Full text of Economic Review (Federal Reserve Bank of San Francisco) : 1995, Number 3

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Macroeconomic Behavior During Periods
of Speculative Pressure or Realignment:
Evidence from Pacific Basin Economies

Ramon Moreno

Federal Reserve Bank of San Francisco. I would like to
thank, without implicating, Ken Kasa, Joe Mattey, and Mark
Spiegel for helpful comments. I am also grateful to ThuanLuyen Le for research assistance.

This paper uses nonparametric tests to provide a description of the “stylized facts”associated with episodes of speculative pressure in foreign exchange markets in Pacific
Basin Economies and to see whether these “stylized facts”
appear to be broadly consistent with the alternative explanations for such episodes suggested in the theoretical
literature.
The empirical results are mixed, but some are nonetheless suggestive. Larger budget deficits and growth in central bank domestic credit appear to be associated with
episodes of depreciation rather than episodes of appreciation or periods of tranquility, indicating that unusually
expansionary or contractionary policies may contribute to
speculative pressures in foreign exchange markets. There
also is some evidence that episodes of speculative pressure
may arise when economic conditions make it costly for the
government to maintain a stable exchange rate.

In recent years, there has been renewed interest in the
causes and characteristics of episodes in which speculators
put strong upward or downward pressure on a currency.
General interest has been motivated by the attack on the
exchange rate mechanism of the European Monetary System in September 1992 and more recently by the devaluation and float of the Mexican peso in December 1994.
In Asian economies, interest in speculative pressures is
largely motivated by their experiences with surges in capital inflows (see Glick and Moreno, 1994).
It is not easy to explain why an exchange rate may be
subject to speculative pressure. One view is that macroeconomic policies that are inconsistent with a government’s exchange rate target trigger speculative pressures.
Another explanation is that the speculators’ beliefs affect
government policy and, specifically, the willingness of a
government to defend a peg, triggering episodes of speculative pressure that may force adjustment in the exchange
rate. For example, expectations of inflation may raise domestic interest rates, making it costly for the government
to preserve a peg that it otherwise would have maintained,
leading to devaluation and higher inflation. Under these
conditions, market expectations take on the characteristics
of self-fulfilling prophecies.
The underlying source of speculative pressure in foreign
exchange markets has important implications for policy. If
such pressures reflect the adoption of inconsistent macroeconomic policies, they can be avoided by pursuing policies that are consistent with the exchange rate peg. However,
if speculative pressures largely reflect more or less arbitrary changes in expectations, sound macroeconomic management may not suffice to ensure the maintenance of
a peg. In response, countries may adopt policies seeking
to enhance the credibility of the peg (for example, by
adopting a currency board), choose to allow the exchange
rate to float, or occasionally adopt capital controls, at the
cost of efficiency and the development of their financial
sectors.
In spite of the possible usefulness of distinguishing between the causes of realignment, there is little evidence on
which type of model is more relevant empirically. The reason is that, with the exception of a study by Eichengreen,

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FBRSF ECONOMIC REVIEW 1995, NUMBER 3

Rose, and Wyplosz (ERW, 1995),1 most empirical studies
of speculative attacks generally assume that pressures to
realign reflect macroeconomic policies that are inconsistent with the exchange rate peg.2
ERW suggest that comparing the behavior of macroeconomic variables during periods of speculative pressure
with their behavior during periods of tranquility may provide insights into the plausibility of alternative explanations
of episodes in which there is pressure to realign. They argue
that a finding that the behavior of macroeconomic variables is different in the two periods supports the view that
episodes of speculative pressure are triggered by inconsistent macroeconomic policies. If no difference is found,
then episodes of speculative pressure may be the result of
arbitrary shifts in expectations.
Using monthly data for 1967–1992 covering 22 countries (mostly OECD members) and applying nonparametric tests, ERW find that, among the European economies,
the behavior of macroeconomic variables during periods
of speculative pressure does not differ significantly from
the behavior of these same variables during tranquil periods. However, their behavior does differ across periods
among the non-European economies in their sample.
This paper applies methods similar to those suggested
by ERW to a sample of economies in the Asia-Pacific
Basin over the period 1980–1994. The experience of these
economies is of interest because it was not considered in
ERW’s study. Also, in contrast to developing economies in
Latin America and Africa, they have by and large adopted
stable macroeconomic policies that have resulted in moderate rates of inflation. Nevertheless, these economies have
also experienced episodes of speculative pressure in which
their currencies tended to depreciate or to appreciate.
The paper has two relatively modest objectives. The first
is to provide a description of the “stylized facts” associated
with episodes of speculative pressure in foreign exchange
markets. The second is to see whether these “stylized
facts” appear to be broadly consistent with the alternative
explanations for such episodes suggested in the theoretical
literature.
The paper is organized as follows. Section I discusses
models of speculative pressure in some detail and their implications for macroeconomic behavior during episodes of
speculative pressure and tranquility. Section II implements

1. Another study that does not assume that attacks are caused by preattack macroeconomic policies that are inconsistent with a peg is by
Drazen and Masson (1994). This study draws on a model developed
by Obstfeld (1991, 1994) which is discussed later.
2. Blanco and Garber (1986), Cumby and van Wijnbergen (1989), and
Goldberg (1994).

the comparisons of episodes of speculative pressure and
tranquility and Section III offers some conclusions.

I. MODELS OF SPECULATIVE PRESSURE
Pre-attack Macroeconomic Policies
To illustrate how macroeconomic policies may lead to
speculative attacks, as in Krugman’s (1979) model, consider the case of a fictitious country, Latinia. The Latinian
currency is the peso, and its exchange rate against the dollar is governed by the relative supply of and demand for
pesos. Suppose that the peso exchange rate is pegged by
the government. The enforcement of the peg depends on the
ability of the government to control the monetary base,
which is the sum of central bank domestic credit and net
foreign assets. The central bank is prepared to defend the
peso peg so long as it has a minimum level of net foreign
assets.
Suppose now that the Latinian central bank increases domestic credit to finance government deficits. The resulting
incipient increase in the money supply will tend to depreciate the peso. In order to prevent the peso from depreciating, the Latinian government must prevent the money
supply from increasing. As reducing the stock of domestic
credit is ruled out by deficit financing, Latinian authorities
must stand ready to sell any dollars demanded by the market at its target exchange rate. The sale of dollars has a
contractionary influence on the Latinian money supply (simultaneously reducing the net foreign assets and the monetary liabilities of the central bank) that fully offsets the
increase in domestic credit and preserves the peso peg.
Although (unsterilized) intervention preserves the peso
peg in the short run, such a peg may be unsustainable in
the long run if domestic credit is used to finance a persistent fiscal deficit. Under these conditions, domestic credit
increases in each period, and Latinia’s central bank must
keep on selling foreign assets to prevent the peso from depreciating. At some point, the central bank will reach its
minimum acceptable level of foreign exchange reserves
and will be forced to abandon the exchange rate peg. Anticipating this, speculators will attack the peg prior to this
point, reducing the central bank’s reserves to zero and forcing the abandonment of the peg.
Blanco and Garber (1986) provide an intuitive way of
identifying the precise point in time at which the exchange
rate peg will collapse. They define the shadow exchange
rate as the floating rate that would clear the foreign exchange market given the stock of domestic credit, after all
foreign exchange reserves have been sold to the private sector. They show that the exchange rate will be attacked at

MORENO/MACROECONOMIC BEHAVIOR : EVIDENCE FROM THE PACIFIC BASIN

precisely the time (say t*) when the shadow exchange rate
equals the fixed exchange rate.
Before t*, if foreign exchange reserves were all sold off
by the central bank, the money supply would be smaller
than at t* (the date when the floating rate equals the fixed),
so that the exchange rate would appreciate from the pegged
level. As speculators are aware that they would experience
capital gains if the peg were abandoned, they will hold on
to their pesos, and no attack will occur before t*. After t*,
the money supply will be greater than at t*, even if all foreign exchange reserves are sold off. The exchange rate
therefore would depreciate if the peg were abandoned, exposing holders of pesos to capital losses. To avoid such
losses, speculators would attack the peso at t*, at which
point the central bank’s foreign exchange reserves would
fall to zero and the currency would float. After t*, the
shadow exchange rate equals the actual floating rate.
As there is no uncertainty in Krugman’s original model,
the exchange rate cannot jump when the peg is abandoned
(otherwise agents could experience fully anticipated capital gains and losses, which would not be consistent with
rationality). By introducing uncertainty into the process of
domestic credit creation, Blanco and Garber obtain two
plausible results. First, the spread between domestic and
foreign interest rates rises over time, as the probability of
a devaluation increases. Second, the timing of a devaluation is no longer fully anticipated (it depends on the size
of the shock to domestic credit at a given point in time), so
the exchange rate can jump when the peg is abandoned.

Self-Fulfilling Expectations
A number of observers have noted that Krugman’s model
does not seem to describe the situation of some European
countries that experienced attacks on their exchange rates
in 1992–1993. In contrast to Krugman’s model, European
countries at the time were not constrained by the availability of foreign exchange reserves. Speculative attacks, which
tended to put downward pressure on the exchange rates of
a number of European countries against the deutsche mark,
were at times directed at countries whose economic policies were not obviously inconsistent with a deutsche mark
peg—such as France. In some of the European countries,
the decision to abandon a currency peg appeared to be related to the perceived cost of defending a peg by raising interest rates. Similarly, speculative pressures on some Asian
currencies such as the Hong Kong dollar, and the Thai bhat,
following Mexico’s financial crisis in December 1994, did
not appear to reflect the perception that those countries’
monetary authorities lacked foreign exchange reserves.
These differences have prompted some authors to consider models in which the beliefs of speculators may

5

affect the government’s incentive to defend or abandon a
currency peg, leading to self-fulfilling crises. As noted by
Obstfeld (1994), a circular dynamic arises because expectations depend on conjectured government responses, which
in turn depend on how changes that themselves result from
expectations affect the government’s desired response.
This “implies a potential for crises that need not have occurred, but that do occur because market participants expect them to” (p.3).
To illustrate how self-fulfilling crises and multiple equilibria may arise in a regime with fixed but adjustable parities, consider Obstfeld’s (1991, 1994) open-economy
extension of Barro and Gordon’s (1983) model. In this
model, labor market rigidities introduce a role for output
fluctuations and stabilization policy in the presence of demand shocks. For example, if the demand shock is deflationary, the real wage set beforehand will be too high, and
output will contract. The government can offset the shock
by devaluing the exchange rate, at the cost of higher inflation. Precisely how the government will respond to the
shock depends on its objective function.
The government is assumed to minimize a quadratic loss
function that penalizes deviations from zero inflation and
a target level of output. It is also assumed that because of
distortions (say, in the labor market) that lead to production that is not fully efficient, the target (log) level of output is positive (compared to the rational equilibrium output
level of zero when the demand shock is at its mean value
of zero).
If the government cannot pre-commit to a fixed exchange rate, the government reaction function can be derived to show that the government ex post will (i) use the
exchange rate partially to offset shocks to output; (ii) attempt a “surprise” depreciation whenever wage inflation
risks eroding competitiveness; (iii) attempt to drive output
above the “natural” level (of zero) by devaluing to offset
the assumed distortion in the economy. Under these conditions, a fixed exchange rate will be optimal only if the
penalty for inflation is infinitely large.3
As is to be expected in this type of model, the economy
is characterized by a systematic inflation bias proportional
to the deadweight output loss. This inflation bias reflects
the government’s attempts to exploit the potential shortrun Phillips trade-off created by predetermined nominal
wages. While a precommitment to a fixed exchange rate
would eliminate the inflation bias, it also would prevent the
government from responding to unpredictable output
shocks. In choosing whether to maintain a peg or to adjust

3. Appendix 1 provides a derivation of these results.

6

FBRSF ECONOMIC REVIEW 1995, NUMBER 3

the exchange rate the government will select the alternative
that minimizes its loss.
To describe the nature of the choice facing the government, Obstfeld assumes that the government cannot credibly commit to fix the exchange rate in all circumstances,
and that instead it faces a fixed realignment cost, c. The
loss function of the government can then be described by:
(1) lt = (θ/2)(et – e t–1)2 + (1/2)[α(et – wt ) – ut – y*]2 + cZt
(Z = 1 if c ≠ 0, Z = 0 otherwise).
In equation (1), et is the nominal exchange rate, wt is the
wage, ut is a demand shock and y* is the target level of output. The first right-hand term reflects the cost of deviations
from zero inflation, the second the cost of deviations from
the target level of output y* associated with changes in the
real exchange rate (et – wt ) or demand shocks, and the third
the fixed cost of realignment.
A realignment will then occur whenever the cost of pegging the exchange rate exceeds the cost of keeping the
exchange rate fixed, or when the following condition is
satisfied:4
(2)

(1/2)λ[α π t + ut + y*]2 > c .

If equation (2) is binding, we obtain two roots which represent the upper and lower bounds for the demand shock
(uH > uL). The government devalues whenever u > uH and
revalues whenever u > uL. Intuitively, when the demand
shock is very large, the cost of unemployment is so high
that the benefits of a stimulus offset the costs of inflation
associated with a devaluation. When the demand shock is
small enough, then the benefits of reducing overemployment outweigh the costs of deflation.
The preceding fixed exchange rate mechanism, which allows for realignment for sufficiently large demand shocks,
opens the door for successful speculative attacks. The reason is that the threshold points uH and uL which determine
whether the government will revalue or devalue depend on
prior expectations of depreciation π t . These expectations
in turn depend on market perceptions of where the points
uH and uL lie. A shift in these market perceptions, or in the
cost of realignment, can lead to a change in the threshold
points and to an exchange rate crisis and devaluation,
whereas none might have occurred in the absence of this
shift. The shift in perceptions may have nothing to do with
the soundness of domestic economic policy or other market fundamentals.
The importance of market perceptions in determining
the timing and success of speculative attacks suggests that

4. See Appendix 1, equations (A4) and (A6).

a reputation for “toughness” may help policymakers deter
an attack and preserve a peg. (This appears to be the rationale for proposals such as the adoption of currency
boards, which can make it less likely that money will be
issued in a manner inconsistent with a peg, and also make
it more difficult to adjust a peg.) Drazen and Masson (1994)
investigate this question and point out that there is still a
trade-off. Speculators may infer that a government resisting a speculative attack is indeed “tough,” thus deterring
them from future attacks, or they may instead infer that the
defense against the first speculative attack was so costly
that the government could not possibly resist a future attack.
Drazen and Masson’s model seems to fit the experience of
Sweden. Obstfeld (1994) observes that in September 1992,
Swedish authorities successfully resisted an attack on the
krona by raising the domestic interbank rate up to 500 percent (annualized). However, they responded to a second attack in November 1992 by floating the currency. The cost
of defending the peg, given high unemployment, was simply too high.

Two-Sided Attacks
Most discussions of pressures to realign focus on episodes
in which devaluations may occur either because a country
has pursued policies that deplete foreign exchange reserves
(as in Krugman’s model) or because the government cannot resist the temptation to inflate when inflationary expectations make the economy less competitive or output
growth is sluggish (as in Obstfeld’s model). However,
speculative pressures involve revaluations as well as devaluations. In Pacific Basin economies, which are the focus
of this paper, episodes of speculation that a currency will
appreciate against the U.S. dollar are not uncommon. For
example, the methods used in this paper identify 54 episodes of appreciation pressures on the exchange rate compared to 72 episodes of depreciation pressure in the period
1980–1994 (see the last row of Table 1).
As is apparent from the preceding discussion, a model
where realignments reflect the government’s desire to offset shocks to competitiveness and employment allows for
appreciation or depreciation pressures. In such a model,
surprise revaluations reduce excess demand by reducing
the competitiveness of the export sector. Appreciation pressures can be interpreted as resulting from a real exchange
rate that is “misaligned,” in the sense that it produces a
macroeconomic outcome that is not consistent with the
government’s ultimate policy objectives.
In contrast to the models with multiple equilibria, the
literature based on Krugman’s (1979) paper typically focuses on episodes of depreciation. This may reflect the fact

MORENO/MACROECONOMIC BEHAVIOR: EVIDENCE FROM THE PACIFIC BASIN

7

SOURCES OF SPECULATIVE PRESSURE

pear that government budget surpluses systematically drain
liquidity in most of the economies in the region (with the
exception of Singapore).5

(Percentage of episodes in which the change in variable led to identification of a speculative episode. Episodes are identified using individual country data.)

II. EMPIRICAL ANALYSIS

TABLE 1

ALL
SPECULATIVE

DEPRECIATION

APPRECIATION

EXCHANGE RATE

49

51

46

RELATIVE NET
FOREIGN ASSET

34

36

31

RELATIVE SHORT
TERM RATE

17

13

22

126

72

54

NUMBER OF
EPISODES

that it is not easy to explain why exchange rate appreciation might matter in this type of model. Grilli (1986) does
examine the implications of appreciation pressures by extending Blanco and Garber’s (1986) model to allow for
both a lower and an upper limit on reserves at which the
exchange rate will be allowed to float.
Grilli does not explicitly discuss why a country would
want to limit the level of reserves. It might be argued that
policymakers worry about the expansionary impact such
foreign exchange reserves may have on the stock of money.
However, this cannot be the case in this type of model, because episodes of appreciation pressure necessarily reflect
monetary contraction (in spite of foreign exchange accumulation). Another plausible explanation is that policymakers do not want to hold too high a level of foreign
reserves because the return on foreign assets is lower than
on domestic assets, imposing a quasi-fiscal cost on the
government. This type of explanation is not ruled out by
this class of models, but neither is it explicitly taken into
account.
Another point worth noting is that it is not entirely clear
what process would lead to the persistent foreign exchange
reserve accumulation described in Grilli’s model. The
counterpart to Krugman’s original scenario of reserve
drainage would be a situation where a country experiences
budget surpluses that the government uses to increase its
deposits with the central bank. The resulting monetary
contraction then attracts capital inflows and leads to increases in reserves. One limitation of this type of scenario
is that it may not explain most appreciation episodes in
Pacific Basin economies. While most of these economies
adopt relatively conservative fiscal policies, it does not ap-

In this section we examine some “stylized facts” about
speculative episodes. The preceding discussion of alternative models of speculative pressure may provide a broad
framework for attempting to interpret the results of this
analysis.
Two broad sets of questions are addressed. First, how
does foreign exchange market adjustment occur during
episodes of speculative pressure? Are most such episodes
associated with sudden adjustment in the exchange rate,
with sharp changes in net foreign asset growth, or with
changes in relative interest rates? Are there differences in
adjustment during periods of appreciation and depreciation? These questions may be addressed by evaluating the
behavior of indicators of speculative pressure (changes in
the nominal exchange rate, relative net foreign asset growth,
and changes in interest rate differentials) and seeing how
the behavior of these variables differs during periods of
speculative pressure and tranquility.
Second, are there significant differences in macroeconomic behavior during periods of speculative pressure and
periods of tranquility? Such differences were not found by
ERW for a sample of European countries, but were found
for a set of non-European economies. Are there also differences in macroeconomic behavior during episodes of
appreciation and depreciation? As argued by Eichengreen,
Rose, and Wyplosz, if speculative episodes are caused by
more or less arbitrary changes in expectations, there may
be no differences in the behavior of macroeconomic variables during periods of speculative pressure and tranquility.
However, if some differences in the behavior of macroeconomic variables are observed, the nature of these differences may shed light on whether speculative pressures
appear to reflect inconsistent macroeconomic policies or
policymakers’ response to adverse economic conditions.
In particular, the policy environment, which can be represented by comparing monetary and fiscal policy indicators during periods of speculative pressure and tranquility,
may shed light on whether expansionary monetary and fiscal policies trigger speculative attacks, as in Krugman
(1979). It may be argued that such policies can be the
source of speculative pressures if it is found that monetary
5. For a discussion of Singapore’s monetary regime, see Moreno (1988).
The monetary regimes of Singapore and other economies are discussed
in Talib (1993).

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FBRSF ECONOMIC REVIEW 1995, NUMBER 3

and fiscal policy variables differ during periods of speculative pressures and periods of tranquility.6
Indicators of internal or external balance may shed light
on whether the cost of maintaining a stable exchange rate
is too high for the government, leading to shifts in expectations associated with speculative pressures. For example,
if output is unusually sluggish, domestic inflation is relatively high, or the current account is unbalanced, the government may find it too costly to defend the exchange rate,
as suggested by some models used by Obstfeld (1991,
1994) and Drazen and Masson (1994).7

The Data
In order to analyze episodes of speculative pressure, a number of data series were constructed. The percentage change
in the bilateral exchange rate against the U.S. dollar,
changes in relative net foreign asset growth, and the differential between the first difference of the logs of the domestic and U.S. interest rate, were used as indicators of
speculative pressure. The differential between the relative
growth (domestic compared to U.S.) in an estimated measure of central bank domestic credit, narrow and broad
money were used to indicate the monetary policy environment. The ratio of the budget deficit to government spending (relative to the U.S.) was used to represent the fiscal
policy environment. The differential (domestic less U.S.)
in inflation and deviations of output growth from the mean
rate of growth for each country were used to represent the
internal balance, while the ratio of exports to imports was
used to represent the external balance.
The data are taken from the IMF International Financial Statistics. All the series are monthly, except real output growth and the government budget balance, which are
quarterly. Speculative pressure episodes were identified
over the period 1980–1994. However, the indicators of the
policy environment or the internal and external balance did
not always span the full period or in some cases were miss-

6. It may be noted that in one of the models described by Obstfeld
(1994), a weak fiscal position may lead to self-fulfilling attacks on the
exchange rate, so it is not entirely possible to rule out this type of explanation when looking at the budget deficit.
7. Although the general approach adopted here is inspired by Eichengreen, Rose and Wyplosz (1995), the interpretation differs from theirs.
Eichengreen, Rose and Wyplosz do not explicitly distinguish between
policy and internal and external balance indicators, but instead interpret
these indicators as broadly representing the behavior of “fundamentals.” They argue that if the tests reveal that the distribution of fundamentals differs during periods of speculative pressure and tranquility,
then this suggests that episodes of speculative pressure are best explained by models in which a peg becomes unsustainable because of inconsistent macroeconomic policies, as in Krugman’s (1979) study.

ing values. For some series data from certain countries are
excluded because of lack of availability. The countries covered are Indonesia, Japan, Korea, Malaysia, Philippines,
Singapore, and Thailand.8

Analyzing Episodes of Speculative Pressure
The models discussed previously assume that the exchange
rate is fixed. However, as is apparent in Appendix 3, the
countries in our sample have adopted a variety of exchange
rate regimes in various time periods, including de facto
pegs to the U.S. dollar (Thailand up to 1984), basket pegs
or managed floats (most of the countries in the 1980s) and
relatively free floats with occasional massive intervention
(Japan). Nevertheless, a review of these exchange rate
regimes suggests that policymakers as a rule seek to
dampen large fluctuations in the exchange rate. 9 For this
reason, it can be argued that while the exchange rate is not
strictly fixed in many cases, episodes of very large exchange rate movements may be interpreted as episodes of
speculative pressure that will be viewed with concern by
authorities and may trigger a policy response, even in
regimes where the exchange rate is supposed to float freely.
Also, large changes in net foreign assets of the central bank
or in short-term interest rates may be interpreted as reflecting episodes of pressure in foreign currency markets
where authorities may have resisted an adjustment in the
exchange rate.
The models discussed previously also tend to assume
that speculative attacks on the exchange rate always succeed because rational agents correctly anticipate that they
will be worse off by delaying an attack. In practice, however, episodes of speculative pressure do not always result
in large adjustments in the exchange rate.
In line with this, episodes of speculative pressure in foreign exchange markets were identified by focusing on large
adjustments in the exchange rate and on episodes in which
there were large changes in net foreign assets or in relative
short-term interest differentials. Using data for each country, an arbitrary band was constructed around each indicator of speculative pressure by taking the mean of the
indicator plus or minus 1.5σ, where σ is the standard deviation of the indicator. To identify episodes of “speculative pressure,” episodes where changes in the exchange rate
were outside the 1.5σ band were selected first. From the
remaining (nonselected) observations, episodes where
changes in relative net foreign assets were outside the 1.5σ
8. Appendix 2 provides more information on the data.
9. For recent reviews of exchange rate policies in Pacific Basin
economies see Glick and Moreno (1995), Glick and Hutchison (1994),
and Moreno (1994).

MORENO/MACROECONOMIC BEHAVIOR : EVIDENCE FROM THE PACIFIC BASIN

band for that series were selected next. The list of speculative pressure episodes was completed by adding episodes
where changes in short-term interest differentials were
outside the 1.5σ bands. The remaining observations (inside the band defined for each of the three indicators) were
treated as periods of “tranquility.” In order to prevent the
continuation of a speculative episode from being identified
as a new episode, windows were created by dropping five
observations around previously identified episodes.10
Eichengreen, Rose, and Wyplosz (1995) use similar indicators but adopt a different approach for identifying
speculative episodes. They construct a weighted average
index of the three indicators, and identify speculative attack episodes by taking those observations that fall outside
the 1.5σ band around the index. Their weights are constructed to compensate for the volatility of each variable,
in effect rescaling, so that each variable has the same influence in the index.11 It may be noted that for some Pacific
Basin countries, data for interest rates (Indonesia) or net
foreign assets (Philippines) are missing over certain periods. If a weighted-average index were used, those periods
would have to be treated as missing, or as periods of tranquility. In either case, the weighted-average index would
not fully utilize information from the indicators of speculative pressure that are observed during periods when data
from one of the series is missing. The selection procedure
used in this paper avoids this difficulty and, as a result,
identifies a larger set of speculative pressure episodes than
would a weighted-average index.

