INTERNATIONAL MONETARY FUNDWashington, DCSeptember 1998

W O R L D E C O N O M I C A N D F I N A N C I A L S U R V E Y S

International Capital MarketsDevelopments, Prospects,

and Key Policy Issues

By a Staff Teamled by

Charles Adams, Donald J. Mathieson,Garry Schinasi, and Bankim Chadha

© 1998 International Monetary Fund

Production: IMF Graphics SectionFigures: Theodore F. Peters, Jr.

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ISBN 1-55775-770-4ISSN 0258-7440

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Page

Preface ix

List of Abbreviations xi

I. Overview 1

The Asian Crisis: Capital Market Dynamics and Spillover 1Emerging Markets in the New International Financial System:

Implications of the Asian Crisis 6Developments and Trends in the Mature Financial Markets 7Selected Issues in the Mature Financial Systems: EMU, Banking System

and Performance, and Supervision and Regulation 8

II. The Asian Crisis: Capital Markets Dynamics and Spillover 11

Part One: Emerging Markets Financing 12Capital Flows, Reserves, and Foreign Exchange Markets 12Bond Markets 20International Bank Lending 29Equity Markets 30

Part Two: Emerging Market Banking Systems 33Part Three: Market Dynamics, Linkages, and Transmission 40

The Boom in Capital Inflows 40The Dynamic of the Southeast Asian Currency Crisis 44The Illiquidity of Foreign Exchange Markets 50The Intensification of Exchange Rate Declines 50The October Turbulence in Hong Kong SAR 51Spillover in the Wake from Hong Kong SAR 51The Winter Recovery 56

Conclusions 57References 58

III. Emerging Markets in the New International Financial System:Implications of the Asian Crisis 59

Is the Asian Crisis a New Type of Systemic Crisis? 59The Similarities 59Some Differences 63

Capital Flows and Market Dynamics 67Terms and Conditions for Market Access 67Market Dynamics 68Abrupt Loss of Market Access 70

Contagion 71Coping with Surges in Capital Inflows 72

Macroeconomic Policy Responses 72Dealing with Banking Sector Problems 73The Role of the Corporate Sector and the Bankruptcy Process 76

Conclusions 78References 80

iii

Contents

CONTENTS

iv

IV. Developments and Trends in Mature Financial Markets 82

Foreign Exchange Markets 82Credit Markets 85

Money and Repo Markets 85Bond Markets 86International Credit Markets 89

Equity Markets 92United States 92Europe 92Japan 97

Derivatives Markets 97Risks to Global Financial Markets 100References 103

V. Selected Issues in Mature Financial Systems: EMU, Banking System Performance, and Supervision and Regulation 104

European Monetary Union 104Implementation of TARGET 104Financial Stability and Crisis Management 105

Developments in Group of Seven Country Banking Systems 110Resolving Japan’s Financial System Problems 110Banking System Developments in North America and the United Kingdom 133Banking System Developments in Continental Europe 136

Developments in Financial Supervision and Regulation 138Supervisory Reforms Relating to Risk Management 139Consolidated Supervision—Regulation by Entity Versus Function 141Developments in International Coordination 143Reforms to Enhance Market Incentives 144

References 145

VI. Conclusions 147

Mature Market Risks 147Emerging Market Risks 148European Monetary Union 149Asian Crisis 149

Annex I: Developments in Selected Emerging Markets Banking Systems 152

Asian Banking Systems 152China 152Indonesia 153Korea 154Malaysia 156Philippines 158Thailand 159

Latin American Banking Systems 160Argentina 160Brazil 161Chile 163Mexico 164Venezuela 165

European Banking Systems 166Czech Republic 166Hungary 167

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Poland 168Russia 169

References 170

Annex II: Dynamics of Asset Prices Around Large Price Changes 171

References 172

Annex III: Leading Indicators of Currency and Banking Crises 173

References 175

Annex IV: Chile’s Experience with Capital Controls 176

A Brief Survey of the Literature on the Effectiveness of the Chilean Controls 177Selective Capital Controls and Prudential Regulation 178References 179

Annex V: Globalization of Finance and Financial Risks 180

Consolidation and Restructuring of the Global Financial Services Industry 180The Changing Business of Banking 180Desegmentation of Financial Services and the Institutionalization of

Asset Management 183Closer Integration of Financial Markets 186

Cross-Border Finance in a Global Securities Market 186Exchange Trading Links 189Similarities Between OTC and Exchange-Traded Markets Increase

Market Integration 191New Markets and Products for Unbundling, Pricing, Trading, and Managing Risk 191

Recent Developments in Markets for Unbundling Risks 192Developments in Risk Management 193

References 196

Boxes

Chapters

1.1. Efforts to Improve the International Architecture 22.1. Capital Flow Reversals During the Mexican and Asian Crises 152.2. The Resilience of FDI in Emerging Markets: An Update from

the Asian Crisis 162.3. Unrecorded Capital Flight from Asia? 172.4. Alternative Forms of Central Bank Intervention in Foreign

Exchange Markets 202.5. The Liquidity of Measured Reserves and “Usable” Reserves:

The Case of Korea 202.6. Enhancements and Innovations in Bond Structures in

Response to the Asian Crisis 292.7. Key Financial Sector Policy Responses to the Asian Crisis 392.8. Bank Capital Adequacy: Issues for Emerging Markets 422.9. The Asian Carry Trade 44

2.10. Peregrine and the Growth of Investment Banking in Asia 452.11. Reserve Impact of Forward Foreign Exchange Market Intervention 472.12. Chronology of Major Events in the Asian Crisis and Its Spillover 492.13. The Timings of Ratings Actions and the Behavior of Spreads 524.1. The October 1997 Turbulence in International Equity Markets 945.1. ESCB Role in Prudential Supervision and Financial Stability 1075.2. Remaining Scope for Lender-of-Last-Resort Operations in EMU 108

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5.3. Turbulence in the Japanese Interbank Market 1115.4. The Expansion of the Bank of Japan’s Balance Sheet 1145.5. Banks’ Self-Assessments and the PCA Framework 1185.6. Resolution Agencies in Japan 1225.7. Exposures of Mature-Market Banks to Asian Crisis Countries 1345.8. Basle Capital Accord: Risk Weights by Category of

On-Balance-Sheet Asset 1405.9. The Financial Services Authority of the United Kingdom 142

Tables

Chapters

2.1. Private Capital Flows to Emerging Markets 132.2. Secondary Market Transactions in Debt Instruments of

Emerging Markets 252.3. Emerging Market Bond Issues, Equity Issues, and Loan Commitments 262.4. Changes in Net Assets of BIS-Reporting Banks Vis-à-Vis Banks

in Selected Countries and Regions 312.5. Annual Stock Market Turnover Ratios in Selected Countries

and Regions 332.6. Average Bank Financial Strength Ratings for Selected Countries

and Regions 362.7. Banks’ Liquidity and Solvency Risks—Selected Asian Countries 372.8. Number of Financial Institutions—Selected Latin American Countries 394.1. Major Industrial Countries: Outstanding Amounts of Private

Sector Domestic Debt Securities 894.2. Announced International Syndicated Credit Facilities by

Nationality of Borrowers 904.3. Outstanding Amounts of International Debt Securities 914.4. Outstanding Amounts and Net Issues of International Debt Securities

by Currency of Issue 914.5. Currency Composition of Notional Principal Value of Outstanding

Interest Rate and Currency Swaps 984.6. Markets for Selected Derivative Financial Instruments:

Notional Principal Amounts Outstanding 994.7. Notional Value of Outstanding Interest Rate and Currency Swaps of

ISDA Members 1004.8. New Interest Rate and Currency Swaps 1014.9. Annual Turnover in Derivative Financial Instruments Traded on

Organized Exchanges Worldwide 1025.1. Japan: Regulatory Changes in the Computation of Prudential

