|  Policy, Planning, and Resow b
WORKING PAPERS
I    World Devlopmont Report
Office of the Vice President
Development Eoonomics
The World Bank
August 1988
WPS 40
Background Pa,er for the 1988 World Development Repott
Financial Deregulation
and the Globalization
of Capital Markets
Eugene L. Versluysen
Rapid financial deregulation and the globalization of capital
markets have led to dangerous financial volatility that could
have a destabilizing impact on major economies. To reduce this
volatility, new regulation may be needed.
The Pdicy. Plamin and Reseach Cmplex distributesPPR Working Papes to dissnnte the findings of wodk in progrcss and to
cnonge the exchange of ideas among Bank staff and all othen interested in development issues. Thcsc papers cany the nanmes of
thea uthos. reflect ondy their views, and should be used and cited sccordingly. The findings, itrepretations, and conclusions are the
authors' own. They should not be attributed to the World Bank. its Boaid of Diretors, its maagement, or any of its menber camnies.



Polay nning, and Resrch
World Develpment RepW.
Finarcial deregulation in recent years has vastly   United States, deregulation has increased the
increased the ability of financial markets to       abillity to borrow abroad, thus contributing to
allocate international capital efficiently. It has  fiscal laxity. In that country, there is a need for
also sparked explosive growth in financial          a single regulatory agency to coordinate the
transactions and resulted in a restnictured, more   supervision of related financial activities -- to
competitive, and less costly financial services     lessen the risk of compounded market failures.
industry.
Some countries, such as England, have
But deregulation has proceeded so rapidly       moved to strengthen the capitalization of baniss
that tlie volume of purely financial transactions   and securities firns. Others (Canada, France,
now greatly exceeds that of transactions driven     Italy, and Spain) are making progress. But there
by international trade in goods and services.       is acute need for improvement in the United
Financial activity is now "delinked" from other     States, where many large banks are unearcapital-
factor markets and increasingly driven by           ized in relation to their exposure on LDC loans.
speculation for short-term profits nather than by
broader economic activity.                              Regulators in the major trading nations need
to address the possibility of a full-scale break-
This new pattem has led to growing eco-         down of the financial system.
nomic uncertainty and instability. Markets now
run around the clock and respond so rapidly that        This is a background paper for the 1988
there is a growing danger of chain reactions that   World Development Report. Copies are avail-
could precipitate global market failures.           able free from the World Bank, 1818 H Street
NW, Washington, DC 20433. Please contact
Deregulation has also made the conduct of       Rhoda Blade-Charest, room S13-060, extension
national monetary policy more difficult and the     33754.
monitoring of markets more complex. For the
The PPR Working PEtper Series disseminates the findings of work under way in the Bankes Policy, Planning, and Research
Complex. An objective of the series is to get these fmdings out quickly, even if presentations are less than fully polished.
The findings, interpretations, and conclusions in these papers do not necessarily represent official policy of the Bank.
Copyright C\ 1988 by the International Bank for Reconstruction and DevelopmnentlThe World Bank



Financial Deregulation and the Globalization
of Capital Markets:
A Stabiizing Force of a
Conduit of Volatility and Uncertainty?
by
Eugene L. Versluysen
Table of Contents
1. Introduction ..........................................................1
2. The Origins of Financial Deregulation and Innovation ...........................5.................5
The Return to External Convertibility ..........................................................5
The Adoption of Floating Exchange Rates .........................................................8
Subsidiary Detenninants of Deregulation .........................................................9
3. The Range and Objectives of Financial Deregulation .................................................                     12
The Scope of Deregulation and its Interaction with Financial Innovation ...                                      13
The Elimination of Capital Controls .........................................................                    13
Despecializing Financial Institutions .........................................................                  16
Improving the Functioning of Bond Markets ....................................................                   18
Increasing the Transparency of Fina                    l Transactions ..................................         21
Harmonizing the Standards of Prudential Supervision .................................                            22
4. Recent Changes in Domestic and Intemational Capital Markets .............................                                 25
The Pace of Change is Uneven   .                             ..................    25
The Divisions between Domestic and Interational Markets are Blurred ....                                         27
Imnproved Hedging Techniques and Risk Management ..................................                              29
Securitization and Disinterniediation .........................................................                  32
Intensified Competition and Lower Costs of Fnanal Intermediation .......                                         36
Concentration and Restructuring in Financial Markets ...................................                         37
The Global Capital Market .........................................................                              42
5. The Broader Economic Impact of Changes in the World's Capital Markets ..........                                          44
The Delinkmng of Financial Markets from the Real Sectors of the Economy                                          44
Responses to lialse Signals and Economic Instability ......................................                      46
Grezater Difficulty in the Conduct of Monetary Policy .....................................                      46
he Limits of Prudential Control....................................................                              47
Financial Deregulation and Fiscal Laxity ...................................................                     48
Has Dreglation Gone Too Far? ...................................................                                 49



1.       INTkODUCTION
Financial markets are a prime example of an economic activity where
regulation and controls are likely to induce distortions and inefficiency,
rather than promote efficiency. Left to themselves, these markets can adjust
rapidly and flexibly to new conditions. They trade fungible assets. With
today's minimal transaction costs--partly as a result of improved
communication and computer technology--and increased liquidity, asset
fungibility prevails on a global scale, even regardless of the cutrency of
denotuination. In this environment price changes are swift, affect all assets,
and spread across borders. These price responses to changing conditions can
also rapidly restore market equilibrium.
However, the financial services industry is but one segment of any
economy. It is also the one where trust, expectations and confidence play a
greater role, and have a more immediate impact in influencing actions and
reactions than in other sectors of the economy. The principal purpose of
regulating financial activities has, therefore, been to preserve trust in the
fiduciary role of financial agents. It has also served to subordinate
financial markets to broader economic policy objectives--for instance,
interest-rate and credit controls to serve monetary policy; capital controls
to stabilize exchange rates. Finally, regulation and controls have aimed to
reduce the feedback of financial volatility on other factor markets.
During the late 1970s and early 1980s, concern grew in industrial
countries about public sector encroachment on economic activities, especially
on private endeavors. That concern was broadly based. It found its
intellectual underpinning in the theories of liberal classical economists of
the 18th and 19th centuries. It also promoted a free-market reformist stance
among governments and policy makers in the leading industrial countries.



-2-
This led to deregulation of a broad range of economic activities. But nowhere
has deregulation been more pronounced and rapid than in financial markets.
The ensuing liberalization of financial activities and rapid pace of
innovation have stimulated competition and have already generated substantia.
efficiency gains: capital markets have become more liquid; the cost of
financial intermediation has fallen; new risk minimization techniques have
improved the scope for active asset and liability management; in a number of
countries financial institutions have been able to strengthen their
capitalization and increase their ability to withstand risks.
But recent changes in the world's capital markets in also carry
significant economic and financial costs.  To cite but tw         iples at this
point, first, the involvement of commercial banks in secur.i-d lending has
led to several instances of excessive off-balance sheet risks that could
mortgage the banks' future solvency. 'Secondly, heightened international
financial volatility and the increasing substitutability of financial assets
for money complicate the implementation of monetary policy.
At a more general level, one of the most worrisome consequences of
deregulation is the progressive delinking of financial markets from other
sector3 of the economy: in most industrial countries the financial services
industry is growing faster than the rest of the economy and the volume of
purely financial transactions now literally dwarfs trade-driven financial
flows. For other sectors of the economy this magnifies the risk of
destabilization that is induced by volatility in financial markets. As
another facet of the same problem, the persisting turbulence in financial
markets since October 1987 also shows that distortions in slower-moving factor
markets can have an immediate--and sometimes barely controllable--feedback on
highly responsive financial markets.



This suggests that certain financial reforms may have been too rapid,
if not excessive, as they have outpaced changes in the goods and labor markets
of major economies. Further structural reforms and deregulation, to improve
the functioning of the latter two sectors are therefore needed. Failing such
reforms, distortions in the slower adjusting real sectors of major economies
could be magnified by the rapid pace of change and adjustment in financial
markets. This could have a destabilizing effect on the economies concerned.
For the same reason, if rigidities in the real economy cannot be dealt with
effectively, there may be cause to reconsider the validity of further
financial deregulation.
Against this broad background, this paper examines the principal
objectives and results to-date of financial deregulation and international
integration, culminating in the emergence of a truly 'global' capital
market. Recent innovations of financial techniques and instruments, and their
impact on the financial services industry are reviewed in detail. The paper
concludes by addressing the effect of changes in financiaL markets on economic
activity ir. general and on the stability of the international financial
system.
The paper is organized in four sections. Following this
introduction, section 2 traces the origins of financial deregulation and
innovation to the growth of the euromarkets and the internationalization of
banking and finance during the 1960s and 1970s. Section 3 reviews the range
and objectives of financial deregulation, in the context of the post-1980
shift in economic poLicies in industrial countries. Sec ion 4 provides a
summary of recent regulatory changes and of the most important new financial
techniques and instruments. It also analyzes their impact on the financial
services industry. Section 5 concludes with an assessment of the broader



- 4 
macroeconomic implications of these changes. The main focus of the paper is
on debt securities. Changes in equity markets are addressed only indirectly,
where they are ger'mane to the discussion.



- 5 -
2.       THE ORIGINS OF FINANCIAL DERECULATION AND INNOVATION
The initial thrust for financial deregulation and innovation can be
traced to two major changes in foreign exchange markets, respectively the
return to external convertibility i.  .e 19509 and the adoption of floating
exchange rates in the early 19709.  t h changes were instrumental to the
development of the eurocurrency market and set in motion the metamorphosis of
international banking.
The return to external convertibility
The return of external convertibility in Europe in 1958 was a major
breakthrough for the expansion of foreign currency business by commercial
banks.!1 It enabled them to accept deposits and make loans in foreign
currencies on a larger scale th~an had been possible under the EPU mechanism.
As the volume of that business grew, an active interbank market for dollars
and other foreign currencies came into being: the eurocurrency market.
At first, outflows of public funds (military expenditure and grants)
and private capital from the United States were the main sou..ce of
l/ From June 1950 to December 1958 foreign exchange transactions in Europe
were governed by the OEEC's (OECD's predecessor) European Payment Union, which
essentially operated on a basis of bilateral settlements between the central
banks of member countries. On 12/27/58, the EPU was terminated by decision of
the OEEC Council and replaced by the European Monetary Agreement. The latter
piovided for multilateral settlements in dollars and thus marked the return to
full convertibility in Europe (BIS Annual Reports, 1958/59, p. 202 & 1963/64,
p. 127).



