8 International bank lending and the securities markets

The relationship between commercial banks anddeveloping countries has been transformed in thepast fifteen years. Before 1970 banks lent develop-ing countries relatively small amounts to financetrade and to meet the requirements of subsidiariesof multinational companies located there. After1970, banks went on to become the fastest-growingand most flexible source of foreign finance fordeveloping countriesprimarily to cover balanceof payments deficitsonly to run into the debtproblems of the early 1980s. The past three yearshave been traumatic for many banks and their bor-rowers in the developing world. There has been aretrenchment of bank lending that has emphasizedthe instability of the relationship with developingcountries. All parties have learned some valuablelessons, which will help to redefine their relation-ship for the years ahead. The securities markets, incontrast, have not had such strong ties with devel-oping countries. Given that the markets for bondsand a number of innovative securities have grownrecently while traditional bank lending has fallen,there is a question as to whether the securitiesmarkets could play a bigger role in financing devel-oping countries.

The banking relationship

The commercial links between banks and develop-ing countries are complex and extensive. They runfrom simple deposit taking to short-term lending,trade financing (both with and without officialguarantees), and medium-term lending (often insyndicated form). All of these types of businessappear on banks' balance sheets. But off-balance-sheet operations have also been important; theyinclude advice on managing debt and reserves,and business such as letters of credit for financingtrade.

These ties often started when developing coun-tries placed their liquid reserves with the banks.As Figure 8.1 shows, the low-income countrieshave consistently been net depositors with the

110

banks, while the middle-income groups havebecome net borrowers. This contrast reflects thefact that low-income countries are seldom credit-worthy enough to borrow from the banks.

Developing countries have dealt both with thehead offices of international banks and with officesoperating in the Eurocurrency markets. However,many banks have set up offices in developingcountries, both to channel external finance and toundertake domestic banking business. Altogetherthe various banks located within developing coun-tries have received about 36 percent of the fundschanneled by outside banks to these countries overthe past four years. Developing countries' ownbanks are playing an increasing role in raisingexternal funds for domestic users as well as in per-forming a broad range of business services (seeBox 8.1).

Lending has been the main form of internationalbanks' business with developing countries (seeFigure 8.2), and it grew very rapidly between 1973and 1981. Bank claims on developing countriesincreased at an average annual rate of 28 percentover this period. In 1973 total new internationallending amounted to $33 billion, of which 29 per-cent went to developing countries. By 1981 newlending was $165 billion, of which developingcountries composed 32 percent. Much of the lend-ing was syndicated Eurocurrency loans carryingfive- to ten-year maturities and floating interestrates. Lending to developing countries in this formincreased from $7 billion in 1973 to $45 billion in1981. Most syndicated loans were arranged by acore of twenty-five to fifty large commercial banks(hereafter called first-tier banks) based in theindustrial countries. Up to 3,000 others (second-tier banks) joined in from time to time. Theyincluded regional banks from industrial countries,banks from developing and centrally plannedeconomies, and consortium banks.

Initially in the 1970s it was the large U.S. banksthat increased their international lending, withmuch going to developing countries. By 1977 the

Figure 8.1 Net position of developing countries with commercial banks, 1974, 1979, and 1983

50

100

200

1974

1979

Billions of dollars

0 50 100 150 200 250

1983 // Upper middle-income countries

/ Lower middle-income countries

/ / Low-income countries

/ 0 All developing countries

Note: Net positions are calculated by subtracting liabilities from assets held with banks reporting to the Bank for International Settlements.

Source: BIS Quarterly Report 1974-85.

Box 8.1 Developing-country banks

In many developing countries, the growing presence ofindustrial-country banks has provided significant com-petition for local banks. They in turn have expandedtheir international operations to include:

More branches and representative offices in the majorinternationalfinancial centers. Banks from the newly indus-trializing countries have often followed domestic compa-nies abroad, financing their trade and other activities.Other banks have set up branches where migrant work-ers have settled, serving as a channel for repatriatingtheir savings.

Lending in the Eurocurrency markets. One example isthe State Bank of India, which has arranged a large shareof India's syndicated loans and played a role in manag-ing loans to a number of other countries. Mexican and

Brazilian banks have also been active managers, whilesome Arab banks have become major internationallenders (see Box 8.2).

Borrowing in the international interbank markets. Somedeveloping-country banks won the confidence of theinterbank market and have been able at certain juncturesto use it for funding some domestic lending. They havetherefore enjoyed cheaper financing than that offered bymore traditional types of loans.

The international experience gained by developing-country banks has benefited their domestic operations aswell. Not only have they been able to identify new busi-ness and develop markets, they have also introducednew techniques and ideas into the financial systems ofdeveloping countries.

111

Figure 8.2 International bank lending, 1973-84

Net new bank lendingBillions of dollars

150

100

50

0

1973

Gross syndicated lending100

All countries

Developingcountries

All countries

Developingcountries

twelve largest U.S. banks derived almost half oftheir total earnings from international lending, thebulk of which came from developing-countryloans. Groups of banks from several differentcountries next increased their inter-national expo-sureparticularly those from the Federal Republicof Germany, France, and the United Kingdom.Japanese banks also assumed an important role ininternational lending, but they were sometimesheld back by adverse developments in Japan's bal-ance of payments position. The second-tier banksfrom the United States also gradually increasedtheir participation. The most notable recententrants, however, were the Arab banks (see Box

112

8.2), but banks from other developing countrieshave also been increasingly active in internationallending. The ability of non-American banks to par-ticipate in what was primarily a dollar-based mar-ket was enhanced by the growth of the interna-tional interbank market (see Box 6.3 in Chapter 6).This market permitted the distribution of dollarliquidity around the international banking system.

The relationship between banks and developingcountries expanded rapidly in the 1970s for twomain reasons: changes in the pattern of global cur-rent account balances and changes in the willing-ness and ability of banks to act as intermediaries.

Global imbalance and portfolio choice

On one theory, changes in the distribution of cur-rent surpluses and deficits around the worldshould not change the role of banks; they wouldstill act as intermediaries between lenders and bor-rowers. But that theory holds good only if (a) theportfolio preferences of all lenders are the same;(b) banks have the same perception of credit-worthiness for all potential borrowers; and (c) theinterbank market operates without friction toredistribute liquidity. Without these conditions,the pattern of surpluses and deficits does indeedhave a powerful effect on the banks.

During the 1970s both the volume and geograph-ical structure of current account balances changeddramatically (see Table 3.1 in Chapter 3). Themembers of OPEC ran large surpluses for much ofthe 1970s and initially had a strong preference forbank deposits (see Box 6.2 in Chapter 6). Theyfavored the Eurocurrency market rather thandomestic banking systems, in part because of thehigher returns available in the former. Over thedecade, sizable amounts of funds were transferredby oil importers from domestic banks in industrialcountries to OPEC members and ultimately to theEurocurrency markets. Such a switch of fundsincreased the lending capacity of the Eurocurrencymarkets.