Capitalization of Banks 1165.2. Japan: Profit and Loss Accounts of the Major Banks in FY1997 1175.3. Japan: Self-Assessments of Loan Classifications 1195.4. Japan: Asset Quality of Major Banks in FY1997 1205.5. Japan: Selected Corporate Financial Indicators 1215.6. Japan: Planned Personnel and Other Expenses Included on the

Application for the First-Round Capital Injection 1235.7. Japan: Conditions for the Subscription of Capital Using Public Funds,

March 1998 1245.8. Japan: Schedule for Reforming the Securities Market and for

Big Bang Financial Reform 1275.9. Claims of Selected Major Banking Systems on Emerging Markets

in Asia as of December 1997 1365.10. International Organizations’ Documents Proposing Principles of

Supervision and Regulation 144

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Annexes

A4.1. Bank Borrowing by Maturity for Selected Emerging Markets, End-December 1997 177

A4.2. Selected Chilean Capital Account Controls and Banking Regulations 178A5.1. Major Industrial Countries: Bank Deposits 181A5.2. Selected Industrial Countries: Negotiable Liabilities 181A5.3. Major Industrial Countries: Bank Loans 181A5.4. Selected Industrial Countries: Tradable Securities Holdings 181A5.5. Top 50 Banks: Balance Sheet Information 182A5.6. Major Industrial Countries: Assets of Institutional Investors 184A5.7. Selected Industrial Countries: Institutional Investors’ Holdings

of Securities Issued by Nonresidents 185A5.8. Major Industrial Countries: Gross and Net Flows of Foreign Direct

and Portfolio Investment 187A5.9. Selected Major Industrial Countries: Cross-Border Transactions in

Bonds and Equities 187A5.10. International Equity Issues by Selected Industrial and Developing

Countries and Regions 188A5.11. Outstanding International Debt Securities by Nationality of Issuer

for Selected Industrial and Developing Countries and Regions 189A5.12. Nonresidents’ Holdings of Public Debt 190A5.13. Foreign Exchange Trading 190

Figures

Chapters2.1. Net Private Capital Flows to Emerging Markets 142.2. Exchange Rates of Selected Emerging Markets,

January 6, 1997–May 29, 1998 182.3. Selected Asian Currencies: Exchange Rate Volatilities,

January 1, 1996–May 29, 1998 212.4. Selected Asian Currencies: Bid-Ask Spreads,

January 1, 1996–May 29, 1998 222.5. Bond Markets: Selected Returns, Yields, and Spreads,

January 1992–May 29, 1998 232.6. Yield Spreads for Selected Brady Bonds and

U.S. Dollar-Denominated Eurobonds 242.7. Emerging Market Debt: Volatility of Returns 252.8. Private Market Financing for Emerging Markets 282.9. Spreads and Maturities for Sovereign Borrowers 30

2.10. Emerging Equity Markets: Selected Returns, Price-Earnings Ratios, and Expected Returns 32

2.11. Emerging Equity Markets: Selected Volatilities Comparisons 322.12. Emerging Market Mutual Funds: Estimated Net Flows 332.13. Financial Sector Lending: Growth and Leverage, 1990–96 342.14. Bank and Nonbank Financial Intermediaries, 1990–96 352.15. Real Estate and Stock Prices in Selected Asian Countries 382.16. Foreign Banks in Latin America: Percentage of Total Banking

System Assets 403.1. Surges of Private Capital Flows Prior to Crises 603.2. Secondary Market Bond Spreads 623.3. Comparing Economic Fundamentals Prior to the Debt, the Mexican,

and the Asian Crises 643.4. Claims of Banking Institutions on the Private Sector 653.5. Real Effective Exchange Rate Appreciation Prior to Crises 65

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3.6. Stock Market Price Indices in Local Currencies 664.1. Major Industrial Countries: Spot Exchange Rates and Nominal

Effective Exchange Rates 834.2. Major European Countries: Local Currency Versus Deutsche Mark,

January 3, 1994–June 30, 1998 844.3. Major Industrial Countries: Short-Term Interest Rates 854.4. Major Industrial Countries: Long-Term Interest Rates 874.5. United States: Yields on Corporate and Treasury Bonds,

January 5, 1962–June 26, 1998 884.6. Weighted Average Spreads for Announced Facilities in the

International Syndicated Credit Market 904.7. Major Industrial Countries: Stock Market Indices 934.8. International Equity Price Movements, 6 p.m., October 22–5 p.m.,

October 31 (EST), 1997 954.9. Major Industrial Countries: Dividend Yields 965.1. Japan: Interbank Rates, January 4, 1996–July 13, 1998 1125.2. Japan: Performance of Selected Bank Stocks,

January 6, 1997–July 13, 1998 113

Annexes

A4.1. Chile’s Short-Term External Debt 176

Page

The following symbols have been used throughout this volume:

. . . to indicate that data are not available;

— to indicate that the figure is zero or less than half the final digit shown, or that the itemdoes not exist;

– between years or months (for example, 1997–98 or January–June) to indicate the yearsor months covered, including the beginning and ending years or months;

/ between years (for example, 1997/98) to indicate a fiscal or financial year.

"Billion" means a thousand million; "trillion" means a thousand billion.

"Basis points" refer to hundredths of 1 percentage point (for example, 25 basis points areequivalent to !/4 of 1 percentage point).

Minor discrepancies between constituent figures and totals are due to rounding.

As used in this volume the term "country" does not in all cases refer to a territorial entity thatis a state as understood by international law and practice. As used here, the term also coverssome territorial entities that are not states but for which statistical data are maintained on aseparate and independent basis.

The International Capital Markets report is an integral element of the IMF’s surveillance ofdevelopments in international financial markets. The IMF has published the InternationalCapital Markets report annually since 1980. The report draws, in part, on a series of informaldiscussions with commercial and investment banks, securities firms, stock and futuresexchanges, regulatory and monetary authorities, and the staffs of the Bank for InternationalSettlements, and the International Swaps and Derivatives Association. The discussions lead-ing up to the present report took place in Brazil, China, the Czech Republic, France, Germany,Hong Kong SAR, Indonesia, Japan, Korea, Malaysia, the Philippines, Singapore, Switzerland,Thailand, the United Kingdom, the United States, and Venezuela, between February and May1998. The report reflects information available up to mid-July 1998, and hence does not coverthe turbulence in Russia.

The International Capital Markets report is prepared by the Research Department. TheInternational Capital Markets project is directed by Charles Adams, Assistant Director,together with Donald Mathieson, Chief of the Emerging Markets Studies Division, and GarrySchinasi, Chief of the Capital Markets and Financial Studies Division. Coauthors of the reportfrom the Capital Markets and Financial Studies Division of the Research Department areLaura Kodres, Charles Kramer, Joaquim Levy, Alessandro Prati, Andrei Kirilenko, all Econo-mists; Todd Smith, Visiting Scholar; Subramanian Sriram, Senior Research Officer; andXuechun Zhang, Research Assistant. Coauthors of the report from the Emerging MarketsStudies Division of the Research Department are Barry Eichengreen, Senior Policy Advisor;Bankim Chadha, Deputy Division Chief; Sunil Sharma, Senior Economist; Subir Lall, Anthony Richards, Jorge Roldos, Amadou Sy, Giovanni Dell’Ariccia, all Economists; AnneJansen, Senior Research Officer; Kenneth Wood, Financial Systems Officer; and Peter Tran,Research Assistant. Shiela Kinsella, Rosalind Oliver, Ramanjeet Singh, and Adriana Vohdenprovided expert word processing assistance. Esha Ray of the External Relations Departmentedited the manuscript and coordinated production of the publication.