-6-
eurodollars--dollars owned by non-US residents.21 London's 'City', which
offeLed a sophisticated financial infrastructure and a long tradition of
international finance, became the main center for eurocurrency business.
Both the supply and use of eurodollars expanded rapidly. Being
strictly 'offshore', eurodollar deposits fell outside the direct jurisdiction
of US monetary authorities. To depositors this offered the advantage of
market interest rates, unfettered by the interest-rate ceilings of US
Regulation Q.31 Higher rates gradually attracted central bank reserves and
working dollar balances from major non-US corporations. Later, as the
eurocurrency market had reached maturity, it became a magnet for surplus funds
of high-income oil exporters, following the first oil shock of 1974.
The demand for eurodollars--and later, for other eurocurrencies--was
equally buoyant. The initial impetus for the full development of long-term
debt instruments in eurocurrencies--eurobonds--was provided by the
reintroduction of capital controls in the major industrial countries. Such
2/ o Market lore gives the term 'eurodollar' a surprising origin: in the
late 1950s, Banque Commerciale pour l'Europe du Nord (BCEN), a wholly-owned
French subsidiary of the Soviet Foreign Trade Bank, became a financial
innovator by placing some of the USSR's dollar holdings with banks located
outside the United States. As BCEN's telex answerback was 'Eurobanque', iLs
dollar deposits became known as 'eurodollars'.
o Given the dollar's role as the principal international trade,
settlement and investment currency, it also dominates the eurocurrency
market.
o The term 'eurocurrencies' is used generically, regardless of their
geographical location.
3/ Regulation Q set ceilings on time and saving deposit rates and, until
1978, prevented any interest payment on checking accounts. These interest
rate ceilings were increased over time and the grip of Reg. Q was
progressively diluted. From 1972 onwards, negotiable order of withdrawal (NOW)
accounts were introduced. In 1978 regulations were further amended to permit
commercial banks to make automatic transfers from savings accounts to demand
deposits. (5IS Annual Report, 1978/79, p. 59.) Finally, in 1980, the US
Congress passed the Depositary Institutions Deregulation Act that provided for
a gradual phasing out of interest ceilings. (The Washington Post, 1/10/88, p.
C4.)



-7-
controls became widespread in the 1960s, when the initial post-war move to
liberalize capital flows was temporarily reversed by maior countries in an
effort to reduce tensions in the foreign exchange markets and salvage the
Bretton Woods adjustable parity grid.41 As US multinational corporations
expanded their activities, eurobonds were the only easily accessible source of
long-term funds. They were subsequently adopted by a number of European
governments5- and major non-US corporations. As new types of bonds (floating-
rate notes, bonds with detachable equity warrants, convertible bonds) gained
acceptance* corporate financing and asset management by major institutional
and private investors also became more sophisticated.
In the money market for eurodollars and other eurocurrencies, the
foreign branches and subsidiaries of large US banks were initially the main
net takers of funds. Interbank deposits of eurodollars served to supplement
their domestic deposit base in the United States.61 But, as the pool of
eurocurrency deposits grew in size and reduced the banks' refinancing risks,
maturity transformation--using short-term deposits to fund long-term loans--
became widespread and revolutionized eurobanking.
Floating-rate eurodollar loans became commonplace. Priced at a
spread over the bank's own cost of funds--LIBOR--these loans eliminated the
4/ J.A.Frankel, "The Yen/Dollar Agreement: Liberalizing Japanese Capital
Markets", Institute for International Economics, Washington D.C., December
1984, p.19.
5/ Belgium and local authorities the United Kingdom were among the first
sovereign issuers of eurobonds.
6/ The interbank deposit market is used by commercial banks to fine tune
their liquidity positions: deposits are offered when liquidity is excessive;
they are bid when it is insufficient. The London Interbank Offered Rate
(LIBOR) remains the principal benchmark for interbank deposits in various
eurocurrencies, ranging from overnight to up to 2 years or longer. Three- and
six-month deposits are the most actively traded.



-8-
lenders' interest-rate risk. Large-size loans of $100 million or more that
exceeded any given bank's lending capacity, could be arranged by consortiums
of several banks and through syndication with smaller banks: each syndicate
member funded its participation in the same interbank market, at the same
reference cost. As is well docLmented, the quantum leap in the volume of
consortium lending came after the first oil shock, through the recycling of
OPEC's surplus funds to developing countries.
As later experience would show, lower refinancing and int .- t-rate
risks in this fast growing market made. commercial banks accept considerable
repayme.-t risks. The banks' limited expertise in assessing sovereign credit
risks at that time partly explains that attitude.
The adoption of floating exchange rates
After 1973, the adoption of floating exchange rates for the major
currencies also spurred innovation and deregulation. It encouraged commerc'al
banks to turn foreign-exchange trading into a separate profit center: volatile
exchange rates offered unprecedented arbitrage opportunities between
eurodeposits and forward exchange markets. Foreign exchange trading became an
integral part of euromarket activities.'/ As trading expanded and gained in
sophistication, the need for more flexible accounting and supervisory rules
rapidly became apparent.
7/ Interest differential between ueposits of similar maturities in two given
currencies are normally equal to the forward exchange premium or discount of
those currencies relative to one another. However, discrepancies between
these respective spreads often occur through market volatility. This
generates arbitrage opportunities. For example, the annualized three-month
forward discount of dollars against deutschemark can be lower than the yield
premium of three-month eurodollar deposits over three-month euro-DM. In such
a situation it is cheaper for a bank that needs a three-month dollar deposit
to buy these dollars with DM in the spot market and to reverse this purchase
in the three-month forward market. Of course, the arbitrage itself grau.:.ally
reestablishes the equilibrium between forward markets and interest spreads.



- 9-
Subsidiary determinant. of deregulation
Other developments in financial markets during the 1960. and 1970s
hastened the pace of innovation and the need for deregulation. The
international expansion of commercial banking, the emergence of offshore
banking cente-s a   te hnological progress in data processing and
communications stand out as key factors.
The momentum for international expansion by major commercial banks
was provided by the internationalization of production and trade by
multinational corporations. As leading US banks--and, later on, Japanese and
European banks--aimed to provide global coverage to their multinational
clients, they established large international networks of branches and
subsidiaries. In highly protected and regulated domestic financial markets,
they enjoyed considerable competitive advantages--captive MNC clients, lower-
cost funding in eurodollars and syndication of eurocurrency loans to
developing countries--over the smaller local banks. These numerous foreign
outlets were also able to promote eurocurrency funding and foreign exchange
management with the governments and corporations in the host countries. The
influx of foreign banks was a catalyst for innovation in those countries. It
also emphasized the need for greater freedom of action for domestic
institutions, lest they be relegated to a marginal role.
The creation of offshore banking centers was promoted by the
governments of a number of developing countries to modernize their domestic
banking systems. These centers started to proliferate during the 1970s in the
Far East (Hong Kong, Singapore), the Middle East (Bahrain, Dubai) and the
Western Hemisphere (Cayman Islands, Bahamas, Panama). In order to attract
subsidiaries of leading international commercial banks, these new centers



- 10 -
offered minimal regulatory constraints and favorable tax regimes.81 This put
central banks in the main financial centers under pressure to adopt more
flexible and coordinated supervisory rules, to prevent an exodus of
aurocurren^v business from their own markets.
Last, but not least, communication and data processing techniques
progressed in leaps and bounds during the 1970s. This enabled financial
institutions to access or disseminate financial information and market prices
instantly between distant locations. Quasi perfect information, available at
the same time to all market participants, shortened the time needed for
decision making and made it easier to manage diversified asset portfolios in
rapidly changing markets. It also boosted efficiency and liquidity in the
growing secondary market for eurobonds: dealers could carry larger bond
inventories and trade more actively on an international scale. In turn,
greater liquidity boosted investor demand for eurobonds and stimulated their
use by major borrow.rs.
In summary, the progressive integration of capital markets worldwide
and the present trend of accelerated financial innovation are mainly the
product of systemic and institutional c.Langes that started in the 1960s and
gathered momentum during the next decade. By the late 1970s, the dividing
lines between individual capital markets were already becoming quite blurred,
as a result of the integration of the major economies and through the
8/ Although it isn't an 'offshore center' as such, Luxembourg offers
comparable benefits to banks--and investors--in terms of low-cost financial
transactions and favorable tax treatment. Moreover, Luxembourg's position
predates that of the newer offshore banking centers. Given its special
position within the EEC (in 1987, Luxembourg Ville, the country's capital
counted some 111 different banks) Luxembourg's financial prominence may, in
fact, be strengthened after the introduction of the EEC's 'single market' in
1992.



- 11 -
internation4lization of capital flows and financial activities in the
euromarkets.
In that environment several factors altered the problems faced by
central banks and other regulatory agencies and created a need for a more
flexible regulatory stance apparent. These factors include the rapid pace of
financial innovation in the euromarkets, international expansion and
competition by major connercial banks that straddled international and
domestic, and the increasing mobility of capital.



- 12 -
3.       THE RANGC  AND OBJECTIVES OF FINANCIAL DEREGULATION:
The late 1970. and early 1980s were marked by fundamental changes in
the macroeconomic policies of industrial countries. To counteract rising
inflation and widening budget deficits, the governments in these countries
resorted to strict anti-inflationary monetary control and, except in the
United States, budgetary consolidation. In the United States and United
Kingdom the new economic policies included a commitment to curb the role of
the public sector in the economy and loosen its regulatory grip on private
enterprise. This involved far-reaching reforms and liberalization of major
sectors of their economies, including the financial services industry. Other
European countries and Japan progressively followed suit.
To a certain extent, financial reforms served to support the
implementation of the new macroeconomic policies. For instance, curbing
inflation and inflationary expectations required that money-market rates--and
even central-bank lending rates--be able to adjust more freely to market
conditions, to make monetary restraint more effective. Interest-rate controls
were lifted to achieve this. Similarly, after 1981, rising budget deficits
and fiscal laxity in the United States, and the continuing need for large
government debt financing in other major industrial countries made
deregulation and innovation desirable to make markets for government debt more
efficient, so as to acomodate public sector financing needs and reduce its
cost.
At the same timie, the rapidly changing economic environment--
particularly the acceleration of inflation and the volatility of exchange
rates and interest rates--stimulated financial innovation: new types of
securities and risk hedging techniques were developed, to minimize the impact
of financial uncertainty on investors and financial intermediaries.



