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December 23,1 983

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In tern ati on al D eb t Man agem en t
The choice of solution to the current
international debt problem depends critically on how one interprets the development of international banking in the last
twenty years. Whether one views the developmentas an extension of domestic banking
or as an irreversible process of international
financial integration leads to divergent
policy recommendations. In this Letter, we
shall propose a simple operating rule for
choosing between the two approaches, and
suggest that the policy measures adopted
thus far as being consistent with both.

Two polar views
The widespread difficulty non-OPEC, lessdeveloped countries experience in servicing
their debts has raised questions about banks'
prudence in international lending. Particularly disturbing have been reports of banks
competing to offer loans on exceedingly
favorable terms in disregard of the risks
involved. Some have maintained that the
banks' behavior was completely rational
because they had correctly counted on the
national and international authorities to bail
them out.
This view suggeststhat banks must be made
to bear the consequences of their imprudence, and the public "bail-out" of imprudent banks is not only unacceptable in a
free-enterprise economy, but also sows the
seed forfuture debt crises. The policy
prescription, according to this view, is to let
the debtor countries default, and the banks
fail, so that the market will learn from past
mistakes. As long as there is adequate
deposit insurance (expandable by legislation) and monetary growth is kept stable, this
view holds that individual banks may collapse but not the banking system.
The alternative view focuses not on the
behavior of individual banks but on the
world environment for international
banking. It recognizes that the worldwide

expansion of international banking activities
over the last twenty years has increasingly
integrated the world's financial markets.
This change in international banking has
allowed banks to diversify risk on an international scale in normal times. However,
because integrated markets also transmit
economic disturbances-monetary or real
-throughout the world, generalized shocks
result in systemized risks that quickly turn
well-diversified asset portfolios into highly
risky ones. This is the same principle as in a
national economy: the risk of a generalized
financial crisis is greater, the higher is the
degree offi nancial integration of the various
regions in an economy.
The financial-integration view attributes the
international-debt problem to a series of
related, generalized shocks-the oil-price
increases in 1 979-80, the subsequent world
recession with falling world demand and
falling primary-commodity prices, and
unprecedentedly high real interest rates. The
problem has been aggravated by the liquidity crisis that has developed since mid-1 982
due to the worldwide withdrawal of banks
from international lending. This view's
policy recommendation is to ensure adequate supply of international credit in the
short run and structural adjustments in
external payments in the longer run.
Distinguishing rule
To choose between these two approaches, it
is necessary to examine their respective
underlying assumptions and compare their
empirical relevance. Finance involves risktaking, and prudence in financial management means making sound judgments on
the basis of reasonable assessmentsof the
likelihood offuture events. In terms of
elementary statistical theory, this means
that individual bankers must project future
events with an implicit, subjective probability distribution and choose a level of risk that
they are willing to accept in making loans.

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Opinion';; c"pw';sed in thi-- fH"H-,,·;ll:'Ut,t" ell) !lot
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of -rl'w federal 1\(.':·;(:1'v('
Hank of San rr,. HH'i.;,co,
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!\('sc'rv(,' SvstelrJ,
Since the probability distribution is based on
each individual banker's past experience, its
basis must I ie in the past even though the
projection is into the future.

gence or integrity, but it does presume a
belief in the efficacy and stabil ity of a private
banking system, buttressed by public supervision and regulation for helping insure
competition and sound banking, without
hampering private risk-taking. The fact that
over the past fifty years, this banking system
has been basically stable seems to indicate
thatthis proposition is more than ideology.

Within this framework, there are three possibilities for a loan to go "bad." First, the
loan assessmentmay have been made by an
inexperienced banker who did not know his
business, that is, he did not make an accurate assessmentof economic reality.
Second, the probability distribution may
have been real istic, butthe banker chose too
high a level of risk. Third, the underlying
economic reality may have changed sodrastically that past experiences are no longer
reliable for judging the probability of future
events. The banking-imprudence view considers the international-debt problem as
the result of a combination of the first two
cases; the financial-integration view stresses
the third.

The rule breaks down, however, if banks
are neither ignorant nor reckless, but are
shrewdly conniving to take high risks for
high profits, counting on the authorities to
get them out of trouble. If so, any policy
measures that directly or indirectly help
banks to get out of trouble might encourage
banks to become reckless and, hence, to
lead to greater financial instability. There is,
however, little empirical evidence for this
attitude. First, in domestic banking, banks
have always known that central banks
would help out in the event of any generalized loan defaults. But, in spite of this
knowledge, there have been cases of individual recklessness leading to bank failures,
but no recurrent financial crises in major
industrial countries over the last fifty years.
Second, even if banks have different expectations in international banking than in
domestic banking (there is neither reason
nor evidence for this), according to this
view, the massive amounts of international
aid to the debtor nations since mid-1 982
should have vindicated their earlier risk
assessment; hence, there should be no
ground for them to withdraw from international lending. In fact, international bank
lending has declined precipitously, thus
lending credence to the opposite view that
the banks were indeed surprised by the
severity of the international-debt problem.