This study benefited from comments and suggestions from staff in other IMF departments,as well as from Executive Directors following their discussions of the International CapitalMarkets report on July 31, 1998. However, the analysis and policy considerations are those ofthe contributing staff and should not be attributed to the Executive Directors, their nationalauthorities, or the IMF.

ix

Preface

ADRs American Depository ReceiptsAFB Association Française de BanquesAMC Asset Management CorporationASB Accounting Standards BoardBIBF Bangkok International Banking FacilityBIS Bank for International SettlementsBFSR Bank Financial Strength RatingsBHCA Bank Holding Company ActBMF Bolsa de Mercadorias e FuturosBNL Banca Nazionale del LavoroCAD Capital Adequacy DirectiveCBO collateralized bond obligationCBOT Chicago Board of TradeCBR Central Bank of RussiaCCPC Cooperative Credit Purchase CorporationCD certificate of depositCFTC Commodity Futures Trading Commission CLO collateralized loan obligationCLS Continuously Linked SettlementCMAs Cash Management AccountsCME Chicago Mercantile ExchangeCNBV National Banking CommissionCSFPs Credit Suisse Financial ProductsDIACs Discretionary Investment Advisory CompaniesDIC Deposit Insurance CorporationDJIA Dow Jones Industrial AverageDTB Deutsche TerminbörseDVP delivery versus paymentEAF2 Euro Access Frankfurt 2EBA European Bankers’ AssociationEBRD European Bank for Reconstruction and DevelopmentECB European Central BankECS Euro Clearing SystemECU European currency unitEMBI Emerging Markets Bond IndexEMCC Emerging Market Clearing Corp. EMI European Monetary InstituteEMU Economic and Monetary UnionERM exchange rate mechanismESCB European System of Central BanksEU European UnionFASB Financial Accounting Standards BoardFCDU Foreign Currency Deposit UnitFDI foreign direct investmentFDIC Federal Deposit Insurance CorporationFFIEC Federal Financial Institutions Examination CouncilFIDF Financial Institutions Development FundFOBAPROA Fondo Bancario de Protección al Ahorro

xi

List of Abbreviations

LIST OF ABBREVIATIONS

xii

FRANs floating rate accrual notesFSA Financial Supervisory AgencyGDDS General Data Dissemination SystemGDP gross domestic productGDRs Global Depository ReceiptsGSA Glass-Steagall ActHKMA Hong Kong Monetary AuthorityHLAC Housing Loans Administration CorporationHTB Hokkaido-Takushoku BankIAIS International Association of Insurance SupervisorsIAS International Accounting StandardsIAPC International Auditing Practices CommitteeIASC International Accounting Standards CommitteeIBRA Indonesia Bank Restructuring AgencyIFAC International Federation of AccountantsIFCI International Finance Corporation IndexIOSCO International Organization of Securities CommissionsISDA International Swaps and Derivatives Association, Inc.ITMCs investment trust management companies JGB Japanese Government BondKDB Korea Development BankKDIC Korean Deposit Insurance CorporationKMAC Korea Asset Management CorporationLIBOR London interbank offered rateLOLR lender of last resortLIFFE London International Financial Futures ExchangeLTCB Long-Term Credit BankMATIF Marché à Terme International de FranceMOU memorandum of understandingNCB Nippon Credit BankNDF nondeliverable forwardNYSE New York Stock ExchangeOECD Organization for Economic Cooperation and DevelopmentOTC over the counterPBC People’s Bank of ChinaPCA Prompt Corrective ActionPIBOR Paris interbank offered rateRCB Resolution and Collection BankRTGS real-time gross settlementS&P Standard and Poor’sSBIF Superintendency of Banks and Financial InstitutionsSDDS Special Data Dissemination StandardsSEC Securities and Exchange CommissionSIMEX Singapore International Monetary ExchangeSOEs state-owned enterprisesSPANs spread adjustable notesSPCs special-purpose corporationsTIBOR Tokyo interbank offered rateTROR total rate of returnTSE Tokyo Stock ExchangeUNCITRAL United Nations Commission on International Trade LawURR unremunerated reserve requirementVAR value at risk

The past year has been a remarkable one in the in-ternational capital markets as the Asian emerging

markets have experienced turbulence unseen since thedebt problems of the heavily indebted emerging mar-kets at the beginning of the 1980s.1 Even though thefinancial crisis has been largely confined to Asia,Japan’s growing economic weaknesses and bankingproblems have spilled over outside the region and thecrisis has produced a reevaluation of the risks and vul-nerabilities in emerging markets outside Asia. Themature financial markets in North America and Eu-rope have not thus far been very adversely affected bythe crisis because of their generally relatively smalland well-provisioned on-balance-sheet banking sectorexposures to the Asian emerging markets in “crisis”(Indonesia, Korea, Malaysia, and Thailand2), and theavoidance of widespread defaults as a result, in part,of the prompt response of the international commu-nity. Indeed, several mature markets have benefited tosome extent from a “flight to quality” and the impli-cations of weaker Asian economic activity and lowercommodity prices for inflation. A continued favorableperformance is not, however, assured and the outlookcould change if Japan’s problems are not quickly ad-dressed, the difficulties in emerging markets deepenor spread, or the current very high valuations in theU.S. and many European equity markets are subject tosharp downward revision. The consequences forglobal capital markets of these risks unfolding couldbe severe.

In the wake of the Asian crisis, the internationalcommunity, including the IMF, has been undertakinga far-reaching reassessment of the international archi-tecture for crisis prevention and resolution (Box 1.1).

Building upon initiatives taken following the 1994–95Mexican financial crisis, measures are being consid-ered or implemented to accelerate the disseminationof best practices in financial sector regulation; im-prove transparency and disclosure in emerging andadvanced country financial systems; strengthen thetimely availability and provision of data, especiallywith regard to external debt and reserves; and enhanceprocedures for dealing with private international debtproblems. This year’s Capital Markets report focuseson a select set of issues surrounding the behavior of fi-nancial markets during the Asian crisis, the similari-ties and differences with earlier emerging marketcrises, and the policy lessons to be drawn for dealingwith volatility in capital flows. The report also re-views recent financial market and banking sector de-velopments in the advanced and emerging markets,developments and initiatives in banking system super-vision and regulation, and the financial infrastructurefor managing systemic risk in the European Economicand Monetary Union (EMU).

The Asian Crisis: Capital Market Dynamicsand Spillover

The key development since the 1997 Capital Mar-kets report has been the Asian financial crisis, whichis notable both for its severity and the virulence withwhich it has affected not only countries within Asiabut also emerging markets in other regions. The crisisfollowed a period characterized by record private cap-ital inflows into the emerging markets and a relativelysharp compression of spreads across a wide range ofemerging market credit instruments. The capital in-flows reflected a number of factors, including thesearch for higher yields on the part of international in-vestors in an environment of low advanced country in-terest rates, apparent strong macroeconomic andstructural policies in many emerging markets, and ex-ternal financial sector liberalization. Already by early1997, however, there were growing concerns amongsome market participants about the extent to whichspreads had narrowed for many emerging market bor-rowers and worries about a reversal of capital flows,especially in the event of a tightening of monetaryconditions in the mature markets. Nevertheless, capi-

1

IOverview

1The term “emerging markets” as used in this report is substan-tially broader than that used in other contexts and includes the IMF’sWorld Economic Outlook classifications of “developing countries,”“countries in transition,” and the advanced economies of HongKong Special Administrative Region (SAR) of China, Israel, Korea,Singapore, and the Taiwan Province of China.

2Here, and in what follows, these four countries are characterizedas Asian emerging markets in crisis. In view of the large number ofAsian countries seriously affected by the regional turmoil, the iden-tification of crisis countries is necessarily somewhat arbitrary.Among the four emerging markets so identified, Malaysia has nothad an open banking crisis while Indonesia, Korea, and Thailandhave experienced severe banking sector problems.

I OVERVIEW

tal inflows to the emerging markets continued at ahigh level through much of 1997, before collapsingtoward the end of the year.

The Southeast Asian currency turmoil has evolvedinto a full-blown financial crisis affecting much ofAsia and necessitating extensive official financial sup-port and assistance, especially from the IMF. Follow-ing the July 1997 devaluation of the Thai baht, otherSoutheast Asian currencies over the next couple ofmonths abandoned their close links to the U.S. dollarand began to depreciate. The most severe pressures inforeign exchange markets in the third quarter of 1997were experienced by Thailand, Malaysia, the Philip-pines, and Indonesia, but the currencies of Singaporeand a number of other Asian countries also weakened.As the pressures spread to Hong Kong SAR andKorea in late October following the depreciation ofthe New Taiwan dollar, the scale of the crisis wors-ened significantly. Several emerging markets outsidethe region, notably Brazil and Russia, also began to beadversely affected by a shift in sentiment regarding

emerging market vulnerabilities, as well as financialand real linkages with Asia.