- 13 -
The scope of deregulation and its interaction with financial innovation
Broadly speaking, financial deregulation consists in lifting or
reducing obstacles to the provision of financial services, or to the creation
of assets and flows for which there is a proven economic need. Deregulation
has therefore focused on (i) eliminating remaining controls or restrictions on
inte-national capital flows and interest rates, to improve the allocation of
capital; (ii) despecializing financial institutions; (iii) improving the
functioning of securities markets; (iv) increasing the transparency of
financial transactions; (v) harmonizing and simplifying standards of
prudential supervision across markets.
Experience gained in the euromarkets became the model for domestic
financial deregulation, as it aimed to replicate the efficiency and
flexibility of these markets. The process of change that started in the late
1970s has been complex. At the outset more flexible regulation encouraged the
introduction of new techniques and instruments. More recently these new
financial tools have started to stretch the regulatory framework itself and
are likely to propell a new wave of deregulation. This trend is again
clearest in the United States, where the validity of retaining the Glass-
Steagall Act is now being questioned.91
The elimination of capitAl controls
Capital controls--also called exchange controls--restrict inflows or
outflows of funds. They can operate in blanket fashion or be selective, for
example by restricting access to borrowings in a given market only to low-risk
9/ Legislation drafted by the Senate Banking Committee--and approved by the
Senate in March 1988--is currently being reviewed by House Committees. If
passed, the new legislation would enable banks and securities firms to compete
directly in each others' businesses. The Washington Post, April 24, 1988, pp.
H.1-7.



- 14 -
sovereign and corporate risks and to MDIs.1O/ In countries such as Japan,
Germany and Switzerland a major purpose of capital controls had been to
prevent the internationalization of their currencies, by restricting their use
for lending and investing in the eurocurrency markets. In such circumstances
the regulatory "cordon sanitaire" isolates interest ratas in domestic markets
from international pressures, and capital controls can, among others, preserve
greater tutonomy for domestic monetary policy.
Given the high degree of international mobility of capital in
eurocurrency markets, capital controls had become increasingly difficult to
maintain during the 1970s. Their progressive elimination was instrumental for
the integration of domestic and international money and capital markets, and
for the full determination of interest rates by market forces. This also
improved efficiency in the international allocation of capital.
The extent of liberalization of cross-border capital flows has varied
among countries. Except during the 1960s and early 1970s, the United States
has traditionally been the most liberal and, until the early 1980s--when the
US external deficit started to spiral--it was the largest capital exporter and
creditor nation. In Europe, the United Kingdom, Germany, the Netherlands and
Switzerland gradually reduced capital controls and liberalized market access
for foreign borrowers in the 1970s. Japan, where the domestic capital market
had remained fully separated from the international markets until the early
1970s, followed suit in stages. A major breakthrough in that country was the
10/ Given its sovereign shareholders, the IBRD has always enjoyed privileged
market access in industrial countries and in certain other capital markets,
even when all other foreign borrowers were excluded from borrowing in those
countries.



- 15 -
abolition, in 1980, of the Foreign Exchange and Foreign Trade Law.I.V That
step permitted borrowings by Japanese residents in other markets and made
access to the Japanese capital market easier for nonresidents.
After 1982, the increasing disparity of international payment
balances among the largest industrial countries became a catalyst for the
elimination of remaining capital controls. As their current-account surpluses
reached unprecedented levels, Japan and Germany liberalized market access for
foreign borrowers for exchange-rate management, to ease upward pressures on
their currencies. An early example of the effectiveness of liberal market
access in that context had been set by the United Kingdom. UK exchange
controls were abolished in 1979 to offset upward pressures on sterling, as the
country moved into current-acount surplus as a result of oil exports.12/
As Japan and Germany became major capital exporters and external
creditors, there was an added benefit in eliminating capital controls. Had
such controls still been in place, their respective central banks--rather than
private investors--would have had to accumulate intolerably large foreign
11/ "Changes in the OrZanization and Regulation of Capital Markets"; BIS,
March 1987, p.121.
12/  BIS, op.cit., March 1987, pp.194-5
- Borrowings by nor-residents in a given domestic capital market are often
used to finance investments or the purchase of goods and services outside the
country whose currency was used. In that case, conversion of the borrowed
currency increases its supply in foreign exchange markets and can hold down
its value. The same holds for outward investments by residents that require
purchases of foreign currencies.



- 16 -
currency reserves. This would have required large-scale sterilization to
counteract the resulting increases in the domestic money supply.131
For the United Stares, which has a huge external deficit and negative
domestic saving-investment balance and is highly dependent on capital inflows
from abroad, the benefits of free cross-border capital flows are also
evident. If the US authorities were *o constrain capital outflows, the
country's access to foreign savings would be jeopardized by investor fears
that funds inves ed in the United States could not be re-exported in the
futur
Despecializing financial institutions
To make financial markets more efficient, deregulation has had to
tackle the principal causes of inefficiency and rigidity, namely the
segmentation of activities among specialized agents and institutions, entry
barriers for foreign institutions, and the cartel behavior of the domestic
banks. This required that a freer rein be given to foreign banks and
securities firms to compete in domestic markets, and that existing financial
institutions be despecialized where necessary, in order to stimulate
competition.
13/ In Japan the dismantling of remaining capital controls only took place
from early 1984 onwards, after the recommendations of the "Yen-dollar Working
Group" were adopted. That working group was the framework for bilateral U.S.-
Japanese negotiations during 1983-84. These negotiations were launched by
Ronald Reagan and Prime Minister Nakasone at their Tokyo summit meeting of
November 1983, at a time when economic friction between the two countries--
essentially the US contention that the undervalued Yen was the prime cause of
mounting US trade deficits--threatened to get out of hand. The underlying
rationale of the working group's recommendations was that the elimination of
Japanese capital controls and the internationalization of the Yen would cause
that currency to appreciate against the dollar and would, in due course,
correct bilateral trade imbalances between these two countries. (J.A. Frankel,
op.cit. pp. 2-4) However, the internationalization of the Yen has proceeded
more slowly than was intended by the working group, and the initial effect of
the abolition of capital controls in Japan was to stimulate an inflow of funds
and depreciation of the Yen, rather than the opposite.



- 17 -
Examples abound. In countries such as the Netherlands, Germany and
Switzerland, where the capital market is dominated by universal banks that
straddle credit and securities markets, competition was stimulated by easing
entry barriers for, and giving greater freedom of action to, foreign banks and
securities houses. For example, in the first two countries local subsidiaries
of foreign banks are now commonly included in underwriting syndicates for
domestic bond issues. They can also provide a full range of retail and
wholesale finanzial services.
In the B'nited States and Japan, by contrast, barking and underwriting
are still separated by law. But the reach of these legal barriers is being
eroded. A number of US commercial banks have obtained permission to
underwrite commercial paper, municipal bonds and asset-backed securities--such
as mortgage-backed bonds. The underwriting of corporate bond and equity
issues, however, remains prohibited for US banks. An oddity of the present
system is that foreign banks that entered the US before 1978 benefit from
certain grandfather clauses that permit them to underwrite securities. They
thus enjoy greater flexibility than their US counterparts.L4/
London's Big Bang of October 27, 1986, is a prime example of sweeping
despecialization. New rules that took effect on that day formally abolished
all restrictions on the ownership of members of the London Stock Exchange,
opened up membership of the Exchange, and eliminated the Exchange's long
14/ In the United States, the Glass-Steagall Act of 1933 separates the
activities of US banks and securities firms, and the former are precluded from
underwriting securities. Given that, after World War 2, Japan's financial
system was largely modeled on that of the US, Article 65 of Japanese banking
law is comparable to the Glass-Steagall Act. It is likely to be amended or
repealed only if the US takes a lead. (Morgan Guaranty Trust, World Financial
Markets,12/86, p.7, and Federal Reserve Bank of New York, Quarterly Review,
Volume 12 No 1, Spring 1987, pp. 4-5.)



- 18 -
standing division between jobbers (market makers) and stockbrokers (retail
agents, acting on behalf of clients).
Improving the functioning of bond markets
With few exceptions--Switzerland is the main exception--the central
government is the largest borrower in the domestic money and capital markets
of industrial countries. In highly regulated and illiquid markets, the sheer
size uf these borrowings pushes up interest rates and crowds out private
borrowings. This was the case in most industrial countries, where government
debt financing had become rigidly structured. Issues of government bonds
usually involved established--and protected--underwriting syndicates, set
underwriting commissions; and fixed allotments to syndicate members, based on
their respective market shares. Moreover, in many countries, purchases of new
government bonds by institutional investors and commercial banks were governed
by compulsory coefficients, as part of the investors' statutory reserves.
Although these methods invariably ensured the prompt placement of new
government bond issues, they also made these bonds highly illiquid assets.
For instance, in the extreme case of Japan, until 1977 financial institutions
were not allowed to sell their holdings of government bonds, except to the
central bank.151
In the early 1980s, rising public-sector borrowing requirements in
most industrial countries created a need for greater depth and efficiency of
domestic markets for government debt. These improvements were needed to limit
crowding out through feed-back on interest rates and, if possible, reduce the
governments' own financing costs. Improvements have taken place on three
15/ This total embargo on secondary-market dealing in government bonds was
designed to keep the yield on new issues below prevailing market rates. (BIS,
March 1987, p. 119.)



- 19 -
fronts: new issuing techniques; more efficient secondary-markets; more
flexible rules for owneiship and trading of government bonds.
Innovative issuing techniques for government bonds were designed to
attract a wider spectruw of investors by means of new debt instruments, more
flexible underwriting arrangements, and new issue yields that were in line
with prevailing secondary market rates.
In the United States, the huge size of borrowings by the US Treasury
and federal agencies had already resulted in flexible and sophisticated
issuing techniques, involving regular auctions of Treasury bonds and notes.
Changes in that country therefore remained minimal. This stands in contrast
with other industrial countries. Examples of recent innovations include: the
adoption of US-type auctions in several markets; partly-paid and index-linked
bonds in the UK; extendible (i.e. renewable) and zero-coupon Treasury bonds in
France; short-term Treasury certificates in Italy; single maturity "bullet"
issues in the Netherlands; longer maturities of up to 30 years in Germany. In
the United Kingdom, where the Bank of England has normally taken up most new
issues of Treasury stock (gilts), the market was broadened by allowing gilt
dealers to participate in the Treasury's tenders.16/
Cbanges in the secondary markets for government bonds were squally
significant. Again, the United States has generally set the pace and served
as model for other countries. In the United States the practice of
"repackaging" existing US Treasury and agency issues has become commonplace.
It consists in changing the original characteristics of an existing bond. Its
primary aim is to stimulate demand by a broader range of domestic and foreign
investors and, thereby, improve the liquidity of government debt. In the
16/ BIS, March 1987, p. xvii.



