18

TABLE 3

DEBT IN BILLIONS OF DOLLARS
(Estimates in September 1983)

NATION DEBT
Brazil $92
Mexico $87
Argentina $37
Venezuela $35
Poland $27
Yugoslavia $19
Chile $18
Nigeria $14
Peru $12
Romania $10

SOURCE: "The International Debt Crisis: The
Major Third World Trouble Spots," The Washington
Post, September 25, 1983, p. HI.

Beenstock's secular explanation for the build-up of LDC debt is
intriguing, but it poses its own set of puzzles. Is it believable that
differentials in the interest rates that could be contracted on loans
in the center and the periphery were grounded in differences in the real
return on capital? Even if Brazil is destined to be where the U.S.A. is
today by the year 2010, does it mean that the typical loan received will
be utilized to generate earnings sufficient to pay the lender the pros-
pective real return?

Kindleberger, for one, has a far less felicitous view of the uses of

funds by LDC borrowers, contending that the historical record reveals that


39

this case, bullishness and bearishness will depend upon the various specu-
lative strategies pursued by stock exchange participants.

Regardless of which theory of stock exchange pricing one adopts it
appears that the cumulative effect of the LDC loans in the 1970s benefitted
bank stock. The cumulative effect of LDC loans in the 1980s has harmed bank
stock thus far. Whether or not the net effect over the course of an entire
15-year period has been advantageous or disadvantageous is an empirical ques-
tion which will not be resolved here.

Suppose further study indicates that all the news about the loans--
despite the recent news that identifies problems with them--has had a posi-
tive effect on bank stock. Also suppose that bank managers want to raise the
value of their enterprise's equity, and suppose they could have anticipated
that the stock exchange on balance would provide a favorable assessment
of their LDC loans. Then it is reasonable to argue that the existence of a
stock exchange facilitated loans to the periphery rather than impeding them.
To the extent that maintenance of high share prices matter to bank manage-
ment, ceteris paribus, it would have been perfectly rational for senior
loan officers to let their employees out in the field push loans. Of
course, the jury is still out on what additional news about the Latin loans
will be forthcoming and about the stock market's future reactions to such
news.

D. Overborrowing

A fourth approach to the international debt crisis shifts the responsi-

bility onto decision makers in the borrowing countries. The borrowers simply

absorbed an unreasonable amount of debt. This could have been due to the


35

of advancement. 4 In either case, those penalties should have a chilling
effect on overexuberant upper-level bank personnel and make them look far
more carefully at loan packages brought to them for approval and support.
One can speculate that with such penalty systems in operation for upper-

level bank managers, if junior loan officers have had a relatively free
hand in arranging foreign loans it must. be because those loans do not go
as blatantly bad as domestic loans. There has been no publicized major
housecleaning of bank personnel over LDC loans as of this time. The afore-
mentioned capacity to roll over foreign loans means indefinite postpone-
ment of the day of reckoning. For example, Citicorp Vice-Chairman Thomas
Theobald, whose bank has the largest exposure in the Third world continues

to maintain that Citibank still makes a profit on its Latin loans.

Skeptics suggest that this is due to various steps that have been taken to

delay a precipitous mark-down of earnings. /°

It is less likely that it
was the actions of the junior loan officers that was as critical as the
permissiveness towards those actions by senior bank management.

This points directly at the old puzzle of the objectives of bank
management--satisficing or maximizing earnings, satisficing or maximizing
shareholder equity, satisficing or maximizing management salaries? To the
extent that it is advantageous to bank management, regardless of their
objectives, to maintain high and/or rising prices for the banks' equity,
the stock exchange may constitute another source of discipline for lending
for banks with publicly traded shares. Even if a bank refuses to mark-

down their earnings on non-performing loans, well-informed investors still

can bear the bank’s stock.


44

to pursue loan options that they might avoid otherwise. The banks do have
an insurance scheme embodied in the Federal Deposit Insurance Corporation
and the capability of the Federal Reserve to perform a lender-of-last-
resort function. 2!

What makes loans to LDC borrowers unique is the potential "insurance"
Provided by the IMF. For although the banks cannot control how the funds
are used by sovereign borrowers when loans are contracted initially, the
IMF can perform the task for them when the borrower runs into balance of pay-
ments difficulties and is turned toward the Fund for "relief "92 Whether or
not the Fund's conditionality criteria truly alleviates a country's debt and/
or payments problems is a hotly debated topic, but the Fund has the ability
to supervise the debtor nations’ use of funds in a way that the commercial
banks themselves cannot.