The extreme turbulence in emerging market curren-cies during the Asian crisis has been virtually withoutprecedent. When these currencies reached their lowpoints in January 1998, the Indonesian rupiah hadfallen (relative to its July 1997 level) by 81 percent,the Malaysian ringgit by 46 percent, and the Thai bahtby 55 percent. Between early October 1997 and itslow in late December, the Korean won depreciated by55 percent. Average volatility, as measured by thestandard deviation of daily spot exchange rate changesfor these currencies, increased by a factor of around10 in the second half of 1997 compared with the sameperiod the previous year. Accompanying the increasein exchange market volatility, transactions costs inspot, forward, and other derivative markets for thesecurrencies skyrocketed and liquidity dropped, withonly modest improvements in the first half of 1998.There was also exchange market pressure in otheremerging markets in the second half of 1997, notably

2

Box 1.1. Efforts to Improve the International Architecture

Efforts by international organizations to improve theresiliency of the international financial system againstsystemic events can be viewed as enhancing the under-standing of the precursors to crises and the subsequentdynamics of these events, as well as helping to preventcrises before they occur. One of the primary ways inwhich the architecture of the international monetary sys-tem may be improved is by developing and implement-ing international standards to strengthen the operation offinancial markets. These standards or principles attemptto (1) foster effective financial market supervision andregulation; (2) improve the institutional infrastructure;and (3) enhance surveillance, market discipline, and cor-porate governance. A selected number of initiatives and abrief description of several sets of international standardsor good practices in these areas is provided below.

Understanding and Predicting Crises

Capital account liberalization and early warning indi-cators. Prevention of future crises may be aided by anunderstanding of role of various factors in previouscrises. The IMF is thus studying a number of related top-ics, including (1) economic policy considerations in cap-ital market liberalization; (2) importance of orderly se-quencing of capital account liberalization for financialsector stability; and (3) early warning indicators of bal-ance of payments and currency crises. The OECD is alsoconducting a study of the structural factors contributingto emergence of financial crises.

Role of private sector and public policy. The potentialinvolvement of the private sector in forestalling and re-solving financial crises is being studied by the IMF. Itwill also evaluate its experience with IMF-supportedprograms in the Asian crises.

Foster Effective Supervision and RegulationBanking supervision. The Basle Committee has devel-

oped the Core Principles for Effective Banking Supervi-sion, which are intended to serve as a basic reference andminimum standard for supervisory and other public au-thorities. Consistent with these principles, the IMF hasdeveloped a framework for financial sector surveil-lance—Toward a Framework for Financial Stability—toguide the analysis of banking system issues by identify-ing key areas of vulnerability.

Securities regulation. The International Organizationof Securities Commissions (IOSCO) is working to estab-lish universal principles for securities market regulationand a draft will be considered for membership endorse-ment in September 1998. The IOSCO is also working onimproving disclosure requirements and has proposed adisclosure standard for international cross-border offer-ings, which members will consider in September 1998.

Insurance supervision. In September 1997, the Inter-national Association of Insurance Supervisors (IAIS) re-leased Principles, Standards, and Guidance Papers forinsurance supervisors dealing with internationally activeinsurance companies.

Improve Institutional Infrastructure

Auditing and accounting. The International Account-ing Standards Committee (IASC) has published a seriesof International Accounting Standards (IAS) that aim atachieving uniformity in the accounting principles used bybusiness and other organizations for financial reportingacross the world. International standards of auditing havebeen established by the International Federation of Ac-countants (IFAC), through its International Auditing Prac-tices Committee (IAPC). The IOSCO has been working

in Latin America, Eastern Europe, and Russia; this,however, did not generally lead to sharp exchange rateadjustments as central bank currency defenses werefor the most part successful and were supported, insome cases, by a strengthening in economic policies.

The large depreciations of the Asian crisis curren-cies seriously impaired the balance sheets of alreadyweak and unhedged domestic financial institutionsand corporates, and led to sharp increases in creditrisk. As a result, 1997 saw the first major reduction inprivate capital flows to the emerging markets in thisdecade and a general reevaluation of emerging marketrisk. After increasing in each of the preceding fewyears, private capital flows to the four Asian emergingmarkets in crisis declined by almost $100 billion dur-ing 1997, with the bulk of the reduction taking placeduring the last quarter. Compared with the situation atthe time of the 1994–95 Mexican crisis, the reductionin capital flows to the crisis countries was not offsetby a reallocation of flows to emerging markets inother regions. Private capital flows to the emerging

markets in Africa, Latin America, Europe, and theMiddle East held up relatively well through most of1997 but, with the exception of the Middle East,slowed late in the year as new issues were deferredand lower-rated borrowers withdrew from the market.

The sharp cutbacks in private capital flows to Asiaduring 1997 were largely in short-term internationalbank credit and portfolio flows. Foreign direct invest-ment (FDI), which has been becoming an increasinglyimportant source of external financing for the emerg-ing markets, was relatively resilient given the long-term considerations typically guiding such invest-ment. After increasing in the preceding two years,bank lending to the Asian emerging markets began toslow early in 1997 and then collapsed late in the yearas interbank credit lines were reduced or withdrawn.The cutback in credit lines was exacerbated by a pull-back of Japanese banks from regional emerging mar-kets in response to domestic weaknesses and efforts tomeet minimum capital standards. Capital flight fromAsia also increased sharply, as suggested by growing

The Asian Crisis: Capital Market Dynamics and Spillover

3

with both IASC and IFAC/IAPC to ensure relevant andcomprehensive approaches to the respective standardsand their harmonization with securities market regulation.

Bankruptcy. Regional and multilateral initiatives toharmonize domestic bankruptcy laws have not beensuccessful, as domestic bankruptcy systems vary consid-erably across countries, reflecting in part disparate legaltraditions and practices. In contrast, harmonization of thetreatment of cross-border bankruptcy problems has beenmore successful, notably under the auspices of theUnited Nations Commission on International Trade Law(UNCITRAL) (a model law on Cross-Border Insol-vency), the International Bar Association (a Cross-Border Insolvency Concordat), and the European Union(a still unratified Convention on Insolvency Procedures).

Payment systems. Payment system reforms have fo-cused on widespread adoption of real-time gross settle-ment (RTGS) systems and the use of delivery versus pay-ment (DVP) schemes for securities settlement. Thesereforms are ongoing with a large number of countriesadopting such systems. Foreign exchange settlementrisk, given settlement lags in different time zones, holdsthe highest potential for a systemic disruption. Severalprivate sector efforts are under way to reduce foreign ex-change settlement risks, including a potential new deriv-atives contract, the contract for differences, and a globalsettlement bank, using the Continuously Linked Settle-ment (CLS) system.

Enhance Market Discipline, Surveillance, andCorporate Governance

Data dissemination. The IMF has established the Spe-cial Data Dissemination Standards (SDDS) to guide itsmarket borrowing members on the provision of eco-

nomic and financial data to the public. The IMF main-tains a Dissemination Standards Bulletin Board on theInternet, which posts information on the statistical prac-tices of subscribers of the SDDS (at end-August 1998there were 46 subscribers). “Hyperlinks” to country datasites on the Internet have been established for 15 sub-scribers. The General Data Dissemination System(GDDS), the other tier of the dissemination standards,was established by the IMF in December 1997. It focuseson improving data quality across the spectrum of IMFmembership. Both the IMF and the Eurocurrency Stand-ing Committee are reviewing current data collection anddissemination efforts with a view to enhancing them. Inparticular, the Bank for International Settlements (BIS) isset to collect information about over-the-counter deriva-tives on a six-month basis for a subset of derivativesdealers.

