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Federal
Reserve Bank of
New York
Quarterly Review
W inter 1993-94 Volume 18 Number 4
1
Causes and Consequences of the
1989-92 Credit Slowdown:
Overview and Perspective
24
International Interest Rate Convergence:
A Survey of the Issues and Evidence
38
Debt Reduction and Market Reentry
under the Brady Plan
63
Index Amortizing Rate Swaps
71
The Pricing and Hedging of
Index Amortizing Rate Swaps
75
Recent Trends in Commercial
Bank Loan Sales
79
Treasury and Federal Reserve
Foreign Exchange Operations
Federal Reserve Bank of New York
Quarterly Review
Winter 1993-94 Volume 18 Number 4
Table of Contents
1
Causes and Consequences of the 1989-92 Credit Slowdown: Overview
and Perspective
M.A. Akhtar
This article is the overview essay for a volume, Studies on Causes and Con
sequences of the 1989-92 Credit Slowdown, published by the Federal
Reserve Bank of New York. The twelve papers in the volume cover a broad
range of issues concerning the credit slowdown, including the importance of
credit demand relative to credit supply factors, the role of bank and nonbank
credit sources, and the impact of credit supply shifts on the economy. This
essay provides a conceptual framework for the analysis of credit issues,
reviews the evidence presented in the volume, and offers a perspective on
the implications for monetary policy.
24
International Interest Rate Convergence: A Survey of the Issues and
Evidence
Charles A. Pigott
World financial markets have become substantially integrated over the last
two decades. Contrary to widespread expectations, however, this integration
has not led to any greater convergence of interest rates across countries.
This article examines why convergence has not occurred and more generally
what financial integration does— and does not— mean for international inter
est rate relations.
38
Debt Reduction and Market Reentry under the Brady Plan
John Clark
In March 1989, U.S. Treasury Secretary Brady proposed a new approach to
resolving the developing country debt problem and restoring the creditworthi
ness of restructuring countries. The Brady Plan encouraged market-based
reductions in debt and debt service for countries implementing economic
reforms. This article analyzes the structure of the financial packages that fol
lowed this change in approach and considers their impact on countries and
their creditors.
Table of Contents
63
Index Amortizing Rate Swaps
Lisa N. Galaif
As short-term interest rates have declined over the past several years,
investors have increasingly sought higher yielding investment vehicles. The
index amortizing rate (IAR) swap is one of several new instruments that
have been developed in response to this investor demand for yield enhance
ment. This article explains the structure and pricing of IAR swaps, some of
the risks associated with the product, and the uses and growth prospects of
the market.
71
The Pricing and Hedging of Index Amortizing Rate Swaps
Julia D. Fernald
IAR swaps have proved difficult to price because of the complexity of their
embedded options. Since these options depend on the path of interest rates,
pricing requires a model of interest rate movements. This article uses a sim
ple interest rate model to illustrate the pricing and hedging of an IAR swap.
75
Recent Trends in Commercial Bank Loan Sales
Rebecca Demsetz
The dollar volume of commercial bank loan sales rose rapidly in the mid1980s but has declined equally rapidly over the past few years. This article
provides insight into these loan sales trends by looking beyond the aggregate
data and separately examining the sales activities of the largest loan sellers
and those of all other banks.
79
Treasury and Federal Reserve Foreign Exchange Operations
84
List of Recent Research Papers
Causes and Consequences of
the 1989-92 Credit Slowdown:
Overview and Perspective
by M. A. Akhtar
This article is the overview essay for a volume, Studies on Causes and Consequences of the
1989-92 Credit Slowdown, published by the Federal Reserve Bank of New York. In addition to
the present essay, the volume contains twelve papers dealing with a broad range of issues con
cerning the credit slowdown, including the importance of credit demand relative to credit supply
factors, the role of bank and nonbank credit sources, the impact of credit supply shifts on the
economy, and the implications of those shifts for monetary policy.
The volume is available from the Public Information Department of the Federal Reserve Bank
York. Purchase information appears on page 85 of this issue of the Quarterly Review.
Between early 1989 and late 1992, U.S. econom ic growth
averaged less than 1 percent, well below the long-run trend
growth of the economy. This sluggish pattern of growth per
sisted in the face of substantial easing in m onetary policy.
Indeed, the econom y failed to recover significantly after the
1990-91 d o w n tu rn . A p p a re n tly the fa vo ra b le e ffe c ts of
m onetary easing were not sufficient to overcom e numerous
factors depressing the economy: lower defense spending,
com m ercial real estate depression, relatively tig h t fiscal
policy, global com petition, corporate restructuring, histori
cally low levels of consum er confidence, and the overex
tended financial positions of households, businesses, and
financial institutions.
T h e s lu g g is h re a l g ro w th w a s a c c o m p a n ie d by an
u n p re ce d e n te d ly sharp slow dow n in c re d it grow th over
1989-92. Many observers have identified high debt service
burdens of the nonfinancial sectors and w idespread bal
ance sheet problem s of borrowers and lenders as crucial
elem ents underlying both the credit slowdown and the per
sistent w eakness of the econom y. Others have attributed
the sluggish econom ic perform ance to supply-side factors
underlying the credit slowdown, w hich resulted in a pro
longed period of substantially reduced credit availability to
b u s in e s s e s and h o u s e h o ld s . M ore re c e n tly , c o n c e rn s
about cred it a va ila b ility appear to have eased as credit
growth has shown some signs of recovery.
A g a in s t the b a ckg ro u n d of th e se d e ve lo p m e n ts, this
overview provides a broad perspective on the causes and
consequences of the 1989-92 credit slowdown. It begins by
presenting a general conceptual fram ew ork for the analysis
and then reviews the evidence from the collection of stud
ies on the credit slowdown. The article also discusses im pli
cations of the evidence for m onetary policy and offers some
tentative general observations on the recent credit slow
down experience.
Overall, studies reviewed here provide substantial evi
dence of credit supply problems, or a “credit crunch,” du r
ing the 1989-92 period fo r both bank and nonbank credit
sources. The evidence on the consequences of credit su p
ply constraints is less com pelling, but the studies do indi
ca te , at le a s t c o lle c tiv e ly , th a t c re d it c o n s tra in ts have
played som e role in w e a ke nin g e co n o m ic a c tiv ity . The
depressing effects of the credit crunch appear not to have
been the prim ary or dom inant cause of the econom ic slow
down, however. As for the im plications for m onetary policy,
credit supply problem s have clearly contributed to reducing
the effectiveness of m onetary policy, although it is difficult
to isolate their effects from those of other factors disrupting
or altering the channels of policy influence to the econom y.
Credit slowdown vs. credit crunch: A general framework
There is no generally accepted definition of the term “credit
FRBNY Quarterly R eview /W inter 1 9 9 3 -9 4
1
crunch,” but it is usually taken to mean a sharp reduction in
the supply or availability of credit at any given level of inter
est rates. To clarify term inology and to provide a broad co n
text for the issues involved in identifying a credit crunch, we
begin with the more encom passing notion of credit slo w
down or decline. At the broadest level, an observed slow
down or decline in credit may result from either the demand
side or the supply side. A t a given lending rate or price of
credit, the dem and fo r cre d it m ay fall because of oth e r
(no nprice) d e te rm in an ts of cre d it dem and. In the usual
graphical supply-dem and fram ew ork, the demand sched
ule for credit may shift down and to the left. This is shown in
Chart 1, panel 1, under very sim plistic market conditions,
where the price of credit includes both the loan rate and
n o n ra te lo an te rm s , su ch as c o lla te ra l, m a tu rity , and
covenants. From a m acroeconom ic perspective, this type
of shift may occur because of lower credit dem and stem
ming from either cyclical w eakness in econom ic activity or
structural factors— such as changes in the tax code, inven
tory techniques, or the borrow ers’ desired debt-to-incom e
ratio— that reduce the perceived need fo r cre d it p e rm a
nently. In general, shifts in credit demand induced by cycli
cal w eakness in econom ic activity are relatively com m on
place while credit dem and shifts due to structural changes
are som ew hat less frequent but not unusual.
A dow nward shift in credit dem and tends to put dow n
ward pressures on loan rates and other loan term s and,
given an unchanged supply schedule, leads to easier loan
term s at the new credit m arket equilibrium . Moreover, if a
dow nward credit dem and shift is caused by structural fa c
tors, it may also be accom panied by a steepening (flatten
ing) of the dem and schedule; the demand for credit may
becom e less (m ore) responsive to changes in the price of
credit (C hart 1, panel 1, D2 schedule).
On the supply side, a credit slowdown or decline may
reflect reduced w illing ne ss to lend at prevailing interest
ra tes and d e m an d c o n d itio n s . F a cto rs th a t can ca u se
reduced w illingness to lend include, among others, balance
sheet difficulties of lenders (poor quality assets, high loan
losses, and so forth), higher capital requirem ents and regu
latory constraints on lenders, and increases in actual or
perceived riskiness of bo rro w e rs’ credit quality. The last
factor is intended to capture credit supply shifts resulting
from changes in a bo rro w e r’s balance sheet conditions.
Specifically, a deterioration in the quality of a borrow er’s
balance sh e e t re fle c tin g , fo r e xa m p le , a d ro p in a sse t
prices, w eakens his a bility to repay existing debts or to
borrow new fu n d s.1 The decline in creditw orthiness of the
borrower, in turn, may reduce the lender’s w illingness to
1 More generally, the deterioration in the quality of the borrower’s balance
sheet (and the associated decline in creditworthiness) may result either
from a cyclical decline or from noncyclical shocks (economy-wide or
partial) such as an asset price drop in one or more sectors. As explained
below, it is very difficult to separate credit supply effects from demand
effects of general cyclical shocks to the economy.
2 forFRBNY
Digitized
FRASERQuarterly R eview /W inter 19 9 3 -9 4
extend a loan, causing a decline in the supply of credit. In
this situation, the supply shift reflects reduced credit a vail
ability to borrowers whose credit quality has been impaired,
Chart 1
Credit Demand and Supply
Price of credit
i
Panel 1
S(k,g,z)
D *
\
\
*
\
i
\
\
\
\
*,
v
*
N
V
/
S
V
/
\
\
\
\
^
ijP
i n
1 \ ^
% i
\
A
1
----------------------------------------------1------C *,
C*
D (y,x)
' D,
Quantity of credit
Price of credit
D=
initial credit demand schedule, where all determinants other
than the price of credit (loan rate and nonrate loan terms)
are held constant (y is a proxy for aggregate demand in the
economy and x represents all other variables)
S = initial credit supply schedule, where all determinants other
than theprice of credit are held constant (k is a proxy for
capital, g is a proxy for regulatory and supervisory
constraints, and z represents all other variables)
C *= initial equilibrium credit
r * = initial equilibrium price of credit
D, and Dz represent the credit demand schedule after shifts,
while S, and S2 represent the credit supply schedule after
shifts. C*,, C*2, r *„ and r*2 represent new equilibrium
values for credit and the price of credit.
but there is no change in the lender’s desire to lend to those
borrowers whose creditworthiness has remained un
changed. Note that the drop in borrowers’ creditworthiness
could be treated, in principle, as a drop in credit demand by
borrowers of given risk characteristics (unchanged credit
worthiness) in that there are fewer such borrowers.
Nonetheless, at a practical level, it is more convenient to
look at the effect of changes in borrowers’ credit quality—
especially those resulting from noncyclical shocks—on the
willingness of lenders to supply credit.
In any event, the reduced willingness to lend may show
up as a leftward shift in the credit supply schedule (Chart 1,
panel 2). In this case, borrowing is rationed by price as loan
rates and nonrate loan terms tend to tighten and the new
credit market equilibrium is attained at higher interest rates
and generally more restrictive loan terms, other things equal.
The reduced willingness to lend may not show up as a
simple leftward shift of credit supply envisaged in the con
text of a market-clearing environment, however. Instead,
lenders may resort to increased nonprice credit rationing;
that is, loans are rationed by quantity rather than by varia
tions in prices (interest rates and nonrate loan terms). In
this case, lenders do not feel that they can protect them
selves against risk by charging higher credit prices. Put
another way, the credit supply schedule is not fully opera
tive; in the extreme case, the schedule shifts leftward and
becomes vertical, with the supply of credit becoming com
pletely insensitive to interest rates (Chart 1, panel 2, S2
schedule). In practice, the existence of nonprice credit
rationing does not preclude the role of interest rates and
other loan terms; some borrowings may be rationed by
price and others by quantity or by both. Nonprice credit
rationing may take many different forms: some borrowers
obtain loans while other borrowers with identical creditwor
thiness do not; loans for certain types of borrowing or to
certain classes of borrowers are unavailable; some appar
ently creditworthy borrowers are denied loans at prevailing
interest rates because lenders do not perceive them to be
creditworthy.2
The papers in this volume deal with both demand and
supply factors in the credit slowdown since 1989, but the
emphasis is on sorting out the role of supply-side factors
and their implications for nonfinancial economic activity.
Accordingly, the term credit crunch as used here refers to a
slowdown or decline in the supply of credit, whether
rationed by price or nonprice mechanisms, or simply to
credit supply problems. This definition is clearly much
broader than the narrow use of that term to describe situa
tions of nonprice credit rationing. It is also broader than
another frequently mentioned definition of credit crunch: “ a
widespread, sudden, sharp, indiscriminate, and rather brief
2 See Jaffee and Stiglitz (1990) for a detailed survey of various aspects of
credit rationing.
credit shutdown” (Wojnilower 1993).3
In a macroeconomic context, the existence of credit sup
ply problems implies that the observed credit slowdown or
reduction cannot be fully explained by cyclical develop
ments in aggregate demand, except insofar as cyclical
developments may have significant adverse effects on bor
rowers’ creditworthiness as perceived by lenders. There
are, of course, numerous identification problems in sorting
out supply from demand factors in the credit slowdown. For
example, a sharp reduction in the willingness to lend may
lead to a decline in output, inducing a reduction in the
demand for credit. In these circumstances, the credit slow
down will be reported as reflecting lower demand for credit
even though it was, in fact, caused by an initial shock to the
supply of credit (Friedman 1993a, 1993b).
More generally, with demand and supply factors operat
ing simultaneously and interacting with each other, it is very
difficult to distinguish shifts in the supply schedule from
developments on the demand side. Lenders usually tend to
tighten credit standards and terms for lending when the
overall economy slips into a recession because, on aver
age, business and household loans entail higher risks than
before. But the extent of lenders’ response depends not
only on the degree of perceived economic weakness and
its effects on borrowers’ credit quality but also on the state
of their own balance sheets. From the perspective of bor
rowers, this situation would look like a contraction in credit
supply, while lenders may believe this to be a response to
developments in aggregate demand. Strictly speaking,
there is no change in the lenders’ willingness to extend
credit to borrowers of given circumstances (that is, un
changed creditworthiness). At the same time, the reduced
supply is not a response to lower demand for credit. The
constriction in the supply of credit has clearly been caused
by a decline in the willingness of lenders, albeit one that
reflects the adverse effect of the weaker economy on the
creditworthiness of borrowers and balance sheets of
banks. Any sorting out of the demand and supply aspects in
this case would be further complicated by the fact that the
recession itself would reduce the demand for credit.
Identifying demand and supply factors in the recent credit
slowdown is particularly difficult because of the conjunction
of the prolonged cyclical weakness in the economy with a
correction of earlier credit excesses. Those credit ex
cesses, as noted below, reflected the unusually rapid in
creases in debt in the mid-1980s and became unsustain
able over time as both borrowers and lenders experienced
balance sheet and other difficulties, with cyclical develop3 For other perspectives on defining a credit crunch, see Peek and
Rosengren (1992), Owens and Schreft (1992),and Wojnilower (1992a).
For other perspectives on the current credit crunch, see Bernanke and
Lown (1991), Cantor and Wenninger (1993), Jones (1993), Jordan
(1992), Kaufman (1991), Kliesen and Tatom (1992), Peek and Rosengren
(1992), Sinai (1993), Syron (1991), and Wojnilower (1993). For detailed
analysis of earlier crunches, see Wojnilower (1980) and Wolfson (1986).
FRBNY Quarterly Review/Winter 1993-94
3
ments reinforcing pressures for correction. In this highly
“endogenous” process, the demand for credit is believed to
have fallen simultaneously with reductions in banks’ capac
ity and willingness to lend.
Notwithstanding these difficulties, the twelve studies in
this volume examine a broad range of issues concerning
the 1989-92 credit slowdown. Five of these studies (Lown/
Wenninger, Cantor/Rodrigues, Johnson/Lee, Demsetz,
Seth) look at various aspects of the role of bank and non
bank credit sources in the slowdown of private nonfinancial
debt, focusing on the importance of credit demand relative
to credit supply factors. One study (Hamdani/Rodrigues/
Varvatsoulis) reviews survey data on credit tightening from
lenders and borrowers, and another study (M osser/
Steindel) explores the role of economic activity and other
“fundamentals” in explaining the recent credit slowdown.
Three studies (Harris/Boldin/Flaherty, Mosser, Steindel/
Brauer) investigate the effects of credit supply problems on
various aspects of nonfinancial economic activity. Finally,
two studies (Hilton/Lown, Hickok/Osler) consider some
special aspects of the credit slowdown: one attempts to
assess the impact of credit supply shifts on the broadly
defined money stock, M2, and the other provides a broad
overview of the nature and extent of the credit slowdown
abroad, largely based on the experience in France, Japan,
and the United Kingdom.
The remainder of this article reviews evidence from the
twelve studies under four broad headings: the extent of the
credit slowdown; factors behind the credit slowdown; con
sequences of the credit crunch for nonfinancial economic
activity; and implications of the credit crunch for monetary
policy. The last section offers a few tentative concluding
observations on the recent credit crunch experience.
Extent of the recent credit slowdown
Collectively, the studies in this volume show that the U.S.
economy has experienced a broadly based and sharp
credit slowdown in recent years. In documenting and
describing the credit slowdown from the viewpoint of vari
ous types of borrowers (business, household, real estate,
small business) or lenders (banks, other depositories,
finance companies, insurance companies, foreign banks,
bond markets), most of the studies begin by examining the
extent of credit slowdown in the recent period. Since the
timing of the slowdown is not uniform across all borrowers
and lenders, however, these studies do not target a com
mon time period for the recent credit slowdown. Nor do they
judge the recent credit slowdown against a common histor
ical benchmark. Instead, each study provides a compre
hensive look at relevant credit developments from its par
ticular vantage point using whatever time periods make
most sense.
Nevertheless, it may be useful to provide a common time
frame for summarizing the extent of the slowdown in private
Digitized
FRASER
4 forFRBNY
Quarterly Review/Winter 1993-94
nonfinancial debt and its main components on both the
lending and the borrowing sides. I use the flow of funds
data to highlight the breadth and depth of credit slowdown
over the three years from 1989-IV to 1992-IV, taken as a
whole, relative to long-term trends in the periods 1960-82
and 1982-89. Because inflation was greater in the earlier
periods than in the most recent period, comparisons of
nominal credit growth rates may be misleading. I have,
therefore, presented data in both nominal and real terms in
many cases. For simplicity and convenience, however, I
have used the GDP deflator to convert nominal dollars into
real dollars rather than search for specific sectoral defla
tors. (Sectoral deflators might change precise real dollar
values but they are unlikely to alter the broader contours of
constant dollar data obtained on the basis of the GDP
deflator.) The points made here provide a broad overview
of the extent of the credit slowdown to nonfinancial borrow
ers from both bank and nonbank sources, and may be
viewed as a summary of details in various studies.
Private nonfinancial debt
Using data on nominal and real debt and ratios of debt to
GDP, I begin by looking at the extent of the slowdown in pri
vate nonfinancial debt in terms of its three broad decompo
sitions: business versus household debt, mortgage versus
nonmortgage debt, and corporate versus noncorporate
debt. As shown in Table 1, private nonfinancial debt growth
declined sharply to about 3 percent, at an annual rate, over
1989-92 from long-term trend rates of 9 1/2 to 10 1/2 per
cent. Both businesses and households experienced large
debt slowdowns, but the rate of decline was much greater
for the business sector. Nonfinancial business sector debt
growth averaged less than 1 percent in the recent period,
compared with a long-term trend rate of 10 percent, while
household debt growth averaged 5.6 percent in the recent
period, about one-half the average growth rate over 1982-89.
In real terms, private nonfinancial debt actually declined
somewhat over 1989-92 compared with trend rates of
nearly 7 percent and 4 1/4 percent over 1982-89 and 196082, respectively. For both the business and household sec
tors, real debt trend growth rates were significantly higher
in the 1982-89 period than in the earlier period. Credit to the
nonfinancial business sector declined by nearly 3 percent,
on average, in real terms over 1989-92, following more
than 6 percent average growth over 1982-89. The sharp
declines in private and business debt growth in recent
years have reversed the rising trends of ratios of private
and business sector debt to GDP (Chart 2 and Table 1)
despite a sustained period of weak growth of nominal GDP.
With nonmortgage debt of both businesses and house
holds slowing to about 2 percent at an annual rate over
1989-92, the greater decline in total business debt growth
relative to household debt growth in recent years appears
to be largely the result of differences in home and business
m ortgage debt developm ents (Table 2). Home m ortgage
debt advanced at a hefty 7 percent annual rate in the 198992 period, although its rate of growth decelerated substan
tially from the historically high average growth rate over
1982-89. By contrast, business debt for real estate de ve l
opm ent declined at an average annual rate of about 2 per
cent during 1989-92, down from an average annual growth
rate of close to 10 percent in the earlier period.
In real terms, both m ortgage and nonmortgage com po
nents of business debt declined significantly in the 1989-92
period. But businesses have experienced a much sharper
decline in credit flow s for m ortgages than for other activity
in recent years.
Recent business debt developm ents have also differed
significantly by the size of borrowers. As a group, large or
corporate business borrow ers fared better than sm all or
no ncorporate b o rro w ers in the recent cre d it slow dow n.
Credit to corporate borrowers increased at an annual a ve r
age rate of nearly 2 percent during the last three years,
down from an 11.3 percent average increase over 1982-89
(Table 3). By con trast, n o n co rp o ra te bo rro w e rs e x p e ri
enced an outright credit decline of 1.3 percent, at an annual
rate, in the 1989-92 period, com pared with growth rates of
about 11 percent in 1982-89. It is interesting to note that
noncorporate borrowing is the only category among those
reported here tha t show ed sig n ific a n tly low er re a l debt
growth in the 1982-89 period than in the earlier period.
broadly spread across depository (banks and thrifts) and
nondepository credit sources (Table 4). Banks and thrifts,
however, experienced a sharper decline in credit growth
over 1989-92 than did o verall nondepository credit growth.
Total depository credit actually declined at an annual rate
of about 2 percent over 1989-92 following 9.3 percent aver-
Chart 2
Ratios of Debt to GDP
Ratio
1.4
Household and Nonfinancial Business Debt
Bank a nd nonbank credit sources
The slowdown in private nonfinancial debt growth was
IS1
Table 1
Nonfina
Fourth Qu
Household
debt/GDP
-Fourth Quarter Percent Change, An
Total
Private
Nonfinancial
8.6
11.0
5.2
9.6
10 6
3.1
10 .0
10 .1
0 .7
9.2
11.1
5.6
Constant 1987 Dollarst
1960-82
3.1
1982-89
7.2
1989-92
1.7
4.2
6.8
-0 .4
4 .5
6 .3
-2..8
3.8
7.3
2.0
Ratio of Debt to GDP
1960-82
0.2
1982-89
3.5
1989-92
0.3
1.2
3.1
-1 .8
1, 6
2. 6
-4..2
0.8
3.6
0.6
31..4
33.9
--------------------- .___
Current Dollars
1960-82
1982-89
1989-92
Nonfinancial business
debt/GDP
Memo: 1992-IV 100.0
current dollar
share of total
nonfina
nonfinancial debt
65.3
P
m
■
r n
t GDP deflator was used to construct constant dollar series.
1.3
1960
Sources: Board of Governors of the Federal Reserve System,
Flow of Funds Accounts; U.S. Department of Commerce.
FRBNY Quarterly R eview /W inter 1 9 9 3 -9 4
5
Table 2
Private Nonfinancial Debt
Fourth Quarter-over-Fourth Quarter Percent Change, Annual Rate
Mortgage
Private
Nonfinancial
Total
9.6
10.6
3.1
Constant 1987 Dollars1
1960-82
4.2
1982-89
6.8
-0 .4
1989-92
Current Dollars
1960-82
1982-89
1989-92
Memo: 1992-IV
current dollar
share of private
nonfinancial debt
100.0
Nonmortgage
Business
Home
Mortgage
Total
Business
Household
9.6
10.9
4.2
10.3
9.7
-1.9
9.3
11.5
7.1
9.6
10.3
2.0
9.9
10.3
1.9
9.1
10.3
2.3
4.2
7.1
0.7
4.8
5.9
-5 .4
3.8
7.8
3.6
4.2
6.5
-1.4
4.4
6.5
-1 .6
3.7
6.5
-1.1
50.2
14.3
35.9
49.8
33.8
16.0
+ Based on GDP deflator.
age growth over 1982-89, while total nondepository credit
growth slowed to a 7 percent average rate in the recent
period from about 12 percent in the preceding period. Both
depository and nondepository credit growth rates are, of
course, much lower on a constant dollar basis. At this level
of aggregation, the bulk of the deceleration in private n onfi
nancial credit growth over 1989-92 relative to the 1982-89
average rate is accounted fo r by depository sources, with
both banks and thrifts making substantial contributions to
the slowdown.
The outright decline in total depository credit over 198992 reflects, to a considerable extent, the collapse of the
savings and loan industry. In fact, the com m ercial bank
credit com ponent— w hich represents about 70 percent of
total depository credit— advanced at a 2 percent average
annual rate over the 1989-92 period, com pared with a long-
Table 3
Nonfinancial Business Debt
Fourth Quarter-over-Fourth Quarter Percent Change, Annual Rate
By Size of Borrower By Type of Borrowing
Total1
Large*
Smali§
Mortgage
Other
8.7
11.3
1.8
14.1
10.9
-1 .3
10.3
9.7
-1 .9
9.9
10.3
1.9
dollars1
4.5
3.3
7.5
6.3
-1.7
-2.8
8.5
7.1
-4 .8
4.8
5.9
-5 .4
4,4
6.5
-1 .6
31.4
15.0
14.3
33.8
Current dollars
10.0
1960-82
1982-89
10.1
0.7
1989-92
1960-82
1982-89
1989-92
48.1
current dollar
share of private
nonfinancial debt
t All corporate and noncorporate debt.
* Corporate sector, excluding farm debt.
5 Nonfarm, noncorporate debt.
11 Based on GDP deflator.
Digitized6for FRBNY
FRASERQuarterly R eview /W inter 1 9 93-94
Table 4
Nonfinancial Private Credit Growth
Fourth Quarter-over-Fourth Quarter Percent Change, Annual Rate
Depository Nondepository Bank Depository Bank
Credit
Credit
Credit
Loans
Loans
Current dollars
1960-82
9.7
1982-89
9.3
1989-92
-2 .0
Constant 1987 dollars1
1960-82
4.2
1982-89
5.5
1989-92
-5.4
Memo: 1992-1V 39.9
current dollar
share of private
nonfinancial debt
9.6
11.8
7.0
10.1
10.1
2.0
9.7
9.0
-2 .7
10.3
9.9
1.1
4.1
8.0
3.5
4.7
6.3
-1 .5
4.3
5.3
-6.1
4.8
6.1
-2 .4
60.1
28.1
36.3
25.5
t GDP deflator was used to construct constant dollar series.
term trend rate of around 10 percent. This m odest bank
credit growth was more than fully offset, however, by a 45
percent (13 1/3 percent at an annual rate) decline in credit
by savings and loan associations.
W hile overall nondepository credit growth has held up
better than overall depository or bank credit grow th, many
co m po nents of n o n d e p o s ito ry cre d it did not fare m uch
b e tte r th a n b a n k c re d it. A s e x p la in e d in th e C a n to r/
R odrigues study, credit grow th to businesses experienced
roughly sim ilar slow dow ns in com m ercial paper, finance
com pany lending, and bank loans in recent years relative
to e arlier trends.
Com paring the contribution of depository and nondeposi
tory sources to business credit developm ents reveals that
banks and thrifts accounted for about four-fifths of the fall in
b u sin e ss m o rtg a g e d e b t g ro w th in 1989-92 re la tiv e to
1982-89 (Table 5). The slowdown in nonm ortgage business
debt in the recent period relative to the earlier period was
som ew hat more evenly divided betw een dep o sito ry and
nondepository sources. For the nonfinancial business se c
tor as a w hole, m ost of the deceleration in the average
c re d it g ro w th from the 1 9 82-89 p e riod to the 1989-90
period reflected the slowdown in depository credit; banks
accounted for som ew hat more than one-half of the deposi
tory contribution.
On the household side, the collapse of the savings and
loan industry and the lending slow dow n by o th e r th rifts
were responsible for m ost of the slowdown in home m ort
gage debt growth in 1989-92 relative to 1982-89. The pace
of com m ercial bank credit flow s for home m ortgages actu
ally picked up som ew hat during the 1989-92 period. Banks,
however, made the largest contribution to the slowdown in
nonm ortgage household credit, accounting fo r more than
half of the total slowdow n in that com ponent.
S elected aspects o f bank business loans
Data reported above clearly indicate that com m ercial banks
have played a m ajor role in the 1989-92 credit slowdown for
both b u s in e s s m o rtg a g e s and n o n m o rtg a g e b u s in e s s
loans. For the nonfinancial business sector as a whole, the
slowdown in bank loans accounted fo r more than one-third
of the deceleration in average credit growth from 1982-89
to 1989-92.
Both large (corporate) and sm all (noncorporate) b usi
ness borrowers from banks experienced outright declines
in bank loans over 1989-92, but the rate of decline was con
siderably g re a te r fo r noncorporate borrow ers (Table 6).
Specifically, over the 1989-92 period, nonm ortgage bank
loans to noncorporate borrowers declined at a 4 1/2 per
cent annual rate, more than tw ice the pace of decline for
corporate borrowers.
In the absence of bank loan sales, bank credit flow s to
bu sin esse s w ould p ro b a b ly have been even w e a k e r in
recent years. The study by Demsetz indicates, however,
that adjustm ents for bank business loan sales to nonbanks
and nonfinancial institutions over the 1986-92 period a ctu
ally increase the severity of the recent slowdown in com
mercial and industrial loans on banks’ books because busi
ness loan sales have decreased in recent years. (Note that
the flow of funds data fo r nonfinancial borrowers reported
here already incorporate loan sale adjustm ents.) Even so,
the liquidity provided by loan sales and securitization has
most likely enabled banks to maintain higher levels of total
loan origination than w ould have been the case otherwise.
Cantor and Rodrigues point out in their study for this vo l
ume that m ortgage-backed securities have grown about 70
.
:
1
Table 5
Contributions to the Credit Slowdown
mMmm
From 1982-89 to 1989-92
|g|j -
Business
: '' WSB3M Household
Mortgage
Other
Total
Mortgage
Other
Total
Decline in credit growth rate*
11.6
8.4
9.4
4.4
6.0
5.6
Percent of total decline contributed by:
Depository sources
82.8
58.3
69.1
84.1
67.5
78.6
38.8
21.4
37.2
-6 .8
55.0
23.2
44.0
36.9
31.9
90.9
12.5
55.4
Nondepository sources
17.2
41.7
30.9
15.9
1 Annual average credit growth rate over 1982-89 minus annual average growth rate over 1989-92 # i
32.5
21.4
Banks
Thrifts
n
FRBNY Quarterly R eview /W inter 1 9 9 3 -9 4
7
percent since 1988 and that securitization of business and
consum er credit has proceeded even more rapidly over
that period.4 Clearly, recent sharp advances in securitiza
tion have, to some extent, cushioned the credit slowdown.
As described in detail in the study by Lown and W en
ninger, the bank credit slowdow n was spread fairly broadly
across various regions of the country, but N ortheast (New
England and M id-Atlantic) and Pacific regions experienced
ve ry large o u trig h t d e clin e s in total and b u sin ess bank
loans over 1989-92. O ther regions also experienced con
tractions in com m ercial and industrial loans, although in
some cases the rates of decline were relatively modest.
W ithin the banking system , the bulk of the recent bank
c re d it slo w d o w n is a ttrib u ta b le to d o m e s tic b a n k s as
opposed to foreign banking offices in the U nited States
(C hart 3). Total loans of U .S .-chartered banks show ed
less than 1 percent annual average growth over 1989-92,
and business loans actually declined outright at a 4.5 p e r
cent annual rate. By contrast, total U.S. loans of foreign
b a n k in g o ffic e s in th e U n ite d S ta te s a d v a n c e d at an
annual rate of about 14 percent over the recent three-year
period, only slightly below the average increase over the
1982-89 period. B usiness loans by foreign banking offices
did register a significa n t slow dow n in the recent period,
4 Cantor and Demsetz (1993) show that over the two years to the second
quarter of 1992, the growth in loans for home mortgages, consumers,
and businesses inclusive of off-balance-sheet lending (securitization and
loan sales) exceeded the growth in loans on the books of banks, thrifts,
mortgage companies, and finance companies as a group.
Table 6
Nonfinancial Business Loans by Banks
but they continued to increase at a hefty annual pace of
about 9 percent.
These trends in foreign bank loans to U.S. borrowers are
analyzed in more detail by Rama Seth in her study fo r this
collection. She finds that as a group, foreign banks su p
p o rte d to ta l U .S . c re d it g ro w th d u rin g th e re c e s s io n ,
although many foreign banks, especially those from Japan,
Italy, and the United Kingdom, cut back on loans over that
period. W hile Seth is unable to provide a full accounting of
the continued strong loan grow th at fo re ig n banks, she
notes that their desire to increase m arket share and their
capital strength may have been im portant in m aintaining
the relative strength of foreign bank lending.
The differing patterns of loan developm ents for foreign
relative to dom estic banks have substantially reduced the
dom estic bank shares of total and business loans (C hart 3).
Moreover, the flow of funds data used here understate the
extent of foreign bank loans to U.S. residents because o ff
shore foreign banks’ U.S. lending is excluded (M cCauley
and Seth 1992). Adjusted for offshore data, the true shares
of U .S .-c h a rte re d banks are c o n s id e ra b ly s m a lle r than
shown in Chart 3.
Factors behind the credit slowdown
Studies in this volum e investigate dem and and supply fa c
tors underlying the slowdown in private nonfinancial debt
for both bank and nonbank sources of credit. The evidence
includes descriptive and econom etric analysis and is based
on hard data as well as survey m aterials for borrowers and
lenders. On the dem and side, the studies look fo r both
cyclical effects— the credit slowdown viewed as a by-prod
uct of the econom ic slow dow n— and noncyclical demand
influences. On the supply side, the evidence for both price
and nonprice rationing of credit is considered.
Fourth Quarter-over-Fourth Quarter Percent Change, Annual Rate
Nonmortgage Business Loans
Total
Current dollars
1960-82
10.6
1982-89
9.9
1989-92
-1.7
Totalf
Large
Small
Business* Business^ Mortgages
10.3
7.2
-2 .3
10.0
8.0
-2 .2
14.0
7.1
-4 .5
12.0
16.5
-0 .7
Constant 1987 dollars'1
1960-82
5.2
4.9
3.5
1982-89
6.1
-5 .7
1989-92
-5 .2
4.5
4.3
-5 .6
8.5
3.3
-7.9
6.5
12.7
-4 .2
8.7
6.9
1.4
5.0
Memo: 1992-IV 13.7
current dollar
share of private
nonfinancial debt
I
*
5
II
All corporate and noncorporate business.
Nonfarm corporate business.
Nonfarm, noncorporate business.
Based on GDP deflator.
Digitized8for FRBNY
FRASERQuarterly R eview / W inter 19 9 3 -9 4
C yclical a nd noncyclical dem and influences
At an im pressionistic level, the recent credit slowdown can
not be fully explained by the 1990-91 recession and the
slow grow th period s u rro u n d in g the recession. S everal
s tu d ie s in o u r c o lle c tio n — e s p e c ia lly th o s e by C a n to r/
Rodrigues, Low n/W enninger, and M osser/S teindel— p ro
vide noneconom etric data analysis of cyclical effects on var
ious debt or credit com ponents. The general thrust of the
authors’ analysis of cyclical effects is captured by data in
Table 7, although collectively these studies cover a much
broader range of issues and detail. Briefly, the growth rate
of private nonfinancial debt in nominal and real term s has
been s u b s ta n tia lly lo w e r in the p e riod su rro u n d in g the
recent recession than over com parable periods for the four
earlier major recessions, on average, or considered individ
ually. Broadly, this pattern holds for m ajor aggregate bor
rowing com ponents and fo r both bank and nonbank credit.
The only significant exception is the flow of home mortgage
debt from both bank and nonbank sources, w hich has been
age in the earlier cycles. Nevertheless, as pointed out by
Low n/W enninger and others, the differences in the pace of
activity do not fully explain the sharp credit slowdown in the
current episode relative to the earlier episodes. Moreover,
the credit w eakness itself may be responsible, in part, for
the slower pace of econom ic activity in the current cycle.
With changing relationships between credit flow s and eco
nomic activity, it is very difficult to assess the contribution of
w eaker than average grow th in the current cycle to the
sig n ifica n tly stronge r in real term s over the period su r
rounding the latest recession than around the last three
major recessions since 1970.
The com parison of credit flow s reported in Table 7 proba
bly understates, to some extent, the contribution of cyclical
developm ents to the private credit slowdown around the
current recession relative to the earlier episodes. As shown
in Chart 4, the pace of econom ic activity, nominal and real,
was w eaker in the current cycle than it had been on a ve r
Chart 3
Comparison of Domestic and Foreign Bank Loan Shares
Percent
Percent
18
102 ------------
r --------------------Share )f Loans to Total Biin k Loans
r * “
1" “ n
V
U.S. char tered loarIS/
bank loans
- Scale
i
to ta l Loans
Fourth Quarter-over-Fourth Quarter
Percentage Change at an Annual Rate
U.S. Banks
Foreign Banks
1961-82
9.8
18.6
1983-89
1990-92
8.7
0.6
15.0
lc
bank loa IS
Scale----/
\ .
/
/
13.9
/
/
/
Vv
w-
/•
__ _________
x '- '
il l Llll 111111111111 LLiJ.Jll
j j i i i i i l m i i i i l l l l m l m l m ............ l l l l l l l l l l l l l l l ,1,11 u l i n t Im l i i i l i i i i i i l j j . i L n l i i i I ii
I
lllllllllll
Share o f Business Loans to Bank B usiness Loans
U.S. chartered business loans;
bank business loans
^
Foreign bank business loans/
bank business loans
Scale------ ►
;
a M t -«------- Scale
B usiness Loans
Fourth Quarter-over-Fourth Quarter
Percentage Change at an Annual Rate
U.S. Banks
Foreign Banks
1961-82
9.7
23.6
1983-89
4.9
14.5
1990-92
-4.5
9.2
Ir H t r ri-
111111i 111111111111
1959
Source: Board of Governors of the Federal Reserve System, Flow of Funds Accounts.
Note: Shaded areas indicate periods designated recessions by the National Bureau of Economic Research.
FRBNY Quarterly R eview /W inter 1 9 9 3 -9 4
9
severity of the credit slowdown. But one simple w ay to get a
very rough sense of this contribution is to use the average
relationship between real credit flow s and econom ic growth
fo r the e a rlie r cycle s as a b e n ch m a rk to c a lc u la te the
implied credit flow s associated with recent growth perfor
mance. This type of exercise suggests that the w eaker than
average pace of econom ic activity accounts fo r only about
35 percent of the gap between the private credit growth in
the current cycle and the average private credit growth in
the past four cycles.
Some noncyclical or structural demand shifts may also
have c o n trib u te d to re d u cin g the dem and fo r c re d it in
recent years. Such shifts are “perm anent,” by definition, but
their influence on dem and may be difficult to separate from
that of cyclical forces. Some studies in this volum e note the
relevance of structural dem and shifts in recent d e ve lop
ments in credit flow s. In particular, the Low n/W enninger
and M osser/Steindel papers discuss the influence of a pos
sible dow nward shift in inventory demand relative to sales,
especially in the m anufacturing sector, on the dem and for
com m ercial and industrial loans. Because of ju st-in-tim e
and other m anagem ent techniques, the amount of invento
ries needed for a given level of sales and, therefore, the
financing requirem ents for those inventories have declined
in recent years. Even though such a shift is likely to have
been gradual and to have started before the recent credit
slowdown, a considerable portion of the unusual w eakness
in com m ercial and industrial bank loans over the recent
period may be explained, Lown and W enninger argue, by
the need to finance a lower than normal level of inventories.