10. More precisely changes in the exchange rate, net foreign assets or
short-term interest rates outside the corresponding 1.5σ band were not
treated as speculative pressure episodes if they fell within the five-month
window following an episode already identified by a large movement in
the exchange rate. In addition, episodes identified by relative net foreign
asset growth or short-term interest differentials were dropped if the five
months that followed included an episode previously identified by the
exchange rate. Episodes identified by short-term interest differentials
were dropped if the five months that followed included an episode previously identified by the relative net foreign assets. The effect of this
procedure is to give first priority to the exchange rate and second priority to net foreign assets when an observation falls within a five-month
window. A similar priority is given to these variables in classifying
episodes of depreciation and appreciation. Macroeconomic behavior is
analyzed in the month or quarter corresponding to the date of the speculative episode.
11. Eichengreen, Rose and Wyplosz’s speculative pressure index is defined as
(st – st–1 )/st–1 + α*(∆log it – ∆log iUSt) – β*(∆NFAt – ∆NFAUSt)
where s is the nominal exchange rate (domestic over foreign), i is the
short-term interest rate, and NFA is net foreign assets of the central
bank. The weights α and β are based on conditional volatilities scaled
so as to dampen the impact of the more volatile components on the
index.

9

A number of plausible episodes of speculative pressure
are identified by the sequential method used in this paper.
In the case of Japan, the present method picks up the pressure on the yen to appreciate in September 1985, around
the time of the Plaza meetings. However, speculation on
the yen in March 1987, after the Louvre meetings, was excluded because it fell within the window that followed a
speculative episode in October 1986. Other plausible
episodes that have been identified include the 1980 devaluation of the Korean won, the December 1993 speculation
on the Malaysian ringgit,12 the Thai baht devaluation of
1984, the depreciation pressure on the Philippine peso during the political-cum-debt crisis of 1983, and the appreciation pressure in Indonesia in recent years after the
country’s depreciation pressures in 1983 and 1986.
Eichengreen, Rose, and Wyplosz use their index to test
for differences in the statistical properties of macroeconomic variables during periods when the index value is inside the band and when it is outside. In this paper, their
approach is taken a step further by also distinguishing between episodes of appreciation and depreciation for those
points outside the band. A depreciation episode is said to
occur if the percentage change in the exchange rate is outside the 1.5σ band for the exchange rate and is greater than
zero, or if the exchange rate is inside its band but the
change in relative net foreign assets is outside its corresponding band and is negative, or if neither the exchange
rate nor the change in relative net foreign assets are outside their respective bands but the change in short-term
interest rates is outside the band and positive. Appreciation episodes are constructed in a similar manner, but the
changes are negative for the exchange rate, positive for net
foreign assets and negative for short-term interest rates.
To describe the characteristics of episodes of speculative pressure more fully, we estimated the proportion of
times that a change in either the exchange rate, relative net
foreign assets or relative short term rates was the criterion
used in selecting a speculative pressure episode. The results, reported in Table 1, indicate that unusual behavior in
the exchange rate accounted for about 50 percent of the
speculative pressure episodes identified (whether we consider all episodes combined, depreciation episodes or appreciation episodes), relative net foreign assets for over
30 percent, and relative short-term interest rates for 13–22

12. However, December 1993 would be classified as a depreciation
episode by the method used here, because the exchange rate depreciated
and this takes precedence over the large accumulation of foreign exchange reserves. Since the main concern of policymakers at the time was
capital inflows, it would seem more reasonable to classify it as an appreciation episode. Such difficulties in interpreting particular episodes
are likely to arise in any procedure adopted for classifying episodes.

10

FBRSF ECONOMIC REVIEW 1995, NUMBER 3

percent. The fact that half of speculative pressure episodes
are identified by unusual movements in relative net foreign
assets and relative short-term interest rates (episodes in
which the exchange rate itself does not make a large adjustment) suggests that monetary authorities in the Asia-Pacific
Basin intervene actively in foreign exchange markets, and
succeed in preventing large movements in the exchange
rate quite often.
Table 2 seeks to shed further light on the characteristics
of speculative pressure episodes by reporting the median
values of changes in the exchange rate, relative net foreign
assets and relative short-term rates during speculative pressure episodes and periods of tranquility. The differences
between the median values for the combined speculative
episodes and tranquil periods appear to be relatively small.
In contrast, median values for all the variables are much
larger (in absolute value) during episodes of depreciation
than during periods of tranquility. Adjustments in the exchange rate, net foreign assets and short-term rates also
tend to be larger during episodes of depreciation than during episodes of appreciation.
To assess more formally whether periods of speculative
pressure differ from periods of tranquility, two nonparametric tests were implemented, both suggested by Eichengreen,
Rose, and Wyplosz (1995). The first test is the Kruskal Wallis (KW) test, and the second is the Kolmogorov-Smirnov
(KS) test. In both cases, the null hypothesis that the distribution of selected variables during periods of speculative
pressure does not differ from the distribution of these same
variables during periods of tranquility was tested.
Consider the distribution of relative inflation rates during periods of speculative pressure and of tranquility. The
KW statistic can be used to test the null hypothesis that the
populations from which the two inflation samples are drawn
(speculative pressure and tranquil populations) are identical, against the alternative that one of the populations
yields a larger observed value (higher inflation) than the
other population. The KW test statistic depends not only
on central location but also on the ranks of the observations in the combined sample. It therefore uses more information than does the median test statistic, which relies
only on determining whether observations are below or
above the median (Conover, 1971).13
13. The KW test combines both samples (speculative pressure and tranquil) into a single, ordered sample. Ranks are then assigned to the combined sample values from smallest to largest. The test statistic is the sum
of the ranks assigned to the values from one of the populations. If the
sum is very small, or very large, the values from that population may be
taken to be smaller, or larger, than the values from the other population.
The null hypothesis of no difference between the samples is rejected if
the ranks associated with one sample are sufficiently large compared
to the ranks associated with the other sample. Ranks are preferred in

One limitation of the KW test is that it assumes that
any difference in distribution reflects only a difference in
central location (if the distribution F(x) ≠ G(x), then F(x)
= G(x + c), where c is a constant).14 The test may not
detect differences of other types, such as differences in
variance. For this reason, the KS test statistic, which
computes differences in the empirical distribution function of two samples (speculative pressure versus tranquility) is also used.

The Behavior of Macroeconomic Variables
Table 3 reports the results of the comparison of indicators
of the policy environment and of internal and external balance during periods of speculative pressure and tranquility. The qualitative features of differences in the behavior
of the various series are presented in Table 4, which reports
the median values during episodes of all types of speculative pressure, depreciation, appreciation, and tranquility.
In line with Krugman’s (1979) model, we would expect
an expansion in monetary aggregates to be associated
with episodes of depreciation pressure, and monetary
contraction with episodes of appreciation. Also, we would
expect budget deficits to be larger during episodes of depreciation pressure than during periods of tranquility. The
data in Tables 3 and 4 provide mixed support for this type
of story.
The results in Table 3 indicate that the distribution of
broad money differs during periods of depreciation pressure
and tranquility (significant at 5 percent) and provide mixed
evidence of differences in central bank domestic credit
during periods of appreciation and tranquility ( p value of
8 percent for the KW test). The median values for central
bank domestic credit are broadly consistent with the view
that depreciation episodes may result from faster money
growth and appreciation episodes from monetary contraction. However, these results should be interpreted with caution, as the central bank domestic credit contraction during
appreciation episodes may reflect sterilization efforts to
offset net foreign asset accumulation. Thus such contraction could be caused by appreciation pressures rather than
this case because the distribution functions may not be normal, in which
case the probability theory underlying the actual data may not be
known. The probability theory of statistics based on ranks is simpler
and may not depend on the distribution of the actual data. Note that difficulties arise in implementing the KW test if there are too many ties in
the rankings. However, this is likely to be a problem only when the test
is applied to the exchange rate if there are periods when the exchange
rate is fixed.
14. Another limitation is that the KW level of significance is likely to
differ from the true level of significance if there are many tied values.
However, this is not likely to be the case for the series being analyzed.

MORENO/MACROECONOMIC BEHAVIOR : EVIDENCE FROM THE PACIFIC BASIN

11

TABLE 2
SPECULATIVE PRESSURE AND TRANQUIL PERIODS
MEDIAN VALUES
CHANGES IN:
Dollar Exchange Rate
Net Foreign Assets
Short Term Interest Differentials

ALL SPECULATIVE

DEPRECIATION

APPRECIATION

TRANQUIL

0.25

2.01

–0.73

0.73

–2.89

4.6

1.37

–0.53

0.34

–1.52

–0.11

0.09

TABLE 3
ALL SPECULATIVE PRESSURE AND TRANQUIL PERIODS
TESTS OF SIMILARITY AND DISTRIBUTIONS
ALL SPECULATIVE
KW

KS

DEPRECIATION
KW

APPRECIATION
KS

KW

KS

Indicators of policy environment
DOMESTIC CREDIT

0.17
(0.68)

0.76
(0.61)

0.91
(0.34)

0.74
(0.64)

3.17*
(0.08)

1.18
(0.13)

NARROW MONEY

1.46
(0.23)

0.93
(0.36)

1.33
(0.25)

1.08
(0.19)

0.35
(0.56)

0.67
(0.76)

BROAD MONEY

2.97*
(0.08)

1.16
(0.13)

5.88**
(0.02)

1.47**
(0.03)

0.01
(0.94)

0.64
(0.80)

0.44
(0.50)

0.92
(0.36)

2.86*
(0.10)

1.14
(0.15)

0.81
(0.37)

0.77
(0.59)

BUDGET DEFICIT

Indicators of internal and external balance
CPI INFLATION

1.13
(0.29)

1.19
(0.12)

0.99
(0.32)

1.22*
(0.10)

0.29
(0.59)

0.60
(0.86)

REAL OUTPUT

0.16
(0.69)

0.95
(0.33)

2.03
(0.15)

1.22*
(0.10)

1.09
(0.30)

0.85
(0.47)

EXPORTS/IMPORTS

0.27
(0.61)

0.97
(0.31)

0.93
(0.33)

1.08
(0.19)

0.09
(0.77)

0.59
(0.88)

NOTE: The test in each case compares the distribution of the data during periods of tranquility with the distribution of the data during all speculative,
depreciation, and appreciation episodes respectively. Test statistics are reported, followed by p values in parentheses.

** Reject null at 5%
* Reject null at 10%

12

FBRSF ECONOMIC REVIEW 1995, NUMBER 3

be the cause of appreciation pressures as is implicitly assumed in our approach here. Further research is needed to
sort out the causality.
It may also be noted that the median values for narrow
and broad money do not appear to be consistent with the
view that excessive money growth contributes to depreciation episodes. As can be seen in Table 4, money growth
rates appear to be larger during periods of tranquility, and
broad money growth seems to be greater during periods of
appreciation than during periods of depreciation. Given
that central bank domestic credit behaves in the opposite
fashion, the behavior of broader money growth appears to
reflect changes in monetary conditions during episodes of
speculative pressure that need to be explored further.
The data provide some evidence that large budget deficits may be associated with speculative pressures. Table 3
indicates that the distribution of budget deficits differs during periods of depreciation pressure and tranquility ( p
value of 9 percent for the KW test).15 Budget deficits also

15. The significant result for the budget deficit should be interpreted
with caution because these are quarterly observations and some of the
countries had to be dropped due to lack of data. See data Appendix 1.

appear to be larger during episodes of depreciation (or
tranquility) than during episodes of appreciation (Table 4).
Further insights may be gained on the characteristics
and possible causes of episodes of speculative pressure by
examining indicators of internal and external balance. As
noted previously, if output is unusually sluggish, domestic
inflation is relatively high, or the current account is unbalanced, the government may find it costly to defend the exchange rate, and this perception of government weakness
may trigger speculative pressures. Such results would lend
support to explanations that do not attribute speculative
pressures to prevailing monetary or fiscal policies (e.g.,
Obstfeld, 1994 or Drazen and Masson, 1994).
Table 3 provides mixed evidence that the distribution of
CPI inflation and output growth differs during periods of depreciation pressure and tranquility ( p values of around 10
percent). In addition, the data in Table 4 suggest that inflation is higher and relative output growth is slower (in fact
negative) during episodes of depreciation than during episodes of appreciation or tranquility. This is consistent with
explanations that suggest that economic conditions (rather
than macroeconomic policies) may contribute to episodes
of speculative pressure. However, it may be noted that the
behavior of the indicator of external balance, the ratio of
exports to imports, does not appear to differ during the various periods, and the median values are close.

TABLE 4
ALL SPECULATIVE PRESSURE AND TRANQUIL PERIODS
MEDIAN VALUES
(Monthly percentage changes or percentage ratios)
ALL SPECULATIVE

DEPRECIATION

APPRECIATION

TRANQUIL

Indicators of policy environment
DOMESTIC CREDIT

–0.14

0.06

–0.38

–0.09

NARROW MONEY

–0.01

–0.07

0.21

0.41

BROAD MONEY

0.64

0.43

0.88

0.90

BUDGET DEFICIT

0.57

0.92

0.28

0.67

Indicators of internal and external balance
CPI INFLATION

0.04

0.09

0.01

0.02

REAL OUTPUT

–0.04

–0.20

0.21

–0.05

0.98

0.99

0.97

1.00

EXPORTS/IMPORTS

MORENO/MACROECONOMIC BEHAVIOR: EVIDENCE FROM THE PACIFIC BASIN

Alternative Assumptions
To see whether the preceding results are sensitive to alternative assumptions, the tests were first rerun excluding
Japan from the sample, as it may be argued that its foreign
exchange market differs from those of other economies in
the region (deeper market with a wider array of domestic
instruments, and a freer float). For the sake of brevity, the
main findings will be summarized but the actual values
will not be listed. With Japan excluded, the behavior of the
budget deficit ratio no longer differs between periods of
tranquility and of depreciation or appreciation. However,
as in the full sample, the behavior of broad money differs
during depreciation episodes (with p values of 5 percent
for the KW test and 9 percent for the KS test), and the evidence that central bank domestic credit differs during
episodes of appreciation is now stronger ( p values of 3 percent and 7 percent for the KW and KS tests, respectively).
The median values still convey the impression that during
episodes of depreciation budget deficits are larger and that
during episodes of appreciation central bank domestic credit
is smaller, and broad money growth is greater.
For the indicators of internal and external balance, as for
the full sample, there is mixed evidence that the distribution of the CPI differs during episodes of depreciation.
However, no significant differences in output behavior are
now found. The median values are qualitatively similar to
those found previously, as they indicate that inflation tends
to be higher and relative output growth contracts during
episodes of depreciation in comparison to other periods
(appreciation or tranquility).
One potential difficulty with the preceding results is that
the crisis episodes and the macroeconomic variables are
contemporaneous, making the direction of causality uncertain. For example, while some of the models described
earlier might suggest that a rise in domestic inflation may
lead to speculative pressures, it is possible that speculative
pressures lead to inflationary pressures instead. To see
whether this possibility affected the results, the tests were
performed by comparing the behavior of monthly variables
in the month before the date of a speculative episode to
their behavior during periods of tranquility (once more including Japan in the data set).16 Using this data set, the evidence that domestic credit of the central bank differs

16. The test was not performed for quarterly data because it is likely that
the indicators of speculative pressure did not cause differences in budget deficits or relative output growth. For the monthly data, it may be
noted that if the observation preceding a speculative episode falls in the
six-month window of a previous speculative episode, it is not included
in the set.

13

during episodes of appreciation was once more mixed (significant at 10 percent for the KS test but not the KW). There
was also mixed evidence that the relative CPI differed in
the month before a depreciation episode (KW test rejects
the null at 10 percent), and that broad money growth differs in the month before an appreciation episode (both KW
and KS tests significant at 5 percent). The other test results
were not significant. As for the median values, those for
central bank domestic credit are very similar to those reported in Table 4. CPI inflation is much smaller during episodes of appreciation, and is in fact negative in this case,
which is consistent with the previous findings. Broad money
growth once again is larger during episodes of appreciation.

III. CONCLUSIONS
This study applied a procedure to identify episodes of
speculative pressures in foreign exchange markets for selected economies in the Asia-Pacific Basin and compared
the behavior of macroeconomic variables during periods
of speculative pressure and periods of tranquility. The empirical results are mixed, but some of the results are
nonetheless suggestive. Episodes of depreciation appear to
be associated with larger budget deficits and growth in
central bank domestic credit than are episodes of appreciation or periods of tranquility, indicating that expansionary policies may contribute to speculative pressures in
foreign exchange markets. There is also some evidence
that episodes of speculative pressure may arise when economic conditions make it difficult for the government to
maintain a stable exchange rate.
Further research using different methods may give additional insights on the sources of speculative pressures in
foreign exchange markets and shed further light on the
properties of speculative episodes. In addition, alternative
statistical techniques may permit estimation of the relative
importance of alternative sources of speculative pressure
on the exchange rate.

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FBRSF ECONOMIC REVIEW 1995, NUMBER 3

APPENDIX 1

expected rate of price inflation is given by the expected
change in the exchange rate. More explicitly,

SUMMARY OF OBSTFELD’S OPEN ECONOMY
MODEL OF SPECULATIVE ATTACKS

(A4)

The model assumes PPP, capital mobility and perfect asset substitution. The log of output in period t depends on
the contemporaneous log real exchange rate and a mean
zero, serially independent shock that reflects the impact of
foreign interests rates, private and government shifts in
demand and so on. Before the demand shock is observed,
labor markets set wages so as to maintain a constant expected real wage. Consider the government’s flow loss for
period t, which can be expressed as:
2

π t = wt – e t–1 = E t–1 (et) – e t–1 .

In (A1) it is assumed that workers negotiate wage changes
to match the expected rate of inflation. Now under a fixed
exchange rate, et – e t–1 = 0, so the loss according to equation (1) in the text is
l Ft = (1/2)[απ t + ut + y*]2

(A5)

If the government instead realigns according to the reaction function described earlier, it incurs a fixed cost c, and
it can be shown that the loss is:
(A6)

l Rt = (1/2)(1 – λ)[απ t + ut + y*]2 + c .

2

(A1) l t = (θ/2)(et – e t–1) + (1/2)[α(et – wt) – ut – y*]

where the first right-hand term reflects the cost of deviations from zero inflation, the second, the cost of deviations
from the target level of output y*. The government chooses
the home currency’s exchange rate et each period to minimize lt given the nominal wages set at t–1. Minimizing the
preceding expression over et yields first order conditions
that imply the following reaction function
(A2) et – e t–1 = λ (ut /α) + λ (wt – e t–1) +λ ( y*/α) .
In the term λ = α2/(θ + α)2, α reflects the responsiveness
of output to changes in competitiveness (the real exchange
rate) and θ reflects the weight assigned to inflation in the
government’s loss function.
Workers and firms know the government’s reaction function and will set wages to take the government’s expected
exchange rate adjustment into account. Under these conditions, it can be shown that the equilibrium depreciation
rate in the economy is:
(A3)

et – e t–1 = λ ut + (λ /1 – λ)(y*/α)

where all variables are in logs, et is the nominal exchange
rate in domestic currency units per foreign currency unit,
ut is the demand shock, y* > 0 is the government’s target
level of output, and λ is a measure of the extent to which
the government accommodates shocks. This last expression is higher the greater is the adverse impact of changes
in the real exchange rate on output, and smaller the greater
is the weight given to inflation in the government’s loss
function. It may be noted that under a discretionary policy, a fixed exchange rate would result here only if inflation
is infinitely costly, in which case the term λ goes to zero.

The Case with Fixed Cost of Realignment
Since the government faces a preset nominal wage wt when
deciding the exchange rate for period t, the predetermined

APPENDIX 2
DATA DESCRIPTION AND SOURCES
The following variables are from the IFS CD-ROM: end of
period exchange rate (line ae), short-term interest rate (line
60b, except for Philippines line 60c), foreign assets (line
11), foreign liabilities (line 16c) where possible, reserve
money (line 14), narrow money (line 34), quasi-money
(line 35), CPI inflation (line 64), exports (line 70), imports
(line 71), budget deficit (line 80), and government expenditure (line 82). Japan’s government expenditure is from
IFS line 91F.C. while the deficit is taken from OECD quarterly National Accounts. The U.S. budget deficit and government expenditure are from Citibase with mnemonics
GGFNET and GGFEX, respectively. To represent output,
real GDP (typically line 99b.p) was used for all countries
except Japan and Taiwan, where real GNP (line 99a.r) is
used. United States money is from Citibase (fm1, fm2).
When IFS data were not available, central bank publications were used. Taiwan data are from Financial Statistics, Taiwan District, The Republic of China. Quasi-money
data for 1980:1–1981:2 are taken from Taiwan’s Supplement to Financial Statistics Monthly. Part of Indonesia’s
interest rate, reserve money and money are from Indonesia’s Financial Statistics. Philippine money data for January 1984 to November 1986 (except the December numbers
in this period) were obtained from Philippines Financial
Statistics. Thailand’s 1994 exports and imports are from the
Bank of Thailand’s Quarterly Bulletin. Malaysia’s 1994
reserve money series is constructed using data from Bank
Negara Malaysia’s Monthly Statistical Bulletin.
The frequency of all the data is monthly except for output and the budget deficit which are quarterly. Net foreign
assets is defined as foreign assets (11) less foreign liabilities. Missing values for foreign liabilities are set to zero if

MORENO /MACROECONOMIC BEHAVIOR: EVIDENCE FROM THE PACIFIC BASIN

these are small as a proportion of foreign assets. Because
of missing values, Philippines liabilities for August 1983,
December 1983 and December 1984 are calculated using
changes over the same period 12 months earlier. Also, the
Thai interest rate for December 1993 was computed using
the 12-month change. A number of macroeconomic series
did not span the entire period or contained missing values.
Estimates were then performed using the available data for
each country. Because of lack of quarterly data, Indonesia,
Thailand and Malaysia were excluded in the output comparisons and Taiwan was excluded in the budget deficit
comparisons.
Many of the variables are transformed by taking the differential between domestic and United States first differences of natural logarithms or percentage changes. Central
bank domestic credit growth is the difference between the
percentage growth in reserve money less the change in net
foreign assets scaled by reserve money in the last period.
Net foreign assets is the first difference of net foreign assets divided by the previous month’s reserve money. The
nominal dollar exchange rate is expressed as the percentage change over the previous month. Output is the deviation from the mean growth of real GDP or real GNP. The
budget deficit is taken as a ratio of government expenditure (to maximize data use, as quarterly output data are often unavailable), and then divided by the corresponding
budget ratio for the U.S. Budget ratios, narrow and broad
money (the sum of narrow money and quasi-money), exports, and imports are seasonally adjusted using X11.

APPENDIX 3
EXCHANGE RATE REGIMES
IN PACIFIC BASIN ECONOMIES
Indonesia. Indonesia has had a managed float in place since
January 16, 1978, when the link with the U.S. dollar was
discontinued. Bank Indonesia (BI) has set the middle rate
of the rupiah in terms of the U.S. dollar, the intervention
currency, by taking into account the behavior of a basket
of currencies of Indonesia’s main trading partners. In September 1989, the foreign exchange system was modified
substantially so that the BI-announced exchange rate applies only to certain transactions undertaken at certain times
of the day. For all other transactions, banks are free to set
their own rates.
Japan. Exchange rates are determined on the basis of underlying demand and supply conditions in the exchange
markets. However, the authorities intervene when necessary in order to counter disorderly conditions in the markets. The principal intervention currency is the U.S. dollar.

15

Korea. From January 1980 to March 1990, the won was
linked to a multicurrency basket (consisting of tradeweighted basket and SDR basket), but other factors were
also taken into account in setting the exchange rate. The
Bank of Korea (BOK) set a daily exchange rate of the won
(BOK base rate) in terms of the U.S. dollar, which is the
intervention currency. A market average rate (MAR) system introduced on March 2, 1990 sets the won–U.S. dollar
rate on the basis of the weighted average of interbank rates
for won-U.S. dollar spot transactions of the previous day.
During each business day, the Korean won–U.S. dollar exchange rate in the interbank market is allowed to fluctuate
within fixed margins (plus or minus 1 percent in 1994)
against the MAR of the previous day. The won exchange
rate against other currencies is determined by the level at
which these currencies trade against the U.S. dollar in the
international market. Buying and selling rates offered to
customers are set freely by foreign exchange banks.
Malaysia. The value of the ringgit is determined by supply
and demand conditions in the foreign exchange market.
Bank Negara Malaysia (the central bank) intervenes to
maintain orderly market conditions and to avoid excessive
fluctuations in the value of the ringgit against a basket of
currencies weighted in terms of Malaysia’s major trading
partners and the currencies of settlement.
Philippines. Up to 1984, authorities intervened when necessary to maintain certain margins around a “guiding rate”
that was established daily by the Bankers’ Association.
Commercial banks were required by the association to observe certain margins for transactions of less than
US$100,000. The minimum and maximum spot buying
(selling) rates were 0.5 percent (0.75 percent) and 1 percent (1.25 percent), respectively below (above) the guiding
rate. For transactions above US$100,000, margins were
determined competitively. Since October 1984, the value
of the peso has been determined freely in the foreign exchange market. However, the central bank is a major participant in this market and intervenes when necessary to
maintain orderly conditions in the exchange market and in
light of medium-term policy objectives.
Singapore. The Singapore dollar is permitted to float, and
its exchange rate in terms of the U.S. dollar and all other
currencies is freely determined in the foreign exchange
market. However, the Monetary Authority of Singapore
monitors the external value of the Singapore dollar against
a trade-weighted basket of currencies. Historically, Singaporean authorities have targeted the exchange rate (through
intervention) to achieve a domestic inflation goal. Rates for
other currencies are available throughout the working day

16

FBRSF ECONOMIC REVIEW 1995, NUMBER 3

and are based on the currencies’ exchange rates against the
U.S. dollar in international markets. Banks are free to deal
in all currencies, with no restrictions on amount, maturity,
or type of transaction.
Taiwan. A managed float was adopted in 1979, involving a
daily exchange rate ceiling set by the central bank. The
ceiling was abandoned in March 1980, and reestablished
in September 1982. Until 1989, the spot central rate of the
U.S. dollar against the NT dollar was set daily on the basis
of the weighted average of interbank transaction rates on
the previous business day. Daily adjustment of the spot rate
was not to exceed 2.25 percent of the central rate on the
previous business day. In April 1989, the limits on daily
fluctuations of the interbank rate were rescinded, and a
new system of foreign exchange trading was established,
based on bid-ask quotations.
Thailand. The Thai baht was de facto pegged to the U.S.
dollar from 1981 until 1984, when it was devalued. The
baht was subsequently pegged to a weighted basket of currencies of Thailand’s major trading partners, but the exchange rate can also be influenced by other considerations.
The Exchange Equalization Fund announces daily the buying and selling rates of the U.S. dollar for transactions between itself and commercial banks. It also announces daily
minimum buying and maximum selling rates that commercial banks must observe when dealing with the public
in various currencies. The EEF intervenes to keep the relationship of the baht to the basket of currencies within a
margin and to maintain orderly conditions in the exchange
market.
SOURCES: IMF. Exchange Arrangements and Exchange Restrictions.
Moreno (1994), Working Paper version.

