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FOR RELEASE ON DELIVERY
TUESDAY, FEBRUARY 9, 1982
11:10 A.M. LOCAL TIME (4:10 P.M. EST)




A REGULATOR’S VIEW OF THE RESCHEDULING PROBLEM

Remarks by
Henry C. Wallich
Member, Board of Governors of the Federal Reserve System
at the
1982 Euromarkets Conference
sponsored by the
Financial Times
London, England
February 9, 1982

A REGULATOR'S VIEW OF THE RESCHEDULING PROBLEM
Remarks by
Henry C. Wallich
Member, Board of Governors of the Federal Reserve System
at the
1982 Euromarkets Conference
sponsored by the
Financial Times
London, England
February 9, 1982

Once more I am glad to have an opportunity to speak to the Euro­
markets Conference sponsored by the Financial Times on a topic related to
international bank lending, specifically, on some aspects of the rescheduling
process.

The Rise of Rescheduling
Three circumstances combine to focus attention on rescheduling in
the U.S. regulatory view.

First, international bank lending, and especially

lending to developing and until recently East Bloc countries, has been
expanding at a faster rate than bank lending in general.

Second, inter­

national lending, at least among U.S. banks and probably those of other
countries, has tended also to be more concentrated among a relatively small
number of large banks.

Third, the frequency of reschedulings has increased

in the last few years.

Thus, international exposure of large U.S. banks, and

perhaps large banks elsewhere, has tended to increase, and the fraction of







-3There is the rest of the financial community*

It is usually well

informed, has its antennas out in all directions, and is capable of throwing
off perceptible signals in response to even very small impulses.

But the

market, in my view, is subject to trends and fashions like all the rest of
us.

Sometimes it puts a disproportionate weight on the views or examples of

a few highly visible participants.

Moreover, the market may believe that

governments and central banks have knowledge, or have powers to deal with
situations, that may represent an overoptimistic appraisal.

In particular,

the faith that financial crises can always be controlled seems to be deeply
rooted in present market psychology.
As a member of a regulatory body, of course, I welcome this
confidence, and I wish only that the same confidence could be transplanted
to the market's view of our capabilities for sticking to our monetary policies,
controlling the money supply, and bringing inflation down.

But the market may

overestimate the authority's powers with respect to the former as it underestimates, I believe, their power with respect to the latter range of purposes.
While financial authorities will always make an effort to prevent or alleviate
serious malfunctions in financial markets, they cannot forestall all difficul­
ties.

Indeed, it would be unwise to do so.

If risks are to be run there must

be winners and losers.
In recent weeks, I have seen newspaper reports urging the use of the
threat of financial crisis as a means of achieving political objectives.

These

reports have focused on the terms in the Polish official 1981 debt rescheduling
that was concluded some time ago.
could be declared void.

Under certain circumstances, that agreement

This could lead to a default on private as well as

official debt.
Using the international financial mechanism in that way could be
extremely dangerous.




A default by itself is something the market must always

-4envisage as an ultimate possibility and should, therefore, be prepared to
live with.

But it makes a great difference how a default comes about.

If

it were to come as the result of market forces, the market can and would
have to deal with it.

If it were the result of a political maneuver, the

implications would be quite different.

Banks would then have to be concerned,

especially after having lived through the Iranian precedent, that international
credit had become a pawn of national political purposes.

Whether one welcomes

such broadened reach of the political purpose or not, the consequences are plain.
’r.y international loan could be exposed to this new type of risk.
\

Conventional

.ovrereign risk analysis using economic criteria in international lending would
avail little.

Governments in borrowing countries may cha-.ge and may run afoul

■jf the political purpose in lending countries.

Governments in lending countries

also may change and may take a different view of existing governments in borrow­
ing countries.

Nobody could foresee these kinds of contingencies.

But the

damage to the mechanism of international credit, to all kinds of countries,
might be widespread.
I view the advice contained in these press comments as all the
more misplaced because demands on the private international financing
mechanism may well'increase.