Econom etric analysis yields results that are broadly con
sistent with the less form al data analysis, namely, demand
influences as reflected in standard m acroeconom ic v a ri
ables are unable, by them selves, to explain adequately the
recent credit slowdown. At the outset, it is worth noting that
the estim ates discussed here generally do not distinguish
between cyclical and noncyclical dem and influences. The
estim ated equations sim ply attem pt to explain particular
cre d it flo w s using a g g re g a te dem and co m p o n e n ts and
other appropriate m acroeconom ic factors as explanatory
variables. M ovem ents of explanatory variables, in this co n
text, capture all relevant normal or long-run influences on
credit flows.
Using cash flow and income or aggregate dem and com
ponents as e xp la n a to ry v a ria b le s, M osser and S teindel
estim ate total loan equations fo r nonfinancial corporations,
consum ers, hom e m ortgages, and business m ortgages.
They find that swings in econom ic a ctivity-re la te d fu n d a
m entals seem to account fo r only about one-quarter to onehalf of the slowdown in corporate and consum er borrow
ings. In the case of consum er credit, the authors reestim ate
equations by adding home equity lines to take account of
shifts betw een co n su m e r cre d it and hom e e q u ity loans
resulting from the Tax Reform Act of 1986; the results are
roughly sim ilar to those w ithout the home equity variable.
For business and home m ortgage com ponents, estim ates
are unstable, although for home mortgages, the estim ated
equations are able to explain the recent slowdown in loans.
M osser and Steindel provide a particularly detailed a n aly
sis of corporate and consum er loans, and argue that most
of the p re d ictio n errors fo r those loans do not seem to
reflect any exogenous shift in the relationships betw een
credit dem and and explanatory variables.
For bank loans, Lown and W enninger estim ate four sets
of equations, one each for com m ercial and industrial loans,
b u s in e s s m o rtg a g e s, hom e m o rtg a g e s, and c o n s u m e r
loans. The equations are estim ated with vector autoregres
sion m ethodology to approxim ate reduced-form relation-
Table 7
Credit Growth over Various Business Cycles
.’ V ■. V ; . ' -.^0%
Private
Business
Nonfinancial
Nonfinancial
.......................................................
Average, current cycle
Average, earlier cycles(A)t
Average, earlier cycles(B)*
Constant 1987 dollars§
Average, current cycle
Average, earlier cycles(A)t
Average, earlier cycles(B)*
3.1
8.8
9.0
-0.4
3.9
3.2
'E m .
Mortgage
Household
Business
Home
Mortgage
Nonmortgage
0.7
9.2
9.7
5.6
8.5
8.3
-1 .9
10.2
10.6
7.1
8.5
8.2
2.0
8.6
9.0
-2 .8
42
3.9
2.0
3.5
2.5
: -5.4
5.2
s-r- -" - ---j
4.7
> v -(llE i
3.6
3.6
2.4
-1 .4
3.7
32
pgp sNilPi
Note: Business cycle periods cover four quarters before trough, trough quarter, and seven quarters after trough.
f Average of the 1958, 1970, 1975, and 1982 cycles.
* Average of the 1970, 1975, and 1982 cycles.
5 Based on GDP deflator.
Digitized
10for FRASER
FRBNY Quarterly R eview /W inter 1 9 93-94
llB B i
ships, using a range of econom ic activity and interest rate
variables. Broadly, the estim ated equations fo r business
m ortgages and consum e r loans u n d e rp re d ict the cre d it
slowdown, while those for home m ortgages more than fully
account for the extent of the slowdown. For com m ercial and
industrial loans, Lown and W enninger are unable to reach
any firm conclusions because of unstable regressions.
C antor and Rodrigues estim ate equations fo r total bank
b u sin ess loans and fo r n o n b a n k b u sin ess c re d it using
GDP, investm ent, and inventories as explanatory variables.
The pre diction errors from both the bank and nonbank
equations are large, indicating that m acroeconom ic activity
Chart 4
Economic Activity in Various Business Cycles
Four quarters before trough = 100
200-
-3
-2
-1 Trough
Quarters
before trough
3
1
Source: U.S. Department of Commerce.
4
Quarters
after trough
variables do not provide an adequate explanation for the
slowdown in either bank business lending or nonbank busi
ness credit.
In summ ary, aggregate dem and influences are unable to
explain a substantial part of the recent slowdown or decline
in nonfinancial business borrow ings from bank and non
bank sources; this is true fo r both m ortgage and nonm ort
gage bu sin ess b o rro w in g s. Dem and fa cto rs also fa il to
account fo r the recent slowdown in consum er credit, and
taking account of shifts between consum er credit and home
equity loans does not significantly alter this result. Recent
developm ents in total home mortgage debt and home mort
g a g e b a n k lo a n s , h o w e v e r, a p p e a r to be a d e q u a te ly
explained by the evolution of aggregate demand influences.
Supply-side factors
W ith a significant fraction of the credit slowdown left unex
p la in e d by s ta n d a rd a g g re g a te dem and v a ria b le s , one
m ust turn to the supply side. Indeed, the prediction errors
or residuals from equations estim ated with dem and v a ri
ables may be viewed as representing one measure of the
supply-side influence on the credit slowdown. Of course,
even if we could account for all of the recent credit slow
down with the help of dem and variables, that result by itself
would not necessarily im ply that supply-side factors did not
contribute im portantly to the credit slowdown. Such a result
m ight sim p ly reflect, fo r exam ple, the fa ct th a t dem and
influences overw helm supply-side factors. More generally,
with both credit dem and and supply falling, if the drop in
credit dem and is larger, actual cre d it d evelopm ents will
tend to be dom inated by dem and influences, making it d iffi
cult to estim ate the net contribution of supply-side factors.
Four studies in this collection— Low n/W enninger, C antor/
Rodrigues, Johnson/Lee, and H am dani/R odrigues/Varvatsoulis— have devoted considerable attention to the role of
supply-side factors in the credit slowdown. T heir analysis
covers bank and nonbank sources of cre d it and survey
data. Overall, the evidence points to significant credit su p
ply problem s fo r both bank and nonbank sources of credit.
On the bank side, Lown and W enninger look at a number
of su p p ly-sid e fa cto rs and provide both d e scrip tive and
econom etric evidence on the role of those factors. They
find that in the 1989-92 period, spreads between bank lend
ing rates and bank funding costs for both corporate and
consum er loans were at or above their previous record lev
els. They also note that the percentages of short- and long
term lo a n s re q u irin g c o lla te ra l in c re a s e d s h a rp ly o ve r
1989-92. Both indicators are consistent with a leftward shift
in the bank loan supply schedule.
O th e r n o n e c o n o m e tric e vid e n ce d iscu sse d by Low n/
W e n n in ge r and o thers sug g e sts th a t banks engaged in
nonprice credit rationing or, more generally, experienced
re d u c e d a b ility o r w illin g n e s s to le n d . B a n ks s h a rp ly
increased their holdings of securities relative to loans, and
FRBNY Quarterly R eview /W inter 1 9 9 3 -9 4
11
some of the increase appeared to be noncyclical.5 Survey
data from banks indicate significant tightening in credit
standards on mortgages and other business loans during
1989-92.
Weakening bank capital positions— reflecting, in part,
deteriorating bank loan quality and increasing charge-off
rates— seem to have played a significant role in credit sup
ply problems over 1989-92. Lown and Wenninger argue
that poorly capitalized banks reduced their lending more
sharply than well-capitalized banks during 1990-91. Draw
ing on a more comprehensive examination of the relation
ship between bank capital positions and bank credit, John
son and Lee reach a somewhat stronger conclusion along
the same lines. Specifically, the results indicate that banks
with weak capital positions did less lending than banks with
strong capital positions during the 1990-92 period.
Lown and Wenninger also argue that the increased
emphasis by the regulators on bank capital and the riski
ness of bank loan portfolios may have contributed to the
bank loan slowdown, although the role of the regulators
and examiners is difficult to separate from other factors.
While Lown/Wenninger and Johnson/Lee explore the
effects of capital positions on bank lending, none of the
studies in this volume explicitly investigate the role of regu
lators and regulatory changes in the credit slowdown
process.6
Using state-level data, Lown and Wenninger estimate
cross-sectional regressions for bank loan growth with
employment, capital, and loan-loss reserves as indepen
dent variables; the latter two variables are intended to cap
ture the effect of banking conditions (that is, supply-side
factors) on loan growth. The results suggest that capital
and/or loan-loss reserves contributed significantly to weak
bank lending in 1990 and 1991 and that the effects of these
supply-side factors were greatest for the New England
region, followed by the Mid-Atlantic and the West South
Central regions. By applying the cross-sectional regression
coefficients to changes in the explanatory variables by
region, Lown and Wenninger provide a quantitative sense
of the contribution of supply-side factors to the overall bank
credit slowdown. Specifically, they suggest that supply-side
problems accounted for roughly 15 to 40 percent of the
slowdown in bank lending from 1989 to 1990.
Also using cross-sectional data, Demsetz estimated
equations for bank loan sales with expected economic
activity, assets, capital ratios, nonperforming loan ratios,
and other bank characteristics as explanatory variables.
5 More formally, Rodrigues (1993) shows that weak economic activity
cannot explain all of the recent run-up in securities holdings and that the
sustained steepness in the term structure of interest rates and risk-based
capital standards may have contributed to that run-up.
6 For various perspectives on the role of regulators/examiners and capital
standards, see Greenspan (1992), Syron and Randall (1992), Peek and
Rosengren (1992), LaWare (1992), and Wojnilower (1992b, 1993).
FRBNY Quarterly Review/Winter 1993-94
Digitized 12
for FRASER
She finds that both capital ratios and nonperforming loan
ratios are significant in explaining loan sales but their con
tribution to predictions of loan sales declines is modest and
swamped by that of economic activity.
Turning to nonbank credit sources, the Cantor/Rodrigues
study offers evidence that supply-side forces were at work
here as well. The authors’ econometric estimates for non
bank business credit using GDP and its components as
explanatory variables yield large prediction errors that sug
gest a significant role for supply-side factors. The results
also indicate that the timing of the credit slowdown for non
bank sources was parallel to that for bank sources, with no
evidence of a shift from bank to nonbank sources of funds.
Cantor and Rodrigues also provide considerable descrip
tive evidence on the role of supply-side factors in the slow
down of credit from nonbank sources such as finance com
panies, life insurance companies, and the commercial
paper market. Business credit extended by finance compa
nies advanced at a significantly slower pace starting in late
1989, when many finance companies were downgraded by
the credit rating agencies because of major losses in com
mercial lending and, more generally, weak balance sheet
positions. With more credit downgrades during the reces
sion and large amounts put up for loan loss provisions and
net charge-offs, total finance company business credit
became roughly flat over 1990-92. Cantor and Rodrigues
note that credit downgrades probably had a significant
effect on lending because finance companies raise most of
their funds in short-term public credit markets. The authors
also suggest that credit stringency at banks may have had
adverse feedback effects on finance company credit avail
ability as many finance companies, faced with problems in
raising funds in the commercial paper market, increased
their borrowings from bank backup credit lines, presumably
at higher costs.
Most of the problems of the life insurance industry, Can
tor and Rodrigues argue, stemmed from commercial real
estate lending, junk bond portfolios, and high rates on guar
anteed investment contracts. Against the background of
weak economic activity, these difficulties led to numerous
credit downgrades, sharp declines in stock prices, and
some outright failures in the life insurance industry. Life
insurers became generally preoccupied with preserving liq
uidity and avoiding a collapse. In this environment, the
National Association of Insurance Commissioners in mid1990 adopted new rules establishing more stringent re
serve and capital requirements for below-investment-grade
bonds and private placements. These developments, Can
tor and Rodrigues believe, have reduced the willingness of
insurance companies to invest in below-investment-grade
bonds and, more generally, have induced a shift toward
low-risk assets.
Nonfinancial business borrowers did not increase the rate
of commercial paper issuance during the latest credit
crunch, as they had done in earlier credit crunches.
Because of numerous credit rating downgrades and fifteen
defaults since 1989 (compared with only two defaults in the
entire earlier history of the market), perceived credit risk in
the commercial paper market increased greatly, leading
investors, especially mutual fund investors, to lose confi
dence. Meanwhile, to protect small investors and sustain
confidence in the money market mutual fund industry, the
Securities and Exchange Commission in July 1990 imposed
strict limits on the amount of “second-tier” (low-quality) com
mercial paper that mutual funds could hold. As a result of
these developments, both the amount of second-tier com
mercial paper issued and the mutual fund holdings of that
paper dropped precipitously over 1990-92. Cantor and
Rodrigues believe that the credit quality concerns are not
fully reflected in the rate spread between the top-tier and
second-tier paper because the second-tier issuers are often
“rationed” out of the market before they drive up rates.
Cantor and Rodrigues also discuss the public bond mar
ket. The market for below-investment-grade public bonds
(“junk bonds”) showed virtually no activity during 1990 and
1991 but recovered significantly in 1992. By contrast, the
market for publicly placed investm ent-grade bonds
remained quite strong, cushioning weakness in other credit
markets to some extent.7
Survey evidence on supply-side factors
Hamdani, Rodrigues, and Varvatsoulis examine survey
data from bank lenders and nonfinancial borrowers on
credit tightening in recent years. Using both the narrative
approach and econometric estimates, they find evidence of
significant credit tightening by lenders because of supplyside factors. By purging the NFIB (National Federation of
Independent Business) Survey data of aggregate demand
influences, they uncover particularly strong and consistent
evidence of a credit crunch for small business borrowers
that depend primarily on banks for their financing (about 90
percent of small business debt consists of bank loans).8
The results indicate that for small borrowers, the recent
credit crunch was more severe than earlier crunches. A sig
nificant part of this credit crunch appears to have taken the
form of nonprice credit rationing or tightening of nonrate
loan terms.
Hamdani, Rodrigues, and Varvatsoulis also find consid
erable evidence of credit supply constriction for large bor
rowers. They conclude that overall, the extent of bank
7 The severity of credit supply reductions, as noted earlier, has also been
moderated somewhat by rapid increases in off-balance-sheet lending
(securitization and loan sales) in recent years.
8 In fact, the authors’ credit supply proxies, purged of aggregate demand
influences, may understate the extent of credit supply shifts because
they exclude supply shifts associated with movements of lending
spreads and at least some of the effect of changes in borrowers’ quality
on the willingness to lend.
credit tightening for large businesses appears to have been
greater than what can be explained by the general eco
nomic slowdown. Using the SLO (Senior Loan Officer) sur
vey data from banks, again purged of aggregate demand
influences, the authors argue that the degree of credit strin
gency during 1990-91 seems to have been similar to that in
the 1974-75 episode.
Finally, Hamdani, Rodrigues, and Varvatsoulis estimate
loan growth models using standard demand variables and
survey variables on loan availability for both the SLO and
NFIB surveys. The results suggest that restrictive loan sup
ply conditions as proxied by the survey supply variables
have had a significant impact on commercial and industrial
bank loan growth over 1989-92.
Correction for the debt overhang of the 1980s
As noted earlier, disentangling the supply and demand fac
tors underlying the recent credit slowdown is particularly
difficult because the economic downturn was superim
posed on a process of balance-sheet corrections for debt
excesses of the mid-1980s. This process of correction for
earlier debt excesses is widely believed to have contributed
significantly to the credit slowdown over 1989-92.
During the last decade, a broad range of forces— includ
ing financial deregulation and innovation, developments in
information and data processing technology, commercial
real estate development, and mergers, acquisitions, and
leveraged buyouts— combined to increase greatly both the
supply of and the demand for credit, resulting in enormous
increases in the amount of debt.9 The upward march of
debt was supported, in part, by speculative asset price
increases, especially for real estate.
Over time, the process of rapid debt increases led, per
haps inevitably, to problems for both borrowers and
lenders. By 1989 and 1990, households and businesses
faced historically unprecedented and unsustainable debt
and debt service burdens (Chart 5). With weakening eco
nomic activity and declining real estate and other asset val
ues, high debt burdens resulted in balance sheet difficulties
for borrowers and loan quality problems for lenders. Not
surprisingly, therefore, bank and nonbank lenders alike
experienced a weakening of capital positions and increas
ingly higher loan loss reserves, charge-offs, and delin
quency rates. All these factors together, so the argument
runs, explain the sharp credit slowdown in recent years.
This account of the correction process is consistent with
the view that the credit slowdown contained important sup
ply-side elements although it was perhaps driven by
demand forces. In particular, in the down-phase, balance
sheet changes induced by declining real estate and other
asset values led to weaker capital positions for banks and,
9 For a review of developments leading up to the credit crunch period, see
Cantor and Wenninger (1993). For a broad perspective on the debt
overhang of the 1980s, see Frydl (1991).
FRBNY Quarterly Review/ Winter 1993-94
13
consequently, lower capacity and w illingness to lend over
1989-92, just as on the up-side, balance sheet changes
had increased capacity and w illingness to lend in the earlier
period. The le n d ers’ reduced w illingness to lend, in this
case, re fle cte d not on ly ch a n g e s in th e ir ow n b a la nce
sheets but also a shift in their attitude associated with the
deterioration, actual or perceived, in the quality of borrow
ers’ balance sheets and creditw orthiness.
Perhaps even more im portant, according to this story,
the correction process seem s to have been dom inated by
m arket forces (both dem and and supply) as opposed to pol
icy factors. In fact, m onetary policy had been easing since
early 1989, and as a result, unlike earlier credit crunches,
in te re st rates had d e clin e d s ig n ific a n tly before se rio u s
credit supply problem s em erged. To be sure, tighter capital
re q u ire m e n ts and re g u la to ry p re s s u re s ,s te m m in g from
both legislative changes and more intensive supervisory
oversight, contributed to the credit slowdown, in part by
reinforcing and highlighting prudential concerns. Such p o l
icy factors, however, appear not to have been the prim ary
cause of the credit slowdown. In any event, any contribu
tion of policy factors to the credit slowdown is likely to have
been much sm aller than the role played by m arket forces;
these forces, particularly evident in a reduced desire to bor
row and hold or extend debt, caused a decline in both credit
dem and and credit supply.10
Research w ork in this volum e does not provide any e sti
m ates of the extent to which the credit slowdown is a ttrib u t
able to the correction process for the debt overhang of the
1980s. W hile several studies discuss developm ents lead
ing up to the credit slow dow n, quantitative assessm ents
are generally aimed at sorting out demand from supply (or
cyclical from noncyclical) factors using historical trends.
The study by Johnson and Lee does address the related
question of the linkage between the earlier credit excesses
by banks and the recent bank credit slowdown. It finds that
banks that indulged in “high-risk” activities during the 198588 period were obliged to curtail their lending more sharply
than other banks during the three years to end-1992. But
the study does not estim ate the extent of “excess d e b t”
resulting from those earlier high-risk activities.
Nevertheless, it may be useful to get a rough sense of the
im pact of the correction for the debt overhang on the credit
slowdown since 1989. S pecifically, I address the following
question: W as the actual cum ulative expansion in private
nonfinancial debt from end-1989 to end-1992 h ig h er or
low er than w hat is co n siste n t w ith “norm al” or long-run
trend credit growth adjusted fo r cyclical developm ents and
for the debt overhang of the 1980s? Using the simple rela-
tionship that the am ount of credit expansion in any given
tim e period is made up of the credit expansion consistent
with the normal or long-run trend rate adjusted fo r cyclical
Chart 5
Debt Service Burdens
Percent
— ------------------- ------------------- ------------------- ... '... ----------H<>usehold Sec tor Debt Ser vice as a
A
P€‘rcentage of Disposable Personal Inco me
Percent
8.0
1
7.5
L
7.0
/ / \
17.C
Home
mortgages . j
SDale-----► J |
Sm‘\.r
1
!
N
------ Scale
6.5
r /
i
l.i
\
5.5
A
15.!
1/
f
1
n / * 7'
15J
4.5
f,
M
14.1
5.0
/
^
V, J
tS
4.0
i i d w k k l i i ) u M u i i i i l m U lllllllllllllllll m i d 3.5
14.1 ii'f U lllllllllllllllll
—
-------------------
r-
isiness Sect sr Net Interest Payments iis a
o l rcentage of Cash Flow plu. Net Intere st Payments
Pe
28 /
26 -
k
24
22
A
20
/
18
6.0
\
r A J
\\
\\
\ A
n l
[ J \
16
s y
uiluiliiMiiiiiliulwlmlmujI i.h1iii 1ih1j.il JuluJ
14'till mlmlmlmlm
1970 72
74
76
78
80
82
84
86
88
90
92
Source: U.S. Department of Commerce.
10 Incidentally, note that shifts in attitudes toward debt would normally be
treated as “exogenous” in most macroeconomic models; the use of
exogenous/endogenous in the current context, however, would appear
to be inappropriate since such terms must be expressed relative to a
specific model.
Digitized14
for FRASER
FRBNY Quarterly R eview /W inter 1 9 93-94
Notes: In the upper panel, debt service is an estimate of
scheduled payments of principal and interest on home mortgage
and consumer debt. In the lower panel, cash flow is defined as
depreciation (book value) plus retained earnings (book value).
and other shifts away from that trend, I attempt to measure
the gap between the actual credit expansion over the threeyear period to the fourth quarter of 1992 and the amount of
credit expansion implied by the adjusted long-run path
under various assumptions for the relevant variables. If the
actual credit expansion over 1989-92 falls short of the esti
mated credit expansion for that period, the recent credit
slowdown has been greater than what could be reasonably
attributed to the combination of cyclical effects and the cor
rection for earlier debt excesses. In this case, the correction
process itself might have produced overshooting or shifts
unrelated to the earlier credit excesses, and cyclical devel
opments might have further depressed credit flows. Of
course, a significant positive gap between the actual and the
estimated credit expansion has the opposite implications.
There is no obvious and definitive way to measure the
“normal” or long-run credit expansion rate. The usual pro
cedure is to use some measure of the historical trend rate.
But with credit expansion rates much higher in the 1980s
than in the preceding two decades, history does not offer a
clear choice for the trend rate or the benchmark period.
Perhaps more important, since long-run credit growth must
be viewed in real terms, we need relevant prices. At an
empirical level, however, the choice of the appropriate
price measures needed to deflate various debt components
is ambiguous. Similarly, the use of the debt-to-GDP ratio at
the component level in figuring out the long-run or normal
rate is quite problematical—the ratio of a particular debt
component to GDP (or to broad sectoral income measures)
need not be stable over time. Adjustment of the long-run
trend to account for cyclical and noncyclical developments
raises equally difficult questions: How should we measure
cyclical effects? How much time should we allow for the
correction of the debt overhang to be completed— as much
time as it took to build up the problem, more time, or less?
Using various alternatives for the long-run or normal
trend credit expansion rate and adjustment factors, I calcu
lated the cumulative amount of excess debt over 1982-89
and several measures of the gap between the level of
actual credit expansion over 1989-92 and the amount of
trend credit expansion, adjusted for the debt overhang and
cyclical developments, during that period. One such exer
cise is reported in Table 8. The long-run trend rates in this
exercise are based on business and household data for
mortgage and nonmortgage debt over the 1960-82 period,
converted into constant 1987 dollars using the GDP defla
tor.11 The cyclical effects are measured on the basis of dif
ferences between the 1960-82 trend rates and the com
11 The use of a national price index instead of sectoral price indexes
seems to be preferable for at least two reasons: appropriate component
price measures are not always readily available, and even when they
are available, their use would legitimatize credit excesses of the 1980s
by incorporating any speculative price increases for particular sectors
such as real estate.
bined average growth rates for the periods surrounding the
1970,1975, and 1982 recessions.
This exercise suggests that the decline in business credit
over 1989-92 has gone far beyond what was necessary to
correct the earlier debt excesses; only about 55 percent of
the decline in business credit over 1989-92 relative to the
long-run trend can be attributed to the need to correct the
debt overhang. Combining the correction for the debt over
hang with cyclical effects still accounts for only a part of the
business credit slowdown. Even assuming complete
adjustment over three years (1989-92) for the credit ex
cesses that took place over seven years (1982-89), the
actual business credit increase over 1989-92 fell short of
the long-run trend expansion, adjusted for the debt over
hang and cyclical effects, by about $246 billion in 1987
prices; the shortfall represents nearly 7 percent of total
business credit at end-1992. Under partial adjustment, with
three-sevenths of the excess debt eliminated over 1989-92,
the debt shortfall from the trend expansion level increases
to $461 billion, or about 12.5 percent of total business
credit at end-1992. While both commercial mortgages and
nonmortgage business debt declined more than implied by
the estimated adjusted trend expansion levels under the
two adjustment scenarios, the bulk of the shortfall reflects
commercial mortgages.
For the household sector, the correction for the earlier
debt excesses and cyclical effects together more than fully
account for the credit slowdown. In fact, actual household
credit expansion over 1989-92 exceeded the amount of
credit expansion consistent with the adjusted long-run
trend, assuming complete adjustment over three years, by
$665 billion in 1987 dollars; the excess is nearly 17 percent
of total household debt at end-1992. About 90 percent of
the excess debt is attributable to home mortgages. Under
partial adjustment, the amount of household excess debt
drops to less than half that under complete adjustment, but
it is more than fully accounted for by home mortgages, with
nonmortgage household debt actually showing a moderate
shortfall relative to the estimated level. In sum, there has
been no correction for the debt overhang for home mort
gages. On the contrary, home mortgage debt over 1989-92
continued to advance at a faster rate than the long-run
trend rate, apparently unaffected by cyclical developments
and by the need to correct earlier debt excesses.
Alternative measures of the long-run trend rate yield, in
some cases, significantly larger or smaller estimates of
the debt excess over 1982-89 and of the gap between
actual and estimated debt changes over 1989-92. Two
general messages of the results in Table 8 hold up, how
ever. First, although the correction process for the debt
overhang played a major role in the credit slowdown, it is
difficult to explain all of the business credit slowdown by
appealing to the need for correction. Second, home mort
gage debt in recent years has remained immune to the
FRBNY Quarterly Review/Winter 1993-94
15
co rre c tio n p ro ce ss fo r the e a rlie r debt e xce sse s. One
im p lica tio n of the firs t p o in t is th a t som e c re d it supply
shifts largely or com pletely unrelated to the m arket c o rre c
tion process for the debt overhang may have played an
im portant role in the cre d it slowdow n. Such supply shifts
were presum ably caused by tig h te r capital standards and
regulatory pressures.
econom ic activity helped reduce the pace of credit growth
in all three countries, but their role appears to have been
relatively m odest in Japan and the United Kingdom. Finally,
bank capital m ovem ents seem to be significant in e xplain
ing credit m ovem ents in Japan and to a lesser extent in the
United Kingdom , but they appear not to have made any
contribution to credit developm ents in France.
The credit slowdow n abroad
A num ber of foreign countries have also experienced credit
slowdowns, to varying extents, during the last three years
or so. The H ickok/O sler study in this volume exam ines the
foreign experience, focusing on Japan, France, and the
United Kingdom. Since a single study cannot be expected
to deal w ith all a sp e cts of th e fo re ig n e x p e rie n c e , the
autho rs con sid er only the broad contours of the recent
credit experience abroad and the common forces that may
have driven that experience.
Using both descriptive analysis and regression results,
Hickok and O sier find that for all three countries, the w a n
ing of the credit surge of the 1980s contributed im portantly
to the credit slowdown during 1990-91. The broadly defined
process of financial deregulation and innovation, working
through expanded access to credit markets, asset va lu a
tio n s, and o th e r chang e s, led to in cre a se s in both the
dem and for and the supply of credit during the mid- and late
1980s. Subsequently, as actual credit changes adjusted to
“perm anently” higher equilibrium levels, credit growth rates
tended to return to more norm al levels.
Hickok and O sier also find that for Japan and the United
Kingdom , a reversal of the speculative factors played a
considerable role in the credit slowdown. Developm ents in
To the extent that the credit slowdown reflects the slow
down in aggregate dem and or econom ic activity, it is a
sym ptom and not a direct cause of the w eakness in the
e conom y. A c c o rd in g ly , an y in v e s tig a tio n of the c o n s e
quences of the credit slowdown for nonfinancial econom ic
activity must focus on credit supply problems. In this vo l
ume, three studies— Mosser, S teindel/Brauer, and H arris/
B oldin/Flaherty— deal with this subject. Overall, the three
studies indicate that credit supply problem s have not been
the prim ary or dom inant cause of the recent w eakness in
econom ic activity. But collectively, the studies do suggest
that credit constraints are likely to have m ade at least some
contribution to the econom ic slowdown.
Credit supply problems and economic activity
A ggregate dem and
M osser exam ines the effects of credit supply problem s on
aggregate demand com ponents while attem pting to control
for changes in credit demand. She estim ates reduced form
equations for several dem and com ponents with and w ith
out variables representing credit supply restraints. Four d if
ferent proxies, all based on other studies in this volum e, are
used for credit supply constraints: (1) regression residuals
from various bank loan equations in W enninger/Low n, rep
resenting part of the credit slow dow n not attrib u ta ble to
Table 8
liv .'
..m m -
Long-Run Trend and Actual Credit Expansion, 1989-92
Total
Actual credit expansion
Trend expansion
Cyclical adjustment
Correction for excess
expansion over 1982-89
Adjusted trend credit expansion
Excess/shortfall
Partial adjustment
Business
tlrtl
.n—.l~« 1
nuubenuiu
a— i m
M ortgage
Home
Mortgage
Other
Other
Total
Total
Private
-261.5
423.6
-62.9
-1 59.0
151.5
-2 .0
-1 0 2 .5
272.1
-60.9
191.6
284.9
-93.5
227.6
185.9
-67.8
-3 6 .0
98.9
-25.6
-6 9 .9
708.5
-156.4
-376.0
-1 5.3
-246.1
-461.0
-75.1
74.4
-2 33.4
-276.3
-301.0
-8 9 .8
-1 2 .8
-184.7
-665.1
-4 73.7
665.3
285.2
-479.9
-3 61.8
589.4
315.2
-185.2
-1 11.9
75.9
-29.9
-1041.1
-4 89.0
419.1
-175.8
Notes: Table reports changes in billions of 1987 dollars from 1989-IV to 1992-IV. Long-run trends are based on the 1960-82 growth rates of busi
ness and household components. Cyclical adjustments are based on the differences between the 1960-82 trend rates and the com bined average
growth rates for the periods surrounding the 1970, 1975, and 1982 recessions. Figures in the last row are estimated on the basis of partial correction
(3/7) for the 1982-89 excess expansion over 1989-92. In current dollars, actual cumulative private credit expansion over 1989-92 was about $680
billion (11.0 percent of 1992 GDP). Sums may not add up precisely because of rounding.
16 FRBNY Quarterly R eview / W inter 19 9 3 -9 4
demand factors; (2) regression residuals from various sec
toral loan equations in Mosser/Steindel, measuring the gap
between actual credit flows and the estimates based on
historical relationships between credit and aggregate
demand variables; (3) residuals from regressions in Hamdani/Rodrigues/Varvatsoulis, capturing credit availability
restraints for small business, purged of cyclical influences;
and (4) interest rate spreads between market rates and
loan rates on business and consumer lending.
Using data for the 1980-92 period, Mosser performs
some Granger-Causality tests to determine whether credit
aggregates or credit supply proxies are statistically more
significant predictors of future economic activity. Her
results tend to favor credit supply proxies. For the more
recent period, Mosser finds significant effects of credit sup
ply problems on commercial real estate activity and produc
ers’ durable equipment. In particular, the credit supply
proxy for small business seems to account for a consider
able part of the 1989-92 weakness in nonresidential con
struction and producers’ durable equipment. Even so,
Mosser argues that the weakness in these demand compo
nents relative to predictions based on normal historical
relationships cannot be fully explained by credit supply
problems. Doubtless, the widespread sluggishness of eco
nomic activity during 1989-92 reflected a broader set of fac
tors than just credit supply problems.
Construction activity
Harris, Boldin, and Flaherty investigate the effects of credit
supply problems on the real estate industry. Focusing on
the three construction industry sectors— single family
homes, multifamily housing, and nonresidential struc
tures—they provide a comprehensive review of credit and
noncredit factors underlying the recent decline in construc
tion activity. Overall, their study finds that credit supply
problems are likely to have played only a modest role in the
real estate contraction.
For single family housing, the authors begin by examin
ing predictions of housing activity from several standard
models that use mortgage rates, income, and other funda
mentals as explanatory variables. Since these models are
not able to predict the recent weakness in housing, the
authors search for an explanation by focusing on “special”
factors or other variables that have been left out of the mod
els. They argue that of the missing variables, demand-side
factors such as a generalized effort to reduce debt and an
adverse shift in investor psychology rather than narrowly
defined credit supply problems explain the bulk of unusual
weakness in housing. This view is consistent with the fact
that because of the mortgage-backed securities market
and other financial innovations, credit supply for home
mortgages has not experienced any significant problems.
The supply of loans to homebuilders has been constrained
significantly, but this appears not to have caused a perva
sive housing shortage. Even so, credit supply problems
may explain part of the recent weakness in housing activity
since without credit constraints, the housing supply would
have been larger and prices lower. More generally, given
the weakness of both credit demand and credit supply, the
identification problems make it difficult to rule out a signifi
cant role for credit supply difficulties.
Multifamily and nonresidential construction have de
clined greatly since 1989 and have remained the two weak
est sectors of the economy. According to the Harris/Boldin/
Flaherty study, overbuilding in the 1980s (together with the
resulting excess capacity) dominates the credit crunch as
an explanation for the collapse of activity in both sectors.
The study recognizes, however, that these sectors have
experienced credit supply problems and that the simultane
ous weakness in (and interaction between) credit demand
and credit supply makes it difficult to isolate the effect of
credit supply constraints. It is likely that in the absence of
credit supply constraints, the decline in the nonresidential
and multifamily sectors would have been more moderate.
Put differently, the credit crunch does not appear to be the
dominant cause of the collapse in construction activity, but
it may well have played some role in the timing and process
of decline.
Business activity excluding construction
The Steindel/Brauer study explores the consequences of
credit supply problems for business activity excluding con
struction. Overall, this study provides only limited support
for the view that credit supply problems impeded business
activity over 1989-92.
Steindel and Brauer consider five different types of evi
dence. First, they review recent movements in corporate,
noncorporate, and manufacturing activity, together with rel
evant credit flows. The review suggests that the sharp
slowdown in credit flows may have been a significant con
tributing factor to weakness in small business activity and
that such firms may have borne a disproportionate share of
the shortfall in both output and debt.
Second, the authors look at survey evidence on lending
to smaller firms and the connection between credit supply
proxies from other studies in this volume and noncorporate
business output. This survey evidence does point to a sig
nificant credit tightening which may have contributed to
weakness in small business activity.
Third, using detailed industry- and firm-level data, the
study compares activity for small and large businesses and
attempts to infer the role of credit in the recent weakness of
small business activity. The focus is on manufacturing busi
nesses, but the analysis does include some nonmanufac
turing establishments as well. In most cases, small busi
ness activity appears not to have shown any unusual
weakness relative to large business activity, and so, by in
ference, Steindel and Brauer do not find any more support
FRBNY Quarterly Review/Winter 1993-94
17
for the effect of credit supply problems on small businesses
than on large businesses. But with data on the relevant
credit flows unavailable, this type of evidence is entirely
indirect and does not necessarily contradict the view that
credit supply problems may have contributed to the slow
down in business activity over 1989-92.
A fourth type of evidence considered by Steindel and
Brauer focuses on indicators of financial strength. Again
using industry- and firm-level data, the authors explore the
role of financial factors in the recent weakness of business
activity by examining various measures of real economic
activity for financially “weak” and “strong” businesses. This
evidence is also indirect and yields mixed results.
Finally, using firm-level data, Steindel and Brauer per
form formal regression tests to look for the effect of size
and debt- to-asset ratios on employment, inventories, capi
tal spending, and spending on research and development
for various periods. Once again, the results are mixed.
Implications for Monetary Policy
In reviewing the implications of the credit crunch or credit
supply problems for monetary policy, this section focuses
on two related issues: implications of the credit crunch for
the impact of monetary policy actions on economic activity,
and consequences of credit supply problems for monetary
policy guides, M2, and other financial variables. The sec
tion begins with some background information on the main
features of the recent credit crunch and on the channels of
monetary policy influence on the economy.
Overview of credit supply problems
The evidence in this volume is consistent with the view that
credit supply problems contributed importantly to the credit
slowdown over 1989-92, although demand influences may
have dominated overall credit movements. The nature and
causes of the 1989-92 credit supply problems were signifi
cantly dissimilar to those of most earlier credit crunches.
The distinctive features of the most recent episode are
summarized below.
First, credit supply problems in the 1989-92 period were
widely spread across both bank and nonbank sources of
credit. As a result, unlike earlier credit crunches, nonfinan
cial borrowers were not able to substitute nonbank credit
freely for bank credit. In fact, finance companies, life insur
ance companies, and commercial paper issuance seem to
have experienced credit supply problems that were essen
tially similar to those of banks. Together with a broadly
based retrenchment in credit demand, credit supply prob
lems led to a sharp slowdown in all major components of
private debt flows.
Second, credit restraints during 1989-92 took the form
both of more stringent price terms— higher lending rates
relative to funding costs and tighter nonrate loan terms—
and of nonprice credit rationing. Although this phenomenon
18 FRBNY Quarterly Review/Winter 1993-94
is probably fairly typical of earlier credit crunches, the per
vasiveness of nonprice rationing and tighter loan terms
over an extended period of time in the recent credit crunch
is unusual. Earlier credit crunches were generally short
lived; the 1989-92 crunch period was characterized by per
sistently high spreads between lending rates and funding
costs, especially at depository institutions, increasingly
tighter credit standards for applications through much of
the credit crunch period, and continued stringent nonrate
terms on loans. These persistent credit restraints were
reflected, among other things, in large increases in hold
ings of government securities relative to loans at banks.
Third, significant evidence points to a capital crunch as
one of the major causes of credit supply problems over
1989-92. None of the earlier credit crunches were charac
terized by a widespread weakening of the capital positions
of banks and nonbank financial institutions. Broadly, the
actual or perceived capital crunch seems to have reflected
three underlying forces (in addition to the normal cyclical
effects): (1) the need to correct balance sheet problems
resulting from the lax lending standards that had prevailed
through much of the 1980s and had left balance sheets
badly exposed to asset prices and other shocks; (2)
increased capital requirements induced by legislative and
regulatory measures and by more intensive supervisory
oversight; and (3) the weakening of capital positions
reflecting declining real estate and other asset values start
ing about late 1988.
Fourth, market forces seem to have played a critical role
in generating the latest credit crunch. To be sure, as noted
above, regulatory measures and pressures contributed to
the actual or perceived capital crunch but, unlike earlier
credit crunches, the current episode emerged in an envi
ronment of accommodative monetary policy and declining
interest rates.
More fundamental to the process of credit slowdown
appears to have been the need to correct the debt excesses
of the mid-1980s, which had become unsustainable over
time. Faced with major balance sheet and other difficulties,
borrowers and lenders alike responded to market forces,
borrowers by lowering their credit demands and lenders by
reducing credit availability. In particular, the so-called credit
crumble phenomenon— the chain running from asset price
declines to capital position weakness to lower capacity and
willingness to lend— contributed importantly to the process
of credit slowdown.12 The role of market forces was rein
forced and perhaps intensified by the regulatory pressures
that highlighted prudential concerns about loan quality and
capital positions and argued for the need to strengthen
lenders’ balance sheets. The capital crunch itself was at
least partly a by-product of the correction process as weak
ening capital positions and mounting loan losses called
12 See Johnson (1991) for a detailed description of this phenomenon.
increasingly greater attention to the need for correction of
earlier debt excesses and for additional capital.
The accumulating loan losses, continuing balance sheet
problems, and full realization of the debt overhang also led
to more conservative lending attitudes—well beyond what
could be attributed to the measurable weakness in capital
positions— and to a complete reversal of the earlier lax
lending standards. To a considerable extent, the pervasive
ness of credit supply problems reflected the widespread
nature of the correction process, with both bank and non
bank creditors experiencing the need to improve loan qual
ity and repair their balance sheets.