- 20 -
early 1980s, repackaging became one of Wall Street's major new products and
growth areas. One of the more innovative forms of repackaging involves the
physical separation of bonds and coupons (coupon stripping). Each is then
sold separately as a zero-coupon security.171 Host leading New York
invcstment banks have launched their own versions of stripped Treasury
bonds--often using catchy acronyms, such as CATS, STRIPS and TIGERS. These
are listed at the New York Stock Exchange. In fact, coupon stripping has
become so commonplace that the US Treasury is now issuing "strippable"
bonds. So far, though, it has not issued zero-coupon bonds in its own right.
In the United Kingdom the number of market makers for gilts has been
increased and now includes a number of foreign dealers. In Canada stripping
of government bonds along the US model has been introduced by major security
dealers. In the case o_ Japan, where the issue and trade of government bonds
had been subject to greater restrictions than in other countries, these
restrictions were lifted in stages between 1977 and 1985, and there now is an
active secondary market for Japanese government bonds. This has brought the
yield on new issues in line with prevailing market yields.
Finally, the easing of existing restrictions on the ownership and
trading of government bonds complements changes in the secondary markets for
these securities. Like the latter changes, more flexible ownership and
17/ As their name indicates, zero-coupon bonds carry no interest coupons.
They are sold at a discount from face value, such that the yield to the
investor is provided by the difference between the original discount and the
redemption value of par. The main attraction of 'zeros' is twofold. As they
produce no current income, but only accrued interest, they can, in some tax
regimes, provide income deferral. Secondly, they protect investors against
the reinrestment risk: whereas earnings on coupon bonds will be reinvested at
the prevailing market rate (that can be significantly lower than the original
yield of the bond), interest accruals on zeros cannot, by definition, be
reinvested and are computed on the basis of a fixed discount rate over the
entire life of the bond.



- 21 -
trading rules serve to make these bond issues more liquid. Again in the case
of Japan, where foreign ownership of yen bonds was prohibited until May 1981,
such limitations no longer exist. In other countries, including the United
States and Germany, reforms have generally consisted in providing more
favorable tax treatment to foreign investors in domestic bonds--for example,
by eliminating withholding taxes on interebt paid on such bonds, so as to
increase their attractiveness to foreign investors--and in opening the
underwriting and secondary trading of government bonds to foreign financial
institutions.
increasing the transparency of financial transactions
In markets for publicly offered securities, investor access to
information pertait.ing to their prospective investments is more limited than
that of professional intermediaries. Investors can therefore be protected by
the compulsory disclosure of financial data and other relevant information
relating to the issuers of securities. Disclosure rules, as provided for
example in issue prospectuses, have long been a major aspect of capital market
regulation.
Given the increasing use of publicly issued and traded securities--
securitization--the need for transparency has increased. In other words, an
increase in the level of micro regulation can pave the way for broader market
liberalization and innovation. In the United States disclosure rules are
governed by the S.E.C. As in most aspects of financial regulation, other
markets and countries have based their own disclosure rules on the US
example. For instance, although there is no legal requirement to do so,



^ 22 -
eurobond issues normally have prospectuses that closely resemble those used in
the United States.18/
Another facet of transparency is the "rating" of borrowers. This
involves the classification of securities by credit risk--the lower the risk,
the higher the rating. The practice of ci.edit rating evolved in the United
States.19/ In recent years rating has become widely used in the eurobond
market and in some domestic markets. For example, Japan established domestic
rating agencies in 1986, to support the growth of its securities market.
Credit rating is provided by independent agencies. All ratings are
reviewed periodically and revised--upwards or downwards--if needed.
Individual borrowers are. ranked by quality, based on a review of their balance
sheets, relative market positions, soundness of management, and past payment
records. The highest rating (AAA) is only attainable by borrowers of
exceptional financial soundness. In some cases, individual debt securities
are rated separately. This is often the case where the borrower itself has
not been rated in the market where those securities are issued and placed.
The advantage for investors is obvious, as rating provides an easy reference
of the quality of a borrower and its debt. This reduces the information on
asymmetry between investors and financial agents.
Harmonizing the standards of prudential supervision
The harmonization of prudential standards has a dual purpose. In
domestic markets despecialization and increased competition among financial
18/ In most capital markets the offer for sale of eurobonds is treated de
jure as a private placement--i.e., as distinct from a public offering for
which disclosure rules are mandatory.
19/ Moody's and Standard and Poors are the two major US rating agencies.
Their techniques and credit criteria are broadly similar. Their ratings of
individual borrowers and their securities seldom differ from one another.



- 23 -
institutions has created a need ior a "level pLaying field", meaning that
equal regulation and supervision should apply Lo all institutions engaged in
similar activities, regardless of their nationality (e.g. branches of foreign
banks) or generic category (e.g. bank or security dealer). Thus, to harmonize
supervisory rules improves competition by making it more equal. However, much
remains to be done in this area. In many countries security dealers and
commercial banks are answerable to different agencies--for example, in the
United States, these are respectively the S.E.C. for investment banks, and the
Federal Reserve and the Comptroller of the Currency for commercial banks.
Prudencial standards often differ among these agencies, mostly to the banks'
disadvantage.20/
In the realm of international markets, the need for equal standards
stems from different circumstances. As discussed in the previous section, lax
supervision and regulation had been among the main attractions of the smaller
offshore financial centers. This became a source of concern tor bank
regulacors in the major markets: a weak link in the supervisory chain could
drive the banks' more risky ventures to branches or subsidiaries located at
the point of minimal control in such offshore centers and, thereby, endanger
the stability of the entire international banking system. Thus, more flexible
rules and uniform regulations in leading domestic financial centers, could
help recapture some of the business and that had migrated offshore.
Similar concerns led to the promulgation of laws permitting the
creation of International Banking Facilities (IBFs) in established financial
centers, such as New York and Tokyo. For domestic financial institutions, IBF
20/ For example, in the United States securities firms that offer banking
services such as money-market accounts have far less rigid capital and reserve
requirements than commercial banks.



- 24 -
subsidiaries offer the advantage of being offshore from a regulatory
perspective, thus segregated from the host domestic market.  In practical
terms this means that eurocurrency business can be transacted "on shore",
without the need for foreign subsidiaries. From the host countries' point of
view, IBFs offer the benefit of making eurocurrency business accessible to a
broader range of--mostly smaller and less diversified-- financial
institutions, which builds up the importance of the financial centers
concerned. For instance, in the United States the expectation that US based
lBFs would eventually reduce London's prominence as a eurobanking center was a
major consideration in promoting the needed legislation. In fact, the United
Kingdom was the precursor in this area. The legal separation of eurocurrency
business from domestic financial activities in the City (of London) amounts to
de jure IBFs, albeit without the name.



- 25 -
4.       RECENT CHANGES IN DOMESTIC AND INTERNATIONAL CAPITAL MARKETS
Financial deregulation and innovation of recent years have
revolutionized the financial services industry, led to an explosive growth in
the volume of purely financial transactions, and vastly increased the
efficiency of financial markets and their resransiveness to changes in
economic conditions.
The globalization of financial activities has become one of the most
visible resuits of these recenc changes. The elimination of most capital
controls has led to the emergence of a truly global capital market that
provides contirous, 24-hour trading, where activity shifts between financial
centers according to time zones. Other recent changes in the financial arena
have had equally important consequences. They include: (i) the blurring of
divisions betwen domestic and international markets; (ii) the increasing
sophistication of risk hedging; (iii) the securitization of debt; (iv) lower
costs for financial services; and (v) restructuring and concentration of
financial intermediaries.
The pace of change is uneven
The extent of regulatory changes and the pace of financial innovation
remain uneven among OECD countries. The United States and United Kingdom
already enjoyed the most flexible markets prior to 1980. They still remain in
the vanguard today. But, as already illustrated, Japan has also adopted major
reforms to liberalize its capital market. However, changes in that country
were not entirely voluntary: the deregulation of financial activities and
interest rates, the internationalization of the yen, and the more favorable
treatment for foreign financial institutions were only introduced in stages
after the Spring of 1984. These steps were the outcome of US pressures in the
the Yen-Dollar Working Group. Moreover, a number of regulations remain in



- 26 -
place in JapanL!/, and have yet to be eliminated. The more accomodating stance
of MOF--Japan's powerful Ministry of Finance--in recent years also reflects
Japan's new prominence as a leading financial power and world's largest
international creditor.22/
Paradoxically, if Japan were to maintain the present pace of
deregulation and allow interest rates to be fully market-determined, yield
spreads between yen and dollar assets would be likely to narrow. This would
put further downward pressure on the dollar, intensify the need for defensive
interest-rate incrfases in the United States, and could precipitate a domestic
recession in that country. The task of correcting payment imbalances among
the leading industrial countries would also become infinitely more complex.
By contrast, financial liberalization is still lagging and patchy in
the EC and in other European countries. Admittedly the Netherlands has
traditionally had an open capital market and the Dutch authorities' regulatory
stance has become even more flexible in recent years. Similarly, the German
authorities have made major strides and France has made considerable progress
in modernizing what used to be a relatively archaic banking and financial
system. But much progress is needed in other EC members. For example,
21/ Remaining barriers--and protections--between specialized financial
insLitutions (such as between banks and securities houses, and between trust
banks, regional banks, and mutual S&Ls--"sogo" banks) remain in place,
particularly as to how each category of banks can conduct its funding. The
Banker, January 1988, p. 49.
22/ Japanese financial institutions have become the most powerful players in
the euromarkets and are the major foreign presence in several domestic
markets. Through the combination of exchange-rate effects and of the
country's position as the main external creditor, Japan now counts seven among
the world's ten largest commercial banks. (The Banker, July 1987, p.91.) These
have completely displaced US money center banks from their former dominant
positions. In late 1986, Japanese banks held over $1 trillion in
international assets, or about one-third of the world total. At that time,
the sahre of US banks had dropped to only 20 percent of such assets. (World
Economic Survey 1987, United Nations, 1987, p.83.)