Fiscal transparency. The IMF has developed a Codeof Good Practices on Fiscal Transparency to guide mem-bers in enhancing the accountability and credibility offiscal policy as a key component of good governance.IMF members will be encouraged to implement the codeon a voluntary basis with no formal subscription processcurrently envisaged.

Corporate governance. The OECD, the Basle Com-mittee, the World Bank, and the European Bank for Re-construction and Development (EBRD) are involved inthe development of principles and good practices in thearea of corporate governance. For example, an informaladvisory group associated with the OECD issued a reportin April 1998 entitled Corporate Governance: ImprovingCompetitiveness and Access to Capital in Global Mar-kets, recognizing that a formal articulation of the basicelements for sound corporate governance was needed.

I OVERVIEW

errors and omissions in balance of payments statisticsand anecdotal reports of domestic entities movingfunds offshore. Bank flows to Latin America alsoslowed in 1997 as key international banks pulled backfrom emerging markets. The slowdown was more thanoffset, however, by a pickup in new bond and equityissues that in recent years have been more importantthan bank financing. Toward the end of the year, manyLatin American borrowers began postponing new se-curities issues in the face of a more general tighteningof external financing conditions, but there was somepickup in early 1998.

The Asian financial crisis and currency turmoilhave had far-reaching effects on volatility in emergingequity markets. After falling substantially followingthe 1994–95 Mexican crisis, volatility in Asian andLatin American equity markets shot up in the after-math of the depreciation of the Thai baht in July 1997.Volatility continued to increase in Asia over the re-mainder of the year and reached levels in excess ofthat in the Latin American markets at the peak of the1994–95 Mexican crisis. The high volatility in Asianequity markets was closely related to the volatility inexchange markets and to uncertainty generated bylarge exchange rate depreciations in the face of signif-icant unhedged foreign currency borrowing.

On emerging debt markets, which are dominated bysovereign Latin American credits, spreads remainedrelatively low through the third quarter of 1997 andthen increased sharply in the aftermath of the financialturbulence in Hong Kong SAR in late October. Theincreases were particularly large for Asian emergingmarket debt, fueled by the worsening regional situa-tion and outlook and a succession of sharp sovereigndowngrades by international credit rating agencies.After maintaining high ratings for Asian sovereignsthrough the third quarter of 1997, international creditrating agencies sharply downgraded many of the crisiscountries in the last quarter of 1997. Korea’s fall tobelow investment-grade status was one of the largestin recent history. Downgrades below investment gradeimplied that certain institutional investors could nolonger hold claims on these countries, and further ex-acerbated the downward pressure on currencies asthese investors sought to reduce their exposures.

Following sizable depreciations and high volatilityin the second half of 1997, many Asian currenciesbegan to recover in early 1998 as capital outflowsfrom the region slowed and current account positionsturned around sharply. Confidence within the regionwas also enhanced by the agreement in late 1997 toroll over and restructure Korea’s external short-termbank debt. Exchange rate volatility, however, re-mained high owing to the thinness of markets and wasexacerbated early in the year by growing uncertaintyabout the political and economic situation in Indone-sia and the risk of spillover to neighboring countries.Many Asian emerging market currencies came under

renewed pressure around midyear as the situation andoutlook in Japan worsened significantly and the yencame under downward pressure. Although depreciat-ing somewhat vis-à-vis the U.S. dollar, most Asiancurrencies (other than the Indonesian rupiah) re-mained relatively stable in effective terms. Althoughboth the Hong Kong dollar and the Chinese renminbiwere reported to have come under pressure in the mid-dle of 1998, both retained their close links to the U.S.dollar. After rebounding strongly in the first quarter,Asian equity markets weakened sharply after April1998, as it became clear that output in many countrieswas declining much more sharply than had been ear-lier expected. The weakening in equity markets mighthave been exacerbated by concerns about the effectsof Japanese yen depreciation and a possible spreadingof the crisis to China.

Banking sectors in the emerging markets during1997–98 were closely influenced by broader macro-economic and financial developments and showedclear regional patterns related to the Asian financialcrisis. Deep-seated weaknesses in many Asian emerg-ing market banking systems and financial sectors con-tributed to—and were exacerbated by—the financialcrisis, sharp currency depreciations, and subsequentsharp slowdowns in economic activity. Accordingly,IMF arrangements with Indonesia, Korea, and Thai-land have placed primary emphasis on the restructur-ing and recapitalization of financial institutions inthese countries. In addition, wide-ranging reforms arebeing introduced to avoid the reemergence of similarproblems, through strengthening supervisory and regu-latory regimes, reducing connected lending, and scal-ing back excessively broad national safety nets thathave contributed to problems of moral hazard. A num-ber of countries are also implementing reforms to fur-ther the development of local capital markets and re-duce the role of banks in intermediating internationalcapital flows. The banking sector restructuring cur-rently under way in the crisis countries is closelylinked to that in the corporate sector. Banking systemsin Latin America have continued a consolidationprocess facilitated by the entry of foreign banks in theaftermath of the 1994–95 Mexican crisis. Reflectingrecent improvements in financial soundness and su-pervisory systems, these banking systems generallyweathered spillovers from Asia relatively well, butsharp interest rate increases to support currenciesaffected by contagion have contributed to some deteri-oration in loan portfolios. Although the regulatory andsupervisory systems have been strengthened substan-tially in many Latin American countries, problems re-main in a number of areas, especially with regard to thetransparency and accuracy of balance sheet informa-tion, the strength of a number of smaller financial in-stitutions, and the consolidation of offshore operations.

Strengthening and consolidating banking systemscontinues to be a priority in the transition economies

4

in Europe and Russia. In Russia, there has been someconsolidation among the larger banks but loan pene-tration remains low and market risk exposure high, thelatter leading to significant vulnerabilities. Russianbanks were adversely affected in mid-1998 by thehigh interest rates required to support the ruble and thesharply deteriorating economic outlook. The Hungar-ian and Polish banking systems have strengthenedconsiderably in the last few years and are viewed bymarket participants as among the strongest in the re-gion. In the Czech Republic, the improvement of bankbalance sheets has been slower, but the authorities arecurrently seeking to privatize and strengthen majorstate banks through the involvement of strategic for-eign partners. Czech banks were affected adversely bythe May 1997 turbulence in local exchange markets asa result of unhedged currency and interest rate expo-sures and a deterioration in credit conditions, but havesubsequently improved their risk management.

The depreciations of the crisis Asian currencies inthe second half of 1997 were far in excess of estimatesof the degree of overvaluation before the crisis. Thelarge exchange rate depreciations resulted from the in-teraction between a number of domestic and externalfactors, compounded by a general increase in uncer-tainty in the region following many years of strongand successful macroeconomic performance. Espe-cially important was a particularly perverse set of mar-ket dynamics under which the initial relatively smallexchange rate depreciations following the July 1997devaluation of the Thai baht led eventually to a funda-mental reassessment of the long and widely held ex-pectation that regional currencies would remainclosely linked to the U.S. dollar. As a result, both for-eign and domestic investors sought to unwind the ex-tensive “carry” trade that had been based on stabilityin exchange rates vis-à-vis the U.S. dollar, and effortswere made to cover or reduce unhedged foreign cur-rency exposures and to liquidate off-balance-sheetcurrency positions. The resulting further downwardmovements in regional currencies created significantproblems of counterparty risk as the balance sheets ofinadequately hedged domestic financial institutionsand corporations weakened sharply. As a result of theincreases in credit risk, derivative and other marketsfor covering increasing exchange rate risk began todry up and spot markets for the crisis-affected curren-cies became very thin. In these circumstances, smalltransactions began to move foreign exchange marketsby large amounts, further adding to currency weaknessand creating a vicious circle. These problems were ex-acerbated by central banks in the crisis countriespulling back from their traditional “market maker”role in foreign exchange markets, in some cases be-cause usable or uncommitted international reserveshad reached critically low levels. Also contributing tothe large currency depreciations were central banks’desire to keep interest rates low to assist already weak

financial institutions and highly leveraged domesticcorporations. The failure to raise interest rates signifi-cantly implied that the cost of speculating against cur-rencies remained low and contributed to large privatedomestic capital outflows during the crisis.