Finally, the debt overhang correction process and its
conjunction with a prolonged cyclical weakness in the
economy made the already difficult task of distinguishing
credit supply malfunctions from credit demand factors even
more difficult. Both borrowers and lenders were deleverag
ing and restructuring their balance sheets in response to
earlier debt excesses and cyclical weakness. In the process,
credit demand and credit supply narrowed simultaneously,
but the drop in demand is likely to have overwhelmed the
fall in supply. As a consequence, it is very difficult, if not im
possible, to detect empirically the contribution of supplyside factors net of demand influences.
Channels of monetary policy influence
Monetary policy influences the economy through at least
four important channels: the money-interest rate channel
(or the “money” channel, as it is commonly known); the
credit channel; the asset valuations or balance sheet chan
nel; and the exchange rate channel.13 The discussion here
deals with only the first three, ignoring the exchange rate
channel. In the money-interest rate channel, as enshrined
in the standard IS-LM model, monetary policy affects
aggregate spending by raising or lowering the cost of funds
through changes in the supply of money relative to the
demand for money. Specifically, monetary policy actions—
open market operations and so forth— induce changes in
bank reserves, money, short-term interest rates and,
through substitution and expectational effects, long-term
interest rates. Higher (lower) interest rates, in turn, raise
(lower) the cost of funds, other things equal.
The credit channel, which may operate alongside the
money-interest rate channel, affects aggregate demand
through direct changes in the availability and terms of bank
loans. A tightening of monetary policy may reduce the sup
ply of bank loans through higher funding costs for banks or
13 A large number of theoretical and empirical studies on the transmission
of monetary policy influence to the economy have appeared since the
mid-1980s. For some recent discussions of various channels of
monetary policy, see Akhtar and Harris (1987), Bennett (1990),
Bernanke (1993), Bernanke and Blinder (1988, 1992), Bosworth (1989),
Friedman (1989), Gertler (1988), Gertler and Gilchrist (1992), Gertler
and Hubbard (1988), Mauskopf (1992), Mosser (1992), and Romer and
Romer (1993).
through increases in the perceived riskiness of bank loans.
Since the credit channel views bank loans as imperfect
substitutes for other assets in bank portfolios (government
securities, corporate bonds, commercial paper and the
like), monetary policy actions that reduce bank reserves
and, therefore, deposits will be matched by decreases in
both securities and bank loans. As a consequence, borrow
ers with no access to other sources of credit will be obliged
to reduce their spending, while others with nonbank
sources of credit, though less affected, will not be immune
to monetary policy influence as long as the alternative
sources of credit are more expensive or less convenient.
The asset valuations channel of monetary policy influ
ence on the economy works through changes in balance
sheet positions. Monetary policy actions that lower interest
rates, for example, tend to increase asset values and
improve liquidity for firms by lowering interest-to-cash flow
ratios. These balance sheet improvements, in turn, may
increase business spending by raising the availability of
internal funds and improving the access to and the terms
on external funds. Lower interest rates may also work to
improve household balance sheet positions through debt
restructuring and higher asset values, thereby increasing
the availability of funds for debt retirement and additional
spending. Note that the argument of this channel is that
interest rate changes may affect spending by weakening
(strengthening) balance sheets or wealth holdings, quite
apart from their effects on the cost of funds in the moneyinterest rate channel.
Effectiveness of monetary policy
Factors relating to the credit crunch seem to have created
significant blockages for the workings of all three channels
of monetary policy. Overall, the blockages are likely to have
muted the impact of monetary policy actions on economic
activity. The empirical size and significance of the block
ages are far from clear, however. Whether any of these
blockages will turn out to have permanent consequences for
the conduct of monetary policy is also not clear at this time.
The credit channel of monetary policy was seriously dis
rupted over 1989-92. With the decline in the willingness
and capacity of banks to lend, monetary policy actions
increasing bank reserves were not translated into addi
tional bank lending. Specifically, easing of monetary policy
apparently had very little impact on the supply of bank
loans over 1989-92. This view is clearly supported by
increasingly tighter credit standards, higher (or at least con
tinued high) lending rates relative to funding costs, and
restrictive nonrate loan terms. With nonbank credit sources
also experiencing supply disruptions, frustrated bank bor
rowers were not satisfied elsewhere. Much academic dis
cussion of the credit channel assumes that nonbank credit
alternatives are easily available to many (perhaps most)
borrowers. This view clearly runs counter to the recent
FRBNY Quarterly Review/Winter 1993-94
19
credit crunch experience. In fact, widespread nonbank
credit supply disruptions appear to have added substan
tially to the severity of the blockage in the credit channel.
The money-interest rate channel of monetary policy also
seems to have experienced some blockage during 198992. Policy-induced increases in bank reserves did translate
into lower short-term open market rates and faster growth
of narrow money, M1. But the response of long-term inter
est rates and broader monetary aggregates to policy
actions was very sluggish and weak throughout 1989-92.
The decline in credit supply, as shown in the Hilton/Lown
study, contributed importantly to slowing the growth of M2.
And presumably the shift in credit supply also played some
role in maintaining high long-term interest rates by putting
upward pressures on rates, other things equal. As a result,
monetary policy actions were less effective in lowering the
cost of capital, hampering the workings of the money-interest rate channel.
The process of correction for earlier debt excesses may
also have weakened the asset valuations or balance sheet
channel of monetary policy influence on the economy.
Given the actual or perceived need to correct the large debt
overhang, lower interest rates may not have induced much
additional spending by businesses and households be
cause the improvements in balance sheets and the under
lying asset values materialized only slowly. Put differently,
easier monetary policy as reflected in lower interest rates
may have encouraged households and businesses to
repair the perceived weakness in their balance sheets by
deleveraging and debt restructuring, without increasing
spending significantly.
While credit supply problems during 1989-92 may have
been important in reducing the effectiveness of monetary
policy, it is difficult to isolate their effects from those of a
broad range of other fundamental developments that are
likely to have disrupted, weakened, or changed the link
ages between monetary policy and economic activity.
Mosser discusses a number of these other fundamental
developments. Of the factors not directly related to the credit
crunch, the following appear to be particularly important:
• the response of long-term interest rates to short-term
open market rates may have been weakened by infla
tion fears or by a high level of investor uncertainty
stemming from large federal budget deficits;
• effects of lower interest rates may have been weak
ened by very high levels of real after-tax interest costs;
• looking from a longer term perspective, financial inno
vation and deregulation over the last two decades are
widely believed to have caused significant changes in
both the size and the speed of monetary policy effects
on various sectors of the economy.
Economic growth in recent years has also been re
Digitized for
20FRASER
FRBNY Quarterly Review/Winter 1993-94
strained by factors unrelated to both the credit crunch and
monetary policy transmission— relatively tight fiscal policy,
a military build-down, excess capacity in the construction
industry, and low levels of consumer and business confi
dence. It is difficult to control for these nonmonetary influ
ences in assessing the effectiveness of monetary policy.
Against this background, the quantitative significance of
the 1989-92 credit supply problems for the transmission
channels of monetary policy is far from clear. As reported
by Mosser, econometric forecasting equations, both
reduced-form and structural estimates from large models,
significantly overpredict real spending from 1989 to 1992.
This finding is consistent with the notion that monetary pol
icy actions have been less effective in recent years than in
the past. Presumably the overprediction reflects both the
credit crunch and other factors, however. Indeed, Mosser is
unable to account for all of the overpredictions by making
use of credit supply proxies. Moreover, the overpredictions
are not limited to sectors that are directly sensitive to mone
tary policy. Instead, they are widely spread across all sec
tors, suggesting a general malaise in aggregate demand
not captured by economic fundamentals.
Notwithstanding these measurement difficulties, credit
supply problems during 1989-92 are likely to have con
tributed to reducing the effectiveness of monetary policy.
Clearly, the credit crunch weakened the credit channel and
caused disruptions in credit flows, producing at least some
adverse consequences for economic activity. The credit
supply shifts are also likely to have hampered the workings
of the standard money-interest rate channel and possibly
to have weakened the balance sheet-related contribution
of lower interest rates to aggregate spending.
The long-term implications of the credit crunch for the
effectiveness of monetary policy are less clear. Recent
credit supply problems may well cause durable changes in
the workings of monetary policy transmission channels by
altering, for example, the relationship between changes in
monetary policy and bank loans, between bank loans and
deposit flows, and/or between debt and income.14 But such
an outcome is by no means certain. Moreover, with numer
ous other potential influences on the linkages between
monetary policy and economic activity, it may not be possi
ble to isolate any permanent traces of the recent credit
crunch on those linkages.
Monetary policy guides
Disruptions in the linkages between monetary policy and
the economy imply adverse consequences for the useful
ness of financial variables as monetary policy guides,
whether viewed as intermediate targets or simply as infor-
14 If, for example, the recent experience makes banks permanently more
risk averse in their lending, monetary policy effects on bank lending
would be smaller than before.
mation variables. The usefulness of any monetary policy
guide depends primarily on two considerations: the
strength and predictability of the relationship between the
guiding variable(s) and the ultimate objectives of price sta
bility and economic growth, and the ability of the Federal
Reserve to define, interpret, and control the guiding vari
able^).15 The recent credit crunch seems to have added to
problems on both counts.
Credit supply problems since 1989 have almost certainly
contributed to reducing the usefulness of M2 and M3 as
policy guides. Hilton and Lown argue that the reduced will
ingness of depositories to lend was an important factor
behind the weakness in deposits, although their work does
not fully isolate the effect of credit supply problems from
that of noncyclical credit demand factors. Specifically, the
authors point out that relatively high lending rates and the
pervasiveness of stringent nonrate loan terms and nonprice
credit rationing reduced the supply of credit and, together
with lower yields on deposits relative to alternative assets,
led to weak depository flows. Controlling for cyclical effects,
Hilton and Lown estimate that by the middle of 1992, the
credit slowdown had lowered M2 growth by about 10 per
cent. Their regression results indicate that the breakdown
of M2 demand equations is at least partially attributable to
the exceptional weakness in credit formation; the predictive
performance of M2 demand equations improves signifi
cantly when direct measures of credit or other factors cap
turing cutbacks in lending are included as explanatory
variables.
Credit supply malfunctions have also affected the rela
tionship between credit aggregates and the economy. None
of the studies in this volume is able to account for develop
ments in various credit measures— household, business,
bank and nonbank, and so forth— over 1989-92 by using
standard historical relations for macroeconomic variables.
Of course, the underlying relationships of credit and mone
tary aggregates to prices and economic activity have not
been particularly reliable during the last decade, even
before the emergence of recent credit supply problems.
The usefulness of interest rates as information variables
for monetary policy has also been adversely affected by the
credit crunch. With the pervasiveness of nonprice credit
rationing and stringent nonrate loan terms, changes in
open market rates have had a smaller impact on credit con
ditions and economic activity than would otherwise have
been the case. Put differently, disruptions in the credit mar
ket mechanisms have made past experience less pertinent
as a reference point for understanding the effects of recent
interest rate changes on credit conditions and the econ
omy. Similarly, to the extent that credit supply problems
influenced the yield curve and various interest rate
spreads— such as that between lending rates and funding
15 See Friedman (1993c) for a recent perspective on the role of financial
variables in guiding monetary policy.
costs or that between the (riskless) Treasury bill rate and
the (risky) commercial paper rate— all these variables
became less useful indicators, at least over 1989-92.
By reducing the information content of a broad range of
financial variables, the credit crunch has compounded the
problems of finding appropriate guides for steering mone
tary policy. More specifically, credit supply problems in
recent years have made it more difficult to use M2 or the
federal funds rate (or any other financial variable for that
matter) for determining appropriate money and credit con
ditions relative to the needs of the economy. Even before
the latest credit crunch, however, there was no significant
agreement on the use of any one or two variables as mone
tary policy guides. Thus, the recent experience with finan
cial sector developments seems to have moved us further
away from a narrow focus on one or two intermediate tar
gets toward the use of a broad set of financial indicators as
information variables to steer monetary policy.
Some concluding observations
Collectively, studies in this volume offer evidence of a sub
stantial, prolonged, and broad-based contraction in credit
supply over 1989-92. This finding strongly contradicts the
view that the recent credit slowdown originated solely on
the demand side.16 Research work reported here conclu
sively demonstrates that demand influences are unable to
explain a significant part of the recent credit slowdown or
decline in nonfinancial borrowings from bank and nonbank
sources. Moreover, the existence of credit weakness
across a wide range of nonfinancial borrowings also chal
lenges the notion that the recent credit slowdown was noth
ing more than the bursting of a speculative bubble in com
mercial real estate.17
The studies in this volume also indicate that the nature
and causes of the recent credit supply problems were
markedly different from those of earlier credit crunches. In
particular, unlike earlier crunches, the credit supply prob
lems during 1989-92 were broadly spread across both bank
and nonbank sources of credit, with stringent loan terms
and nonprice credit rationing persisting over a relatively
long period. Also, unlike earlier episodes, the recent credit
crunch was marked by a capital shortage and was driven to
an important degree by market forces. Set in motion by the
widespread balance sheet difficulties of both borrowers
and lenders, these market forces led to the correction
process for the debt overhang of the 1980s.
The sharp, prolonged, and widespread decline in credit
supply over 1989-92 would be expected to have had signif
icant adverse consequences for the economy. It is there
fore not surprising that the credit crunch has sometimes
16 See Meltzer (1991) and Klieson and Tatom (1992) for particularly strong
expressions of this view.
17 See, for example, Jordan (1992).
FRBNY Quarterly Review/Winter 1993-94
21
been blamed for much of the weakness in econom ic activity
since 1989. Yet the studies in the volume do not support
this conclusion. On the contrary, they clearly indicate that
credit supply problem s were not the prim ary or dom inant
cause of the w eakness in econom ic activity over 1989-92.
Nevertheless, the studies do suggest, at least collectively,
that credit constraints alm ost surely made some co n trib u
tion to that w eakness, and probably played a significant
role in slowing the econom y before the recession and in
impeding the recovery process.18
The apparent inconsistency between sharply reduced
credit availability and its m odest effects on econom ic activ
ity is not hard to reconcile. The credit crunch has by no
m eans been the only factor depressing the economy. O ther
factors that contributed significantly to the 1990-91 reces
sion and the subsequent w eak recovery include the Gulf
War, the defense build-down, relatively tight fiscal policy
throughout the period, generally high real long-term inter
est rates, low levels of consum er confidence, corporate
restructuring, and the com m ercial real estate depression
18 Perry and Schultz (1993) and Friedman (1993b) reach a roughly similar
conclusion.
that followed the great buildup of excess capacity during
the 1980s. W ith so many powerful forces slowing econom ic
activity in recent years, one can hardly expect the credit
supply problem s to dom inate the picture. M oreover, the
co n flu e n ce of w id e -ra n g in g a d ve rse in flu e nce s on e co
nomic activity and the m arket-driven elem ents in the credit
crunch make it difficult to isolate em pirically the effects of
credit constraints on the economy.
Finally, this collection of studies suggests that credit su p
ply problem s over 1989-92 contributed to w eakening the
influence of m onetary policy actions on the econom y and to
reducing the usefulness of M2 and other financial variables
as policy guides. W hether recent shifts in credit supply fa c
tors will have any long-term consequences fo r the conduct
o f m o n e ta ry p o lic y is fa r fro m c le a r, h o w e v e r. In th e
absence of further changes in the regulatory environm ent,
the long-term effect will depend to a considerable extent on
the durability of recent changes in attitudes tow ard debt on
the part of lenders and borrow ers— specifically, w hether
le n d e rs w ill c o n tin u e to fo llo w th e re c e n t ris k -a v e rs e
approach to lending and w hether the decline in the desired
ratio of debt to income will turn out to be perm anent. The
new co n se rva tive a ttitu d e tow ard d ebt m ay p ersist, but
such an outcom e is by no m eans certain.
References
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the Economy: A Empirical Analysis.” Federal Reserve Bank of New
York Quarterly Review, Winter 1987.
Cantor, Richard, and John Wenninger. “Perspective on the Credit
Slowdown.” Federal Reserve Bank of New York Quarterly Review,
Spring 1993.
Bennett, Paul. “The Influence of Financial Changes on Interest
Rates and Monetary Policy.” Federal Reserve Bank of New York
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Dwight, Jaffee, and Joseph Stiglitz. “Credit Rationing.” In Benjamin
Friedman and Frank Hahn, eds., Handbook of Monetary Econom
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Bernanke, Ben. “Credit in the Macroeconomy.” Federal Reserve
Bank of New York Quarterly Review, Spring 1993.
Friedman, Benjamin. “Changing Effects of Monetary Policy on
Real Economic Activity.” In Monetary Policy Issues in the 1990s.
Federal Reserve Bank of Kansas City, 1989.
Bernanke, Ben, and Cara Lown. “The Credit Crunch." Brookings
Papers on Economic Activity, 1992:2.
Bernanke, Ben, and Alan Blinder. “Credit, Money, and Aggregate
Demand.” American Economic Review, May 1988.
__________ . “The Federal Funds Rate and the Channels of Mone
tary Transmission.” American Economic Review, September 1992.
Bosworth, Barry. “Institutional Change and the Efficacy of Mone
tary Policy.” Brookings Papers on Economic Activity, 1989:1.
Cantor, Richard, and Rebecca Demsetz. “Securitization, Loan
Sales, and the Credit Slowdown.” Federal Reserve Bank of New
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__________ . “The Minsky Cycle in Action: But Why?” Federal
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__________ . Comments on “Was This Recession Different? Are
They All Different?” by George Perry and Charles Schultz. Brook
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_____
. “Ongoing Change in the U.S. Financial Markets:
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Frydl, Edward J. “Overhangs and Hangovers: Coping with the
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Gertler, Mark. “Financial Structure and Aggregate Economic Activ
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Owens, Raymond, and Stacey Schreft. “Identifying Credit
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Gertler, Mark, and Simon Gilchrist. “The Role of Credit Market
Imperfections in the Monetary Transmission Mechanism: Argu
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May 1992.
Peek, Joe, and Eric Rosengren. “Crunching the Recovery: Bank
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Gertler, Mark, and R. Glenn Hubbard. “Financial Factors in Busi
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Greenspan, Alan. Remarks at the 55th Annual Dinner of the Tax
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Johnson, Ronald. “The Bank Credit Crumble.” Federal Reserve
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Jordan, Jerry L. ‘The Credit Crunch: A Monetarist’s Perspective.”
Paper presented at the Annual Conference on Bank Structure and
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Kaufman, Henry. “Credit Crunches: The Deregulators Were
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Perry, George, and Charles Schultz. “Was This Recession Differ
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Rodrigues, Anthony. “Government Securities Investment of Com
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FRBNY Quarterly R eview /W inter 1 9 9 3 -9 4
23
International Interest Rate
Convergence: A Survey of the
Issues and Evidence
by Charles Pigott
The international integration of financial markets has
increased dramatically over the last two decades. Techno
logical advances and the progressive elimination of official
barriers to capital flows have spurred an enormous
increase in cross-border financial transactions and activi
ties and rapid growth in the Eurocurrency and other interna
tional financial markets. As a result, linkages among
national financial markets have been greatly strengthened,
and financial conditions in individual countries have
become increasingly sensitive to developments in the mar
kets of their partners.
It was widely expected that international financial inte
gration would also lead to convergence of interest rates
across countries, or at least to greater synchronization of
interest rate movements than in the past. In fact, however,
considerable international interest divergences have per
sisted across a broad spectrum of assets, even very
recently. Over the last two years, for example, domestic
short-term rates in the United States have fallen sharply
while those in Germany and other continental European
countries have remained at considerably higher levels.
This article examines why interest rates have apparently
failed to converge internationally. We first consider in con
ceptual terms what financial integration means for interest
rate relations in an international context. We then examine
the evidence on interest rate convergence and the circum
stances under which it has or has not occurred.
As we will see, the key feature distinguishing the interna
tional economy from a single country is the presence of
multiple currencies whose exchange rates are subject to
change. Interest rate convergence has several meanings in
this context. Where currency distinctions are absent, inte
Digitized for
24 FRASER
FRBNY Quarterly Review/Winter 1993-94
gration generally has led to interest rate convergence. But
where assets differ in their currency denomination, as they
typically do in comparisons of national interest rates, finan
cial integration does not imply convergence unless the eco
nomic conditions determining the rates become more
closely aligned and exchange rates are fixed, or nearly so.
In fact, the evidence strongly suggests that for countries
with flexible exchange rates, national interest rates have
varied nearly as freely with financial integration as earlier,
although with much greater repercussions on exchange
rates. There appears to be no systematic tendency for
cross-country disparities among either nominal or real
interest rates to decline, much less disappear — despite a
dramatic reduction in barriers to international capital flows.
The article examines one further concept of interest rate
convergence particularly relevant to international investors.
This is the extent to which national interest rate differentials
tend to be systematically offset by currency movements, so
that returns expressed in a common currency are equalized
on average. This seemingly simple and intuitive presump
tion has raised a number of somewhat complex, and to this
point largely unsettled, issues. Currency risks arising from
uncertainty about future exchange rates as well as system
atic errors made by investors in predicting currency move
ments can, and probably have, prevented full convergence
in this sense. However, the evidence suggests that these
considerations, at least as they are presently understood,
do not seem to provide an adequate explanation for the
large systematic return differentials among currencies that
are observed in practice. These findings raise questions
very similar to those long encountered in analyses of the
behavior of stock and bond returns within a single country.
The meaning of international financial integration
Complete integration of an economy’s financial markets
basically means that all participants have equal access to
all markets. Equal access implies that interest rate and
other terms faced by participants depend only on objective
indicators of creditworthiness such as financial position and
credit history— not on residence or nationality. Integration
allows portfolio diversification across markets and instru
ments; thus the tendency of investors to hold assets issued
in their own locale when markets are isolated is likely to be
substantially reduced, if not altogether eliminated, when
markets become integrated.
Financial integration within a single country, where all
assets are denominated in the same currency, affects the
behavior of interest rates in several important ways. First,
because integration allows arbitrage across markets,
returns on instruments with identical characteristics are
equalized regardless of where they are issued or traded.
For example, within the United States, regional interest dif
ferentials among comparable assets are quite small or neg
ligible in most cases. Second, and more generally, integra
tion is likely to lead to much greater synchronization of
interest rate movements across markets and to lower inter
est differentials among similar (though not necessarily
identical) assets. The basic reason is that with integration,
local differences in credit conditions tend to be largely elim
inated by flows of funds among markets. Thus, regional
fluctuations in real income, saving, or other determinants of
credit demands and supplies do not themselves lead to sig
nificant interest rate divergences, as they would if markets
were isolated. Instead, interest rates tend to vary with
national credit conditions as determined by real growth,
inflation, government fiscal positions, and other domestic
macroeconomic conditions. Reinforcing this tendency is
the fact that a single-currency economy sharply limits the
degree to which certain key interest rate determinants,
notably inflation, can differ among regions.
It follows that interest differentials within a single country
largely reflect differences in instrument characteristics
such as maturity, liquidity, and risks that are valued, or
priced, in the common national market. For example, inter
est rates on ten-year corporate and U.S. government
bonds move together quite closely over time, but the corpo
rate rate is typically greater by an amount that largely
reflects market perceptions about the risks of business
defaults.
Integration in the international economy
While the implications of financial integration for the inter
national economy are broadly similar to its implications for
a single country, the specific consequences for interest
rates are much less straightforward, for three reasons.
First, impediments to financial flows among nations arising
from overt restrictions on capital flows and from differing
tax laws, regulatory policies, and other institutional
arrangements typically far exceed the barriers that exist
among states, provinces, or regions of a single country.
Second (and substantially as a result of the first), key
instrument characteristics such as available maturities,
minimum denominations, and liquidity generally vary much
more across countries than within any single country.
Third, and most fundamentally, the international econ
omy is distinguished by the existence of multiple currencies
whose values are subject to change. Interest rate conver
gence in such an environment has two quite distinct, if
closely related, meanings. The first, the convergence of
national interest rates (as they are normally expressed),
involves a comparison of returns denominated in different
national monies: the quoted yields on U.S. and German
government bonds, for example, refer to their yields in
terms of dollars and German marks, respectively. Likewise,
comparisons of real interest rates across countries usually
involve returns expressed in terms of national commodity
bundles whose composition typically varies across coun
tries.1 For investors deciding how to allocate funds among
assets, however, it is the degree to which their prospective
relative returns expressed in a common currency converge
that matters. These relative returns are determined not only
by the national interest rates themselves but also by the
change in the relevant exchange rates over the investment
horizon: the dollar return on, say, a three-month German
mark-denominated asset depends upon the rate at which
marks can be exchanged for dollars at maturity.
Even with multiple currencies, linkages among markets
in a financially integrated international economy are no less
strong than within a single country. The connections are
more indirect, however, because the national markets are
linked through the markets for foreign exchange. This fact
would be of little practical consequence if exchange rates
were completely and irrevocably fixed. In that case, inte
gration would have virtually the same effects internationally
as within a single economy: national interest rates would
largely converge and their movements would be closely
synchronized; remaining interest differentials would be
determined by disparities in market and (noncurrency)
instrument characteristics rather than by macroeconomic
disparities among the countries.
In the actual world economy, however, exchange rates
are very seldom completely fixed. The fact that national
markets are linked through foreign exchange markets then
has two important practical consequences. First, dispari
ties in underlying determinants of national interest rates
can be, and generally are, much greater than within a sin
gle country. In particular, inflation rates can diverge indefi1 The U.S. real interest rate, typically defined as the nominal interest rate
less some measure of anticipated domestic inflation, is effectively a
return in terms of U.S. products, while German real interest rates
measure returns in German goods.
FRBNY Quarterly Review/Winter 1993-94
25
nitely provided that exchange rates can change to offset
the differences.
Second, divergences in macroeconomic forces typically
will lead to cross-country differences in national interest
rates when exchange rates are free to vary. In the world
economy, as in a single economy, a tightening of credit that
pushes up interest rates in one country’s markets tends to
attract funds from abroad. This inflow, however, first places
upward pressure on the home currency, raising its current
value above the level expected to prevail in the future (and
thus increasing the amount by which the currency is
expected to fall subsequently). If the home government
allows its exchange rate to float freely, this process will
continue until the currency’s prospective future decline is
sufficient to eliminate the incentive for funds to flow in —
leaving national interest rates both at home and abroad
largely unaffected.
In a variable exchange rate environment, therefore, dif
ferentials among national interest rates stem not only from
differences in their characteristics or imperfect integration
of the markets, but also from divergences in macroeco
nomic and other determinants and their interactions with
exchange rates. Disparities in economic conditions lead to
national interest rate differentials, which in turn reflect per
ceptions about the magnitude of, and (as we will see
shortly) the risk associated with, future currency move
ments.2 Financial integration, even if complete, need not
lead to interest rate convergence nor indeed to any
increased synchronization of national rate movements
across countries; interest differentials are likely to vary in
magnitude as their underlying determinants become more
or less aligned across countries. The main, and critically
important, effect of financial integration in this context is to
greatly increase the sensitivity of exchange rates to
national interest rate fluctuations: as explained earlier, inte
gration has meant that changes in a nation’s interest rates
relative to rates abroad lead to offsetting currency move
ments. The result is that financial developments in one
country tend to affect conditions in others through their
impact on foreign exchange markets.
Convergence in a common currency?
Although financial integration need not lead to equalization
of national interest rates, it might seem that it should result
in the convergence of returns expressed in a common cur
rency. This is true in a narrow sense: yields on otherwise
identical instruments whose returns are guaranteed by
hedging (“covering”) in forward foreign exchange markets
must be equalized with complete integration. In the
2 In effect, therefore, national interest differentials (aside from
characteristic differences and imperfect financial integration) can be
viewed as the proximate reflection of expected future exchange rate
changes and currency risks that, at least in principle, are ultimately
determined by divergences in countries’ fundamental interest rate
determinants.
Digitized for
26 FRASER
FRBNY Quarterly Review/Winter 1993-94
Eurocurrency markets, for example (where the instruments
are identical except for their currency), the dollar return on
a three-month German mark deposit whose proceeds at
maturity are covered through forward market sale (for dol
lars) is the same as that on a three-month dollar deposit.
Note, however, that hedging the mark asset amounts to its
redenomination in dollars (since the hedged instrument is a
fixed claim to future dollars); currency distinctions among
assets are effectively abolished in comparisons of their
covered returns. The sources of covered interest differen
tials therefore are the same as those present within a single
nation — barriers to financial flows across markets and dif
ferences in instrument characteristics.3
The broader and much more controversial question is
whether returns that are not hedged (in other words, that
are “uncovered” in the sense that they depend upon actual
exchange rate movements that cannot be fully predicted)
converge when expressed in a common currency. In practi
cal terms, this question amounts to asking whether
exchange rate movements tend on average to offset differ
ences in national interest rates on otherwise similar assets.
If so, investing in one currency as against another will pro
duce no systematic difference in realized returns, and
national interest rate differentials (apart from differences in
asset characteristics) will simply reflect market expecta
tions about future exchange rate movements. This principle
is commonly referred to as “uncovered interest parity.”
As explained further below, the degree to which uncov
ered interest parity holds in a practical sense depends pri
marily upon the importance of two factors. The first and,
until recently, the predominant focus of debates in this area
is the importance of the “currency risks” associated with
investing in one currency as opposed to another. Currency
risk in this context refers to the differential riskiness among
assets that arises from their denomination. To understand
what currency risk means, consider a U.S. investor who
holds two government bonds, one denominated in dollars
and the other in German marks. Both bonds are risky in that
their prices, in dollars and German marks, respectively, are
to some degree unpredictable; in addition, the return in dol
lars of the German mark bond depends upon future
exchange rate changes — which are also unpredictable.
The risks of the two bonds therefore are likely to differ,
3 Complete hedging is generally available only to fairly large market
participants and for fairly widely used or traded instruments. Moreover,
there are well-known factors other than unanticipated exchange rate
movements that may impair the liquidity or solvency of an instrument and
that tend to be currency-associated, including the possible default of a
government or government-guaranteed borrower on its external foreign
currency obligations (“sovereign" risk) and the potential inability of
private domestic entities to obtain foreign exchange to meet their
external obligations because of actual or prospective capital controls
(“transfer” and “political" risks). These risks are currency-associated
mainly because national authorities can regulate or otherwise impede the
convertibility of their national money. In this discussion, however, these
factors are treated as barriers to capital mobility or as sources of
differences in asset (noncurrency) characteristics.
most obviously (although, as we will see later, not entirely)
because of the uncertainty about exchange rates.
Currency risks are reflected (as “currency risk premia”) in
the uncovered returns that investors anticipate receiving in
a common currency; the corresponding national interest
differentials also incorporate these risks in addition to
expectations about future currency changes. As with any
other type of risk, the importance of currency risk depends
not upon the volatility of any particular currency when
viewed in isolation, but rather upon the extent to which
holding an asset denominated in one money as against
another contributes to the overall risk a typical investor
faces; thus, uncovered interest parity is likely to hold
exactly only if currency risks can be completely diversified,
that is, offset by other sources of risk. From this perspec
tive, the key question is not whether currency risk premia
exist at all (the considerable volatility of exchange rates
makes it very likely that they do) but how important they are
in practice. If representative investors view these risks as
comparatively large, there are likely to be significant aver
age differences in dollar returns from investing in one cur
rency relative to another.
Even if currency risks were quite small, however, com
mon currency returns could still differ considerably and sys
tematically for a second reason, namely biases in market
forecasts. Suppose, for example, that investors consis
tently underpredicted increases in the value of the German
mark versus the dollar during some period: mark-denomi
nated instruments would tend to outperform their dollardenominated counterparts even though the ex ante returns
anticipated by investors would be the same. Economists
have normally assumed that such biases are very small or
sporadic but, as we will see later, growing evidence sug
gests that they may be sizable and pervasive.
Evidence on the convergence of national interest
rates
There can be little doubt that the major financial markets of
the industrial countries have become much more closely
integrated over the last two decades. Official barriers to
capital flows have largely been eliminated by the industrial
countries and substantially reduced by many developing
nations. Larger financial institutions and nonfinancial cor
porations now have access to an array of international
financial markets with relatively low transactions costs, as
well as to major domestic markets of the larger countries;
portfolio diversification, particularly by banks and, in some
countries, by institutional investors, has increased markedly
since the late 1970s.4 International financial integration is
certainly not complete (indeed barely begun for markets
4 See Benzie (1992) for a detailed description and analysis of the
remarkable development of the international bond market during the
1980s. For an excellent analysis of the international diversification by
pension funds and insurance companies, see E. P. Davis (1988, 1991).
catering to smaller businesses and individuals), nor is it as
great as that found within the United States or most other
countries, but it is still considerable in economic terms.
Nonetheless, despite the obvious interdependence
among financial markets resulting from integration, national
interest rates, whether nominal or real, do not seem to have
converged in any very meaningful sense. Indeed, the
recent record is quite consistent with the conclusion of an
earlier study by Kasman and Pigott (1987) that the disper
sion in national interest rates fluctuates considerably over
time but without any systematic tendency to decline. At pre
sent, U.S. short-term interest rates are fairly close to those
of Japan but substantially below those in Germany, the
United Kingdom, and Canada; substantial gaps among the
countries’ long-term interest rates also remain. As Chart 1
shows, divergences among short-term interest rates are
now actually somewhat above their average of the last
twenty years, and while the dispersion in longer term rates
has declined over the last decade, it is still noticeably
higher than in the early 1970s.5
Although financial integration has led to no discernible
convergence of national interest rates, its effects are dra
matically manifest in covered interest differentials. As
explained earlier, these differentials largely reflect barriers
to capital flows and instrument characteristics rather than
currency distinctions and so provide a direct indicator of the
progress of integration. By this standard, the major short
term industrial country financial markets have become very
highly integrated: as Chart 2 indicates, covered interest
rate differentials among national money markets, which
were at times quite large during the 1970s, have largely dis
appeared, as have gaps between the domestic money mar
kets and the corresponding Eurocurrency markets.6 Analo
gous evidence suggests that integration has also increased
in the markets for longer term instruments, although the
5 Despite this evidence, some observers have argued that integration has
at least increased the synchronization of interest rate movements over
the last decade. Several studies, in fact, have reported that by some
measures, correlations between U.S. and foreign interest rates were
somewhat greater during the 1980s as a whole than in the 1970s; see,
for example, Frankel (1989) and the introduction to Bank for International
Settlements (1989). But other, equally plausible measures do not show
any consistent increase in this tendency (for example, see Kasman and
Pigott 1988), and in many cases national interest rates appear to have
been less synchronized during the latter 1980s than during much of the
1970s, when markets were presumably less integrated than now.
Variations in these correlations are more likely a reflection of changing
alignments among national economic conditions than a product of
financial integration.
6 Numerous studies have documented the decline in short-term interest
differentials resulting from the lowering of official capital controls,
beginning with the major industrial nations in the 1970s and early 1980s
and spreading to virtually all the industrial countries in the latter half of
the decade. Among the more extensive studies are Caramazza et al.
(1986) and Frankel (1988). In addition, Akhtar and Weiller (1987) and
Frankel (1990) provide excellent discussions of conceptual issues
concerning the definition and measurement of international capital
mobility.
FRBNY Quarterly Review/Winter 1993-94
27
change has been more recent and less com plete. In partic
ular, as shown in Table 1, hedged (dollar) returns on go v
ernm ent bonds are also now fairly closely aligned fo r at
least the major currencies.7
Financial integration thus has significantly altered the re l
ative importance of the factors underlying national interest
rate d iffe re n tia ls m entioned earlier. Institutional barriers
along with noncurrency instrum ent characteristics are now
a relatively m inor source of the divergences; national inter7 Long-term instruments can be hedged through currency and interest
rate swaps. The development of these facilities beginning in the mid1980s is itself a strong indication of the growing integration of major
bond markets. Popper (1990) was the first to use this data to
demonstrate the near-parity of hedged returns for such instruments.
est diffe re n tia ls reflect, nearly entirely, disp a ritie s in the
m acroeconom ic determ inants of interest rates and the cor
responding exchange rate m ovem ents they induce.8
Indeed, at least the broad m ovem ents in national rate d if
ferentials in recent years can be fairly plausibly explained
by fluctuations in real income, inflation, m onetary and fiscal
policies, and the changing alignm ent of these conditions
across countries. For exam ple, the largest divergences in
nominal interest rates, particularly longer term rates, have
tended to occur during periods of rising and relatively high
inflation such as the m id- and late 1970s and the early
8 Admittedly, heterogeneity of instrument characteristics is more important
for mortgages and other assets that are less standardized than typical
money market securities or government bonds.
Chart 1
Cross-Country Dispersion of National Interest Rates
Percent
/VV's
m S
jV"Jitf
11 \ AXV\A
j\
jM
JV\ir^Uv^ / /Vh
v/r \ r i' M
i
rji
ffv-v
’
,Ij W V
No minal Rates
Short-term rates
„
I I .I--I—--1-1-L_J--..i..i.i i.. i—i—i—i——i—i—I
—
Notes: Dispersion is calculated as the average absolute deviation from the country mean of each month. Short-term rates are the call money rate for
Japan and three-month money market rates for the United States, Canada, Germany, France, and the United Kingdom. Long-term rates are long-term
government bond yields for the above six countries plus Italy, Belgium, and Switzerland. The real short-term rate is the nominal rate less the inflation
rate over the last year; the real long-term rate is the nominal rate less the inflation rate over the last three years.
28 FRBNY Quarterly R eview /W inter 19 9 3 -9 4
1980s, largely because cross-country disparities in infla
tion, the stance of m onetary policy, and business cycle
positions have generally been greatest in these periods.
Likewise, the decline in long-term interest rate divergences
over much of the last decade can be attributed in large part
to the general fall (and convergence) of national inflation
rates during the same period.9
F urtherm ore, m ajor shifts in the a lignm ent of interest
rates across countries have usually been associated with
substantial m ovem ents in exchange rates. A dram atic illus
tration is the prolonged appreciation of the dollar accom pa
nying the rise in U.S. interest rates relative to rates abroad
during the first half of the 1980s.
The persistence of real interest rate differentials, while
more surprising to many observers, is also understandable
in these terms. As norm ally measured, the real interest rate
on a given country’s asset is effectively its return in term s of
some aggregate of com m odities produced or consum ed in
that country. The com position of these com m odity aggre9 These conclusions are also broadly consistent with more direct evidence
about the forces shaping domestic interest rates. This evidence
suggests on the whole that while the influence of international factors has
risen in some cases, traditional domestic macroeconomic factors remain
the most important determinants. For example, although international
factors may now have some modest influence, short-term interest rates
still appear to be largely determined by variations in the domestic supply
and demand for liquidity. See, for example, Radecki and Reinhart (1988).
There are reasons to believe that international factors may have
somewhat greater influence on long-term interest rates, but the evidence
is limited.
gates typically varies across countries because of the inclu
sion of nontraded goods and services and differences in
production and consum ption patterns. The belief that real
interest rates should converge internationally is based on
the presum ption that returns to capital will ultim ately be
eq ualized and th a t p u rchasing pow er p a rity de te rm in es
nominal exchange rates — conditions that are likely to hold,
if at all, only in the very long run. O ver the medium term,
Table 1
Covered Interest
Bonds
for Government
(Foreign minus U.S. Yield to Maturity)
Germany
Japan
Switzerland
Average
Standard
Deviation
-7 0
-4 6
18
15
42
19
Notes: Table reports the difference between the domestic (tenyear) yield to maturity on the foreign bond and the yield in the
same currency of a “sw apped” U.S. ten-year Treasury bond. The
differential com bines the applicable interest rate swap rate for tenyear Treasuries (that is, from ten-year fixed payments into floating
rate LIBOR payments in dollars) and the currency swap rate (from
floating LIBOR payments in dollars into ten-year fixed payments in
the relevant foreign currency).
All figures refer to averages for the period 1987-90.
.....Ill#
Chart 2
Covered interest Differentials
Domestic Three-Month Rates
Percent
Notes: Data are end-of-month. The three-month commercial paper rate is used for the United States. The foreign rates are three-month interbank
rates whose dollar returns are covered in the three-month forward exchange rate.
