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FRBSF

WEEKLY LETTER

May 6,1988

U.5. Banks and LDC Debt
Brazil's announcement in February 1987 that it
was suspending interest payments on debt owed
to commercial bankS highlightedthe persistence
of the international debt problem. This moratorium led to renewed concerns about the economic health both of certain lesser developed
country (LDC) borrowers and of the banks that
have heavy loan exposures to those countries.
As a result of these concerns, a number of u.s.
banks added in the aggregate over $17 billion to
loan loss reserves in mid-1987 and another $2
billion at the end of the year. Bank regulators,
likewise, have been concerned about u.s.
banks' exposure. For example, U.S. bank regulators have endorsed proposals that would require
banks with large exposures to troubled LDCs to
hold higher amounts of capital relative to assets
than would other banks.
In this Letter, we examine the background of the
current debt problem and its effect on new and
outstanding bank loan exposure to developing
countries. We find three important trends have
emerged since the onset of the crisis in 1982.
First, banks have curtailed net new lending dramatically. Second, exposure to troubled LDCs
has fallen, but not as much as exposure to other
foreign borrowers. Finally, concentration of
exposure to troubled borrowers is shifting
increasingly towards the largest banks.

Changing roles
Prior to the 1970s, longer-term lending to
developing countries occurred primarily through
official sources. The bulk of private capital
flows, to the extent they occurred, took the form
of foreign direct investment. Bond financing was
very limited and private lenders like commercial
banks tended to provide funds primarily to
finance trade. Yet even before the first oil crisis
in 1973-74, the role of private lenders began to
change dramatically. Increasingly, banks took
on the role of financiers of longer-term capital
investment projects. As bmrowing by LDCs
mushroomed in the 1970s, so did banks' role in
supplying credit.

Trouble signs
In the early 1980s, LDC debtors' real debt burdens increased dramatically, making it harder
for them to continue to meet their debt service
obligations as originally contracted. The dramatic rise in real and nominal interest rates
through 1982 was translated immediately to
LDCs' borroWing costs since most ofthis indebtedness was at floating rates. Also, the sudden
decline in worldwide inflation reduced LDCs'
export earnings without simultaneously reducing
LDCs' debt service obligations. And the recession in industrial countries exacerbated the
problem by reducing the demand for exports
from LDCs.
These developments led in August 1982 to Mexico's imposition of a moratorium on the payment
of interest on its debt obligations. Other LDCs
followed Mexico's example. At this point, the
potential for difficulties in the international
financial system became a real concern.
Lenders, investors, regulators, and policymakers
were forced to reassess the risks involved in
international lending generally, and in LDC
lending particularly.

Changing risk perceptions
The abrupt change in perceptions of default risk
on LDC loans is evident in the dramatic changes
in the bond and bank loan markets, as well as in
the behavior of bank equity prices and secondary market prices for LDC loans. Studies of international bond and bank loan pricing following
Mexico's announcement found that borrowing
rates for LDCs rose significantly relative to the
rate for other international borrowers, and that
this reflected an increase in the risk premium on
LDC debt.
Additional eVidence for the change in perceived
default risk is available from the secondary market for bank loans to LDCs. For example, the
financial press noted the emergence of secondary market discounts of ten to twenty-five percent relative to the face value of LDC loans in
1983. By 1985, this market was well estab-

FABSF
lished, and today secondary market discounts of
fifty percent or more are not uncommon for
loans to certain LDCs.
Other studies have found that the stock market's
reaction to the debt crisis also reflected a concern for increased default risk. Specifically, these
studies concluded that investors tended to discOunt the market values of banks that had large
exposures to developing country debt.

Fewer Iqans for riskier borrowers
Given the strong evidence of an increase in perceived default risk following Mexico's actions,
one would expect to have seen a sharp decrease
in the supply of loans to LDCs. Of course it may
be difficult to attribute patterns in LDC lending
exclusively to changes in loan supply when
changes in demand for loans on the part of
LDCsalsomay have occurred. But the decline
in gross lending to LDCs from an average of
$39.2 billion per year in the five years prior to
the crisis to $24.1 billion per year after the crisis
(according to data reported by the Organization
for Economic Cooperation and Development) is
at least consistent with the view that lenders
became less willingto extend credit after the
debt crisis.
Moreover, only a relatively small proportion of
the "new" lending to LDCs after the crisis actually represents a net increase in the amount of
borrowed funds available to these countries.
Instead, most of the new lending involves
rollovers of maturing obligations and/or
reschedulings. Lenders typically have provided
net new funds only to enable the borrower to
meet a portion of interest payments coming due
on outstanding obligations. Without such continued lending (on both a gross and a net basis),
these borrowers would not have been able to
meet their interest obligations.