The expansion of liquidity in the banking mar-kets coincided with a positive shift in the attitudeof the banks toward international lending. Afterthe first major increase in oil prices, when therewas a need to recycle large amounts of funds,banks were lauded for the success with which theyperformed this function. Confidence in the bank-ing system was maintained by central banks anddeposit insurance agencies, which graduallyincreased their protection for depositors at themajor banks. The behavior of regulatorsor, more

1973 1977 1981 1984

Note: International bank lending is measured here in two ways.First, total international lending is measured net of loan repay-ments for a defined set of reporting banks (in this instance, banksreporting to the Bank for International Settlements). These data,after 1976, are adjusted for the valuation effects of exchange ratemovements. Second, a major element of international lendingsyndicated loansis measured on a gross basis, no allowancebeing made for repayments. Only published syndicated lendingis covered by the data, however.

Source: For net bank lending: Watson, Keller, and Mathieson1984; for syndicated lending: OECD Financial Market Trends.

1977 1981 1983

precisely, expectations of their behavior-gavecomfort to depositors and helped attract money tobanks. This may have led banks, in turn, to takelarger lending risks than would otherwise havebeen the case.

The preferences of developing countries alsoencouraged the growth of bank lending in the1970s. Developing countries were attracted by thegeneral purpose nature of bank finance and by thelarge volumes and flexibility of instruments avail-able at a time when alternative sources of financewere growing very slowly. Developing countriesnaturally favored the low or negative real interestrates charged by banks in preference to the condi-tionality attached to some official finance and thestrict creditworthiness standards of bond markets.

The supply of banking services

In addition to the macroeconomic forces workingto increase bank lending in the 1970s, several fac-tors specific to the behavior of banks were pushingin the same direction.

The increased efficiency of international banking.

As in many other industries, banking benefitedfrom innovations that increased its efficiency. Thegrowth of the Eurocurrency market (described inBox 8.3) was especially significant, because banksoperating there were free of reserve requirements.They were therefore able simultaneously to offerhigher interest rates for depositors and lower ratesfor borrowers than other banks could. The marketwas also efficient in that it could quickly mobilizevery large loans.

Changes in the portfolio objectives and preferencesof banks. Banks radically changed their portfolioobjectives in the 1970s, placing greater emphasison balance sheet growth rather than the immediaterate of return on assets or other measures of profit-ability. International lending was a means of satis-fying this aim when domestic loan demand wasweak and when banking liquidity, induced by easymonetary policy, was high. Foreign lending alsooffered a means of diversifying portfolios, whichwas seen as a way of reducing risks becausedomestic lending often had an inferior loan-lossrecord. Banks saw the rapid growth achieved bymany developing countries as an indication that

113

Box 8.2 Arab banks and international business

Many of the well-established Arab banks became Arab banks increased gradually during 1978-80, butinvolved in international lending during the 1970s, some sharply during 1981 (see Box table 8.2A). Their lendinglinking up with Western partners to form consortium volume fell in 1983 and 1984, amid generally more sub-banks. Further impetus came from wholly owned Arab dued activity in the market as a whole. Arab-led syndi-international banks and the establishment of Islamic cates channeled about one-quarter of their lending to thebanks (offering an alternative to nba, the charging and industrial countries and the rest to developing countries.paying of interest). Some banks set up in the new Arab developing countries received the bulk of Arabregional centers-Bahrain, Dubai, and Kuwait-and bank lending in 1978-80, but others then took an increas-many expanded abroad. London hosts the largest num- ing share. The main source of finance for Arab banks hasber of Arab banks (sixty), followed by Paris (thirty-nine), been the international interbank market, though someNew York and Singapore (nineteen each), and Switzer- OPEC money may have been channeled through themland and Hong Kong (fifteen each). Arab banks have also as well. Some specialized Arab banks have become heav-been expanding into developing countries. ily involved in arranging international bond issues and

The volume of syndicated Eurocurrency loans led by in undertaking direct investment.

Box table 8.2A Arab-led syndicated lending, 1977-84(billions of dollars, unless otherwise noted)

Type of lending 1977 1978 1979 1980 1981 1982 1983 1984

Total market lending 34 74Arab-led syndications' 1.0 2.3

Toindustrialcountries 0.1 0.3To developing countries 0.9 2.0

Arab-led syndications asa percentage of totallending 2.9 3.1

79 81 91 91 60 522.5 3.6 9.1 9.8 6.9 5.30.7 1.1 2.6 1.9 1.61.8 2.5 6.5 7.9 4.6

3.2 4.4 10.0 10.8 11.5 10.2

Note: Data are for Eurocurrency credits with a maturity of one year or more, publicly announced in the year given.a. Syndications in which one or more Arab banks acted as lead or colead managers.Source: For total market lending: OECD Financial Market Trends; for Arab-led syndications: Middle East Economic Survey.

Box 8.3 The origins of the Eurocurrency markets

The origins of the Eurocurrency marketsthat is, themarkets in currencies traded outside their respectivedomestic economiesgo back to the late 1950s and early1960s. Several factors were behind their birth.

The centrally planned economies were reluctant tohold bank deposits in the United States, so they put theirdollar earnings on deposit in London. Gradually otherEuropean dollar holders did the same, a tendency thatwas particularly marked when the United States ranlarge balance of payments deficits.

Balance of payments pressures made the UnitedKingdom government limit British banks' external use ofsterling, so they had a strong incentive to develop busi-ness in foreign currencies.

By the end of 1958 the main industrial countries hadrestored full convertibility of their currencies. The newfreedom produced a surge of international banking busi-ness.

Box figure 8.3A Stock of international andEurocurrency loans, 1973-84

Billions of dollars

2,800

Note: Data indicate stock at the end of the last quarter of each year,except data for 1984 are as of the end of the third quarter.

Source: BIS Quarterly Report 1974-85.

The growth of the Eurocurrency market was also stim-ulated by certain monetary regulations in the UnitedStates. For instance, Regulation Q put a ceiling on theinterest rates that banks operating in the United Statescould offer to domestic depositors. Since market ratesoften went above the ceiling, depositors were naturallyattracted to Eurobanks that were not bound by Regula-tion Q. In addition, banks in the United States wererequired to hold non-interest-bearing reserves. Bydiverting dollar deposits to their offshore branches orsubsidiaries, U.S. banks were able to avoid tying up somuch of their funds in reserve requirements at a zerorate.