FRBNY Quarterly R eview /W inter 1 9 9 3 -9 4
29
real exchange rates have varied nearly as much as nominal
exchange rates. Long, variable, and persistent fluctuations
in real interest rates are quite consistent with this pattern,
as is the corresponding tendency for domestic real interest
rates to be the primary source of nominal interest rate
movements over similar intervals.10
Overall, therefore, actual experience is quite consistent
with the conceptual arguments presented earlier in this
article. Integration has had clear and dramatic effects,
most noticeably on covered interest rate differentials. Inte
gration has not, however, led to any appreciable conver
gence of national interest rates, because of the combina
tion of variable exchange rates and continued large
disparities among nations’ macroeconomic conditions that
has characterized the world economy for over twenty
years. Indeed, the experience of the European Monetary
System, which is summarized in the box, strongly sug
gests that only when exchange rates are very nearly fixed
and national macroeconomic policies are largely harmo
nized is integration likely to lead to any genuine conver
gence of national interest rates.
Uncovered interest parity?
While most investors and analysts have become quite
accustomed to large and persistent divergences among
national interest rates, there remains a very widespread
belief that these differences tend to be offset by currency
movements. Investing in one currency rather than another
may yield higher or lower returns at certain times, but,
according to this view, the returns should be equal on aver
age over longer periods. Some tendency toward this
“uncovered” interest parity is evident even when markets
are isolated: countries with high inflation rates tend to have
relatively high interest rates but also depreciating curren
cies. Moreover, as noted in the first section, currency-asso
ciated risks are likely to prevent uncovered returns from
being fully equalized even with complete integration.
Nonetheless, it seems plausible to assume that uncov
ered returns would be more closely aligned now that mar
kets are substantially more integrated and investors more
diversified internationally than they were in the 1960s or
1970s. As we will see shortly, however, it is far from clear
that this presumption is valid. Indeed, we will see that the
10 In most empirical models of the U.S. and other economies, fluctuations
in real income, inflation, and other macroeconomic determinants of
credit market demands and supplies produce substantial variations in
real interest rates. The corresponding international macroeconomic
models — of the type first introduced by Dornbusch (1976) — view
variations in real interest differentials across countries as a major, if not
dominant, source of real exchange rate fluctuations. In an empirical
analysis of several large industrial countries, Howe and Pigott (1992)
develop evidence suggesting that long-term real interest rates vary
substantially and are influenced both by persistent factors, such as
aggregate debt and returns to physical capital, and, in the mediumterm, by changes in macroeconomic policies. There is some evidence
(see Mishkin 1984) of long-run real interest rate convergence, however.
30 FRBNY Quarterly Review/Winter 1993-94
issues raised by empirical analyses in this area have
proved to be (at least by comparison with those encoun
tered in the last section) often complex and perplexing —
as well as substantially unresolved.
Historical evidence on uncovered interest parity
The historical record of return differences across curren
cies provides one very rough indication of the degree to
which uncovered yields have converged under financial
integration. Table 2 lists average ex post differential
returns, expressed in dollars, of foreign relative to U.S.
assets over five-year intervals for three types of instru
ments, namely short-term (three-month) money market
securities, longer term government bonds, and stocks.11 In
principle, these differentials reflect the returns anticipated
(ex ante) by investors as well as any errors made in fore
casting future exchange rates and the assets’ prices. The
differentials are often remarkably large. Indeed in certain
periods they appear (even for short-term assets) to be of
greater magnitude than the national interest rates them
selves. The return disparities are also highly variable: in
some periods, foreign assets strongly outperform their U.S.
counterparts, while in other periods, they underperform
them. (Partly as a consequence, average divergences over
decade intervals, as well as the entire period, are generally
smaller in magnitude than the five-year average.) And, of
most relevance here, the differentials seem to show no ten
dency to decline over time.12
While unexpected changes in currency and asset prices
are undoubtedly responsible for some portion of the
recorded divergences, a large and growing body of evidence
strongly suggests that they cannot be the only explanation.
If return differentials on comparable instruments result sim
ply from random and unbiased forecast errors, they ought to
vary randomly and average out to zero. Most evidence,
though, indicates that the divergences are larger than is
explainable by pure chance (that is, they are statistically sig
nificant). Moreover, variations in return differentials appear
to be systematic in the sense that they are at least partially
predictable. Several studies have found, for example, that
trading rules specifying when to invest or withdraw from one
currency or another tend to yield significantly greater returns
11 All data are computed from monthly holding period returns. The bond
return estimates are taken directly from Ibbotson and Siegal (1991) and
are based on long-term interest rate figures from the International
Monetary Fund’s International Financial Statistics. Note that the
corresponding instruments are almost certainly not as comparable as
those used for the data in Chart 1 and Table 1 (which generally are
available only for a much shorter period). The stock returns are derived
from aggregate stock price indexes and dividend-price ratios for the
major exchanges in each country.
12 Return differentials during the 1980s as a whole are smaller than during
the 1970s in slightly more than half the cases. More often than not,
however, the divergences in the three-month instruments and the bonds
recorded in the first half of the 1980s are greater than during either half
of the preceding decade.
Box: When exchange rate flexibility is limited
Because interest rates do diverge considerably when cur
rencies are relatively free to vary, a natural question is, what
happens when exchange rate flexibility is substantially lim
ited? Some light is shed on this question by the experience
of the members of the Exchange Rate Mechanism (ERM) of
the European Monetary System (EMS).
Until last fall, about half of the members (Germany,
France, Belgium, Denmark, Ireland, and the Netherlands)
limited their exchange rate movements to a band of 2.25
percent around the central parity; the remainder (Italy,
Spain, Portugal, Greece, and for most of its period of partic
ipation, the United Kingdom) adhered to 6 percent bands.*
The central parities have been changed several times since
the system’s inception in the late 1970s, although with
somewhat decreasing frequency up to the fall of 1992.
Moreover, capital controls among the members have been
removed gradually over a number of years—as early as the
mid-1970s in Germany and the United Kingdom but not until
the latter 1980s in several other countries.
As Chart 3 shows, interest rates among the ERM coun
tries have moved considerably closer, but only fairly
recently. Except for the Netherlands, short-term interest
rates did not achieve near-parity with Germany until about
1990. Most effective barriers to financial flows among these
markets were removed some years earlier, as indicated by
the fact that gaps between domestic money and Eurocur
rency rates were largely closed by 1986 for France, and well
before that for Belgium and the Netherlands. Moreover, it
was not until 1991, at the earliest, that any genuine align
ment of longer term rates occurred (again except for the
Netherlands, whose long rates have followed those of Ger
many for much of the 1980s).
This sequence of developments suggests that it was not
financial integration alone but rather the interaction of inte
gration, the exchange rate regime, and the evolution of
macroeconomic conditions that produced the gradual con
vergence of ERM interest rates. Given the margin for
exchange rate fluctuations within the system, substantial
divergences in shorter term interest rates are consistent
even with complete integration. For example, under the nar
rower bands, three-month interest rates can differ by as
much as 9 percentage points.* Even the larger divergences
among European rates in the mid-1980s were well within
such limits. The marked narrowing of the differentials in
recent years is substantially the result of changes in mon-
tary policy operating procedures: monetary authorities in
France and several other countries have chosen to keep
their official rates closely in line with those of Germany. This
shift has been prompted by the planned European Monetary
Union, but it is also reflective of the considerable conver
gence in macroeconomic conditions, particularly inflation,
that has occurred.5
5 For a useful recent analysis of interest rates in the ERM, see
Mizrach (1993).
Chart 3
Evolution of European Interest Rates
Percent
—
Tht ee-Month Interest RahiS
♦
%
United KingcJom
A *
%
0
*
\
o \ j
*
» ♦%
V *
V
*****
\
V ♦
\
F ra n c e
•
\
a
0
■
• > /
A /i
i
\ \
• w
N e th e r la n d s
'* A *
■**«P
Germany
III
l l l l l l l l l l l l l l l l l l l
111 1 1 111, 1,1 i l l 11,1, 1 1 1
-.........
II 1 1 1 111111
-..........
Lc>ng-Term Interest Rate
'ranee
/,**. \
United Kin gdom
>
*• «
-
-
-
• ,
9
-
\
" 'l
v **
V
/
Germany
\
Netherlands
* In addition, Austria, and more recently Sweden and Norway, have sought
to closely tie their currencies to the German mark even though they are
not formal members of the ERM.
* This figure corresponds to the annualized movement of a currency
across the full “width" of the permissible band. In practice, the maximum
possible interest differentials depend upon a currency’s position within
the band.
III
1980
lllllllllllllllllll
82
84
.lllllllllllllllllll
86
88
90
1111 1111 1111
92 93
Notes: The short-term rate is the three-month interbank rate;
the long-term rate is the government bond rate.
FRBNY Quarterly R eview /W inter 1 9 9 3 -9 4
31
B o x : W hen e x c h a n g e ra te fle x ib ility is lim ite d (C ontinued)
Such macroeconomic harmonization has contributed
even more to the convergence of longer term rates. In the
ERM, gaps among long-term rates p rim arily reflect
prospects that the central parities will be maintained over
the longer term, a virtually impossible feat unless inflation
rates remain equalized. Thus the near-equality of Dutch and
German long-term rates for most of the 1980s essentially
stemmed from the very close alignment of their inflation per
formances and policies. Also understandable in these terms
is the relatively late convergence of French with German
long-term interest rates: not until the end of the 1980s had
France’s underlying inflation rate clearly fallen into line with
that of Germany.
than sim ply holding a diversified portfolio of assets.13
Particularly rem arkable in this respect is an apparent te n
dency, first pointed out by Fama but since supported by
other studies, fo r returns on shorter term assets to rise
w hen the corresponding national interest rate differential
in c re a s e s .14 T hus, fo r exam ple, when G erm an national
in te re st rates rise relative to U.S. rates, realized d o lla r
returns on m a rk-den o m in a te d assets ty p ic a lly increase
also. This pattern is clearly inconsistent with uncovered
interest parity, w hich im plies that an increased Germ anU.S. interest rate gap should be fully offset (again on a ve r
age) by greater mark depreciation (or less appreciation).
Overall, the evidence indicates that financial integration
has not led to convergence of asset returns expressed in a
comm on currency. Indeed it is even unclear w hether in te
gration has produced any closer alignm ent of uncovered
returns. Instead we fin d a p p a re n tly siza b le sy s te m a tic
uncovered differentials w hose m agnitude and sign appear
to vary over time. To most observers, the most plausible
explanation of these patterns is currency risk. We will see,
however, that this explanation seems to be incom plete in
im portant respects.
A matter of risk?
We noted earlier that otherw ise identical assets denom i
nated in different currencies are inevitably subject to d iffe r
ent risks unless their exchange rates are com pletely fixed.
T ypically when any asset has an uncertain return, its inter13 Prominent examples are Dooley and Shafer (1983), Sweeney (1986),
and Levich and Thomas (1993). In general, the profits found under
these rules easily exceed the transactions costs incurred (by a large
investor) in their implementation.
14 See Fama (1985). Even more remarkable, the results suggest that a rise
in national interest rates in favor of a country is associated with an
appreciation of its currency (or a diminished rate of depreciation). More
generally, Fama’s findings and related results imply that variations in
national interest rates predominantly reflect changing risk premia.
32 FRBNY Quarterly R eview /W inter 1993-94
The record of the ERM thus indicates that under financial
integration, national interest rates probably would have con
verged had a completely fixed exchange rate system,
including the harmonization of policies required to sustain it,
been maintained. That same record also shows, however,
that even modest departures from completely fixed rates
can lead to very substantial interest rate divergences of a
magnitude and variability barely distinguishable from those
observed under floating exchange rates. The reason is that
interest rates, particularly longer term rates, are very sensi
tive to prospective disparities in economic conditions and
policies. Thus an option to depart from completely fixed
rates, however improbable or distant its exercise, may sus
tain considerable interest rate divergence.
est rate must incorporate a risk prem ium as com pensation.
From this perspective, system atic uncovered return diver
gences are the natural result of risk fa cto rs s p e cifica lly
associated with currency denom ination.
C u rre n cy risk is often vie w e d as sim p ly re fle c tiv e of
uncertainty about future exchange rates and in this respect
q u ite d is tin c t from risks m ore n o rm a lly e n co u n te re d in
dom estic markets. This view is misleading fo r at least two
reasons. First, as we have seen, when exchange rates are
va ria b le , the d e te rm in a n ts of in te re s t rates, and hence
dom estic asset prices, are likely to be only im perfectly co r
related across currencies. As our earlier exam ple of the
U.S. and Germ an bonds indicated, instrum ents d eno m i
nated in different currencies thus are subject to differing
risks from fluctuations in their dom estic price (price risk) in
a d d itio n to th e ris k s a ris in g d ire c tly fro m u n e x p e c te d
exchange rate movem ents.
Second, the factors underlying the risks associated with
foreign cu rre n cy a sse ts are not fu n d a m e n ta lly d iffe re n t
from those determ ining risks on dom estic instrum ents. Any
investor holding U.S. bonds or Japanese bonds, for exam
ple, has to consider the outlook for inflation, real growth,
and other factors in those countries that contribute to flu ctu
ations in the bond’s dom estic currency price. M oreover,
exchange rate m ovem ents, at least in principle, are de te r
mined by differences across countries in very much the
same set of underlying conditions. From this perspective,
the overall size of currency risk prem ia largely reflects the
extent to which the im portance of these standard d eterm i
nants differs am ong currencies — whether, for exam ple,
uncertainties about U.S. inflation are more or less im por
tant to investors than uncertainties about inflation in other
countries. Likewise, the risk prem ia are likely to change
o ve r tim e if and w hen the d e te rm in a n ts change. Thus,
assessing relative currency risks involves considerations
fairly sim ilar to those that have traditionally guided assess
ments of dom estic instrum ents.
Risk prem ia generally should decline with international
fin a n c ia l in te g ra tio n b e ca u se in te g ra tio n a llo w s m uch
greater risk diversification than is norm ally available from
holding dom estic assets only. The scope for such d iversifi
cation is greatest when exchange rates vary sim ply to o ff
set differences in national inflation rates. In that case the
relative risks of assets denom inated in different currencies
w ould be the sam e fo r all inve sto rs regardless of th e ir
nationality (that is, w hether returns are calculated in term s
of U.S. or foreign consum ption goods), and their portfolios
w ould be very sim ilar in com position. In reality, purchasing
power parity does not hold, except perhaps in the very long
run, and the variability of real exchange rates does reduce
the p o s s ib ilitie s fo r w o rth w h ile d iv e rs ific a tio n by g iving
d o m e stic in v e s to rs an e ffe c tiv e h a b ita t p re fe re n c e fo r
assets denom inated in th e ir own currency. T hat is, to a
German investor (one who assesses returns in term s of
German goods), dollar instrum ents appear to be substan
tially more risky than a German mark asset, while the oppo
site is the case fo r a U.S. investor. N onetheless, even
though real exchange rates have often been quite volatile,
much evidence suggests that investors can sig n ifica n tly
improve their tradeoff between risk and return by devoting a
significant portion of their holdings to foreign a sse ts.15
Most standard fram ew orks for assessing risk also sug
gest that currency-associated risk prem ia are likely to be
fairly modest. In the most w idely used approach, the risk
prem ium of any asset is proportional to its contribution to
the fluctuations in the value of the m arket portfolio as a
w h o le .16 From th is p e rs p e c tiv e , c u rre n c y flu c tu a tio n s
account for only a small fraction of the total risk facing a
typical investor; unforeseen fluctuations in dom estic asset
prices, for exam ple, generally are a much more im portant
15 Recent studies include Levich and Thomas (1993) and Tesar and
Warner (1992). Real exchange rate variability is probably one important
reason why the portfolios of even the most internationalized financial
institutions are far from fully diversified.
16 The framework is known as the “capital asset pricing model," first
developed by Sharpe (1964) and Lintner (1965). An individual asset’s
risk premium in this framework is proximately determined not only by the
asset’s own return volatility but also by its correlation with fluctuations in
the other asset prices. Both are determined by the fundamental
economic conditions prevailing during a given period and are subject to
change over time. Many extensions of this approach have been
developed, the most common of which bases asset risk premia on their
contribution to the variability of consumption rather than the market
portfolio's value.
Table 2
Foreign-U .S. Return Differentials in Dollars
(Annual Average Percentage Rates)
86-90
70-80
81-9(
-2.4
-7 .0
-9 .6
-11.7
17.8
-4 .9
7.2
6.9
8.7
10.3
-5 .0
4.6
-1 .0
3.6
2.5
2.1
—
-0 .2
2.4
-0 .2
-0 .7
-1.1
5.7
-0 .2
6.0
—
0
9.8
-7 .3
5.4
-8.1
6.6
-1 .5
-1 .2
-1.1
4.6
-5 .0
1.9
9.0
5.8
-1 .2
6.7
3.2
-6 .6
2.8
3.8
-10.9
10.5
-6 .6
4.2
3.6
2.2
-1 .2
5.7
1.0
11.0
2.3
17.4
-0 .8
14.9
-3 .7
-9.7
-10.0
-10.3
-6 .8
-4 .8
1.2
3.2
7.9
4.6
12.6
0.6
-0 .4
10.6
4.0
5.6
-2.1
9.1
-1 .0
-3.3
-1.1
-2 .9
2.9
-2.1
71-75
76-80
Short rates
Canada
Germany
France
United Kingdom
Italy
Japan
0.4
7.2
5.4
-1 .6
—
4.4
-2 .4
0.2
-0.1
5.8
11.3
6.2
Equity1
Canada
Germany
France
United Kingdom
Italy
Japan
0.5
—
4.6
-1 .2
-11.8
12.6
Bonds*
Canada
Germany
France
United Kingdom
Italy
Japan
-1 .8
10.1
5.7
-6 .2
-3.4
3.3
81-85
Note: Reported values represent the difference between foreign and U.S. average monthly returns, including reinvested earnings, expressed at
an annual rate.
t The 1970s periods are 1970-75, 1976-80, and 1970-80.
4: Figures are taken from Ibbotson and Siegal (1990).
FRBNY Quarterly R eview /W inter 1 9 9 3 -9 4
33
source. This point is illustrated in Table 3, which lists e sti
mates of the average (ex ante) differential between foreign
currency and U.S. dollar-denom inated bonds predicted for
the period 1978-91 on this basis.17 The differential returns
seem relatively m odest in m agnitude — between 1/4 and
slightly more than 1/2 of 1 percentage p oint.18
Limitations of the risk explanation
These estim ates suggest that currency-associated risk pre
mia based on econom ic fundam entals provide a plausible
explanation of w hy system atic return differentials exist and
w hy they m ight vary over time. At the same tim e, however,
em pirical analyses based on risk considerations have not
accounted satisfactorily fo r key aspects of observed return
differentials. The main problem is that even after the influ
ence of random fo re c a s t e rro rs is ta ke n in to a cc o u n t,
17 The model for these estimates extends the standard capital asset
pricing model to an international context and allows for the effects of
real exchange rate variability and differing investor consumption
preferences; see Lewis (1988). The estimates are derived from the
variances and correlations of (real) bond returns and exchange rates for
the period. Figures for different intervals will generally differ from those
in the table because of the differences in the distribution of the asset
returns. The framework used here is essentially the same as that used in
Hung, Pigott, and Rodrigues (1989) to estimate the potential effects of
the accumulation of U.S. debt to foreign countries.
18 By comparison, since the 1920s, the annual returns on U.S. common
stocks have exceeded the yield on U.S. Treasury bills by an average of
6 percentage points, while government bond yields have averaged
about 1 percentage point over the bill return (see Ibbotson 1992).
Nevertheless, differential returns are highly variable, even across
decades. The return differentials for short-term assets implied by this
analysis are even smaller than those shown in Table 3 since short-term
assets are largely free of price risk.
Table 3
Hypothetical Differential Currency Risk Premia
for Bonds
observed ex post return differentials (such as those shown
in Table 1) seem to be too large as well as too variable to
be explainable sim ply in term s of risk factors — at least as
they are understood by standard risk assessm ent fram e
works of the type used fo r the figures in Table 3 .19 Further
more, em pirical studies generally have had little success in
explaining observed uncovered return differences in term s
of the fundam ental econom ic factors thought to determ ine
asset risks.20
The shortcom ings of such approaches have led a num
ber of analysts to consider an alternative possibility, m en
tioned earlier: ex post return differentials am ong currencies
m a y re fle c t s y s te m a tic e rro rs in m a rk e t fo re c a s ts of
exchange rates and dom estic asset prices, and not sim ply
(or even prim arily) risk. Such errors could lead to system
atic d ive rg e n ce s in ex post returns even if the ex ante
returns expected by investors were equalized (that is, risk
prem ia were negligible). A lthough usually ruled out in fo r
m al e c o n o m ic a n a ly s e s , w h ic h ty p ic a lly a s s u m e th a t
expectations are rational and therefore unbiased, the view
that expectations are biased is not im plausible. Studies of
survey data on the forecasts of m arket participants and
analysts indicate that forecasts are generally biased, often
substantially so.21
Market survey data do not, however, support the notion
that expectations biases are the main reason fo r the large
system atic return differentials observed across countries. If
such biases were the reason, we w ould expect that antici
pated (ex ante) returns on com parable assets calculated
using survey data as a m easure of expected exchange rate
changes w ould be fairly small. In fact, as illustrated in Chart
3, this does not seem to be the case. The chart show s the
expected return differential, expressed in dollars, between
U.S. and foreign three-m onth E urocurrency deposits. The
d iffe re n tia ls are ca lcu la te d by su b tra ctin g th e expected
change in the relevant exchange rate, taken from a prom i
nent su rve y of m a rke t fo re c a s ts , from the U .S .-foreign
(Ex ante Return Differential for Foreign Relative to U.S.
Government Bonds)
Basis
Points
Canada
Germany
France
United Kingdom
Japan
-2 4
-6 0
-2 4
-2 4
24
Notes: Figures refer to the annualized differential ex ante yield of a
representative foreign government bond over a U.S. counterpart.
The estimates are averages for 1986-91 calculated from monthly
realized returns on a portfolio of bonds from seven industrial coun
tries (the above plus Belgium). The estimates are calibrated so
that the ex ante return on the aggregate (world) bond portfolio cor
responding to these figures is about 150 points above the U.S.
Treasury bill yield. For details of the model used for these calcula
tions, see Lewis (1988).
34 FRBNY Quarterly R eview /W inter 19 9 3 -9 4
19 Indeed, the Fama evidence cited earlier implies that risk premia, if
viewed as the sole source of observed uncovered return differentials,
are the dominant contributor to fluctuations in national short-term
interest rates. This implication is both remarkable and implausible; it is
hard to see why the normal determinants of domestic interest rates
should be so strongly associated with risk.
20 Generally, empirical applications of capital asset pricing models
(including consumption-based versions) have not been able to explain
observed return differentials either domestically or internationally, and
their underlying assumptions are quite often statistically rejected. See,
for example, Engle and Rodrigues (1989) and Lewis (1990). Moreover,
research to identify the underlying economic determinants of asset
price volatility, asset risks, and risk premia has barely begun.
21 Frankel and Froot (1989, 1990) and numerous subsequent papers have
demonstrated considerable biases in market forecasts of exchange
rates as measured by surveys. Forecasts over near-term horizons tend
to draw heavily on recent experience. Earlier studies have shown a
similar pattern in surveys of expected inflation.
interest rate d iffe re n tia l.22 The return differences, w hich
can be viewed as the risk prem ium between the dollar and
foreign currency assets that m arket investors expect to
receive, appear to be quite substantial, indeed com parable
in m agnitude and variability to the historical return d iffe re n
tials shown in Table 1. In short, the survey data (assum ing
they reasonably represent expectations) seem to confirm
the im pression from the ex post return data that investors
believe that substantial currency-associated risk prem ia
exist. But the question raised e a rlie r rem ains: W hy are
these apparent risk prem ia so large compared with those
predicted by standard theoretical fram ew orks?23
O verall, th e re fo re , u n c e rta in tie s rem ain a b o u t d iffe r
ences in uncovered returns among assets denom inated in
alternative currencies as well as the effects that financial
integration has had on these differences. Significant and
variable com m on-currency return divergences apparently
have persisted, but we cannot say to what degree currency
risk factors or m arket expectations are responsible, individ
ually or collectively, much less w hat the basic econom ic
determ inants of the divergences are.
Before closing, however, we note that these uncertainties
are not peculia r to intern a tio n a l com parisons or foreign
exchange markets. Systematic divergences among returns
on bonds, stocks, and indeed a wide range of assets have
long been observed in domestic markets in the United States
as well as abroad.24 Attempts to attribute these divergences
to risk or other factors have likewise met with only limited
success. As here, these divergences have suggested to
m any analysts tha t the determ ination of asset risks and
expectations may be much more com plex, and financial
markets much less “efficient,” than was previously thought.
Quite possibly, com plexities of this sort may be more im por
tant in international financial markets, given their shorter his
tory and more limited experience relative to domestic finan
cial markets, but they probably are not unique.
Conclusions
There can be little doubt that financial m arkets across the
Chart 4
Ex Ante Return Differentials in Dollars Implied by
Surveys of Market Expectations
Percent
United States versus Germany
j \
A
A
\ J
/ y
l \
I
/
U
W
\
/
\
. i l l
i !
\ J
v
on L m
1111111 i i
11 1 1 1 1 1 1 1 1 1
10
United States versus Japan
22 The premia shown are calculated as the difference between the threemonth U.S. and foreign interest rates for the date of the survey, less the
(consensus) expected dollar depreciation over the next three months.
The survey data are from Consensus Forecasts, various issues.
23 An alternative possibility is that deviations from uncovered interest parity
reflect market expectations about discrete events, such as major policy
shifts, that occur only infrequently but have large impacts on asset
prices if they materialize. (See, for example, Evans and Lewis 1992.)
The situation of the Mexican peso during the 1980s is often cited as an
example. Mexican rates were substantially above those for some time in
large part because of market perceptions that a devaluation was
inevitable. Thus, for a substantial interval before the actual devaluation,
dollar returns on peso-denominated instruments were consistently
higher than the returns on com parable U.S. alternatives. Deviations from
uncovered interest parity seem so pervasive, however, that such factors
could only be responsible in fairly isolated instances.
24 A provocative analysis by Cutler, Poterba, and Summers (1990) reveals
several stylized facts common to a wide range of asset markets,
including those for foreign exchange and those for art and other
collectibles. These facts are 1) systematic persistence of excess returns
over the near term, 2) some tendency for those returns to be reversed
(“mean reversion”) over longer periods, and 3) a tendency for actual
asset prices and returns to converge over the long run with the values
predicted by economic fundamentals (according to some model). The
latter two tendencies, however, appear to be considerably weaker than
the first.
*5
-15
-?5 L L I I I I I I I I I I _ u
1991
111J1.1L11
1992
i i I, i i J
1993
Notes: The ex ante dollar return difference is the U.S.-foreign
interest differential less the survey's consensus forecast of the
rate of dollar depreciation over the three months to maturity,
expressed at an annual rate. Interest rates are returns on threemonth Eurocurrency deposits. Market forecasts of currency
movements are from Consensus Forecasts.
FRBNY Quarterly R eview /W inter 1 9 9 3 -9 4
35
w orld have becom e highly interdependent. News a bout
conditions in one country’s markets typically has repercus
sions in foreign exchange m arkets and nearly as often in
the dom estic money, bond, and equity markets of the c o u n
try’s partners. So rapidly do these reactions am ong m ar
kets occur that an observer of their daily m ovem ents might
easily conclude that dom estic and foreign interest rates are
directly and very closely linked.
W e have seen that financial integration has indeed had
im portant and tangible effects on international interest rate
relations. Most obviously, integration has nearly elim inated
covered interest differentials among the m ajor m arkets of
the industrial countries.
But we have also seen that, largely because of the e xis
tence of multiple currencies with changeable relative v a l
ues, the effects of integration on the international econom y
are much less straightforw ard than they are within any sin
gle country. In the international environm ent, there are sev
eral distinct relations among interest rates that are jointly
determ ined by the currency regim e, m arket perceptions
about currency fluctuations, and countries’ m acroeconom ic
conditions. Localized fluctuations in credit dem ands or su p
plies th a t w ould be tra n sm itte d d ire ctly a cro ss m arkets
w ithin a single country are, in the international economy,
m ore o fte n th a n not s u b s ta n tia lly a b so rb e d in fo re ig n
exchange markets. Thus in principle— and as the evidence
review ed here stro n g ly suggests, in p ra c tic e — fin a n cial
integration need have little if any im pact on divergences
am ong natio n a l in te re s t rates, e xce p t w here e xchang e
rates are fixed or very nearly so.
Financial integration has also led to considerable interna
tional d ive rsifica tio n of financial holdings. It thus seem s
plausible to expect that national interest rate differentials
would tend to be offset by exchange rate changes, so that
average returns on com parable assets w ould be substan
tially if not com pletely equalized when expressed in a com
m on c u rre n c y . In fa c t, h o w e v e r, re tu rn d iffe r e n tia ls
recorded over the last two decades appear to have been
sizable and system atic. Little is yet known about the exact
nature of these differentials or how they are determ ined: in
particular, they seem to be too large and variable to be
explainable purely in term s of risk considerations — at least
as th e y are p re se n tly understood. T hese fin d in g s raise
questions about the form ation of in ve sto rs’ expectations
and the assessm ent of risk quite sim ilar to those encoun
tered in analyses of the term structure of interest rates or
the pricing of equities. Thus the issues posed by the inte r
national integration of financial markets, while new in cer
tain respects, are in others quite fam iliar.
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Countries: An Empirical Investigation of International Parity
Conditions.” Journal of Finance, vol. 39 (1984).
Mizrach, Bruce. “The ERM since Basle-Nyborg.” Federal
Reserve Bank of New York, unpublished paper, June 1993.
Popper, Helen. “International Capital Mobility: Direct Evi
dence from Long-Term Currency Swaps.” Board of Gover
nors of the Federal Reserve System, International Finance
Discussion Papers, no. 382, June 1990.
Radecki, Larry, and Vincent Reinhart. “The Globalization of
Financial Markets and the Effectiveness of Monetary Policy
Instruments.” Federal Reserve Bank of New York Quarterly
Review, Fall 1988.
Hung, Juann, Charles Pigott, and Anthony Rodrigues.
“Financial Implications of the U.S. External Deficit.” Federal
Reserve Bank of New York Quarterly Review, Winter-Spring
1989.
Sharpe, William F., “Capital Asset Prices: A Theory of Mar
ket Equilibrium under Conditions of Risk.” Journal of
Finance, vol. 19 (1964).
Ibbotson Associates. Stocks, Bonds, Bills and Inflation:
Market Results for 1926-91. Yearbook, 1992.
Sweeney, Richard J. “Beating the Foreign Exchange Mar
ket.” Journal of Finance, March 1986.
Ibbotson, Roger G., and Laurence B. Siegal. "The World
Bond Market: Market Values, Yields and Returns.” Journal
of Fixed Income Research, vol. 1 (1991).
Tesar, Linda, and Ingrid Warner. “Home Bias and the Glob
alization of Securities Markets.” National Bureau of Eco
nomic Research, Working Paper no. 4218, November 1992.
FRBNY Quarterly R eview / W inter 1 9 9 3 -9 4
37
Debt Reduction and Market
Reentry under the Brady Plan
by John Clark
In March 1989, U.S. Treasury Secretary Brady proposed a
new approach to resolving the developing country debt
problem and restoring the creditworthiness of restructuring
countries. From the outbreak of the debt crisis in mid-1982,
financial packages for restructuring countries had empha
sized new lending to give countries time to grow out of their
debt-servicing difficulties. However, seven years later, few
countries appeared close to returning to normal debt ser
vicing and financing was becoming progressively harder to
arrange. Drawing on banks’ and countries’ widening experi
ence with agreements to convert and reduce debt, Secre
tary Brady urged a shift in emphasis toward permanent
relief through market-based debt and debt service reduc
tion for countries adopting strong economic reform pro
grams. This article examines the impact of this new
approach on participating countries and their creditors.1
The agreements that followed the new approach pro
vided for long-term net cash flows broadly comparable to
the net flows previously achieved on a temporary basis
through new money packages. Thus, countries were
encouraged to embark on reform efforts by a new confi
dence that needed financial support would be available
over time. Moreover, by marshaling this support through
1 The analysis focuses on the experiences of eight middle-income
countries— Argentina, Brazil, Costa Rica, Mexico, Nigeria, the Philippines,
Uruguay, and Venezuela— that had obtained agreement to reduce their
bank debts by end-1992. Some comparisons are also made to Chile,
which significantly reduced its debt through market-based debt
conversions. Bank claims have been substantially reduced in several
other cases, but the affected claims accounted for a small portion of
these countries’ total indebtedness. For example, since 1988 five lowincome countries— Bolivia, Guyana, Mozambique, Niger, and Uganda—
have completed buybacks of their debts at steep discounts. These latter
operations were largely financed out of grants and concessional loans
from official creditors.
FRBNY Quarterly Review/Winter 1993-94
Digitized38
for FRASER
market-based debt reduction, the new approach contained
the growth in debt and fostered cooperation between
debtors and creditors. Nonetheless, the immediate benefits
to countries should not be exaggerated. The need to con
tinue reform efforts was underscored by countries’ ongoing
debt burdens, which remained heavy notwithstanding the
reductions in claims, and the persistence of deep discounts
on the countries’ external obligations immediately after the
restructurings. Indeed, for countries that in recent years
had unilaterally curtailed interest payments, such as
Argentina and Brazil, restoring normal relations with credi
tors through Brady restructurings required significant
increases in debt service payments.
The ultimate results of the change in approach have been
impressive. In particular, several countries that mounted
sustained reform efforts and reduced their debts have bene
fited from growing market access on improving terms.
Although stronger economic performance by debtors has
undoubtedly been the key to reopening market access, the
Brady operations catalyzed and accelerated this process.
Because the Brady agreements provided cash flow relief
over a longer time horizon than conventional restructuring
packages and insulated countries from possible future inter
est rate increases, the operations improved prospects for
breaking the cycle of continual renegotiation that impeded
capital flows under the previous approach. In the event,
lower global interest rates have made the Brady operations
more effective by giving countries additional cash flow relief
and encouraging investors seeking alternatives to low-yield
ing industrial country investments to reevaluate restructur
ing countries’ payment prospects.
The change in approach has also contributed to the
recovery in the secondary market value of creditor claims,
enhanced the claims’ liquidity, and helped create expanded
income opportunities in the secondary market trading of
restructured bank claims and the underwriting of securities
flows to restructuring countries. From mid-1988 until Febru
ary 1989, as the market’s confidence in the existing new
money approach waned, the price of claims in what
remained a fairly thin secondary market declined sharply.
In fact, the amount of debt reduced in relation to cash out
lays in the early Brady deals was broadly consistent with
what could have been achieved through a cash purchase at
these lower market prices. The subsequent substantial
appreciation of prices, which came with a lag, reflected the
market’s reassessment of the reinforced strategy’s overall
prospects for success in an environment of improved
macroeconomic performance by several countries as well
as lower global interest rates.
The Brady Plan and the evolving debt strategy
While reaffirming the basic tenets of the existing debt strat
egy—a case-by-case approach stressing reform by debtor
countries and financial support from private and official
creditors— the Brady Plan introduced important innova
tions. Tactically, the new approach emphasized using
financial incentives such as collateralized partial guaran
tees to encourage banks to provide financial relief. At the
strategic level, the new initiative completed an evolution
toward longer term horizons in bank debt restructuring
packages by emphasizing permanent relief through princi
pal write-downs and interest reductions.
The pre-Brady new money approach
When the debt crisis erupted, the international commu
nity— debtors, creditors, governments, central banks, and
international financial institutions— moved swiftly to avert a
systemic disruption of international trade and finance.2 The
strategy emphasized cooperation among debtors and cred
itors and timely financing to allow countries to reorient their
economies while remaining current on interest payments.
Banks rescheduled amortization payments falling due and
in arrears, maintained short-term credit lines, and in effect
partially refinanced interest obligations by extending new
loans. Multilateral creditors— initially the International Mon
etary Fund (IMF) and later the World Bank— increased their
lending. Countries tightened their belts by cutting public
investment and noninterest current expenditures and by
2 Worries about the international financial system grew out of the risks to
the international banking system posed by the high exposure to
developing country debt. For example, at the end of 1982, exposure to
restructuring developing-country borrowers equaled 215 percent of the
capital and 260 percent of the equity of the U.S. money center banks.
Many of the large regional banks also were heavily exposed, as were
leading banks of other industrial countries. For example, at the end of
1984 the less developed country exposures of the major banks of the
United Kingdom and Canada were about 275 percent and 195 percent of
equity, respectively; see David Mengle, “Update: Banks and LDC Debt,”
Morgan Guarantee Trust Co., Economic Research Note, May 1992.
devaluing their currencies and slashing imports.3
As restoring creditworthiness proved a time-consuming
process, the strategy adopted a progressively longer hori
zon. Debt packages became more comprehensive, often
restructuring the entire stock of medium-term bank debt
rather than just the obligations falling due in a one- to twoyear period. Repayment periods lengthened from around
eight years out to as much as twenty years, and interest
rate spreads narrowed to 13/16 of a percent over bank
funding costs.4 On the policy side, the emphasis broadened
under the “Baker Plan” to include structural reforms, such
as trade liberalization and tax reform, that were designed to
enhance countries’ longer term growth prospects.5 To sup
port faster growth, the Baker initiative also called for
increased official and commercial bank lending.
By 1989, this basic case-by-case approach had achieved
some measure of success. It had afforded banks the time
to increase their capital, thereby containing systemic
threats to the international financial system.6 In addition,
after peaking at mid-decade, most restructuring countries’
debt and debt service indicators had begun to decline
(Chart 1).
Nonetheless, important strains had emerged, leading to
deepening fatigue and frustration for both debtors and
creditors. The net cash drain on debtors remained burden
some and the goal of countries’ servicing their obligations
without further extraordinary financing arrangements
remained distant. While principal deferrals were longer,
relief from interest payments continued to be of short dura
tion because new loans covered a fraction of the interest
falling due only during a tw o-year period. Debtor
economies had grown disappointingly slowly and in many
cases policy reform had not been adequate. Rates of capi
tal formation had failed to recover from their sharp declines
at the onset of the crisis, and domestic investors continued
to express their lack of confidence by hoarding financial
3 Nonetheless, as a result of transfers of external debt obligations from the
private to the public sector and the public sector’s greater reliance on
more expensive internal financing following the cutoff of international
bank lending, overall deficits declined by less than the improvements in
the noninterest balances of the central governments. For a review of
fiscal adjustment by several major debtors, see William Easterly, “Fiscal
Adjustment and Deficit Financing during the Debt Crisis," in Ishrat Husain
and Ishac Diwan, eds., Dealing with the Debt Crisis (Washington D.C.:
World Bank, 1989).
4 Reschedulings at the onset of the debt crisis typically entailed spreads
over LIBOR ranging between VA and 2 / percent.
5 This adaptation of the official strategy, emphasizing growth-oriented
reform and new lending, was adopted along lines suggested by United
States Treasury Secretary Baker during presentations at the October
1985 annual meetings of the World Bank and IMF, and hence was named
the “Baker Plan.”
6 By end-1988, U.S. money center banks’ exposure to restructuring
countries in relation to capital had been cut by more than half, to about
95 percent.
FRBNY Quarterly Review/Winter 1993-94
39
assets abroad. The growing liabilities of international banks
to depositors from restructuring countries partly indicate
the extent of this capital flight (C hart 2).
A t the sam e tim e, on the fin a n cin g side, new m oney
packages becam e increasingly difficult to arrange. The new
money approach relied on banks to act in their collective
interest even though, individually, banks m ight have pre
ferred to “free ride”— that is, to benefit from the financial
packages by receiving interest payments w ithout providing
new money. The approach was successful so long as the
contradiction betw een co lle ctive and individual interests
was not too severe. However, as the m arket’s confidence in
the prevailing strategy tum bled— as revealed by secondary
m arket discounts that w idened from one-third at end-1986
to an average of tw o-thirds by early 1989— disbursing cash
in return fo r uncertain loan claim s appeared ever more
unattractive.7 The slide in secondary market prices in part
reflected co u n trie s’ uneven econom ic perform ances and
the souring of the general atm osphere that followed some
c o u n trie s’ im positions of unilateral paym ents m oratoria.
M o re o ve r, th e s tre n g th e n in g of bank b a la n c e s h e e ts ,
including increased loa n -lo ss provisioning by the m ajor
banks, reduced the adverse consequences of tem porary
paym ent interruptions and allowed banks to take a harder
line in negotiations.8 This tension between stronger coun
tervailing individual interests and weakened perceptions of
collective interest produced a growing num ber of free riders
and in cre a sin g ly con stra in e d the fe a sib le fin a n cing that
could be raised through new money.