The existence of insurance schemes of this sort pose the moral hazard
problem-~"the existence of the insurance may have the particularly perverse
effect of increasing the incidence of the contingency being insured against--
bank failures in one case and burglaries in the other. "93 Insurance against
the consequences of bad loans may increase the incidence of bad loans.

But does the insurance protect the decision makers within the bank
who make the loans? Do the bank managers gain security from the FDIC and
Federal Reserve back-up capabilities or is it merely the depositors who
receive protection? When Continental Illinois' senior management finally
surrendered on efforts to find a private institution to inject new funds

into their bank, they turned as a "last-resort solution" to the FDIC. Part

of the bail-out plan designed to keep the institution afloat involved the


TABLE 1

INTEREST RATE SPREADS (OVER LIBOR) AND MATURITIES ON EURO-

CURRENCY CREDITS TO NON-OPEC LDCs, OPEC
NATIONS, AND ALL NATIONS, 1975-1981

NOW-OPEC LOCs 1975Q4 197604 =—-197794
WEIGHTED MEAN SPREADS 1.65 1.87 1.77
EIGHTED MEAN SPREADS 1.82 1.90 1.76
GHTED MEAN MATURITIES 5.44 5.14 7.32

OPEC 1975Q4 197604 197794
WEIGHTED MEAN SPREADS 1.67 1.34 1.59
UNWEIGHTED MEAN SPREADS 1.65 1.56 1.52
WEIGHTED MEAN MATURITIES 5.66 6.95 5.48

TOTAL SAMPLE 197504 1976Q4 197704
WEIGHTED MEAN SPREADS 1.63 1.58 1.48
UNWEIGHTED MEAN SPREADS 1.67 1.56 1.41

WEIGHTED MEAN MATURITIES 5.63 5.61 6.79

197894
1.06
1.04
9.79

197804
ww
1.14
8.59

197894
+83
82

8.88

Interest rate spreads are calculated as percent per annum.

Maturities are calculated as numbers of years.

1979Q4
76
-90

10.11

197994
75
82
8.42

197994

198004
1.10
+93
8.06

198094
-81
1.16
4.80

198094
83

81
7.79

12

198194
1.16
95
7.31

198194
69
79
9.60

198194
88

75
8.11

Weights were based on the volume of credits for each country in the current quarter.

Source: Memorandum prepared by Rodney H. Mills Ur. entit ed "Spreads and Maturities

on Eurocurrency Credits--Fourth Querter 1981 and Two

Governors of the Federal Reserve System, March 3, 1982.

Year Review," Board of


7.

18.

19.

54

There is some controversy over why the transition has taken place from
bond finance to bank loan finance. In an excellent survey of the
literature on international capital markets and dynamic contract theory
Vince Crawford has identified one argument--attributable to Sachs and
Cohen--as the claim that there are “increased benefits of renegotiation
in response to debt crises." Such renegotiations are ruled out in the
case of bond finance “because of the large number of bond-holders whose
consent would be required." Crawford muddies the waters a bit for this
explanation by pointing to Hellwig's finding that there also can be
benefits associated with a "precommitment not to renegotiate in some
circumstances . . . ." Crawford concludes, ". . . in general, the
superiority of bank lending over bond lending depends on the relative
importance of default-risk moral-hazard problems and uncertainty that
cannot be dealt with adequately by contingent contract." Bond lending
actually might be superior in an environment where "moral-hazard prob-
lems predominate," makina it desirable to minimize reschedulings. See
Vincent Crawford, “International Lending, Long-Term Credit Relation-
ships, and Dynamic Contract Theory," Discussion Paper 84-14 University
of California, San Diego 1984 pp. 33-4. Crawford's discussion, rooted
in all the best presumptions of modern economics, suggests that one should
seek an explanation for the transition in terms of collective ration-
ality of the market. Charles Kindleberger, on the other hand, has indi-
cated in correspondence that the explanation for the transition lies in
(1) investors' continued skittishness about low grade foreign dollar
bonds, (2) the impact of the Glass-Steagall Act of 1936 that separated
commercial and investment banking, (3) the impact of the Interest Equali-
zation Tax over the interval 1963 through 1974, and (4) the general
preference of Euro-currency banks for sovereign loans over Euro-bond
issues. My colleague Bobbie Horn suggests that the latter preference
might be shared on both sides of the loan contract due to the greater
flexibility associated with shorter term commitments.