The choice between the two views might
appear to be necessarily arbitrary. However,
most people would perhaps agree to a
"majority rule," which states that although
indi Vidual bankers may be ignorant or reckless or both, it is unlikely that the majority
are. This rule does not presume a favorable
pre-disposition towards bankers' intelli-

Policy measures
The proposed "majority rule" and the
empirical evidence validate the financialintegration approach to the international
debt problem. Practical considerations of
minimizing risk in policymaking lead to the

2

troller of the Currency, and the Federal
Deposit Insurance Corporation-have
jointly proposed a program to improve
information about international banking
and to tighten its regulation. The proposed
measures include quarterly reports and
prompt disclosure to individual banks'
exposures to country risks, a requirement
of a special reserve for protracted nonperforming loans, and new accounting rules
for spreading loan fees over the life of a loan.
In addition, the U.s. has strengthened its
coordination with foreign bank regulators to
ensure regulatory equity among countries.
All of these may be regarded as appropriate
supplements to the principal strategy of
ensuring an adequate supply of internationalliquidity.

same conclusion. The world is facing the
serious threat of a financial crisis of large
dimensions. To follow the policy recommendations of the bank-imprudence view
and be wrong could lead to disasterforthe
world economy, including our own. But to
follow those of the financial-integration
view and be wrong would only mean that
we have helped some banks that we should
not have. A strategy of risk minimization
wou Id, therefore, call for extending aid to
the debtor nations in order to ensure adequate supply of international liquidity and,
at the same time, tightening supervision and
regulation over international lending so as to
guard against banks' laxity in vigilance in
expectation of international aid to the debtor
nations.

This interpretation appears to be consistent
with the policy measures that have been
taken thus far. In the world economy,
without a world monetary authority, the
central banks of major industrial nations
have banded together through their monthly
meetings atthe Bank for International Settlements to monitor current developments and
to pursue a coordinated strategy forensuring
the supply of international liquidity. Together with the national treasuries, they
have provided temporary funds to help out
cash-strapped debtor nations in order to give
them time to negotiate for medium-term
loansfrom the International Monetary Fund.
The mainstay of the strategy, however, lies
in the IMF credits, in conjunction with loan
packages from banks, which are granted
upon the condition that the debtor countries
adopt austerity programs to reduce their
payments deficits; thai is, to adopt appropriate policy measures for structural adjustments to make their payment positions
viable in the longer run. The I MF member
nations have agreed to a 47.5 percent
increase in IMF funding to carry out this
important task.

With these policy measures, much has been
accomplished since the tensions started
sixteen months ago. In this turbulent world,
sheer survival is victory. The international
debt problem is not resolved yet. However,
with the revival of the world economy and
the recovery of world trade there is ground
for optimism that the world will achieve sustained economic recovery without a crippling financial crisis-provided that banks
stop the back-sliding out of international
lending that had continued through the first
half of this year.
Hang-ShengCheng

In add ilion, the three Federal banking
agencies---'the Federal Reserve, the Comp-

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BANKINGDATA-TWELFTHFEDERAL
RESERVE
DISTRICT
(Dollar amounts in millions)

Selected
Assets Liabilities
and
Large Commercial Banks

Loans'
(gross,
adjusted) investments'"
and
Loans
(gross,
adjusted) total#
Commercial and industrial

Realestate
loans to individuals
Securities
loans
U.S.Treasury
securities*
Othersecurities'"
Demanddeposits- total#
Demanddeposits adjusted
.......
Savings
deposits totalt
Time deposits - total#
Individuals,part.& corp.
(Large negotiable CD's)

y
g
Weeki' Avera es
of Daily Figures
MemberBankReserve
Position
Excess Reserves (+ l/Deficiency (-)
Borrowings
Net free reserves (+ l/Net borrowed( -)

Amount
Outstanding
12/7/83

164,796
144,704
44,196
57,610
25,371
3,395
7,783
12,309
45,437
31,148
66,669
70,340
64,476
17,414

change
from

Change from
year ago
Dollar
Percent

11/30/83
1,335
1,228
215
99
121
672
104
2
1,414
1,617
547
165
2
42

2,368
2,993
727
405
1,740
H89
824
1,449
3,583
1,881
33,650
- 26,965
- 22,932
- 16,102

Weekended

Weekended

12/7/83

11/30/83

80
5
75

-

-

-

1.5
2,1
1.6
0.7
7.4
35,5
11.8
10.5
8.6
6.4
101.9
27.7
26,2
48,0

Com parable
year-ago period

92
17
75

94
2
92

'" Excludes tradmg account secunttes,
#
items not shown separately.
t Includes Money Market Deposit Accounts j Super-N OW accounts, and N O W accounts.

Editorialcomments
maybeaddressed theeditor (GregoryTong) to the author.••. Free
to
or
copies
of
this andother FederalReserve
publications beobtainedby callingor writing the Public
can
InformationSection,Federal
Reserve
Bankof SanFrancisco,
P.O.Box7702,Sanfrancisco94120.
Phone (415) 974-2246.

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