W hile ever more banks resisted new lending, at least
some banks were willing to sell their claim s. By 1987 most
m ajor debtors had instituted conversion schem es under
w hich foreign debt could be exchanged for local currency to
make direct or portfolio investm ents. Some banks directly
transform ed th e ir loan claim s into equity stakes in local
businesses; others sold their claim s at a discount for cash
to foreign or local investors who in turn undertook the co n
version. Debt retirem ents under ongoing official debt co n
version schem es rose from a total of $3.7 billion in 1984-86
8 When exposure was high in relation to banks’ capital, banks had
stronger incentives to cooperate with the debtor to prevent the loan
from lapsing into nonperforming status. Analyses of the rationale for and
drawbacks of the new money process can be found in William Cline,
International D ebt and the Stability of the World Economy (Washington,
D.C.: Institute for International Economics, 1983); and Paul Krugman,
“Private Capital Flows to Problem Debtors," in Jeffrey Sachs, ed.,
Developing Country Debt and Economic Performance (Chicago:
University of Chicago Press, 1989).
7 This concept of cost, based on the difference between the amount of new
money disbursed and the expected future receipts associated with the
new claim, did not necessarily accord with the “accounting cost” of
providing new money. The regulatory authorities of some creditor
countries required banks to establish reserves against their new money
loans. Even where such provisioning requirements did not exist, however,
new money could be perceived as lowering shareholder wealth if free
riding presented a viable alternative.
Chart 2
Cross-Border Liabilities of International Banks to
Nonbank Depositors from Selected
Restructuring Countries
Billions of U.S. dollars
80----------- —-----------------------------------------------------Volume at End of Period
Chart 1
Evolution of the External Debt Burden of Selected
Developing Countries, 1981-89
70
60
Percent
400 ............................................................................ .... ..
External Debt as a Percentage of Exports of
Goods and Services
_
50
300
40
Group of fifteen heavily
indebted countries*
30
200
20
......................
100
................
Countries without recent
debt-servicing difficulties
I
°
I
1981
I
82
I
83
I
84
10
I
85
I
86
87
1..1
J
88
89
Source: International Monetary Fund, World Economic Outlook.
* Argentina, Brazil, Bolivia, Chile, Colombia, Cote d'Ivoire, Ecuador,
Mexico, Morocco, Nigeria, Peru, the Philippines, Uruguay,
Venezuela, and Yugoslavia.
FRBNY Quarterly R eview /W inter 1 993-94
Digitized 40
for FRASER
0
1981
82
83
84
85
86
87
88
89
90
91
92
Source: International Monetary Fund, International Financial
Statistics.
Note: The selected restructuring countries are Argentina, Brazil,
Chile, Mexico, and Venezuela.
to $4.7 billion in 1987 and $8.8 billion in 1988.9 In one
important transaction in 1988, Mexico used its reserves to
finance a debt-for-debt exchange in which $3.7 billion of
bank loans were swapped for $2.6 billion of partially collat
eralized twenty-year bonds.10 In addition, large amounts of
cross-border debt were extinguished through unofficial
conversions, particularly in Mexico and Brazil.11 These lat
ter transactions usually involved direct negotiations
between corporations and their foreign bank creditors.
Nonetheless, despite the demonstrated increased willing
ness of banks to sell, debtor countries became increasingly
disenchanted.12 The burden of essentially prepaying exter
nal debt at a discount proved difficult for fiscal and mone
tary authorities to manage. Concerns about possible
adverse inflationary or balance-of-payments impacts led
many countries to suspend or curtail their official programs
by early 1989.
The Brady Plan
The need for a new, more comprehensive, and longer last
ing approach was widely appreciated.13 Against this back
ground, Secretary Brady proposed a shift in emphasis
toward permanent relief through market-based debt and
debt service reduction. Instead of providing new money,
9 Charles Collyns and others, Private Market Financing for Developing
Countries (Washington D.C.: International Monetary Fund, December
1992).
10 In some other notable experiments in 1988, Venezuela’s bank creditors
disbursed $100 million in cash and swapped $400 million of loans for
$500 million of new securities, and banks exchanged $1.1 billion of
loans for an equivalent amount of uncollateralized “exit" bonds carrying
a 6 percent fixed interest rate as part of the financial package for Brazil.
Most of the experiments of 1987-88 were less successful than countries
had hoped. However, the lessons of these experiments were later
applied to the Brady restructurings.
11 Eli Remolona and Paul DiLeo estimate that $11.4 billion of Brazilian and
Mexican debts were canceled through informal conversions in 1987-88
(“Voluntary Conversions of LDC Debt,” in Kate Phylaktis and Mahmood
Pradhan, eds., International Finance and the Less Developed Countries
[London: MacMillan, 1989], p. 75).
12 Major U.S. banks initially remained on the sidelines. However, following
the increases in reserves against developing country debt by money
center banks in 1987, several U.S. money center banks became more
active. For example, Citibank reported in 1989 that it had reduced
cross-border exposure to developing countries by some $2.4 billion at
an average discount of about one-third. Regulatory changes that
allowed U.S. banks to take larger equity shares in companies as a
result of debt conversions also facilitated greater participation. See
Mark Allen and others, International Capital Markets: Developments
and Prospects (Washington D.C.: International Monetary Fund, April
1989).
13 By the eve of Secretary Brady’s speech, many prominent individuals
and politicians had made public proposals for new approaches
involving elements of debt reduction. Included in this group were
French President Mitterand and Japanese Finance Minister Miyazawa.
Moreover, in 1988 the U.S. Congress had directed the Treasury to study
the feasibility of creating an international debt management authority to
purchase the bank debts of developing countries in the secondary
market and to pass the discount along to the debtors.
banks would voluntarily reduce their claims on the debtor
countries in return for credit enhancements on their remain
ing exposure, such as collateral accounts to guarantee the
principal and/or interest in a bond exchange, or cash pay
ments in the context of buybacks.
To support countries’ economic reform programs and
help debtors make the required up-front cash outlays for
the debt operations, official creditors would provide finan
cial assistance. Under the strategy, reforming countries
would continue to benefit from loans from the IMF and
World Bank, reschedulings from Paris Club creditors, and
loans and loan guarantees from government agencies.
However, a portion of the loans from the Fund and Bank
would be set aside specifically to finance operations involv
ing debt reduction. Additional Fund and Bank financing
could also be made available to fund interest guarantees.14
To receive such support, countries would need to adopt
strong policies to ensure that they would be able to service
their reduced debt burdens. Measures to promote domestic
savings and the repatriation of flight capital, such as remov
ing interest rate controls, received particular emphasis. In
addition, countries would be encouraged to maintain ongo
ing debt conversion schemes to provide additional relief.
By offering individual banks direct financial incentives,
such as collateralized guarantees, to provide the targeted
levels of financial relief, the new approach addressed the
contradiction between individual and collective interests
that had increasingly troubled its predecessor. Whereas
high discounts and increased capital levels had worked
against the new money strategy, they actually supported
the new approach. High discounts allowed limited amounts
of public moneys to “buy” a higher targeted level of cash
flow relief, while strengthened capital and reserves allowed
banks to take the hit on their balance sheets.
The new plan in action: the menu approach
In implementing the Brady approach, countries and bank
steering committees negotiated comprehensive packages
that offered “menus” of debt and debt service reduction
options. These menus, which differed in their details from
case to case, gave banks a range of choices that varied
from as few as two to as many as six.
From the debtors’ perspective, these packages were
equivalent in impact to a combination of a partial debt buy
back at market prices and a restructuring of the remain
der.15 The restructurings usually securitized the claims—
that is, converted the form of the claims from loans to
14 The distinctions between the uses of “set-asides" and “additional
financing" were relaxed in January 1994.
15 The first debt package for the Philippines, completed in 1990 and
involving a buyback and new money, differed from other Brady
packages in that it deferred the handling of the remaining exposure
to a subsequent operation. The second stage was completed three
years later.
FRBNY Quarterly Review/Winter 1993-94
41
bonds—and lengthened the repayment periods, sometimes
to as much as thirty years. Much of the remaining exposure
(about half in total) was converted from floating to fixed rate
obligations.
For the banks, the Brady operations offered complex
ranges of options designed to accommodate banks’
diverse needs and expectations (Chart 3 ).16 At one
extreme, some menus included buyback options—that is,
outright sales of bank claims at a discount for cash— that
enabled well-provisioned, pessimistic, or risk-averse banks
to exit completely. At the other extreme, new money/debt
conversion options permitted banks to exempt their existing
exposure from debt and debt service reduction and usually
to convert the exposure into a security, provided that they
disbursed fresh money. Such financing in turn helped coun
tries replenish reserves used to finance the up-front costs
of debt reduction options chosen by other banks. Although
the disbursement of new money for risky bonds was costly,
some optimistic banks were attracted to the possibility of
capital gains on their base exposure. Such gains might be
anticipated because of securitization or because the debt
reduction agreed to by others decreased competing claims.
Banks valued securitization because it imparted greater liq
uidity to their claims. In addition, since securitized claims
would be more widely held, a future restructuring would be
more difficult to organize and hence less likely.17
Discount and par exchanges, which combined elements
of both a buyback and a restructuring, proved the most
popular options (Chart 3). Creditors swapped existing loans
for new bonds with a lower principal amount (discount
exchange) or with the same principal but submarket, fixed
interest rates (par exchange). Instead of receiving cash as
in a buyback, creditors benefited from the attachment of
irrevocable collateral accounts to the securities. Most com
monly, the principal would be fully secured by zero coupon
U.S. Treasury bonds, and the next twelve to eighteen
months of interest payments would be backed by escrowed
high-grade short-term securities.18 If the country remained
current on interest, the interest guarantee would roll for
ward, covering the next twelve- to eighteen-month period,
but usually the interest earnings from the escrow account
would return to the debtor.19 Altogether, par and discount
exchanges reduced banks’ economic exposure by the pre
sent value of the outright interest or principal reduction plus
the present value of any principal or interest guarantees.
For the debtor, the collateral accounts also effectively
reduced the burden of the debt because expected rebates
of interest and later principal from the accounts would
eventually cover the cost of funding the collateral
accounts.20 By contrast, in the case of a simple buyback,
there would be no prospect of future rebates; a country’s
debt would merely decline by the amount of debt purchased
and increase by the borrowings to finance the operation.
Par and discount exchanges generally entailed lower
cash outlays in relation to exposure reduction than did buy
backs or secondary market sales.21 Many banks were
nonetheless attracted to bond exchanges rather than out
right sales because of the upside potential on the remaining
exposure— again owing to securitization and the reduction
in claims. Relative to new money/debt conversion options,
bond exchanges held the additional attraction for banks of
concentrating remaining unsecured exposure into interest
claims, which were less commonly rescheduled than amor
tization obligations. Against this, par and discount ex
changes required a longer maturity for the remaining expo
sure than debt conversion options and usually involved
registered rather than bearer securities.
16 The range of options has varied across packages from just two for
Argentina (par and/or discount exchanges) and Costa Rica (buyback
and/or par exchange) to as many as six (Brazil). All packages have
included at least one bond exchange option. Buybacks were included in
all packages except those for Argentina, Brazil, and Mexico. New money
options were omitted in the Argentina, Costa Rica, Dominican Republic,
and Jordan agreements. More information on the structure of individual
agreements and bank choices may be found in World Bank, World Debt
Tables, various issues, and Collyns and others, Private Market Financing
for Developing Countries, 1992 and 1993.
20 Usually with collateralized guarantees, as the country serviced its debt it
would receive rebates of interest earned by the interest collateral
account; at maturity the country would also receive the principal and
accrued interest in the principal collateral account and the collateral
deposited in the interest account. The rebates of course would be
expected to equal in present value the money originally borrowed or
drawn from reserves and deposited in the accounts. Hence, the gross
debt reduction achieved through, say, a discount exchange would
typically be equal to the discount times the exchanged debt plus the
present value of the expected rebates, while the net debt reduction
(which takes into account financing costs) would be equal to just the
discount. For a further discussion of guarantee structures and the
concepts of gross and net debt reduction, see John Clark, “Evaluation of
Debt Exchanges," IMF Working Paper 90/9, 1990.
17 Against this view, it could be argued that the difficulty of rescheduling
widely held bonds would make debtors' future cash flow problems more
difficult to resolve and would increase the likelihood of default should
difficulties arise. Some advocates for securitization pointed to
restructuring countries’ record of regularly servicing their bonds
throughout the 1980s as evidence that the new securities would be
serviced better than the previous loans. However, this argument ignores
the likelihood that the privileged servicing record of bonds has owed
more to their small share of total debt than to their actual form.
42 FRASER
FRBNY Quarterly Review/Winter 1993-94
Digitized for
18 The amounts deposited in the interest guarantee accounts varied from 7
to 13 percent of the expected present value of the interest streams on
the bonds, depending on the number of months covered and the interest
rates involved.
19 Temporary interest reduction bonds differed in that the interest would
cumulate in the interest collateral account. When the temporary interest
reduction expired after about six years, the collateral and accrued
interest would be returned to the debtor.
21 As shown in Collyns and others, Private Market Financing for Developing
Countries, pp. 12-13, the ratio of collateral costs to exposure reduction
was generally slightly lower for par and discount exchanges than
prevailing secondary market prices. In contrast, buybacks took place at
the prevailing price.
U niform ity and diversity in terms
Brady packages have shown tendencies toward both uni
form ity in the design of som e aspects of individual options
and a tailoring to countries’ individual needs. On the one
hand, the discount and par exchanges, the prim ary debt
re d uction ve h icle s fo r the pa cka g e s of the fo u r largest
debtors, generally kept the extent of principal or interest
rate reductions at about o n e -th ird because banks were
u n w illin g to g ra n t te rm s m o re fa v o r a b le th a n th o s e
accorded M exico.22 The lone exception was the discount
exchange for Bulgaria agreed upon in principle in N ovem
ber 1993; the agreed term s in this case specified a discount
of one half. On the other hand, through differing degrees of
22 The par exchange for Mexico, whose terms were agreed to in July 1989
while LIBOR stood at 8.81 percent and thirty-year Treasury bonds were
yielding 8.14 percent, specified a fixed interest rate of 6.25 percent.
Reflecting subsequent movements in the yield curve, some later
agreements have specified initial coupon rates as low as 4 percent,
which gradually rise to levels similar to those negotiated with Mexico.
Chart 3
Principal Restructuring Options in a Brady Menu
Original Payment Obligation
9%
Menu Option
Immediate Payment or Enhancement
Residual Payment Obligation
Buyback
Cash payment
None
Par exchange
Prepayment of principal and
9 to 12% of remaining interest;
securitization of remaining obligations
Fixed interest stream, usually at a
rate of about 6.25%, less rebate
received by debtor of earnings on
interest collateral account *
Discount exchange
Prepayment of principal and
7 to 13% of remaining interest;
securitization of remaining obligations
Floating interest stream at a rate of
LIBOR + 13/16 on a reduced (by 30-35%)
principal amount, less rebate received by
debtor of earnings on interest
collateral account
Temporary interest
reduction exchange
Prepayment of about 10% of
remaining interest; securitization
of remaining obligations
Rising submarket fixed interest stream,
switching to LIBOR + 13/16 after 5-6 years;
amortization of principal t
Debt conversion/
new money
Securitization of remaining obligations
(new loans equal to about one-fifth
of base exposure)**
Interest of LIBOR + 7/8
+ amortization of principal
46%
Source: Federal Resen/e Bank of New York staff estimates.
Notes: Most menus did not include the full range of options. Several packages provided for the refinancing of outstanding overdue interest at market
rates following an initial cash down payment. Percentages show proportion of aggregate principal allocated to each menu option for agreements
concluded by mid-1993. Countries also achieved debt relief through debt conversions. These conversions took place before and after the Brady
operations but were not part of the menu in a Brady exchange.
* Initial interest rates were sometimes lower (for example, 4 percent for Argentina), reflecting the shape of the yield curve at the time of agreement in
principle.
t Rates reflected term structure at the time of agreement in principle.
* * The Mexican new money option did not entail securitization of the base. The Brazilian agreement provides for an interest capitalization option in
addition to a debt conversion/new money option.
FRBNY Quarterly R eview /W inter 1 9 9 3 -9 4
43
Chart 4
Buyback Equivalent Prices of Brady Packages
Cents per dollar of contractual claim
6 0 -------------------------------------------------------------------------------------
10
20
30
40
50
Average secondary market price prevailing from
March 1989 until agreement in principle
Sources: Salomon Brothers and Federal Reserve Bank of
New York staff estimates.
Notes: The buyback equivalent price is the price at which the
same amount of cash could have purchased an equivalent
amount of debt reduction through a buyback. It is calculated as
the ratio of the actual cost of the package to the amount of gross
debt reduction achieved. The gross debt reduction comprises the
outright principal reduction through buybacks and discount
exchanges, the present value of interest reduction on par
exchanges, and effective prepayments of principal and interest
through collateral accounts.
The solid line plots the results of a cross-sectional
regression of the buyback equivalent prices (BEP) on the price of
the Mexican agreement (Mexican BEP) and the secondary
market price for each country's debt during the period of
negotiations (Avg Price). T-statistics are shown in parentheses:
BEP=
0.77 (Avg Price) + 0.29 (Mexican BEP) + u.
(6.06)
(2.07)
R2 = 0.78
This regression suggests that the price of a Brady deal can
be expected to reflect a weighted average of the secondary
market price prevailing during negotiations (3/4 weight) and the
price established for Mexico (1/4 weight).
* The buyback equivalent prices for Argentina and Costa Rica do
not reflect down payments made at closing against interest
arrears. Inclusion of these costs would raise the Argentina price
by around 5 cents and the Costa Rica price by about 2 cents.
t The estimated price for Brazil reflects bank choices among
options and interest rates prevailing in July 1992, when the terms
of the package were agreed upon in principle. The actual cost of
the package may be higher because long-term interest rates
have subsequently declined, raising the cost of thirty-year zero
coupon bonds.
FRBNY Quarterly R eview /W inter 1 9 9 3 -9 4
Digitized 44
for FRASER
60
collateralization, effective pricing varied in a m anner corre
lated with the differing secondary m arket discounts prevail
ing before the deals (C hart 4). For example, Argentina and
Brazil collateralized only tw elve months of interest w hile
M exico collateralized eighteen; likewise, C osta Rica did not
guarantee the principal on its par bonds. In addition, the
range of options included varied from package to package,
reflecting the circum stances of particular cases. In particu
lar, sm aller debtors were able to achieve higher percentage
reductions in claim s payable to banks by securing a greater
role for buybacks.23
In many cases, countries were slow to im plem ent and
sustain policy changes th a t w ould provide the basis for
needed o fficia l fin a n cia l support. In a d d ition , the richer
menu of options made negotiations more com plex, particu
larly when precedents did not yet exist or countries tried to
vary from the precedents. In cases where significant inte r
est arrears had accum ulated, agreem ent on the level of
paym ents to banks ahead of com pletion of the debt pack
age often presented a key hurdle. Moreover, reconciling
o verdue in te re st claim s proved arduous. As a result of
these fa cto rs, im plem enting the new stra te g y has been
tim e consum ing. Still, progress has been steady and com
prehensive packages have been com pleted for eight coun
tries: Mexico, C osta Rica, and V enezuela in 1990; Uruguay
in 1991; N igeria and the P hilippines in 1992; A rgentina in
April 1993; and Jordan in Decem ber 1993. Also in 1993
banks form ally com m itted to participate in the package for
Brazil and agreem ents in principle w ere reached fo r the
Dominican Republic and Bulgaria. Altogether, the first ten
of these m iddle-incom e countries account fo r about fourfifths of all bank claim s on countries that had encountered
debt-servicing d ifficulties at the start of the last decade.
D iscussions are in progress in a num ber of other cases,
including Poland, Peru, Ecuador, and Panam a.24
A dvantages a nd disadvantages o f the m enu approach
The menu approach encouraged nearly universal participa
tio n and helped co u n trie s m axim ize the d ebt reduction
achieved with a given am ount of collateral resources by
allowing banks to choose options that best fit their particu
lar tax, regulatory, and accounting situations, as well as
23 Countries could encourage more banks to choose the buyback by
offering a relatively attractive price. Costa Rica’s Brady agreement was
contingent on banks' offering at least 60 percent of their aggregate
exposure to the buyback option. To encourage individual banks to
tender at least 60 percent of their claims to the buyback option, Costa
Rica offered more attractive terms, in the form of guarantees and shorter
maturities, on the remaining exposure of banks that met that threshold.
24 Not all countries with recent bank debt-servicing difficulties have sought
Brady-type restructurings. Among the countries targeted for special
attention under the Baker initiative, Chile has achieved a more
manageable debt profile through debt conversions that canceled much
of the country's medium-term debt, while Colombia and Morocco have
refinanced principal without reducing debt.
their views on interest rates and the countries’ prospects.
N onetheless, for countries, the approach introduced uncer
tainty as to the overall cost and impact of the packages. For
example, if banks allocated too much exposure to the debt
reduction options, the cost m ight exceed available fin a n c
ing, whereas if banks opted excessively for new money, the
country might not achieve its debt reduction objectives. In
this context, par and discount exchanges were often a ttra c
tive to countries because they em bodied in one option an
ou tcom e close to the ove ra ll d e sire d mix, and th e re b y
reduced uncertainty surrounding the overall im pact of the
package.
In addition to the above uncertainties, allowing banks to
choose among options proved costly to countries when the
external environm ent changed between the tim e of agree
ment on a menu and the actual selection of options. This
com plication reflected the convention, still observed, of fix
ing the interest rates and guarantees at the tim e of agree
ment in principle rather than indexing them to m ovem ents
in m arket rates before the com pletion of the deal. As a
result, m ovem ents in rates could shift the overall pricing
and also favor some options over others. This problem did
not arise with the early bank packages but em erged as an
im portant issue for A rgentina and Brazil, which saw a fall in
long-term interest rates follow ing agreem ent in principle
with banks on a restructuring menu. These declines, to the
extent they were unhedged, increased the cost of the T rea
sury zero coupon bonds used to secure the Brady bonds’
principal, raising collateral costs for both the par and d is
count bonds. The cost increase was more pronounced for
the par bonds because they had a larger principal am ount
to be secured. In addition, when the gap narrowed between
m arket rates and the agreed fixed rates for the par bonds,
banks stron gly preferred the par option, w hich becam e
more costly for the debtors. In both cases the countries
sought a “ rebalancing” or reallocation of choices away from
the unexpectedly less concessional par exchange.
Financing
The debt operations entailed large up-front cash outlays for
buybacks, collateral purchases fo r the bond exchanges,
and in som e cases dow n paym ents on arrears. O fficial
sources provided the bulk of the financing of these costs for
the seven operations that have been com pleted.25 In partic
ular, three-fifths of the overall financing came from official
sources, although in every case the debtor also made a sig
nificant contribution (Table 1). However, fo r M exico, the
P h ilip p in e s, and V e n ezue la , new m oney c o m m itte d by
b anks e ffe c tiv e ly co ve re d a s u b s ta n tia l p o rtio n of the
debtors’ share of the financing burden. Interpretation of the
fin a n c in g of the A rg e n tin e p a ck a g e is m ore co m p le x .
Although A rgentina did not receive new money, banks refi
nanced accum ulated interest arrears. H ence, to a large
extent the resources th a t A rgentina is expected to con
tribute are the coun te rp a rt of e a rlie r unpaid interest. To
date, only the financing for N igeria’s debt operation breaks
with the prevailing pattern. N igeria received neither new
m oney nor direct official financial support.26
D ebt conversions
As noted above, the revised official strategy encouraged
the m aintenance of debt conversion schem es.27 In n e g oti
ating th e ir debt packages, m ost countries agreed to m ain
tain or reestablish debt conversion schem es and to carry
out an agreed m inim um level of conversions. In contrast
with the Brady packages, w hich w ere concerted o p e ra
tions that dealt w ith all the debt at one go on preset term s,
these co n ve rsio n s w ere u su a lly sm a lle r scale, ongoing
operations that involved auction m echanism s. O verall, the
pace of conversions did accelerate after 1989, with some
$28 b illio n in cla im s c o n ve rte d u n d e r o ffic ia l schem es
from 1989 thro u g h 1992. For m ost countries, how ever,
these debt co nversions played a sm aller, com plem entary
role to the B rady p ackages in reducing c o u n trie s ’ debt
26 Under the Nigeria agreement, since all debt service arrears were to be
eliminated before the closing, no effective financing was achieved
through arrears.
27 The IMF and World Bank guidelines on support for debt and debt
service reduction explicitly endorsed the existence of debt equity swap
programs as a useful step in encouraging investment. Banks pressed
strongly for debt conversion schemes, reflecting beliefs that such
programs enhanced the value and liquidity of their claims.
Table 1
Financing for Debt Reduction Packages
Billions of Dollars
Own
Total Cost
Official
of Operation Support1 Reserves
IVICI1lUl dl iUUIIl.
New Money from
Commercial Banks
7.12
0.22
2.38
0.46
1.70
1.80
3.64
5.33
0.18
1.46
0.06
0.00
0.88
2.53
1.79
0.04
0.92
0.40
1.70
0.92
1.12
1.20
0.09
—
0.85
—
Total
17.32
(as a percentage
of total cost) (100.0)
10.44
6.89
3.23
(60.3)
(39.8)
(18.7)
Mexico
Costa Rica*
Venezuela
Uruguay
Nigeria
Philippines
Argentina*
1.09
—
in c lu d e s disbursements of parallel financing from Japan
Eximbank. Although not directly tied to debt reduction, this financ
ing supported the programs of several countries that com pleted
debt packages.
♦Includes down payments made at closing against interest
25 Most of the operations involving middle-income countries were directly
or indirectly financed with loans or reserves; grants have more
commonly been used to finance operations for low-income countries.
FRBNY Quarterly R eview /W inter 1 9 9 3 -9 4
45
service burdens (Table 2).
The principal exceptions to this rule have been Chile and
Argentina, w hich account for about three-fifths of the debt
converted under official schem es since 1989. For Chile,
debt-equity conversions constituted the prim ary m eans of
reducing debt ow ed to banks, although som e debt was
re d u c e d th ro u g h b u y b a c k s in 1 9 8 8 a n d 1 9 8 9 . F o r
Argentina, debt conversions ahead of its Brady operation
were an integral part of the country’s overall debt reduction
strategy. From 1990 onward these conversions consisted
entirely of exchanges of debt for equity in privatized firms.
T he re d u ctio n in b ank cla im s th ro u g h such o p e ra tio n s
exceeded th a t achieved th rough the d ebt package and
more than offset the $8 billion accum ulation of bank debt
from 1988-92 stem m ing from interest arrears.
Impact on countries’ debt and debt service burdens
T he B rady o p e ra tio n s gave c o u n trie s a leg up in th e ir
efforts to surm ount the ir debt-servicing difficulties. E ssen
tially the operations provided perm anent cash flow relief on
a sca le c o m p a ra b le to th e te m p o ra ry re lie f p re v io u s ly
achieved through new money packages. N onetheless, sig
nificant debt service obligations remained, to other cre d i
tors as well as to banks, so that debtors had to continue to
pursue sound econom ic policies to service the rem aining
debt and maintain growth.
Reduction in debt service obligations
The seven Brady Plan operations com pleted to date are
e x p e c te d to c a n c e l d e b t s e rv ic e o b lig a tio n s w ith an
expected present value of roughly $50 billion, or about onethird of the eligible bank debt (Table 2). The expected per
centage reductions in the present value of gross claim s
payable to banks have differed across cases, from a low of
about three-tenths for Venezuela and A rgentina to about
four-fifths for C osta Rica and N igeria.28 W ith the com pletion
of the Brazil package, the present value of obligations ca n
celed is expected to rise to about $65 billion.
Com parison o f changes in debt stock a nd d ebt service
obligations
The stock of debt to banks, however, will decrease by a
much sm aller am ount. R oughly th re e -fifth s of the gross
reduction in debt service burdens is expected through in ter
est rate reductions on par exchanges and effective prepay28 The gross reduction in claims payable to banks might alternatively be
called the gross reduction in bank exposure. It measures the partial
effect of those features of the packages that reduce debt and debt
service; it does not include the increases in debt to banks through new
money. It is the sum of the reduction in principal through discount
exchanges and buybacks, the present value of debt service reduction
on the reduced interest par bonds, and the prepayment of principal and
interest through collateral accounts. The present value of the interest
reduction is an ex ante calculation based on the long-term interest rates
prevailing when agreement in principle was reached.
U B illiliiil
Table 2
ll& tH i
. I
Debt Reduction through Concerted Bank Packages
Gross Reduction in Claims
Payable to Banks1
Net Debt Reduction*
as a Percentage of:
Memorandum:
Debt Retired under
Official Debt Conversion
Schemes5
(Billions of Dollars)
Billions
of Dollars
Percent
of Eligible
Bank Debt11
GDP
(1991)
Exports
(1991)
Total
External Debt
(1989)
1984-92
1989-9;
Mexico
Costa Rica
Venezuela
Uruguay
Nigeria
Philippines
Argentina
Braziltt
Chile
21.1
1.2
6.4
0.9
4.3
3.7
10.5
16.0
N.A.
43.5
75.0
32.1
55.3
79.6
57.8
36.7
27.1
N.A.
5.1
13.5
7.5
4.7
8.2
4.2
5.3
2.8
N.A.
30.8
43.0
21.6
18.1
19.4
13.0
46.3
32.1
N.A.
14.6
25.2
12.2
10.3
8.1
6.8
10.5
10.1
N.A.
7.3
0.3
1.7
0.2
0.8
3.2
12.9
5.2
11.4
3.1
0.2
1.6
0.1
0.8
2.6
11.3
1.3
5.2
Total/(average)n
64.0
(38.2)
(4.8)
(30.6)
(11.8)
43.0
26.1
Sources: International Monetary Fund; World Bank; Federal Reserve Bank of New York staff estimates.
f Principal reduction through discount exchanges and buybacks, present value of reduction in interest rates on interest reduction bonds, and prepay
ments of principal and interest through collateral accounts.
*Gross reduction in claims payable to banks less the cost of financing the operation.
in c lu d e s the 1988 Mexican collateralized bond exchange but excludes estimates of unofficial debt conversions.
flAs a percentage of public sector medium-term bank debt, including interest arrears, at the time of the operation.
™Author's estimate, based on banks’ latest allocation among eligible options
**Averages are weighted by shares in total bank debt as of en d-1986.
46FRASER
FRBNY Quarterly R eview /W inter 1 9 9 3 -9 4
Digitized for
m ents of principal and interest through collateral accounts,
that is, operations that reduce the present value of debt
service but not the stock of debt (Chart 5). The impact on
total debt stocks is even sm aller than the direct reduction in
bank debt because of new borrowing to finance the o pera
tions.29 For exam ple, because they involve loans to finance
the collateral accounts, par exchanges a ctually increase
the stock of debt even though they fix interest rates below
prevailing m arket rates.
Cash flow im pacts
A lth o u g h the B rady o p e ra tio n s c a n c e le d a s ig n ific a n t
amount of claims, they did not necessarily directly provide
countries with more cash to finance growth and investm ent
than did the previous approach. Recall that under the new
money approach, banks often effectively refinanced a por
tion of the interest due by extending new loans. Moreover,
some countries forced an even greater degree of cash flow
relief by instituting unilateral partial or com plete m oratoria
on interest payments.
In fact, the Brady operations on average tended to leave
net transfers largely unchanged. This observation is borne
out by a com parison of the absolute levels of net financial
flow s (debt service actually paid less disbursem ents from
banks) during the Baker plan period and before and after
the Brady operations (Table 3 ).30 These calculations also
re fle ct the co m p le m e n ta ry im pact of debt c a n c e lla tio n s
under debt conversion schem es as well as the level and
structure of interest rates at the tim e of each agreem ent.
Net cash flow im pacts have varied, however, fo r the d if
ferent countries. C ountries that were paying full interest
before their Brady deals, that is, countries not benefiting
from new m oney loans nor incurring arrears, achieved the
largest expected savings in cash outflows. In contrast, for
Argentina and Brazil, restoring normal relations with credi
to rs th ro u g h B ra d y re s tru c tu rin g s re q u ire d s ig n ific a n t
increases in debt service paym ents. The agreem ents pro
vided for net paym ents that were expected to rise over time
to levels com parable to those of the e a rlie r B aker plan
period.31 For Mexico, which had benefited from large new
m oney packages in 1983, 1984, and 1987, projected debt
service paym ents after the Brady operation were slightly
higher than the average net paym ents made in 1986-88 but
lower than those made in the years im m ediately following
the onset of the crisis.
The Brady operations departed more strikingly from the
previous new m oney approach by greatly extending the
tim e horizon of contractual relief. A com parison of M exico’s
net debt service obligations on restructured principal result
ing from the financial packages of 1983, 1986, and 1989
shows the lowering and flattening of contractual obligations
(Chart 6). C om pared with the earlier agreem ents, the Brady
packages su b sta n tia lly reduced the likelihood of fu rth er
rescheduling or new m oney requests. Thus they enhanced
countries’ access to the international capital markets, fu r
ther improving their net cash flow.
Implications of declining U.S. interest rates
The central goal of the Brady operations w as to reduce
Footnote 31 continued
accruals. In addition, full interest has been paid on 1989-90 interest
arrears refinanced in 1992.
Chart 5
Reduction in Claims Payable to Banks through
Concerted Bank Packages, by Modality of
Debt Service Reduction
Interest reduction
through par
exchanges
32.8%
Principal reduction
through discount
exchanges
21.0%
29 On average, countries achieved net reductions in total debt service
obligations of about one-eighth. The net debt reduction is defined as the
gross reduction in claims payable to banks less the cost of financing the
operation. The low reduction in net debt reflects the fact that the Brady
restructurings to date have dealt only with medium- and long-term public
sector debt to banks; these debts have generally accounted for between
one-half and one-quarter of the total debt of the participating countries.
30 For alternative calculations of debt service savings for packages com
pleted through mid-1991 and a discussion of alternative counterfactual
scenarios, see Eduardo Fernandez, “Cost and Benefits of Debt and Debt
Service Reduction,’’ World Bank Working Paper no. 1169, August 1993.
31 Brazil has already begun to step up its payments. After interest payments
were suspended in 1989, a $2 billion down payment on overdue interest
was made in 1991 along with 30 percent of the current interest accruals
on principal. The partial payment rate was stepped up to 50 percent of
the accrued interest in 1993, with retroactive payments made on 1992
Source: Federal Reserve Bank of New York staff estimates.
Notes: Chart does not show claim reductions resulting from
packages agreed upon but not yet finalized (as in the case of Brazil).
Separated portion of pie represents outright reduction of
principal (39.9%).
FRBNY Quarterly R eview /W inter 1 9 9 3 -9 4
47
co untrie s’ debt service outflow s to m anageable levels on a
perm anent basis. To achieve this, countries prepaid a por
tio n of th e ir debt se rvice o b lig a tio n s at a d is c o u n t and
locked in the interest rates on a significant portion of the
rem ainder.32 These steps helped insulate them from future
interest rate changes, up or down.
T his locking in of in te re st rates may have resulted in
additional ex ante costs w hich are not reflected in the c a l
cu la tio ns above if lon g -te rm rates g e n e ra lly exceed an
average of relevant short-term rates. The calculations of
the present value of countries’ expected debt service sav
ings are based on long-term interest rates at the tim e of
agreem ent in principle for each of the packages. S pecifi
cally, the interest rates on the par bonds are com pared with
the hypothetical fixed rate that w ould result from swapping
a LIBOR plus 13/16 paym ent stream into a fixed paym ent
stream .33 In this way, the ex post costs or benefits from
32 The transformation of debt obligations from floating to fixed rates may be
considered an extra benefit of the restructurings to the extent that the
debtor country prefers fixing the rates on a portion of its liabilities but is
prevented by its credit standing from achieving such rates through the
swap market.
33 The swap rate is taken as the market’s expectation of the average level
of future short-term rates.
unanticipated interest rate changes are separated from the
ex ante relief negotiated with creditors. H owever, to the
extent that long-term interest rates have an upward bias in
predicting short-term rates, this m easure overstates the
expected savings resulting from the par exchanges.34
In the e vent, d e v e lo p m e n ts in d o lla r m oney m arkets
since the launching of the B rady initiative have thus fa r
turned out rem arkably well fo r debtor countries. The LIBOR
rate fo r U.S. dollar deposits, to which m ost loan contracts
34 The literature on the predictive power of the term structure has cast
strong doubts on the accuracy of the pure expectations theory of the
term structure, particularly as the theory relates to the ability of short
term rates to predict movements in shorter maturities. However, some
research suggests that at longer time intervals, medium- and long-term
rates do tend to be useful predictors of medium-term movements in
short rates: see, for example, Eugene Fama and Robert Bliss, “The
Information in Long-Maturity Forward Rates," American Economic
Review, vol. 77 (1987); Kenneth Froot, “New Hope for the Expectations
Hypothesis of the Term Structure of Interest Rates,” Journal of Finance,
vol. 44 (1989); and John Campbell and Robert Shiller, “Yield Spreads
and Interest Rate Movements: A Bird’s Eye View,” Review o f Economic
Studies, vol. 58 (1991). Studies have also found that when the yield
curve slopes upward, the yields on longer bonds subsequently tend to
decline, while short-term interest rates tend to rise. Although many
theoretical models have been developed to explain the existence of a
possible term premium, no consensus has emerged on the degree to
which long-term rates overpredict future short-term rates.
Table 3
Annual Net Transfers to Banks before and after Completion of Debt Reduction Packages
Billions of Dollars
Memorandum:
Before
Conclusion
of Bank
Package1
Mexico
Costa Rica
yenezuela
Uruguay
Nigeria
Philippines
Argentina
Brazil
Total
3.24
0.04
2.02
0.29
0.64
1.04 §
0.59
2.20 t t
10.05
After Conclusion of
Bank Package*
Short-Run
3.59
0.05
1.53
0.10
0.22
0.28
1.19
2.45
9.42
Cumulative
New Money
Disbursements
Net Transfers
Long-Run
3.59
0.05
1.69
0.11
0.28
0.49 1
2.09
4.44
12.73
1983-85
1986-88
1983-88
3.95
0.22
1.12
0.06
1.05
0.00
0.68
0.74
3.22
0.06
2.21
0.17
0.48
0.71
1.33
3.70
14.27
0.28
0.00
0.24
0.00
0.93
6.50
14.90
7.82
11.88
37.11
Sources: World Bank, World D ebt Tables; author’s estimates.
Notes: Net transfers before debt reduction are defined as cash debt service payments less disbursements from banks. Transfers after debt reduc
tion are defined as net interest payments due on new debt instruments issued plus interest on funds used to finance the transaction, including use
of reserves and new money from commercial banks. Floating rate interest obligations are projected on the basis of swap rates prevailing at the time
of agreement in principle. The calculations do not reflect additional expected savings due to downward shifts in the yield curve following the initial
agreements.
t Average net transfer in the three years preceding the completion of the bank package.
*The difference between short- and long-run projected net transfers reflects temporary interest reduction on par bonds and the expected path of
floating rate interest rates based on the term structure of interest rates at the time of agreement in principle. For cases with rising interest payments,
the long-run level of interest payments is generally expected to be reached in five to seven years.
§Average net transfers during 1987-89.
in c lu d e s interest but not principal on bank debt not eligible for debt reduction.
^E stim ated average during 1991-93. Includes 1991 down payment against interest arrears and interest on refinanced interest arrears (so-called
interest due and unpaid bonds).
FRBNY Quarterly R eview /W inter 1 9 9 3 -9 4
w ere indexed before the Brady operations, d eclined by
about 500 basis points between Novem ber 1990 and Feb
ruary 1993. For most debtors the interest savings implied
by this decline are significantly larger than those resulting
from the debt restructurings. For countries that had already
agreed on debt packages (Mexico, Venezuela, C osta Rica),
the declines did produce additional savings on the portion
of their rem aining medium -term bank debt that was left at
flo a tin g ra te s (fo r e xa m p le , d is c o u n t and new m o n e y
bonds). Moreover, savings accrued on other floating rate
debts, such as short-term debt and debt to international
Chart 6
Mexico: Debt Service Due on Restructured Principal
under Selected Restructuring Agreements
Principal and interest due, in percent of restructured principal
4 0 --------1983 Restructuring Agreement
30
20
Buying back into the market
10
0
institutions. Nonetheless, fo r Mexico and Venezuela, coun
tries that restructured early, near-term interest obligations
on their medium -term debt to banks are currently about the
same as if the restructurings had not taken place (Chart 7).