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Sterilization of Capital Inflows through
the Banking Sector: Evidence from Asia

Mark M. Spiegel

Federal Reserve Bank of San Francisco. Thuan-Luyen Le
and Warren Chiang provided capable research assistance.
Helpful comments were received from Reuven Glick, Hopi
Huh, Mark Levonian, and Tim Cogley.

This paper develops an open-economy version of the
Bernanke-Blinder model which indicates that sterilization
efforts through increases in reserve requirements will have
limited impact if viable financial alternatives to the commercial banking sector exist. I then examine the capital inflow surge experiences of seven developing Asian nations.
Our analysis yields three stylized conclusions: First, the
timing of capital inflow surges indicates a causal role for
both domestic and foreign factors. Second, there is little
general rule as to the most effective sterilization instrument. Finally, the experiences of the developing nations
during their capital inflow surge period largely coincide
with the predictions of the model. Korea, the country with
the largest nonbank financial sector, had the least success
in stemming the impact of capital inflow surges despite
intervention through both open market operations and increased reserve requirements.

The magnitude of recent capital inflows into developing
countries in the Pacific Basin has been staggering. During
the period from 1990 to 1993, Asian developing nations received a net capital inflow of $151 billion. These flows
were large relative to the countries as a whole. Capital inflows reached 13 percent of GDP in Thailand and Malaysia, 10 percent of GDP in Singapore, 6 percent in the
Philippines, and 5 percent in Indonesia (Glick and Moreno
1994). The source of these surges in capital inflows is controversial. Calvo, Leiderman, and Reinhart (1993) present
evidence that external factors played a dominant role in the
pattern of capital inflows in Latin America. However,
Schadler (1994) stresses that external developments did not
always coincide with surges in inflows, and that domestic
factors must have played a role as well. Among these, she
stresses structural changes that improved potential productivity, improved fiscal policies, and a tightening of domestic credit policies. Chuhan, Claessens, and Mamingi
(1993) also find that while the foreign environment matters, domestic factors were the primary determinants of the
magnitude of Asian capital inflows in their study.
A large literature has emerged analyzing the implications of these capital inflows, and in particular, investigating the contention that the extremely large magnitudes of
the inflows can be disruptive to a nation’s economy, resulting in the desire to mitigate their influence. It has been
suggested that while capital inflows may be desirable because the marginal product of capital is larger in developing countries, rapid reversals of these flows can lead to
domestic liquidity problems. Bercuson and Koenig (1993)
question whether large increases in financial flows can be
handled efficiently by the financial system, suggesting that
flows of sufficient magnitude may jeopardize the safety of
the banking system. In addition, the real exchange rate appreciations that often accompany these capital inflows can
lead to undesirable resource reallocation, particularly if
the reallocation of resources motivated by the capital inflow surge is likely to be temporary.
Asian developing country governments in particular
have responded to these capital inflows with aggressive attempts at sterilization. In 1993, one-third of the $100 billion in net capital inflows into Asia Pacific Economic

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FBRSF ECONOMIC REVIEW 1995, NUMBER 3

Cooperation Forum (APEC) nations was absorbed by central banks as foreign currency reserves. By the end of 1993,
the stock of reserves of the Asian region equalled $261 billion, far exceeding the combined total of all the developing nations and nations in transition in the rest of the world.
While sterilized intervention through open market operations appears to be the most common response to capital inflows, its use appears to diminish over the course of
an extended capital inflow episode. In Asia, for example,
the share of capital inflows which became increases in reserves has declined over time (Khan and Reinhart 1994).
This may reflect the problems associated with prolonged
sterilized intervention noted by Calvo, Leiderman and
Reinhart (1993). First, sterilization requires governments
to purchase low-yielding foreign securities despite the fact
that they are often paying high interest rates on external
debt. This process obviously places a burden on the recipient country government. These “quasi-fiscal costs” have
been estimated to amount to up to one-half percent of GDP
in Latin America (Kiguel and Leiderman 1993). Second,
by preventing a decrease in the interest rate differential between domestic and foreign assets, sterilized intervention
fails to eradicate the conditions which led to the capital
inflow.
As nations become dissatisfied with the costs or the effectiveness of sterilized intervention through open market
operations, they turn towards other, less standard sterilization instruments. In this paper, we examine an alternative
policy response to capital inflows which has been particularly popular in Southeast Asia, increases in commercial
bank reserve requirements.1 This policy attempts to limit
the impact of foreign capital inflows by reducing the magnitude of capital which flows into the banking sector.
Banking institutions retain a significant role as financial
intermediaries in developing countries in Asia. Consequently, a significant portion of the capital which flows
into these countries either enters directly into, or finds its
way into, the developing country banking system.
Most of the portfolio inflows into APEC developing
countries in recent years have been bonds issued by APEC
borrowers in foreign currencies (Folkerts-Landau, et al.,
1994). However, the potential for an increase in bank lending resulting from this form of inflow is similar. If the local bond issuer deposits his capital in a domestic bank, it
is the same as if the domestic bank had issued a foreign li-

1. While the Pacific Basin countries have been particularly active in using reserve requirements as the instrument for limiting capital inflows,
they have not been alone. In 1992, for example, Chile levied a 30 percent reserve requirement on foreign credits, while Mexico imposed a
10 percent limit on the share of foreign currency liabilities (FolkertsLandau, et al., 1994).

ability itself. Consequently, regardless of the form of the
capital inflow, the impact is likely to be an expansion of
the domestic financial system.2
Policymakers may also have particular interest in limiting the activities of their banking sector during capital
inflow surges. Large and volatile capital flows can contribute to bank problems by causing large swings in bank liquidity. Calvo, Leiderman, and Reinhart (1993) discuss the
possibility of capital inflows leading to “improper intermediation.” These could result from a variety of sources, including improperly priced government deposit insurance,
either explicit or implicit. The problem with addressing the
improper intermediation through a mandatory deposit insurance scheme, according to Calvo, Leiderman, and
Reinhart, is that such a scheme would need to be highly sophisticated, incorporating the loss associated with a reversal in the flow of capital. The authors argue that “…in the
short run, it may be more practical simply to preclude
banks from intermediating much of the new capital inflow
by increasing required reserve ratios” (p. 144). They argue
that by limiting the investments of banks in markets prone
to speculative bubbles, such as real estate and equity markets, the country’s banking system will be less exposed
when the bubble bursts.
However, placing the burden of sterilizing the capital inflow surge on the commercial banking sector is not a costless policy. Folkerts-Landau, et al. (1994) identify two
primary disadvantages of sterilization through increases in
bank reserve requirements. First, since reserves do not earn
market rates of return, an increase in reserve requirements
distorts the share of intermediation handled by the banking sector. Second, raising reserve requirements may not
be effective at addressing capital inflows which are intermediated outside the banking system. These include bond
and equity markets which have been growing rapidly in
these countries over the previous decade and the informal
lending or “curb markets” prevalent in many Asian developing countries. Raising reserve requirements will put
banks at a competitive disadvantage relative to these nonbank institutions and lead to disintermediation.
Below, we develop a simple model which can analyze
the implications of enhanced capital inflows on the domestic credit markets of the capital recipient countries.
Our model is an open-economy Mundell-Fleming version
of the Bernanke-Blinder (1987) model. The BernankeBlinder model introduces an explicit banking sector into a
standard IS-LM macro model. Our “open economy” extension is essentially the introduction of a balance of payments equation. This extension allows us to trace out the
2. The exception would be if the capital immediately flowed back out
of the nation to support a current account deficit.

SPIEGEL /STERILIZATION OF CAPITAL INFLOWS: ASIA

implications of a surge in capital inflows and a reserve requirement increase policy response.3
We then examine the empirical experiences of seven
Asian developing countries over this period. These nations
experienced a variety of capital inflow episodes and responded to them with an assortment of government policies, including a variety of policies designed to curtail the
activities of the banking sector.
Both our theoretical analysis and our empirical evidence
demonstrates that the effectiveness of sterilization policies, including those specifically targeted at the banking
sector, depends on the ability of the nonbank sector to play
a substitute role for intermediation. The greater is the degree to which foreign investors can substitute nonbank for
banking sector investments, and the greater is the degree
to which these nonbank investments influence the level of
aggregate demand, the lesser is the ability of the recipient
country’s government to mitigate the impact of capital inflows through the use of reserve requirements.
The remainder of this paper is organized into four sections. Section 1 introduces an open-economy version of
the Bernanke-Blinder model. Section 2 conducts comparative static exercises concerning the implications of a decrease in the foreign rate of interest for this model and the
impact of policy responses through either an increase in
reserve requirements or a decrease in the stock of highpowered money. Section 3 examines the experiences of
seven Asian countries during the period of relatively large
capital inflows. Finally, Section 4 concludes.

I. A SIMPLE MODEL OF THE MACROECONOMIC
IMPACTS OF CAPITAL INFLOWS
Assumptions
There are three domestic assets, as in the BernankeBlinder (1987) augmented IS-LM framework: money,
bonds, and bank loans. Domestic bank loans pay interest rate r, as do bank deposits, while domestic bonds pay
interest rate i. The real side of the economy is assumed
to be similar to a standard Mundell-Fleming model.
Domestic aggregate demand follows a standard IS-LM
pattern:

3. Chinn and Dooley (1995) use a similar model to explain inconsistencies found in the literature concerning the degree of capital mobility
in Pacific Rim economies. Their argument is that studies based on
money market rates ignore that “bank credit is special.” Their empirical finding that capital inflows positively affect bank lending for a group
of Pacific Rim countries is also consistent with the predictions of the
open-economy Bernanke-Blinder model.

(1)

19

A = A(i,r)

where Ai < 0 and Ar < 0. Income is equal to domestic aggregate demand plus the net trade surplus:
(2)

Y=A+T

where T represents the trade balance. We assume throughout that prices are fixed and that the monetary authority
maintains a pegged exchange rate regime. For the purposes
of this paper, we also implicitly hold foreign income levels constant and express T solely as a function of Y:
(3)

T = T(Y)

where TY < 0.
We make the simplifying assumption that all foreign
capital inflows come directly into the domestic banking
sector in the form of foreign deposits, which we term D*.
The supply of foreign capital to the domestic banking sector is assumed to be increasing in the spread between domestic bank interest rates and the risk-free foreign rate of
interest, r*:
(4)

D* = D*(r – r*)

where D*r–r* > 0. We assume that domestic agents only hold
domestic assets for simplicity, and thus rule out the possibility of capital flight.
We assume that when foreign source deposits enter the
commercial banking system, the central bank, in order to
maintain the exchange rate peg, issues enough reserves to
match these assets one for one in domestic currency. Define τ as the bank reserve requirement, 0 < τ <1. Assuming
that banks hold no excess reserves and letting R* represent
the reserves issued to monetize foreign capital inflows, the
central bank issues reserves such that
(5)

D*(r – r*) = R*/τ .

Note that this component of high-powered money is not
discretionary to the monetary authority. Under free capital
mobility, this change in the stock of high-powered money
is required to defend the nominal exchange rate peg. We
examine the implications of monetary policy below by examining changes in the discretionary component of the
monetary base, R, the high-powered money issued to underlie domestic credit.
We next turn to the market for bank loans. Banks hold
reserves equal to τ (D + D*) and divide up their remaining
assets between bank loans and bank holdings of bonds.
Define λ(r,i), λ r > 0, λ i<0, as the share of free assets banks
hold as loans. The bank loan supply curve then satisfies
LS = λ(r,i)(D + D*)(1 – τ). We specify a standard loan demand curve, LD = L(r,i,Y ), Lr < 0, Li > 0, LY > 0. Equilibrium in the market for bank loans then satisfies:

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FBRSF ECONOMIC REVIEW 1995, NUMBER 3

(6)

L(r,i,Y) = λ(r,i)(D + D*)(1 – τ) .

Finally, we derive the equilibrium condition in the
money market.4 Since banks do not hold excess reserves,
the supply of deposits is equal to the stock of high-powered
money divided by reserve requirements, (R+R*)/τ. Following Bernanke and Blinder, we specify the demand for
money as a function of the bond rate and income D =
D(i,Y), Di < 0, DY > 0. The equilibrium condition in the
money market then takes on the characteristics of a standard LM curve:5
(7)

D*(r – r*) + D(i,Y) = (R + R*)/τ .

By (5), equation (7) simplifies to
(7′)

D(i,Y) = R/τ .

Using equation (7′) to substitute for D in equation (6)
yields the equilibrium condition in the bank loan market
as
(8)

L(r,i,Y) = λ(r,i)[R/τ + D*(r – r*)](1 – τ) .

Equation (8) suggests that we can express the bank loan
rate r as a function of the world interest rate, r*, the required reserve ratio, τ, the size of the monetary base underlying domestic deposits, R, the bond market interest
rate, i, and the level of income, Y:
(9)

r = φ(r*,τ,R,i,Y)

where φr* > 0, φτ > 0, φR < 0, φi > 0, and φY > 0. We demonstrate these comparative static relationships in the appendix.
In addition, we obtain the result that dr/dτ is decreasing
in the absolute value of both Lr and λr. Intuitively, these relationships reflect the fact that the degree to which an increase in reserve requirements results in an increase in the
bank loan rate depends on the elasticity of bank loan demand and supply. In particular, the ability of banks to pass
their additional cost of funds on to its borrowers will depend on the elasticity of demand for bank loans, which presumably depends on the ability of bank loan customers to
obtain funds elsewhere. Similarly, the willingness of substitute bonds for bank loans in their portfolio depends on
the quality of alternative investment instruments available.
Consequently, the relatively poorer are the alternative potential sources of funds, the greater is the bank loan rate
response to an increase in bank reserve requirements.
Substituting (9) into equation (2) yields:

4. Satisfaction of equilibrium in the goods, bank loans, and money markets implies satisfaction of equilibrium in the bond market by Walras’
law.
5. The demand for money should also be a function of total wealth. As
in Bernanke and Blinder, we assume that this is constant and suppress it.

(10)

Y = A[i,φ(r*,τ,R,i,Y)] + T(Y) .

We can refer to equation (10) as the “CX curve.” The
curve should be thought of as a variant of the standard IS
curve, along which domestic and external goods markets
are in equilibrium, which also defines equilibrium in the
bank loan market. Like a standard IS curve, the CX curve
is negatively sloped. However, the introduction of a bank
loan market allows the CX curve to shift due to credit market shocks, such as policy changes in R or τ, as in the
Bernanke-Blinder model. In addition, the external sector
can provide a source of foreign shocks, proxied simply
here by changes in r*.
Our CX curve reduces to a standard Mundell-Fleming
“XX curve,” where aggregate supply is equal to domestic
absorption plus the net trade balance, if loans and bonds
are perfect substitutes to either lender or borrowers.6 Similarly, the CX curve becomes flat if foreign and domestic
assets are perfect substitutes under our maintained smallcountry assumption. Of course, as in the standard IS-LM
model, the LM curve becomes flat if money and bonds are
perfect substitutes.
While the CX curve measures equilibrium in the goods
market, it does not imply a balance of payments equilibrium. The balance of payments is equal to the sum of net
exports and capital inflows. As in the standard MundellFleming model, we define the “BP curve” as the locus of
points where the balance of payments is equal to zero. The
BP curve therefore satisfies
(11)

T(Y ) = –D*(r – r*) .

We then have our model as shown in Figure 1. Note that
the BP curve is upward-sloping reflecting our assumption
that foreigners consider their deposits imperfect substitutes for their domestic deposits. The intersection of all
three curves implies that the goods market, the money market, and the balance of payments are all in equilibrium.

II. COMPARATIVE STATICS
Implications of a Decrease in r*
Many authors, such as Calvo, Leiderman, and Reinhart
(1993), attribute the surge of capital inflows into Latin
America to a change in the relative demand for these assets due to a fall in developed nation interest rates. We can
express the system in balance of payments equilibrium by
substituting for T in equation (10) by using equation (11),
6. This is analogous to the fact that the Bernanke-Blinder CC curve reverts to a normal IS curve under the same conditions. Closing the economy to foreign capital inflows would obviously result in the CX curve
reverting to the standard Bernanke-Blinder CC curve.

SPIEGEL /STERILIZATION OF CAPITAL INFLOWS: ASIA

21

FIGURE 1

FIGURE 2

OPEN ECONOMY BERNANKE-BLINDER MODEL

IMPACT OF A DECREASE IN r*

which yields

domestic interest rates. This implies an additional channel
for the transmission of a decrease in the foreign interest
rate through the positive impact the reduction in foreign
interest rates has on bank loan interest rates. This leads us
to point B (as in Bernanke and Blinder). This additional
channel also implies that a larger degree of monetization
is necessary to accommodate the now-larger magnitude of
capital inflows. As in Bernanke and Blinder, the final impact on the level of interest in the nonbank financial sector
is unclear because of the rise in the transactions demand
for money associated with the increase in output.7 However, the level of r, the bank loan rate, must decrease.
In an international setting, equation (10′) reminds us
that there are forces at work which serve to dampen this effect. In particular, the reduction in foreign interest rates, by

(10′ )

Y = A[i,φ(r*,τ ,R,i,Y)] – D*(r – r*) .

Equations (7′ ) and (10′ ) form our basic system under balance of payments equilibrium of two equations in two endogenous variables, i and Y.
Graphically, we can see the effect of a decrease in r* in
Figure 2. The decrease in r* leads to a downward shift
in the BP curve. At a point like E0 , there will be positive
foreign capital inflows. To maintain the exchange rate peg,
these foreign currency inflows must be monetized through
the issue of R* in reserves. This leads to an outward shift
in the LM curve until a new equilibrium is reached. In a
standard Mundell-Fleming model (where the CX curve
fails to shift), the required intervention needed to maintain
the nominal exchange rate peg leads us to point M, so labelled by Frankel (1994) due to its correspondence with
the monetary approach to the balance of payments.
In our model, however, the impact of a decrease in foreign interest rates will also fall directly on the domestic
goods market. By equation (10′), a decrease in r* has an
expansionary impact on aggregate demand by reducing

7. Previous studies that have not included a “credit channel” have treated
the widespread failure of interest rates to drop noticeably during the period of high capital inflows as an anomaly. For example, see Frankel and
Okongwu (1995), who ascribe the failure of interest rates to fall in capital recipient countries during the 1989–1994 period to increased expectations of precipitous exchange rate devaluations.

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FBRSF ECONOMIC REVIEW 1995, NUMBER 3

generating capital inflows, must correspond to a reduction
in net exports under balance of payments equilibrium. Differentiating the right-hand side of equation (10′) with respect to r* yields
(12)

Aφφr* – D*r* .

The first term of (12) is negative, implying that a decrease in r* shifts out the CX curve due to the expansionary effect on the banking market. However, the second
term is positive reflecting the fact that a decrease in r* results in increased capital inflows and a deterioration in the
trade balance, which would shift in the CX curve. This can
be seen in Figure 2. If the capital inflow were not monetized so that the LM curve was shifted outward, the final
equilibrium would have to be at a point like A, implying
that backward shifts in the CX curve, in response to deterioration of the trade balance, would have to do the work
of bringing the balance of payments back into balance. We
proceed under the assumption that (12) is negative, implying that the CX curve indeed shifts out in response to a reduction in r*.
Given this assumption, we show in the appendix that the
comparative statics of the model with respect to r* satisfy
(13a)

di/dr* = – DY (Ar* – D*r*) /Λ > 0

(13b)

dY/dr* = Di(Ar* – D*r*)/Λ < 0

where Λ represents the determinant of the system, shown
to be negative in the appendix. As suggested, a decrease in
the foreign interest rate is expansionary, leading to an increase in Y and a decrease in i (as well as a decrease in r
by equation (9)).

Central Bank Policy Responses
We next turn towards the impact of policy responses to the
capital inflows. As we discussed above, the balance of payments equilibrium in this model subsequent to a drop in r*
corresponds to point B. Any effort to deviate from this
equilibrium through monetary policy will eventually be
thwarted by capital inflows or outflows which require adjustments in reserves. In other words, monetary policy cannot take us indefinitely off the BP curve. Nevertheless,
countries sometimes do attempt to sterilize their intervention through offsetting reductions in domestic credit. In
our model, this corresponds to shifting back both the LM
curve and the CX curve towards a point above the BP
curve. At this point, since the domestic interest rate still
lies above the world rate of interest, the position must be
defended by an accommodating change in the reserve
position of the central bank, and further pressure will be
experienced in the future. Nevertheless, we can examine

the “short run” implication of a sterilization effort by examining the comparative statics in equations (7′ ) and (10)
(instead of (10′) above, which also indicates balance of
payments equilibrium).
Increase in the Required Reserve Ratio. We first consider an increase in the level of the required reserve ratio,
τ. The standard channel for the transmission mechanism
of an increase in the required reserve ratio can be found in
equation (7′ ). An increase in τ reduces the magnitude of
domestic deposits, shifting the LM curve back.8
However, equation (10) demonstrates that there will also
be a shift in the CX curve. An increase in τ, by increasing
the rate of interest on bank loans, will reduce investment
and shift the CX curve back. Moreover, consider the explicit sensitivity of the bank interest rate with respect to a
change in τ derived in the appendix:
(14)

dr
λ[ R(1 − τ) /τ 2 + R / τ + D*]
=−
> 0.
dτ
Lr −[ λr (R / τ +D*) + λD *r ](1 − τ)

Among other factors, it can be seen that the magnitude of
dr/dτ is decreasing in the absolute value of both L r , the interest rate sensitivity of the demand for bank loans, and λ r ,
the interest rate sensitivity of the supply of bank loans.
Holding all else equal, the greater is the ability of borrowers to turn to the nonbank financial sector to substitute for
the intermediation provided by the banking sector, the
smaller will be the decrease in aggregate demand resulting from a given increase in τ. The ability of a nation to
use a given reserve requirement increase to stem the impact of capital inflows will therefore be less the greater is
the ability of the nonbank financial sector to substitute as
the channel of intermediation.
To see the overall impact of an increase in bank reserve
requirements more clearly, consider the complete comparative static solutions for an increase in τ derived in the
appendix:
(15a)

di/dτ = – [R(1 – AY – TY) /τ2 + Aτ DY] /Λ

(15b)

dY/dτ = [Di Aτ – Ai R /τ2] /Λ < 0.

See Figure 3. Beginning at point B, an increase in the
required reserve ratio results in a backward shift of both
the LM and the CX curves to a point like B′. The LM curve
is shifted back through the standard channel, so that an increase in reserve requirements reduces the money multiplier and the resulting money supply. The CX curve also is
shifted back through the credit channel. The increase in

8. Such an expansion in the amount of foreign deposits does not occur
by equation (6), since R* will now be increased to offset the reduction
in τ.

SPIEGEL /STERILIZATION OF CAPITAL INFLOWS: ASIA

FIGURE 3
IMPACT OF AN INCREASE IN

τ OR A DECREASE IN R

23

to more capital inflows and further exchange rate appreciation pressure. Unless the foreign interest rate change is
temporary, this alternative attempt at achieving independent monetary policy in a fixed exchange rate regime with
an open capital market will be as susceptible to pressure
from international capital markets as standard sterilization
efforts.
Impact of an Decrease in the Stock of High-Powered Money.
We next consider such a “standard” effort at sterilization,
through a decrease in R, the stock of high-powered money
underlying domestic assets. As in the case of an increase
in τ, a decrease in R will also work through two channels
in this model. A decrease in R shifts back the LM curve,
through its impact on the stock of money underlying domestic deposits, and also shifts back the CX curve, through
its impact on the bank loan rate and its subsequent impact
on credit markets. Consequently, the qualitative picture
corresponds to Figure 3. The comparative static results for
a decrease in R derived in the appendix also look quite
analogous to those above:
(16a)

di/dR = [(1 – AY – TY) /τ – ARDY]Λ

(16b)

dY/dR = [Di AR – Ai / τ]/Λ > 0.

However, the graphical analysis masks some differences
in the transmission mechanism underlying the two policies. To see this, consider the determinants of φR derived
in the appendix:
(17)
bank reserve requirements reduces the amount of bank
transactions, reducing output, as shown in equation (15b),
and hence the transactions demand for money.
It can be seen that in this model (15a), unlike the standard
IS-LM model, the immediate impact on interest rates in the
nonbank sector of such a policy is ambiguous. However, by
equation (9), interest rates in the banking sector must rise.
The additional shift in the CX curve implies that for a given
level of income and interest rates subsequent to a capital inflow surge, the magnitude of reserve requirement increase
necessary to restore pre-inflow income levels is smaller.
However, such a conclusion is somewhat misleading, because the inflow itself leads to an outward shift in the CX
curve and hence a larger level of income. Consequently, the
addition of a credit channel does not imply that for a given
capital surge caused by, for example, a reduction in the foreign rate of interest, the magnitude of increase in τ required to restore initial income levels is smaller.
Finally, we reiterate that our BP curve demonstrates that
this sterilization effort is not consistent with long-run equilibrium because the high domestic interest rate will lead

dr
λ(1 − τ) /τ
=
< 0.
dR Lr − [λr (R /τ + D*) + λD *r ](1 − τ)

As in the case of an increase in reserve requirements, the
impact of a given decrease in the stock of high-powered
money will be greater the less desirable are alternative
sources of intermediation, i.e., the greater is the absolute
value of both Lr and λr. In other words, the lower is the
elasticity of demand and supply of bank loans, the more
effective are standard sterilization techniques as well.
However, the absolute value of the numerator of (17) is
smaller than that of (14). This is because a change in reserve requirements works through two channels not relevant to a change in the stock of high-powered money.
While both policy instruments influence the money supply, increases in reserve requirements also reduce the level
of intermediation by banks, both of domestic and foreign
deposits. Define the elasticity of r with respect to τ as
ε r,τ = (dr/r)/(dτ /τ), and define the elasticity of r with respect to R similarly. By (14) and (17):
λ[R /τ + τ D*]
(18a) ε r, τ = − r[ L − [λ ( R /τ +D*) + λD* ](1 − τ) > 0.
r
r
r

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(18b)

FBRSF ECONOMIC REVIEW 1995, NUMBER 3

ε r, R = r[L

λ R(1 − τ)/τ
< 0.
r − [λ r ( R / τ +D*) + λD*r ](1 − τ)

Comparing (18a) and (18b), it can be seen that ε r,τ is
greater than ε r,R in absolute value. In addition to the larger
first term in the numerator, the additional numerator term
in (18a) represents the reduction in the rate of intermediation of foreign deposits which find their way into the
banking system as a result of the increase in reserve requirements. It is this channel on which policymakers have
concentrated in advocating reserve requirement increases
as a mechanism for mitigating the impact of surges in capital inflows.