T. H. Donaldson. International Lending By Commercial Banks. New York:
Wiley and Sons, 1979, p. 159 emphasis added.

Charles P. Kindleberger. Manias, Panics, and Crashes: A History of
Financial Crises. New York: Basic Books, 1978, pp. 23-4 emphasis
added.

At least by early 1978 Kindleberger already perceived that the foreign
loans might be "going bad." He wrote on p. 24 of his book, "Some of
the chickens have already come home to roost, in defaults by Zaire and
Peru; others, such as Petamina in Indonesia have had close calls." And
the following passage appeared in an article by Peter Field, David
Shirreff, and William Ollard "The IMF and Central Banks Flex Their
Muscles" Euromoney January 1983 p. 1: "'They[the banks] lent $12

to 15 billion to Mexico over 12 to 15 months when the situation was
clearly going wrong,’ gloated an American monetary source. And even a
senior banker in Luxembourg was prepared to ask: ‘Who should be pun-
ished more? The addict, or the money-pusher?'"


52

FOOTNOTES

*Distinguished Visiting Professor of Economics, University of Tulsa and
Associate Professor of Economics, University of North Carolina at Chapel
Hill. This paper was presented at a conference on The World Debt
Crisis held at Middlebury College in September 1984. The author
has benefitted from comments, criticisms, and suggestions from Ed Green,
Bobbie Horn, Charles Kindleberger, Jeffrey Marquardt, Rodney mills, and
Guy Stevens. The author also is grateful to the Board of Governors of
the Federal Reserve for providing him with support as a visiting scholar
to extend this research effort. This paper represents the views of the
author and should not be interpreted as reflecting the views of the Board
of Governors of the Federal Reserve System or other members of its staff.

1. Irving Friedman. "Emerging Role of Private Banks," in Stephen S.
Goodman (ed.). Financing and Risk in Developing Countries. New
York: Praeger, 1978, pp. 19-24.

For example, Friedman (p. 20) writes ". . . the response of the banks
is the response to a demand. Bankers do not make loans to countries,
or entities within countries, that do not ask for a loan. The fact is
that someone comes to a bank and asks for a loan. Then the banker
judges whether to do it. Banks compete for attractive loans, but the
borrower is essentially the genesis of the loan." And also (p. 20):
"It is sometimes said that banks are 'reaching' for loans. This is a
concept that is often found, even in periodicals which are considered
friendly to the private banks. I do not think it is right."

2. Max Winkler. Foreign Bonds: An Autopsy. Philadelphia: Roland Swain
Company, 1933, pp. 86-7.

3. Ibid., p. 87.
4. Ibid., p. 47.
5. Ibid., p. 47.
6. Ibid., p. 47.
7. Ibid., pp. 87-8.

8. Cleona Lewis. America's Stake in International Investments. Washing-
ton, D.C.: Brookings, 1938, pp. 377-8.

The history of lending to Cuba was especially notorious. For details
on the "dance of the millions" see Leland Hamilton Jenks. Our Cuban
Colony. New York: Vanguard Press, 1928 and Henry Wallich. Monetary
Problems of an Export Economy: The Cuban Experience 1914-1947. Cam-
bridge: Harvard University Press, 1950.



49.
50.

51.

52.

53.

54.

58

Ibid., p. 7.

G. Christian Hill. "Lender Beware: List of Troubled Banks Shows
Realty, Energy Lead Bad-Loan Areas," The Wall Street Journal.
March 19, 1984, p. 1.

John H. Makin. The Global Debt Crisis: America's Growing Involvement.
New York: Basic Books, Inc., 1984, p. 135 emphasis added.

It is interesting to note that the initial loan contracts included a
contingency clause--the sixty day nonperformance clause--but that the
banks effectively recontracted with the Brazilian borrowers by extend-
ing the nonperformance clause to ninety days. At first blush, recon-
tracting may appear to be incompatible with the behavior associated

with invocation of rational expectations on the part of the bankers.