Of course, the sharp upward slope of the yield curve indi
ca te s th a t the m a rke t e xp e cts an e ve n tu a l re co ve ry in
short-term rates. Should this occur, these countries’ inter
est obligations will rise, but by much less than if the debts
had not been restructured.
C ountries that restructured later, particularly A rgentina
and Brazil, benefited more from the decline in rates. The
coupon profiles on their par bonds m imicked the slope of
the U.S. yield curve at the tim e of their agreem ents.35 Most
of the countries that had not yet reached agreem ents by
early 1991 were making at best only partial paym ents on
accruing interest obligations. For these countries, a Brady
package required a significant increase in cash outflows.
The decline in short-term rates made for a more gradual
step-up in paym ents, giving these countries tim e to grow
into their long-term debt-servicing capacity (Chart 7).
i,
I I Li I I I I I
I IU I IIM I
30
1986-87 Multiyear Rescheduling Agreem ent*
20
10
........ ...............
1989 Par Bond Exch ange Agreement
20
As argued above, the Brady operations did more to lock in a
longer horizon of debt service relief than to change immedi
ate net debt service outflow s from their levels during the
B aker Plan p eriod. T h is locking in im p ro ve d c o u n trie s ’
prospects for breaking out of the cycle of continuous rene
gotiation that characterized the previous approach (Table
4). Of course, it was crucial that countries implem ent and
sustain the policy reforms that would allow the servicing of
the rem aining reduced claim s as well as any new borrow
ings. In this way, the Brady operations in concert with sound
econom ic policies helped countries return to the interna
tional capital m arkets and played an indirect but catalytic
role in helping countries achieve a positive net cash flow .36
Breaking the cycle of continuous renegotiation
10
1111111111 inniiiiii lllllilillai i
10
15
20
Years from start of agreement
25
30
Source: Federal Reserve Bank of New York staff estimates,
based on the terms of the respective agreements.
Notes: The 1983 and 1986 financial packages also provided for
new loans that effectively covered a portion of the interest due in
the initial years. In contrast, the 1989 agreement required outlays
for principal and interest guarantees. Floating rate interest
obligations on the 1983 and 1986-87 agreements are projected on
the basis of long-term U.S. Treasury yields at the time the
packages were finalized. Payments on par bonds exclude
principal and interest payments prepaid through collateral
accounts.
* The terms of the rescheduling agreement were agreed upon in
principle in September 1986, and the package was finalized in
April 1987.
Under the new m oney approach that predated the Brady
initiative, bank packages provided “front-loaded” cash flow
35 For example, the Argentina and Brazil par exchange agreements
provided for interest rates that rose gradually from 4 to 6 percent over a
six-year period.
36 Restoration of market access has always been a central goal of the debt
strategy, and the shift toward debt reduction was presented as an
important means toward this end. Secretary Brady, in his March 10,
1989, address to the Bretton Woods Committee, argued that “the path
towards greater creditworthiness and a return to the markets needs to
involve debt reduction” (reprinted in Edward Fried and Philip Trezise,
eds., Third World Debt: The Next Phase [Washington D.C.: Brookings
Institution, 1989]). The IMF guidelines on Fund support for debt and
debt service reduction, approved in May 1989, stated that in consid
ering requests for support, particular reference would be made to the
strength of economic policies, “the scope for voluntary market-based
debt operations that would help the country regain access to credit
markets and attain external viability with growth,” and the efficiency of
resource use. See International Monetary Fund, Selected Decisions and
Selected Documents, no. 16, 1991.
FRBNY Quarterly R eview /W inter 1 9 9 3 -9 4
49
Chart 7
Mexico's and Argentina's Interest Savings on U.S. Dollar Brady Bonds
Interest due per period in percent of restructured principal
Interest due per period in percent of restructured principal
12 --------------------------------------------------------------------------
12
Argentina: Ex Ante Outlook
Mexico: Ex Ante Outlook
No-debt-reduction scenario
No-debt-reduction scenario
(based on July 1989 yield curve)
i--------- (based on April 1992 yield curve) — j
--------------------------------■Ex ante interest savings
Ex ante interest savings
Expected interest obligations on Brady bonds
Expected interest obligations on Brady bonds
(based on yield curve at the time of agreement in principle)
Mexico: Ex Post Interest Savings and Current Outlook
. (based on yield curve at the time of agreement in principle)
Argentina: Ex Post Interest Savings and Current Outlook
No-debt-reduction scenario
No-debt-reduction scenario
(reflects actual LIBOR rates through 1993;
projections based on October 1993 yield curve)
(reflects actual LIBOR in 1993;
projections based on October 1993 yield curve)
E x p o s t in te re s t s a v in g s
Actual and projected interest
obligations on Brady bonds ■
Actual and projected interest.
obligations on Brady bonds
(projections based on
October 1993 yield curve)
1990
1993 1995
2000
(projections based on
October 1993 yield curve)
1993 1995
2010
Notes: Mexico's and Argentina's annual interest savings on their par and discount bonds are shown as the shaded distances between the "no-debtreduction scenario" lines and the lines showing the interest obligations on their Brady bonds. The no-debt-reduction line presents a counterfactual
scenario under which interest accrues at a rate of LIBOR plus 13/16, and amortization is continually deferred. The Brady bond line shows the interest
coupons expected on par and discount bonds weighted by their shares of restructured principal. The coupons are expressed as a percentage of the
base exposure; hence, the market interest rates for discount bonds are reduced by the size of the discount.
In the ex ante panels, interest coupons (including those for the floating rate Brady discount bonds) are projected from forward interest rates
implied by the yield curve prevailing when the Brady operation was agreed upon in principle (July 1989 for Mexico and April 1992 for Argentina). In the
case of Argentina, the rising projected interest obligations on the Brady bonds reflect the step-up in coupon rates on the fixed rate par bonds as well
as the expected rise in interest rates on the discount bonds. The ex post panels reflect the actual path of short-term rates through 1993 and the future
path of short-term rates implied by the October 1993 yield curve.
50 FRASER
FRBNY Quarterly R eview / W inter 1 9 93-94
Digitized for
I
relief. Since new money loans would generally cover a
fraction of the interest due only over the next year or two,
further packages would be necessary unless debt-servicing
prospects improved sharply.
On the face of it, this approach served the interests of
banks by maintaining a contingent claim on future improve
ments in debt-servicing capacity. If a country’s debt-servicing prospects improved in the years following a new money
package, then continuing with the current agreement (which
usually provided for rising amortization payments and no fur
ther new money) would ensure that banks would benefit.37
However, as indicated earlier, this approach was becom
ing harder to implement over time. Renegotiation was time
consuming and distracting for decision makers. Moreover,
such arrangements increased the already high stock of
debt and blunted the perceived incentives for restructuring
countries to improve their debt-servicing capacity. Finally,
this approach impeded the resumption of voluntary lending.
Potential new creditors were wary of being caught up in this
cycle of continuous renegotiation. Given the unclear rules
of the game, in which contracts were continually reopened,
they feared that cash flow relief might be required from
37 A formal model exploring how bank packages would be expected to
address only the debtor’s near-term need for debt service relief is
presented in Jeremy Bulow and Kenneth Rogoff, “A Constant
Recontracting Model of Sovereign Debt," Journal of Political Economy,
vol. 97 (1989). To encourage creditors to agree to contractual relief over
a longer time horizon, a number of countries agreed to “recapture
clauses” in their Brady packages that provided for increased debt
Footnote 37 continued
service payments in the event of certain largely exogenous
improvements in debt-servicing capacity; these clauses were usually
linked to higher export proceeds (oil for Mexico, Venezuela, and Nigeria
and agricultural commodities for Uruguay), although the Costa Rica
clause was linked to GDP growth. The more recent agreements for
Argentina, Brazil, and the Philippines have not included such clauses.
Table 4
Chronology of Restructuring Agreements, 1983-92
Country
Brady Countries
Mexico
Costa Rica
Venezuela
Uruguay
Nigeria
Philippines
Argentina
Brazil
Dominican Republic
Jordan
Bulgaria
1983
1984
1985
N
N
N
R
N
N
R
N
N
R
P
N
1986
P
R
R
N
N
R
R
1987
1988
1989
N
P
P
B
Bp
Np
R
N
P
Selected middle-income countries currently negotiating debt reduction packages
Ecuador
N
N
Np
N
m
N
Panama
m
N
m
m
Peru
Rp
N
N
N
Poland
Other selected middle-income countries with recent debt servicing difficulties
N
N
R
Chile
R
Colombia
Rf
m
N
R
Cote d’Ivoire
Morocco
R
R
Yugoslavia1'
N
R
R
m
N
N
B
m
m
m
R
m
m
m
R
P
m
m
R
Rf
Nm
N
1990
1991
1992
B
B
P
Bp
P
m
m
m
d
P
P
m
P
d
B
Bp
Bp
m
P
P
P
m
m
m
P
m
m
P
m
m
m
m
Rf
m
m
R
m
m
R
m
Sources; International Monetary Fund, International Capital Markets: Developments and Prospects; World Bank, World Debt Tables; Federal Reserve
Bank of New York.
Notes; Brady countries are those that have completed or reached agreement in principle on operations to substantially reduce their commercial
bank debt. Brady countries are ordered by the date of agreement in principle.
N: Agreement includes provisions for new financing.
R: Agreement provides for principal rescheduling only.
B: Agreement in principle on a Brady Plan debt restructuring,
d: Rolling agreement to defer all payments of principal and interest.
Rf: Principal refinancing agreement.
m: Indicates that at year-end country had suspended interest payments to banks. Excludes moratoria of less than twelve months,
p; Indicates that the country was making partial interest payments to banks; bold indicates that the level of payments was consistent with an agree
ment in principle with the bank steering committee.
fSerbia and Montenegro in 1992.
FRBNY Quarterly Review/Winter 1993-94
51
them as well or that new inflows from them would be used
to justify a cut in debt relief by existing creditors.38 Then,
instead of improving debtor countries’ capacity for growth,
the new creditors would in effect be buying out the old cred
itors’ heavily discounted debt at par. In contrast, debt
reduction and longer maturities capped existing creditors’
claims on current cash flows, allowing new flows to finance
new growth and investment.
Lowering the profile of contractual obligations would not,
by itself, be expected to lead to renewed market access. To
be successful on its own, the Brady operation would need
to convince the market that enough reduction had taken
place so that the debtor, without further changes, would
have sufficient capacity to service the remaining claims.
Here market-based debt reduction faced an inherent limita
tion: to the extent that the reduction in the stock of claims
was expected to raise the probability that the remainder
would be more fully serviced, creditors would only be willing
to sell at higher prices. With prices being bid up and financ
ing limited, less debt reduction would be achieved and the
overhang would persist, deterring new flows.39 In the event,
despite the reductions in claims owed to banks, discounts
on unsecured restructured obligations generally remained
steep, albeit somewhat lower, immediately after the Brady
operations. In part, this discount reflected the longer matu
rities arranged under the restructurings. Hence, in order to
gain significant market access, countries have had to show
evidence of improved debt-servicing capacity as reflected
in declining yield spreads.
38 Pari passu clauses in the contracts on the existing debt specified that
the old debt would be treated equally with all other debts of the
borrower. Charging a higher interest rate on new credits to cover the
possibility of a debt consolidation could lead to an explosion of debt;
moreover, new creditors might not be able to maintain their interest
premia if their claims were consolidated under a restructuring exercise.
The debt overhang deterred nonbank flows as well as new bank loans.
For example, while most rescheduling countries exempted their external
bonds from refinancing during the 1980s—a move reflecting both the
bonds' small share of total indebtedness and difficulties in organizing
debt relief—discounts on bonds still tended to be high. These discounts
reflected fears that de facto seniority was not absolute, and access to
new flows appeared to be ruled out. Portfolio and direct investment
equity flows could also be reduced because of concerns that debtservicing difficulties could lead to restrictions on repatriations of profits
and capital and/or costly confrontations with creditors that could
adversely affect the return on capital. Similar fears of cost shifting could
induce domestic investors to engage in capital flight.
39 Countries did try to circumvent the problem of capital gains for
nonexiting banks through a combination of novation (converting the
remaining claims of participating creditors into bonds that might be
treated more favorably than the claims of free-riding creditors) and
requirements that nonexiting banks provide new money. In theory these
efforts could have led to a complete elimination of the discount at little
cost; however, in practice the Brady operations generally entailed up
front resource costs (that is, buyback equivalent prices) broadly similar
to those prevailing in the period of negotiations. Discussions of the
limitations of market-based debt reduction can be found in Stijn
Claessens, Ishac Diwan, Kenneth Froot, and Paul Krugman, “MarketBased Debt Reduction for Developing Countries: Principles and
Prospects,” World Bank Policy and Research Series no. 16 (1990); and
Jeremy Bulow and Kenneth Rogoff, “The Buyback Boondoggle,”
Brookings Papers on Economic Activity, 1988:2, pp. 675-703.
http://fraser.stlouisfed.org/
52 FRBNY Quarterly Review/Winter 1993-94
Federal Reserve Bank of St. Louis
Mexico as prototype
The experience of Mexico, the first and most successful of
the Brady countries to return to the international capital
markets, illustrates the interactions between debt reduc
tion, improved debt-servicing capacity, and market reentry
(Chart 8). Mexico’s implementation of a broad-based
macroeconomic stabilization and structural reform program
was already well advanced before the Brady initiative was
announced.40 Even as the Brady operation was being
negotiated, Mexican borrowers began returning to the inter
national bond markets. However, initial yield spreads were
very steep (although lower than those on the old bank
debt), overall volumes were not high compared with later
levels, and most of the initial placements were enhanced by
the attachment of receivables accounts or favorable equity
conversion rights.41 Later, as perceptions of improving eco
nomic performance and rising payments capacity led to
lower yield spreads on the restructured long-term (Brady)
debt, yield spreads on new unenhanced issues decreased,
the volume rose significantly, and the composition shifted
toward unenhanced issues. Maturities were initially short
because creditors were not sure that the improvements in
debt-servicing capacity would last. By lending over the
short term, creditors could monitor whether the improve
ment in capacity was being sustained; if not, they could
then try to reduce their exposure as it matured. More
recently, most Mexican Eurobond issues, particularly by
public sector borrowers, have carried maturities of at least
five years, and the maturity of several issues has exceeded
ten years. In fact, in November 1993, Pemex, the state oil
company, was able to place a thirty-year issue.
Market reentry: broad based but not universal
Certainly one of the more remarkable recent developments
in the international financial arena has been the explosion
of private capital flows to borrowers, especially Brady coun
tries, that were once credit constrained. Most of the new
flows have been in the form of direct and portfolio invest
ment, both through equity and securities markets, and
repatriation of flight capital. Syndicated lending from com
mercial banks has not resumed on a significant scale.
Not all Brady countries, however, have been able to
40 See Claudio Loser and Eliot Kalter, eds., Mexico: The Strategy to
Achieve Sustained Economic Growth, International Monetary Fund,
Occasional Paper no. 99, September 1992.
41 The fact that new issues carried lower spreads than the Brady bonds
may have reflected perceived de facto seniority owing to the new issues’
shorter maturity and small share of total indebtedness. Receivablesbacked borrowings eliminated convertibility risk by directing an entity
outside of Mexico to pay funds owed to the Mexican borrower into a
special purpose vehicle (a specially created trust, partnership, or
corporation) that would then issue securities on behalf of the Mexican
borrower. For example, Telmex, the Mexican telephone company,
directed AT&T to deposit long-distance payments owed to Telmex into a
trust located in the United States. See Andrew Quale, “Securing the
Future," LatinFinance, May 1991.
regain access to the international capital markets (Table 5,
Chart 9).42 As reflected in secondary market prices, the
m arket did not perceive an im provem ent in N ige ria ’s
prospects for growth and reform following the completion of
its package, and the country has not returned to the inter
national capital markets. In addition, the Philippines, which
experienced a decline in secondary market prices following
its 1990 buyback, was largely absent from the capital
42 Observed credit flows are of course only partial indicators of credit
availability. Some countries, such as Chile, have taken active measures
to limit the extent of capital inflows, while other countries have not been
willing to borrow unless the terms were sufficiently attractive.
Chart 8
Mexico: Volume and Yield Spreads on New
International Bond Issues
1989 to 1993, First Half
Basis points *
Millions of dollars
2000
1750
markets until the completion of the second stage of its
Brady restructuring further reduced its debt and lengthened
the maturity of the remaining exposure.
Argentina and Brazil
The success of Argentina and Brazil in regaining access to
the international capital market when their debt packages
were not yet completed and they were still incurring interest
arrears raises questions about the relative importance of
the debt operations. This is particularly the case for Brazil,
where high levels of inflation persist and uncertainties con
tinue regarding when the package will be completed.
Support for the view that the debt operations were a cata
lyst for reentry can be found in the timing of the countries’
entries into the market in the third quarter of 1991. For both
countries, market reentry followed developments indicating
that the probability of a “Brady package” in the near future
was increasing sharply. Brazil had just recently reached a
preliminary agreement with the banks on the treatment of
accumulated interest arrears that cleared the way for nego
tiations on a debt reduction package.43 While Argentina’s
negotiations were not as advanced as Brazil’s (although
partial payments of interest had resumed sooner), the
1500
43 Brazil initiated partial interest payments on its medium- and long-term
public debt in early 1991 after an eighteen-month moratorium.
Agreement with the banks on the treatment of interest arrears
accumulated during 1989-90 was reached in April 1991. Moreover,
earlier in the year, in an effort to restore market access for Brazilian
corporations, all private sector borrowers as well as several leading
publicly owned corporations were given permission to negotiate directly
with their bank creditors. Concerted interbank and short-term trade
facilities were allowed to expire in April 1991 and were replaced with
voluntary facilities.
1250
1000
750
500
250
Table 5
Net Capital Inflows to Restructuring Countries
0
Billions of Dollars
1989
1990
1991
1992
1993
Sources: International Financing Review, Euroweek,
Financial Times, Salomon Brothers, J.P. Morgan, and
Federal Reserve Bank of New York staff estimates.
* Spread over comparable maturity U.S. Treasuries.
t Unenhanced bonds are new issues that do not carry equity
conversion rights and are not backed by collateral or
receivables accounts.
* * Volume of bonds enhanced by attachment of collateral or
receivables accounts or equity conversion rights.
t t Yield spread on unguaranteed portion of par bonds, that is,
stripped yield spread. Before the issuance of Brady bonds,
spreads are implied yield spreads on Brady-eligible bank
loans. Implied yields on bank loans are constructed by
dividing the long-run average expected interest rate by the
price of the loan.
1989
1990
1991
1992
1993e
Mexico
Costa Rica
Venezuela
Uruguay
Nigeria
Philippines
Argentina
Brazil
Chile
4.5
0.6
-1.1
-0.1
0.1
1.9
-0.5
-0.1
1.3
10.4
0.3
-3.4
-0.1
-2.5
2.3
1.2
4.3
2.7
21.9
0.5
0.7
0.1
-0.6
3.0
4.9
1.0
0.9
24.0
0.5
2.2
0.2
-6.0
2.7
12.8
8.4
2.9
23.9
0.7
1.3
0.3
1.3
3.7
12.7
8.7
2.8
Total
6.5
32.5
47.7
55.4
.
ss«iisssi
15.2
| JiplP
I
£
Sources: International Monetary Fund, International Financial
Statistics; Federal Reserve Bank of New York staff estimates.
Notes: Net capital inflows are defined as the current account
deficit plus the increase in gross reserves. The inflows include
errors and omissions and exceptional financing
FRBNY Quarterly Review/Winter 1993-94
53
country was making important progress in controlling infla
tion and restructuring the economy. As a result, Argentina’s
prospects for receiving official financial support for a future
Brady restructuring appeared to be on the rise.44 In addi
tion, the precedents established through the debt opera
tions with Mexico, Venezuela, and other countries tended
to make the timing of an agreement less crucial because
potential new creditors were able to project reasonably well
how existing bank claims would be treated under a debt
package. The likely future structures were further clarified
once the April 1991 Brazilian arrears agreement estab
lished a pattern for the treatment of such claims. The notion
that term s for the treatm ent of old debt were already
broadly defined apparently contributed to a presumption,
reinforced by the countries’ policies, that pending a restruc
turing of the old debt, new obligations would be given a de
facto senior status. Hence the new flows were priced more
on the basis of expected post-deal creditworthiness.
44 Since mid-1989 Argentina had been implementing sweeping measures
to encourage competitiveness, including liberalizing the trade regime
and privatizing several major public enterprises. Argentina’s reentry into
the international capital markets in August 1991 followed the adoption of
a new stabilization program in March 1991. The program, which involved
a tightening of public finances, further structural measures, and a fixed
exchange rate, was showing success in sharply curbing inflation and
formed the basis for a stand-by arrangement with the IMF approved that
same month.
For both Argentina and Brazil, access to new capital
flows followed changes in the market’s perception of their
capacity to service existing debts. In both cases, the yield
spreads on their long-term debt sharply improved ahead of
their reemergence in the international bond markets. In the
case of Brazil, it is notable that bond issues peaked in the
first half of 1992; this development coincided with a low
point in yield spreads on the long-term debt as the country
approached an agreement in principle, announced in July
1992, on a debt reduction package (Chart 10). Afterwards,
in the face of political uncertainties culminating in the resig
nation of President Collor and continued high inflation,
prospects for a deal dimmed, the yield spread on the long
term debt widened, and the flow of new issues slowed
m a rk e d ly .45 A rg e n tin a made an in itia l fo ra y into the
Eurobond market in the third quarter of 1991, but it was not
until after agreement on a term sheet for the bank operation
in June 1992 that further significant bond issues took place
(Chart 11). Moreover, the completion of the par and dis
count exchanges in April 1993 and the deepening success
of the country’s stabilization and reform effort, reflected in
further declines in yield spreads in 1993, led to an explo
sion of new issues in the second and third quarters of 1993.
45 Net foreign purchases of Brazilian equities followed a similar pattern:
they fell to $0.3 billion in the second half of 1992 after rising to $1.4
billion in the first half of 1992 from $0.6 billion in all of 1991.
Chart 9
Intern atio nal Capital M arket Financing Received by R estructuring C ountries, 1990-93
Billions of dollars
20
Gross international bond issues
International equity issues
15
Net Euro-CD issues
Net Euro-commercial paper issues
10
5
0
Mexico
Costa Rica
Venezuela
Uruguay
Nigeria
Philippines
Argentina
Brazil
Chile
Sources: For bonds and equities, Financial Times, International Financing Review, and Euroweek\ for Euro-CDs, Euroclear; for Euro-commercial
paper, Bank for International Settlements, International Banking and Financial Market Developments.
Note: Data include issues through September 1993, except for Euro-commercial paper issues, which are through June 1993.
http://fraser.stlouisfed.org/
54 FRBNY Quarterly Review/Winter 1993-94
Federal Reserve Bank of St. Louis
Brazil’s access to capital market inflows still appears
somewhat tentative in comparison with that achieved by
Mexico. Argentina, which in 1993 saw growing interest from
institutional investors, occupies a somewhat intermediate
position . Through 1992, alm ost all of the unsecured
Eurobond issues by Brazilian borrowers carried maturities
of two to three years, whereas most recent Mexican issues
have had maturities of five years or more. Argentina has
been relatively more successful in placing longer term bor
rowings; notably, all of the five-year issues came after
agreement on a term sheet for the debt exchange (Chart
12). While institutional and retail investors from developed
countries are reportedly showing substantial interest in
Mexico, Brazil has not captured institutional investors’
interest to nearly the same degree. Market participants
reported in mid-1993 that flight capital still accounted for
the bulk of the demand for Brazilian Eurobond issues, par
ticularly for private sector borrowers; in contrast, industrial
country investors, particularly from the United States,
accounted for most of the demand for recent bond issues
by Mexican corporations.46 These differences suggest that
if Brazil is to emulate some other countries’ success in
broadening the investor base, achieving a longer maturity
structure, and narrowing yield spreads, investor concerns
a bo ut c ro s s -b o rd e r risk m ust be add re ssed th rough
improvements in debt-servicing capacity and completion of
the debt package.
Overall, the pattern of sharply increased capital inflows
received by many Brady restructuring countries since 1990
confirms that the debt operations, when accompanied by
46 Inform ation on final h old e rs of E u rob o n ds is s ke tch y at best. H ow ever,
e v id e n c e of the intere st of d e v e lo p e d c o u n try investors in M e xico can be
found in the stro n g g row th of fo re ig n h o ld in g s of d o m e s tic a lly issued
M exican g ove rn m e n t b on d s, w hich in cre a se d b y a b o u t $20 billion
b etw een e nd -1 9 90 and m id-1993.
Chart 11
Argentina: Volume and Yield Spreads on New
International Bond Issues
Chart 10
Brazil: Volume and Yield Spreads on New
International Bond Issues
1990 to 1993, Third Quarter
Basis points*
4000
Millions of dollars
---------------- 2000
1990 to 1993, Third Quarter
Basis points*
Millions of dollars
8000--------------------------------------------------------------------------------- 2000
7000
Implicit yield
spread on B ra d y -_______
eligible debt -|Volum e of bond issues
- Scale
Scale
3500
3000
Yield spread on
■Brady-eligible debt t
---- Scale
1750
1250
5000
Volume of Eurobond issues
Scale------- ►
2500
4000
2000
3000
1500
Average
yield spread
on new
- Eurobond
issues
• * ------Scale
2000
1000
1000 Yield spread
Average yield
spread on new
500 — Eurobond issues.
• * ------- Scale
on 89 bonex
------ Scale
1991
1990
1991
1992
1993
0
1993
Sources: International Financing Review, Euroweek,
Financial Times, LatinFinance, Salomon Brothers, J.P.
Morgan, and Federal Reserve Bank of New York staff
estimates.
* Spread over comparable maturity U.S. Treasuries.
t Implied yields on medium-term bank loans are constructed
by dividing the long-term expected interest rate by the price
of the debt.
** T h e 1988 new money bonds were issued as part of Brazil's
1988 financing package. They are amortizing bonds with a
final maturity in 1999.
1992
Sources: International Financing Review, Euroweek,
Financial Times, LatinFinance, Salomon Brothers, J.P.
Morgan, and Federal Reserve Bank of New York staff
estimates.
* Spread over comparable maturity U.S. Treasuries.
t Implied yields on medium-term bank loans are constructed
by dividing the long-term expected interest rate by the price
of the debt. From April 1993, yield spreads are based on
the stripped yields on par bonds. Stripped yields measure
the yield to maturity on the uncollateralized or risky portion
of a Brady bond.
* * Bonex 89 are sovereign bonds issued in 1989 that fully
mature in 1999.
FRBNY Quarterly Review/Winter 1993-94
55
improved policy performance, have played a catalytic role.
Countries that have boosted their debt-servicing capacity
and reduced their debts have been rewarded with growing
market access on improving terms. However, the pattern of
inflows suggests that other factors are at work as well. Most
im portant, lower global interest rates, p articularly the
medium- and long-term declines in 1993, have encouraged
yield-sensitive investors to reconsider the prospects of
restructuring countries. The generally more favorable envi
ronment for capital flows helps account for the magnitude
of net capital flows to Mexico, which greatly exceed the
debt reduction achieved through the Brady operation, and
the 1993 rebound in flows to Brazil despite uncertain funda
mentals. In the current environment, some investors seem
more willing to lend on the promise of reform, provided the
contractual yield is sufficiently attractive.
Impact on investment performance
Many advocates for debt reduction argued that lowering
countries’ debt and debt service burdens would lead to
Chart 12
Maturity Structure of Unsecured International Bond Issues, 1990-92
Argentina
Brazil
Mexico
I_____ I_Maturity of two years or less
I Maturity of between two and three years
] j Maturity of between three and five years
|
| Maturity of five years
I Maturity of more than five years
Sources: International Financing Review, Euroweek, and Financial Times.
Note: In cases where put options are incorporated, time to put is used.
56 FRBNY Quarterly Review/Winter 1993-94
higher rates of capital formation. In fact, for most Brady
countries, investment rates have been increasing in recent
years (Table 6). Nonetheless, although in some cases cap
ital inflows now rival those observed before the debt crisis
and secondary market discounts have narrowed, in most
Brady countries investment still accounts for a substantially
smaller share of GDP than in the pre-debt crisis period.
The “debt overhang” hypothesis, advanced by a number
of analysts of the developing country debt crisis, had sug
gested the possibility of a stronger investment response, at
least in some cases. According to this hypothesis, elimina
tion through debt reduction of the substantial discounts on
countries’ external debts would encourage investment,
thereby producing important efficiency gains.47 The “over
hang,” or excess of what debtors owed over what they
could pay (as indicated by the market value of the debt),
was thought to dissuade countries from improving their
debt-servicing capacity: any improvements were expected
to be largely “taxed away” through reduced debt relief in the
future. This disincentive was seen to act both at the level of
governments reluctant to adopt unpopular austerity mea
sures and on the microeconomic level of investors who
feared confiscatory tax policies. A variant of the overhang
hypothesis argued that the discounts constrained invest
ment by restricting the availability of financing. Absent
credible seniority for new flows, potential creditors refused
47 Amongst the most widely cited expositions of this view are the theoretical
arguments of Jeffrey Sachs, “The Debt Overhang of Developing
Countries,” in Jorge de Macedo and Ronald Findlay, eds., Developing
Country Debt and the World Economy (Helsinki: WIDER Institute, 1988),
and Paul Krugman, “Market Based Debt Reduction Schemes," in Jacob
Frankel, Michael Dooley, and Peter Wickham, eds., Analytical Issues in
Debt (Washington, D.C.: International Monetary Fund, 1989). The overhang
hypothesis was by no means universally endorsed. For example, Jonathan
Eaton in “Debt Relief and the International Enforcement of Loan Contracts,”
Journal of Economic Perspectives, vol. 4 (1990), and Jerem y Bulow and
Kenneth Rogoff in “Cleaning up Third World Debt Without Getting Taken to
the Cleaners,” Journal of Economic Perspectives, vol. 4 (1990), strongly
questioned the empirical significance of the overhang effect.
to finance new investments for fear that their loans, like the
old loans, would not be fully serviced.48
To be fair, overhang proponents were skeptical about
market-based debt reduction, as opposed to mandatory
writedowns of excess claims, arguing that the former would
not make much of a dent in the prevailing discounts.
Indeed, discounts often remained high immediately follow
ing the implementation of the Brady packages. Nonethe
less, even in those countries experiencing the largest ex
post reductions in discounts—for example, Mexico— or the
greatest restoration of capital flows, the improvements in
investment rates have not generally been striking compared
with the deterioration at the outset of the debt crisis.49
Impact on banks
The secondary market value of claims on restructuring
countries has recovered significantly in the period following
the change in strategy. Some banks have also gained from
48 Ishac Diwan and Dani Rodrik developed an argument broadly along
these lines in "Debt Reduction, Adjustment Lending, and Burden
Sharing," World Bank, mimeo, September 1991. Eduardo Borenzstein
presented numerical simulations suggesting that credit rationing
associated with excess indebtedness may be more important in
restraining investment than negative incentive effects; see “Debt
Overhang, Credit Rationing and Investment,” International Monetary
Fund, Working Paper no. 89/74, 1989. Daniel Cohen presented empirical
evidence of a negative linkage between net debt service outflows and
investment in “Low Investment and Large LDC Debt in the Eighties,”
CEPREMAP Working Paper no. 9002, 1989. Cohen’s results implied that
a restoration of capital inflows should lead to increased investment.
49 Adherents of the debt overhang hypothesis did not specify how rapidly
investment would recover. However, the comparisons that some made
with the collapse in investment at the start of the debt crisis appeared to
imply that a rapid rebound would be possible. The weak association
observed to date between debt reduction and investment may reflect in
part countries’ monetary and fiscal policies. In the aggregate, about half
of the increased capital inflows in recent years have been channeled
into increased holdings of official reserve assets. Public sector
investment has declined relative to the period immediately preceding
the debt crisis, a change that reflects both public sector austerity and
reductions in the size of the state sector through privatization.
Investment Performance in Restructuring Countries
Nominal Gross Fixed Capital Formation, Percent of GDP
____________________ 1978-82________1983-89________ 1990-92___________________ 1989___________1990___________1991___________ 1992
24.4
23.5
29.6
15.9
22.7
26.4
23.7
22.7
19.1
Mexico
Costa Rica
Venezuela
Uruguay
Nigeria
Philippines
Argentina
Brazil
Chile
19.3
19.3
19.4
11.3
8.7
206
18.5
20.2
18.0
19.9
18.2
21.1
20.5
17.6
17.2
11.4
11.6
13.1
8.2
22.3
20.9
15.1
15.5
19.9
24.8
23.3
23.1
'"jlH
1
H$§§I
Sources: International Monetary Fund, International Financial Statistics; Federal Reserve Bank of New
.v;
mm
: IB #
illlii "p : r-g ;
■:
V'-' .C-,.
19.4
19.7
18.2
11.3
12.7
20.6
14.6
19.0
21.7
*t _ ;■
York staff estimates.
18.6
22.4
14.1
10.8
11.9
24.1
14.0
21.6
24.6
•* . 7 r ;
21.6
21.2
20.6
12.1
14.6
22.3
16.7
19.1
23.7
-wmjm ,i®
FRBNY Quarterly Review/Winter 1993-94
57
expanding income opportunities in the secondary market
trading of restructured debts and the underwriting of new
securities flows to restructuring countries. Although in the
early cases the prices paid to banks in the form of collateral
and cash for their forgone claims were close to the histori
cal lows that had prevailed in the secondary market, banks
have regained ground through subsequent price apprecia
tions on their remaining exposure. This price rebound,
which came with a lag, reflects growing optimism about the
effectiveness of the new strategy. Moreover, the dramatic
increase in secondary market liquidity, thanks in large mea
sure to the securitization of claims through the Brady
restructurings, has given banks new flexibility in managing
their developing country exposure.
Sorting through the aftermath of the debt crisis has been
a painful and costly process for the banks. From 1987 to
1992, the leading U.S. money center and regional banks
charged off more than $25 billion of their loans to restruc
turing country borrowers, or about one-third of their aggre
gate exposure at the end of 1987.50 For the largest banks,
these losses equaled two-thirds of these banks’ capital at
the start of the debt crisis.51
It is difficult to determine the extent to which the change
in the debt strategy caused or contained these losses. Dif
ferent views reflect largely unconfirmable hypotheses
about what would have happened had another course been
followed. In one view, shifting of the rules of the game to
recognize that the loans were no longer fully collectible
weakened the position of banks and created losses. This
perspective imputes a strong role to the official community
in arbitrating between countries and their creditors. By con
trast, others maintain that banks were bound to incur losses
anyway; providing official financing to help countries buy
back their debts benefited banks by driving up prices and
shifting risk to the official sector.52 One could also argue
that the strategy helped all parties by encouraging greater
economic efficiency.
A Brady bounce or a Brady dip?
One kind of evidence that bears on this problem is the
reaction of secondary market debt prices to the Brady
50 Some charge-offs and provisions were made before 1987, but these
were relatively insignificant compared with the post-1986 actions.
Although some of these charge-offs are potentially recoverable because
the banks have retained their legal claims, many are not because they
reflect losses through swaps and sales.
51 In contrast, leading U.S. banks’ net earnings on foreign operations,
which include many activities unrelated to developing country lending,
were on the order of $1.1 billion per year in 1981-82.
52 See, for example, Bulow and Rogoff, “Cleaning up Third World Debt."
Why creditors might or might not be better off is also discussed in
W. Max Corden, “An International Debt Facility?” in Analytical Issues
in Debt; and Michael Dooley, “Buy-Backs, Debt-Equity Swaps, Asset
Exchanges, and Market Prices of External Debt,” in Analytical Issues
in Debt.
58 FRBNY Quarterly Review/Winter 1993-94
initiative.53 Secondary market prices have generally been
on an upward trend since the launching of the Brady initia
tive; in particular, prices rose just after the proposal was
announced (Chart 13). Some critics have pointed to such
price behavior even against a background of continued
steep discounts to suggest that the new plan was beneficial
for banks, in some arguments to the exclusion of other par
ties.54 However, any focus on the short-term movement
immediately after the announcement needs to be tempered
by awareness that the market anticipated the possibility of
a tilt toward debt reduction well before Secretary Brady’s
March 1989 speech. Once this is taken into account, the
initial reaction of the market to the change in approach
appears on balance to be unfavorable. In particular, the
free fall in secondary market prices from mid-1988 to the
eve of Secretary Brady’s speech must be regarded as at
least partly reflecting fears that a change in strategy would
adversely affect banks.55 In the debate leading to the
change in strategy, banks expressed concerns that any
new approach be voluntary and that the Baker Plan’s
emphasis on policy reform continue. Secondary market
prices did rise in the two months following Secretary
Brady’s speech as the official community worked out the
details of the new approach, but this rebound offset the
declines that had taken place only since December 1988,
when President-elect Bush announced that the debt strat
egy was under review, and was still much smaller than the
fall from mid-1988.
Buyback equivalent prices and post-deal price improvements
Brady deals can also be examined on a country-by-country
basis to determine the effects on banks. The financial impact
of Brady restructurings can be separated into two aspects:
(1) the effective purchase price in the form of collateral and
53 Because of the thinness of the secondary market before the launching of
the Brady initiative, prices from this period might be regarded as
unreliable. However, even after secondary market volumes increased in
1989 and 1990, trading stayed broadly in the ranges reached at end1988, with prices rising somewhat in cases where economic
performance was improving and falling where it did not.
54 Conclusions about the implications of price movements for other parties,
such as the borrowing countries, are generally based on strong
assumptions that usually rule out the very efficiency gains that the
reinforced strategy was seeking.
55 In March 1989, the U.S. Treasury cited “heightened publicity on
establishing debt facilities in the latter part of 1988" as one of the factors
contributing to downward pressure on secondary market prices in the
second half of 1988 (Department of the Treasury, “Interim Report to the
Congress Concerning International Discussions on an International Debt
Management Authority,” in Third World Debt—Reports and the Brady
Plan, Hearings before the Subcommittee on International Development,
Finance, Trade and Monetary Policy of the House Committee on
Banking, Finance and Urban Affairs, 101st Cong., 1st sess.
[Washington, D.C.: GPO, 1989], p. 64). Clearly the decline reflected
pessimism about the pre-Brady strategy. However, neither anticipation
of a new approach nor clarification of how the strategy would change
fully reversed the downward adjustment.
cash paid to compensate banks for forgone claims and (2)
the returns on remaining exposure. Banks realize a benefit
on market accounting when the effective purchase price is
high compared with the prevailing secondary market price.
However, even when it is low, they may be better off
because of an induced capital gain on their remaining expo
sure due to a reduction in the amount of debt outstanding.56
The effective pricing of the early deals was consistent
with the low levels to which prices had fallen (Table 7). In
the case of Mexico, the buyback equivalent price—that is,
the price at which the same amount of cash could have pur
chased an equivalent amount of debt reduction through a
buyback—was below the secondary market prices prevail
ing during the period of negotiations.57 Despite a rise in
58 In fact, some have argued that banks could have been paid less in
anticipation of a post-deal price rise. However, this would give rise to
free rider problems because any single bank selling off its exposure
would be worse off than those that did not.
57 The buyback equivalent price for a Brady package is the ratio of total
up-front cash outlays for buybacks and collateral purchases to the
present value of the exposure reduction by exiting banks. For a further
discussion of buyback equivalent prices, see John Clark, “Evaluation of
Debt Exchanges,” International Monetary Fund, Working Paper no. 90/9,
February 1990.
prices just before the agreem ent with Venezuela was
reached, the buyback equivalent price was in line with the
average price prevailing during the negotiation period.
Still, despite the relatively low compensation received by
creditors for their reductions in nominal claims, they have
benefited as their remaining exposure has appreciated in
value. This recovery in prices was not immediate and it
reflects a variety of factors, including some unrelated to
the change in strategy. Undoubtedly the most important
influence has been the increase in debt-servicing capacity.