III. INDIVIDUAL COUNTRY EXPERIENCES
In this section, I summarize the experiences of seven Asian
developing nations who experienced capital inflow surges
between 1986 and 1993. As an informal “test” of the predictions of the model above, we pay particular attention to
the nations who attempted sterilization through the banking sector.

Indonesia
As in a number of Asian developing nations, changes in
domestic Indonesian policy also contributed to its capital
inflow surges. Indonesia initially pursued a policy of reforms designed to encourage capital inflows. Between
1979 and 1991, the central bank conducted foreign currency swaps with banks on demand at forward premia
which were below expected depreciation rates (FolkertsLandau, et al., 1993). In addition, it pursued an aggressive
policy of financial liberalization from 1988 to 1993. Prior
to this liberalization period, Indonesian banks faced numerous ceilings on foreign borrowing. These were eased
during the period of liberalization, as were restrictions on
entry for domestic banks.
This liberalization was followed by a surge in capital inflows. Foreign-owned assets as a percent of GDP increased
from 45 percent in 1988 to 74 percent in 1993. In addition,
many of these found their way to the commercial banking
sector. Commercial bank foreign liabilities as a percentage
of GDP increased from 2 percent in 1988 to 7 percent in
1993. Looking at Table 1, we see that the Indonesian capital account balance plus net errors and omissions reached
3.8 percent of GDP during 1986 and 1987, fell somewhat
during 1988 and 1989, and then topped 5 percent in both
1990 and 1991, and 4 percent in 1992. This surge then decreased to 2 percent of GDP in 1993.
Indonesia maintained a strong fiscal balance over the
capital inflow period. Consequently, the 1990-1993 capital

inflow period coincided with a much more moderate real
exchange rate appreciation, indicating success at sterilization. The surge in capital inflows also resulted in a rapid
buildup of foreign liabilities of domestic banks, as well as
a rapid expansion of the banking sector. Indonesia’s asset
ratio, the share of assets in the banking sector, increased
from 60.87 percent in 1986 to 85.43 percent in 1992. Similarly, the “credit ratio,” the ratio of commercial bank assets to domestic credit, increased from 84.26 percent to
93.27 percent.
Indonesia’s rapid surge in foreign capital inflows coincided with a deterioration in the stability of the nation’s financial sector. Nonperforming loans reached 16 percent of
outstanding loans in the 1990s. Two major banks failed,
bank Duta in 1990 and Bank Summa in 1992. These were
followed by increased restrictions on the banking industry
to reduce the growth of credit. It has been argued that these
capital restrictions in 1991 became the primary instrument
of monetary policy (Cole 1994). In addition, the two large
bank failures were covered completely from assets obtained
in the private sector. This strong stance towards owner liability also contributed to a slowdown in lending.
Indonesia also pursued sterilization activities. During
the reform period, Indonesia sterilized capital inflows by
requiring its public enterprises to convert commercial bank
deposits to Bank Indonesia certificates, known as SBIs.
From 1988 to 1993, the stock of SBIs increased from 8
to 34 percent of total liabilities. This policy placed the burden of limiting the expansion of liquidity on the public
enterprises.
While Indonesian authorities did not increase reserve requirements as a form of sterilization, their tightening of
financial policies in 1991 did reduce the pace of intermediation of these inflows. Folkerts-Landau, et al. (1994) suggest that Indonesia’s initial unwillingness to sterilize
through reserve requirements led to increased interest volatility. Given the initial interest rate reductions associated
with the financial liberalization, when sterilization finally
did take place, interest rates rose and asset quality declined.
Nonperforming loans at large state-owned banks rose from
6 percent at the end of 1990 to 21 percent by October 1993.
Indonesia responded by easing capital adequacy and loan
deposit ratios in May of 1993.

Korea
Korea experienced a capital inflow surge in 1991 and 1992
(Table 2). The Korean capital account balance plus net errors and omissions topped 2.5 percent in both years. However, this capital inflow was largely offset by a current
account deficit, so that the overall balance was actually
negative in 1991 and only 1.2 percent of GDP in 1992. In

SPIEGEL /STERILIZATION OF CAPITAL INFLOWS: ASIA

25

TABLE 1
INDONESIA (1986–1993)
1986

1987

1988

1989

1990

1991

1992

1993

Growth of Real GDP

5.88

4.93

5.78

7.46

7.24

6.95

6.46

6.50

Inflation

5.83

9.28

8.04

6.42

7.81

9.41

7.53

9.23

Fiscal Balance

–3.53

–0.83

–3.09

–2.01

0.41

0.43

–0.42

0.67

Change in Real Eff. Exchange Rate

28.66

30.57

2.91

–0.90

2.64

–0.64

1.29

–1.96

Reserves (Bil of US$)

4.05

5.59

5.05

5.45

7.46

9.26

10.45

11.26

Reserves to Imports

2.80

4.17

3.51

3.01

3.07

3.55

3.75

4.25

Balances of Goods, Services, and
Private Transfers

–4.10
(–5.1)

–2.27
(–3.0)

–1.55
(–1.8)

–1.28
(–1.4)

–3.24
(–3.1)

–4.39
(–3.8)

–3.12
(–2.4)

–2.30
(–1.6)

Balance on Capital Account Plus
Net Errors and Omissions

3.10
(3.9)

2.90
(3.8)

1.44
(1.7)

1.77
(1.9)

5.49
(5.2)

5.92
(5.1)

5.19
(4.1)

2.89
(2.0)

0.33

0.46

0.67

1.78

6.65

5.99

7.86

NA

Deposit Bank Assets

16.77

20.62

26.77

37.47

55.43

63.12

66.69

NA

Asset Ratio (%)

60.87

62.09

62.73

74.58

78.02

84.47

85.43

NA

Credit Ratio (%)

84.26

84.57

86.62

89.72

92.37

93.84

93.27

NA

MACROECONOMIC INDICATORS

BALANCE OF PAYMENTS

FINANCIAL SECTOR
Foreign Liabilities (Bil of US$)

NOTE: Balance of payments data are in billions of U.S. dollars. Numbers in parentheses indicate component as a percentage of GDP. Variables are
defined in the appendix.

contrast, in 1988 Korea’s large current account surplus
yielded a large surplus in the balance of payments. Korea
responded to its capital inflows through a number of policies. Korea used “money stabilization bonds” to sterilize
foreign capital inflows through open market operations.
The quantity of these bonds outstanding increased from
9.6 percent of M2 in 1986 to 21 percent of M2 in 1992
(Folkerts-Landau, et al., 1994).
In addition, Korea raised reserve requirements and the
degree of regulation on the banking sector. Reserve requirements for commercial banks were raised to 11.5 percent on demand and time deposits. Because of Korea’s
extensive nonbank financial sector, this policy shifted assets out of commercial banks. The share of deposits held
by banks, which had been 70 percent in the 1970s, fell to
36 percent in 1992 (Folkerts-Landau, et al., 1994).
Korea grew very rapidly over the period, averaging
about 10 percent growth over the period. Its sterilization
effort also resulted in a large buildup of government reserves. The reserve to import ratio tripled from 0.77 to 2.42
between 1985 and 1994. Korea also experienced large real
exchange rate appreciations in 1988 and 1989.

Korea had a unique financial sector experience. Foreign
liabilities of the banking sector remained relatively unchanged from 1986 through 1993. However, deposit bank
assets did triple over the period. Most interestingly, the
relative share of the commercial banking sector fell by
both the asset ratio and credit ratio measures. This demonstrates the existence of disintermediation in Korea over the
period, in part presumably due to Korea’s sterilization efforts through increases in reserve requirements.

Malaysia
Malaysia’s capital inflows surged from 1991 to 1993.
Looking at Table 3, we can see that the balance on its capital account plus net errors and omissions as a percentage
of GDP reached unprecedented magnitudes even for a developing Asian nation. However, Malaysia is notable as a
country which pursued an aggressive policy of sterilization, both through increased reserve requirements and
through other instruments. Malaysia sold central bank securities to stem the impact of capital inflows. From 1989
to 1993, the value of government deposits increased by 72

26

FBRSF ECONOMIC REVIEW 1995, NUMBER 3

TABLE 2
KOREA (1986–1993)
1986

1987

1988

1989

1990

1991

1992

1993

11.55

11.52

11.27

6.38

9.51

9.13

5.06

5.53

2.75

3.05

7.15

5.70

8.58

9.30

6.24

4.80

Fiscal Balance

–0.09

0.43

1.51

0.19

–0.67

–1.62

–0.84

NA

Change in Real Eff. Exchange Rate

17.62

1.10

–8.21

–10.68

7.73

2.67

10.40

2.95

Reserves (Bil of US$)

3.32

3.58

12.35

15.21

14.79

13.70

17.12

20.23

Reserves to Imports

1.01

0.83

2.53

2.71

2.29

2.01

2.49

2.71

Balances of Goods, Services, and
Private Transfers

4.61
(4.2)

9.84
(7.2)

14.12
(7.8)

5.01
(2.3)

–2.18
(–0.9)

–8.55
(–2.9)

–4.50
(–1.5)

0.53
(0.2)

Balance on Capital Account Plus
Net Errors and Omissions

–4.53
(–4.2)

–7.73
(–5.7)

–4.80
(–2.6)

–1.89
(–0.8)

0.97
(0.4)

7.45
(2.5)

8.23
(2.7)

(0.8)

Foreign Liabilities (Bil of US$)

14.54

11.59

10.25

9.78

10.18

13.79

14.65

14.80

Deposit Bank Assets

58.13

72.50

94.79

117.78

139.86

158.21

171.20

Asset Ratio (%)

54.77

51.59

48.79

48.13

48.76

49.01

45.81

42.80

Credit Ratio (%)

62.00

57.81

53.37

51.36

51.96

51.88

48.98

45.57

MACROECONOMIC INDICATORS
Growth of Real GDP
Inflation

BALANCE OF PAYMENTS

2.48

FINANCIAL SECTOR

188.2

NOTE: Balance of payments data are in billions of U.S. dollars. Numbers in parentheses indicate component as a percentage of GDP. Variables are
defined in the appendix.

percent. In addition, Malaysia used the assets of its pension fund, the Employee Provident Fund, to sterilize capital inflows. The assets of the Employee Provident Fund and
the government deposits were transferred to the central
bank. The value of Federal and local deposits at the central bank increased from 3 to 19 percent of total deposits
from 1989 to 1992 (Folkerts-Landau 1994).
Reserve requirements were raised three times. First, they
were increased from 6.5 percent in 1991 to 7.5 percent. They
were then raised again to 8.5 percent in 1993. Finally, they
were further increased to 11.5 percent in 1994. Much of the
impact of reserve requirement increases was passed on to
depositors. The margin between borrowing and lending
rates increased from 3.8 percent to 4.7 percent. The cost of
maintaining reserves was estimated to have increased 23.5
percent over the period, while the margin increased almost
as much, 22.7 percent (Folkerts-Landau, et al., 1994).
The financial industry also became subject to more extensive regulation. In 1993, Bank Negara Malaysia placed
limits on banks’ foreign liabilities. In the securities markets, residents were forbidden from selling short-term se-

curities to nonresidents for a few months in 1994. Foreign
financial accounts in Malaysia had to be deposited in
“vostro” accounts with the central bank. These did not pay
interest and were subject to reserve requirements, effectively placing a tax on nonresident deposits. The reserve requirement on these accounts was lifted in May and the ban
on the issue of short-term securities was lifted in August.
Malaysia’s aggressive response to capital inflows was
felt both in the financial sector and in the real side of the
economy. Malaysia’s banking sector experienced relatively
subdued growth over the period. Nevertheless, the asset
and credit ratio measures both indicate that the relative
share of the commercial banking sector increased over this
period. In addition, Malaysia had a relatively moderate real
exchange rate appreciation during the 1990–1993 period.

Philippines
The Philippines’ surge in capital inflows was also preceded
by a period of liberalization. From 1986 to 1993, the Philippines undertook major trade, financial, and foreign ex-

SPIEGEL /STERILIZATION OF CAPITAL INFLOWS: ASIA

27

TABLE 3
MALAYSIA (1986–1993)
1986

1987

1988

1989

1990

1991

1992

1993

Growth of Real GDP

1.05

5.39

8.94

9.21

9.73

8.66

7.81

8.46

Inflation

0.74

0.29

2.56

2.81

2.62

4.36

4.77

3.54

–10.48

–7.73

–4.28

–5.13

–4.76

–4.35

–4.22

–5.21

22.23

6.55

12.05

2.45

2.93

1.04

–6.93

–2.82

Reserves (Bil of US$)

6.03

7.44

6.53

7.78

9.75

10.89

17.23

27.25

Reserves to Imports

6.16

6.10

4.22

3.82

3.49

3.58

4.98

6.61

Balances of Goods, Services, and
Private Transfers

–0.18
(–0.6)

2.47
(7.8)

1.73
(5.0)

0.16
(0.4)

–0.97
(–2.3)

–4.24
(–9.0)

–1.93
(–3.3)

–2.54
(–3.9)

Balance on Capital Account Plus
Net Errors and Omissions

1.63
(5.9)

–1.35
(–4.3)

–2.16
(–6.2)

1.07
(2.8)

2.92
(6.8)

5.48
(11.6)

8.56
(14.8)

13.88
(21.5)

2.37

2.00

1.87

2.34

3.01

4.32

7.15

11.66

Deposit Bank Assets

24.22

26.51

25.85

30.88

36.30

43.06

49.77

52.49

Asset Ratio (%)

55.02

53.47

51.51

93.46

97.34

98.65

71.23

64.85

Credit Ratio (%)

69.36

66.16

63.90

96.15

97.34

98.65

95.67

95.58

MACROECONOMIC INDICATORS

Fiscal Balance
Change in Real Eff. Exchange Rate

BALANCE OF PAYMENTS

FINANCIAL SECTOR
Foreign Liabilities (Bil of US$)

NOTE: Balance of payments data are in billions of U.S. dollars. Numbers in parentheses indicate component as a percentage of GDP. Variables are
defined in the appendix.

change liberalizations (Lamberte 1994). In addition, the
Philippines liberalized the rules for foreign investment in
the 1991 Foreign Investment Act. As in other countries
where liberalizations preceded the capital inflow surge, it
is difficult to assess the share of capital inflows attributable
to domestic and foreign factors.
Looking at Table 4, we can see that the Philippines’ capital account plus net errors and omissions has been large
and growing since 1988. The Philippines case is unique,
however, because in addition to standard capital account
inflows, their surge in capital inflows also came from the
nonmerchandise portion of the current account. Most notably, this includes remittances of overseas workers and
withdrawals of foreign currency deposits. 1993 remittances
equaled $2.3 billion or 4 percent of GDP. The foreign currency deposit withdrawals may be considered capital flight
repatriation.
The Philippines responded to its capital inflow surge with
a myriad of instruments, including high reserve requirements. Reserve requirements have been very high, averaging
22 percent between 1987 and 1992. In addition, the Philip-

pines responded by reducing its request to the Paris Club for
loan rescheduling, and lifting the restrictions on repatriation of foreign investments. It also allowed outward investment to increase from $1 million to $6 million per year.
Finally, the Philippines also used sterilized intervention
to increase the demand for foreign exchange. From 1991 to
1994, the Central Bank purchased $6.6 billion U.S. dollars.
The Philippines did not experience large capital inflows
relative to the magnitude of its current account deficit until 1992. As a consequence, there was little impact on domestic credit. Lamberte (1994) has shown that, during this
latter period, “standard” sterilization policy in the Philippines through open market operations was relatively ineffective. Consequently, if sterilization efforts did play an
important role in mitigating the impact of capital inflows
on domestic credit levels, they must have stemmed from
more “nonstandard” efforts, such as increases in reserve
requirements, which directly affected the domestic banking sector.
This can be seen most clearly in Table 4 from the experience of the Philippines’ real exchange rate. From 1988–

28

FBRSF ECONOMIC REVIEW 1995, NUMBER 3

TABLE 4
PHILIPPINES (1986–1993)
1986

1987

1988

1989

1990

1991

1992

1993

Growth of Real GDP

3.42

4.31

6.75

6.21

3.04

–0.58

0.34

2.14

Inflation

0.75

3.79

8.76

12.21

14.14

18.71

8.92

7.59

Fiscal Balance

–5.03

–2.45

–2.91

–2.11

–3.45

–2.11

–1.18

–1.48

Change in Real Eff. Exchange Rate

26.76

3.59

–2.09

–5.68

6.07

3.15

–8.14

8.52

Reserves (Bil of US$)

1.73

0.97

1.00

1.42

0.92

3.25

4.40

4.68

Reserves to Imports

3.91

1.45

1.47

1.54

0.84

3.06

3.13

2.79

Balances of Goods, Services, and
Private Transfers

0.75
(2.5)

–0.64
(–1.9)

–0.67
(–1.8)

–1.81
(–4.3)

–3.05
(–6.9)

–1.39
(–3.1)

–1.34
(–2.5)

–3.59
(–6.6)

Balance on Capital Account Plus
Net Errors and Omissions

0.39
(1.3)

0.58
(1.8)

1.34
(3.5)

2.11
(5.0)

3.01
(6.8)

3.14
(6.9)

3.03
(5.7)

3.88
(7.1)

Foreign Liabilities (Bil of US$)

1.83

1.94

2.10

2.02

2.38

2.06

3.00

2.91

Deposit Bank Assets

6.26

7.23

8.65

10.38

10.40

11.67

15.65

18.88

Asset Ratio (%)

72.90

82.40

84.53

86.46

87.41

88.11

93.95

97.12

Credit Ratio (%)

63.20

70.17

75.63

79.94

82.76

85.24

79.65

62.55

MACROECONOMIC INDICATORS

BALANCE OF PAYMENTS

FINANCIAL SECTOR

NOTE: Balance of payments data are in billions of U.S. dollars. Numbers in parentheses indicate component as a percentage of GDP. Variables are
defined in the appendix.

1993, the Philippines actually experienced a small net real
exchange rate depreciation. The reserve to import ratio
also tripled from 1985 to 1986, from 1.21 to 3.91 percent.
However, this ratio subsequently decreased to 0.84 percent
by 1990, only to triple again during the subsequent capital
inflow surge period.
Despite its increases in reserve requirements, the share
of the commercial banking sector in the Philippines grew
dramatically over the studied period, as measured by our
asset and credit ratios. In addition, foreign liabilities of
Philippine commercial banks and the asset size of deposit
banks also grew demonstratively.
As the surge in capital inflows cooled down, the Philippines weakened its policy to allow for the maintenance of
a sustainable level of capital inflows. By August of 1994,
reserve requirements had been reduced to 17 percent from
a high of 24 percent in January 1993 (Lamberte 1994).

Singapore
Singapore has had a relatively volatile capital inflow expeience over the period. Looking at Table 5, we can see that

the capital account balance plus net errors and omissions
surged in 1985, 1987, 1990, and 1992–1993. These periods
were separated by periods of relatively minor capital account balance surpluses. Despite this volatility, Singapore
maintained a high and relatively stable rate of GDP growth
and moderate inflation. In addition, Singapore’s real exchange rate appreciation from 1989 through 1993 was
moderate relative to other Asian developing countries.
Singapore took a relatively nonstandard approach to
sterilize its capital inflow surge. First, it resisted any increase in bank reserve requirements. Second, because it
lacked the government bonds to use in more standard sterilization efforts, it sterilized capital inflows through the assets in its large mandatory government pension fund, the
Central Provident Fund. While its stock of reserves more
than quadrupled over the period, its outward orientation
and its high rate of GDP growth implied that the reserve to
import ratio stayed relatively constant.
Singapore’s policy response to its capital inflow surge
had a relatively neutral impact on the share of the commercial banking sector, which stayed relatively constant
at around 85 percent, according to the asset ratio and the

SPIEGEL /STERILIZATION OF CAPITAL INFLOWS: ASIA

29

TABLE 5
SINGAPORE (1986–1993)
1986

1987

1988

1989

1990

1991

1992

1993

1.84

9.41

11.14

9.24

8.76

6.65

6.04

9.94

–1.37

0.47

1.53

2.38

3.44

3.42

2.27

2.42

1.45

–2.73

6.97

10.25

10.87

8.84

NA

NA

Change in Real Eff. Exchange Rate

18.60

8.29

0.75

–5.65

–4.52

–2.38

–2.48

–0.85

Reserves (Bil of US$)

12.94

15.23

17.07

20.35

27.75

34.13

39.89

48.36

5.71

4.61

4.02

4.70

4.81

6.19

5.55

6.16

Balances of Goods, Services, and
Private Transfers

0.33
(1.9)

–0.09
(–0.5)

0.98
(3.9)

2.91
(9.9)

2.26
(6.2)

4.16
(9.8)

3.94
(8.1)

2.25
(4.1)

Balance on Capital Account Plus
Net Errors and Omissions

0.21
(1.2)

1.19
(5.9)

0.68
(2.7)

–0.17
(–0.6)

3.17
(8.7)

0.05
(0.1)

2.16
(4.5)

5.32
(9.7)

Foreign Liabilities (Bil of US$)

13.44

15.37

17.36

23.95

24.94

24.57

29.45

32.08

Deposit Bank Assets

17.68

21.01

23.74

29.34

36.53

44.46

48.90

57.24

Asset Ratio (%)

85.48

85.35

84.45

84.26

84.60

84.82

84.72

84.02

Credit Ratio (%)

85.46

85.33

84.44

84.25

84.60

84.81

84.71

84.01

MACROECONOMIC INDICATORS
Growth of Real GDP
Inflation
Fiscal Balance

Reserves to Imports
BALANCE OF PAYMENTS

FINANCIAL SECTOR

NOTE: Balance of payments data are in billions of U.S. dollars. Numbers in parentheses indicate component as a percentage of GDP. Variables are
defined in the appendix.

credit ratio. There was, however, some moderate growth
in foreign commercial bank liabilities and the deposit
bank assets grew at a robust pace. Of course, this was necessary over the period to keep pace with the rest of the
economy.

Taiwan
Taiwan experienced a large episode of capital inflows in
1986 and 1987. In both years, the capital account balance
plus net errors and omissions exceeded 9 percent of GDP.
Nevertheless, this was followed by a seven-year period of
capital outflows, from 1989 to 1994, as measured by this
proxy. The net impact on domestic credit from this capital
inflow surge was therefore relatively minimal.
Taiwan did engage in efforts subsequent to the initial
capital inflow surge to limit the expansion of domestic
credit. However, instead of raising reserve requirements, it
required commercial banks to directly purchase treasury
bills and central bank certificates of deposit. The government also shifted the assets of the postal system from the
commercial banking sector to the central bank. As in the

case of Indonesia described above, therefore, the burden of
sterilization that did take place was partly financed by the
public sector.
Looking at Table 6, it can be seen that the period was
one of rapid increase in GNP growth.9 In addition, we
see that while Taiwan’s real exchange rate did appreciate
over the period 1987–1989, a prolonged spell of moderate
depreciation from 1990–1993 mitigated the net real exchange rate movement. Taiwan also rapidly accumulated
reserves over the period, particularly in 1986 and 1987.
However, the country grew so rapidly that the reserve to
import ratio was lower in 1994 than in 1985, despite a large
initial increase.

Thailand
Unlike most capital-recipient countries, Thailand did not experience an increase in domestic rates prior to its capital
inflow surge. This evidence has been used by proponents
9. GNP figures were used for Taiwan because GDP figures were not
available.