-27 -
Belgium still operaties a dual exchange-rate system and has burdensome
withholding taxes that discourage purchases of Belgian securities by
nonresidents. In the same vein, Italy has recently reintroduced capital
controls that curtail resident purchases of foreign securities. Taking the EC
as a whole, the full abolition of capital controls and financial deregulation
may continue to progress quite slowly until the introduction of the single
market for goods and services in 1992.
It is also noticeable that, despite attempts to reduce divisions
between offshore and domestic markets, the euromarkets have continued to
expand faster than their domestic counterparts. They remain the most
innovative and dynamic sector of the global capital market. Surprisingly too
the dollar is still a key lending and investment currency despite its
weakness.
The divisions between domestic and international markets are blurred
The progressive elimination of capital controls has made access to
domestic capital markets easier for major sovereign borrowers and nonresident
corporations. In the case of the US dollar, pound Sterling, Yen and Dutch.
guilder, a point has been reached where the traditional distinctions between
offshore and domestic markets--namely, the distinction between foreign bonds
and eurobonds--has been virtually eliminated. These developments also
stimulated cross-fertilization of instruments and techniques between these
markets and become the major channel for financial innovation.
Foreign bonds are bonds issued by non-residents. They often have
unusual names: Samurai bonds in Japan; Yankee bonds in the United States;
Bulldog issues in the United Kingdom. Although eurobonds are by far the
largest international bond market, the issue volume of foreign bonds has grown
substantially in recent years, from $21 billion in 1981 to $39 billion in



- 28 -
1986.231 The most active foreign bond markets are in the United States,
Germany, Switzerland and, most recently, Japan. Switzerland continues to
enjoy a special position in this market sector. Despite its very small
domestic capital market, it remains the most important primary market for new
issues of foreign bonds, as well as the largest market for the placement of
eurobonds and foreign bonds issued in other currencies.24- Corporate issues
are dominated by Japanese borrowers, for whom the SwF is a preferred
currency. The high volume of their borrowings in that currency has
contributed to its prominence in foreign bond issues. For its part, the World
Bank remains the largest single issuer of SwF foreign bonds.
Given that prime quality sovereign and corporate borrowers have
almost equal access to euromarkets and foreign issues, the decision to proceed
in either sector is usually governed by cost considerations, issue
formalities, or the wish to reach certain groups of investors. Total issue
costs--the sum of issue yield, commissions and other costs--can vary greatly
between euro and foreign markets. Whereas offering yields on eurobonds are
sometimes higher, due to the greater volatility of interest rates in that
market, fees and commissions for eurobonds are generally lower and more
competitive than for foreign issues.
23/ Over the same period, eurobond issues increased from $ 32 billion to $189
billion. World Financial Markets, Morgan Guaranty Trust, NYC, June 1984, p.13
and March 1988, p.20.
24/ Switzerland accounts for about 60 percent of all foreign bonds issued in
1986. (World Financial Markets, Morgan Guaranty, March 1988, p. 20.) The
country's unique position in international capital markets can be explained by
its strict banking secrecy law. This stands in contrast with the Swiss
authorities' strong opposition to the internationalization of the Swiss
franc. The latter accounts for the total absence of euro-Swf bond issues.
However, strict regulation of the underwriting syndicates, fee structures,
timing and amounts of foreign bonds denominated in Swiss francs have been
progressively relaxed in recent years.



- 29 -
Issue formalities in eurobond markets are not subject to domestic
regulations and, therefore, quite flexible. This stands in contrast with
practices in domestic markets. For example, in the United States the S.E.C.
imposes strict and complex registration and d'isclosure requirements for new
security offerings. These formalities can be time-consuming and costly for
infrequent borrowers.25/
Targeting specific investors is also important in determining the
choice of market given that ceratin capital controls persist. For example,
only three countries--the United States, Japan and the Netherlands--have their
currencies represented in both eurobonds and foreign bonds.26- Yet, the first
two still maintain restrictions on the placement with resident investors of
eurobonds in their respective currencies.27- Thus, if a borrower wants to
improve direct placement with domestic investors in these two countries
eurobonds are less effective, regardless of cost considerations.
Improved hedging techniques and risk management
Treasury operations have gained from new firnancial techniques.
Active asset and liability management through risk hedging (i.e. coverage) and
25/ For frequent borrowers, such as the World Bank, the S.E.C. has simplified
its procedures by introducing 'shelf registration'. This enables such
borrowers to file only one issue prospectus at the beginning of each year, to
cover all issues during that year. The main advantage of shelf registration
is that a new issue need not be held up by formalities. Thus the borrower can
take advantage of favorable market conditions ('windows'), when they arise.
26/ Like Switzerland, Germany still restricts the internationalization of its
currency and has, so far, prevented the issuing of euro-DM bonds. Both
countries also require that all public offerings of bonds in their markets--by
resident or foreign borrowers--be underwritten by a syndicate managed by a
major domestic bank.
27/ These are the so-called 'lock-up clauses' that prohibit the placement
with, and purchase by, domestic investors of newly issued eurodollar and
euroyen bonds. Originally these clauses banned resident purchases until 180
days, but have since been reduced to 90 days.



- 30 -
risk transformation are among the most significant recent innovations in this
field. Risk--of loss, or of opportunities foregone--is inherent in all
financial decisions. A hedge reduces that risk. In its simplest form, a
hedge offers protection against unforeseeable future events For instance, if
a foreign currency to be received in the future--for example as settlement of
a sale of goods and services--that currency can be sold in the forward market
before it is actually received. That will protect, or "cover", the creditor
against the risk of devaluation of that currency. However, as a trade-off for
that risk coverage, potential--speculative--gains arising form a subsequent
appreciation of that same currency are automatically foregone.
More complex hedges are designed to minimize downside risks without
foregoing opportunities of future gain. This explains why a good hedge--there
are no perfect hedges--has to: (i) share the financial characteristics of the
asset it protects; (ii) have a predictable price pattern that is the
reciprocal to that of the asset concerned; and (iii) involve a minimal cash
investment.
The ability to hedge certain financial risks has considerable
economic importance, particularly in highly inflationary or volatile
environments.  Hajor corporations and sovereign entities--including a number
of developing countries--can use hedging techniques to reduce the cost
volatility or exchange rate exposure on new and existing debt. In so doing
they can significantly improve their debt servicing capability. Similarly,
risk hedging in asset management can noticably improve the real return of
asset portfolios.
Hedging exchange and interest-rate risks mostly involves the use of
financial options and futures. Futures are distinct from cash markets. In
the latter, purchases and sales of securities or foreign currencies are



-31-
settled in full, at the time of exchange. In financial futures, contract
sizes and settlement dates are standardized, and purchasers only make small
margin deposits, depending on variations in the price of the contract over
time. In other words, a small cash investment can be highly leveraged.
Financial options are different from cash or futures markets. They involve a
contract between two parties (the seller, or 'writer', and buyer) that gives
the right, but not the obligation, to either sell (put) or buy (call) a
foreign currency or interest-rate instrument. The underlying financial
instrument, however, is seldom delivered.
The theory of options and futures is extremely complex.281 Put
simply, they can be used in their own right as speculative instruments and are
traded as such. They can also serve as financial hedges for cash
transactions: a cash purchase can be hedged by the sale of an option or
future: a potential loss arising from decline in the value of the underlying
cash instrument will be partly compensated by the profit on the option or
future--in that case covering the delivery at the (high) option or future
price, by covering it with a purchase at the prevailing (lower) market
price. The reverse is also true. For example, the disposal of a cash asset
may be needed to generate liquid funds. If the value of that asset is
expected to continue to appreciate after its sale, an option or future can be
bought to capture that potential gain.
Not all applications of futures to hedging have been successful
however. A good example is the use of futures in stock markets. This
technique, which became known as portfolio insurance, involves the use of
stock and stock index futures to hedge cash investments in equities.
28/ For a detailed study of the instruments described in this section, see
nRecent innovations in International Banking", BIS, Basel, April 1986.



- 32 -
Portfolio insurance singularly failed in its objective during the crisis in
stock markets in October 1987. As cash prices started to plummet, the massive
unwinding of futures made those prices tumble and spill over into the cash
markets. In combination with program trading, the compounding effect of
collapsing stock futures precipitated the market meltdown.
Risk transformation, which is also a form of hedging, is achieved
through swaps. Swaps are transactions in which two parties exchange their
respective interest payments on fixed- and floating-rate debt , or exchange
their respective debt service obligations on debts denominated in different
currencies. In other words, swaps enable debtors to change the currency of
indebtedness (foreign exchange swaps) or its interest profile--for example
from fixed to variable, or vice versa (interest-rate swaps). In just a few
years, swaps have grown into a multi-billion market in which commercial banks
have become the main intermediaries, but also guaranteed one of the parties to
the swap agreement.291 The World Bank has pioneered long-term currency swaps
as part of its treasury operations and annual borrowing programs and is a
major factor in that growing market. The World Bank also provides technical
advice on liability management and swap techniques to developing countries.
Securitization and disintermediation
Securitization had become a dominant feature of international
lending. Many forms of credit are now represented by negotiable securities
29/ Any swap involves a 'performance risk'--that one of the parties to the
agreement will not perform its obligations. Given the difficulties of
arranging swaps between mutually acceptable counterparties, the intermediary
banks often guarantee the performance of the lesser-rated party.



- 33 -
that are underwritten, rather than funded, by a financial agent.30/
Securitizacion is mos#tly the domain of highly-rated corporate and sovereign
borrowers, for *whom direct access to money and capital markets, through the
issuance of negotiable instruments--commercial paper or bonds--is usually less
costly and more flexible than bank loans. It also affects traditional
markets, such as housing mortgages: mortgage-backed securities are now
commonplace in the United States, the United Kingdom and other countries.
Securitization has reduced the traditional function of commercial
banks, as intermediaries in the saving-investment cycle. In other words, as
investor funds are channelled to the borrowers directly, rather than via bank
depoRits, the banks are "disintermediated". The prenounced shifts in the
respective volumes of international syndicated credits and bond issues in
recent years illustrates this trend: in 1981, total eurocurrency credits
amounted to $133 billion, and international (foreign and euro) bond issues $53
billion; in 1986, these totals were respectively $93 billion and $228 billion.
Securitization has also affected commercial banks in other ways.
First, much of their quality business was lost to the securities markets. The
risk element of their loan portfolios has increased as a result, as they now
comprise a large proportion of marginal credits. This is particularly true
for many US money-center banks. In the 1960s and 70s their business
strategies emphasized asset growth and international lendir.g to sovereign
borrowers (many of them developing countries) and multinational
corporations. In recent years the best multinational and sovereign credits
30/ Note that this trend was partly reversed in 1987: the total volume of
bond issues declined for the first time since 1982, falling to $177 billion,
while the volume of eurocurrency credits increased to $123 billion. (Morgan
Guaranty, June 1984, pp. 13-15, January 1988, p. 20.)