But in the context of strategic gamesmanship where both partners to

the contract--lender and borrower--must form expectations about the
other's reactions, the possibility of renegotiation and recontracting can
mute the moral-hazard problem. See Crawford, op. cit., pp. 19-42.

See Lawrence Rout. "Banks Want Interest From Mexico Firms: Institu-
tions Threaten to Bar New Government Loans Unless Debt Is Paid Off,"
Wall Street Journal. November 24, 1982, p. 30 and "Mexico Arranges
Over $4.8 Billion In Loans For 1983," Wall Street Journal. February 9,
1983, p. 34.

Lawrence Rout. "Mexico's Debt Load Troubles Banks," Wall Street Journal.
April 21, 1983, p. 33.

dane D’Arista makes a similar point in "Private Overseas Lending: Too
Far, Too Fast?" in Jonathan D. Aronson (ed.). Debt and the Less Developed
Countries. Boulder: Westview Press, 1979, pp. 69-70:

"Despite fiascoes in Indonesia and elsewhere, some analysts argue
that banks have not been reckless in their LDC lending. They cite

as evidence a Federal Reserve Board study showing that loan loss
experience on foreign loans has been significantly lower than on
domestic loans. An obvious question arises: Is it possible that

the same banks that lent $22 billion to REITs were miraculously more
prudent when lending to foreigners? Albert Fishlow suggests that this
could be so if banks are more willing to accept losses on domestic
portfolios than on foreign. Domestic bankruptcy laws offer some pro-
tection unavailable abroad, especially where governments are involved.
It may be rational for banks to accept refinancing or rescheduling of
foreign loans rather than default.

“Thus, evidence of problems in international lending may lie elsewhere.
The Securities and Exchange Commission has, in fact, turned over a
stone ignored by other bank regulatory authorities. It requires bank
holding companies to report aggregate nonperforming loans and some-
times has pressed banks to break out these loans by source and state


80.

81.
82.

83.

84.

85.

86.

62

that there were rumors in the London money market that Manufacturers
Hanover "was selling off a large position in British government bonds."

Ibid., p. 6.

Citicorp was first in line among U.S. banks in entering the Latin
American loan market in the late 1960s. See "Citibanks's Pervasive
Influence on International Lending," Business Week, May 16, 1983, p. 124.
It also happened to have led U.S. banks into Latin America’ in the 1920s
as well. See Sampson, op. cit., pp. 69-70.

"Citibank's Pervasive Influence," Ibid., p. 126.

"Corporate Profits Advanced 31% for Second Quarter; Rises Are Expected
to Extend Into '85 At Slower Pace," Wall Street Journal, August 6,
1984, pp: 2, 12.

Banks registering earnings declines included Citicorp, Bank America,
Chase Manhattan, Manufacturers Hanover, and J. P. Morgan--all with
significant Latin American loan exposure.

Yves Maroni. "How to Borrow Reasonably," International Finance Dis-
cussion Paper No. 203, Federal Reserve Board of Governors, February
1982.

Hyman Minsky. "Financial Interrelations, the Balance of Payments, and
the Dollar Crisis" in Jonathan D. Aronson (ed.). Debt and the Less
Developed Countries. Boulder: Westview Press, 1979, pp. 103-22.

The financial instability hypothesis has been elaborated by Minsky in a
variety of places. Of particular note are his essays "Can ‘It’

Happen Again" reprinted in Hyman Minsky. Can "It" Happen Again?:

Essays on Instability and Finance. Armonk: MTM. E. Sharpe, 1982, pp. 3-13;
"Longer Waves in Financial Relations: Financial Factors In the More
Severe Depressions," American Economic Review: AEA Papers and Pro-
ceedings, Volume 54:3, May 1964, pp. 324-35; "The Financial Instability
Hypothesis: A Restatement," Thames Papers in Political Economy, Autumn

1978 and his book John Maynard Keynes. New York: Columbia University
Press, 1975.