30

FBRSF ECONOMIC REVIEW 1995, NUMBER 3

TABLE 6
TAIWAN (1986–1993)
1986

1987

1988

1989

1990

1991

1992

1993

11.65

11.86

7.33

7.98

5.54

7.55

6.23

6.02

0.70

0.50

1.28

4.46

4.06

3.60

4.54

2.86

–0.77

0.13

0.76

0.92

1.64

–0.93

–2.45

–1.27

9.79

–5.33

–3.54

–6.12

6.99

2.82

1.27

3.34

Reserves (Bil of US$)

46.31

76.75

73.90

73.22

72.44

82.41

82.31

83.57

Reserves to Imports

19.95

20.17

18.87

17.59

14.84

15.57

13.96

12.90

Balances of Goods, Services, and
Private Transfers

16.27
(21.6)

17.99
(17.7)

10.18
(8.3)

11.39
(7.6)

10.77
(6.7)

12.04
(6.7)

8.19
(4.1)

6.74
(2.9)

Balance on Capital Account Plus
Net Errors and Omissions

7.05
(9.4)

10.10
(10.0)

1.60
(1.3)

–12.16
(–8.2)

–14.69
(–9.2)

–2.36
(–1.3)

–6.79
(–3.4)

–5.17
(–2.2)

7.98

15.06

12.86

12.14

11.12

15.05

15.18

16.75

Deposit Bank Assets

58.99

85.37

119.72

167.66

186.13

239.03

310.18

Asset Ratio (%)

90.89

90.29

92.85

90.26

88.33

87.81

90.08

89.89

Credit Ratio (%)

91.76

91.46

92.43

91.91

90.98

90.61

92.07

91.84

MACROECONOMIC INDICATORS
Growth of Real GDP
Inflation
Fiscal Balance
Change in Real Eff. Exchange Rate

BALANCE OF PAYMENTS

FINANCIAL SECTOR
Foreign Liabilities (Bil of US$)

352.3

NOTE: Balance of payments data are in billions of U.S. dollars. Numbers in parentheses indicate component as a percentage of GDP. Variables are
defined in the appendix.

of external factors as the dominant cause of capital inflow
surges over the period, such as Schadler, et al. (1993). In
addition, it has been argued that Thailand’s history of low
inflation and outward-oriented policies may have enhanced its ability to weather its surge in capital inflows
(Schadler, et al., 1993). Its capital inflows were extremely
high: The capital account balance plus net errors and
omissions averaged about 10 percent of GDP from 1988
through 1992 (see Table 7).
While it failed to engage in extensive sterilization, Thailand did pursue a variety of measures designed to mitigate
the magnitude of capital inflows. These included encouraging capital outflows through early service of external
debt and easing the restrictions on foreign capital outflows.
In 1991, Thailand allowed individuals to open foreign exchange accounts up to $500,000 and corporations to open
accounts up to $2 million. In addition, they eliminated the
requirement for Bank of Thailand approval for repatriation
of investment funds.
Thailand’s macroeconomic indicators suggest that it
weathered the capital inflow surge period well. It achieved

a high rate of GDP growth with minimal inflation and an
increasing share of investment in GDP. Thailand experienced a very moderate real exchange rate appreciation
from 1988–1993. Thailand’s reserves also more than tripled from 1989 to 1994. However, its reserve to import ratio
less than doubled over the period, due to its growth in GDP
and outward orientation.
Thailand’s capital inflows resulted in a rapid expansion
of its domestic banking sector. This expansion included a
large expansion in foreign liabilities. Foreign liabilities of
the banking sector grew to twelve times their 1986 level by
1993, primarily due to borrowing from foreign financial institutions. Deposit bank assets also quadrupled over the
same period. In addition, the share of the commercial
banking sector grew according to both the asset ratio and
credit ratio measures.

Summary
The experiences of the seven developing Asian nations in
this study are summarized in Table 8. A number of pat-

SPIEGEL /STERILIZATION OF CAPITAL INFLOWS: ASIA

31

TABLE 7
THAILAND (1986–1993)
1986

1987

1988

1989

1990

1991

1992

1993

Growth of Real GDP

5.53

9.52

13.29

12.29

11.57

7.88

NA

NA

Inflation

1.84

2.47

3.86

5.36

5.93

5.70

4.14

3.57

Fiscal Balance

–4.23

–2.23

6.80

2.95

4.53

4.73

2.94

NA

Change in Real Eff. Exchange Rate

17.64

6.47

–0.55

–2.93

0.28

–2.20

3.86

–1.35

Reserves (Bil of US$)

2.80

4.01

6.10

9.52

13.31

17.52

20.36

24.47

Reserves to Imports

3.55

3.10

3.30

4.16

4.59

6.43

5.95

6.01

Balances of Goods, Services, and
Private Transfers

0.86
(0.2)

–0.49
(–1.0)

–1.84
(–3.0)

–2.70
(–3.7)

–7.47
(–8.7)

–7.67
(–7.8)

–6.49
(–5.8)

–6.96
(NA)

Balance on Capital Account Plus
Net Errors and Omissions

0.63
(1.5)

1.43
(2.8)

4.44
( 7.2)

7.73
(10.7)

10.74
(12.5)

12.29
(12.5)

9.33
(8.5)

14.13
(NA)

1.22

1.48

2.44

3.32

4.34

4.90

6.57

13.79

Deposit Bank Assets

25.15

31.79

39.13

48.46

63.53

75.89

89.38

Asset Ratio (%)

63.43

65.75

68.98

70.81

70.81

71.13

69.69

71.51

Credit Ratio (%)

76.56

78.93

84.64

87.61

89.19

91.19

92.95

94.35

MACROECONOMIC INDICATORS

BALANCE OF PAYMENTS

FINANCIAL SECTOR
Foreign Liabilities (Bil of US$)

109.1

NOTE: Balance of payments data are in billions of U.S. dollars. Numbers in parenthesis indicate component as a percentage of GDP. Variables are defined in the appendix.

terns are notable. First, not all of the Asian nations experienced capital inflow surges at the same time, although
all except Taiwan experienced some capital inflow surge
between 1991 and 1992. This indicates, as suggested by
other authors (e.g., Schadler 1993), that internal factors
also played a role in determining capital inflow surges.
Nevertheless, the importance of external factors is demonstrated by the simultaneous capital inflow surge in the
early 1990s.
Second, note that the policy response to the capital inflow surge varied widely across countries. The instruments
used in “nonbank” sterilization ranged from standard open
market operations by Korea to the use of pension funds by
Malaysia and Singapore, to the use of increased external
debt service by the Philippines and Thailand. Instruments
used to sterilize the impact of the inflows in the banking
sector were also diverse. While Korea, Malaysia, and the
Philippines used increases in reserve requirements, Indonesia and Taiwan used a variety of measures designed to
lower the assets of the commercial banking sector. All of
these instruments had cases of successes and failures

which appear to be more closely related to the initial conditions in the country than the instrument of sterilization
they chose.
The pattern of greatest relevance to the model concerns
the relationship between the relative share of a country’s
intermediation conducted ex-ante by the banking sector,
which provides a coarse proxy for the elasticity of supply
and demand for bank loans and its sterilization experience.
Our model above suggests that the more developed is the
nonbank financial sector, the less effective will be either
standard sterilization policy through open market operations or through distorting the banking sector.
If this were the case, our model would predict that of the
three countries which raised reserve requirements, the increase would lead to more disintermediation in Korea than
in Malaysia or the Philippines. Because of the availability
of other forms of financial intermediation, this would imply that the backwards shift in the CX curve would be
smaller, as would the backward shift in the LM curve, due
to the reduction in the money multiplier. This second effect from the existence of nonbank financial markets has

32

FBRSF ECONOMIC REVIEW 1995, NUMBER 3

TABLE 8
SUMMARY OF CAPITAL INFLOW EXPERIENCES
COUNTRY

Indonesia

CAPITAL INFLOW
SURGES

1986–1987;
1990–1991

NONBANK

STERILIZATION

——

BANK SECTOR
STERILIZATION

Increased regulatory
restrictions
Decreased public
sector assets in
commercial banks

REAL
EXCHANGE
RATE IMPACT

1986 RATIO
OF BANKING
ASSETS (%)

AVG. RATIO (%)
FOR 1986–1993

Asset

Credit

Moderate real
exchange rate
appreciation

60.87

72.60*

98.24*

1986–1993 AVG.
ANNUAL CHANGE
IN BANKING
ASSETS RATIO (%)

5.99*

Korea

1991;1992

Used “Money
Stabilization Bonds”
in open market
operations

Increased reserve
requirements

Large real
exchange rate
appreciation

54.77

48.71

52.87

–3.41

Malaysia

1991–1993

Used government
and pension fund
securities in open
market operations

Increased reserve
requirements

Moderate real
exchange rate
appreciation

55.02

73.19

85.35

6.24

Increased reserve
requirements

Moderate real
exchange rate
depreciation

72.90

86.61

74.89

4.26

——

Moderate real
exchange rate
appreciation

85.48

84.71

74.70

–0.24

Moderate real
exchange rate
appreciation

90.89

90.05

91.63

–0.14

Moderate real
exchange rate
depreciation

63.43

69.01

86.93

1.75

Philippines

1988–1993

Increased foreign
debt service

Singapore

1987, 1990,
1992–1993

Used pension funds
in open market
operations

Taiwan

1986–1987

——

Increased regulatory
restrictions

Required commercial
banks to directly
purchase treasury bills
and central bank
certificates of deposit
Decreased public
sector assets in
commercial banks

Thailand

1988–1992

Increased foreign
debt service

——

Eased restrictions
on capital outflows
*Average Banking Assets Ratio for Indonesia from 1986–1992.

been noted by Van Wijnbergen (1983). Holding all else
equal, reserve requirements should then be less effective as
an instrument for lessening the impact of capital inflow
surges on the real side of the economy in Korea because
of substitute avenues of intermediation.

The crude evidence appears to bear out this prediction.
While Korea experienced a large real exchange rate appreciation over the period 1986–1993, the real exchange
rate showed only moderate appreciation in Malaysia and
actually showed moderate depreciation in the Philippines.

SPIEGEL /STERILIZATION OF CAPITAL INFLOWS: ASIA

Consequently, the evidence suggests that reserve requirement increases are more effective at sterilization the more
limited are a country’s financial alternatives.
The model predicts a similar relationship for nations
which used open market operations as the mechanism for
sterilization. Table 8 demonstrates that the evidence is
largely consistent with the model. Of the nations that used
open market operations or enhanced foreign debt service
as mechanisms of sterilization, Korea, the nation with the
largest nonbank financial sector, experienced the greatest
degree of real exchange rate appreciation. This occurred
despite the fact that it engaged in both open market operations and increases in reserve requirements. Nations with
large shares of assets in the commercial banking sector,
such as the Philippines and Singapore, had no or moderate real exchange rate appreciation. In addition, Thailand,
a nation with a relatively small share of assets in the commercial banking sector, also experienced very moderate
real exchange rate appreciation.

APPENDIX I
I. DERIVATION OF EQUATION (9)
Totally differentiating (8) with respect to r and τ, M, i, Y,
and r* yields
dr λD *r*
=
Lr / (1 − τ) −[λ r ( R / τ + D*) + λD * r ] > 0.
dr *
I
dr
λ[ R(1 − τ) /τ 2 + D*]
=−
> 0.
dτ
Lr − λr [( R / τ + D*) + λD * r ](1 − τ)
dr
λ/τ
=
< 0.
dR Lr / (1 − τ) −[λ r ( R /τ + D*) + λD *r ]
dr
Li − λi ( R /τ + D*)(1 − τ)
=−
> 0.
di
Lr −[ λr (R /τ + D*) + λD * r ](1 − τ)
dr
LY
=−
> 0.
dY
Lr −[ λr (R /τ + D*) + λD* r ](1 − τ)

IV. CONCLUSION
This paper develops an open-economy version of the
Bernanke-Blinder model which demonstrates how foreign
interest rate shocks can lead to an expansion through capital inflows. In addition, the model sheds light on the determinants of the impact of instruments commonly used
for sterilization. In particular, the model claims that the
ability to mitigate the impact of capital inflows by either
sterilizing through open market operations or raising reserve requirements will be limited if viable financial alternatives to the commercial banking sector exist.
We then examine these predictions in the context of the
capital inflow surge experiences of seven developing Asian
nations. Our analysis yields three conclusions: First, the
timing of capital inflow surges exhibited both similarities
and differences, arguing for a role for both domestic and
foreign factors in causing capital inflow surges. Second,
there is little evidence of dominant sterilization instruments. Third, we demonstrated that in comparing the nations which used either increases in reserve requirements
or open market operations over the period, the predictions
of the model were borne out.
Of the nations which increased reserve requirements,
Korea, the country with the largest nonbank financial sector, had the least success stemming the impact of capital
inflow surges. A similar pattern was found in comparing
the set of nations which pursued sterilization through open
market operations. Of course, we held much constant
when making these predictions. Nevertheless, the fact that
Korea is both the country which experienced the greatest
degree of disintermediation and the greatest real exchange
rate appreciation fits the model rather well.

33

II. COMPARATIVE STATICS
Equations (7′) and (10′) yield the system of equations:

[[

[[

Di

– Ai D*i

]] [[ ]]

DY

di

1 – AY + D*Y

dY

=

]] [[ ]]

0

–R/τ2

1/τ

Ar* – D*r*

Aτ – D*τ

AR – D*R

dr*
dτ
dR .

The determinant of the system satisfies:
Λ = Di (1 – AY – D*Y) + DY (Ai – D*i) < 0 .
The comparative statics of the model satisfy:
di/dr* = – DY (Ar* – D*r*) /Λ > 0
and

dY/dr* = Di(Ar* – D*r*) /Λ < 0 .

Equations (7) and (10) yield the system of equations

[[

Di

– Ai

[[

0

Ar*

DY
1 – AY – TY
–R/τ2 1/τ
Aτ

AR

]] [[ ]]
di

dY

=

] [ ]]

dr*
dτ
dR .

The determinant of the system satisfies
Λ = Di (1 – AY – TY) + DY Ai < 0 .

34

FBRSF ECONOMIC REVIEW 1995, NUMBER 3

The comparative statics of the model for policy changes
satisfy
di/dτ = – [R(1 – AY – TY)/ τ2 + Aτ DY] /Λ ,
dY/dτ = [Di Aτ – Ai R /τ2]/Λ < 0 ,
di/dR = [(1 – AY – TY)/τ – ARDY]Λ ,
and

dY/dR = [Di AR + Ai / τ]/Λ > 0.

APPENDIX 2
The data are from International Monetary Fund’s International Financial Statistics and from Financial Statistics,
Taiwan district, The Republic of China. The source of real
effective exchange rate (1990 = 100) is JP Morgan.

Macroeconomic Indicators
Growth of real GDP (99b.p), inflation (64), and real effective exchange rate are calculated using changes over the
previous year. Taiwan uses real GNP (99a). The fiscal balance (80) is expressed as percentage of nominal GDP
(99b). Reserves (.1L.D) are in billions of U.S. dollars. The
ratio of reserves to imports (71 for all countries except Indonesia which uses (71..d) are end-of-year ratios. Imports
were converted to dollars using the exchange rate (rf).

Balance of Payments
The balance of goods, services, and private transfers is current account (77a.d) less unofficial unrequited transfers
(77agd). The balance on capital account plus net errors and
omissions is the sum of unofficial unrequited transfers
(77agd), direct investment (77bad), portfolio investment
(77bbd), other capital (77g.d), and net errors and omissions (77e.d).

Financial Sector
Foreign liabilities (26c) are in billions of U.S. dollars. Deposit bank assets is the sum of lines 22a-f of IFS. The asset ratio is the bank deposit assets divided by the sum of
bank deposit assets, central bank assets (12a-f) and lines
(42a-f). The credit ratio is the ratio of bank deposit assets
to domestic credit, sum of lines (32a-f), where (32a) is approximated by the sum of (12a), (22a), and (42a).

REFERENCES
Bercuson, Kenneth B., and Linda M. Koenig. 1993. “The Recent Surge
in Capital Inflows to Three ASEAN Countries: Causes and Macroeconomic Impact.” SEACEN Occasional Paper No. 15.
Bernanke, Ben A., and Alan S. Blinder. 1987. “Credit, Money, and Aggregate Demand.” American Economic Review vol. 78, no. 2, pp.
435–439.
Calvo, Guillermo A., Leonardo Leiderman, and Carmen Reinhart. 1992.
“Capital Inflows to Latin America: The 1970s and the 1990s.” IMF
Working paper no. 92/85 (October).
__________ , __________ , and __________. 1993. “Capital Inflows
and Real Exchange Rate Appreciation in Latin America.” IMF
Staff Papers Vol. 40, No. 1 (March), pp. 108–151.
Chinn, Menzie, and Michael Dooley. 1995. “National, Regional, and
International Capital Markets: Measurement and Implications for
Domestic Financial Fragility.” U.C. Santa Cruz Working Paper #317
(June).
Chuhan, P., Stijn Claessens, and N. Mamingi. 1993. “Equity and Bond
Flows to Latin America and Asia: The Role of Global and Country Factors.” World Bank Working Paper WPS-1160 (July).
Cole, David C. 1993. “Financial Reforms in Four Southeast Asian
Countries: Indonesia, Malaysia, Phillippines and Thailand.” Paper
prepared for ADB Conference on Financial Sector Devleopment
in Asia (October).
Economist Intelligence Unit. Financing Foreign Operations. Various
issues.
Folkerts-Landau, David, Garry Schinasi, Marcel Cassard, Victor Ng,
Carmen Reinhart, and Michael Spencer. 1994. “The Effect of Capital Inflows on the Domestic Financial Sectors in APEC Developing Countries.” International Monetary Fund (September 26)
mimeo.
Frankel, Jeffrey A. 1994. “Sterilization of Money Inflows: Difficult (Calvo)
or Easy (Reisen)?” IMF Working Paper WP/94/159 (December).
__________ , and Chudozie Okongwu. 1995. “Have Latin American
and Asian Countries So Liberalized Portfolio Capital Inflows that
Sterillization is Now Impossible?” Mimeo.
Glick, Reuven, and Ramon Moreno. 1994. “Capital Flows and Monetary Policy in East Asia.” Federal Reserve Bank of San Francisco
Working Paper No. PB94-08 (November).
Khan, Mohsin S., and Carmen M. Reinhart. 1994. “Macroeconomic
Management in Maturing Economies: The Response to Capital Inflows.” International Monetary Fund (March).
Kiguel, M., and L. Leiderman. 1993. “On the Consequences of Sterilized Intervention in Latin America: The Cases of Colombia and
Chile.” World Bank, mimeo.
Lamberte, Mario B. 1994. “Managing Surges in Capital Inflows: The
Philippine Case.” Philippine Institute for Development Studies
Discussion Paper No. 94-20 (December).
Schadler, Susan. 1994. “Surges in Capital Inflows: Boon or Curse?” Finance and Development (March) pp. 20–23.
__________ , Maria Carkovic, Adam Bennett, and Robert Kahn. 1993.
“Recent Experiences with Surges in Capital Inflows.” IMF Occasional Paper No. 108 (December).
Van Wijnbergen, Sweder. 1983. “Interest Rate Management in LDC’s.”
Journal of Monetary Economics 12, no. 3, pp. 433–452.

Implementing the Single Banking Market in Europe

Gary C. Zimmerman

Economist, Federal Reserve Bank of San Francisco.

Financial integration of the European Community requires actions by both the EC and its member states to
create a common EC-wide competitive and regulatory environment. This paper focuses on the EC’s creation of the
single market for retail banking services. It tracks the EC
legislative process and the adoption of EC directives designed to create the single market. The study also examines some of the costs and benefits associated with the
single banking market. This paper evaluates the EC’s success in creating the single market by examining the rate of
implementation by the member states of the EC single banking market directives. It concludes with an assessment of
the European Community’s progress toward its goal of a
single banking market.

Following a turbulent year for European unity the European Community (EC) created the framework for a single
European market for retail banking services on January 1,
1993. This action is expected to increase competition in the
financial services industry in Europe as national markets
are integrated into an EC-wide market. This paper attempts to evaluate the progress of the EC member states in
implementing the framework for the single banking market based on their actions taken to adopt the key single
banking market standards.
After adding three new members on January 1, 1995, the
EC now encompasses fifteen European nations that cover
most of western Europe. 1 As a single market with nearly
368 million people, the EC is a major economic and financial power that accounts for up to 20 percent of world
trade.2
Financial integration of the EC requires actions by both
the EC and the member states to create a common ECwide competitive and regulatory environment. Member
states must eliminate competitive barriers that may protect
their domestic financial service industries. While some national industries and some firms may suffer as a result of
the transition to a more competitive environment, the single market is expected to generate significant overall benefits for the EC and the member states.
The EC integration process is complex. The single European market initiatives for banking institutions were only
one part of a wide array of “single market” initiatives for
financial services. Creation of a single market for insurance services, both life and nonlife, was instituted on December 31, 1993, and on July 1, 1995, a single market for
securities investment services was implemented. (See
Commission of the European Communities 1994c, pp.
31–53 and pp. 54–66.)
Moreover, the single market for financial services is just
a small part of the EC efforts to create a huge integrated

1. On January 1, 1995 the EC added Austria, Finland and Sweden to the
dozen member states: Belgium, Denmark, France, Germany, Greece,
Ireland, Italy, Luxembourg, the Netherlands, Portugal, Spain and the
United Kingdom. Norway, which also had been accepted for entry,
voted in November 1994 not to join the European Community.
2. Harrison (1988) p. 13, reports 40 percent.

36

FBRSF ECONOMIC REVIEW 1995, NUMBER 3

single EC market by eliminating impediments, such as
tariffs, quotas, nontariff barriers and differing national
standards, that can reduce the trade of real goods and services within the EC.
The single banking market is primarily designed to increase competition for retail banking services across the
large EC market. Traditionally retail banking services primarily have been provided to customers in the member
state where the bank is headquartered. These are primarily offered to businesses and individuals and include payments services, consumer credit, credit cards, mortgage
products, foreign exchange and travelers checks, as well as
commercial loans and letters of credit.
In addition to offering retail banking services, many
banks also are active in providing wholesale banking services. These services are typically designed to provide financial and money market products to large corporations
and financial institutions. However, these services often are
supplied to large and multinational firms in competitive financial markets that are already integrated on a regional or
global scale.
The focus of this article is on the EC’s creation of the
framework for a single banking market for retail banking
services and the adoption and implementation of the EC’s
single banking-market standards by the twelve nations that
were EC members in 1993. The paper is organized as follows: Section I describes both the history and the legislative process for the EC banking reform legislation and
reviews the major EC Banking Directives that set the
framework for the single market. Section II examines some
of the costs and benefits of the EC’s move toward a single
banking market. Section III evaluates the success of member states in the implementation of the EC directives designed to create a single banking market. Section IV
provides an assessment of the progress toward creation of
the single market.

I. LEGISLATION AND BANKING DIRECTIVES
The Treaty of Rome (1957) created the basis for establishing an internal “market” for goods and services, including financial services, within the European Community.
The Community’s goal is the elimination of barriers to the
movement of goods, services and capital (Commission of
the European Communities (1988c) p. 8).
Slow progress in financial services reform led to the
EC’s 1985 White Paper that called for renewed efforts to
establish a single financial market by 1992. As a result of
this action, the EC passed the Single European Act of 1986.
The act redefined the EC market as “an area without internal frontiers in which the free movement of goods, serv-

ices, persons and capital is ensured.” It also targeted 1992
for the achievement of a unified European market.

Integration
A key to the success of the EC integration process is that
the expected gains from increased efficiency of the single
market are expected to benefit all member states. The EC
also tries to offset adverse impacts by allowing for transfer
payments to help mitigate transitions that hurt certain industries, regions or nations, as they adjust to the imposition of market forces. There are tradeoffs however; not all
member states will benefit from all aspects of the single
market.
This latter point is worth returning to when we examine
the pace of the adoption of the single market for specific
goods or services, like the banking industry. Integration
may provide some member states with an incentive to allow their adoption of some single market activities to lag
behind the EC deadlines, especially if they expect an unusually large negative impact. Still, in the long run, given
the wide array of markets involved and the overall expected
benefits, it seems likely that member states will accept
some hardships in selected industries as the price to pay
for the overall benefits of EC membership.

Legislative Process
The integration of the EC has taken place using a legislative process that starts with the European Commission,
which acts as the executive and administrative body of the
EC. The Commission proposes EC legislation, which is
then reviewed and potentially modified by the European
Parliament, before going on to the European Council for
adoption. The Commission also is responsible for negotiating trade agreements for the EC and for ensuring that EC
rules and regulations are enforced.
The EC legislative processes include the use of both regulations and directives. Regulations are binding laws that
take precedence over national laws. Regulations may take
effect as soon as 20 days after they have been published
and they become effective throughout the entire EC. Member states need not pass implementing legislation (see
Price Waterhouse (1994) pp. 1–7 and Commission of the
European Communities (1994a) pp. 1–11).
Directives are legislation that also are legally binding.
However, directives generally require action on the part of
the member states to be implemented. EC directives set a
result or objective that must be achieved by each member
state while leaving the means of compliance to the member states. Typically the member states pass legislation that

ZIMMERMAN/SINGLE BANKING MARKET IN EUROPE

conforms their national laws and regulations with EC
standards. This process creates similar statutes across
member states while still allowing for some variation between member states.
Once legislation is adopted, the member states “notify”
the EC of their actions and then the European Commission
reviews them to determine whether the national legislation
meets the EC requirements. Member states commonly
have about two years from the date of publication of the
directive to take action to revise their laws and regulations
to conform with the EC directive, although in some cases
they have had four years or more.

The Infringement Process
In cases where the European Commission is not satisfied
that a member state has implemented the required directive, or has not done so in a timely manner, the EC automatically begins infringement proceedings against the
member state. These legal actions are designed to force
the member state to take action on implementation before
infringements are referred to the Court of Justice. However, the EC also allows member states to miss implementation deadlines.3

Banking Directives
From this multi-step legislative process two key banking
directives have emerged. The First Banking Directive
(1977) and the Second Banking Directive (1988) set the
framework for the integration of the EC banking market
in 1993. Through 1993 these two directives were followed
by eight additional banking directives. The First Directive
was designed to “...establish the rules for banks to establish branches in other Member States.” Essentially, this directive set the rules for expansion across national
boundaries within the EC by adopting the concept of “host
country rule.” Under host country rule, expansion is possible. However, a foreign bank or branch is required to

3. Commission of the European Communities (March 29, 1994) p. 5.
Infringement proceedings are the first step if a member state fails to
comply. More serious failures may be referred to the Court of Justice
for a decision, although this is not very common. Both infringement
proceedings and referrals to the Court of Justice typically are resolved
in a settlement between the EC and the member state. Failure to implement EC directives into national law, even after a Court of Justice
judgement against a member state, would lead the Commission to start
a new infringement action against the member state. This process allows a member state to lag in the adoption of a directive that it finds particularly onerous.