Since 1988, most Brady countries have increased their
exports, lowered their fiscal deficits, curtailed inflation, and
strengthened their balance of payments positions (Table
8).58 The shift in strategy may well have encouraged such
changes by making needed policy reforms more politically
a ccep tab le. The reduced debt burden m agnified the
effects of im provem ents in debt-servicing capacity on
perceived creditworthiness, helping speed the return to
market access. In addition, the securitization of remaining
58 The country that made the least progress in some of these areas, Brazil,
is also the country that showed the weakest price performance.
Chart 13
Average Secondary Market Prices for Medium-Term Bank Debt
Price in percent of face value
Sources: Salomon Brothers; Federal Reserve Bank of New York staff estimates.
Notes: Index weights countries' debt prices by their share in total debt at the start of the period. The countries included are Argentina, Bolivia, Brazil,
Chile, Colombia, Cote d’Ivoire, Ecuador, Mexico, Morocco, Nigeria, Peru, the Philippines, Uruguay, Venezuela, and Yugoslavia. Index reflects stripped
prices (that is, prices adjusted to remove the effects of partial collateralization and interest reduction) following Brady restructurings.
FRBNY Quarterly Review/Winter 1993-94
59
claims greatly expanded liquidity (some Brady bonds are
among the most actively traded instruments in the Euro
markets) and facilitated the entry of new investors into the
market.
An important factor in the price rises not linked to the
change in strategy has been the recent decline in global
interest rates, particularly at medium- and long-term matu
rities. Lower rates raise the present value of future expected
Table 7
Evolution of Secondary Market Prices of Bank Claims on Selected Restructuring Countries
Cents per Dollar of Contractual Claim
Secondary Market Prices
Mid1988
Country
February
1989
Average
during
Negotiationsf
Following
Agreement
in Principle
December
1992*
Memorandum Item:
Buyback Equivalent
Price of
Brady Package
Weighted Average§
(excluding Chile)
48.3
Mexico
Costa Rica11
Venezuela
Uruguay
Nigeria
Philippines (1990)
Philippines (1992)
Argentina
Brazil
Chile
31.9
34.3/38.3
41.8
46.8
33.6
51.3
14.7
55.6
61.3
29.5
54.8
36.5
13.5
35.0
60.5
22.0
42.8
41.1
13.0
37.8
53.4
29.1/36.1
47.4
59.4
34.1
53.9
65.4
39.5
54.7
26.5
52.1
61.6
19.0
30.0
59.5
21.1/39.3
29.5/34.2
N.A.
44.5
16.0
42.8
56.3
44.6
51.5
53.3
44.8
35.9
N.A.
33.7
17.4 *
37.5
51.0
39.0
50.0
46.2
29.9 *
28.5 n
N.A.
48.0
29.5
93.0
Sources: Salomon Brothers; Federal Reserve Bank of New York staff estimates.
f Average price from March 1989 until agreement in principle. In cases where formal negotiations did not begin in 1989, the second price is the aver
age during the period of formal negotiations.
♦Reflects weighted average price of new instruments issued under debt exchanges. In cases where buybacks were included, the price includes the
buyback price weighted by the share of debt allocated to the buyback option.
§Prices are weighted by shares in total debt to commercial banks as of end-1986.
'The buyback equivalent prices for Argentina and Costa Rica do not reflect down payments made at closing against interest arrears. Inclusion of
these costs would raise the Argentina price by around 5 cents and the Costa Rica price by about 2 cents.
n The estimated price for Brazil reflects bank choices among options and interest rates prevailing in July 1992, when the terms of the package were
agreed upon in principle. The actual cost of the package may be higher because of subsequent declines in long-term interest rates that have raised
the cost of thirty-year zero coupon bonds.
Table 8
Selected Indicators of Economic Policy Performance
Primary Fiscal Balance1
(Percent of GDP)
Inflation
(Annual Percent Change in Consumer Price Index)
1988
Mexico
Costa Rica
Venezuela
Uruguay
Nigeria
Philippines
Argentina
Brazil
Chile
51.7
25.3
35.5
69.0
64.7
9.0
387.5
1,006.5
12.2
1989-91
22.8
20.8
49.5
99.9
23.8
15.0
2,119.0
1,302.9
22.5
Cumulative
Export Growth*
1992
1988
1989-91
1992
(1988-92)
11.9
17.0
31.9
58.9
48.8
8.1
17.7
1,156.4
12.8
8.0
2.5
-6.1
-0.4
-2.9
2.7
-0.6
-0.4
5.0
7.1
1.5
3.5
1.3
6.5
3.6
0.3
1.5
5.5
5.6
4.3
-1.2
3.4
1.8
4.6
1.4
2.0
4.6
47.5
60.6
33.2
36.5
78.0
62.4
33.0
11.7
53.4
Sources: International Monetary Fund, International Financial Statistics; Federal Reserve Bank of New York staff estimates.
Excludes privatization receipts.
♦Exports of goods and services.
60 FRBNY Quarterly Review/Winter 1993-94
net debt service payments.59 In addition, lower global rates
raise the prospects for productive new inflows as yield-sen
sitive investors seek alternatives to industrial country
investments. These new inflows in turn can raise debt-servicing capacity, increasing the value of existing debt.60
The emerging markets fixed income business
Finally, the Brady operations have helped create a new
industry focused on investments in countries that have
restructured their debts. The operations catalyzed a
restoration of market access and encouraged the emer
gence of a vibrant secondary market for restructured
claims. Secondary market trading rose more than seven
fold from 1988 to 1992, reaching about $0.7 trillion during
the latter year.61 On the fixed income side, the main lines of
business include investing and trading in Brady bonds and
Brady-eligible medium-term bank claims, and underwriting
and investing in new international bond, commercial paper,
and certificate of deposit issues.62 In addition, derivatives
underwriting has expanded in recent years. In some cases,
the increased investor interest has spilled over into domes
tically issued debt instruments as well, principally those of
Mexico and Argentina.
Most of the income earned in these markets accrues
directly in the form of yield spreads and capital gains to
investors willing to put their capital at risk. However, ancil
lary noninterest income opportunities have arisen as well
from market making and underwriting. Although banks
have captured a large, although shrinking, share of the
noninterest income, they generally have been reluctant to
expand their exposure significantly. Most of the growth in
claims has been taken up by an expanding pool of nonbank
investors.
reformers, particularly Mexico and Chile, demonstrated
how policy reform and debt reduction could lead to restored
market access and sustainable growth, and as the interest
rate outlook improved, a reassessment took place.
For late-restructuring countries, including those yet to
negotiate a Brady deal, this reappraisal represents a mixed
blessing. These countries have been helped by the en
hanced credibility given to needed structural reforms,
which makes their adoption more likely, and by the acceler
ation of their return to the market. Hence, their debt-servic
ing capacity has improved. However, this reappraisal has
also tended to push up the price at which banks are willing
to reduce their claims.63 For example, market participants
cited this demonstration effect to explain market bullish
ness in third-quarter 1991 for claims on countries in the
earlier stages of policy reform and debt restructuring.
Late restructuring countries also face more of an uphill
debt-servicing path because of their past interest arrears.
Banks have taken a harder line on the treatment of interest
arrears relative to principal, as part of their strategy of dis
couraging forced relief through such arrears. For example,
in the bank packages for Brazil and Argentina, refinanced
interest arrears were excluded from principal or interest
reduction and carried maturities of ten to twelve years in
contrast to maturities of as long as thirty years for restruc
tured principal. As a consequence of not granting as flat a
repayment profile as that accorded Mexico, the banks have
effectively maintained a claim on these countries’ expected
increases in market access over the medium term.64
Conclusion
Since the emergence of the developing country debt crisis
in 1982, policymakers have sought to avert systemic threats
to the international financial system, to gain time for debtor
The experience of late-restructuring countries
The early Brady deals (Mexico, Venezuela, Costa Rica)
were priced at levels that reflected skepticism about the
effectiveness of the new approach. However, as the early
59 The value of a country’s external debt may be viewed as a function of
the portion of export receipts or national income that the country is
presumably willing to devote to the debt’s servicing in the future. When
the discount rate is lowered, the present value of any future path of
service payments rises.
60 Of course, this outcome requires that the inflows be channeled into
activities with appropriate returns.
81 For estimates of the growth in trading volumes based on periodic
surveys of market participants, see Richard Voorhees, “A Trillion Dollar
Market," LatinFinance, no. 45, pp. 49-62. The 1992 estimate is taken
from the Emerging Markets Traders Association’s (EMTA) survey of
market participants. The EMTA estimate does not adjust for double
counting; see “EMTA Volume Study: Brazil, Mexico Grab Top Spots in
$734 Billion Debt Market,” LDC Debt Report, October 4, 1993, p. 7.
62 For a discussion of recent developments in equity flows, see John
Mullin, “Emerging Equity Markets in the Global Economy," Federal
Reserve Bank of New York Quarterly Review, Summer 1993.
63 In many cases, before recovering, the prices of claims on the laterestructuring countries fell well below the buyback equivalent price of
the Mexican Brady package. Note that fears that countries might drive
down the price of their debt so as to purchase it subsequently on the
cheap do not appear to have been borne out. Banks have used
arguments of precedence to resist offering more generous terms to laterestructuring countries; the power of precedent has pushed buyback
equivalent prices of debt exchanges to conform more closely to those
offered Mexico. Countries that did not adopt strong adjustment
programs generally lacked the resources to complete comprehensive
restructuring operations because direct support from official creditors
was not available. When countries that had been incurring interest
arrears showed signs of moving toward a debt operation, debt prices
tended to recover sharply. As a result, the effective prices of the bank
packages reflected precedent, expected future debt-servicing capacity,
and up-front enhancements rather than past debt-servicing history.
64 Although capturing the benefits of the improved outlook for capital
inflows might not have directly informed banks’ negotiating positions on
the treatment of interest arrears, countries surely considered the outlook
for future flows in deciding whether to agree to the banks' terms.
Moreover, it seems reasonable to expect that banks as negotiators
attempted to anticipate countries’ positions. Hence, in this way, the
outcomes on the arrears restructurings reflected the more optimistic
outlook.
FRBNY Quarterly Review/Winter 1993-94 61
countries to build up their debt-servicing capacity and get
back on a sustainable growth path, and to restore coun
tries’ access to the international capital markets. Advances
toward these goals were uneven under the new money
strategy, and the process proved less and less workable
over time. Designed to address these shortcomings, the
Brady approach has achieved impressive results. The
Brady restructurings did not achieve significantly more
near-term cash flow relief for debtors than the previous
approach. But they did provide a more stable long-run
62 FRBNY Quarterly Review/Winter 1993-94
financial framework that, in combination with structural
reforms by debtors and a favorable environment of lower
global interest rates, helped to restore market access.
Although there has been a remarkable turnaround in the
market’s assessment of restructuring countries, significant
risks remain. Debt service obligations remain heavy for the
Brady countries. While the restoration of market access is
helpful, the key to sustained growth and creditworthiness
continues to be sound macroeconomic policies comple
mented where needed with further structural reforms.
Index Amortizing Rate Swaps
by Lisa N. Galaif
As short-term interest rates have declined over the past sev
eral years, investors have increasingly sought higher yield
ing investment vehicles. The index amortizing rate (IAR)
swap is one of several new instruments that have been
developed in response to this investor demand for yield
enhancement. An IAR swap is an interest rate swap based
on a notional principal amount that may decrease over time
in accordance with the path of future interest rates.1
The IAR swap market has grown rapidly since its incep
tion in 1990, achieving a market size in late 1993 estimated
at $100 billion to $150 billion notional principal. IAR swaps
should continue to be popular because they can be an
attractive investment under certain interest rate scenarios
and a good hedging vehicle for dealers’ written options
exposures.
This article explains the structure and pricing of IAR
swaps, the risks associated with the product, and the uses
as well as the growth prospects for the market. We find that
while the product has advantages for dealers and investors,
its complexity may be a drawback. To price and hedge IAR
swaps, dealers must use highly technical models with para
meters whose values are difficult to forecast. Investors may
have trouble comparing the risk-return tradeoffs of an IAR
swap with those of more liquid and traditional instruments.
The structure of IAR swaps
An IAR swap is an over-the-counter contract between two
parties to exchange interest payments—one based on a
fixed rate and the other on a floating rate—on an amortizing
notional principal amount. Like the so-called plain vanilla
1 The IAR swap is also known as an index principal swap (IPS) or an index
amortizing swap (IAS).
interest rate swap, the IAR swap involves no exchange of
principal. But unlike the plain vanilla swap, whose net inter
est payments are made on a fixed notional amount, the IAR
swap calls for net interest payments made on a notional prin
cipal balance that may decrease over the life of the swap.
The rate at which the notional principal amount decreases
will vary with a specified short-term interest rate according to
a schedule predetermined by the two parties. In general,
however, notional principal amortizes more quickly when
short rates fall and more slowly when short rates rise.2
In a typical IAR swap, an end-user3 (or fixed rate
receiver) receives interest payments based on the fixed
rate while paying the dealer (or fixed rate payer) floating
interest indexed to three-month LIBOR. The amortizing
notional amount on which both interest payments are
based is typically $100 million at origination. Net interest
payments are most often made quarterly throughout the life
of the swap, just as they are in a plain vanilla swap.
The standard contractual maturity for an IAR swap is five
years with a two-year “lockout” period, meaning that the
swap does not start amortizing until the beginning of the
third year. The amortization schedule is usually designed
so that if short-term interest rates remain unchanged, the
IAR swap will have a life of about three years. However, if
the floating rate index falls sufficiently, the swap could fully
amortize at the end of the lockout period. Alternatively, if
rates rise, the swap would amortize at a slower rate and
2 Despite the use of the term “amortization” by market participants, the
amortization of notional principal does not imply payment of principal; it
refers to the declining notional principal amount on which interest
payments are based.
3 An end-user or customer is typically an institutional investor such as an
insurance company, bank, or mutual fund.
FRBNY Quarterly Review/Winter 1993-94 63
have a longer than expected maturity, perhaps reaching its
five-year maximum life. The variable maturity of an IAR
swap is another feature distinguishing it from a plain vanilla
swap, which has a fixed maturity date.
Table 1 presents a typical IAR swap amortization sched
ule. If LIBOR remains at 4.50 percent, the swap amortizes
by 80 percent per year after the lockout period; if LIBOR
rises to 5.50 percent, the swap amortizes at 30 percent per
year. Alternatively, if LIBOR drops to 3.50 percent, the
swap amortizes at 100 percent in year 3. This particular
schedule assumes yearly amortization, although quarterly
amortization is also common in IAR swap schedules.
Changes in future short-term interest rates affect the
Table 1
Amortization Schedule of Typical IAR Swap
LIBOR*
(Percent)
Change in Basis
Points
Amortization Rate
(Percent)
3.50
4.50
5.50
6.50
-100
0
+ 100
+200
100
80
30
10
Notes: The amortization rate in the table is based on annual
changes in LIBOR. The terms and conditions of the IAR swap
illustrated here are as follows:
Notional amount:
Fixed rate:
Lockout period:
Final maturity:
Payment frequency:
Amortization:
$1,000
4.745 percent
2 years
5 years
Annual
After the lockout period, yearly amortization
of remaining notional principal balance
based on changes of yearly LIBOR.
f The initial spot rate is 4.50 percent.
swap in three ways: they 1) directly affect future net interest
payments, 2) indirectly affect future net interest payments
by changing the principal amount on which interest calcula
tions are based, and 3) alter the maturity of the swap.
The interest rate scenarios presented in Table 2 illustrate
how the notional principal of an IAR swap amortizes given
the schedule set forth in Table 1. If future interest rates fol
low LIBOR path 2 (case 2), then, in year 3, $800 of the
notional princip al a m o rtize s, reducing the rem aining
notional principal to $200.4
An IAR swap’s maturity is usually described in terms of a
weighted average life because the instrument’s maturity
and notional principal may vary. First, the date of the
swap’s last payment will vary with the path followed by
short-term interest rates. Second, the date of the last pay
ment can be a misleading representation of the swap’s
maturity because the remaining notional principal is also
variable. Consider, for example, two IAR swaps that origi
nate with the same notional principal of $100. While both
may end after three years, one may end with a notional
principal amount of $60 while the other may end with a
notional amount of $30. The weighted average life of an
IAR swap is calculated by summing the percentage of the
remaining notional principal amounts over each interest
rate path. These amounts are then averaged across the
possible paths. Note that the weighted average life is sim
ply used to describe the instrument’s maturity. It is not used
for pricing and hedging because it does not describe the
actual cash flows with sufficient precision.
4 Given an interest rate of 4.50 in year 3 (case 2), the amortization
schedule specifies that $800 of the notional principal will amortize. This
amortization leaves $200 in remaining notional principal at the end of
year 3. In this example, the amortization rate applies to the current
outstanding notional principal.
Table 2
IAR Swap Notional Principal Balance
Notional Principal Given Various LIBOR Paths
0-1*
1-2*
2-3
3-4
4-5
Case 1: declining rates
LIBOR
Notional principal
4.50
1,000
4.00
1,000
3.50
0
3.25
0
3.00
0
Case 2: stable rates
LIBOR
Notional principal
4.50
1,000
4.50
1,000
4.50
200
4.50
40
4.50
8
Case 3: rising rates
LIBOR
Notional principal
4.50
1,000
5.01
1,000
5.53
705
5.82
539
6.13
445
Paths
Year:
Notes: Amortization is applied to the remaining notional principal balance of the previous period and is based on the schedule in Table 1
Amortization for rates not given in Table 1 is computed through linear interpolation.
1 No notional principal amortization during two-year lockout period.
64 FRBNY Quarterly Review/Winter 1993-94
Optionality of an IAR swap
The amortizing feature of an IAR swap is an implicit call
option that essentially gives the fixed rate payer the right to
“call” or cancel a portion of the swap (according to the pre
determined schedule) if interest rates decline substantially.
The fixed rate payer in an IAR swap thus owns an implicit
option analogous (but not identical) to the prepayment
option in a callable bond or mortgage security. For this
right, the fixed rate payer pays a yield premium for the
im plicit option. However, in contrast to the embedded
options on long-term rates in callable bonds and mortgage
securities, the implicit options in an IAR swap are usually
options on short-term interest rates.5
Because an IAR swap’s behavior is dependent on the
path of interest rates, the exact set of interest rate options
embedded in an IAR swap are difficult to determine directly
from the amortization schedule. Instead, these im plicit
options must be determined indirectly from interest rate
models that estimate the IAR swap’s exposure profile in dif
ferent interest rate scenarios. For example, in Table 2, the
amount of notional principal remaining in case 2, year 4,
depends not only on the short-term rate that will prevail in
year 4, but also on the rate that will prevail in year 3. Hence,
it is not always possible to purchase the correct number of
options or futures contracts in year 1 to hedge the cash flow
risk in year 4, since the exposure in year 4 depends on the
interm ediate path of future interest rates. Specifically,
dynam ic hedging is required as the exposures to be
hedged change with each period.
However, for large parallel shifts in the yield curve, the
IAR swap will provide a lower return than the plain vanilla
swap. If both short and long rates fall, the IAR swap will
amortize rapidly after the lockout period, subjecting the IAR
swap’s fixed receiver to reinvestment losses at the lower
rates. If both short and long rates rise, the amortization rate
will slow, lengthening the maturity. In this scenario the fixed
rate receiver is paid a below-market fixed rate for a longer
period than would be the case in the plain vanilla swap.
As the chart shows, if the net present value of the plain
vanilla swap is subtracted from the net present value of the
IAR swap, the difference is similar, but not identical, to the
exposure profile of a short straddle.6 In other words, an IAR
swap can be thought of as a plain vanilla swap (of the same
maturity as the expected maturity of the IAR swap) com
bined with a collection of interest rate options written by the
fixed rate receiver that replicate the “straddle-like” exposure
in the chart. For the fixed rate receiver, the option premium
6 A short straddle is a collection of written interest rate options. Some pay
off when rates rise, while others pay off when rates fall.
Our chart is modeled loosely on a chart that appeared in Derivatives
Week, vol. 2, no. 3 (January 25, 1993).
Net Difference between an Index Amortizing Rate
Swap and an interest Rate Swap from the
Perspective of a Fixed Rate Receiver
Dollar net difference in present value
10000 -----------------------------------------------------------
Behavior of IAR swaps when interest rates change
Like a plain vanilla interest rate swap, an IAR swap has a
present value for the fixed rate receiver that will fall when
interest rates rise and increase when interest rates fall.
However, the magnitude of these changes for an IAR swap
and a plain vanilla swap differs because of the option-like
behavior of the IAR swap. Specifically, when rates fall, the
gain in an IAR swap’s value is smaller than the gain in a
plain vanilla swap’s value; when rates rise, the loss in value
of an IAR swap exceeds that of a plain vanilla swap.
The chart illustrates the performance difference between
an IAR swap and a plain vanilla interest rate swap (of the
same maturity as the expected maturity of the IAR swap)
from the perspective of the fixed rate receiver. When long
and short rates move together (producing parallel shifts of
the yield curve), the IAR swap outperforms the plain vanilla
interest rate swap in a stable interest rate environment and
underperforms it in a volatile environment. In other words, if
interest rates do not change by a large amount, an IAR
swap offers the investor a more favorable fixed rate of
return than the plain vanilla swap because of the option
premium embedded in the IAR swap’s fixed rate.
5 Thus, IAR swaps are not ideal hedges for mortgage securities unless
perfect correlation exists between long-term and short-term rates.
5000
0
-5000
-10000
-15000
-200
-150
-100
-50
0
50
100
Interest rate change in basis points
150
200
Notes: The net difference equals the present value of the
cash flows of the IAR swap along the given interest rate path
minus the present value of the cash flows of the interest rate
swap along the same interest rate path. The interest rate
changes, are based on parallel shifts in the yield curve. The
weighted average life for the IAR swap is three years, with a
contractual maturity of five years and a two-year lockout
period. The maturity of the interest rate swap is three years.
The original notional principal for both the IAR swap and the
interest rate swap is $1,000,000. The fixed rate on the IAR
swap is 4.745 percent and the fixed rate on the interest rate
swap is 4.50 percent.
FRBNY Quarterly Review/Winter 1993-94
65
embedded in the fixed rate of the IAR swap causes the IAR
swap returns to exceed the plain vanilla swap returns when
interest rates stay within a narrow range (because the
option is not exercised). But when rates either fall or rise by
a large amount, some of the embedded options will be
exercised against the fixed rate receiver, thus causing the
returns from the IAR swap to fall short of the returns from
the plain vanilla swap.
Nonparallel shifts in the yield curve
The embedded options in an IAR swap have complex fea
tures that become apparent as soon as nonparallel yield
curve changes are considered. If long rates rise and short
rates fall, an IAR swap outperforms a plain vanilla swap
from the perspective of the fixed rate receiver.7 As short
rates decline, an IAR swap amortizes faster, allowing the
fixed rate receiver to enter into another swap at a higher
long-term fixed rate, whereas the owner of a plain vanilla
swap will continue to hold an instrument that now pays a
below-market fixed rate.
Similarly, if long rates fall and short rates rise, the IAR
swap will also outperform the plain vanilla swap for the
fixed rate receiver. As short rates rise, the IAR swap amor
tizes at a slower pace, enabling the fixed rate receiver to
continue receiving an above-market fixed rate for a longer
period. In contrast, the owner of a plain vanilla swap experi
ences reinvestment losses at the now lower long-term fixed
rate when the plain vanilla swap matures.
Pricing of IAR swaps
In principle, the fixed rate of an IAR swap is set at the level
that gives the swap an expected net present value of zero
at origination. That is, the IAR swap is priced by taking the
swap’s net cash flows over each of the possible paths of
LIBOR rates (in Table 3, three equally likely paths) and
solving for the fixed rate that makes the average present
value of the net cash flows equal to zero. In practice, all
pricing models apply weights to the possible paths. To
maintain the internal consistency of the pricing model,
these paths and their weights are chosen so that arbitrage
possibilities are eliminated.
Table 3 illustrates the difference in pricing between an
IAR swap and a plain vanilla swap. Consider an IAR swap
with a $1,000 initial notional principal and the amortization
schedule presented in Table 1. The cash flows calculated
in the example are from the perspective of the fixed rate
receiver. For simplicity, assume that the possible future
paths of LIBOR rates are the three paths indicated by
cases 1,2, and 3. Case 2 is the path of LIBOR rates implied
by forward rates derived from the initial yield curve, and the
other two paths are possible alternative interest rate paths.
7 In reality, medium-term rates of under five years are relevant for IAR
swaps because the contractual maturity in most IAR swaps is five years
or less.
Digitized66
for FRASER
FRBNY Quarterly Review/Winter 1993-94
The price (or the fixed rate) of the plain vanilla swap is
the fixed rate that causes the present value of the fixed pay
ments to equal the present value of floating payments as
forecast by the initial forward rates.8 The fixed rate of the
IAR swap is 4.745 percent, while the fixed rate of the plain
vanilla interest rate swap is 4.50 percent. In effect, the 24.5
basis point difference between the two rates represents the
value of the implicit options in the IAR swap.
The complexity of the IAR swap’s valuation process is
itself a source of uncertainty. Market participants will use
different assumptions about volatilities, future interest rate
paths, and the correlations between long and short rates in
their IAR swap interest rate models. These different
assumptions can create larger price variations between dif
ferent market participants’ pricing models for IAR swaps
than is the case with plain vanilla interest rate instruments,
which are priced using the observable yield curve.
Risk issues
Price risk
The greatest risk for an investor (that is, fixed rate receiver)
in an IAR swap is the opportunity cost of holding an IAR
swap in the event of a significant interest rate move up or
down. If short rates rise sufficiently, the net payout for the
fixed rate receiver (end-user) can become negative if the
amount of the floating rate payment exceeds the amount of
the fixed rate receipt. This interest rate risk is amplified in
an IAR swap because as rates rise, the swap’s amortiza
tion slows and the fixed rate receiver may have a negative
cash flow for a longer period.
Since the birth of the IAR swap market in 1990, short
term rates have declined. Thus, most IAR swaps initiated to
date have ended immediately after the lockout period, and
the behavior of IAR swaps in a rising rate environment has
not yet been tested.9
Many end-users may find it difficult to determine pre
cisely the risk-return tradeoff provided by IAR swaps. The
exact set of interest rate options embedded in an IAR swap
is not easily identified because of the IAR swap’s pathdependent nature. Hence, buyers cannot go to an exchange
and price a specific set of options equivalent to those
embedded in the IAR swap. As a result, fixed rate receivers
will have a difficult time judging whether or not they have
received the appropriate premium for the implicit options
• Alternatively, the plain vanilla swap can be priced over the same set of
possible interest rate paths used in pricing the IAR swap. If these
interest rate paths satisfy a consistency condition known as the
“arbitrage-free” condition—a requirement that profitable, riskless
strategies be ruled out—then the two pricing methods for the plain
vanilla swap will produce the same price.
9 Recently, barrier-type options called “knock-outs” have been offered on
some IAR swap contracts. A knock-out clause typically states that if
interest rates rise above a certain level (the knock-out rate), the swap will
terminate automatically. This feature effectively eliminates the extension
risk for the end-user. However, these contracts are expensive and thus
tend to defeat the yield-enhancement feature of the IAR swap.
as mentioned previously, the exact structure of the interest
rate options embedded in an IAR swap cannot be easily
determined from the swap’s amortization schedule. The
path-dependent nature of the IAR swap requires dealers to
use interest rate models to “reveal” and then dynamically
hedge the swap’s embedded options because the pathdependency of these options cannot be replicated by any
simple buy-and-hold options portfolio. Moreover, dealers
must use sensitivity analysis or simulations of both the IAR
swap and the rest of th eir portfolios to determ ine the
degree to which the IAR swaps and other exposures in the
portfolio offset each other. Hence, hedging the IAR swap’s
exposures depends on the reliability of the interest rate
model used in the simulations.
they have sold, because they lack readily apparent and
equivalent market prices for the set of options embedded in
an IAR swap.
Hedging risk
To hedge IAR swaps, dealers use interest rate term struc
ture models that incorporate several assumptions about the
volatility of rates and the correlation of movements in short
and long rates. As a first step, the dealers estimate the IAR
swap’s exposures with an interest rate model.10 Next, they
take into account the offsetting exposures already in their
portfolios to determine a residual exposure. These residual
exposures (both to changes in interest rate levels and
changes in interest rate volatilities) are then hedged, usu
ally using Eurodollar futures and interest rate options.
An interest rate model is required for hedging because,
Model risk
Estimating the true profitability over time of an IAR swap
can be difficult. Because of the IAR swap’s path-dependent
behavior, the instrument cannot be easily broken down into
10 See Julia Fernald, “The Pricing and Hedging of Index Amortizing Rate
Swaps," in this issue of the Quarterly Review.
Table 3
Comparison of the Pricing of an IAR Swap and a Plain Vanilla Swap
Year
Forward
Rate
(Percent)
Notional
Principal
Fixed
Payment1"
Floating
Payment*
Net§
Present
Value
of Net
4.50
4.00
3.50
3.25
3.00
1,000
1,000
0
0
0
47.45
47.45
0.00
0.00
0.00
45.00
40.00
0,00
0.00
0.00
2.45
7.45
0.00
0.00
0.00
2.35
6.85
0.00
0.00
0.00
IAR swap pricing
Case 1
0-1
1-2
2-3
3-4
4-5
Sum
Case 2
0-1
1-2
2-3
3-4
4-5
1,000
1,000
200
40
8
4.500
4.500
4.500
4.500
4.500
47.45
47.45
9.49
1.90
0.38
45.00
45.00
9.00
1.80
0.36
2.45
2.45
0.49
0.10
0.02
2.35
2.24
0.43
0.08
0.02
Sum
Case 3
0-1
1-2
2-3
3-4
4-5
4.50
5.01
5.53
5.82
6.13
1,000
1,000
705
539
445
47.45
47.45
33.45
25.58
21.12
45.00
50.10
38.99
31.37
27.28
2.45
-2.65
-5.54
-5.79
-6.16
(9.20
Plain vanilla swap pricing11
1
4.50
2
4.50
3
4.50
+
5.12
1,000
1,000
1,000
+
45.00
45.00
45.00
-14.32)
45.00
45.00
45.00
-h3
5.12
2.35
-2.41
-4.79
-4.73
-4.74
Sum
Average11
9.20
-14.32
0.00
0.00
0.00
0.00
0.00
0.00
0.00
f Fixed payments are calculated by multiplying notional principal by 4.745 percent.
* Floating payments are calculated by multiplying notional principal by LIBOR.
® Net is the difference between the fixed and floating payments.
1 The average is calculated under the assumption that the three possible LIBOR paths are equally likely.
ft Since the average life of this IAR swap is approximately three years, the comparable swap is the three-year plain vanilla swap.
FRBNY Quarterly Review/Winter 1993-94
67
pieces that look exactly like other instruments whose prices
are known. Hence, the product’s valuation depends criti
cally on interest rate models. This dependence on interest
rate models and the possibility of mispricing is known as
“model risk.”
The set of possible interest rate paths over which an IAR
swap is priced and valued is usually generated using one or
two factor interest rate models. One factor interest rate
models implicitly assume perfect correlation between
changes in short and long rates. Two factor interest rate
models, by contrast, can simulate imperfectly correlated
short- and long-term rates. In this respect, two factor models
would appear to provide better representations of the term
structure than one factor models. Two factor models, how
ever, require their users to make explicit assumptions about
the correlation between separately varying short- and long
term rates. If inappropriate assumptions are made, then a
two factor model’s results can be less accurate.
The pricing models must also rely on assumptions about
the volatility of short- and long-term rates. Assumptions
about volatility, like those concerning the correlation of
short and long rates, make IAR swaps difficult to “mark to
market” and to hedge. The correlation of rates, however, is
an especially difficult parameter to forecast, and problems
can arise because pricing model results are particularly
sensitive to the assumed magnitude of the correlation. For
example, the assumptions about correlations can have a
substantial impact on the level of the fixed rate determined
by the model.
Closely related to model risk is “personnel risk.” When
the IAR swap market was first formed, finding personnel
familiar with the instrument’s pricing and hedging demands
was difficult. In some cases, only one trader at an institu
tion may have been familiar with IAR swap pricing models.
If that trader left the firm, a knowledge gap could arise,
making the risk management of outstanding IAR swap
positions more difficult. Fortunately, personnel risk tends
to diminish as a product matures and market participants
become more familiar with the instrument’s behavior in a
variety of market conditions.
Liquidity risk
For end-users, significant illiquidity exists in the IAR swap
market because of the difficulties of hedging and the cus
tomized nature of the instrument. Because only dealers
with sizable interest rate option exposures can successfully
compete in the IAR swap market, only a handful actively
trade this product. Smaller dealers, who generally lack siz
able interest rate options positions, find it more difficult to
hedge IAR swaps in a cost-effective way and typically exe
cute these swap deals only if they can earn a substantial
margin up front. Without a sizable interest rate options
book, small dealers would have to sell options in the market
to offset their IAR swap positions.
68 FRBNY Quarterly Review/Winter 1993-94
Dealers have expressed their willingness to make a sec
ondary market in this product for customers, but as of yet
an active secondary market has not developed.11 Normal
industry practice is for the initiating dealer to make a bid to
the customer who wants to liquidate an existing contract.
But if the dealer chooses not to buy back the swap from an
end-user and the end-user is unable to find another dealer
to assume the swap, the end-user cannot easily liquidate or
offset the position. Hedging, instead of unwinding, would
be difficult for most end-users because the precise nature
of the exposure to be hedged can be discovered only with
an interest rate model, which IAR swap end-users normally
do not possess.
Credit risk
Principal risk is not present in an IAR swap because there
is no principal investment (as there is in mortgage securi
ties). Hence, potential credit losses are limited to the net
exchange of interest payments over the remaining life of
the swap. Like plain vanilla interest rate swaps, IAR swaps
are priced with a zero net present value at inception. As
short-term interest rates change, the net interest payments
will acquire a net positive or negative present value. This
present value is the credit exposure between the two coun
terparties and is usually only a small fraction of the notional
principal. Thus, IAR swaps pose no additional or funda
mentally different credit or settlement risks than those
already present in the plain vanilla interest rate swap.
The market for IAR swaps
The number of dealers currently active in the IAR swap
market is small but growing. While major U.S. securities
firms dominate the market, U.S. money center banks and
foreign bank subsidiaries also participate in the market.
New York is the market center for IAR swaps, and most IAR
swaps are denominated in U.S. dollars. The low short-term
interest rate environment in the United States has no doubt
been more conducive to the development of the IAR swap
market than have other countries’ interest rate environ
ments. If the yield curves of other countries begin to
steepen, however, investors may begin to use IAR swaps
pegged to non-U.S. rates.
Initially, regional banks were the primary end-users of
IAR swaps. Much of the recent growth in demand, however,
has come from mutual funds, insurance companies, and
other institutional investors.
Uses of IAR swaps
For dealers with sophisticated risk management systems,
IAR swaps provide offsets to the exposures arising from
11 Secondary market liquidity has yet to be tested in the swaps initiated
before or during 1991 because these swaps ended immediately after
the lockout period owing to a dramatic drop in rates over the past two
years.
their over-the-counter interest rate options business. As
fixed rate payers, the dealers own the options embedded in
the IAR swap. Hence they can use these options to hedge
their written interest rate option positions as well as other
exposures in their interest rate swap book.
From the viewpoint of investors such as mutual funds,
insurance companies, and regional banks, IAR swaps pro
vide enhanced yields in a low interest rate environment.
These investors, as writers of the options embedded in IAR
swaps, are essentially speculating that interest rate
changes will be less volatile than buyers of the embedded
options expect. In other words, these investors are betting
that short- and medium-term rates will remain unchanged
or will rise more slowly than predicted by the forward curve.
If this scenario does in fact occur, investors will receive an
above-market fixed return over the life of the swap from the
premiums on the unexercised implicit options that they sold
in the swap.
Investors also find IAR swaps to be a useful substitute for
mortgage-related securities such as collateralized mort
gage obligations (CMOs) and pass-throughs. IAR swaps
offer mortgage-bond-type yields and a similar risk profile,
but remove the idiosyncratic portion of prepayment risk
associated with mortgage securities. Idiosyncratic prepay
ment risk refers to risk not directly related to changes in
interest rates. For example, the need to relocate or a death
in the family may prompt a homeowner to prepay a mort
gage in what would otherwise seem to be an unfavorable
interest rate environment. IAR swaps eliminate risks of this
kind, leaving only the interest-rate-sensitive portion of pre
payment risk.
For many end-users, the IAR swap combined with a posi
tion in Treasury securities provides additional advantages
over owning CMOs and other types of cash mortgage
instruments. IAR swaps offer a less uncertain absolute final
maturity than do CMOs, and as a result, they have a more
predictable weighted-average-life profile than CMOs and
other mortgage assets. IAR swaps also have fewer opera
tional complexities than mortgage securities. For example,
the IAR swaps’ typical quarterly pay structure is easier to
track than the pay structure of mortgage-backed securities,
whose principal and interest payments must be recalcu
lated monthly as prepayment rates change.
By entering into an IAR swap while holding Treasury
securities, a regional bank can increase its liquidity while
receiving yields similar to those of a CMO and maintaining
an interest rate exposure comparable to a mortgage pro
duct’s. Dealers’ marketing materials for IAR swaps also
emphasize “capital efficiency,” suggesting that some
regional bank end-users use IAR swaps to reduce capital
requirements. A position combining government securities
and an IAR swap has low capital requirements that can
offer advantages over the purchase of similar short-dated
CMO securities. Note, however, that this difference in capi
tal requirements is justified by the lack of any principal risk
in the IAR swaps.
Size and growth prospects
The IAR swap market has been expanding rapidly for the
past two years, showing particularly fast growth through the
first half of 1993. An estimated $100 billion to $150 billion in
notional principal has been originated since 1990. It is
unlikely that this expansion will slow markedly unless the
yield curve flattens dramatically.
The market for IAR swaps to date is almost completely
one-way in nature. Dealers are almost exclusively the
fixed rate payers (buyers of the embedded options), and
end-users are almost exclusively the fixed rate receivers
(writers of the embedded options). Recently, however, a
small interdealer market has developed and a modest
number of transactions have been completed through
interdealer brokers.
Although the market seems to be expanding and matur
ing, growth could ultimately be limited by dealers’ inability
to sell the embedded options they have purchased by pay
ing the fixed rate. Dealers must manage their options risk
and thus do not want a large net long or net short options
position. Dealers may be forced to cease writing IAR swaps
if they cannot use the purchased options to hedge other
written option risk or if they cannot resell the long options
exposures. The cost of hedging the residual exposures cre
ated by unmatched positions can become prohibitive,
especially as the IAR swap market becomes more competi
tive and the cost of the embedded options begins to
increase.12 In fact, some dealers have shown reluctance to
originate new transactions because the difficulties of hedg
ing and evaluating the prospective profitability of these
instruments become more critical as spreads narrow.13
Conclusions
IAR swaps have proved useful to both investors and deal
ers. Investors in this instrument can acquire a position that
pays off if rates rise more slowly than predicted by the for
ward curve. Investors in the swaps have also earned
enhanced yields comparable to those on mortgage bond
securities while remaining exempt from the idiosyncratic
portion of the prepayment risk embedded in mortgage
securities. Through IAR swaps, investors have been able to
earn short-dated mortgage-type yields for at least two
12 If dealers were able to sell all of the IAR swaps’ embedded options, they
would not be forced to go to the Eurodollar futures market to hedge
residual risk not offset within their portfolio of other options. Alternatively,
if a two-way market for IAR swaps existed, dealers would be able to
receive the fixed rate and create a natural hedge for those existing IAR
swap positions where they are the fixed rate payer.
13 The rating agencies have prohibited dealers from placing IAR swaps in
their special-purpose AAA-rated swap subsidiaries. The agencies cite
concerns that the one-way nature of the IAR swap market would make it
more difficult to unwind such a swap book in a timely manner.
FRBNY Quarterly Review/Winter 1993-94 69
years, while many cash mortgage securities have prepaid.
Dealers with large interest rate options books have found
IAR swaps attractive as an alternative instrument for hedg
ing the exposures arising from their over-the-counter
options business. In other words, IAR swaps have created
a natural offset for most dealers’ net short positions in
options, thereby helping dealers to meet the m arket’s
demand for interest rate options.
Most of the risks associated with IAR swaps are similar to
those of other instruments. The IAR swap poses the same
threat of negative cash flows as plain vanilla interest rate
swaps or equity-index swaps, along with prepayment and
reinvestment risks similar to those of mortgage securities.