Minsky, "The Financial Instability Hypothesis," op. cit., p. 15 indi-
cates that enterprises can take up "three types of financial postures"--
hedge finance, speculative finance, and Ponzi finance positions. In
the first case the inflow of cash is expected to exceed the outflow

of cash in every period, so that financial units in such a position
expect to cover their immediate debt obligations with current gross
receipts. Speculative finance units can be expected to run shortfalls
in the near-term but "in the longer term are expected to [have cash
inflows that] exceed cash payments commitments that are outstanding."
In the short-term the speculative finance unit will have "to roll over
or refinance debt. . . ." Finally, the Ponzi finance unit only can


50

There are a variety of reasons why foreign loans potentially are of
special benefit to large money-center banks, regardless of loan quality.
First, the money-center banks can obtain loan fees up front for setting up
the syndication. Second, the regulatory climate permits foreign loans to
be kept on the books as performing far longer than domestic loans when
borrowers are in arrears. Third, when smaller banks withdraw from syndi-
cations when problems appear the larger banks can absorb their claims, pre-
sumably at a lower cost than the price of the initial commitment. Fourth,
foreign loans to LDCs have potential international insurance agents, for
example, in the form of the IMF. The World Bank also appears to be taking
on more of this type of function lately. Fifth, LDC loans can contribute
to an overall climate of financial pressure that facilitates greater large
bank dominance of the banking industry--in part because of the way in which
regulators respond to the crisis. Sixth, there might be a net gain on the
stock market from the foreign loan commitment, depending on market partici-
pants reaction over time to the loan.

Loan pushing is most consistent, within the context of the rational
expectations hypothesis, with this third possibility. This third possi-
bility--bankers opting to contract for loans having a high probability of
going bad--rests heavily on the existence of public sector institutions that
the bankers anticipate will function as "guarantors" in their stead. The
Minsky position augments the incentives for lending brought on by the exis-
tence of these back-up institutions with competitive pressure. Based upon

evidence from the earlier lending waves to the less-developed countries,


22

view that the crisis is not a crisis after all. But the figures on loan
losses on foreign debts are deceptive. The large money-center barks are
able to avoid listing their nonperforming loans as “nonperforming" in their
regulatory reports. They can roll the loans over through automatic or near-
automatic refinancing or rescheduling arrangements to avoid having to deduct
them from their assets .°0 Makin provides details on how the major U.S.

Money-center bankers "handled" their nonperforming loans to Brazil in 1983:

Citicorp was not alone in facing heavy write-downs
on Brazilian loans, where arrearages had mounted by
the fall of 1983 to over $4 billion. Among Citi-
corp's fellow New York banks, Manufacturers Hanover
had $2.0 billion in Brazilian loans, and development-
loan-oriented Chase, $2.6 billion--both exposures
comparable to Citibank's in view of their smaller
net worth. It is likely that some judicious rolling
over of loans had been required to avoid triggering
the "nonperforming" alarm bell on Brazilian loans.
We have already seen that loans that had a sixty-day
nonpermanence clause had in September 1983 been re-
laxed to a ninety-day clause to avoid the costly
nonperformance designation. With respect to their
LDC clients, the mighty banks were in the position
of a bomb squad disarming a time bomb. Top priority
at the moment was to disarm the nonperforming
fuse--or worse yet, the default fuse--before it ig-
nited the debt bomb. At such a critical moment
capturing the bomber--like reflection on fundamental
causes of, and long-run solutions to, the massive
overhang of developing country debt--was a secondary
consideration.51

Companies in Mexico did not pay any interest on their debts between
August 1982 and January 1983 because they could not get access to U.S.
dollars. The government inaugurated exchange controls on August 5, 1982,
dictating that only the government could buy and sell dollars at a prefer-

ential rate of 50 pesos per dollar. But the government of Mexico had no


40

lack of good sense about policymaking to achieve growth via borrowing on the
part of LDC finance ministers. Or it could be due to entirely sensible
judgments by national leaders, given their personal political objectives
and the tenuousness of their tenure of leadership. Nations may continue
to exist, as Citicorp's executives always point out, but regimes can change--
sometimes quite rapidly. A large debt burden can be passed on to the suc-
cessor regime as a problem for them to solve, while the accumulation of
debt may have resolved a variety of other problems faced by the regime
incurring the debt. For whatever reason the borrowing countries failed to
follow Yves Maroni's instructions on "How to Borrow Reasonably. "°3 This
approach is the most fiercely incompatible with loan “pushing” by the banks.
But overreaching for credit by borrowing nations actually throws the
ball back into the lenders' court. If the world really follows Irving
Friedman's description, where banks are passive actors waiting patiently for
potential borrowers to appear on their doorstep, the banks still have the
option of denying applications for loans from borrowers whose prospects for
repayment are dubious. It is possible that the potential borrower will pro-
vide individual banks with false information, especially about how many
other banks from whom it has obtained funds. But this presses the argument
back to the position that bankers acted out of ignorance. Moreover, ignor-
ance about the other banks who have made loans to an overextended borrower
is less likely when commercial bank loans have been made through wide-

ranging syndications.