In this sense, then, most bank lending since the
onset of the debt crisis has been considered
"involuntary." To avoid losses, lenders have
rescheduled loans at below market-clearing
rates. Moreover, lending syndicates have had to
invoke "fair-share" rules to induce their members to continue lending. In situations where
only a few lenders hav~ held the bulk of the
total exposure to a country, fair share rules
largely have been unenforceable. In these cases,
it is only a few lenders that have had real incen-

tives to continue lending; lenders with small
exposures - and therefore little to lose --.."... simply have refused to provide additional funds,
even though they also stood to benefit from continued lending and a resolution of the immediate
repayments crisis.

u.s. bank portfolios
As a result of the decline in the value of LDC
loans outstanding, US. banks suffered market
value capital losses even though they generally
did not record these losses on their books, nor
increase their loan loss reserves significantly
until the spring of 1987.
However, U.s. banks did take other steps to
counter the effects of the decline in the market
values of their portfolios. For example, they
raised additional capital through increased
retained earnings, asset sales, and sales of new
equity and subordinated debt. They also curtailed asset growth overall and LDC loan growth
particularly. Outstanding loans to LDCs (including OPEC and non-OPEC)' fell from a total 'of
$152.6 billion in 1981 to $133.6 billion at the
end of 1986. As a result, LDC loan exposure relative to book capital (for banks with foreign loan
exposure) fell from a peak of 243 percent in
1982 to 115 percent in 1986. (See chart.)

A closer examination
Despite this encouraging decline in exposure,
closer examination of the patterns of exposure
among LDCs and other international borrowers,
as well as of exposures by size of bank, yields
some interesting and possibly disturbing observations. First, exposure to all nations excluding
LDCs declined more rapidly than total LDC
exposure. For example, U.s. banks' exposure
(relative to capital) to the major industrial
nations declined 54.5 percent from 1982 to
1986. By contrast, LDC loan exposure declined
by only 50.5 percent, by far the smallest decline
for any country group.
Second, even within the category of LDC borrowers, the decline in U.S. bank exposure has
varied, with more dramatic declines reported for
the LDCs that are not experiencing debt problems. For example, exposure to the troubled
"Baker Fifteen" (that is, the fifteen principal LDC
debtors, including Argentina, Brazil, Mexico,
and Venezuela, identified in Treasury Secretary
Baker's 1985 plan) declined, but less than the

u. S. Banks' International Lending
Exposure as a Percent of Capital

Percent

Total

•

LDC

550
500
450
400
350
300
250
200
150
100
50

o
1977

1978 1979

1980

1981

1982 19831984 1985

1986

Source: Country Exposure lending Survey

decline in exposure to other, more creditworthy
LDC borrowers, some of which, particularly
Korea, were repaying their bank debt. As a
result, exposure to the Baker Fifteen rose as a
percentage of U.s. banks' international loans
outstanding from 25.9 to 31.3 between 1981
and 1986. Thus, the decline in total LDC
exposure noted above overstates the decline in
U.S. banks' exposure to default risk associated
with lending to LDCs because it has been concentrated, in claims on countries without debtservicing problems.
A third observation is that exposure by size of
bank also has varied, with the nine largest U.s.
banks now holding a larger percentage of troubled LDC loans than was the case in 1982. The
nine major money center banks now hold 63
percent of total loans outstanding to troubled
borrowers, compared to a low of 56 percent in

1982. In contrast, the other two groups of banks
-the next 14 largest and all other u.s. banks
involved in international lending - both
reduced their shares of total u.s. bank exposure
to troubled LDCs.
In terms of absolute changes in exposure, the
nine money center banks reduced their troubled
LDC loans outstanding by only $1 billion, while
the next 14 largest banks and all other banks
reduced theirs by $4 billion and $6 billion,
respectively, over this period. These latter two
groups have sold loans in the secondary markets
to a much greater extent than have the largest
banks. Also, the non-money center banks have
been able to limit their participation in new
money packages associated with debt reschedulings, while the money center banks, with their
larger exposures, have had stronger incentives to
continue lending. Still, because of large
increases in book capital, even the largest banks'
exposure relative to capital has declined
significantly.
A role for loan loss reserves
u.s. banks' exposure to international borrowers,
especially troubled LDC nations, has fallen in
absolute terms, and relative to capital. Yet that
decline is not as dramatic as the decline in
exposure to more creditworthy borrowers. Since
the problems of highly indebted countries are
likely to continue into the future, the recent
moves many u.s. banks have madeto
strengthen their loan loss reserves take on
greater importance.
Barbara Bennett
Gary C. Zimmerman

Opinions expressed in this newsletter do not necessarily reflect the views of the management of the Federal Reserve Bank of
San Francisco, or of the Board of Governors of the Federal Reserve System.
Editorial comments may be addressed to the editor (Barbara Bennett) or to the author...• Free copies of Federal Reserve
publications can be obtained from the Public Information Department, Federal Reserve Bank of San Francisco, P.O. Box 7702,
San Francisco 94120. Phone (415) 974-2246.

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NOTE

The table entitled, "Selected Assets and Liabilities of Large Commercial Banks in the Twelfth
Federal Reserve District," will no longer be published in conjunction with the Weekly Letter.
For those in need of these data, a more timely publication entitled, "Weekly Consolidated
Condition Report of Large Commercial Banks and Domestic Subsidiaries" (F.R. 2416x), is
available from the Statistical and Data Services Department of this Bank.