- 34 -
have flocked to the capital markets; the marginal and bad credits remain in
the banks' loan portf6lios.Ži'
A second consequence is that, to make up for lost income, many banks
have started to compete head-on with securities firms through new forms of
short-term or revolving securitized credits, such as Note Issuance Facilities
(NIFs) and Revolving Underwriting Facilities (RUFs). Put simply, NIFs and
RUFs involve issues of bearer securities that are backed up by underwriting
commitments from commercial banks. Thus, if the primary market for that paper
dries up, the bank is committed to provide a credit in an amount equal to that
of the intended issue.
The main problem is that lack of experience in risk evaluation and
excessive competition in this business have, in many instances, led to
unrealistically low commitment fees that do not fully reflect the contingent
risk of having to provide large credit facilities. Indeed, by definition, the
banks' underwriting commitments can only be called on if the issuer no longer
enjoys market access, in other words, in periods when liquidity is scarce and
could also affect the banks themselves.
Finally, for longer maturities, the temporary dominance of floating-
rate notes (FRNs) in the international bond markets--from 1981 to 1985, the
share of FRNs in total international credits grew from 5.5 to 24 percent32/--
has involved commercial banks in the international securities markets, as
issuers and investors. Several banks incurred substantial losses on their
31/ However, in countries such as the Netherlands and Germany, where
universal banks already dominated the securities markets as underwriters, the
impact of disintermediation has been diluted: the shift to securitization
simply meant that a greater share of these banks' profits was generated by
underwriting, wit4out affecting total earnings.
32/ Over the same period, the share of syndicated eurocurrency bank loans
declined from 68 percent to 9 percent. (BIS, April 1986, p. 130.)



- 35 -
large inventories of FRNs, when that market literally collapsed in late
1986.
The risks inherent in securitization are not one-sided, however, and
can also affect borrowers. Securitization and the globalization of the
financial market have increased the mobility of financial assets, and
introduced a direct link between interest rates and foreign exchange rates, as
institutional investors are able to arbitrage large blocks asset between
various currencies. Massive shifts in asset preferences can rapidly spread
across markets. For instance, in late 1987, the weakness of the dollar
depressed the price of eurodollar bonds--the market for which is now
practically non-existent--and pushed long-term dollar interest rates higher.
For major borrowers that have come to rely heavily on securitized debt, this
can endanger the refinancing of maturing debt in the preferred currency or
maturity. Similarly, after the FRN market collapsed in 1986, several banks
had to postpone indefinitely planned issues of long-term FRNs that were
intended to increase their base capital.J"
Securitization has also had other implications that transcend the
narrow confines of capital markets. First, given that securitization embraces
the entire maturity range, from short term (commercial paper) to long term
(bonds), the traditional divisions between money and capital markets have been
eroded. As is pointed out below, this has profound implications for the
conduct of monetary policy. A second case is the widespread use of "junk
bonds" in the United States to finance a large number of leveraged buyouts.
In many instances these buyouts--by so-called corporate raiders--were followed
33/ Issues of long-term FRNs, with maturities of 30 years or longer could, in
some cases, be treated as capital stock by commercial banks. As a result that
practice became widespread, especially in the United Kingdom.



- 36 -
by the break up of the corporations that had been purchased, to repay the debt
that had been accumulated to finance the purchase. Rather than improving US
competitiveness, these buyouts have mostly created a more precarious corporate
environment and caused instaoility of employment.
Intensified competition and lower costs of financial intermediation
The breadth of recent changes has intensified competition between
commercial banks and securities firms. This has had visible benefits. The
costs of financial intermediation, and transaction costs generally, have
fallen significantly. In several markets, cost reductions hove been
formalized by the abolition of minimum brokerage fees and inderwriting
commissions: they were abolished in 1975 in New York, and in 1986 in
London.341 In the United States, this led to the eFtablishment of "discount
brokers". In other major capital markets, such as Switzerland and Japan,
underwriting commissions for bond issues were reduced by respectively one
eighth and one quarter percent in 1986, thereby reducing the total cost of
launching bond issues in those markets.
Lower issuing costs obviously have stimulated securitization and
increased the supply of tradeable securities. At the same time, lower
transacLton costs in secondary markets have improved the fluidity and
liquidity of financial assets. This has, among others, influenced investment
strategies by shortening their time horizon. For example, even traditionally
conservative institutional investors now tend to turn over their asset
34/ One of the main purposes of London's 'Big Bang' of October 1986 was the
abolition of standard fees for financial services. Of course, improved
communication and data processing techniques were instrumental in reducing
transaction costs and operating expenses. This too made lower intermediation
fees possible.



- 37 -
portf'lios rapidly and often trade, rather than hold, long-term investments,
to take advantage of short-term gains.
Unfortunately, intensified competition among financial agents has
also had less desirable effects. Active trading of long-term assets can
intensify their price volatility. Secondly, the combination of lower
commissions and extremely generous remuneration packages for financial
professionals has created a need for large transactions and high turnover, to
ensure profitability. In extreme cases, this has led brokers and professional
asset managers now to resort to "portfolio churning"--i.e. generating forced
turnover, regardless of underlying price trends--to generate fee income and
commissions, and justify their high incomes.
Concentration and restructuring in financial markets
In financial markets, as in most other industries, deregulation and
greater competition have triggered a pattern of successive, but contradictory
trends. In a first stage more flexible market rules attract new participants
and lead to product diversification. But as competition intensifies, margin
cutting and increased risk taking eliminate marginal players. A phase of
concentration and restructuring usually follows as the more marginal firms are
either taken over, or cease their activities.
This trend has been most pronounced in anglo-saxon countries, where
financial deregulation is more advanced. For example, in Canada and the
United Kingdom, where there is no legal division between commercial banking
and underwriting, past restrictions on the ownership or control of securities
firms have been lifted or relaxed, often with the explicit purpose of
strengthening their capital base. A case in point is the change of the
province of Ontario Securities Law in 1987. Large Canadian brokerge firms



- 38 -
have now gained from takeovers by Canadian banks and from large injections
of equity capital by new US shareholders.
The 'City' in London provides an interesting example of the cycle of
expansion-restructuring in the financial services industry. In preparation
for Big Bang, UK clearing banks and several major foreign banks strengthened
their market positions by absorbing a number of merchant banks and members of
the London Stock Exchange. During the same period, UK and foreign banks, and
securities houses began to extend the range of their activities in euromarkets
and domestic trading. New markets for Euro Commercial Paper (ECP) and
Euroequities were growing rapidly. They attracted new underwriters,35/ market
makers and traders. In the domestic arena, primary dealing in gilts was
opened to several new British and foreign houses. Since the stockmarket crash
of October 1987 the City has moved into a consolidation phase that has partly
reversed the previous expansion. The UK clearers and many merchant banks are
now retrenching: a number of them have pulled out of eurobond underwriting,
equity trading and gilts. Leading US securities firms like Salomon Bros.,
Shearson Lehman and Coleman Sachs are also scaling down their activities and
shedding staff in the City. Several US and other foreign banks have followed
suit, and are closing their London offices.
In the United States the banking industry is also undergoing profound
changes following the relaxatio- f barriers on interstate retail banking. As
a result, the balance of power is shifting from the money-center banks to
smaller and less well-known regional banks.
35/ Although the Glass-Steagall Act bars US commercial banks from securities
underwriting in the United States, their foreigs subsidiaries are not bound by
these restrictions, unless similar rules exist in the host country. Their
London subsidiaries are major factors in underwriting and managing eurobond
issues, as well as ECB and Euroequities.



- 39 -
Money-center banks, most of which are located in New York City, have
traditionally dominated US banking. As noted earlier, during the 1970s they
focused on asset growth, rather than profitability. Global lending to
prestige clients, such as MNCs and developing countries were their prime
targets, and innovation and large international branch networks became their
hallmarks. Yet, in the US domestic market, deposit taking and retail businesq
were severely circumscribed by the McFadden Act of 1927.36/ Until 1985, when
the Supreme Court abolished all federal restrictions on interstate retail
banking, banks were not permitted to have out-of-state branches or to conduct
out of state retail banking, such as deposit taking and consumer credit. To
fund their expanding loan portfolios the largest banks therefore had to rely
on costly interbank funds from the domestic and eurocurrency markets--hence
their name 'money-center banks'. Moreover, the elimination of interest-rate
controls, the introduction of new types of interest-bearing checking accounts,
and direct competition from nonbank checkable accounts, such as money market
accounts, had increased the cost of domestic retail deposits and brought the
banks' direct funding costs in line with money-market interest rates.
36/ The McFadden Act that prevented inter-state banking accounts for the
uniquely fragmented structure of US banking, with close to 14,000 individual
banks. To add to the banks' difficulties, state laws compounded the effects
of the &ct by restricting intra-state retail banking. California was the only
exception, and allowed state-wide multi-branch retail banking. In most other
states local laws restricted retail banking to the point of often allowing
only one office per bank. Following the Supreme Court ruling of 1985, state
legislatures, not the federal government, can determine the criteria for
accepting out-of-state banks. The scene is changing rapidly, as many states
are introducing more flexible rules. Only six states still bar all interstate
banking. Others have established reciprocal rules to accept banks from other
states. only if those states reciprocate privileges for their own banks.
Others still have abolished all restrictions or have also passed laws that
will relax rules after specific dates. (For a more detailed discussion. (The
Economist, 3/26/88; International Banking Survey, pp.21-22.)



- 40 -
By contrast, the smaller regional banks had generally followed more
cautious strategies. Their exposure to LDCs remained small. Their corporate
client base mostly comprised medium-size regional companies. Finally they
benefited from more stable local retail deposits that were less subject to
competition from money-market funds.
The diverging strategies of these two groups of banks are now
highlighting the contrasts between their respective fortunes. Several money-
center banks are entering a phase of declining profits and growth, and facing
an uncertain future. Despite their considerably larger assets and remaining
strenghts, they continue to suffer large losses on their portfolios of non-
performing domestic loans--for instance, farm loans and enargy loans--and are
caught up in debt reschedulings and write-offs of problem loans to LDCs.
Their growth and profit prospects have also been affected by securitization
and by the dramatic reversal of the US position, from creditor nation, to the
world's largets net external debtor. In parallel with this shift, net foreign
lending by US commercial banks declined from $111 billion in 1982 to $1
billion in 1985.J1! Finally, impending changes in the treatment of loan loss
provisions on LDC debt could make it increasingly difficult for many major
banks to comply with the Fed's guidelines on minimum equity capital.381 The
declining fortunes of the Bank of America, long the world largest commercial
bank, provide an extreme example of this situation. Share prices and market
37/ United Nations, op. cit, p. 77. To cite another example, Japanese
insurance companies, now the largest foreign holders of US Treasury debt,
conduct their business through Japanese securities houses, whose New York
subsidiaries have been admitted as primary dealers for Treasury securities.
38/  Under current rules, loan loss provisions--essentially the transfer of
retained earnings or of capital funds into a special provision account--can be
treated as base capital until they are used to write off provisionned loans.
From 1992 onwards, these provisions will no longer be counted as base capital,
but will have be treated separately.