General controls on the movement of capital alsohelped to boost the Eurocurrency markets. One examplewas the introduction, in 1965, of the Voluntary ForeignCredit Restraint Program (VFCR) in the United States.The specific goal of the VFCR was to limit the growth offoreign lending by U.S. banks. Instead, their foreignbrancheswhich were not subject to the VFCRtookdeposits and onlent them outside the ceiling. Between1964 and 1973 the number of U.S. banks with overseasbranches increased from 11 to 125. The number ofbranches increased from 181 to 699 over the same period.

At the end of the 1960s and during the early 1970s theEurocurrency markets, which had been located in West-ern Europe (and centered in London), expanded to anumber of other "offshore" banking centers. Thesewere typically small territories that had tax, exchangecontrol, and banking laws favorable to internationalbanks. The business was entrepôt in nature, with foreigncurrency funds deposited by one foreign source and thenonlent to another. Offshore centers have been set up inthe Caribbean area, Latin America, the Middle East, andSoutheast Asia. A recent development has been theestablishment of international banking facilities (IBFs) inthe United States designed to bring the locus of Ameri-can banking business back "onshore."

With the recent strong growth of domestic currencylending abroad, total international lending is now themost meaningful lending aggregate, and it encompassesEurocurrency market activity. Box figure 8.3A shows thegrowing stock of total bank lending alongside that of theEurocurrency market.

the returns on lending to these countries would behigh compared with the risks involved. Aside fromthe direct returns they expected on loans, bankswanted to develop a wider and more profitablebusiness relationship with developing countries.

The development of mechanisms for dealing withsovereign risk, One important development thathelped banks overcome their concern about sover-eign risk was the introduction of a cross-defaultclause covering publicly guaranteed debt. A cross-

114

default clause specifies that the loan will be consid-ered to be in default if the borrower defaults onany other loan. It strengthened the guarantee onsovereign loans and blurred the differences in riskbetween individual borrowers or projects within adeveloping country. Hence, bankers paid lessattention to the viability of the particular projectsthey financed, and more to macroeconomic condi-tions in borrowing countries. Furthermore, if adeveloping-country borrower defaulted, cross-

1973 1976 1979 1982

default clauses would ensure that all bank lenderswould be affected. As a result, a borrower con-fronted with debt-servicing difficulties had astrong incentive to reschedule its lending ratherthan default on a loan. This type of lending there-fore appeared less risky to banks. Furthermore,the view that sovereign lending was less risky thandomestic commercial lending because the sover-eign states could not go bankrupt was widely heldamong banks. These perceptions contributed tothe growth of lending and the fine terms (spreadand fees) carried on many loans.

Innovations in banking. Banks proved adept atdesigning instrumentslike the syndicated loanthat would match their portfolio requirements (forcountry risk diversification and interest risk mini-mization) with the requirements of borrowers(longer-maturity, high-volume loans). This partic-ular innovation enabled banks to make long-term

Figure 8.3 Outstanding bank claims ondeveloping countries, 1978-83

Billions of dollars500

LI Upper-middle-income countries

Lower-middle-income countries

Low-income countries

- International Monetary Fund dataBank for International Settlements data

Note: The IMF has only recently been collecting and publishinginternational banking statistics. The difference between IMP andBIS data is largely accounted for by the different coverage of thetwo series. The IMF series includes statistics from all its membercountries, as well as statistics from major international bankingcenters.

Source: BIS Quarterly Report 1974-85; IMF International FinancialStatistics.

loans on the basis of short-term depositsaprocess of maturity transformationwithout hav-ing to absorb the interest rate risk themselves,since lending rates were tied to a short-term rate(LIBOR). But this proved to be a volatile element indebt service for borrowers. Other key innovationsincluded the certificate of deposit (and variationson it), which allowed banks to offer a marketableand high-yielding asset to depositors while provid-ing the banks themselves with flexibility in themanagement of their liabilities.

Changes in the regulatory environment. Mostchanges in the regulatory environment were con-ducive to bank lending to developing countries.The industrial countries eased or abolished theirexchange controls, thus encouraging banks to alsolend abroad off their base of domestic deposits.The growth of largely unregulated offshore bank-ing centers (as noted in Box 8.3) also gave a signifi-cant stimulus to overseas lending. Regulationssuch as the requirement to maintain certain capitalratios, which had the effect of limiting the growthof banks' total assets, did not disproportionatelyaffect developing countries.

All of these factors produced a strong momen-tum for lending to developing countries. Althoughsome banks may have come up against their lend-ing limits for certain developing countries, overalllending grew rapidly in part because uncon-strained banks new to international lendingentered the market. Indeed, banks competed vig-orously, exhibiting, in some instances, "herdlike"behavior in their quest for new business.

Problems in the banking relationship

In the late 1970s and early 1980s banks werebecoming increasingly concerned about their expo-sure to both lending and funding risks in theirinternational business. Much of their developing-country lending, for instance, had been concen-trated in a narrow range of countries (see Figure8.3). On average, 72 percent of it went to theupper-middle-income countries over the 1978-81period. The five largest borrowers alone accountedfor 53 percent of developing-country borrowing.Having shifted the interest rate risk onto the bor-rowers, banks were becoming increasingly awarethat in practice they had simply traded off one risk(see Box 3.2 in Chapter 3) for greater potentialtransfer and commercial risk. On the liabilitiesside, many banks had come to depend on inter-bank markets for a large part of their funding. Thishad made them susceptible to sudden funding

115

1978 1979 1980 1981 1982 1983

Box 8.4 Bank supervision and its impact on lending to developing countries

Banking supervisors in industrial countries seek in avariety of ways to ensure that commercial banks are pru-dent in their lending and balance sheet management.

The assessment of Ca pi (a! adequacy. To ensure thatbanks have enough capital to meet potential losses,supervisors typically prescribe a ratio of capital to totalassets. The ratio varies in its makeup and desired levelfrom country to country, but the normal range is 4 to 6percentthat is, $4 million to $6 million of capital cansupport $100 million of lending. In determining thisratio, some supervisors weight assets according to theirriskiness: the riskier the loan, the more capital a bankmust have to back it.

Exposure limits. Supervisors pay close attention tohow bank assets are diversified, aiming to avoid anyundue concentration of risk. In recent years some of theadverse risks attached to international lending material-ized simultaneously, which underlined the need to bol-ster banks' capital bases. Supervisors normally requirethat lending to a single borrower be limited to a fractionof the bank's capital, or a group of large exposures to amultiple of capital. In some countries, borrowers may beconsolidated for the purpose of determining exposure

limits, and lending to two or more subsidiaries owned bya single holding company may count as a single expo-sure. Typically borrowers within a country are not con-solidated, so that banks can lend to a variety of enter-prises within a country without meeting exposure limits.Tighter exposure limits have not generally been intro-duced. Increasingly, however, as developing-countrydebt is rolled over in new financing packages for thegovernment and, as sometimes occurs, the governmenttakes over private sector debt, these loans are accrued toa single borrower, and exposure limits may be reached.