37

gain permission from the supervisory authorities in the
host country before they are allowed to operate in the host
nation. Thus before 1993, banks and branches were typically regulated by each host country’s regulatory agency.
Under this regulatory regime, banks involved in crossborder expansions were required to operate under multiple regulatory and capital standards, i.e., one for their
home country and another for each host country where
they operated.
While host country rule opened the way for crossborder expansion of retail banking services in the EC, it
did little to eliminate the differences in banking powers
and regulatory regimes that existed across member states.
Furthermore, as long as those differences continued to exist, they were likely to act as barriers to cross-border competition in retail banking services. As a result, there was
relatively little movement by banks in cross-border mergers, acquisitions or alliances in the retail banking area until after passage of the Second Banking Directive.
The Second Banking Directive (1988), adopted in 1989
for implementation on January 1, 1993, went well beyond
the reforms of the First Banking Directive. It included several major changes that are expected to lead to a more efficient financial sector, and one that is more competitive
in the global financial markets. Among the key changes
leading to the creation of a single market or “single passport” for banking services are: (1) The “harmonization”
across EC nations of essential standards for prudential supervision of financial institutions; (2) “Mutual recognition” by the supervisory authorities of financial institutions
in each member state of the way in which they apply those
standards; and (3) “Home country control and supervision” by the member state in which the financial institution is based.4
These changes have brought about major alterations in
the framework for banking in the EC. The first principle,
harmonization, lead to the creation of directives designed
to create uniform safety and soundness standards and a
comparable competitive environment across the EC member states. Under this principle, banks operating in more
than one EC member state face only a set of uniform EC
standards and capital requirements, not a dozen different
regulatory systems and capital standards.
The mutual recognition of a single banking “license” or
“passport” eliminates the need for EC banks to get a local
banking charter from the host country for branches and/
or bank products that are permitted by their home country

4. Commission of the European Communities (February 1988) and
American Bankers Association (1990) p. 18 or Fitchew (1990) p. 9.

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FBRSF ECONOMIC REVIEW 1995, NUMBER 3

bank regulations.5 Moreover, the directive defined a list of
banking services that may be provided throughout the EC,
provided that they also are authorized by a bank’s home
country. This list thus sets the standard for banking services across the EC.
Home country rule requires the regulators to give up the
primary regulatory responsibility for foreign-owned banking institutions operating within their borders and turn it
over to the institution’s home country regulators. Thus,
since January 1, 1993, the primary regulatory responsibilities for the entire banking firm have been shifted to its
home country regulators, even when a bank operates or enters the retail banking business in another member state.
As an example, these reforms mean that a Dutch-owned
bank or banking subsidiary operating in Belgium would be
regulated by its “home” or Dutch regulatory authorities,
rather than by the “host” or Belgium regulators. Its list of
authorized EC banking activities would be determined by
its Dutch or “home” country powers, not by the list of
banking activities for “host” Belgium.
Between 1986 and 1992 eight additional banking directives were passed by the EC. They are described in Box 1.
They deal with an array of safety and soundness issues, accounting standards, solvency and exposure issues, and
have the net effect of increasing the EC’s regulation of
banks in those areas. The directives require that banks b e
examined annually for risk management and risk exposure
and that the review take place at the fully consolidated banking institution level. Other directives set minimum capital
and solvency standards, both for on- and off-balance sheet
assets. Others limit an institution’s exposure to borrowers
and set standards for reporting financial and accounting
data. It is critical for the successful integration of the single banking market that these directives, along with the key
First and Second Banking Directives, be adopted by the
member states.

Defining Banking Services
As noted earlier, the Second Banking Directive also sets
forth a broadly defined list of appropriate banking activities or powers for EC banks. Individual member states may
have their own definitions of banking activity that may be
more or less restrictive than the EC. Individual EC mem-

5. Although it has since been superceded by the Uruguay Round Agreement on Financial Services, the EC had adopted a “national reciprocal
treatment” standard that allowed non-EC banks to operate throughout
the EC as long as the EC banks in the foreign market were treated the
same as domestic banks. This was less stringent than “mirror treatment,” that would have required EC banks to have had the same p owers in a foreign market that a foreign bank would have had in the EC.

ber states typically have permitted banks to offer a much
wider array of financial products than are permitted for U.S.
banks, especially in the securities and insurance powers.
The EC list of appropriate services includes both traditional banking activities as well as some new ones (e.g.,
trading in securities). The list of permitted “banking activities” within the EC was included in the Annex to the
Second Directive and is presented in Box 2 below. Most
of these activities may be conducted within the bank, or
through bank subsidiaries, rather than through a bank
holding company as is typical in the U.S. banking industry (Table A1). Finally, the EC also allows banks to hold
partial ownership interests in industrial firms and for industrial firms to own banks, as is shown in Table A2.

Integration Incentive
Because the Second Banking Directive embraced the principle of home country regulation for member states that already allowed universal banking, it effectively created an
incentive to open up the regulatory process in member
states with restrictive banking legislation. The liberal EC
standards—compared to the U.S.—combined with the single banking license and home country regulation, give
member states with more restrictive banking laws an incentive to loosen those restrictions. Otherwise their domestic banks would face a more restricted set of activities,
even in their home country, than would a foreign bank operating there (Financial Times, 1991). This incentive also
appears to be compatible with the deregulatory forces created by technology and innovation in the financial system.
Banking integration also is made more complicated because the EC banking industry varies widely across member states and within member states as well. As is shown
in Table 1, the industry varies widely in terms of the number of banks, branches and the relative size of the industry
across countries. When the single market was created at
the beginning of 1993, the EC had far fewer banks than the
U.S., under 2,500 compared to over 11,700. The United
Kingdom, with 511 banks had the largest banking industry
as measured by assets, while Greece with only 40 banks,
had the smallest volume of assets. Average bank size ranged
from a high of $3.4 billion in the Netherlands to a low of
$863 million in Denmark, which is still well above the
$300 million average for U.S. banks.
Bank structure also varies considerably across member
states, although two to five key banks tend to dominate
the industry in most countries (Financial Times, 1991).
The mix of industry orientation between retail and wholesale also varies, complicating cross-border comparisons of
size, productivity and profitability (Hawawini and Rajendra (1989) pp. 10–28).

ZIMMERMAN/SINGLE BANKING MARKET IN EUROPE

BOX 1

BOX 2

ADDITIONAL BANKING DIRECTIVES

BANKING ACTIVITIES
PERMITTED WITHIN THE

• Directive on Supervision of Credit Institutions
on a Consolidated Basis (1992)
Requires that supervision of a credit institution,
including the review of financial statements, risk
exposure and management, take place annually on
a consolidated basis.
• Own Funds of Credit Institutions Directives
(1989 and 1991)
Define common rules on core capital and supplementary capital for all credit institutions in the EC.
Require those rules to be compatible with capital
standards set by the Basle Committee and the
Group of Ten.

EC

• Deposit taking and other forms of borrowing
• Lending (including consumer credit, mortgage
lending, factoring, invoice discounting, and trade
finance)
• Financial leasing
• Money transmission services
• Payments services (including credit cards, electronic funds transfer, point of sale, travelers
checks and bank drafts)

• Solvency Ratio Directive (1989)
Designed to harmonize prudential supervision
and to strengthen solvency standards among Community credit institutions. It sets risk weights on
various types of on- and off-balance sheet assets
that are used in estimating solvency ratios.

• Providing guarantees and commitments

• Directive on Money Laundering (1991)
Designed to safeguard the EC financial markets
by eliminating activities associated with illegal
money laundering.

• Participating in share issues and the provision of
services related to such issues (for shares, bonds
and other securities) including corporate advice,
and arranging mergers and acquisitions

• Directive on the Monitoring and Controlling of
Large Exposures of Credit Institutions (1992)
Sets limitations on credit institution exposure by
category of borrowers.

• Money brokering

• Directive on the Publication of Annual
Accounting Documents (1989)
No longer requires branches to publish separate
annual reports as long as the parent organization
publishes these annual documents.
• Directive on the Annual Accounts and Consolidated Accounts of Banks and Other Financial
Institutions (1986)
Sets the requirements for banks and other financial institutions reporting balance sheet and profit
and loss statements, special provisions, and valuation rules. It also sets consolidation and publication requirements.

• Trading on their own account or for customers
in money market instruments, foreign exchange,
financial futures and options, exchange and interest rate instruments and securities

• Portfolio management and advice
• Safekeeping of securities
• Offering credit reference services
• Safe custody services
FROM: Commission of the European Communities,
“Second Council Directive,” Brussels, 16 Feb 1988,
see Annex.

39

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FBRSF ECONOMIC REVIEW 1995, NUMBER 3

(RANKED BY COMMERCIAL BANK ASSETS, DEC. 31, 1992)

focus from collusion and regulatory capture to competition” (p.10). Eliminating regulatory barriers associated with
cross-border expansion into retail banking markets was a
special concern of single market proponents.

EC MEMBER
STATES

Barriers

TABLE 1
COMPARISON OF EC COMMERCIAL BANKS
NUMBER BRANCH
BANKS OFFICES

OF

ASSETS POPULATION
STAFF (US$,BIL) (MIL)

United Kingdom

511

13,100

397,400

1,454

57.8

France

419

10,366

200,400

930

57.4

Italy

319

18,635

327,192

683

56.9

Germany

334

7,542

221,700

632

80.6

Netherlands

109

4,734

115,563

372

15.2

Spain

159

17,288

152,025

317

39.1

Luxembourg

213

310

17,592

297

0.4

Belgium

93

3,515

49,574

270

10.4

Denmark

119

2,467

47,560

103

5.2

Portugal

35

2,852

60,772

80

9.9

Ireland

43

918

20,731

46

3.5

Greece

40
–––––
2,394

1,233
40,188
–––––– ––––––––
82,960 1,650,697

40
–––––
5,224

10.3
–––––
346.2

Total, EC–12
Sweden

15

2,564

40,381

141

8.7

Austria

57

723

18,411

84

7.9

Finland

14
–––––
2,480

902
24,021
–––––– ––––––––
87,149 1,733,447

68
–––––
5,516

5.0
–––––
367.8

Total, EC–15

U.S. BANKING INDUSTRY COMPARED TO THE EC
U.S. Banks

11,719

US as % of EC 472.5%

53,858 1,477,619

3,506

255.5

61.8%

63.6%

69.5%

85.2%

SOURCES: Banking Federation of the European Community (1993)
pp. 88–89; OECD (1994) pp.6–7; .FDIC (1992), p.5; Board of Governors, Annual Statistical Digest, (1992), pp.150–151; and Council of
Economic Advisors (1995), p. 307.

II. BENEFITS AND COSTS
OF A SINGLE MARKET
Proponents of unified EC markets long have maintained
that the pre-EC 1992 banking system was less than ideal. In
most national markets the industry was highly concentrated
and regulated, and in some cases those regulations tended
to create barriers that limited competition (Price Waterhouse, 1994). Hence, analysts like Vives (1991) contended
that, “the main effect of integration will be to change the

Barriers to trade in the financial services area may take
many forms. Exchange controls have been a traditional favorite for limiting international capital flows and were still
in effect in Greece and Portugal during the 1980s. Spain,
Greece, and Portugal have phased out restrictions on foreign direct investment that could prohibit acquisitions of
foreign banks. Regulations prohibiting cross-border solicitation of deposits or securities activities also limit crossborder competition and create barriers to entry, as did
restrictions on banking powers, deposit and loan interest
rate ceilings, restrictive product standards and different tax
structures. The EC hoped to remove these types of barriers, along with “red tape” and nation-by-nation capital requirements and regulatory structures.
As the traditional barriers are removed, the EC also has
to monitor the use of “technical standards,” standards that
also may insulate national banking markets from foreign
bank competition. These include such areas as consumer
protection laws, ATM network standards and access polices,
company policies and merger and acquisition policies.

Price Differentials
The existence of barriers is consistent with discrepancies
in cross-border banking service prices prior to the single
banking market. The EC tried to verify and measure the
potential price differential for financial services in a
March 1988 study for the Commission of the European
Communities. The study, reported in European Economy,
indicated that the barriers were responsible for sizeable
price differentials for similar banking services across EC
countries.6
The Price Waterhouse Study, as it is known, estimated
the country-by-country price differentials based on the percentage differences in prices of standard financial service
6. There may be a number of explanations for the pre-1993 price differentials. They may have been made possible by barriers to entry like
different national requirements for a banking license, different regulatory standards, limited banking powers and varied product standards,
or the differences may have at least partially arisen from different cost
structures. Clearly, to the extent that barriers existed, they would have
increased the cost of entry across national boundaries within the EC.
With potential competition limited by these barriers, banking firms in
some national markets would be shielded from vigorous competition
for retail banking services.

ZIMMERMAN/SINGLE BANKING MARKET IN EUROPE

products for each country compared with the average price
for the four lowest-priced countries. Use of the average
price for the four lowest-priced countries as a competitive
benchmark may eliminate some distortions if “standard”
services vary somewhat across borders.7
The Price Waterhouse benchmark may be a less-thanideal measure of competitive prices since it is not measuring strictly comparable services. Moreover, as was shown
by Neuberger and Zimmerman (1990), even when comparing similar deposit services across states in the U.S.,
holding service differences and cost factors constant, it is
still not possible to explain a large share of the price differentials for some services.8
Despite these shortcomings, the study has become the
benchmark for estimating potential price changes and benefits arising from the integration of the EC’s banking markets. In the following paragraphs, the Price Waterhouse
study provides the basis for estimating price differentials
across countries, for projecting changes in interest rates
and for measuring any macroeconomic impacts arising
from the integration of the EC banking market.
Cecchini, et al. (1988) and Klausner and Schwartz
(1989) relied on the study to illustrate the large pre-single
market differences in cross-border prices for a single banking product. Both highlighted a country-by-country comparison of consumer credit prices showing that France,
Germany and the UK reported prices for the same services
that were more than double the average price for the four
countries with the lowest prices.
Price Waterhouse estimated the price differentials for
seven retail banking services: consumer credit, credit cards,
mortgages, letters of credit, foreign exchange drafts, travelers checks and commercial loans. These single product
prices were then used to generate the service-by-service
and country-by-country price reductions for the basket of
banking services (Klausner and Schwartz (1989) p. 5). The
potential price changes for the basket of banking services,
as well as for securities and insurance services, are shown
in Table 2.
7. This benchmark also allows for estimates of both increases in prices
for “low” price countries and decreases in prices for “high” price countries; a result that is not intuitive with increased competition. These estimates are presented in Table 2.
8. See Neuberger and Zimmerman (1990) for a discussion of the difficulties of measuring and explaining interstate interest-rate differentials
while holding deposit service quality measures constant within a rela tively uniform banking market like the United States. A sizeable portion of the interest differentials between California and the U.S on
transaction-oriented accounts could not be explained, hence the existence of the “California Rate Mystery.” The Price Waterhouse study
tried to find comparable services and then estimate the differentials
across eight countries, a much more difficult task.

41

Of course, these large price differentials are symptomatic
of what Vives (1991) has described as markets having, “...a
lack of vigorous competition” (p. 10). Elimination of crossborder barriers through creation of the single banking market was expected to reduce those differentials.

Lower Prices
The Price Waterhouse study estimated an EC-wide reduction of 21 percent in banking prices following adoption of
the single market.9 However, like the banking industries
across the member states, the estimated price reductions
for banking services varied dramatically across countries.
The Netherlands, where the study estimated a theoretical
reduction of 10 percent in the price level of the basket of
banking services after implementation, and Spain, where a
34 percent reduction was calculated, represent the extremes
of the changes shown in Table 2. The study projected that
countries like Spain and Germany could experience price
reductions of 33 percent or more for banking services as a
result of the integration of the EC’s banking market.
The significance of such large price reductions for the
“basket of banking services” also could be expected to
have a sizeable impact on bank profitability in the EC and
perhaps on the speed of member state adoption of the
banking directives. A 1993 survey by Gemini Consulting
for the European Financial Management and Marketing
Association (EFMA) suggests that European bankers are
expecting deregulation and the single market to have a significant impact on their profitability as measured by return
on equity (ROE) over the next decade. This survey of
bankers suggests that ROE will average 10 percent in 2005,
far below the 12 to 25 percent reported (1989–1991) for the
top ten banks in five EC member states. The lower expected profitability is a result that is consistent with the
large reductions in banking service prices estimated by
Price Waterhouse (EFMA (1993) pp. 6–7).

Lower Rates for Borrowers
The study also was used to generate estimates of the impact of integration on several types of loan products. Based
on the Price Waterhouse results, Cecchini (1988) reported
that liberalization of financial services would lower the
price of credit for borrowers. Although noting that the estimates were subject to considerable uncertainty the Cecchini report concluded that consumers were expected to
benefit from lower interest rates on credit for consumer
purchases (about 2 percentage points) and mortgage costs
9. Commission of the European Communities (1988b) reports the results of the Price Waterhouse study.

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FBRSF ECONOMIC REVIEW 1995, NUMBER 3

TABLE 2
ESTIMATES OF POTENTIAL CHANGES IN FINANCIAL PRODUCT PRICES
RESULT OF COMPLETING THE INTERNAL MARKET

AS A

(FOR EIGHT EC MEMBER STATES—CHANGES IN PERCENT)
BELGIUM

FRANCE

GERMANY

ITALY

LUXEMBOURG

41

–105

–136

na

26

Credit Cards

–79

30

–60

–89

Mortgages

–31

–78

–57

Letters of Credit

–22

7

–6

NETHERLANDS

SPAIN

UK

–31

–39

–121

12

–43

–26

–16

4

na

6

–118

20

10

–9

–27

–17

–59

–8

–56

–31

–23

–33

46

–196

–16

–35

–39

7

–22

7

–33

–30

7

5

7

–6

–9

–6

–43

–19

–46

BANKING SERVICES:
Consumer Credit

Foreign Exchange Drafts
Travelers Checks
Commercial Loans

THEORETICAL POTENTIAL PRICE CHANGES (%) BY TYPE OF FINANCIAL SERVICE
Banking

–15

–25

–33

–18

–16

–10

–34

–18

Insurance

–31

–24

–10

–51

–37

–1

–32

–4

Securities

–52

–23

–11

–33

–9

–18

–44

–12

Total

–23

–24

–25

–29

–17

–9

–34

–13

SOURCE: Price Waterhouse Study, reported in European Economy, “The Economics of 1992,” Commission of the European Communities, Brussels,
Number 35, March 1988.

(about 0.3 percentage points). Businesses also would benefit from a reduction in the rate of interest on long-term
credit (about 0.5 percentage points).

Macroeconomic Benefits
The EC also tried to evaluate the macroeconomic effects
to the EC of the single market for financial services, including banking. Integration was expected to reduce cost
differentials between domestic and foreign banks operating within the EC market, although it would not necessarily eliminate them. Some cost differentials arising from
different languages, customs and local business practices
likely would remain. Still, EC studies suggest that the integration of the EC financial markets would have a positive impact on the EC economy and financial services in
the long run. For example, Cecchini (1988) reported combined estimated savings from three areas, banking and
credit, insurance and brokerage and securities, in eight EC
countries included in the study. Combined macroeconomic
benefits were estimated to be on “…an order of magnitude
of ECU 22 billion [about $18.6 billion, or] 0.7 percent of

[EC] GDP.”10 Of course, even relatively small benefits on
an annual basis may be significant within the context of the
EC, given the size of the EC financial services market and
the importance of the EC’s financial sector (Commission
of the European Communities (1988b) p. 92 and Hunter
(1991) p. 17).

Winners and Losers
While the EC evidence pointed to a positive overall benefit from EC 1992, not all of the EC’s 2,500 banking institutions may be beneficiaries. Table 1 provides a snapshot
of the European banking system when the single market
was created on January 1, 1993. As noted by Klausner and
Schwartz (1989), Hunter (1991) and Vives (1991) vigorous
competition in the single market likely will allow banks
with technical expertise and efficient operations and mar-

10. See Annex B, page 193, of Commission of the European Communities (1988b) for a discussion of the methods used to estimate these
“macroeconomic” benefits.

ZIMMERMAN/SINGLE BANKING MARKET IN EUROPE

keting to take advantage of “deregulation.”11 More competitive markets will favor more competitive firms, while
other firms may find that increased competition in overbanked or protected national markets reduces prices and
profits (Klausner and Schwartz (1989) pp. 5–6).
Across countries, the impact of integration then may be
influenced by the history of the existence of competitive
restrictions facing the industry. Newer member states like
Spain, Portugal and Greece, for example, generally have
liberalized their capital markets more recently than countries like Belgium, Denmark, Germany, Luxembourg, the
Netherlands and the United Kingdom. France, Ireland and
Italy also have a history of competitive restrictions in the
capital markets and financial services areas (Eizenga and
Pfisterer (1987) pp. 338–341).
Within countries, actions and opportunities may depend
on a bank’s size and situation and ability to diversify. In
Germany for example, Deutsche Bank, that country’s largest bank, has already taken actions to expand its banking
and financial services and to broaden its competitive position in the EC. Other large EC financial institutions also
have expanded their activities to coincide with the move to
a single market. In contrast, the potential price reductions
estimated by the Price Waterhouse study suggest that many
small German banks may find that their competitive positions deteriorate as barriers to entry into the German retail
banking market are removed and new entry occurs. This is
not unlike the occasional splits in the U.S. banking industry, when large and small banks may face differing prospects as a result of a policy change.
With respect to the type of banking firms that likely will
prosper in the integrated banking market, the European Financial Management and Marketing Association (EFMA)’s
“European Banking: A View to 2005” suggests several types
that European bankers believe are likely to successfully
adapt to the single market. Their list of “winners” (with the
percent of banks providing this response) includes European banks (70%), large banks (68%) and specialist banks
(55%). Regional banks and insurance companies were expected to be the major losers. Furthermore, 68% of the
bankers surveyed believed that by 2005 the European re-

11. Klausner and Schwartz, page 6, point out that there will be both winners and losers as a result of EC 1992. Some banks that had been “protected” may find that they experience serious margin pressure from
more efficient competitors and they will find that their share values will
erode along with their protection. Vives (1991) also notes that the benefits may be “overstated” because the single banking market will not
become “perfectly competitive.” Language and cultural barriers will
remain, and depositors face costs of “switching” from bank to bank
as well.

43

tail banking market would be dominated by about fifteen
to twenty major retail banks, a forecast that would foreshadow a major consolidation in retail banking in the EC
nations.12

Getting Ready
With the 1989 passage of the Second Banking Directive for
implementation on January 1, 1993, EC banks had several
years to prepare and position themselves for the single
banking market. During that period a number of major EC
banks had been involved in mergers and acquisitions, some
increasing their presence in other EC nations, some adding
insurance or securities firms to their product lines. Other
EC banks, some faced with the high cost of new entry, have
entered into cross-border “alliances” with banks in other
countries as a way to improve their competitive prospects.
These alliances typically involved cross-border participation agreements that allowed the participants to cooperatively provide services over a broader market area than
would be possible individually.13 The established universal
banks of the EC played a prominent role in this jockeying
for competitive position prior to implementation of the single market in 1993.14,15

12. EFMA (1993). This survey of bank executives from fifteen European countries was conducted by Gemini Consulting for the EFMA.
13. The Bray (1993) article describes several types of alliances, such as
Societe Generale’s bilateral cooperative agreements with banks in several markets, or agreements where banks share office space and refer
business to each other and share in the proceeds from that business.
BNP (France) and Dresdener Bank (Germany), Commerzbank (Germany) and Central Hispano (Spain), Banco Popular Español (Spain) and
Rabobank (the Netherlands), Bayersiche Hypotheken- und Wechselbank (Germany) and Banco Commercial Portugues (Portugal) have
entered into cross-border agreements. Banks from Spain, the U.K., Portugal and France are establishing a joint real-time, cross-border payments system.
14. Deutsche Bank, Germany’s largest bank, France’s largest bank, major UK banks, and Dutch and Belgium banks have expanded their financial services activities during this period. Since 1990 banking
leaders like Deutsche Bank acquired Gerling Konzern, an insurance
firm, Crédit Lyonnais acquired BFG Bank, while Cassa di Risparmio
purchased large interests in Banco di Roma and Banco di Santo Spirito.
See European Economy, “Evolution of Mergers in the Community,”
number 57, 1994.
15. Over the 1991–1992 period, EC documents indicate that crossborder mergers accounted for almost half of the total mergers, and a
number of these mergers involved financial institutions. The report
noted the following significant patterns in banking and finance mergers: Belgian and French institutions were likely purchasers, Spanish institutions were likely sellers, and Irish institutions were active both as
purchasers and sellers.

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FBRSF ECONOMIC REVIEW 1995, NUMBER 3

While there were a number of well publicized mergers,
acquisitions and strategic alliances that took place in anticipation of the enactment of the single market, the severity
of the European recession between 1991 and 1993 hurt
many EC financial institutions and therefore likely slowed
the pace of consolidation. During this period, many banks
also were constrained by more stringent capital and riskbased capital standards that limited their ability to expand.
Now that we have examined some of the actions taken
by the banking industry in Europe in anticipation of the
single market, let us move to the crucial actions taken by
the member states to implement the single market reforms.

III. IMPLEMENTATION PROCESS
Banking is only a small part of the single market, and it
may not be the driving force behind the move toward EC
integration. Thus, the actions of the member states with respect to the impact on their domestic banking industry also
may play a role in the implementation process and the
speed of integration. Given the infringement process, member states that expect to experience large adjustments to a
particular industry, like banking, may drag their feet on the
implementation of the banking directives.
The Price Waterhouse results identify which of the
member states (in this case, Germany and Spain, and perhaps France) might be expected to experience especially
large adjustments that could make them strong candidates
for a more “relaxed” pace of adoption. In the remainder of
this paper, the pattern of adoption of EC banking directives
is analyzed.
The speed and extent of implementation of the ten banking directives by the member states can be used as a way
of measuring the success of the integration of the EC banking industry.

Single Market Implementation
By early 1993 most of the EC (directives and regulations)
legislation necessary for the creation of the single market
had been passed by the European Council. The Commission of the European Communities 1993 report, The Community Internal Market, noted that by the end of 1993, 265
of the 282 White Paper measures had been adopted by the
European Council. This represents a 95 percent passage
rate for the single market directives. The next stage is more
difficult.
Progress has been somewhat slower at the national level,
where each of the member states, including the three new
members, must take actions to adopt the EC directives necessary to implement the single market. Of the White Pa-

per measures that have taken effect, 222 required adoption
or implementation by the member states. Implementation
rates vary, both across countries, markets, and products.
The progress in implementing the entire single market is
often evaluated using the percentage of EC directives transposed into legislation by the member states.16
EC documents point out that at year-end 1993, only
about half of all the single market measures (including
banking) had been enacted in all twelve member states
(Austria, Finland and Sweden did not become members
until January 1, 1995 and are not evaluated in the measures
that follow). Still, about three-quarters of the measures had
been enacted in at least ten of the twelve member states.
At year-end 1993, Denmark and the United Kingdom, two
countries that at times have been less than enthusiastic
about the EC, were the leaders in converting EC directives
into national legislation. Both had implemented over 90
percent of the measures. At the other end of the scale,
Greece, France, Spain and Ireland had adopted less than
83 percent of the necessary measures. Based on these
adoption rates, by 1993 the EC was making significant
progress in its goal of creating a single market.