- 41 -
capitalization reflect the compa-sPtive weakness of most money-center banks,
and have plummetted to all-time lows. Even a high performer like J P Morgan
has lost its AAA rating.39/
By contrast, the regional banks are building up strength and
profitability. The US Supreme Court ruling on the McFadden Act was a turning
point. Some of the most dynamic regional banks in New England and in Southern
and Western states were able to merge across state borders, to form powerful
"super regionals".40/  Although the asset portfolios of the super regionals
are still smaller than those of the money-center banks, they are sounder. As
a consequence, their shares perform well in stock markets, to the point that
the market capitalization of a number of regionals now exceeds that of many
large New York banks.41/
If the present trend continues, significant concentration is likely
to take place in the US banking industry. Indeed, current problems may lead
New York banks such as Chemical, Manufacturers Hannover Trust or Chase
Manhattan to seek mergers, possibly among themselves. But the growing market
clout of super regionals could make some of them to bid for prestige New York
names. A precedent, though not a successful one, was set by a regional bank
bid for the Batik of America in 1987.
39/ There now isn't a single AAA-rated commercial bank in the United States.
40/ In fact, the Supreme Court ruling on the McFadden Act was triggered by
Citicorp's challenge of a proposed merger between two New England banks. (The
Economist, ibid.)
4d/ The New York Times, 4/1O/88, Section 3, pp. 1-6.
Admittedly, not all regional banks have fared that wsell, as shown by the
acute crisis of large regional banks in Texas.



- 42 -
The global capital market
Continued improvements in communication and computing technology have
also left their mark on financial markets. A stage has been reached where
there is constant feed back between technological progress and innovation, and
the pressure for further deregulation. On the one hand, technological
breakthroughs improve the fluidity of financial markets and the international
mobility of capital flows. On the other hand, the pressures of competition
and the constant mutations of the financial services industry lead to further
progress in financial applications of computer technology and programming.
For example, bond and foreign exchange trading have benefited from
the fact that banks and brokers can constantly monitor their positions and
risk exposures on a global basis. Similarly, futures and options trading, and
derived hedging techniques that require complex calculations and instant
decisions in highly volatile markets could not have been fully developed
without sophisticated computer programs. Yet another example is "program
trading", where computers activate cash or futures sales and purchases
automatically by reacting to pre-programmed price thresholds.421
The combination of enhanced technology with the various other changes
described above has brought about the creation of a multi-center global
financial market. This market rests on three key centers--New York, London
and Tokyo--whose trading hours and time zones overlap sufficiently to permit
activity to remain continuous by shifting between these centers according to
time zones. Major financial institutions whose office networks span the
42/ Computer-activated program trading played a major role in the stock-
market crash of October 1987. Paradoxically, far from abating after the
October crash, program trading continues, has become more aggressive and is
making the US stock market more volatile than ever. (The New York Times,
5/1/88, Section 3, p. 1)



- 43 -
principal--and subsidiary--centers in this global market can now trade their
portfolios around the clock: as one center closes, their entire trading
position is passed on to another location through computer links. Similarly,
institutional investors can trade their asset portfolios on a continuous basis
by moving the execution of sales and purchases according to time zones.
24-hour trading undeniably improves the liquidity of financial
assets, thus the efficiency of markets. But it can also increase the
amplitude of price volatility. If trading is interrupted by discreet time
limits--for example, trading on the New York Stock Exchange comes to a halt at
4 p.m.- price movements cannot continue after closing. However, if trading in
the same asset can be moved to another location, a price trend that was
started in a given market--say Tokyo--can continue in the next time zones
--London or New York. This, together with the high degree of
interchangeability of financial assets, regardless of currency of
denomination, undoubtedly played a major role in prompting the worldwide
collapse of share prices in October 1987.



- 44 -
5.  THE BROADER ECONOMIC IMPACT OF CHANGES IN THE WORLD'S CAPITAL MARKETS
The impact of financial deregulation is now so far-reaching that it
raises broader macroeconomic issues. Areas of concern include: (i) the
delinking of financial activities from the rest of the economy; (ii) the risk
of reacting to 'false' signals; (iii) the impact of securitization on the
conduct of monetary policy; (iv) limitations in the conduct of prudential
control; and (v) inducements to fiscal laxity.
The delinking of financial markets from the real sectors of the economy
A first cause for concern is that the rapid pace of change in capital
markets has created a visible gap between these and other factor markets,
where the pace of adjustment and reform has been much slower. International
financial integration in general, and financial innovation in particular, have
outpaced structural changes and reforms in the rest of the economy. Compared
with the slower-moving factor markets, capital markets can react almost
instantly, on a global scale to constantly changing economic signals and
information.
A point has been reached where financial activities are virtually
delinked from the "real" sector. Examples of this trend abound. For
instance, the volume of purely financial transactions now vastly exceeds those
driven by international trade in goods in services.431 In other words, an
increasing share of trading in financial products takes place exclusively
between financial institutions and is driven by speculation and short-term
profit objectives, rather than by broader economic activities. Among other
43/ In 1986, the average daily transaction volume on trade in gocds and
services was around $5.5 billion. By comparison, dollar transactions driven
by financial trading reached $200 billion per day. In 1979, the respective
figures were £5 billion and $75 billion (see: United Nations, op. cit., p.
47).



- 45 -
examples of delinking, until the stock market crash of October 1987, the
profitability of specialized financial institutions, such as investment banks,
outpaced that of industry and commerce, and the cumulative gains in share
prices exceeded those of any other financial or economic indicator. For
instance, between 1982 and 1986 the cumulative real GDP growth in OECD
countries was 13 percent. By comparison the world index of financial market
growth increased by 130 percent over the same period.44/
Although delinking and asymmetry in the rates of growth of financial
services and of other sectors of the economy are not bad per se, they are a
source of tensions. For example, the fact that financial decisions are often
divorced from underlying dievelopments in the real economy raises the level of
economic uncertainty. The stockmarket crash of 1987 shows that such risks
cannot be underestimated: on October 19 the band-wagon effect of simultaneous
action by major institutional investors and feedback between the cash and
futures markets precipitated the market collapse and rekindled fears of an
imminent global recession.
Admittedly, the continued momentum of growth in industriaL countries,
and the limited impact of negative wealth effects--following the fall of share
prices--have shown that those recessionary 5ears were largely exagerated at
the time.45/ However, the point remains valid that there is a need to
44/ Bernard Snoy: Le decouplage entre la finance et l'economie et la crise
financiere d'Octobre 1987; Processed, IEC, Brussels.
While this disparity in price performances is not unique--it is a common
feature of past "bull markets"--it had become more pronounced then in the
past.
45/  The IMF has substantially revised its of real GNP growth in industrial
countries. In October 1987, these were estimated at 2.4% for 1987, and 2.6%
for 1988. (World Economic Outlook, IMF, October 1987, Table A2, p. 40.) In
April 1988, these estimates were revised to respectively 3.1% and 2.8%.
(World Economic Outlook, April 1988, Table A2, p. 112.)



- 46 -
complement financial deregulation with accelerated reform in the real sectors
of the economy to reduce tensions that arise from the slower pace of
adjustment in the latter sectors.46/
RespODses to false signals and economic instability
The huge daily flow of information that influences financial
decisions adds to the potential for broader economic destabilization. Among
that wealth of data it is often difficult to discern signals that denote
changes in economic fundamentals from those that do not. Thus, financial
markets are constantly exposed to the danger of precipitating chain reactions
to "false" signals or to surrogate key indices--such as US monthly trade
figures--that have acquired a major importance, yet are often inaccurate.
More generally, the financial markets' ability to respond and adjust
to constantly changing data induces interest-rate volatility. It also
contributes to misalignment of exchange rates to the extent exchange-rate
determination is incerasingly the outcome of financial agents' responses to
spurious signals. This poses the danger that attempts to correct market-
induced exchange-rate misalignments through official intervention become an
overriding priority that constrains other objectives of monetary policy.
Greater difficulty in the conduct of monetary policy
Short-term financial assets, such as shares in money-market funds,
are now widely held by households. High liquidity--money market funds are
instantly cashable--low risk profile and minimal transaction costs give these
assets many of the characteristics of morey, as reserves of purchasing power.
This has made the demand for money unpredictable and lowered the velocity of
circulation of money. The scope for monetary targeting is thereby diluted and
46/ World Economic Outlook, IMF, April 1978, p.6.



- 47 -
the effectiveness of monetary tightening is reduced, relative to the role of
financial prices, such as interest rates and exchange rates.471 In
combination with currency misalignments, this means that exchange rates are
gaining in importance as a channel for the conduct of monetary policy.
Less evident consequences for the conduct of monetary policy flow
from the securitization of lending. The widespread use of short-term
securities has eroded the respective functions of money markets as conduits
for the investment of cash balances, and of capital markets as the principal
link between savings and investments.48/ Secondly, the instant marketability
of securitized loan assets enables banks to mobilize their loan portfolios if
needed, thus to circumvent possible credit controls by creating room for new
credits.
The limits of prudential control
The combination of lower commercial banks profits with the effects of
disintermediation and securitization is also worrisome and raises issues of
prudential control. Bank asset portfolios now show a large concentration of
lesser quality credits, while the contingent liabilities they have assumed in
garanteeing swaps and as part of new techniques such as RUFs and NIFs led them
to take on considerable financial risks. These risks may have outstripped the
capacity of established mechanisms for prudential control, as shown by
increassing difficulties in the implementation of prudential rules by bank
regulators and supervisory agencies. This emphasizes the need for further
strengthening of the banks' capital ratios and for the harmonization of
capital-adequacy guidelines across markets.
47/ BIS, April 1986, p. 4.
48/ BI8, March 1987, p. 131.