Loan-loss provisioning. Supervisors have been con-cerned in recent years that the quality of assets on banks'books are properly reflected in their balance sheets andso have encouraged banks to provision against losses.Policies regarding provisioningthat is, the setting asideof funds to cover potential general or specific lossesvary significantly among countries. The accounting andtax treatment of loan losses can have important implica-tions for the profitability of banks' loans to some coun-tries and therefore for their willingness to lend. Theaccounting issue revolves around whether provisionscan be counted as part of a bank's capital base or not;

Box 8.5 Financial deregulation in Japan: some implications for developing countries

Developing countries and international developmentbanks have been active in raising funds from Japan (seeBox tables 8.5A and B). As of the end of 1983, developingcountries accounted for 24 percent of total yen-denomi-nated foreign bonds issued in Japan, with internationaldevelopment banks accounting for another 24 percent.In 1983, Japanese banks made total medium- and long-term loan commitments of some $16.8 billion, 49 percentof which were for oil-importing developing countries.Along with other foreign borrowers, developing coun-tries could perhaps benefit from the gradual liberaliza-tion of the world's second-largest capital market.

The deregulation of the Japanese financial system hasbeen prompted by a marked change in the domestic flowof funds resulting from the slowdown in economicgrowth since the mid-1970s. Industrial investment grewless rapidly; corporate demand for credit fell; and house-

Box table 8.5A External loans by Japanese banksdenominated in foreign currency, 1980-83

Source: Japanese Ministry of Finance International Finance BureauAnnual Reports.

Box table 8.5B Foreign bond issues denominated inyen, 1980-83

a. Developing countries as defined by the DAC.Source: Japanese Ministry of Finance International Finance BureauAnnual Report 1984.

hold savings, which had once gone largely into compa-nies, either were used to finance the public sector deficitsor found profitable investment opportunities overseas.Exchange controls were liberalized, while many Japa-nese corporations raised money abroad to strengthentheir overseas operations. At the same time, the govern-ment liberalized some domestic interest rates to be ableto finance its own deficits.

These moves have recently been extended. Externallending by Japanese banks is now free of any restrictionsexcept those dictated by prudential guidelines. The gov-ernment has made it easier for foreigners to issue yen-denominated bonds in Japan through both public issuesand private placements. It has also eased restrictions onEuroyen bond issues and Euroyen lending. As a result,the Euroyen market could become as accessible to non-residents as the Eurodollar market already is.

116

1980 6.7 411981 12.7 441982 18.0 331983 16.8 49

1980 261.0 351981 612.5 16

1982 856.0 11

1983 899.0 16

Shareof oil-importing

Amount developing countriesYear (billions of dollars) (percent)

Share ofAmount developing countries

Year (billions ofdollars) (percent)'

this can affect a bank's capacity to lend. The tax treat-ment is a matter of whether banks can write off theirprovisions as a tax loss against income. In some Euro-pean countries banks benefit from relatively favorabletax treatment, but in the United States and Japan bankshave had more limited possibilities for tax deductibility.

As supervisory rules and practices vary from countryto country, central bankers have been trying to harmo-nize them through the Cooke Committee,1 which meetsunder the auspices of the Bank for International Settle-ments. At present supervisors are seeking to consolidatebranches and subsidiaries into the accounts of parentbanks. The need to ensure adequacy of capital and diver-sification of lending on a global basis could slow lendingto developing countries as the adjustment in reporting isbeing made. However, by strengthening the fabric of theinternational banking system, effective supervision canensure a more stable flow of funds to developing coun-tries in the long run.

1. The committee has drafted a revised concordat that sets Out theprinciples that should govern the allocation of supervisory responsi-bilities for banks operating in different international centers.

pressure if concerns about the quality of theirassets developed.

In addition, the capital to assets ratios of manybanks in the industrial countries had been fallingfor much of the period between 1977 and the early1980s (see Figure 8.4), partly reflecting the growthin their international lending, which outstrippedthe growth of their capital. This trend was exacer-bated for non-U.S. banks by the strength of theU.S. dollar after 1980. Capital to assets ratios wereweakened because a dollar appreciation increasedthe domestic currency equivalent of a bank's out-standing dollar lending, inflating the denominatorof the ratio.

Given these pressures alone, the banks' relation-ship with developing countries may well have runinto difficulties. In any case the large growth inbank lending registered in the 1970s could perhapsbe attributed to a one-time stock adjustmenttoward international assets, which was nearingcompletion at the turn of the decade. A naturalmoderation in the pace of lending growth mighthave been expected.

The banking relationship was modified moreabruptly, however, by three factors. First, theonset of debt difficulties in a number of developingcountries led to a need to reschedule significantvolumes of debt. The sudden deterioration in the

perceived creditworthiness of developing coun-tries led to a reduced willingness by banks toincrease their exposure further. Bank regulatorsresponded to the same concerns by seeking tomonitor liquidity and solvency ratios more closely.Furthermore, banks were urged to diversify theirlending and also encouraged or required to setmore funds aside in loan-loss reserves (see Box8.4). The need to strengthen capital ratios led tothe banks' placing greater emphasis on profitabil-ity; the growth of assets became less important.

Second, these changed attitudes to internationallending were reinforced by the emergence of prof-itable opportunities for lending within someindustrial countries, particularly as economicgrowth revived. In addition, financial markets inseveral industrial countriesespecially the UnitedStates and the United Kingdombegan a processof deregulation, so banks faced competition fromother financial institutions and concentrated onconsolidating their domestic position. In the caseof Japan, however, financial deregulation has ledto the opening up of domestic capital markets toforeign borrowers, including developing coun-tries, and Japanese banks will now be freer to lendoverseas (see Box 8.5). One casualty of the trendtoward domestic lending has been the syndicatedloan market, which has become much less activethan it once was (see Box 8.6).

Third, the era of OPEC surpluses and large bank

117

Figure 8.4 Capital assets ratios of banksin major financial markets, 1977-83

Percent

5.5 United States

4.5'-Switzerland

- - ....- United Kingdom

3.5Germany

2.5

1.5 France

1977 1979 1981 1983

Note: Given the problem of inconsistency among banks and overtime in the accounting of bank assets and capital, aggregate fig-ures such as the ones presented here must be interpreted withcaution.

Source: Watson, Keller, and Mathieson 1984.