The currency weakness was further compounded bymarket concerns about the adequacy and implementa-tion of the first round of IMF-supported programs inthe region and the degree of domestic political com-mitment to reform. In Korea, the disclosure that us-able reserves had reached critically low levels andmore comprehensive data on external debt generatedmarket concerns about the adequacy of financing inthe IMF-supported program in early December 1997.External confidence remained very weak until agree-ment was reached late in the month to roll over andeventually restructure Korea’s external debt. In thefirst IMF arrangement with Indonesia, confidence wasadversely affected by the decision early in the pro-gram to close only a small number of the seriously in-solvent banks, raising concerns that further closureswould be necessary. The Indonesian central bank’s ef-forts to keep insolvent banks afloat through sizableliquidity injections in turn contributed to a looseningof monetary policy and downward pressure on the ru-piah. In Thailand, a failure to deal adequately withtroubled financial institutions led to large-scale offi-cial support and efforts to recycle funds from strong toweak institutions. In all the crisis countries, marketparticipants initially expressed doubts about the com-mitment to the economic reforms included in the IMF-supported programs, based in part on the slowprogress in dealing with financial sector and otherproblems and, in some cases, reversals in the reformprogram.

The spillovers during the Asian crisis were particu-larly virulent and exceeded those associated withmacroeconomic and trade linkages. Incomplete infor-mation about key financial variables and a “wake-up”call about the worsening regional situation appear tohave contributed to the spillovers, but the importanceof these factors is obviously difficult to assess. Thespillovers seem also to have been related to growingfinancial linkages that had developed among the Asianemerging markets. Within Asia, for example, the im-pairment of Korean bank claims on a number ofSoutheast Asian emerging markets after the Thai cri-sis contributed to a weakening of the liquidity positionof Korean financial institutions and their ability tocope with credit withdrawals by international banks.When the crisis spread to Korea in late October, Ko-rean financial institutions’ attempts to liquidate theseclaims contributed to spillovers to Southeast Asia. Fi-nancial linkages also help explain the emergence ofpressures in Brazil and Russia following the spread ofthe crisis to Korea in late October 1997, as Koreanbanks were reported by market participants to havesold some of their holdings of Brazilian Brady bonds

The Asian Crisis: Capital Market Dynamics and Spillover

5

I OVERVIEW

and Russian debt. There were also market reports ofadditional linkages through off-balance-sheet deriva-tive exposures, but little information is available ontheir size.

Emerging Markets in the NewInternational Financial System:Implications of the Asian Crisis

Despite some distinctive features, the Asian finan-cial crisis shares a large number of similarities withthe two most recent emerging market crises—the1980s’ debt crisis and the 1994–95 Mexican crisis.The common features are helpful in understanding the“virtuous” and “vicious” elements that characterizethe periods of capital inflow and outflow surroundingthe crises, and aspects of the subsequent pressures.The most important similarities are that the periodsleading up to each of the crises were characterized by:

• Surges in private capital inflows, significant im-provements in the terms and conditions of accessto international financial markets, and, in the lasttwo crises, sharp compression of spreads onemerging market debt;

• Increasingly wide investor participation as creditrating and other agencies supplied very strong as-sessments or ratings;

• Emergence of large unhedged exposures of do-mestic borrowers, especially with regard to ex-change rate risk; and

• Existence of weak regulatory regimes and lack oftransparency in the operation of financial systems.

Moreover, each of the crises was unanticipated bymost observers right up to when the crisis occurred,and involved sharp cutbacks in short-term financingand severe curtailment in access to international capi-tal markets. In addition, each crisis involved large ad-justments in domestic asset markets—including, inparticular, in the value of the domestic capital stock—and severe banking sector problems, exacerbated bylarge exchange rate and interest rate adjustments, aswell as sharp slowdowns in growth and capital flight.

There are, however, a number of features of theAsian crisis that differentiate it from earlier crises.First, while there were some shortcomings, monetaryand fiscal policies in all the crisis countries had notbeen judged to be seriously out of line before thecrises, and macroeconomic performance as measuredby growth and inflation was generally strong. Whilesome concerns had been expressed by market partici-pants about the high rates of domestic credit growth ina number of the crisis countries and the relativelyclose links to the U.S. dollar, macroeconomic policieswere not generally seen as a problem. Second, com-pared with earlier crises, the external liabilities ac-quired by the Asian emerging markets were largely inthe private rather than the official sector, as current ac-

count imbalances had reflected excesses of private in-vestment over savings. Rather, the most importantcauses of the Asian crisis were structural: notably,weakly supervised and regulated financial sectors,poor risk management in financial institutions, prob-lems of connected lending, and weak corporate gover-nance. In addition, there were problems of moral haz-ard in the financial and corporate sectors associatedwith implicit or explicit national safety nets. In thesecircumstances, large-scale private capital inflows andhigh domestic saving were not invested and managedefficiently with due regard to the risks, creating severevulnerabilities and fragilities.

The Asian financial crisis has raised the question ofthe factors underlying the large surges in capital flowsto emerging markets and the reasons for the typicallyabrupt and sharp reversals. Sudden shifts in flows andprices are, to some extent, a feature of asset markets inwhich “new information” arrives randomly and is im-mediately apparent in investors’ behavior. An impor-tant issue is whether there are any specific distortionsor market failures that contribute to virtuous circlesaccompanying the periods of strong inflows and thesubsequent vicious and sharp curtailments of emerg-ing market access. The empirical literature has, unfor-tunately, had only limited success in shedding light onthe causes of the surges in capital flows and reasonsfor the sharp changes in the terms and conditions ofmarket access. The literature has helped clarify theroles of various “push” and “pull” factors in the in-flow periods, including liquidity conditions in the ad-vanced markets, improved policies in emerging mar-kets, and external financial sector liberalization. Inaddition, the increased participation of the emergingmarkets in the global capital markets is seen as re-flecting the ongoing trends toward globalization, thegrowing importance of institutional investors, and theimplications of portfolio diversification by advanced-country investors. Recent research has paid increasingattention to the interactions between different classesof creditors and the dynamics of “herding,” in whichinvestors are importantly influenced by the behaviorof other investors. Such herding behavior is typicallymost prevalent in situations in which there are defi-ciencies in information and the behavior of creditors isviewed as revealing important information about bor-rowers’ creditworthiness. These models are still toopreliminary to draw strong conclusions, but they dosuggest that improved information can potentiallyplay an important role in encouraging a more rigorousassessment of risk. The experience with surges in cap-ital flows suggests that such surges are more likely toend “badly” the more important has been herding-likebehavior and the further down the credit spectrumnew lending has gone.

An important issue in understanding the surges incapital flows and financial crises is the extent to whichprivate investors are encouraged to undertake impru-

6

dent risks on account of the expectation of officialsupport. Clearly, financial crises linked to cross-bor-der capital flows are not a new phenomenon and dateback at least to the last century, well before currentbroad official safety nets. Even though there has beenwidespread publicity given to the view that the Asiancrisis was exacerbated by moral hazard, there is littleevidence on the extent to which it has influenced thestructure and pricing of capital inflows. More gener-ally, the assessment of the role of moral hazard has notmade a clear distinction between the explicit or im-plicit safety nets provided by national authorities andthe support packages provided by the internationalcommunity, including the IMF. Many of the Asianemerging market economies had a history of relativelygenerous support to financial institutions that ran intodifficulty. It does not seem unreasonable that suchsupport would be taken into account by internationalinvestors in their acquisition of claims on entities inthese emerging markets. Moreover, except in the un-likely event of a major systemic shock, investorsmight believe that the support could credibly be pro-vided, even when external claims are denominated inforeign rather than domestic currency. The expecta-tion of domestic support is also likely to have dis-couraged effective market discipline on the part ofemerging market depositors, creditors, and equityholders, especially in large financial institutions. Onthe other hand, there is no evidence that private capi-tal flows to Asia were based on the expectation thatthe international community would need to put to-gether packages to “bail out” international investors.For one thing, it appears that investors were acting toa significant extent on the assumption that the Asiancountries were “star performers” who would continuetheir strong performance. At the same time, it is gen-erally recognized that any international support woulddirectly affect only a limited number of creditors, andwould not be provided on a scale to cover all theclaims on countries facing balance of paymentsdifficulties.

