more capital, and that capital will be less efficient in doing its job of absorbing risk. Given the pressure on the banking system to help support the continuing needs of developing countries and the recovery of the U.S. domestic economy, such a proposal seems particularly difficult for banks to deal with effectively.

The legislation before the House of Representatives also calls for an “economic impact study” for every loan over $1 million by a U.S. bank to a foreign mining, manufacturing, or production enterprise. The study has to find that the loan can be serviced entirely from the proceeds of the activity financed, without benefit of gov- ernmental guarantees or subsidies. This implies that even a U.S. government guar- antee, the participation of the Export-Import Bank in the financing of the project, or minor tax concessions on behalf of the foreign government might endanger the ability of a U.S. bank to participate in the financing.

While some may welcome this new source of employment for economists, I can assure you that there would not be much international lending activity by U.S. banks for them to study if the bill is enacted as currently proposed.

In sum, these regulations would severely handicap the competitiveness of Ameri- can banks, and will react adversely upon income and employment growth in the U.S.

Ill. IMPLICATIONS FOR INTERNATIONAL BANKING

Let me briefly summarize my main conclusions about the future of U.S. banks. A. In view of expected slower growth of the world economy, the banking indus-

try as a whole will grow at a slower rate. B. Protectionism and tougher control programs will depress the growth of world

trade. Given the excess capacity in many key industries, international investment financing needs will be modest as well.

C. Many developing countries already labor under heavy external debt burdens, and the overriding goal should be to rearrange payments scheduling in such a way as to harmonize them more closely with their longer term ability to generate sufficient debt service from trade. The fact that balance-of-payments deficits are sharply reduced will be beneficial as well. Together, these factors imply a much slower rate


of growth for international bank lending for balance of payments purposes. D. The new rules and regulations promulgated by the U.S. supervisory agencies

will make American banks less inclined to engage in low-spread business such as international interbank lending and lending to international borrowers at risk- adjusted spreads driven too low by aggressive competitors. This means that spreads will have to increase, substantially in many cases, in order to sustain the new capital burdens. Failing this, U.S. banks will simply become a shrinking part of the global financial network.

E. If Congress should enact the provisions of the House bill on special reserves and economic impact studies, international lending by U.S. banks would be severely affected, while this would further increase the advantages of foreign banks. But I am still hopeful that this outcome can be averted. E The continuing liberalization of U.S. financial markets and the improving

health of the American economy will provide a powerful incentive to U.S. banks to give top priority to domestic expansion. To the extent that capital resources are scarce, priorities for U. S. banks will shift from international to domestic business.

These conclusions imply that the pace of international lending will slow- perhaps significantly. The '80s are likely to be a decade of international debt consoli- dation, rather than rapid debt growth. But this does not imply that large multinational banks will turn away from international lending, provided they can obtain reasonable risk-adjusted returns in a highly volatile environment. The commitment of the large U.S. banks to service their American customers abroad and to do business with and within their host countries can be maintained with proper support in a generally improving environment.

But it is also important for foreign countries to open up their domestic banking markets to international banks if they wish to become truly integrated into the international banking system and if they want to become equal partners in world financial markets.

The current international debt crisis involves much dislocation, pain, and suffer- ing: for developing countries, for banks, for industrialized countries, and for international agencies. We are by no means in the clear on dealing with this crisis. Basi- cally, it represents the evolution of long-term economic forces of a structural nature. In short, the world economy has changed significantly in a structural sense, and we must deal with the debt crisis effectively within the context of these significant structural changes. With a proper amount of understanding, devoted attention, and a little luck, we should be able to manage this situation.

outlook for the world financial system: a banker's perspective

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