Box 8.6 The rise and fall of syndicated lending

The syndicated Eurocurrency credit is a relatively newinvention. Although some small private syndicationswere arranged in 1968 and 1969, the market did not takeoff until 1972 (see Box table 8.6A). From then on, it grewrapidly-and particularly for developing countries in1976-79. With the world economy moving into recessionin the early 1980s, banks' perceptions of risk-especiallyin regard to developing countries-increased. Bankersincreasingly felt that the spreads on their loans did notadequately reflect the risks. Lending spreads rose in theearly 1980s and the average maturities of loans fell (seeBox figure 8.6A). With the onset of debt-servicing prob-lems in many developing countries in 1982, new lendingcommitments fell sharply. Only the most creditworthyborrowers-including some developing countries fromEast Asia-were able to borrow on the same terms asbefore.

Developing countries now face a two-tier market. EastAsian countries can still attract "spontaneous" lendingfrom banks on competitive terms. But countries with

debt difficulties have had to rely on "concerted" lendingarranged in conjunction with debt restructuring. Thedata in Box table 8.6A contain $14.3 billion in 1983 and$11.3 billion in 1984 of new money provided under theumbrella of rescheduling packages. Most of theseamounts went to Latin American countries. These coun-tries were able to secure very litle spontaneous lendingin 1983 and 1984. During 1984 there was a more generaleasing of terms (in conjunction with multiyear resche-duling) reflecting what were perceived to be favorablepolicy adjustments in those developing countries thathad earlier experienced debt-servicing difficulties.

The stock of syndicated loans outstanding was esti-mated at about $125 billion at the end of 1982. By the endof 1984, however, this figure had fallen to close to $100billion. When the present difficulties subside, traditionalsyndicated lending may well revive-but it is unlikely toregain its earlier momentum. As illustrated in Boxes 8.7and 8.8 there are an increasing number of substitutes forthe syndicated loan. For many highly creditworthy bor-

Box table 8.6A Syndicated Eurocurrency lending to developing countries, by region, 1972-84(billions of dollars, unless otherwise noted)

a. Includes sub-Saharan Africa, China, India, the Middle East, North Africa, and South Asia.Source: OECD Financial Market Trends.

deposits has given way to an entirely different mix-ture of surpluses and deficits, with different finan-cial implications. OPEC members are now net bor-rowers from the international banks, and theindustrial countries, which had also been signifi-cant net depositors until recently, are placing lesswith banks (see Figure 8.5). The major imbalancein the world economy is now between the UnitedStates, with a large current account deficit, and theFederal Republic of Germany and Japan, withlarge surpluses. Given the nature of the U.S.financial system, the deficit has been financedrather more by trading in financial assets thanthrough the intermediation of banks. The UnitedStates has both the assets and the markets to makethis feasible. The option might also be open to sev-

118

eral other industrial countries, but not available todeveloping countries. As a result the process ofintermediation has been shifting from banking toasset markets even while many developing coun-tries remained dependent on bank finance.

In principle, had the interbank market workedwithout friction, their demand for banking fundscould have been satisfied. Even though the surpluscountries chose not to hold bank deposits, interna-tional banks could have bid in money markets tofund the continuing demand for credit by deficitdeveloping countries. International banks were,however, increasingly constrained by both capitaland sovereign risk considerations, so were reluc-tant to increase their exposure to developing coun-tries or their banks. In fact, many developing

Region 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984

East Asia and Pacific 0.40 0.5 2.0 3.3 2.9 2.4 7.5 7.6 8.8 10.7 10.3 7.7 7.4Percentage of total 11 7 24 28 20 15 22 16 24 24 27 25 33

Europe and Mediterranean 0.60 0.8 1.2 0.5 0.6 0.9 2.3 6.6 3.9 3.5 3.2 2.9 2.2Percentage of total 16 11 14 4 4 5 7 13 11 8 8 10 10

Latin America andCaribbean 2.00 3.4 4.5 6.0 8.7 9.0 17.4 26.0 19.9 24.9 22.2 15.0 11.4Percentage of total 53 47 53 51 60 55 51 53 55 55 58 50 50

Other regions' 0.80 2.6 0.8 1.9 2.4 4.1 6.9 8.8 3.6 5.8 2.6 4.6 1.7Percentage of total 20 35 9 16 16 25 20 18 10 13 7 15 7

Total 3.80 7.3 8.5 11.7 14.6 16.4 34.1 49.0 36.2 44.9 38.3 30.2 22.7

rowers the syndicated loan is now a relatively expensiveborrowing option. Indeed, some banks have reportedlydisbanded their syndicated credit departments in favorof a more broadly based lending operation.

Box figure 8.6A Spreads and maturities on syndicatedlending, 1972-84

Average spreadsPercent

1.8

1.4

1

0,6

1972

Years

9

7

5

1972

All countries

Developing countries

Average maturities

All countries

1976 1980

Note: Data are for new publicized syndicated loans.

Source: Bond 1985.

Developingcountries

1984

countries, even some that did not experience debt-servicing difficulties, reduced their demand forbank lending.

As a result of these factors, banks' net lending todeveloping countries fell significantly after 1981(see Figure 8.2). Spontaneous lending fell mostand concerted lending (in conjunction with IMFprograms) became an increasingly importantsource of funds for developing countries (see Box8.6). Most of the spontaneous lending went todeveloping countries in East Asia and Europe. Evi-dence provided by the latest BIS data for end-December 1984 suggests that banks' outstandingclaims on developing countries have remained vir-tually unchanged, at $433 billion, compared with ayear earlier (see Figure 8.3).

Debt rescheduling and the banks

Banks have had to temper their desire to containthe growth of exposure to some developing coun-tries with their need to safeguard existing loans.Accordingly they have adopted a flexible approachto dealing with countries with debt-servicing diffi-culties. Banks quickly realized that reschedulingonly principal payments due or in arrears was notadequate. Debtors needed more relief, and banksrescheduled debt and provided new loans in thecontext of IMF programs. Each bank's share of thenew loan was based on its share of all the bankdebt owed by the rescheduling country. While notwithout difficulties, this burden-sharing approachhas been generally successful.

In some of the early reschedulings, short-termbank debt was included along with one or twoyears of maturities of long-term bank debt. How-ever, all the participants soon recognized the spe-

Figure 8.5 Net new bank deposits andborrowing of selected country groups, 1979-83

Net new deposits Net new borrowing

Othercountries

Centrally0 planned

economies

Oil-importingo developing

countries

Oil-exportingo developing

countries'

D Industrialcountries

1983

1981

1980

1979

1

I I I

40 20 0 20 40Billions of dollars

Note: Data are for banks reporting to the Bank for InternationalSettlements. Net deposits with the banks take place when newdeposits by a country group exceed new borrowing; a repaymentof past borrowing would also serve to increase net deposits. Netborrowing takes place when new borrowing exceeds newdeposits by a country group; it might also reflect a reduction inoutstanding deposits with banks.

a. Mainly OPEC members.