The evidence from the Asian crisis indicates thatmany equity and bond investors (as in earlier crises)have experienced substantial losses. Unless these in-vestors incorrectly believed they would be bailed out,moral hazard seems unlikely to have been an impor-tant factor in their decisions. The extent to which theprospect of official support—from the internationalcommunity or national governments—influenced thebehavior of the globally active commercial and in-vestment banks is less clear. These institutions are per-ceived by some market participants as being bailedout during previous emerging market crises and tohave not, for the most part, suffered large losses ontheir balance sheet exposure to Asia. On the otherhand, a full assessment of how these institutions wereaffected by the crisis would need to take into accountthe extent to which they faced losses on their off-bal-

ance-sheet exposures and activities, such as securitiesunderwriting. Income statements released early in1998 suggest that at least some losses were incurred inthese areas, but their full extent is not yet known.

The Asian crisis has underscored the importance ofstrong financial supervisory and regulatory structuresand sound corporate governance for the efficient in-termediation of private capital flows and the appropri-ate management of risk. Notwithstanding the reformprograms currently being implemented in these areas,some emerging markets are likely to take a long timeto develop the strong supervisory and risk manage-ment systems in place in many advanced economies,and deal effectively with problems of moral hazard.This will leave these countries vulnerable to futurecrises. In these circumstances, it has been suggestedthat there may be a role for temporary taxes on emerg-ing markets’ private sector external borrowing—espe-cially at short maturities—to safeguard against exces-sive and imprudent external debt accumulation byentities that by virtue of their size or importance mightbe expected to receive official support in the event ofdifficulties. The empirical evidence on the general ef-fectiveness of such taxes is somewhat inconclusive,and the potential for circumvention is likely to in-crease over time. A number of countries, includingChile, have, however, had some success in discour-aging short-term capital inflows through implicit“taxes.” Alternatively (as discussed below), vulnera-bility could be partially reduced through higher capi-tal requirements on short-term cross-border interbanklending. The intention would be to address the kindsof difficulties created by such lending during theAsian crisis, namely that it can be withdrawn veryquickly and it is difficult for the authorities to allowmajor domestic banks to fail.

Developments and Trends in the MatureFinancial Markets

Notwithstanding the Asian crisis, the performanceof the mature financial markets in North America andEurope has remained favorable with only limited neg-ative spillovers and a modest pickup in volatility. Thefavorable performance has reflected relatively strongmacroeconomic conditions and policies in manycountries, the environment of low and stable inflation,and generally relatively small and well-provisionedbank exposure to the Asian emerging markets. Nega-tive macroeconomic spillovers on output have alsobeen relatively small and helped lessen the risk ofoverheating in those countries where resource use hasrisen to high levels. Among the major advanced coun-tries, performance in the United States has been espe-cially strong with inflation remaining low notwith-standing unemployment falling to rates that in the pasthave been associated with growing price pressures.

Developments and Trends in the Mature Financial Markets

7

I OVERVIEW

Following cyclical weakness, economic activity hasbegun to strengthen in continental Europe as confi-dence has grown in the successful launch of the euroat the beginning of 1999. The main exception to thegenerally favorable situation has been Japan, whererecession and severe domestic banking sector prob-lems have contributed to, and been aggravated by, thecrisis in the rest of Asia. The advanced economies ofAustralia and New Zealand have to some extent beenadversely affected by their close trading links withAsia and weakness in commodity prices.

In the major foreign exchange markets, the key de-velopments have been the further appreciation of theU.S. dollar in terms of the deutsche mark and Japan-ese yen. The strength of the dollar has been related tocyclical factors and safe haven effects associated withthe Asian crisis, and has facilitated the widening of theU.S. external current account deficit as the Asiancountries strengthen their external positions. Conti-nental European exchange markets have been charac-terized by a high degree of stability as a result ofprogress in macroeconomic convergence and growingmarket confidence in the successful launch of theeuro. As Japan’s economic problems worsened during1998, the yen-dollar exchange rate came under pres-sure and the yen weakened sharply in June 1998,prompting joint intervention by Japan and the UnitedStates.

Long-term interest rates in many mature marketshave declined to their lowest levels in years and yieldcurves have flattened. In the United States, declines inlonger-term yields—across the credit spectrum—havereflected low inflation, improvements in the federalfiscal balance, and a rebalancing of portfolios towardthe U.S. market in response to the Asian crisis. WithinEurope, there has been a convergence of longer-terminterest rates at relatively low levels among the coun-tries that will participate in the first round of EMU asa result of a high degree of macroeconomic policyconvergence at relatively low inflation rates. Long-term yields in Japan are currently at historic lows, butcredit spreads have widened as a result of growing fi-nancial sector and corporate difficulties. Concernsabout the banking sector contributed to sharp in-creases in the premiums charged to Japanese banks ininternational markets to above 100 basis points in De-cember 1997; even though the premium fell backearly in 1998, it increased to over 40 basis points inJune.

The year 1997 was a very strong year for the majorequity markets in North America and Europe with themomentum carrying through into 1998, especially inEuropean markets. Most notable has been the perfor-mance of the U.S. market, which, notwithstandinggrowing concerns about overvaluation and historicallyhigh price-earnings ratios, has continued to rise andovercome a number of setbacks including the sharpOctober 1997 decline. The current high stock valua-

tions appear to be based on expectations that interestrates will remain low and continued relatively strongearnings growth, despite some recent slowing. Con-cerns about a correction have, however, contributed tovolatility. European equity markets have also per-formed strongly with many markets reaching recordhighs. In addition to the improving macroeconomicsituation and outlook, the performance is linked bymarket participants to growing optimism about theprospects for the EMU and the accelerated develop-ment of European-wide capital markets. Japanese eq-uity markets have been lackluster thus far in 1998 andbegan to weaken around midyear.

Selected Issues in the Mature FinancialSystems: EMU, Banking System

and Performance, and Supervision and Regulation

The May 1998 decisions by the European Union(EU) on the 11 countries that will participate in thefirst round of EMU represent a further important steptoward the goal of a European currency area. The po-tential benefits to European financial markets are farreaching and include the development of EMU-widecapital markets, creation of a European payments sys-tem, and the restructuring and consolidation of na-tional banking systems. Nonetheless, there is uncer-tainty among market participants about severalaspects of EMU, including the role that will be playedby the TARGET real-time payments system in reduc-ing systemic risk, the organization and structure ofpan-European interbank and money markets, and howpolicymakers and institutions will handle EMU-widecrisis management. Some of the uncertainty is ex-pected to be reduced in the second half of 1998 as keydecisions are taken in a number of areas such as themonetary operating and control procedures of the Eu-ropean Central Bank (ECB) and the role of reserve re-quirements. The TARGET payments system is a cen-tral feature of the financial infrastructure of EMU andis intended to play an important role safeguardingpan-European financial markets and institutions fromsystemic risk by ensuring finality of payments andavoiding the accumulation of large counterparty expo-sures. Under a well-functioning real-time paymentssystem, the reduction in systemic risk diminishes theneed for lender-of-last-resort interventions for pay-ments system reasons and facilitates the integration ofnational money markets. Although the TARGET sys-tem is well designed, there is some uncertainty aboutwhether it will play its planned role, because the highcosts of holding collateral for intraday credit under thesystem and the relatively high fees might lead to high-value payment being routed through other channels.