The Single Market for Banking
In the financial services sector, the adoption rate has been
relatively fast with respect to laws designed to free the
movement of capital and for the adoption of a single market for some types of financial services. The 1993 Commission Report notes that the implementation of the
banking-related single-market measures has been good
(Commission of the European Communities (1994c) p. 7).
At year-end 1993, the twelve member states were evaluated on the implementation of ten key banking directives.17 Of the 120 possible implementations (ten measures
times twelve member states), in 98 cases (about 82 percent) the banking directives were properly transposed into
national statutes. As shown in Table 3, by April of 1994,
the number transposed rose to 107, a transposition rate of
89 percent. Still, in 13 cases, or 11 percent, the countries
had not implemented the measures, in some cases several
years after the deadline. The European Commission has
begun “infringement proceedings” in the cases where member states have failed to transpose the directives into law
16. The EC and others commonly use these measures to evaluate the
progress of the single market, both by sectors and overall. See The Economist (1993) p. 72.
17. The Deposit-Guarantee Directive was not implemented until 1994
and member states are now in the process of transposing the legislation,
so it is not included in the measured adoption rate used here.

ZIMMERMAN/SINGLE BANKING MARKET IN EUROPE

45

TABLE 3
SUMMARY OF THE IMPLEMENTATION OF BANKING DIRECTIVES
B

DK

D

GR

E

F

IRL

I

L

NL

P

UK

First Banking Directive
Dir. 77/780 12–16–79

I

I

I

I

I

I

I

I

I

I

I

I

12 of 12

100%

Second Banking Directive
Dir. 89/646 1–1–93

I

I

I

I

IR

I

I

I

I

I

I

I

11 of 12

92%

Own Funds
Dir. 89/299 1–1–91

I

I

I

I

I

I

I

I

I

I

I

I

12 of 12

100%

Dir. 91/633 1–1–93

I

I

I

I

I

I

I

I

I

I

I

NN

12 of 12

100%

Solvency Ratio
Dir. 89/647 1–1–91

I

I

I

I

I

I

I

I

I

I

I

I

12 of 12

100%

EU MEMBER STATES:

DIRECTIVE:

IMPLEMENTATION:

CONDITIONS AND PRUDENTIAL RULES

Derogations –Year
Consolidated Supervision
Dir. 92/30 1–1–93

D–96 D–96 D–00
I

I

IR

IR

I

I

I

I

I

I

I

I

10 of 12

83%

I

I

I

IR

I

I

I

I

I

I

I

I

11 of 12

92%

Publication of Annual Account Documents
Dir. 89/117 1–1–91
I

I

I

IR

I

I

I

I

I

I

I

I

11 of 12

92%

Prevention of Money Laundering
Dir. 91/308 12–31–92

I

I

IR

IR

I

I

IR

I

I

I

I

IR

8 of 12

67%

IR

I

IR

I

IR

I

I

I

I

I

IR

I

8 of 12

67%

Number Adopted (of 10)

9

10

7

6

8

10

9

10

10

10

9

9

107 of 120

Adoption Rate (%)

90

100

70

60

80

100

90

100

100

100

90

90

SUPERVISION AND ACCOUNTS
Annual and Consolidated Accounts
Dir. 86/635 12–31–90

Controlling Large Exposures
Dir. 92/121 1–1–94

89%

LEGEND: I=Implemented, IR=Infringement, NN=No Measure Necessary, NI=Not Implemented, D=Postponed. April 30, 1994.

within the allotted time span (Commission of the European Communities (1994c) pp. 137–139).

Across Countries
The progress in adopting the EC banking standards since
1991 has varied significantly across countries as can be
seen from Table 4. By April of 1994, five of the twelve
member states had adopted all of the banking directives.
Those states included Denmark, France, Italy, Luxembourg and the Netherlands. Belgium, Ireland, Portugal and
the United Kingdom had adopted all except one. As of

April 1994 Ireland and the UK had not yet implemented
the Directive on Money Laundering, while both Belgium
and Portugal still needed to transpose the Directive on
Large Exposures.
At the other end of the spectrum, as of April 1994, Spain
had yet to implement the key Second Directive and the
Large Exposures Directive. Germany had yet to implement
three directives, Large Exposures, Money Laundering, and
the critical Consolidated Supervision Directive, while
Greece needed to implement four directives, including
Consolidated Supervision (Commission of the European
Communities (1994c) pp. 137–139).

46

FBRSF ECONOMIC REVIEW 1995, NUMBER 3

TABLE 4
PERCENT OF KEY BANKING DIRECTIVES
IMPLEMENTED, BY COUNTRY
1991

1992

1993

1994

Belgium

60%

100%

90%

90%

Germany

40%

50%

70%

70%

Denmark

80%

88%

90%

100%

Spain

60%

63%

70%

80%

France

100%

88%

80%

100%

United Kingdom

60%

50%

90%

90%

Greece

20%

50%

60%

60%

Italy

40%

100%

90%

100%

Ireland

60%

88%

80%

90%

Luxembourg

20%

63%

90%

100%

The Netherlands

60%

63%

80%

100%

100%

88%

90%

90%

58%

74%

82%

89%

COUNTRY:

Portugal
EU TOTAL
Directives:
Total Implemented

35

71

98

107

Total

60

96

120

120

In cases where member states have not yet implemented
directives, there often were actions in progress to do so. In
1994 Germany was evaluating proposals on the Directives
on Consolidated Supervision, Large Credit Exposure, and
Money Laundering. In Greece, the Directive on Consolidated Supervision was scheduled for implementation later
in 1994. And the United Kingdom was in the process
of adopting EC-based money laundering legislation in
1994.18
The pace of adoption across countries appears to be negatively correlated with the expected reduction in prices in
the banking sector reported in the Price Waterhouse study.

18. The efforts to revise legislation and regulatory requirements to meet
the EC standards has not been limited to the member states alone. Even
before their entry into the EC in 1995, EFTA (European Free Trade Association) members had b egun to conform their banking legislation to
EC standards. Austria, in anticipation of EC membership adopted most
of the key directives during 1994. Finland has taken similar steps, and
Sweden is planning to do so in 1995. See Institute for International
Bankers (1994).

Of the eight countries where post-single-market price reductions were estimated, the six showing price reductions
in the range of 10 to 25 percent had adopted either all, or
all but one banking directive by April 1994. In contrast, the
two member states, Spain and Germany, where prices were
estimated to fall the most (34 and 33 percent, respectively),
have been much slower to implement the directives.
Moreover, since 1992, three countries, Germany, Spain,
and Greece, have lagged well behind the other member
states in implementing the banking directives, as can be
seen from Table 5. The banking industries in all three nations likely face relatively large adjustments to the single
market.
Price differentials were not estimated for Greece, a
newer EC member, however, its banking industry has had
protection from competition through capital controls and
other barriers. Although those barriers are now being removed, the Greek banking industry also remains relatively
highly concentrated, both factors that are consistent with
a slow adoption pace (Financial Times (1991) pp. 152–156,
and Hawawini and Rajendra (1989) p. 20).

Performance by Directive
The community-wide adoption rate for the banking directives is similar to that for the securities directives. And,
both are much higher than that experienced for the combined insurance directives (Third Insurance Directives for
Life, Nonlife and Motor Vehicles).19
Four of the ten banking directives have been adopted by
all twelve member states, as can be seen from Table 3.
These include the First Banking Directive, and the two
Own Funds Directives and the Solvency Directive, which
deal with bank capitalization. Three other directives have
been adopted by eleven of the twelve member states; they
include the critical Second Banking Directive and the two
accounting standards directives, the Directives on Consolidated Accounts and Publication of Account Data. Spain’s
failure to adopt the Second Banking Directive is the most
serious setback to the completion of the single banking
market.
19. Only three member states have adopted the life and nonlife directives. Moreover, a number of significant tax and premium treatment issues appear likely to continue to slow the creation of the single market
for insurance. As of April 1994, nine member states had adopted the directive on motor vehicle insurance that was targeted for adoption by December 31, 1992. By December 31, 1993 both the third life and nonlife
directives should have been implemented; however, by April 1994 only
one member state had adopted the key third life assurance directive and
only two the third nonlife directive. In contrast, the six securities-related
directives covered had been adopted by either 11 or 12 member states.
See European Commission (1994a) pp. 36–65.

ZIMMERMAN/SINGLE BANKING MARKET IN EUROPE

TABLE 5
TRANSPOSITION RATES FOR BANKING DIRECTIVES,
1992 TO 1994
—MEMBER STATES—
OTHER NINE ALL TWELVE SPAIN GERMANY GREECE
1992

81%

74%

63%

50%

50%

1993

87%

82%

70%

70%

60%

1994 (April)

96%

89%

80%

70%

60%

The slow adoption of the important Consolidated Supervision Directive, which is a key to the single banking
market supervision by home country regulators, also is a
key concern, especially since the largest member and community leader, Germany, is one of the two member states
lagging in the adoption of this key part of the integration
process. This is another area of concern for regulators,
since home country supervision is a key to regulation of
multi-state EC banking institutions.

IV. CONCLUSIONS AND OBSERVATIONS
Despite these shortcomings, the EC has come a long way
toward creation of the framework for a single banking market in Europe. The critical directives have been implemented, or are in the process of adoption by almost all the
member states, both overall and for the banking industry.
The EC describes a “profound change in the nature of
cross-border competition” as a positive impact of its efforts in the financial services area (Commission of European Communities (1994c) p. 18).
The retail banking services market has been opened to
competition from banks in other member countries. The
“single passport” and companion directives now make it
possible for banks to provide retail banking services
throughout the EC based on business, rather than regulatory, considerations. This was a fundamental goal of the
single market.
Harmonized regulations are now in place authorizing
banks to operate outside their home country with a wide
array of financial service powers determined by the EC and
their home country. Standards for capitalization, solvency,
risk exposure, supervision, disclosure, and money laundering are all in place in most member states. Furthermore,
almost 90 percent of the major banking directives have
been implemented, and most of the remaining cases are
likely to be resolved by EC and member state efforts already underway.

47

While cross-border activity has been slowed by the European recession, EC financial institutions actually began
taking steps toward an expanded market once the EC approved the proposal for a single market, well before its January 1, 1993 implementation date.
One area of concern is the continuation of efforts to minimize barriers, like “technical standards,” that limit crossborder banking competition. Some of these types of
barriers may exist even after the passage and adoption
of all the single market legislation at the member state
level. To some extent that reflects the difficulty of standardizing and harmonizing over many nations; however it
may also reflect the powerful incentives some industries
and firms may have to continue to protect themselves from
competition. EC efforts to eliminate such protection can
be a time-consuming process, but they are an important
next step.
The EC has plans for a study of the effectiveness of the
single market reforms in 1996. The plan reflects the EC’s
concerns about the progress of the single market and its potential remaining barriers. The study also is a way for the
EC to try to evaluate the progress it has made since the White
Paper of 1985 and since the creation of the single market
on January 1, 1993. Clearly, the study also should identify
areas where the EC needs to take further action to speed up
implementation by member states that are lagging behind
and to reduce the residual barriers that may be limiting the
extent of cross-border activity and competition.
Finally, in the post-1992 EC banking environment in Europe, cross-border activity and financial services consolidation are likely to accelerate. Larger, well capitalized,
better diversified and/or more efficient banks are likely to
be able to take advantage of market opportunities to increase their activities. Less efficient banks, especially those
that had been shielded from cross-border competition by
“national” protection, must adapt to the new situation.
Whether or not the projection of fifteen to twenty large
banks dominating the retail banking industry in Europe
over the next decade is correct, the single market has the
potential to make major changes in the financial services
industry in the European Community. It should revitalize
the European financial system and it should cause the U.S.
to reconsider again the future competitive and regulatory
environment of our own banking and financial services
industries.

48

FBRSF ECONOMIC REVIEW 1995, NUMBER 3

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50

FBRSF ECONOMIC REVIEW 1995, NUMBER 3

APPENDIX
TABLE A1
PERMISSIBLE ACTIVITIES FOR BANKING ORGANIZATIONS
—BY ACTIVITY—
SECURITIES

INSURANCE

Austria

Permitted

Permitted through subsidiaries

Belgium

Permitted, some activities through subsidiaries

Permitted through subsidiaries

Denmark

Permitted

Permitted through subsidiaries

Finland

Permitted

Sales as an agent permitted

France

Permitted

Permitted, usually through subsidiaries

Germany

Permitted

Permitted, through insurance subsidiaries

Greece

Underwriting permitted by certain credit institutions;
B&D permitted through subsidiaries

Permitted to hold shares in insurance
companies subject to limitations based on capital

Ireland

Permitted, usually through subsidiaries

Permitted agency and certain life insurance
activities through an independent subsidiary

Italy

Permitted, but not permitted to operate
directly on Stock Exchange

Permitted, but limited by own funds
and aggregate investment

Luxembourg

Permitted

Permitted through subsidiaries

Netherlands

Permitted

Permitted through subsidiaries

Portugal

Generally permitted, mutual funds only
through a subsidiary

Permitted through subsidiaries

Spain

Permitted; banks may own up to
100% of stock exchange members

Permitted through subsidiaries

Sweden

Permitted

Permitted

United Kingdom

Permitted, usually through subsidiaries

Permitted through subsidiaries

COUNTRY:

AUTHORIZATION:
Permitted:

15

15

By Subsidiaries:

5

11

With Limitations:

2

4

SOURCE: Institute of International Bankers, 1994

ZIMMERMAN/SINGLE BANKING MARKET IN EUROPE

51

TABLE A2
PERMISSIBLE BANK OWNERSHIP
BANK INVESTMENTS IN INDUSTRIAL FIRMS

INDUSTRIAL FIRM INVESTMENTS IN BANKS

Austria

Permitted, with limits

Permited, with limitations

Belgium

Permitted, with limitations

Permitted, subject to prior approval

Denmark

Permitted, with restrictions,
permanent control prohibited

Not prohibited, but rare

Finland

Permitted, with limitations

Permitted

France

Permitted, with regulatory
approval if greater than 10%

Not prohibited

Germany

Permitted, with limitations

Permitted, subject to regulatory consent

Greece

Permitted, subject to the EU
directive on qualified holdings

Permitted, subject to the EU
directive on qualified holdings

Ireland

Permitted, subject to approval of
Central Bank if greater than 10%

Permitted, subject to Central Bank prior approval
if acquisition is of more than 10% of bank shares

Italy

Not permitted

Permitted up to 15% of shares of bank subject to
Bank of Italy approval

Luxembourg

Strictly limited

Investment may not exceed 50% of banking capital

Netherlands

Permitted, subject to regulatory approval for
voting shares greater than 10%

Permitted, subject to regulatory approval for
voting shares greater than 5%

Portugal

Permitted, but subject to limitations
on own funds and voting shares

Permitted, subject to regulatory approval for
acquisition of large shares

Spain

Permitted, subject to capital-based limits

Permitted, subject to approval of the Bank of Spain
if 5% or more

Sweden

Limited

Not prohibited, but such investments are rare

United Kingdom

Permitted, subject to consultations with the
Bank of England

No prohibitions contained in The Banking Act of 1987

Each 10% or more shareholding may not
exceed 15% of the bank’s own funds and
such shareholdings on an aggregate basis
may not exceed 60% of own funds

No general restriction; does not allow investments
of 10% or more if home country supervisor is not
satisfied with the suitability of the shareholder.

COUNTRY:

European Union

SUMMARY ACROSS EC MEMBER STATES
Permitted:

14

11

14

10

Not Prohibited:

0

4

Not Permitted:

1

0

With Limitations:

SOURCE: Institute of International Bankers, 1994

Structure and Pricing of Large Bank Loans

James R. Booth and Lena Chua

Associate Professor, Arizona State University and Visiting
Scholar, FRBSF; and Assistant Professor, University of
Hawaii, Manoa, Visiting Professor, The American Graduate School of International Management, and Associate of
the Pacific Basin Center for Monetary and Economic Studies, FRBSF.

This paper examines the characteristics of large bank
loans as a form of corporate finance. We compare the characteristics of a sample of these loans with private placements and public issues of debt. The unique features of
large bank loans that may encourage firms to continue using this source of financing include:borrower flexibility in
deciding on the timing and amount of borrowing; the use
of fixed-spread floating rate of interest, flexibility of changing and renegotiating contract features,such as covenants,
during the life of the contract.

The role that bank debt plays in the capital structure of corporations has received much attention in recent years.1
Among the issues addressed in this research are the possible unique role of bank loans in financing firms’ activities
and how contract features may serve to reduce the adverse
consequences of differential information between the borrower and the bank. This body of literature focuses on contract features as a means to reduce the costs associated with
debt when the incentives of the borrower and lender differ
(see for example Berlin, 1987). Most of the research on
contract features is theoretical due to the lack of detailed
data on the contract features of bank loans. The scarcity of
information results from the fact that these are private debt
contracts and hence are often not available to researchers.
In this study we examine a sample of large bank loans to
gain insights into the nature of the lending arrangements
between banks and large corporations. By examining loan
characteristics we can gain insight into the unique aspects
of this source of corporate finance as compared to private
placements of debt and public debt issues. This also permits us to provide an update of information on the pricing
of business loans since that available in Brady (1985) and
Boltz and Campbell (1978).
We begin with a comparison of the characteristics of
bank loans in private placements and public debt issues.
This includes a discussion of contract features and the use
of commitments in bank lending. We next focus on pricing issues across the markets, with special emphasis on
large bank loans. In the loan pricing discussion, we focus
on the use of fixed-spread, floating-index contracts to determine the borrowing rate, and the use of a variety of fees
in bank loans. This is followed by a discussion of covenants
in our sample of bank loans compared to those reported in
earlier studies for private placements and public debt. The
final section summarizes the unique aspects of this source
of corporate finance relative to other sources of debt finance.

1. See for example Bhattacharya and Thakor (1993).

BOOTH AND CHUA/STRUCTURE AND PRICING OF LARGE BANK LOANS

I. A COMPARISON OF BANK LOANS
WITH PRIVATE AND PUBLIC DEBT
A firm’s choice between bank loans and securities has been
a topic of much interest to academics and policymakers
over the years. A basic theme of much of this research is
that, for some firms, it is too costly for outsiders to stay
informed about the developments of the firm that affect
credit risk. In turn, they are unable to influence the firm to
protect their interests as creditors. Banks arise as delegated
monitors to keep a check on the behavior of managers.2
This argument may be extended to suggest that the degree
of information asymmetry associated with the borrower
will influence the market in which a firm borrows.
Evidence consistent with the role of information in the
choice of finance is provided by Carey, Prowse, Rea, and
Udell (1993). They suggest that small firms are dependent
almost entirely upon banks because their loans require extensive lender due diligence and monitoring associated
with bank lending. They argue that large firms capable of
issuing securities with few information problems are able
to borrow in any of the major debt markets, from banks, or
by issuing commercial paper. Their findings are consistent
with the notion that as a firm becomes larger, their informational problems diminish, and they increasingly rely on
more direct sources of corporate finance.
One piece of evidence they use to support this is the relative characteristics of business loans, private placements,
and public debt issues. Bank loan data used in their study
is from the Federal Reserve Board’s Quarterly Survey of
Terms of Bank Lending to Business for 1989. As expected,
their results reveal that most bank loans are quite small
compared to private placements and public debt issues.
Figures 1 and 2 show the percent of private and public debt
issues distributed by loan size and length to maturity, respectively. From the 1989 survey, the median loan size was
about $50,000 and the mean was about $1 million. They
note that approximately 82 percent were under $1 million
and 96 percent were under $10 million. These bank loans
are smaller than their sample of private placements, with a
median size of $32 million and a mean size of $76 million.
Additionally, Figure 1 shows that around 80 percent of the
private placement issues in Carey, et al.’s study were between $10 million and $100 million in size. This compares
to a median and mean size for public debt issues of $150
million and $181 million, respectively. Examining the
characteristics of firms that borrow in each market in 1989,
they find support for the creditworthiness of the borrower
playing a role in their financing choice.

2. For a formal development of this argument, see Diamond (1984).

53

FIGURE 1
SIZE DISTRIBUTION OF PRIVATE AND PUBLIC DEBT
ISSUES BY PERCENTAGE OF ISSUES, 1989

SOURCE: Carey, et al., 1993

The Carey, et al. study also provides comparisons of the
maturity characteristics of these sources of business borrowing. They find that the average maturity of private placements is much longer than the average maturity of bank
loans in their sample. Figure 2 shows that, of the private
placements offered by nonfinancial corporations, 77 percent have maturities between three and fifteen years. The
median and mean maturities were both nine years. They
note that because most are amortizing, the median average
life falls between five and seven years. The median for public bonds in their sample was ten years. The median maturity of bank loans to businesses, in 1989, was just over three
months, and nearly 80 percent had maturities of less than
one year. These findings confirm that average issue sizes
and average maturities differ drastically between bank
loans and both private placements and public debt issues.
However, the data set they examine do es not allow for a
comparison of the characteristics of bank loans by large
corporations having access to one or both of these nonbank
sources of debt.
To focus on the issue of bank borrowing by large companies, we analyze a sample of large bank loans collected

54

FBRSF ECONOMIC REVIEW 1995, NUMBER 3

by Loan Pricing Corporation, provided in their Dealscan
database. Using the data provided for the year of 1989, we
are able to gain insight into the structure of the loan market for large bank loans during the same time period as
Carey, et al. (1993). The sample data is collected from loan
contract information included in corporate filings with the
Securities and Exchange Commission. This data is supplemented with information from publications such as
American Banker, among others. Because of news coverage and filing requirements, the sample is biased toward
large loans and large firms. To gain some insight into the
types of firms in the sample data provided by Loan Pricing, we note the mean sales level of borrowing firms is approximately $1.1 billion. This average size of sample firms
is expected to be much larger than that of an average firm
that borrows from a bank since sample firms are required
to file with the Securities and Exchange Commission. Typically, this involves only firms that have public debt or equity outstanding. Though this data is incomplete and thus
may be upwardly biased, it allows a suggestive comparison
with the sample firms examined in Carey, et al. (1993).
They find that for the same year, firms with public debt out-

standing have sales of $3.2 billion and firms with privately
placed debt have sales of $1.0 billion. Both were much
larger than firms that relied on bank or equity only, at average sales of $40 million. Thus our sample firms appear
to be much closer to the types of firms that issue privately
placed debt than those that only use equity or bank debt.
Data on the size of loans in the sample suggest these
may be substitutes for either the private placement or, in
some cases, public sources of debt. In Figure 3, we provide
summary statistics on the sample of large loans we examine. Several differences exist relative to those reported in
Carey, et al. (1993). The most notable is that our sample is
comprised of much larger loans than those included in the
Quarterly Survey of Terms of Bank Lending to Business.
The median loan size is $36 million as compared to $50
thousand for the Survey. The mean loan size is $184 million, with approximately 96 percent of the loans above $1
million in size. Moreover, around 73 percent of the bank
loans in our sample are above $10 million in size. This suggests that in terms of size, a large fraction of sample loan
contracts could compete with private placements. Additionally, based on percent of issues distributed by size between

FIGURE 2

FIGURE 3

MATURITY DISTRIBUTION OF PRIVATE AND PUBLIC
DEBT ISSUES BY PERCENTAGE OF ISSUES, 1989

SIZE DISTRIBUTION OF LARGE BANK LOANS
IN OUR SAMPLE BY PERCENTAGE OF ISSUES, 1989

SOURCE: Carey, et al., 1993

BOOTH AND CHUA/STRUCTURE AND PRICING OF LARGE BANK LOANS

private placements and public issues of debt, as reported
in Carey, et al. (1993), many sample loans could be competing with public issues. For our sample, approximately
32 percent of the loans are above $100 million in size and
would thus likely be of sufficient size to compete with public issues of debt.
The maturity of the loans in our sample vary widely (see
Figure 4), but, on average, they are much longer than those
reported in the Fed survey. With an average maturity of
44.86 months, these contracts are shorter than those reported for the private placement market and the public debt
market for 1989. Compared to the private placement market studied by Carey, et al. (1993), the average maturity of
loans is approximately 45 percent of the average for the private placements. The reported maturities for our sample
may understate the true maturity since, for a substantial percentage of revolving credit agreements, the borrower is allowed to convert the outstanding balance of the commitment
at maturity to a term loan typically payable over a three-tofive year period. An examination of the loan contracts that
take the form of commitments to lend have an average maturity of 44 months. This permits the borrower to extend the

FIGURE 4
MATURITY DISTRIBUTION OF LARGE BANK LOANS
OUR SAMPLE BY PERCENTAGE OF ISSUES, 1989

IN

55

maturity to approximately seven years in the commitments
with an option to convert to a term loan. Thus our sample
includes lending arrangements that are longer, on average,
than those reported in previous studies. This difference may
reflect the fact that very short-term borrowing from banks
may not be outstanding at the time the firm files with the
Securities and Exchange Commission.