Source: IMF 1981, no. 7; Watson, Keller, and Mathieson 1984; BISdata.

119

1982 nj

-U- I

'U

976 1980 1984

cial nature of short-term debt and its importancefor maintaining the debtor's foreign trade. Morerecently, banks have been handling short-termcredits separately or creating short-term creditfacilities. Bankers have also realized that highspreads and large fees may be self-defeating. In1983, when they signed major rescheduling agree-ments with (among others) Brazil, Chile, Ecuador,Mexico, Uruguay, and Yugoslavia, their interestspreads on rescheduled loans ranged from oneand seven-eighths to two and a half percentagepoints. However, during the second half of 1984spreads on rescheduled loans under agreements inprinciple with Argentina, Mexico, and Venezuelawere reduced to a range of seven-eighths to oneand one-quarter percentage points. Bankers havereduced or eliminated their fees and sometimesdropped the expensive pricing option of using theU.S. prime rate. Lenders are also being given theoption of shifting the denomination of some oftheir dollar loans to their home currencies, whichcould reduce some mterest costs for debtor coun-tries.

Perhaps the most significant development indebt reschedulings is the movement toward multi-year agreements for some countries that havemade significant progress in adjusting their econo-mies. A bunching of loan maturities poses anobstacle to the restoration of a normal market rela-tionship between a rescheduling country and itscreditors. The Mexican agreement covers publicsector maturities through 1990 and stretches outpayments over fourteen years. The Venezuelanagreement covers public sector maturities through1988 and spreads payments over twelve and a halfyears. In both these schemes, a combination oflong repayment periods and shorter grace periodssmooths out principal payments. Both agreementsprovide for the monitoring of the debtor's eco-nomic performance; banks wanted to be assured ofthe strong commitment of rescheduling countriesto policy adjustment and reform. In the cases ofMexico and Venezuela, the banks will receive thesemiannual reports on consultations betweenthese countries' authorities and the InternationalMonetary Fund.

The first-tier banks have therefore adopted apragmatic approach to the debt-servicing problemsof major debtors. The second-tier banks, however,with smaller exposures to the big debtors, havebeen less willing to join in debt reschedulingarrangements because there was a strong incentivefor an individual bank to withdraw from lending tocountries in difficulty.

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Despite the progress made in tackling debt-servicing difficulties, problems remain. Banks andother creditors have, for instance, sometimesreduced trade financing when a developing coun-try has run into difficulty. They have insisted onguarantees and have preferred sovereign borrow-ers. They have also been reluctant to lend for fearthat foreign exchange will be reserved for servicinglong-term public debt and that short-term com-mercial credits will be rescheduled into long-termclaims. The decline in commercial credit has there-fore harmed borrowers and inhibited developingcountries' ability to secure needed imports.

In summary, new lending by banks is an essen-tial part of a financing package designed to sup-port policy reforms for structural adjustment bydeveloping countries. On a case by case basis, con-sideration needs to be given to multiyear debtrestructurings to smooth out debt service streamsfor those countries that are implementing struc-tural adjustment programs.

Access to securities markets

At the same time as banks are reappraising theirrelationship with developing countries a signifi-cant structural change is taking place. The securi-ties marketsand the institutions that operate inthemhave increased in importance. A number ofnew instruments have been developedsuch asthe note issuance facility (see Box 8.7)whichblend some of the features of bank loans andbonds. These innovations increase the marketabil-ity and hence the liquidity of international assets.From the banks' standpoint such innovations haveserved to reduce some of the risks associated withmore traditional lending. Those banks that wish tomaintain a significant presence in internationallending are switching the focus of their operationstoward these new instrumentalities. A trendtoward the securitization of international lendingmay be under way, which could have significantimplications for the nature of private lending todeveloping countries in the future.

Despite the development of hybrid instruments,the traditional international bond markets haveflourished in recent years. International bond mar-kets have two components: the Eurobond and theforeign bond markets. Eurobonds are under-written by an international group of banks and areissued in several different national markets simul-taneously; they are not subject to formal controls.Foreign bond markets are simply domestic bondmarkets to which foreign borrowers are permitted

Box 8.7 Increasing the flexibility of bank lending

Two new market instruments are examples of financialinnovation that help increase the liquidity of banks' port-folios and encourage banks (especially in the second tier)to maintain a lending relationship with developing coun-tries.

Transferable loan instrument (TLI). The TLI provides astandardized means by which a transfer of lending com-mitments can take place from a primary lender to a sec-ondary market. In effect, TLIs create a secondary marketfor bank loans. When a bank makes a loan commitment,it can sell one or more TLIs to another bank or financialinstitution. The TLI entitles its holder to receive interestand other benefits of the original loan agreement, just asthough the holder had itself been the primary lender.The TLI would be sold in various denominations, subjectto some minimum size. It would typically be repaid inone lump sum on a date determined by the scheduledrepayment dates on the original loan. From the borrow-er's standpoint, the amount, terms, and conditions ofthe original loan remain intact. From the lender's stan-point, TLIs offer international banks scope for managingtheir assets more flexibly. And because TLIs can be soldin packages of varying maturities and denominations,they are potentially attractive to second-tier banks.

Although TLIs have thus far been used for industrial-country loans, they could be extended to developing-country finance as well. However, borrowers andlenders will have to move gradually, so that the market

access. Foreign bonds are denominated in the cur-rency of the host country, which often subjectsborrowers to tight entry requirements.

Developing countries have been attracted to theinternational bond markets primarily because theyoffer long-term money, at either fixed or floatingrates of interest. As a group, developing countrieshave indirect access to the bond markets, since theWorld Bank and regional development banks aremajor borrowers there and onlend the proceeds totheir member governments. However, few devel-oping countries have managed to borrow in thosemarkets directly, and then only in small amounts.One important reason is the existence of sovereignrisk (described in Chapter 6, Box 6.4). Bondholdersenjoy none of the advantages that banks have incoping with sovereign risk. Their relationship withdeveloping countries is extremely remote, so theyhave virtually no leverage to enforce repaymentsin the event of debt difficulties. It is noteworthy,however, that those developing countries in diff i-culty have continued to service outstanding bondsheld by nonbanks so as not to damage their repu-tation in the bond markets.

value of developing-country debt is not abruptlyreduced when TLIs are traded.