The development of pan-European financial mar-kets that is expected to be facilitated by EMU is likely

8

to place considerable pressure on weak banks, whichmay then be encouraged to undertake excessive risk asinterest and profit margins are squeezed. In these cir-cumstances, the institutional framework and under-standings among EMU policymakers for dealing withbanking sector problems and systemic risk will becritically important. Achieving these understandingswithin the context of EMU—and moving rapidly todeal with any problems in a pan-European bank—isexpected to present a number of challenges given thatthe ECB will have a relatively narrow mandate fo-cused on price stability while banking supervision andlender-of-last-resort responsibilities may remain at thenational level. The approaches to crisis managementwithin the EMU are currently under discussion, andthere is a growing recognition that workable arrange-ments for sharing information and responsibilities be-tween national central banks, the ECB, and nationalsupervisors are needed to allow for rapid coordinatedresponses to emerging systemic problems.

Developments in the mature banking systems con-tinued to diverge among the major advanced coun-tries, with serious challenges and risks remaining inJapan’s financial system. Profitability and asset qual-ity has generally remained at relatively high levels inthe banking systems of the United States as a result ofcyclical factors as well as efforts to strengthen balancesheets in the wake of earlier weaknesses. The mainrisk in these banking systems is that it is often at thetop of the credit cycle when banks take on increas-ingly risky concentrations of loans in an effort tomaintain high profitability, and the Federal Reserve inearly July 1998 offered warnings in this regard. Gen-erally, U.S. banks have relatively low (on-balance-sheet) exposure to the crisis-affected emerging mar-kets in Asia and are seen by market participants asbeing able to absorb expected losses given strongprofitability and high provisioning. Exposure toJapanese banks is more significant and represents anarea of potential vulnerability.

Banking system performance in the large continen-tal European countries has been mixed. Profit levelshave been maintained at fairly high levels in the Ger-man banking system, where asset quality has re-mained at reasonably high levels. Tarnishing theprospects for continued good performance somewhatare the exposures of some of Germany’s largest andsecond-tier banks to the crisis countries in Asia. TheFrench banking system has continued to face difficul-ties, despite some recent improvement in banks’ prof-itability. Expansion abroad in response to growingpressures on profits at home has brought new risks, asillustrated by the deterioration in asset quality in manyof the large French institutions because of exposure tothe Asian crisis countries. Profitability in Italy’s bank-ing system has declined, reflecting the narrowing ofinterest margins on the heels of interest rate conver-gence to core-European levels and heavy provisioning

by some major banks in anticipation of privatization.Consolidation, however, has accelerated, and therehas been some progress in addressing labor costs, al-though other structural weaknesses remain.

The most serious banking problems among theGroup of Seven countries are in Japan. Seven yearsafter the bursting of the asset price bubble, Japan’s fi-nancial system problems have still not been resolvedeven as “Big Bang” financial sector reforms get underway. While asset quality in the banking system hascontinued to deteriorate, new problems have emerged,reflecting Japanese bank exposures to the crisis coun-tries in Asia, worsening financial conditions in Japan’snonfinancial corporate sector, and emerging problemsin the nonbank sector. The authorities have announceda new strategy to resolve financial system problems,including the commitment of public funds to recapi-talize and restructure large and small banks, a new su-pervisory framework, and a timetable for deregulatingdomestic financial and capital markets. While thesemeasures and blueprints are promising, the first-roundimplementation of bank recapitalization and restruc-turing raised concerns in the markets about the au-thorities’ commitment to the new approach. Moreover,the perceived need for the new supervisory agency tostrengthen and reinforce its organizational structure,including its staffing, left markets with some doubtsabout its ability to achieve what is required over thenear term.

The structure of supervision and regulation in theadvanced countries has been undergoing evolutionarychange in response to the increasing conglomerationand internationalization of financial institutions, ad-vances in private risk management, and the prolifera-tion of new financial instruments. Most of the recentadvances have been focused on refining market riskmanagement systems. Stress testing (using crisis sce-narios) has become a more critical component of riskassessment and management, but credit risk assess-ment and management and internal controls are mov-ing to the forefront of risk managers’ thinking. TheAsian crisis exposed the inadequacy of traditionalvalue-at-risk (VAR) modeling, as these models are un-able to predict losses from “fat-tailed” events and theassociated changes in correlations and volatilitiesacross markets. Moreover, the crisis had a soberingimpact on some large financial institutions that did notanticipate the link between credit and market risk:even if market risks were managed perfectly and wereprofitable, it cannot be taken for granted that the coun-terparties to these transactions will have the ability topay if extreme events cause them to become insolvent.Currently, reforms are being discussed or adopted infour main areas.

First, the Basle Committee on Banking Supervisionintroduced new guidelines on market risk require-ments on January 1, 1998. Under these guidelines, na-tional supervisors are permitted to allow banks to use

Selected Issues in the Mature Financial Systems

9

I OVERVIEW

their own internal VAR models for determining theamount of capital to set aside for market risk, providedthese models satisfy certain conditions. An importantconsideration in allowing banks to use their own riskmodels is the increasing use of complex financial in-struments and techniques for managing market risk.These techniques are viewed as making “rules-based”approaches to allocating capital increasingly inappro-priate as they do not allow for the correlations be-tween returns on different assets and the scope to re-duce risk through portfolio diversification. With theincreased use of credit derivatives and improvementsin loan portfolio management, there has also been in-creasing concern in the private sector about the dis-torting effects of the current relatively undifferentiatedBasle weights on credit risk. The Institute of Interna-tional Finance has urged a rethinking of the 1988Basle Accord. A number of Group of Ten centralbanks, however, have expressed reservations about amajor overhaul of the Basle credit risk weights on ac-count of the time that it could take to reach consensusand the urgent need for many emerging markets toreach even the simple Basle standards.

Second, a number of members of the Basle Com-mittee have been considering changes to the Baslecredit risk weights to address concerns about sover-eign and interbank lending. There are two main areasof contention: the zero weight applied to banks’ sov-ereign or sovereign-guaranteed claims on membercountries of the Organization for Economic Coopera-tion and Development (OECD), and the 20 percentweight applied to interbank lending of less than 12-months’ residual maturity. On the former, it has beensuggested that the zero weight applied to OECD sov-ereign claims has encouraged banks to steer funds to-ward OECD emerging markets rather than to non-OECD sovereigns without adequate account of therisks. Some Basle Committee members have sug-gested that the weights could be linked to countries’progress in implementing reforms such as the core

principles of banking supervision, or the provision ofeconomic and financial data. As regards interbanklending, the current 20 percent weight applied toshort-term interbank lending is viewed by a number ofBasle Committee members as contributing to exces-sive funding in the interbank market, including duringthe Asian crisis. Changes being discussed include rais-ing the weight “creditor” banks must apply to short-term interbank lending from the current 20 percent tothe 100 percent applying to longer-term interbankfunding, or linking banks’ capital requirements to thematurity structure of their interbank funding. Therehas, in addition, been some discussion of changing theBasle weights to encourage a more cyclically neutralapplication of the capital adequacy standard. Thiscould be achieved by requiring that the ratio be main-tained at a minimum of 8 percent on average, thus cre-ating a buffer during the business cycle.

Third, a number of countries have been adaptingtheir supervisory and regulatory frameworks to en-hance their ability to conduct effective supervision ona consolidated basis. A prominent recent example isthe decision by the U.K. authorities to merge nine reg-ulatory bodies into a single financial services authorityand to move the responsibility for banking supervisionaway from the Bank of England. As part of the merg-ing of supervisory oversight into one body, Australiahas also recently moved banking supervision out of thecentral bank but has not yet embraced consolidated su-pervision across banks and securities firms. Finally, ef-forts are continuing in various forums to strengthen theframework for the supervision of globally active fi-nancial institutions as progress thus far has generallybeen perceived to have been slow. Recent steps haveinvolved clearer understandings on the responsibilitiesof “home” and “host” supervisors, improved harmo-nization of national rules and standards for informa-tion sharing, and clarification of supervisory responsi-bilities for internationally active financial institutionsengaged in banking and securities activities.

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