In @ more general vein Winkler observed that "[d]uring a period of

prosperity there is a tendency to extend loans for non-productive purposes

u4

or upon clubious security... . But Winkler warned that even if the

loans were made "for so-called productive purposes," during "good times”
there is still an impulse toward overlending.” Plus, Winkler made explicit
his opinion that loan pushing took place when he observed ". . . at times
even pressure has been brought to bear to induce foreign governments and
municipalities to contract loans which they did not want or need. "® This
was the cutcome of voracious competition among the underwriters to be first
in line to handle bond issues.’

Clecna Lewis also provided several examples from the 1920s that are
compatible with images of forced borrowing in the following passage:

Whereas in the middle decades of the nineteenth
century American promoters had scoured Europe in
search of foreign lenders, in 1925-29 they were
searching the world over for foreign borrowers.

At one time, according to testimony before the
Senate Committee on Finance investigating the sale
of foreign securities in the United States, there
were 29 representatives of American financial
houses in Colombia alone trying to negotiate loans
for the national government, for the departments,
and for other possible borrowers. Some 36 houses,
most of them American, competed for a city of
Budapest loan and 14 for a loan to the city of
Belgrade . . . In Peru, a group of successful
American promoters included one Peruvian, the son
of the President of that republic, who was after-
ward tried by the courts of his country and con-
victed of ‘illegal enrichment.' In Cuba the son-
in-law of the President was given a well-paid
position in the Cuban branch of an American bank
during most of the time the bank was successfully
competing against other American banks for thg
privilege of financing the Cuban government."


33

may have rationally adopted such habitual behavior to cope in a world that
is arational in providing guidance about the future. Indeed, the latter
perspective is consistent with much of Keynes' later argument about supbjec-
tive uncertainty in The General Theory.?!

C. Principal-Agent Dilemma

A third approach to explaining the debt crisis with loan pushing arises
from an application of the problems confronted in the analysis of the
relationship between a "principal" and an “agent" in pure contract theory.
The principal in this case could be either the senior loan officer or vice
president in the commercial bank's home office; the agent would be the
junior loan officer working overseas who makes first-hand arrangements for
the loan.

The junior loan officers are rewarded by their success in meeting and
surpassing assigned loan quotas. They gain by arranging as many loans as
possible--loans that must meet with the approval of their superiors. It
is to the junior loan officers’ advantage to doctor the loan package suffi-
ciently to sell it successfully to those higher up. This may include setting
up all manner of "guarantees" from sources in the borrowers' country. But per-
haps more important, before the results of any particular junior loan officer's
loans are realized, he or she is likely to have moved on to new employment.
They are highly mobile participants in the lending industry. ?2 The junior
loan officers receive high points for bringing the loan package to fruition

and few demerits when the loan proves to be of poor quality.


19

» productive loans in the developing countries are not very productive

and do not stay long out of default... 37

Indeed, one wonders why
the grounds for optimism about the relative potential for economic develop-
ment in Argentina in the 1970s ought to be any greater than it was in the
1920s. "Development" loans do not have an impressive history of success.
They rarely have produced anything that resembles economic development, and

they often have produced defaults. 2°

If the past provides a guide to the
future, commercial bankers in the 1970s should have forecast rationally that
their foreign loans to the periphery were going to go bad.
Regardless, calculation of the real returns on loans, inclusive of an
accounting for risks of repayment difficulties, is a dubious proposition.
A climate of non-calculable risk envelops lending decisions. Uncertainty
takes on a subjectivist cast in the sense that it precludes formulation of
mathematical or even ordinally systematic expectations. In his discussion
of country risk analysis, Wallich says, "Practitioners of this activity are
the first to point out that analysis of country risk is not a science. I
hesitate to call it an art; perhaps it may be dignified by the term ‘craft. 199
Wallich adds that a host of variables typically are examined to gauge debt
service capability--export volume, GNP, level of foreign reserves, available
credit facilities, and "compressibility of imports"--but warns:
. these are very partial relationships. In some
of them the variables are not even accurately defined.
Far more subtle and detailed relationships and data
can and need to be brought to bear on the problem.