II. CONTRACT FEATURES
IN LARGE BANK LOANS
Use of Loan Commitments
Avery and Berger (1990) report that over 70 percent of
bank loans are created under commitments to lend. These
may take different forms, the most common of which are
revolving credit agreements. These arrangements are formal
commitments which represent official promises to lend a
customer up to a preset amount within a set time period at
a predetermined loan rate. In our sample this is the most
common type of lending arrangement. We also have loans
defined as lines of credit. These contracts are frequently referred to as informal lending contracts in which the lending terms are not set. To be included in our sample, the
loan must include the pricing terms. Thus our sample of
lines of credit are formal agreements in which pricing and
other contract features are negotiated at the beginning of
the commitment. Under these lines and revolving credit
agreements, the timing and amount borrowed are at the borrower’s discretion. The loan rate usually involves a fixed
markup over a reference rate such as the prime or LIBOR.
Frequently these contracts are for multiple years and are
revolving so that funds may be borrowed and repaid multiple times without contract renegotiation. Also the revolving
commitments frequently call for the outstanding balance
to be converted to a term loan payable over a fixed number
of years.
The motivation for purchasing loan commitments is addressed in the May 1988 Senior Loan Officer Opinion Survey on Bank Lending. Those surveyed responded that their
customers’ motivations for borrowing under formal revolving commitments, as opposed to other lending arrangements, were most frequently related to convenience and loan
arrangement costs. Additional reasons provided are related
to ensuring their access to credit against deterioration in
their creditworthiness and against a general credit crunch
affecting their access to noncommitment loans. These
results emphasize that the nature of a typical bank loan
contract differs substantially from that of the private placement and public market alternatives.

56

FBRSF ECONOMIC REVIEW 1995, NUMBER 3

Primary use of funds
Since our sample of loans provide data on the purposes of
the borrowing, we can gain insights into the primary reasons stated by the firm (in the loan contract) for the borrowing. In Table 1, we provide a list of the frequencies of
the primary reason given for a loan. As indicated, a number of reasons exist for the borrowing. Five primary reasons were given for approximately 88 percent of sample
loans. These include working capital, debt repayment or
consolidation, general corporate purposes, takeover, or leveraged buyout. The most popular reason provided in our
1989 sample was for working capital purposes (approximately 23 percent of sample loans). These loans show that
a strong amount of corporate restructuring occurred in industrial firms during 1989. Data on the use of funds for the
private placements are not reported by Carey, et al. (1993)
for comparison. Data provided in Eckbo (1986) suggest
that the primary reasons listed for the issuance of public
debt are to refund old debt, finance capital expenditures,

TABLE 1
NUMBER AND PROPORTION OF 1,347 SAMPLE LOANS
DISTRIBUTED BY LOAN PURPOSE AND LOAN TYPE

and fund general business activities. Thus large bank loans
more often are used for working capital, LBO and restructuring. The large percentage of loans used for restructuring may reflect unique aspects of the sample or the wave
of corporate restructuring in the late 1980s.

III. PRICING CONSIDERATIONS
Much of the focus on bank loan pricing has been on the
structure of the loan rate. In this paper, we not only focus
on the loan rate, but also on an additional component cost
of these loans, the various fees. As noted in the study by
Berger and Udell (1990), bank loans almost always carry
floating rates of interest. However, the procedures for adjusting the rates vary across contracts and have been the
subject of much controversy. Other sources of private and
public finance traditionally carry fixed rates of interest.
Carey, et al. (1993) note that only 2 percent of private
placements in 1989 had floating interest rates. They note
that private placements of debt, like public bonds, generally have fixed rates. In our sample of large bank loans, the
pricing includes many components and it frequently permits the borrower a choice of indices to be used to determine the loan rate.

Fixed-Spread Floating-Index Loans
NUMBER

PROPORTION

PANEL A: BY LOAN PURPOSE
Working Capital

305

0.227

Debt Repayment/Consolidation

243

0.181

General Corporate Purposes

235

0.175

Takeover Acquisition

218

0.162

Leveraged Buyout

185

0.137

Recapitalization

36

0.027

Security Purchase

29

0.022

Real Estate Loan

24

0.018

72

0.053

Revolving Credit

605

0.449

Term Loan

432

0.321

310

0.230

Other

a

PANEL B: BY LOAN TYPE

Other

b

a
Other loan purposes include general acquisition program, employee
stock ownership plan, commercial paper backup, project finance, stock
buyback, and trade credit.
b
Other loan types include bridge loans, demand loans, letters of
credit, notes, multi-option facilities, and subordinated debt.

One of the early explanations for the use of loan commitments was that firms were attempting to lock in the interest
rate. However, as noted in the 1970s study by Boltz and
Campbell (1978), the use of fixed interest rates in bank lending was on the decline. Today, virtually all large bank loans
include interest rates that float over the life of the loan. Today, pricing is most frequently tied to one or more indices.
Under this arrangement, the loan is fixed at a spread relative to one or more floating indices. The most popular
pricing index for spreads has been the, sometimes controversial, prime rate of interest. Boltz and Campbell (1978)
note economists traditionally had difficulty providing explanations for the purpose and role of the prime rate convention. The accepted view until the mid-1960s, when a
higher percentage of loans were fixed rate, was that the
prime represents the rate charged to the class of customers
with the least risk of default. The advent of below-prime
pricing and the increased use of a fixed-spread, floating
rate have changed the role of this index.
Much of the debate over the role of the prime rate in
bank loan pricing has focused on its use as a means of
maintaining discretionary control over the contract rates
on outstanding floating-rate loans. The inability of borrowers to switch costlessly from one bank to another frequently allows banks to retain their customers and increase

BOOTH AND CHUA/STRUCTURE AND PRICING OF LARGE BANK LOANS

their profits. This view, frequently espoused by the popular press, is that the bank may be able to increase the rate
charged to an existing customer as long as the increase
does not exceed the borrower’s costs of locating and contracting with the new lender.
Boltz and Campbell (1978) note that if the prime rate is
a means for maintaining discretionary control over outstanding floating-rate loans, then banks may find it advantageous to leave the prime rate stable to protect the return
on existing loans but to use below-prime rates on new
loans. This is the rationale for below-prime pricing. Others have predicted that because of competition from direct
finance, the prime would be replaced by some rate more
responsive to market rates. From Table 2, we can observe
how the role of the prime rate has evolved.
In examining Table 2, we find that the usefulness of the
prime as a management tool relating the costs of funds to
returns on loans continues in the late 1980s. Its role in pric-

57

ing large bank loans has evolved from that described in earlier studies. In our sample, the prime continues to be the
most frequently quoted index in pricing large bank loans.
Perhaps due to concerns over the responsiveness of the
prime to changing market conditions, many large bank
loan contracts include quotes to two or more indices. Under these pricing arrangements, the borrower is permitted
to choose, at each pricing interval, the desired index and
the associated spread for the next pricing interval. This represents a major innovation in loan pricing. As an additional
feature, contracts often permit the borrowing firm to lock
both the index and spread for three, six, nine, or twelve
month periods.
Approximately 39 percent of the loans in our 1989 sample included a fixed spread to more than one index. Of the
loans that contained quotes to more than one index, approximately 27 percent of these contained quotes to two
indices and approximately 12 percent contained quotes to

TABLE 2
NUMBER AND PROPORTION OF 1,347 SAMPLE LOANS WITH DIFFERENT PRICING INDICES IN 1989,
DISTRIBUTED BY LOAN SIZE
< 250k

250k–1m

1m–10m

10m–25m

LOAN SIZE
25m–100m

100m–250m

250m–500m

> = 500m

Overall

Prime Only

5
(.36)

25
(.61)

173
(.56)

81
(.39)

84
(.24)

23
(.10)

9
(.09)

14
(.14)

414
(.31)

LIBOR Only

3
(.21)

2
(.05)

24
(.08)

25
(.12)

53
(.15)

37
(.17)

28
(.27)

22
(.22)

194
(.14)

CD Only

6
(.02)

2
(.01)

8
(.01)

Prime, LIBOR and CD

5
(.01)

19
(.09)

52
(.14)

45
(.20)

20
(.19)

18
(.18)

159
(.12)

Prime and LIBOR

17
(.06)

32
(.16)

89
(.25)

56
(.25)

32
(.30)

21
(.21)

247
(.18)

Prime and CD

6
(.02)

3
(.01)

LIBOR and CD

2
(.01)

7
(.03)

35
(.10)

35
(.16)

9
(.09)

19
(.19)

107
(.08)

9
(.01)

Fixed and Other Indexa

6
(.43)

14
(.34)

73
(.24)

39
(.19)

41
(.11)

25
(.11)

7
(.07)

4
(.04)

209
(.15)

Total

14
(1.0)

41
(1.0)

306
(1.0)

206
(1.0)

356
(1.0)

221
(1.0)

105
(1.0)

98
(1.0)

1347
(1.0)

a

Other indices include T-bill rates, commercial paper rates, cost of funds indices, and federal funds rates.

58

FBRSF ECONOMIC REVIEW 1995, NUMBER 3

three indices. For both single and multiple index loans, the
prime rate continues to be the most popular pricing index.
Approximately 62 percent of the loan contracts include a
quoted spread to the bank’s prime rate. Among those contracts quoting spreads to a single index, the prime was
quoted in approximately 67 percent of these contracts. In
the contracts in which a fixed spread was quoted to more
than one index, the prime was included as one choice in
approximately 80 percent of the contracts. One possible
reason is casual evidence that banks offer more flexible
early repayment features if the loan is priced relative to the
bank’s prime rate of interest. The next most popular index
for both single and multiple choice contracts is the LIBOR.
This is followed in popularity by the bank’s CD rate. Much
less frequently used indices include the treasury bill rate,
the commercial paper rate, the federal funds rate, a cost of
funds index, and an index of money market rates.
Among the contracts that quote fixed spreads to more
than one index, the most popular is the combination of
prime and LIBOR. A close second in popularity is prime,
LIBOR, and the bank’s CD, followed by a LIBOR and CD
combination. An infrequently used combination is a
spread to the prime and the bank’s CD rate.
In Table 2, we provide summary statistics on loan size
stratified by the pricing structure used. As a general rule,
the contracts that utilize floating-index pricing relative to
only one index are on average of smaller size than those
that specify pricing to more than one index. An exception
is pricing relative to LIBOR only. These contracts are on
average much larger than the contracts that specify pricing
relative to prime, CD, or any of the other indices. The same
cannot be said of the contracts specifying more than one
index. The largest of this class of loans are those that specify pricing relative to the LIBOR, but do not include the
option for the borrower to price relative to the bank’s prime
rate.

Other Fees in Loan Pricing
The loan rate is not the only component in pricing sample
loans. A typical bank loan commitment provides the borrower substantial flexibility in determining the quantity of
borrowing during the life of the contract. To price these
contracts so as to receive an adequate return on capital, the
banks use a variety of fees. This appears to be in contrast
with both private placements and public debt issues. The
rationales for the use of fees in bank lending traditionally
have focused on the presence of informational asymmetries related to the credit risk of the borrower. Specifically,
James (1987) and Thakor and Udell (1987) develop models in which borrowers can be induced to reveal their credit
risk class by the choice of loan rate and the fee structure

they select. Berlin (1989) also describes a similar use of a
combination of fees and loan rates to control borrower’s
behavior.
In Table 3, we provide a list of the most frequently used
fees in the sample. In addition to the loan spread relative
to prime (the most frequently used index, averaging 11 percent in 1989), two fees are considered the most common;
the first is an up-front fee based on the total amount of the
loan or commitment. A close second is a fee on the unused
portion of the loan commitment. The up-front fee is charged
at the b eginning of the loan arrangement; it is charged in
approximately 45 percent of sample loan contracts with an
average fee of 105 basis points of the total amount of the
contract. The next most frequently reported fee, an annual
fee on the unused balance of the loan, is charged in approximately 44 percent of sample loan contracts. The average
amount of this fee is 41 basis points of the unused balance.
The third most common fee is an annual fee based on the
total amount of the loan contract. This fee appears in approximately 22 percent of the sample loans and averages
16 basis points in those contracts in which it appears. In
approximately six percent of the contracts, a cancellation
fee is charged for early termination of the contract, this fee
averages 53 basis points of the loan contract. Also included
in approximately 12 percent of the contracts is a letter of
credit fee equal to approximately 143 basis points.
As noted above, studies have attempted to explain the
use of fees as part of the pricing structure of loan contracts.
These explanations have focused on the combination of
fees and loan rates to elicit information about the likelihood of default for a particular borrower. In Thakor and
Udell (1987), borrowers are shown to reveal their default
risk characteristics based on their choice of contract terms.
Alternatively, in Berlin (1987), borrowers are shown to selfselect across contract types based on their probability of
borrowing. Both of these models suggest that the use of different types of fees is expected to vary over the type of loan
contract. For example, Berlin (1987) suggests that loan fees
are designed to compensate the bank for the quantity risk
and the credit risk associated with the loan. Clearly the
quantity risk is larger under commitments to lend than under traditional or spot lending. In Table 3, we separate sample loans into revolving commitments, lines of credit, and
term loans. As can be seen, the use of all types of fees is
more frequent for revolving loan commitments than for either term loans or for lines of credit. The fact that lines of
credit typically do not specify the fees in the contract likely
reflects the lack of formal pricing in these arrangements.
The use of up-front fees are slightly more prevalent in
term loans than revolving credit agreements. In term loans
where these fees are charged, the fees are, on average, approximately 1.2 times as large as the average of this fee re-

BOOTH AND CHUA/STRUCTURE AND PRICING OF LARGE BANK LOANS

59

TABLE 3
PROPORTIONS AND AVERAGE BASIS POINTS OF FEES USED IN THE SAMPLE OF 1,347 LOANS,
DISTRIBUTED BY TYPES OF LOANS
TYPES OF LOANS
Up-front

Annual

TYPES OF FEES
Unused Balance

Early Cancellation

Letter of Credit

0.46

0.38

0.69

0.06

0.18

88

18

40

55

147

Proportions

0.47

0.20

0.24

0.05

0.02

Average Basis Points

105

11

44

52

112

0.21

0.13

0.21

0

0.11

55

38

33

—

106

Proportions

0.43

0.15

0.25

0.07

0.13

Average Basis Points

148

20

44

51

142

Proportions

0.45

0.22

0.44

0.06

0.12

Average Basis Points

105

16

41

53

143

Revolving Loan Commitments
Proportions
Average Basis Points
Term Loans

Line of Credit
Proportions
Average Basis Points
Other Types of Loans a

Overall Sample

a

Other types of loans include bridge loans, demand loans, letters of credit, notes, multi-option facilities, and subordinated debt.

ported in revolving credit agreements. The most frequently
included fee in revolving credit agreements is an annual fee
on the unused balance of the commitment. This fee is
charged in approximately 69 percent of all revolving credit
agreements in our sample. This fee, and the less frequently
used annual fee on the total amount of the line, suggests
the need for continuing fees associated with this source of
potential funding during the life of the contract. These suggest a relatively high cost to the quantity uncertainty associated with these contracts. Early cancellation fees appear
in about the same percentage in commitments as in term
loans. Letter of credit fees are reported in approximately
18 percent of loan commitments and in only 2.3 percent of
term loans.
Overall, these results suggest that substantial heterogeneity exists in the pricing structure of loan contracts.
This pricing structure varies across contract types in a fashion suggesting customized contract features. Unlike the
private placements and public debt samples examined by

Carey, et al. (1993), virtually all loans in our sample are
floating-rate loans. Additionally, the pricing structure appears to reflect the complexity of the package of financing
options the bank provides to the borrowing firm.

IV. COVENANTS TO PROTECT LENDERS
It is frequently suggested that, like other debt contracts,
bank loans contain restrictions designed to protect the
lender from the borrower behaving in an opportunistic way.
Smith and Warner (1979) note that in public debt contracts,
covenants usually take the form of restrictions regarding
cash distributions, claim dilution, asset substitution, and
underinvestment. Each of these may represent opportunistic behavior that can benefit shareholders at debtholders’
expense.
In this section, we look at the covenants and collateral
requirements that appear in the sample of loan contracts.
Carey, et al. (1993) suggest that covenants tend to be used

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FBRSF ECONOMIC REVIEW 1995, NUMBER 3

more frequently in private placements and are more restrictive than in public debt issues. Compared to bank
loans, covenants are less frequently used in private placements and they are less restrictive. Due to the private nature of bank loan contracts, as with private placements, a
lack of data has resulted in limited analysis of covenants in
these contracts. In general, Carey et al. (1993) note that
participants in private placement markets indicate that
bank loans contain roughly the same types of covenants as
found in the private placement market, with two differences. First, financial covenants in bank loans are typically
maintenance covenants, while most covenants in private
placements are incurrence covenants. With maintenance
covenants, the criteria set forth in the agreement, such as
minimum ratios of assets to liabilities, must be met on a
continuing basis. With incurrence covenants, default is
triggered if an event, such as issuing public debt or equity,
occurs at any time during the contract. The second difference is that the covenants of bank loans tend to be set at
levels that are more likely to be binding during the life of
the loan. They report that bank loan covenants tend to reflect a different lending philosophy than private placement
covenants. Banks are argued to take an approach that emphasizes liquidity and/or working capital. In Table 4 we report the proportion of our sample of bank loans segmented
by loan size that contain one or more of the most frequently
discussed covenants.

The Role of Collateral
One of the most common covenants to protect the lender
from losses associated with default risk is collateral.
Berger and Udell (1990) find evidence that for a large sample of relatively small (median $50,000) business loans,
approximately 70 percent were collateralized. Kwan and
Carleton (1995) report that for a large sample of private
placements, approximately one-third were secured. Carey,
et al. (1993) note that both of these percentages are higher
than for publicly issued bonds.
The traditional explanations for the use of collateral is
that it reduces potential losses related to default. Smith and
Warner (1979) note that this represents one of the most effective ways of combating the possibility of substituting
more risky assets for less risky. Consistent with this,
Berger and Udell (1990,1993) find evidence that riskier
borrowers are more likely to pledge collateral. Loans in
our sample of loans are much larger on average than those
examined in earlier studies. Approximately 45 percent of
the loans in our sample pledge collateral.
Earlier studies of the incidence of collateral suggest the
presence of collateral is a positive function of default risk

(see Berger and Udell, 1990, and Scott and Smith, 1986).
Scott and Smith (1986) examine a sample of small business loans and find that the presence of security is a negative function of loan size and loan maturity. Berger and
Udell (1990) find evidence that riskier loans are more
likely to be secured and the commitments to lend tend to
be less risky. In our sample, collateral is pledged in approximately 60 percent of loans used to finance takeovers
and LBOs. This compares with approximately 45 percent
for the entire sample. Highly leveraged corporate restructuring loans are frequently considered to carry a high level
of default risk. This suggests that for our sample of large
business loans, the presence of collateral is a positive function of default risk.

Other Covenants in Bank Loans
In addition to frequently requiring collateral, bank loans
include additional restrictions on borrower behavior. Covenants in bank loans are either negative or affirmative. Negative covenants restrict certain actions by the borrower. Most
of the negative covenants in bank loans take the form of financial covenants. Affirmative covenants require a borrower
to meet certain standards such as discharging contractual
obligations and providing information at regular intervals.
The covenants reported for the sample of large loans we
are examining are generally negative and are based on financial variables.
Historically, compensating balances have been used frequently as covenants in bank lending arrangements. Under
these arrangements, the borrowing firm is required to
maintain a compensating balance at the lending bank equal
to a small percentage of the loan balance during the life of
the loan. In our sample of relatively large loans, required
compensating balances appear in only 1.8 percent of loan
agreements. Thus, as shown in Table 4, in the market for
relatively large bank loans, these covenants are largely missing. This may reflect the fact that our sample consists of
relatively large borrowers and the trend to the reduced importance of this pricing feature in bank lending.
The most commonly reported negative financial covenant is the restriction on the debt ratio of the borrowing
firm. The covenants related to this ratio appear in slightly
more than 28 percent of sample loans. The next most frequently reported is a solvency covenant which appears in
approximately 20 percent of loans. This is followed by an
interest coverage ratio covenant in approximately 16 percent of sample loans. Also reported in approximately 16
percent of loans is a requirement that the borrower hedge
interest rates through either futures or swaps. The next
most frequently reported covenants are the maintenance of

BOOTH AND CHUA/STRUCTURE AND PRICING OF LARGE BANK LOANS

61

TABLE 4
PROPORTION OF LOANS WITH COLLATERAL REQUIREMENTS AND COVENANT RESTRICTIONS,
DISTRIBUTED BY LOAN SIZE
TYPES OF LOANS
< 50k

50k–250k 250k–1m

LOAN SIZE
1m–10m 10m–25m 25m–100m 100m–250m 250m–500m > = 500m

Which are Secured

.50

.58

.63

.64

.48

.43

.38

.53

.38

With Solvency Covenants

—

.08

.05

.24

.23

.24

.16

.12

.02

With Debt Ratio Covenants

—

—

.15

.33

.31

.29

.28

.24

.18

With Interest Coverage Covenants

—

—

—

.11

.21

.19

.22

.17

.16

With Profit/Sales Covenants

—

—

—

.02

.01

—

.01

—

.08

With Agreement that Calls
for Hedging the Interest Rate

—

—

—

.03

.11

.18

.25

.30

.36

With Compensating Balance

—

—

—

—

.01

.01

.04

.05

.06

a minimum borrowing base of assets (approximately 10 percent of contracts) and a profitability or sales constraint in
approximately 1.2 percent of contracts.
These findings provide evidence consistent with the analysis of covenants for private placements in Carey, et al.
(1993). They report that market participants suggest two
differences between covenants in private placements and
bank loans. First, financial covenants in bank loans are typically maintenance covenants, while most covenants in private placements are incurrence covenants. We find that
most of the covenants reported for our large bank loans are
maintenance covenants. They also suggest that bank covenants are set to restrict borrowers’ behavior more closely.
We have no direct evidence of this. However, a substantial
percentage of sample loans include covenants that are set
to be relaxed during the life of the loan. For example, the
borrower may be required to maintain a long-term debt to
equity ratio of .5 during the first year and .75 in subsequent
years. In our sample, covenants are permitted to change in
approximately 22 percent of the loan agreements. Consistent with the statement of Carey, et al. (1993) that bank
loan covenants are tight, we find in approximately 22 percent of loan agreements that covenants are permitted to be
relaxed in stages during the life of the loan. A related feature of many of the loan agreements is that the loan contract calls for the loan rate to reflect a violation in the
covenants. For instance, the contract may call for the loan
rate to increase the spread from 100 basis points over prime
to 200 basis points over prime if the borrower violates the

total debt to net worth constraint. Assuming that incorporating such contract features is costly, the fact that violations are explicitly priced may indicate that they are seen as
more likely to be binding. This is consistent with the proposition that bank loan covenants are normally tight.
Overall, our results suggest that a wide variety of covenants are used in large bank loans and that these covenants
are set very tight. The covenants tend to be maintenance
covenants and focus on the liquidity and leverage of the
borrowing firm.

V. SUMMARY AND CONCLUSIONS
The evidence in this paper represents the first attempt at
comparing the characteristics of large bank loans with private placements of debt and public debt issues. The motivation for this comparison has been to examine the unique
aspects of large bank loans that encourage firms to continue this source of finance even though they have access
to the private placement market, and in many cases, the
public debt markets. By examining the characteristics of a
sample of large bank loans, we are able to gain insights
into this form of corporate borrowing compared to private
placements and public debt issues. Among the major differences in these sources of corporate finance are that bank
loan agreements are approximately one-half the maturity
of private placements and one-third that of public bonds.
Virtually all bank loan agreements are fixed-spread, floating-index loans. Most are in the form of commitments to

62

FBRSF ECONOMIC REVIEW 1995, NUMBER 3

lend that permit the borrower flexibility in deciding on the
timing and amount of borrowing.
Within these complex lending arrangements, we find that
the prime continues to be the most popular index for fixedspread floating-rate loans. However, a majority of the loans
quote a fixed spread to more than one index. Additionally,
in modern loan contracts, the loan rate is only one part of
the pricing structure. Loans frequently include a variety of
additional fees. These include one time fees, annual fees,
cancellation fees, and in commitments to lend, fees on the
unused portion of the credit agreement.
Evidence related to covenants in large bank loans indicates wide variety in the types of covenants used. Additionally, covenants often change automatically during the
life of the contract and it is not uncommon for loan spreads
to increase with covenant violation. Pricing covenant violations ex ante suggests that they are likely to become binding and perhaps be violated. This suggests that flexibility
in contract features and the ability to renegotiate are important features in demand for large bank loans. These
findings are consistent with the monitoring role of banks
as unique sources of borrowing for businesses.

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WORKING PAPERS
RESEARCH DEPARTMENT, FEDERAL RESERVE BANK OF SAN FRANCISCO
95-02

Federal Reserve Interest Rate Targeting, Rational
Expectations, and the Term Structure
GLENN D. RUDEBUSCH

95-10

Does State Economic Development Spending Increase
Manufacturing Employment?
CHARLES A. M. DE BARTOLOME AND MARK M. SPIEGEL

95-03

The Temporal Relationship between Individual Stocks
and Individual Bonds
SIMON H. KWAN

95-11

Regime Switching in the Dynamic Relationship between
the Federal Funds Rate and Nonborrowed Reserves
CHAN HUH

95-12

An Analysis of Inefficiencies in Banking:
A Stochastic Cost Frontier Approach
SIMON H. KWAN

95-13

The Role of Private Placement Debt Issues
in Corporate Finance
SIMON H. KWAN

95-14

Signal Extraction and the Propogation of Business Cycles
KENNETH KASA

95-04* Speculative Attacks on Pegged Exchange Rates: An
Empirical Exploration with Special Reference to the
European Monetary System
BARRY EICHENGREEN, ANDREW K. ROSE,
AND CHARLES WYPLOSZ
95-05* Is Monetary Policy Becoming Less Effective?
RAY C. FAIR
95-06* A Theory of North-South Customs Unions
EDUARDO FERNANDEZ-ARIAS AND MARK M. SPIEGEL
95-07* The Monetary Transmission Mechanism: An Empirical
Framework
JOHN B. TAYLOR
95-08* The Exchange Rate in Monetary Policy
MAURICE OBSTFELD AND KENNETH ROGOFF

Working papers are available free of charge from:
Federal Reserve Bank of San Francisco
Public Information Department
P.O. Box 7702
San Francisco, CA 94120
Fax: 415-974-3341

95-09* Measuring Monetary Policy
BEN S. BERNANKE AND ILIAN MIHOV

* These working papers were not edited by the Federal Reserve Bank of San Francisco.