- 48 -
Other areas of concern in the realm of prudential standards include
the activities of 'non-bank banks', and the risk 'f infection in financial
markets. Non-bank banks are specific to the US market. These affiliates qf
non financial conglomerates can conduct financial and banking activities
without a banking charter. While this puts commercial banks at an obvious
competitive disadvantage, it also leaves a major gap in the regulatory
framework.49/
The risk of financial "infection" results from the fact that, as
financial institutions diversify the scope of their activities, problems in
one field--for example, bond underwriting--can erode confidence in the other
activities of a given institution--such as deposit taking and general
solvency. At the limit this can precipitate confidence crises. The problem
is that, these various activities mostly fall under the supervision of
different regulatory bodies. Danger signals in one area are therefore likely
to escape the attention of an agency that is only mandated to supervise other
activities.
Finally, the explosion in the volume securities trading and in the
pace of corporate mergers and takeovers--itself a product of securitization--
has, in a number of cases, been accompanied by a breakdown of market ethics.
Although recent instances of insider trading are well publicized, the point is
that the task of monitoring and implementing standards of ethical market
behavior has become considerably more complex than in the past.
Financial deregulation and fiscal laxity
As noted in section 3, in the early 1980s the need to accommodate:
large amounts of government debt financing, and the shift to an expansionary
49/ BIS, March 1987, p. xvi.



- 49 -
fiscal policy by the US government were among the catalysts for financial
innovation and deregulation. Cause has now become effect: the markets'
ability to absorb unprecedented amounts of debt instruments, such as US
Treasury notes and bonds, has induced fiscal laxity and permitted the United
States to build up its external deficits and indebtedness to unsutainable
levels.
The main potential hazard of this situation lies in the unprecedented
concentration of external liabilities of the US government in the portfolios
of the largest Japanese life insurance companies. As discussed earlier, even
traditionally conservative institutional investors have shifted to much
shorter time horizons in their investment strategies. They are much more
likely to trade long-term investments actively and to make major asset shifts
--for instance, from shares to debt securities, or vice-versa, and between
assets in various currencies--in response to price movements.
So far, Japan's MOF has cautioned these investors to exercise
restraint in shifting cut of US dollar assets, in response to the devaluation
of the dollar. But, once instutional investors in Japan and other countries
perceive that excessive currency risks can no longer justify holding large
amounts of dollar assets, the consequences for the US bond market and for the
value of the dollar would be serious.
Has deregulation gone too far?
This paper has argued that the rapid pace of financial liberalization
during recent years has brought substantial efficiency gains. Financial
markets in general have also displayed a considerable resilience to withstand
shocks. That strength may, in fact, be attributable to recent reforms. For
example, the restructuring of securities firms in London, prior to Big Bang



- 50 -
increased their capital backing and ability to absorb trading losses.50/
Similarly, a number of Self Regulating Organizations (SROs) have been set up
in the City, to cover the various aspects of the financial services industry
and a Securities Investment Board (SIB)--analogous to the US S.E.C.--was
created to coordinate the various SROs.51/
These are all positive and encouraging developments. However, there
is also cause to argue that asymmetry in the degree of reform of real and
financial markets, and the progressive delinking between these two sectors,
have become a major source of excessive tensions and economic instablity.
This raises the question whether financial liberalization has gone too far.
The answer to this question is far from clear cut. On the one hand,
progress achieved through financial liberalization points to the need to
accelerate reform in the slower-moving factor markets, so as to replicate
these benefits. Moreover, if progress can be made in that area, the present
asymmetries and tensions will be reduced over time. On the other hand,
certain aspects of recent financial reforms have given rise to specific
problems that need attention--and intervention--regardless of future
improvements in the functioning of the 'real' economy. The areas concerned
include (i) the need for a single agency to coordinate supervision of related
activities, to minimize the risk of compounded market failures; (ii) the need
for further strengthening of the capital base of banks and securities firms;
(iii) a full asessment of the risks resulting from securitization and other
off-balance sheet items; (iv) the need to lessen systemic risks.
50/ N. Goodison, Chairman of the London Stock exchnage, in: The Financial
Times, 1/20/1988.
51/ BIS, March 1987, p. 198.



- 51 -
The need for a single regulatory agency was stressed by the Brady
Commission after the October crash.
"From an economic viewpoint, what have tradtionally been seen as
separate markets...are in fact one market. Under ordinary
circumstances, these marketplaces move sympathetically, linked by
financial instruments, trading strategies, market participants and
clearing and credit mechanisms.
To a large extent, the problems of mid-October (1987) can be traced
to the failure of these market segments to act as one...
Because stocksp futures and options constitute one market, there must
be in place a regulatory structure designed to be consistent with
this economi. reality.
The single agency required to coordinate cross-market issues murst
have broad and deep expertise in the interactioon of the stock, stock
option and stock index futures marketplaces, as well as in all
financial markets, domestic and global. It must have broad expertise
in the financial system as a whole." 52/
The need for improved capitalization of financial agents is another
key issue. Successful steps have already been taken to strengthen securities
firms in England. Progess is also being made in Canada, France, Italy and
Spain.53/ But the need for improvement remains acute in the United States,
where many large banks are undercapitalized in relation to their outstanding
52/ Report of the Presidential Task Force on Market Mechanisms, Washington
D.C., January 1988, Executive Summary.
53/  OECD, Committee on Financial Markets, CM(88)5, '11188, p.8.



- 52 -
exposure on LDC loans and need for further provisioning. Measures are being
drafted accordingly by the Fed and will be implemented in stages, by 1992.54j
The question of coverage of contingent off-balance sheet risks in
commercial banks is more complex. Banks have taken on underwriting risks for
the refinancing of securitized loan facilities, such as RUFs and NIFs,55/ and
have guaranteed performance risks in a large volume of interest-rate and
currency swaps. In several instances risk premiums to cover the banks'
underlying commitments are insufficient to compensate them for potential
contingent losses.561 Thus there is now a substantial financial risk that
could erode the banks' future solvency. To remedy this situation will require
that central banks attempt to evaluate the risks involved, determine
appropriate reserves and capital ratios for these risks, and, in the extreme
case, limit the banks' freedom to undertake such contingent risks beyond
appropriate limits.
Finally, there is the broader question of systemic risk. Again this
goes back to the October 1987 stock market crash. As pointed out in the
Brady-Commission report: "the massive volume, violent price volatility, and
staggering demands on clearing and credit raised the possibility of a full
scale financial system breakdown".57- While the unification of regulatory
54/ The New York Times, 2/1/88, pp. Al and D8.
55/ The volume of NIFs has reached staggering proportions. During the four
years from 1884 to 1987, their total was of $104.7 billion. OECD, op. cit.,
Table A, p.9.
56/ OECD, op. cit., p.8 and BIS, April 1986, p.190.
57/ Brady commission, op.cit., January 1988, p.69.



- 53 -
standards, as discussed above, may be a satisfactory remedy581, it fails to
address to broader question of whether the degree of securitization may have
reached a level that is incompatible with the paramount needs of financial and
economic stability. Suffice it say that current proposals to repeal the
Glass-Steagal Act, and ensuing freedom for US banks to cover all aspects of
the securities indiustry, should be interpreted with a note of caution, as they
may increase these systemic risks. As put eloquently by a recent commentator
on the proposal:
"The fact is that if the firewalls between banking and other pro-duct
lines are whittled away, the consumers' peace of mind in terms  f
their accounts is at risk..."'591
58/ OECD, op.cit. p.9.
59/ Paul Equale, VP for government affairs, Independent Insurance Agents of
America. The New York Times, 1/3/1988, p.El.



PPR Working Paper Series
Title                              Author                    Date             Contact
WPS0   Cote d'lvolre's Vocational and
Technical Education                         Christlaan Grootaert    June 1988           R. Vartanlan
34678
WPS20   Imports and Growth in Africa                Ramon Lopez               June 1988          61679
Vinod Thomas
WPS21   Effects of European VERs on Japanese
Autos                                       Jaime de Melo            June 1988          S. Fallon
Patrick Messerlin                           61680
PS22   Methodological Problems in Cross-
Country Analyses of Economic Growth         Jean-Paul Azam           June 1988          E. Zamora
Patrick Guillaumont                          33706
Sylviane Guillaumont
WPS23   Cost-Effective Integration of
Immunization and Basic Health Services
in Developing Countries: The Problem
of Joint Costs                              A. Mead Over, Jr.        July 1988          N. Jose
33688
WPS24   World Bank Investments in Vocational
Education and Training                      John Middleton           July 1988          W. Ketema
Terri Demsky                                33651
WPS25   A Comparison of Alternative Training
Modes for Youth in Israel: Results
from Longitudinal Data                     Adrian Ziderman           July 1988          W. Ketema
33651
WPS26   Changing Patterns in Vocational
Education                                   John Middleton           July 1988          W. Ketema
33651
WPS27   Family Background and Student
Achievement                                Marlaine E. Lockheed    July 1988            R. Rinaldi
Bruce Fuller                                33278
Ronald Nyirongo
WPS28   Temporary Windfalls and Compensation
Arrangements                               Bela Balassa              June 1988          N. Campbell
33769
WPS29   The Relative Effectiveness of
Single-Sex and Coeducational Schools
in Thailand                                Emmanuel Jimenez
Marlaine E. Lockheed



PPR Working Paper Series
Title                              Author                   Oate              Contact
WPS30   The Adding Up Problem                       Bela Balassa
WPS31   Public Finance and Economic Development  Bela Balassa
WPS32   Municipal Development Funds and
Intermediaries                             Kenneth Davey             July 1988          R. Blade-Charest
33754
WPS33   Fiscal Policy in Commodity-
Exporting LDCs                             John Cuddington           July 1988          R. Blade-Charest
33754
WPS34   Fiscal l$sues in Macroeconomic
Stabilization                              Lance Taylor
WPS35   Improving the Allocation and Manage-
ment of Public Spending: Some
Lessons of African Experience              Stephen Lister
WPS36   Means and Implications of Social
Security Finance In Developing
Countries                                  Douglas J. Puffert
WPS37   Black Market Premia, Exchange Rate
Unification and Inflation in
Sub-Saharan Africa                         Brian Pinto               July 1988          R. Blade-Charest
33754
WPS38   Intergovernmental Grants in
Developing Countries                       Larry Schroeder
WPS39   Fiscal Policy in Low-Income Africa          Stephen A. O'Connell    July 1988            R. Blade-Charest
33754
WPS40   Financial Deregulation and the
Globalization of Capital Markets           Eugene L. Versluysen    August 1988          R. Blade-Charest
33754
WPS41   Urban Property Tax Reform in
Developing Countries                       William Dillinger
WPS42   Government Pay and Employment Policies
and Government Performance in
Developing Economies                       David L. Lindauer         August 1988        R. Blade-Charest
33754