Note issuance facility (NIF). The NIF combines thecharacteristics of a traditional syndicated credit and abond. The NIF is one of a set of hybrid instrumentswhich have recently been launched in the market. A NIFis a medium-term loan which is funded by selling short-term paper, typically of three or six months' maturity. Agroup of underwriting banks guarantees the availabilityof funds to the borrower by purchasing any unsold notesat each roll-over date or by providing a standby credit.As funds are drawn, the underwriter either sells thesecurities or holds them for its own account. The bor-rower has guaranteed access to long-term funds; theunderwriter holds a liquid, marketable security, poten-tially attractive to a wide range of investors. The facilityhas the added attraction to the borrower that it can besubstantially cheaper than a standard Eurocurrencyloan. The Korean Exchange Bank and the Republic ofPortugal have, for instance, recently arranged Euronotefacilities.

The fast pace of growth of NIFs and similar hybridinstrumentswhich totaled $9.5 billion in 1983 andincreased to about $20 billion in 1984has raised con-cerns among banking regulators. Banks could have totake on their books high-risk loans if a borrowing entity(faced with, say, a fall in its creditworthiness) were notable to refinance its Euronotes in the market.

In the 1960s and early 1970s bonds issued bydeveloping countries averaged little more than 3percent of total issues (see Table 8.1). By 1978developing countries had increased the volume oftheir borrowing to $5.2 billion and their marketshare to 15 percent. In 1979 and 1980, however,their borrowing and market share declinedsharply, reviving only slightly in 1981. Since then,only developing countries that have avoided debtproblems have been able to tap the markets. In1984 they raised $3.8 billion in bond issues, withten countries accounting for the bulk of the total.

The most promising conditions in which devel-oping countries might issue bonds are when themarkets as a whole are buoyant and competitionfrom more creditworthy borrowers is light. Fixedrate markets are most buoyant when inflation isrelatively low and stable. The shape of the yieldcurve also influences the chances of issuing fixedrate bonds: if short-term interest rates exceed long-term rates, it is difficult to launch new issues. Asfor competition from other borrowers, that can beaffected by the actions of the host government. If itis borrowing heavily to finance its own budget def-

121

icit, it is likely to crowd out others. However, if thehost country has a strong current account andwishes to encourage a capital outflow, it will oftenallow its domestic bond market to be tapped byforeign borrowers.

Another type of security that is already estab-lished and may become more important for devel-oping countries is the floating rate note (FRN).These instruments have flourished in recent yearsin the Eurobond market and some foreign bondmarkets (see Table 8.1 and Box 8.8). They haveprovided much of the buoyancy in bond markets.

Table 8.1 International bond issues and placements, 1965, 1970, and 1975-84

Note: Details may not add to totals because of rounding.Source: OECD Financial Statistics 1971; OECD Financial Market Trends 1984.

122

As FRNs can be more marketable than fixed ratebonds, they offer a means by which some develop-ing countries might graduate to the fixed rate mar-kets.

Assessment

The growth in international bank lending duringthe past fifteen years has on balance been benefi-cial to developing countries, despite the difficulteconomic adjustments they have had to makerecently. In the 1970s, the banks' recycling of the

Box 8.8 Floating rate notes

The first floating rate note (FRN) was launched in theEurodollar market in 1970. As Box figure 8.8A shows,issues grew quite slowly until the late 1970s, but haveexpanded dramatically in the past four years.

Private corporations, commercial banks, and govern-ment bodies all issue FRNs. Only a few developing coun-tries have done so: Mexico and Brazil before their debt-servicing difficulties in 1982, and since then mainly thoseEast Asian countries that have avoided debt problems.For some developing countries-such as Malaysia andThailand recently-the FRN market has became lessexpensive than syndicated loans. Institutional investorsand individuals have bought FRNs, but the biggest buy-ers are commercial banks. They have taken about 70 per-cent of all FRNs, either holding them on their books asinvestments (to match their floating rate liabilities) orusing them as a substitute for syndicated lending.

There may be scope for developing countries to tapthis market further as their creditworthiness improves.These instruments, however, require the borrower tobear the interest rate risk.

Box figure 8.8A Growth of the floating rate notemarket, 1975-84

Billions of dollars

40

30Floating rate notes of all entities

20

10

Floating rate notes ofdeveloping countries

0

1975 1977 1979 1981 1983

Source: OECD Pinoncial Market Trends.

(billions of dollars, unless otherwise noted)

Type of issue or placement 1965 1970 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984

Issues or placements in foreign markets 2.4 2.4 12.3 18.9 16.6 20.7 20.3 17.9 20.5 25.2 27.1 27.8

Amount by developing countries 0.1 0.1 0.5 0.9 1.6 2.2 1.2 0.6 1.1 0.6 0.6 1.2

Percent by developing countries 4.2 4.2 4.1 4.8 9.6 10.6 5.9 3.4 5.4 2.4 2.2 4.3

Issues in the Eurobond market 0.9 3.5 10.5 15.4 19.5 14.9 18.6 20.4 31.3 50.3 50.1 81.7

Amount by developing countries 0 0.1 0.2 1.1 2.5 3.0 1.9 1.2 3.1 3.7 2.1 2.6

Percent by developing countries 0 2.9 1.9 7.1 12.8 20.1 10.2 5.9 9.9 7.4 4.2 3.2

Total international bond issues 3.3 5.9 22.8 34.3 36.1 35.6 33.9 38.3 51.8 75.5 77.2 109.5

Amount by developing countries 0.1 0.2 0.7 2.0 4.1 5.2 3.1 1.8 4.2 4.3 2.7 3.8

Percent by developing countries 3.0 3.4 3.1 5.8 11.4 14.6 8.0 4.7 8.1 5.7 3.5 3.5

Issues of floating rate notesAmount by all entities 0.3 1.4 2.2 2.9 4.2 4.8 11.3 15.3 19.5 38.2

Percent of total bond issues 1.3 4.1 6.1 8.1 10.8 12.5 21.8 20.3 25.2 34.9

Box 8.9 World Bank cofinancing

The World Bank has long encouraged other lenders-bilateral aid agencies and official export credit and bank-ing institutions-to link their financing with the Bank's.The number of cofinanced projects almost doubledbetween 1975 and 1984, and cofinancing averaged $3.6billion a year over this period (see Box table 8.9A).

The type of partners involved in cofinancing dependslargely on the borrowers. For the poorest countries,lenders that can offer concessional terms are the maincofinancing sources, whereas for creditworthy develop-ing countries the World Bank seeks commercial banksand official export credit agencies as cofinanciers. Thevolume of export credits used in cofinancing World Bankprojects has grown in recent years, but is still a small partof the long-term export credits annually committed byindustrial lenders to developing countries. Given theconstraints on official aid and the cautious approach ofcommercial banks to increasing their international expo-sure, export credit cofinancing may play a bigger role inthe future. The Bank is pursuing a more systematicapproach that would help borrowers secure exportcredits in larger volumes and possibly on better terms.