Even then different views can be supported by the same
basic facts.


25

But in an environment of softening petroleum prices during the start
of the 1980s both sets of countries began to experience serious balance of
payments difficulties. The falling petroleum prices would have an obvious
adverse effect on the oil-exporters with large external debt, e.g., Mexico
and Venezuela. The oi] importers, e.g., Brazil and Argentina, should have
benefitted but several factors combined to undermine the presumptions of
portfolio diversification. The combination of rising real interest rates,
the drop in commodity prices for their (non-oil) exports, and the general-
ized global downturn of 1980-82 pushed them into the hole of illiquidity as
well. Plus while the oil-exporters had benefitted from the oil price rise
of 1978 and 1979, the oil-importers already had been placed in a difficult
situation by the last oi] price boom. °8 Retrospectively, important aspects
of the "risks" of foreign lending were "non-diversifiable." The correlation
between the poor growth experiences of the LDCs in the banks’ foreign loan

portfolios proved to be quite strong rather than weak in the early 1980s .°9

All this suggests that if one is to maintain an explanation of the
debt crisis compatible with the assumption that the bankers acted based
upon expectations formed rationally there are three options. First one
can continue to hold that the present problems are transitory and will
reverse themselves in the normal course of events without a major interven-
tion by national or multinational monetary authorities. One might continue

to hold such a position despite the historical precedents on LDC lending,


21

a deterioration in the external position of several of these countries to
levels that are very high by historical standards "46 Note that the
Dooley et al. measure of debt-service capability is more conservative than
Beenstock's because their measure does not include Payments on principal
that would permit amortization of the debt. If anything, the Dooley et al.
measure understates the problems LDC's face in meeting their debt
obligations.

By their measure of real net interest as a percentage of exports the
situation is especially drastic for Mexico, Brazil, and Argentina. The
Dooley et al. debt service ratio was 16% for Mexico and 24% for Brazil and
Argentina by 1982.47

Dooley and his coauthors suggest that the debt-service ratios were
quite different before 1981 and 1982 because (1) "the dollar value of these
countries' exports grew rapidly throughout the 1970s in both volume and
value terms," (2) "dollar prices of oi] and other exports grew faster than
the dollar prices of traded goods in general," and (3) growth of the debt
burden was contained "by generally low or at times negative real interest

rates on dollar [denominated] debt. "48

In 1981 and 1982 conditions changed.
The rate of export growth tailed off due to the impact of worldwide reces-
sion. Plus ". . . interest rates on floating rate dollar debt rose relative
to inflation rates so that real interest costs on existing debt increased
substantial ly."49

It is true that losses on bank loans to LDC borrowers remain low
relative to losses on loans to domestic borrowers for U.S. banks in par-

ticular. This fact may provide comfort to those who share the Beenstockian


34

The principals--in this case senior loan officers or bank vice presi-
dents--have not managed to construct an incentive scheme for the junior
loan officers abroad that will extract greater prudence in their efforts
to arrange loans. The debt mess, then, is due to a breakdown in the hier-
archical operations of the lending institutions.

This is a clever explanation for an international liquidity crisis
but probably not a substantive one. It leaves unanswered why the failure
to rein in the junior loan officers would be so widespread and persistent
as to produce a decade-long accumulation of low caliber loans. Coase's
theorem dictates that sooner or later a new scheme of rewards would te
designed for the strata of bankers who do the legwork in foreign countries.
Sooner or later the results of their lending records even should follow
them to new employers.

Presumably, their supervisors--the "principals"-- have strong incen-
tives to get the junior loan officers to stop pushing loans, unless they
are of a reliable quality. The penalties for the results of the actions
taken by inferiors fall heavily on superiors in the corporate world. For
example, the Drysdale and Penn Square Bank incidents led to the removal of
two high-level Chase officials and five middle-level executives at Chase
Manhattan Bank. In addition, two more vice presidents resigned after news
reports identified them as accepting loans generated by Penn Square./3
Citibank is a bit more benign in its treatment of executives who make de-
cisions that later prove to be bad. Instead of firing those "who show
potential" they are removed from decision-making authority (put in the

"penalty box") for 12 to 18 months; this clearly slows an executive's rate


16

marginal product of capital schedules in each region. The downward shift
in the center nations and the upward shift in the periphery nations raised
the rate of return on capital in the developing countries relative to the
developed countries. Short-term effects from the oil price hikes have
contributed to the increased indebtedness of the non-OPEC LDCs, but the
structural change in the world economy that has shifted industrial growth
toward some of those nations becomes the fundamental cause of the increase
in debt.