Flows from official sources of international

lending do not seem to have much prospect of expanding.
less financing seems to be the watchword in that sphere.
mean that the private sector should do more.
done without excessive risk.

More adjustment and
This does not

That depends on what can be

But the private sector should not be expected

to confront types of risks other than those that it is capable, to an extent,
to evaluate.




-

5-

On the subject of international lending risk of the traditional
kind, several things deserve to be recalled.

Banks' loss record in inter­

national lending has been good, much better in fact than the domestic record
in the United States.

Nevertheless, there is the growing number of

reschedulings underway and probably a growing volume of rescheduled loans
on the books of the banks.

There is

a range of circumstances that differ­

entiate today's risks from those of 10 years ago as far as international
lending is concerned.

The banks, in effect, had discovered the developing coun­

tries well before the first oil shock.

However, that was

environment of rapid

growth both of the developing world and their customers among the developed
countries.

It was a world of low interest rates, relatively speaking, of

low international debt, of often strong raw material prices.
of these things have changed.

Two oil shocks, together with other factors,

have slowed down growth everywhere.
portion of export proceeds.
risen.

Today, most

Costly oil imports preempt a sizable

Debt service ratios for many countries have

So has exposure to developing countries for many banks.

of many raw materials are weakat least temporarily.

Prices

And, above everything,

real interest rates, which used to be preponderantly negative, now have
become pronouncedly positive.

Nobody any longer gets paid to borrow, unless

he can deduct interest including an inflation premium for tax purposes.
Developing countries cannot.

Beliefs That Will Be Tested
Therefore, I believe, that we may have ahead of us a time when
some of the old hypotheses about international lending may be tested.

One

such theory, which I have already mentioned, says that losses in interna­
tional lending have historically been lower than at home and will, therefore,




-6continue that way.

But one reason for this seemingly favorable experience

may be that it is harder to recognize a loss on a sovereign loan than on a
commercial loan.

On a loan to a business firm, the loss is final when the

borrower goes out of business.

That kind of tap on the head with a

two-by-four usually does not happen in the international field.

Another

theory, which relates to the last, says that while old corporate borrowers
may die, sovereign borrowers at worst can fade away.
might be a claim on the smile of a Cheshire cat be?
countries need credit in order to grow.

But just how good
We know that developing

But, as the man running from a

barking dog said, it did not matter whether he knew that barking dogs
don't bite but whether the dog knew.

Will all developing countries act

as if they knew that they must preserve their credit standing in order to
grow?

Will this knowledge still mean something when a country approaches the

stage where its new borrowing is needed increasingly to pay interest rather
than to finance a trade deficit reflecting a real resource transfer?
Another theory we have often heard is that domino effects among
borrowing countries don't happen.

Default of country A historically has

not induced similar action by countries B-Z.

The case that nobody wants

to be first but many want to be second clearly has not arisen.

One hopes

that the banks will remember this doctrine as they look at different East
Bloc countries.

The credit quality of most of these countries is different.

It would be a mistake to give them all the same treatment.

But a careful

and discriminating evaluation of East Bloc country credit is not going to
be made any easier by the questions that now have to be raised about another
old foreign lending hypothesis —




the Soviet umbrella theory*

-7Maintaining Perspective
What can one say about the present status of international lending,
without falling back on any of these more or less uncertain theories?

We

can reject the implication of the frequently heard question "how can all
those countries repay all that money?"

Likewise to be rejected is the

alternative view that there is nothing to worry about because these loans
just will be rolled over and over ad infinitum« Whether or not a borrowing
country ever "repays" in the sense of ceasing to be a net capital importer
and becoming a net capital exporter depends on its own circumstances and
policies as well as on those of the rest of the world.

Many of the

industrial countries that were structural capital exporters before OPEC
to some extent pushed them out of that role once were structural capital
importers, including the United States.

Some of today's capital importers

no doubt some day will make the same transition.

One may wonder why some

of the most advanced among them are not already moving closer to that role.
Their great developmental opportunities, and the more ready availability
of capital in more mature countries, may be the reason.