Cofinancing with commercial banks has evolved more

Box table 8.9A World Bank cofinancing operations, 1975-84(billions of dollars, unless otherwise noted)

Cofinanciers' contribution

recently. In the mid-1970s, banks lent in parallel withstandard World Bank loans (known as A loans in thiscontext), with or without an optional cross-default clauseor a memorandum of agreement with the World Bank. In1983, however, the Bank introduced its B loans, whichhave terms and conditions that are more closely alignedwith the loans of the cofinanciers.

These B loans offer three options designed to extendthe range of cofinancing instruments and to benefit allthree parties-the borrowers, the colenders, and theBank. These options are (a) direct Bank participation inthe late maturities of the B loan, with an option to sell allor part of its share; (b) a Bank guarantee of the late matu-rities, with an option to release all or part of its guaran-tee; and (c) Bank acceptance of a contingent obligation tofinance part of the deferred principal at final maturity ofa loan, with level debt service payments of floating rateinterest and variable amounts of principal repayments.Despite the financial difficulties of the past few years, thenew instruments have been broadly welcomed in themarket. They have produced cofinancing worth morethan $1 billion so far.

Note: Components may not add to totals because of rounding. These amounts represent private cofinancing as reflected in the financing plans at thetime of Board approval of A loans. They do not represent private cofinancing loans actually signed in the fiscal year. An analysis of cofinancingoperations can also be found in World Bank Annual Reports.Source: World Bank data.

OPEC surpluses prevented what might otherwisehave been an even deeper world recession. Fur-thermore, the banks contributed to the substantialexpansion of world trade through the provision oftrade-related finance. Banking innovations alsoincreased the flexibility of the international finan-cial system's response to the borrowing require-ments of developing countries in the 1970s. How-ever, the "herd instinct" of banks periodicallyundermined the stability of finance for developingcountries. More recently, banks have agreed to

provide new money in conjunction with IMF pro-grams. And the fact that bank lending was domi-nated by floating rate loans meant that developingcountries were vulnerable to the vagaries of policyin the industrial countries.

Several factors are likely to shape the develop-ment of the international capital markets over therest of this decade. International banks are cur-rently redefining their strategies, after a decade ofunprecedented growth in a highly competitivemarket. It is not clear whether their current caution

123

Fiscalyear

Number ofprojects withcofinancing

Commercialbanks

Exportcredit

agencies

Otherofficialsources Total

Bankcontribution

TotalprojectcostsIBRD IDA

1975 51 0.1 1.0 0.9 1.9 1.0 0.3 8.81976 67 0.3 0.9 1.1 2.2 1.6 0.4 9.61977 78 0.7 0.2 1.5 2.4 1.9 0.7 10.01978 79 0.2 0.5 1.8 2.5 1.7 0.8 11.41979 105 0.5 0.3 2.0 2.8 3.0 1.1 13.31980 86 1.7 1.6 2.6 5.9 3.0 1.6 20.31981 72 1.1 0.5 1.5 3.1 2.6 1.5 15.11982 98 1.2 1.8 2.2 5.3 4.1 1.2 20.01983 84 1.1 3.0 1.8 5.7 3.3 1.1 20.81984 98 1.1 0.9 2.0 4.0 4.6 1.3 21.7

signals a permanent shift toward slower growth intheir international lending, or whether they aremerely consolidating before starting a new phaseof expansion. However, it is clear that internationalbanks are having to learn new ways of collaborat-ingwith each other, with the International Mone-tary Fund, with their own central banks, and withtheir largest borrowers in the developing world.They are also showing a renewed interest inproject-related lending, so they are also cooperat-ing with the World Bank on cofinancing (see Box8.9). Furthermore, the banks are seeking ways tocope with some of the risks involved in interna-tional lending.

Despite the many problems they have hadrecently, developing countries need a continuingflow of bank lending to regain their growthmomentum. For this to happen, however, devel-oping countries must restore their creditworthi-nessand that depends on their own policies andon the strength and stability of world economicgrowth. Because banks examine closely the returnsrelative to the risks involved on each loan, anincrease in creditworthiness would reduce the riskand increase the attractiveness of developing-country loans. Beyond that, the revival of banklending depends upon:

The ability of banks to rebuild their capital bases.There is evidence that such a trend is alreadyunder way among U.S. banks. This is significantbecause these banks have been major lenders todeveloping countries in the past. Their capitalgrew by approximately 12 percent a year during1982-84, and their capital ratios have risen sharply.U.S. banks' exposure to developing countriesdeclined substantially relative to their capital in1982-84. Whether this development will presagean increase in lending to developing countries willdepend on the relative attraction of domestic lend-ing during the present phase of financial deregula-tion in the United States. The capital position ofnon-U.S. banks would also improve if the dollarweakened appreciably on the foreign exchangemarkets.

The degree to which developing countries can

124

embrace new instruments. These instruments nowevolving in the international markets may encour-age second-tier banks and nonbanking institutionsto maintain or increase their presence in interna-tional lending.

The evolution of a viable secondary market for bankloans. Banks making loans are typically locked infor the duration, albeit at a variable interest rate, soare less able to adjust their exposure to changingcircumstances. This makes them more reluctant toincrease their lending. A secondary market mightadd depth to the lending market by encouraging awider range of investors to take up developing-country paper. Without a mature secondary mar-ket, there is no adequate mechanism for pricingassets and revealing the market's collective judg-ment about risk. As a result, bank lending is morelikely to be volatile. Secondary markets for loans todeveloping countries are controversial, however.Bankers, for instance, do not want to publicize thefluctuating value of their assets, and borrowers areconcerned about the difficulty of managing theirdebt in the secondary market. Moreover, second-ary markets offer a guide to creditworthiness thatcould signal the need to modify policies if borrow-ing difficulties were emerging. The expansion ofsecondary markets is desirable, but it must be aphased process in which creditors and debtors, aswell as banking regulators, are given time to delin-eate and then adapt to their functions. Without aphased introduction of secondary markets, thebanks, for instance, might be forced to write downthe value of large amounts of lending, which couldreduce their ability to provide new resources.

The international bond markets may continue toflourish, as they have done for the past threeyears. For the fixed rate markets to remain buoyantwill require a continuation of low inflation. Float-ing rate notes, meanwhile, are likely to remain afeature of these markets. It is possible that thelocus of lending to developing countries may shiftto the innovative shorter-term segment of thesecurities markets. The restoration of the cre-ditworthiness of developing countries will be thekey to their access to the securities markets.