Nevertheless, while IAR swaps pose few unique risks for
most market participants, significant problems may materi
alize in a portfolio with a high concentration of IAR swaps.
Certainly, model risk figures more prominently in IAR
swaps than in other kinds of instruments. Pricing and hedg
ing IAR swaps require highly technical interest rate models,
and the absence of benchm ark market prices and the
instrument’s relatively long life mean that pricing model
inaccuracies may not become immediately apparent. A
dealer who enters the market w ithout strong technical
expertise may encounter problems arising from mispricing
and mishedging. Risk management systems in place for
plain vanilla interest rate swaps and options may not be
sufficient to handle the complexity of IAR swaps. A firm ’s
internal risk control unit must be capable of accurately
monitoring the trading desk’s pricing and hedging models
for IAR swaps. In sum, dealers who are active in the IAR
swap market need considerable technical knowledge as
well as strong risk management systems.
The variable maturity feature of IAR swaps requires that
an in s titu tio n ’s risk m anagem ent system take proper
account of longer term exposures embodied in these instru
ments. For example, excessive emphasis by management
on short-term trading results may create incentives to enter
into IAR swaps strictly for short-term yield enhancement or
trading gains, without consideration of the long-term perfor
mance results of the instrument. Note, however, that this
problem exists for all instruments with medium- to long
term option-like exposure, not only IAR swaps.
This problem highlights potential weaknesses in current
methods of recognizing trading gains in accounting sys
tems. For example, the fixed rate return of an IAR swap
contains an option premium for future option-like liabilities
or exposures. This feature leads one to ask how much of an
IAR swap’s yield premium should be incorporated in cur
rent income. From a broader perspective, the proliferation
of IAR swaps and similarly complex financial transactions
underscores the need for accounting and disclosure prac
tices suited to such instruments.
Appendix: Reverse Index Amortizing Rate Swaps
Instrument structure
Anticipating a possible rise in short-term interest rates,
investors are seeking to limit potential losses on their float
ing rate exposures. In response to this demand, dealers are
currently marketing a variation of the IAR swap called the
reverse index amortizing rate swap or RIAR swap. Like an
IAR swap, an RIAR swap is an interest rate swap whose
notional principal amortizes at a rate that varies with the
level of market interest rates according to a predetermined
schedule. In a typical RIAR swap, as in an IAR swap, an
end-user receives the fixed rate while paying the dealer a
floating rate. An RIAR swap’s amortization schedule differs
from that of an IAR swap, however, in calling for the notional
principal to amortize more quickly as market interest rates
rise. For example, if the floating rate index rises sufficiently,
the swap could fully amortize at the end of the lockout
period. Alternatively, if rates decrease, the predetermined
structure of the RIAR swap could cause the swap to amor
tize more slowly or, in some cases, not at all.
The amortizing feature of an RIAR swap can be viewed
as an implicit put option, giving the floating rate payer the
right to “put” or reduce a floating rate liability if rates
increase. For this right, the floating rate payer receives a
70 FRBNY Quarterly Review/Winter 1993-94
somewhat lower fixed rate than would be paid on a plain
vanilla interest rate swap.
At the present time a small number of U.S. securities
firms and money center banks are developing this product.
Only a handful of trades are believed to have taken place in
the market to date.
RIAR swaps are being marketed to corporate end-users,
banks, mutual funds, insurance companies, and other insti
tutional investors.
Risks
The RIAR market is presently one-sided. To date, only deal
ers have written the embedded put option in the RIAR swap,
and in their normal course of business, they are typically net
sellers (writers) of options. Thus, for dealers with net short
option positions, writing put options embedded in RIAR
swaps may increase their overall portfolio’s residual expo
sure and raise hedging costs.
Like IAR swaps, RIAR swaps involve no principal risk.
The greatest risk to an investor would be the opportunity
cost of holding an instrument paying a below-market rate of
interest if rates were to remain stable.
The Pricing and Hedging of
Index Amortizing Rate Swaps
by Julia D. Fernald
Index amortizing rate (IAR) swaps have been popular yield
enhancement instruments over the past few years.1 The
enhanced yields associated with these instruments result
from premiums earned on options embedded in the swaps.
Because these options depend on the path of interest
rates, the pricing of IAR swaps requires a model of interest
rate movements.2
This article presents a simple example of an interest rate
model, outlines IAR swap pricing derived from the model,
and develops a hedging strategy to offset the uncertain
cash flows from the swap. Finally, the article discusses the
complications that arise in more realistic pricing and hedg
ing situations.
rising or falling equal one-half.4
Description of the swap
Although the interest rate tree has only two periods of
uncertainty, the IAR swap in our example has three cash
flow payments. If we assume an IAR swap with a one-year
lockout period, the first cash flow at time 0 is based on an
original notional amount of $100 and the current one-year
rate. The two subsequent payments depend on the realiza
tion of the one-year rates at time 1 and time 2 and on the
amortization schedule in Table 1.
4 The price of a two-period zero coupon bond with an interest rate of 9.995
Interest rate model
In this example, we assume that one-year interest rates are
well represented by a model with the binomial tree structure
illustrated in the figure.3 The tree is consistent with initial
two- and three-year interest rates of 9.995 percent and
9.988 percent, respectively, if the probabilities of rates
1 See Lisa Galaif, “Index Amortizing Rate Swaps,” in this issue of the
Quarterly Review.
p e rc e n t e qu a ls the p ric e of a tw o -ye a r zero co up o n bon d d erive d from
the tree:
iTo * I
* ( 4 + i“Tt) = ' 827'
In the pricing and hedging of IAR swaps, the relevant probabilities are
those that make the binomial tree consistent with the current term
structure of interest rates.
Figure: Binomial Distribution of One-Year
Interest Rates
One-Year Interest Rates
2 Models used to value path-dependent interest rate options must be free
from arbitrage in the sense that they price fixed-income instruments
consistently with the current term structure of interest rates. The models
can be represented by interest rate trees or lattices that give possible
outcomes of future short-term interest rates. These representations are
used to calculate both the initial price of the IAR swap and the dynamic
hedges that swap dealers would enter over time.
Time 0
Time 1
Time 2
Path
3 Our example assumes that future short-term rates are determined by one
factor. The example is consistent with one-year rates that are normally
distributed with a constant annual volatility of 1.0 percentage point.
FRBNY Quarterly Review/ Winter 1993-94
71
Because the swap’s notional principal amortizes on the
basis of the short rate, the swap cash flows at each period
depend not only on the rate that period but also on the path
of previous rates. Table 2 shows the four possible cash flow
paths (from the perspective of the fixed rate payer) that
arise from our interest rate model. In this example, F is the
fixed rate paid on the IAR swap.
Pricing
As with any swap, the fixed rate on a IAR swap is deter
mined such that the initial present value of the swap’s cash
flows is zero. The present value of the cash flows from an
IAR swap is more difficult to calculate than the correspond
ing value for a plain vanilla swap, however, and depends on
the assumed arbitrage-free interest rate model. In pricing
our IAR swap, we find the fixed rate consistent with the pre
determined amortization schedule, the assumed distribu
tion of one-year interest rates, and our binomial represen
tation of the model. The cash flows are functions of the
fixed rate F, the current rate, and the path of previous rates.
Because we have only four possible cash flow paths, we
can solve explicitly for the fixed rate, F, that makes the
average present value over these possible cash flow paths
equal to zero. In this way, we obtain a fixed rate of 10.26
percent.5
In this example, with its virtually flat 10 percent term
structure, the fixed rate on a plain vanilla swap is approxi
mately 10 percent. The 26 basis point premium in the IAR
swap fixed rate is the value of the embedded options that
the fixed rate payer implicitly purchases.
Table 3 shows the fixed rate payer’s cash flows over the
four paths and the three time steps, given the 10.26 percent
fixed rate. Notice that when the interest rate is 10 percent at
time 2 (paths 2 and 3), the cash flows depend on the inter
est rate at time 1. This difference illustrates the pathdependent nature of the IAR swap.
5 Let R t be the one-year interest rates and let CFpt be the cash flows for
the four possible paths, p, and the three time periods, t. We solve for the
fixed rate that sets the present value of the cash flows, or
p= 1 t=0
Hedging
Fixed rate payers (usually swap dealers) may wish to
hedge their highly variable payments. For example, if rates
rise in the first period, dealers receive $.663, but if rates
fall, the dealer pays $.631. In the second period, dealers
face a similarly variable outcome that depends on the path
of interest rates. We show that if fixed rate payers hedge
the uncertain cash flow s every period, they w ill earn
exactly the additional 26 basis points that they pay as
option premium.
Although there are many ways to implement hedges, all
methods involve calculating changes in the swap’s value
given sm all changes in the underlying interest rates.
Because our interest rate model involves only one factor,
we need only one instrument to hedge the swap. For sim
plicity of exposition, we choose to replicate the IAR swap’s
payoffs using forward contracts instead of the more typi
cally used futures contracts. In our example, the forward
rate implied by the initial term structure is 9.991 percent on
one-year contracts maturing at time 1.
We choose the first hedge at time 0 to offset the two pos
sible time 1 swap values. The time 1 swap values are com
posed of two elem ents: the actual cash flow s paid or
received on the swap and the expected value of the time 2
payments or receipts. The actual cash flows from the swap
are the value of the time 0 payment (-$.263) at time 1 plus
the time 1 amount (+$.663 in the up-state, or -$.631 in the
Table 2
Fixed Rate Payer’s Cash Flows from the
IAR Swap
Cash Flows
Path
Time 0
Time 1
Time 2
1
2
3
4
$100'(10%-F)
100*(10%-F)
100*(10%-F)
100*{10%-F)
$90*(11%-F)
90*(11%-F)
50*(9%-F)
50*(9%-F)
$90’ (12%-F)
72*(10%-F)
40*(10%-F)
0*(8%-F)
C \+ R p ,q )
<7=0
equal to zero.
Table 3
Fixed Rate Payer’s Cash Flows from the IAR
Swap with a Fixed Rate of 10.26 Percent
Table 1
Amortization Schedule
Interest Rate
(Percent)
Notional Amortization
(Percent)
12
11
10
9
8
0
10
20
50
100
Digitized 72
for FRASER
FRBNY Quarterly Review/Winter 1993-94
Cash Flows
Path
Time 0
Time 1
Time 2
1
2
3
4
$-0,263
-0.263
-0.263
-0.263
$0,663
0.663
-0.631
-0.631
$1,563
-0.189
-0.105
0.0
allows for nonparallel shifts in the yield curve, it implicitly
assumes multiple sources of risk; it thus requires multiple
hedging instruments. Bucket hedging is useful if interest
rate dynamics are more complicated than the single factor
model assumes.
down-state).6 The expected remaining value of the swap is
$.612 in the up-state, and -$.048 in the down-state.
If the dealer combines the $100 swap with -$97.5 of the
forward contract, the portfolio’s value will be equal to zero
at time 1 whether rates rise to 11 percent or fall to 9 per
cent.7 At time 1, the dealer follows the same type of calcula
tion, keeping track of the time 2 values of the swap and the
previous hedge. The new hedge amounts are -$87.0 if we
are in the up-state or +$5.2 if we are in the down-state. The
process of readjusting hedges through time is known as
“dynamic hedging.”
If we adopt these hedge amounts, the outcome from
hedging the swap along each path offsets the payoffs from
the swap along that path. Table 4 illustrates the calcula
tions of the hedged swap’s value along the first path. The
hedged swap’s value along the other three paths will also
equal zero at time 2.
Another hedging method computes the change in the
sw ap ’s value fo r changes in each forw ard rate. This
“bucket” hedge method involves (1) the initial purchase of a
series of forw ard contracts in amounts that offset the
recomputed swap’s value and (2) the dynamic adjustment
of the hedge through purchases or sales of additional for
ward contracts in the future.8 Because bucket hedging
Issues
In this example, the hedges perfectly offset the swap if any
of the four modeled interest rate paths is realized. Although
it is simplistic to assume that interest rates will follow one of
these four paths, the example illustrates potential issues
that can arise when valuing and hedging interest-ratedependent derivatives. In particular, the pricing and hedg
ing of any interest rate derivative security depend on deci
sions at several levels concerning:
• the interest rate model: How many factors are rele
vant? W hat type of process do they follow — for
example, normal, lognormal?
• the parameters of the model: What are the volatili
ties? If the model includes more than one factor,
what are the correlations?
• the implementation of the model: How small are the
time steps? Is it a binomial or trinomial tree? How
many simulations are used?
6 The total cash flow from the swap in the up-state is therefore $.372,
which equals -$.263*( 1.11) + $.663.
If assumptions about the model and the parameters of
the model are incorrect, the hedging cannot offset realized
gains and losses. In our example, hedging depends on the
forward rates implied by our interest rate tree. If these rates
are not realized, the cash flows from the hedges cannot
perfectly offset the cash flows from the swap. These rates
can be wrong because the short rate process is in fact not
well represented by a single factor normal distribution with
constant volatility. Valuing the swap using other interest
rate models— for example, a two factor lognormal interest
7 The hedge amounts are essentially (the negative of) the derivative of the
swap's value with respect to interest rates. In our example, the first
hedge amount, $97.5, equals $.983 (the swap's value in the up-state)
less $-.966 (the value in the down-state), divided by .02 (the difference in
the interest rates).
8 In our example, we would initially sell $80.1 of the forward contract
maturing at time 1 and $19.1 of the contract maturing at time 2. If rates
rise to 11 percent, we would sell $68.1 of the contracts maturing at time
2 at the new forward rate; if rates fall to 9 percent, we would buy $24.5 of
the time 2 forward contracts.
Table 4
Payment Stream for the First Path
gfiSS
Swap at time 0
Cash Flows
Time 1
Time 2
-.263
-.263(1.11)
-.263(1.11)(1.12)
=
-.327
.663(1.12)
=
-.743
1.563
=
1.563
-97.5(.11-.0999)(1.12)
=
-1.102
Swap at time 1
.663
Swap at time 2
Hedge entered at time 0
Hedge entered after up-jump
at time 1
Value of the hedged swap
at the end of time 2
Future
Value
Time 0
-97.5(.11-.0999)
MB
jjjj
-87 .0(.12-.1099)
-.878
0.0
FRBNY Quarterly Review/ Winter 1993-94
73
rate model—can give a different fixed rate and different
hedges.
Different assumptions about the parameter values also
affect the fixed rate. In our example, if the volatility is 1.5
percentage points instead of 1.0, the fixed rate will increase
from 10.26 percent to 10.60 percent. The differences
across models and parameter values can be considerable,
and careful judgment should be used when testing the sen
sitivity of the results to different assumptions.
The fixed rate and the subsequent hedging also depend
on how the model (with its assumptions) is implemented.
The goal in implementing the model is to approximate
numerically a stochastic process. If we shorten the time
steps, we will find a different fixed rate than we find with
annual time steps. The appropriate time step for valuation
Digitized 74
for FRASER
FRBNY Quarterly Review/Winter 1993-94
is the one in which the fixed rates have converged on a
value. In our example, the hedge ratios at time 1 are sig
nificantly different when the rates rise to 11 percent than
they are when the rates fall to 9 percent. If we shorten the
time steps and update the hedge ratios more often, the
hedging will change more gradually than is illustrated by
our example.
Actual models are more complex than our example at all
levels: volatilities are not necessarily constant, the initial
term structure is not conveniently flat, and models are
implemented with higher frequencies. Adjustments need to
be incorporated for nonparallel shifts in the yield curve
because nonparallel shifts will affect the swap’s value.
Making errors at any of these levels will potentially result in
a misvalued instrument.
Recent Ttends in Commercial
Bank Loan Sales
by Rebecca Demsetz
Loan sales represent an important departure from the tra
ditional bank activity of originating credit to be held until
maturity. The dollar volume of commercial and industrial
(C&l) loan sales rose rapidly in the mid-1980s but has
declined equally rapidly over the past few years. Previous
studies have discussed these aggregate trends;1 however,
aggregate data mask some interesting differences
between the loan sales activities of the largest sellers and
those of all other banks. This article seeks to provide
insight into recent loan sales declines by examining the
sales activities of two distinct groups of institutions. The
first group includes the top few sellers only and is referred
to as the market’s “first tier.” All other institutions are
labeled “second tier.”
The article finds that recent declines in loan sales appear
to reflect a drop-off in the origination of loans likely to be
traded in the secondary market, rather than a disruption of
the secondary market process. Diminished origination of
salable loans reduces the volume of “inputs” available for
secondary market transactions. This pattern seems to have
characterized the sales activities of both first-tier and sec
ond-tier banks. Second-tier sales first fell during the 199091 recession and have continued to decline with the persis
tent weakness of C&l lending since the recession. First-tier
trends also reflect recession-related origination declines
and the ongoing weakness in C&l lending, but appear to be
1 For example, see Joseph Haubrich and James Thomson, “The Evolving
Loan Sales Market," Federal Reserve Bank of Cleveland Economic
Review, July 1993; Richard Cantor and Rebecca Demsetz,
“Securitization, Loan Sales, and the Credit Slowdown,” Federal Reserve
Bank of New York Quarterly Review, Summer 1993; and Allen Berger and
Gregory Udell, “Securitization, Risk, and the Liquidity Problem in
Banking,” in Michael Klausner and Lawrence White, eds., Structural
Change in Banking (Homewood, III.: Irwin Publishing, 1992), pp.227-91.
driven mainly by a decrease in large credits related to cor
porate acquisitions, leveraged buyouts (LBOs), and recapi
talization. The following three sections examine loan sales
trends; the role of corporate acquisitions, LBOs, and recap
italization; and the importance of economic conditions.
Aggregate, first-tier, and second-tier sales trends
Chart 1 tracks the aggregate loan sales activity of all
insured domestic commercial banks from the first quarter of
1986 through the first quarter of 1993. The data in Chart 1,
drawn from banks’ Reports of Income and Condition (“Call
Reports”), measure the dollar volume of C&l loans origi
nated and sold without recourse during each calendar
quarter.2 Quarterly loan sales flows attributable to insured
domestic commercial banks peaked at $285 billion in 1989.
By 1993, these flows had dropped to $89 billion, a decline
of almost 70 percent.
The aggregate trends revealed in Chart 1 mask important
differences in loan sales trends associated with first-tier
and second-tier sellers. Chart 2 adds two additional series
describing the loan sales activities of these subsets of the
insured domestic commercial bank population. The first-tier
subset includes the top five sellers in each quarter exam
ined. All other banks belong to the second-tier subset. The
size of the first-tier subset may seem arbitrarily small; how
ever, loan sales attributable to the second five sellers are
much smaller than those attributable to the top five sellers
and follow trends similar to those experienced by the
2 The term “loans sold” refers to the sale of entire loans or portions of
loans; “loans originated" refers to loans made directly by the reporting
bank and does not include loans purchased from other institutions. When
a loan is sold “without recourse,” the risk of the loan is transferred to the
buyer.
FRBNY Quarterly Review/Winter 1993-94 75
remainder of the loan sales market.3 Two first-tier sellers
are especially important, accounting for an average of 42
percent of aggregate sales between first-quarter 1986 and
first-quarter 1992.4
Chart 2 shows that first-tier banks, all very large institu
tions, account for a substantial fraction of both the level of
aggregate sales and trends in aggregate sales. Sales by
first-tier banks increased rapidly through 1988, fell sharply
from the third quarter of 1989 through the first quarter of
1990, and then fell more gradually over subsequent years.
These first-tier sales account for 81 percent of the aggre
gate loan sales increase between first-quarter 1986 and
third-quarter 1989 and 80 percent of the subsequent loan
sales decline. Second-tier sales trends differ from first-tier
trends but also show a rise and subsequent decline over
the 1986-93 period. Second-tier sales rose gradually in the
mid-1980s, peaked in the first quarter of 1990 (after the
peak in first-tier sales), and then fell at a rate similar to the
rate of decline in loan sales by first-tier banks.
3 In addition, the composition of the first-tier subset is quite stable over
time. A total of eight institutions appear in the seven first-tier subsets
corresponding to the first quarters of 1986-92.
The role of corporate acquisitions, LBOs, and
recapitalization
For firs t-tie r banks, loan syndication a ctivity provides
insight into trends in the origination of salable loans. Syndi
cations are large credits shared by a group of banks upon
origination. Since syndications are commonly parceled into
smaller credits that are sold in the secondary market, syndi
cated loan volume gives some indication of the strength of
secondary market loan supply by large sellers. The table
reports annual syndicated loan volume by purpose from
1987 through 1992. These data reflect lines of credit as well
as actual loan originations, so they overestimate the vol
ume of syndicated loans available for secondary market
sale. Nevertheless, they do clarify the trends in the origina
tion of salable loans by large banks.
The table shows that total syndicated loan volum e
increased between 1987 and 1989 and then fell abruptly.
Furthermore, the sharp drop in total syndicated loan vol
ume was driven by loans in the “leverage” category. Syndi
cated loans extended for leverage purposes finance corpo
rate acquisitions, LBOs, and recapitalization. They are
unlikely to represent lines of credit, because investmentgrade borrowers generally use credit lines to support com-
4 Berger and Udell first noted the importance of these two institutions,
Security Pacific and Bankers Trust. See “Securitization, Risk, and the
Liquidity Problem in Banking.”
Chart 2
Chart 1
Quarterly Sales of Commercial and Industrial
Loans by Insured Domestic Commercial Banks:
Aggregate Trends
Quarterly Sales of Commercial and Industrial
Loans by Insured Domestic Commercial Banks:
Subsample Trends
Billions of dollars
Billions of dollars
3 0 0 ------;------------------------------------------------------ --------------------
/
250
/
/
1//r
/
/ y I/
200
150
100
/
♦'V*
'
J
/
\
\
' V
\
\
\
First-tier sales
Source: Federal Financial Institutions Examination Council,
Reports of Condition and Income.
76 FRBNY Quarterly Review/Winter 1993-94
Aggregate sales
\
v.
V
"
Second-tier sales
50
0I I1986' ' I ' 87M I M88 I I M89 ' I M90 ' ' M91 ' I M92 I I93I
^
1
1 i i. i . l 11 i 1 i i i 1 i ; i i i i i
1986
87
88
89
90
— \
V
111 1. 1I
91
I l l
92
93
Source: Federal Financial Institutions Examination Council,
Reports of Condition and Income.
Note: "First-tier" banks are defined as the top five sellers in each
quarter. All other banks are defined as "second-tier.”
mercial paper issuance. Data from the Bank Loan Report, a
publication of Investment Dealers Digest, confirm a dra
matic drop in syndications related to acquisitions, LBOs,
and recapitalization between 1989 and 1990.
Chart 3 compares trends in loan sales by first-tier sellers
with trends in the volume of syndicated loans in the lever
age category. In the chart, loan sales are reported at quar
terly intervals and syndicated loan volume is reported at
annual intervals, so comparisons should be made with cau
tion. It is clear, however, that trends displayed by the two
series are similar. Several authors have noted a positive
correlation between aggregate sales and corporate merger
Syndicated Loan Volume by Purpose
activity.5 Chart 3 demonstrates a strong correlation between
first-tier sales and lending related to acquisitions, LBOs,
and recapitalization.6 Conversations with market partici
pants confirm the importance of these activities in explain
ing aggregate trends in the secondary market volume of top
loan sellers. In the future, the effect of such activities on the
loan sales market will depend on the extent to which they
involve bank financing.
The importance of economic conditions
Trends in lending related to corporate acquisitions, LBOs,
and recapitalization appear to be less important in explain
ing loan sales by second-tier banks, which continued to rise
through the first quarter of 1990. The timing of the secondtier sales decline suggests that the recession-related slow
down in C&l loan origination was a key underlying factor.
As Chart 4 shows, a composite index of four coincident
Billions of Dollars
1987
Purpose
Leverage
(acquisition, LBO,
recapitalization)
Debt repayment
Specialty finance
General purpose
Total
1989
1988
1990
1991
1992
66.1
11.5
17.0
42.5
162.7
42.3
8.6
70.7
186.5
44.4
7.1
95.3
57.9
42.6
17.4
123.4
20.9
46.5
16.6
150.4
39.9
58.5
23.0
215.1
137.1
284.4
333.2
241.3
234.4
336.5
5 See, for example, Berger and Udell, “Securitization, Risk, and the
Liquidity Problem in Banking,” and Haubrich and Thomson, “The
Evolving Loan Sales Market.”
6 Other authors have attempted to explore the relationship between bank
loan sales and merger-related lending using Call Report data on “highly
leveraged transactions,” or “HLTs.” (See Joseph Haubrich and James
Thomson, “Loan Sales, Implicit Contracts, and Bank Structure,” in
Proceedings from a Conference on Bank Structure and Competition,
Federal Reserve Bank of Chicago, 1993.) The main drawback of these
data is that they were introduced in the Call Report only after the
dramatic declines in corporate merger activity and aggregate loan sales.
Other important limitations are that the HLT data measure the existing
stock of highly leveraged transactions rather than the flow of new HLT
originations and that all credits extended to an HLT borrower are
considered HLT transactions, regardless of their particular purpose.
Source: Loan Pricing Corporation.
Chart 3
Chart 4
First-Tier Sales and Volume of Syndicated Loans
in the Leverage Category
Second-Tier Sales and Index of
Coincident Indicators
Billions of dollars
250 ---------------------------------------------------------
Billions of dollars
Index
Index of
^
dent in d ic a to rs / '
Scale — ►
/
Q uarterly first-tier sales
____ A —A __________
200
110
\
Annual syndicated
X_____
loan volume,
_j
V
leverage category
150
100
V
100
\
'
y t
/
•
t
Qua rterly
'
second- ier sales \
M___ Scale
»
t
*
\ / \
1986
87
88
89
90
91
92
Sources: Federal Financial Institutions Examination Council,
Reports of Condition and Income; Loan Pricing Corporation.
93
1 1 1 1 1..I I ...!..I l l
1986
87
88
1.. M l ...I I I ..1
89
90
i i i 1 m
91
M 90
92 93
Sources; Federal Financial Institutions Examination Council,
Reports of Condition and Income; Survey of Current Business.
FRBNY Quarterly Review/Winter 1993-94
77
indicators of business conditions was highly correlated with
second-tier sales from 1986 through the recent recession,
peaking just one quarter after the peak in second-tier
sales.7 The correlation between second-tier sales and the
index of coincident indicators weakened after the reces
sion. Economic conditions improved, but loan sales by both
second-tier and first-tier banks continued their decline. This
divergence of trends may be attributable to the persistent
weakness in borrowing by large corporations after the
recent recession.
An econometric analysis confirms the importance of eco
nomic conditions and lending opportunities in explaining
cross-sectional variation in loan sales activity.8 This analy
sis divides the country into fourteen geographical regions
and investigates the effects of regional economic condi
tions and a variety of bank characteristics on the loan sales
activities of individual banks. Five of the geographical
regions are identical to Census regions; the remaining four
Census regions are divided into smaller geographical
areas, with states that experienced similar economic cir
cumstances over the relevant period grouped together.
Variables used to measure economic conditions in each of
the fourteen regions include the unemployment rate (a
measure of current conditions) and consumer confidence
(a measure of expected future conditions). Results of this
empirical analysis suggest that regional economic condi
tions have been relatively important determinants of loan
7 The four coincident indicators included in the composite index measure
employment on nonagricultural payrolls, personal income less transfer
payments, the index of industrial production, and manufacturing and
trade sales. The composite index is available on a monthly basis from
the Survey of Current Business. Values reported are from March, June,
September, and December.
8 See Rebecca Demsetz, “Economic Conditions, Lending Opportunities,
and Loan Sales,” Federal Reserve Bank of New York, working paper,
1994.
78 FRBNY Quarterly Review/Winter 1993-94
sales activity in recent years. In addition, the positive effect
of economic conditions can be attributed, at least in part, to
the relationship between economic conditions and loan
origination opportunities.
Declines in the dollar volume of loan sales are consistent
with either a drop in secondary market supply or a drop in
secondary market demand. Price data can help determine
whether the recession-related reduction in sales was sup
ply- or demand-driven. Data from the Asset Sales Report of
the American Banker magazine reveal that secondary mar
ket yields on C&l loans to investment grade borrowers fell
relative to commercial paper yields during 1990 and 1991.9
In conjunction with the decrease in loan sales volume over
the same time period, this yield decline (price increase)
suggests a drop in secondary market supply. Data from the
Board of Governors’ Senior Loan Officers Opinion Survey
are consistent with this interpretation of secondary market
dynamics in the early 1990s. The majority of banks
included in the August 1992 and August 1993 surveys
reported either increased demand or little change in
demand by typical loan purchasers over the previous year.
In summary, while the initial decline in first-tier sales is
associated with a sharp drop in lending to finance corporate
acquisitions, LBOs, and recapitalization, the turning point
for second-tier sales can be linked to recent cyclical slow
downs in C&l lending. The continued declines in both firsttier and second-tier sales since the recent recession have
coincided with persistent weakness in C&l originations and
the resulting reduction in secondary market supply.
Together, these relationships suggest that recent drops in
loan sales volume may be best explained by declines in the
origination of salable loans.
9 Reported yields are on loans and commercial paper to borrowers rated
A1 (Standard and Poor’s)/P1 (Moody’s) and borrowers rated A2/P2.
Treasury and Federal Reserve
Foreign Exchange Operations
August-October 1993
During the August-October period the dollar appreciated
3.7 percent against the Japanese yen, depreciated 3.2
percent against the German mark, and was little changed
on a trade-weighted average basis,1declining 0.4 percent.
On August 19, the U.S. monetary authorities purchased
$165 million against yen in the period’s only intervention
operation.
The yen appreciates, then reverses against the dollar
During early August, the yen strengthened against the cur
rencies of all major industrialized countries, reaching
record highs against the dollar, mark, Swiss franc, the
pound sterling, and the Canadian and Australian dollars.
On August 11, the release of data indicating a wider than
expected 28 percent year-on-year expansion of Japan’s
merchandise trade surplus to $11.84 billion triggered sharp
yen appreciation, and the yen traded to a new high against
the dollar of ¥103.50. Continuing weakness in domestic
economic indicators was perceived as evidence that reduc
tion of Japan’s current account surplus was unlikely in the
near term, and the yen moved to several new daily highs
against the dollar, peaking at a postwar high against the
dollar of ¥100.40 on August 17.
From August 16 to 18, conditions in the Japanese money
This report, presented by Peter R. Fisher, Senior Vice President, Federal
Reserve Bank of New York, and Manager for Foreign Operations, System
Open Market Account, describes the foreign exchange operations of the
U.S. Department of Treasury and the Federal Reserve System for the
period from August 1993 through October 1993. Frank Keane was
primarily responsible for preparation of the report.
1 The dollar’s movements on a trade-weighted basis are measured using
an index developed by staff at the Board of Governors of the Federal
Reserve System.
markets were eased. On August 19, the Japanese cabinet
met and agreed to try to devise additional measures to
stimulate domestic demand. The dollar was trading at
¥102.50 in early New York dealing on August 19, but then
declined quickly to ¥101.35 following the release of the
worse than expected $12.1 billion U.S. merchandise trade
deficit for June; at the same time, the dollar abruptly
declined one pfennig against the mark. The U.S. monetary
authorities intervened shortly after the release of the trade
data. During the day they purchased a total of $165 million
against the yen, shared equally between the Federal
Reserve and the Treasury’s Exchange Stabilization Fund.
This operation was coordinated with another monetary
authority.
Initially, the operations surprised market participants,
and the dollar promptly rose. During the morning, Treasury
Under Secretary Summers released a statement welcom
ing the decline in Japanese money market rates and
expressing concern that further yen appreciation could
retard growth in the Japanese and world economies. Oper
ations continued after Under Secretary Summers’ state
ment but ceased before noon. Market participants subse
quently continued to cover short positions throughout the
afternoon, and the dollar reached a high of ¥106.75 before
closing the day at ¥105.95.
In the month following the operation, the dollar-yen
exchange rate largely traded between ¥103.00 and ¥106.00
as market participants increasingly focused on the appar
ent weakness of the Japanese economy. A series of Japan
ese data releases showed continued weak business senti
ment, deteriorating corporate profits, and a 0.4 percent
decline in second-quarter GDP. Consequently, when
the Bank of Japan lowered the official discount rate (ODR)
FRBNY Quarterly Review/Winter 1993-94 79
on September 21 by a greater than expected 75 basis
points to 1.75 percent, the action was perceived as an
appropriate supplement to the government’s efforts to stim
ulate the economy, not as a device to avoid further yen
appreciation. Favorable reactions by senior U.S. officials to
the Bank of Japan’s action led to a perception that tensions
between the U.S. and Japan on trade issues had given way
to greater cooperation, and the yen declined about 1.5 per
cent, closing on September 21 at ¥106.18.
The dollar firmed gradually over the latter half of the
three-month period while expectations of near-term volatil
ity in the dollar-yen exchange rate dwindled substantially.
The implied one-month option volatility fell from about 14
percent in mid-September to around 10 percent in late
October. The period closed with the dollar-yen exchange
rate trading steadily above ¥108.00 in late October.
Mark appreciates against dollar in wake of ERM crisis
The European Community finance ministers and central
bank governors agreed, effective Monday, August 2, to per
Chart 1
The Dollar against the Japanese Yen
Japanese yen per U.S. dollar
Note: Inset panel shows the six-month exchange rate movement.
80 FRBNY Quarterly Review/Winter 1993-94
mit currencies participating in the Exchange Rate Mecha
nism (ERM) to fluctuate within 15 percent of their central
parities. However, a uth orities from Germ any and the
Netherlands agreed to maintain their bilateral exchange
rate within 2.25 percent of their central parity. During the
uncertainty created by the currency turmoil in Europe, mar
ket participants had aggressively accumulated dollar posi
tions in late July. When widely anticipated European inter
est rate reductions failed to m aterialize in the first few
weeks of August, the mark began to appreciate against the
dollar. The negative sentiment toward the dollar during this
period was reinforced by market reports of dollar sales by
European central banks to adjust reserve positions after
July’s currency turmoil, and by a widening of interest rate
differentials in the mark’s favor implied by Eurocurrency
futures contracts.
The Bundesbank C ouncil’s decision on August 26 to
leave official rates unchanged disappointed market expec
tations of an interest rate cut, and banks were caught short
of funds at the end of a reserve period. When the Council
did lower the discount and Lombard rates by 50 basis
points to 6.25 percent and 7.25 percent, respectively, on
September 9, the concurrent sm aller than expected 10
basis point reduction in the Bundesbank’s money market
repurchase rate, to 6.70 percent, led to continued tightness
in short-term German money markets. These develop
ments resulted in continued mark strength against the dol
lar. Although the mid-September political unrest in Russia
caused the dollar to appreciate briefly against the mark, the
dollar again drifted lower against the mark when the crisis
was resolved, closing at DM 1.6013 on October 13.
On O ctober 21, the B undesbank Council surprised
exchange markets by again reducing its discount and Lom
bard rates by 50 basis points to 5.75 percent and 6.75 per
cent, respectively. The Council also announced that it would
conduct the following week’s fourteen-day repurchase agree
ment at a fixed rate of 6.40 percent, a 27 basis point reduction
from the prior day’s variable rate repurchase agreement. The
dollar, which had begun rising gradually against the mark
before the announcement, rose steadily over the remainder
of the period, closing at DM 1.6857 on October 29.
Other operations
The Federal Reserve and the Treasury’s Exchange Stabi
lization Fund (ESF) each realized profits of $22.1 million
from the sales of Japanese yen in the market. Cumulative
valuation gains on outstanding foreign currency balances
as of the end of October were $3,368.5 million for the Fed
eral Reserve and $2,839.0 million for the ESF.
The Federal Reserve and the ESF regularly invest their
foreign currency balances in a variety of instruments that
yield market related rates of return and have a high degree
of liquidity and credit quality. A portion of the balances is
invested in securities issued by foreign governments. As of
the end of October, the Federal Reserve and the ESF held
either directly or under repurchase agreements $10,004.3
million and $10,276.6 million, respectively, in foreign gov
ernment securities valued at end-of-period exchange rates.
FRBNY Quarterly Review/Winter 1993-94
81
Chart 3
Doliar-Yen Interest Rate Differential
Implied by the Three-Month Eurodeposit Futures (December Contract)
Interest rate
Interest rate differential
1.50
1.25
1.00
0.75
0.50 I
.
............HIM iiiiiiiiiiimmni iiiiniumi....
October
August
1993
September
1993
Chart 4
German Mark-Dollar Interest Rate Differential
Implied by the Three-Month Eurodeposit Futures (December Contract)
Interest rate differential
3.00
Interest rate
2.75
2.50
2.25
2 . 0 0 '................ ............................. ,
August
1993
Digitized for
82 FRASER
FRBNY Quarterly Review/Winter 1993-94
i i i i i i i i i m i i i i i i i
" I M I I I I ......................
September
1993
October
..
Chart 5
Table 1
Federal Reserve
Reciprocal Currency Arrangements
Short-Term Interest Rates for Selected Countries
Percent
Millions of Dollars
Amount of Facility
Institution
October 31, 1993
Austrian National Bank
National Bank of Belgium
Bank of Canada
National Bank of Denmark
Bank of England
Bank of France
Deutsche Bundesbank
Bank of Italy
Bank of Japan
Bank of Mexico
Netherlands Bank
Bank of Norway
Bank of Sweden
Swiss National Bank
Bank for International Settlements:
Dollars against Swiss francs
Dollars against other
authorized European currencies
Total
250
1,000
2,000
250
3,000
2,000
6,000
3,000
5,000
700
500
250
300
4,000
600
1,250
30,100
1993
Table 2
Net Profit (+) or Losses (-) on
United States Treasury and Federal Reserve
Foreign Exchange O perations
Millions of Dollars
Valuation profits and losses on outstanding assets
and liabilities as of July 31, 1993
Realized profits and losses
August 1-October31, 1993
Valuation profits and losses on outstanding assets
and liabilities as of October 31, 1993
Federal Reserve
U.S. Treasury Exchange
Stabilization Fund
+3,226.6
+3,005.5
+22.1
+22.1
+3,368.5
+2,839.0
Note: Data are on a value-date basis.
FRBNY Quarterly Review/Winter 1993-94
83
Recent FRBNY Unpublished Research Papers*
Single copies of these papers are available upon request. Write Research Papers,
Room 901, Research Function, Federal Reserve Bank of New York, 33 Liberty Street, New
York, N.Y. 10045.
9328.
Abate, Joseph, and Michael Boldin. “The Money-Output Link: Are F-Tests
Reliable?” September 1993.
9329.
McCarty, Jonathan. “Does the Household Balance Sheet Affect Durable Goods
Expenditures?” November 1993.
9330.
Brauer, David. “Why Do Services Prices Rise More Rapidly Than Goods
Prices?” December 1993.
9331.
Malz, Allan M. “New Varieties of Foreign Currency Operations.” December 1993.
9332.
Boldin, Michael D. “Econometric Analysis of the Recent Downturn in Housing
Construction: Was It a Credit Crunch?” December 1993.
9401.
Packer, Frank. “Venture Capital, Bank Shareholding, and the Certification of
Initial Public Offerings: Evidence from the OTC Market in Japan.” January 1994.
9402.
Osier, C. “Policy Stablization and Exchange Rate Stability." January 1994.
9403.
Demsetz, Rebecca S. “Economic Conditions, Lending Opportunities, and Loan
Sales.” February 1994.
+ Single copies of these papers are available upon request. Write Research Papers,
Room 901, Research Function, Federal Reserve Bank of New York, 33 Liberty Street, New
York, N.Y., 10045.
FRBNY Quarterly Review/Winter 1993-94
. FEDERAL RESERVE BANK OF NEW YORK
Studies on Causes and Consequences of the 1989-92 Credit Slowdown
The persistent weakness of the U.S. economy between early 1989 and late 1992 was
accompanied by an unprecedentedly sharp slowdown in credit growth. Economists have
debated the linkages between these events, particularly the possibility that credit supply
constraints may have played a significant role in weakening economic activity it
period. Studies on Causes and Consequences o f the 1989-92 Credit Slowdown, a collec
tion of papers by staff members of the Federal Reserve Bank of New York, explores this
and other issues relating to the credit slowdown. The volume considers the relative
importance of credit supply and credit demand factors, the role of bank and nonbank
credit sources, the impact of credit supply shifts on the economy, and the implications of
those shifts for monetary policy. Postpaid $5.00 U.S., $10.00 foreign.
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