I must confess that

1 would feel more comfortable if this secular historical transition from
capital importer to capital exporter were more often visible in the
developing world.
On the other hand, the eternal rollover view is equally fallacious.
A country can roll over its debt, just like a corporation, if it keeps its
economic base strong and growing.

So long as that is the case, the strength

of the country's credit will be documented, not by net repayment, but by the
terms on which old debt can be refinanced and new debt incurred.

It is not

usual, in any case, for old loans specifically to be rolled over.

They are




-

8-

amortized on schedule and their place taken, in the structure of the economy,
by new borrowings*

The market is always in a position to deny these new

borrowings or allow then only at penalty rates.

Some of a country's creditor

banks, to be sure, may be so deeply involved that they may find it difficult
to refuse to participate in new financings.
centration.

There is danger in such con­

But there will always be other potential creditors who are

free to make their decision whether to participate or not.
rollovers are never assured.

Thus, perpetual

But neither is continued refinancing of debt

by itself a sign of weakness.
What one can say positively is that sovereign borrowers, like other
units, have a certain debt capacity.

In the normal course of events this

capacity will be growing if they manage their affairs competently.

To be

safe, their debt should not be growing faster than this capacity, once it
has been fully utilized.

In recent years, the debt of most developing

countries has grown faster than their economy and probably their debt capacity.
Because the limits of a country's debt capacity are not easily definable, one
cannot be sure to which extent debt capacity has been utilized or perhaps
overutilized.

For countries that have to reschedule the limits obviously

have been exceeded.

What one can say for certain is that a continuous

rise in debt relative to debt capacity is not feasible.

At some point there

must be a leveling off, so that the debtor economy and its debt burden grow
at the same rate.
ahead.

For most countries, I fear, this transition is still

The need to navigate it is one of the problems of our situation.

Provision Against Rescheduled Loans
This thought leads me back to the question of rescheduled loans.
Their volume on many b




probably has been increasing.

There

-9are reasons to fear that they may continue to increase.

Moreover, the

quality of the rescheduled loans may in some cases diminish, particularly
where the International Monetary Fund cannot, or cannot adequately, exert
an influence for better policies on the part of the borrower.

It seems

increasingly desirable for regulators to move toward requiring the making
of provision against some part of such loans.
At the present time, there is very little international uniformity
as regards the treatment both of nonperforming and of rescheduled loans.

As

regards international loans that are nonperforming, either with respect to
interest or principal, the banks are free to recognize this condition in some
form as they wish or as their auditors advise them.

If interest is seriously

deliquent, a loan may be placed in nonaccrual status.

Only if a default is

called, leading to an attachment of assets and possibly the triggering of
cross-default clauses, do legal requirements seem to take over in some
countries.

In the United States, regulatory judgment continues to prevail

even in cases of apparent default.

Fending an agreement and rescheduling

between borrower and lenders, some American banks might, but would not be
required to make reserve allocation against a nonperforming loan.
have the effect of reducing its loan loss reserve.

Both would

To the extent that increased

provisions are needed to restore the adequacy of the reserve account, the net
loans are reduced.

In any event, the loan remains on the books as part of

gross loans.
A U.S. bank can reduce its taxable income by building up its loan
loss reserve to a statutory limit.




That limit may be governed by its

-10hlstorical loan loss experience, if the bank elects to use the experience
basis.

Alternatively, the bank may raise its loan loss reserve tax ‘
de­

ductibility up to a statutory limit, given by a percentage of eligible
loans.

Prior to legislation passed in 1969 that percentage was 2.4 percent.

It is now being reduced periodically until 1987 when all banks will go on
an experience basis.

At the present time, the statutory limit is 1.0 percent.

It was to have been reduced to 0.6 percent in 1982 but was kept at 1.0 per­
cent by special legislation.

Most banks are at their loan loss reserve

limits by one definition or the other.

The limit, of course, can be

exceeded for financial accounting purposes, but without tax deductibility.
When a bank wants to charge off a loan loss against its reserve
account and make provisions to restore the adequacy of the reserve account,
the attitude of the Internal Revenue Service becomes decisive for the
tax consequences.

Provisions to the loan loss reserve reduce earnings.

The IBS will allow this if the charge-off reflected an unquestioned loss.
This will be the case if the regulator has classified the loan as a loss,
in which case, the bank is required by law or requested by the supervisory
authority to write off the loan.

If the regulator has not so classified

the loan, the bank would probably have to convince the IRS by other evidence.
In sane instances, the examiner

may decide to classify a loan,

whether or not it is still performing and whether or not it is in accrual
status, as "substandard" or "doubtful."
fication,

the examiner

In instances of "doubtful' classi­

will make a charge of 50 percent for the purpose

of evaluating capital adequacy of the bank.
examiner

If the amount is material, the

may encourage but does not require the bank to make a correspond­

ing allocation of the reserve for that particular credit.




If the bank makes

-11such allocation on its own initiative, the IRS ordinarily will not accept
it as an unquestioned partial loss» unless the examiner can also be convinced,
upon a second examination of the facts, that a charge-off should be made.
Hence provision for doubtful loans to offset corresponding charges to the
loan loss reserve usually cannot be claimed as tax deductions.
Most of the experience with the classification of loans has been in
the domestic field.

Here it usually is possible, in cases of work-out or

bankrupty, to make a reasonable guess at the ultimate loss.
tional field, this is much more difficult.

In the interna­

The circumstances and policies of

the debtor, the possible long duration of a default, the eventual consequences
of a rescheduling are difficult to foresee.

A full loss of the type that the

regulator would certify and the IRS would recognize is not easy to envisage.
A partial loss is hard to substantiate.

Thus the chances of tax deductibility

for sovereign loans before or after rescheduling are slight under present conditions.
Making provisions to the loan loss reserve, whether general or special,
without tax deductibility, of course, is possible but without immediate tax
benefit and more costly in the sense of yielding only future rather than current
"tax savings."

Such "extra" provisions charged to income are assigned future

income tax benefits in accordance with the deferred tax concept used in financial
accounting.

At least that is the case for banks whose tax payments are large

enough to cause a significant difference between deductible and nondeductible
provisions.

The reluctance of banks to make nondeductible provisions is likely

further to be enhanced by the possibility that lawyers and accountants may
require equal treatment to be given to domestic and international problem
loans.

This might increase the volume of total credit loss expense once

the desirability of provisioning for international loans was accepted.




-12Against a requirement for provisioning against international problem
loans before or after rescheduling, it has also been argued that banks could
avoid the requirement by refinancing.

They might, in effect, avoid rescheduling

by lending the borrower the interest through a new loan.
course, the two procedures amount to the same thing.

Economically, of

It would, therefore, be

up to the regulator to observe such cases and penalize a bank for increasing
its exposure to a bad risk.

Reportedly the expected reaction of regulators

to such a practice has already caused banks,in some cases, to prefer resched­
uling to refinancing*
Finally, in opposition to provisioning against rescheduled loans,
it has been argued that this would give the debtor a motive not to pay.
If some of his debt has been written off, why should he make the effort?
Actually, experience of past negotiations suggests that banks that are
prepared to write off loan losses partially or fully are in a stronger nego­
tiating position with a sovereign borrower than banks which, perhaps because
of weak earnings, are trying to avoid a write-off.
As the foregoing observations show, potential arguments against a
more rigorous balance-sheet treatment of weak loans, rescheduled or other­
wise, are numerous.

They cannot be completely ignored.

Nevertheless, a

case for recognition of such situations, whether tax deductible or not, is
strong.

Rescheduled loans weaken the bank in many respects.

Its liquidity

suffers, the proportion of weak loans tends to increase, its maneuverability
suffers unless it is prepared to weaken its capital position.

A more

rigorous approach will make for better banks and better banking.
help present a more nearly "true" picture of a bank.

It would

It will also help to

discipline sovereign borrowers and strengthen the forces making for better




-13balance-of-payments adjustment.

In the field of sovereign lending, this

is the direction in which regulators should look.




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