Beenstock points to the fact that growth in LDC manufactures has
accompanied growth in their debt as an indication of the correctness of
his explanation. He suggests that the situation is analogous, for example,
to the indebtedness incurred by borrowers in the United States during its
19th century phase of industrialization. The growth in LDC debt today is
merely an equilibrium adjustment reflecting the necessary flows in finance
from low return regions to high return regions. There is no reason for
panic, according to Beenstock. The NICs will become industrial centers
within twenty to thirty years and the current disarray is only a temporary
period of pain that goes hand in hand with the international structural
rearrangements.

Beenstock also offers evidence on LDC debt-service ratios to reinforce
his claim that there is nothing extraordinary about the present episode.
He utilizes a graph that reveals that interest and payments on principal
divided by exports for LDCs was not unusually high by historical standards
over the interval 1970-79; by 1979 the ratio had reached only 12%.33

The bankers' loans, then, were perfectly reasonable. If they did set

terms that would lure LDC borrowers into their clutches those terms reflected


61.
62.
63.
64.
65.
66.

67.
68.

69.

70.
71.

72.

73.

74.

60

James Street also has argued that the Latin American debt situation is
entirely due to oi] shocks. See his paper "The Latin American Debt
Problem: Liquidity or Growth Crisis?" unpublished manuscript Rutgers
University, December 1983.

Makin, op.cit., p. 152.

Gwynne, op. cit., p. 23

Ibid., p. 23.
Makin, op. cit., p. 139.

Gwynne, Ibid., p. 26 also describes how he put the ribbon and bow on
his Philippine loan by arranging a guarantee on the loan from a
Philippine bank that was "handing them out . . . like free samples."

Makin, Ibid., p. 139.

See, e.g., Robert Slighton. "Improving Country-Risk Judgments ,"
The Chase Economic Observer, Vol. 3: No. 4, July/August 1983,
pp. 3-4.

Sli ghton argues that improved information would enhance the quality of
bank lending decisions to borrowers in foreign countries.

J. M. Keynes. "The Consequences to the Banks of the Collapse of Money
Values (Aug. 1931)," Essays in Persuasion. New York: W. W. Norton
& Company, 1963, pp. 176-7.

The bankers, Keynes observed, were "blind" in their support for defla-
tion--a deflation which would accelerate "if a really conservative
valuation were made of all doubtful assets [the] Proportion of the
banks of the world [to] be found to be insolvent .. .

Ibid., p. 176.

J. M. Keynes. The General Theory of Employment. Interest, and Money.
London: Macmillan, 1936, especially Chapter 12.

For example, the ubiquitous S. U. Gwynne, op. cit., p. 26 was long gone
from his Midwestern bank when his Philippine loan went bad.

"Chase Reports Operating Loss for 2nd Quarter," The Wall Street Journal,
July 21, 1982, p. 2.

Daniel Hertzberg. "Banking Behemoth: Citicorp Leads Field In Its
Size and Power--And In Its Arrogance," Wall Street Journal, May 11,
1984, p. 1.


arranging a $10 million loan from an anonymous "medium-sized Midwestern
bank with $5 billion in assets" to a Philippine construction company throws
out a host of hints in this direction as the author describes his maneuvers
in 1978 in southeast Asia.2°

Gwynne's article does provide explicit evidence of the loan performing
a market making function. A major depositor with Gwynne's bank--an "“earth-
moving equipment company, a subsidiary of a major auto company and an old
client of the bank"--emerges as the principal force pressuring for the

24 The earth-moving company anticipated, correctly, that the loan

loan.
would finance shipments of its product to the Philippine construction
company. As Gwynne reports, once the loan had been approved formally, "Three
weeks later, we disburse $5 million, the first in a series of 'drawdowns'
that will correspond to shipments of earth-moving equipment. Although our
transfer bank, Chase Manhattan, manages to lose the $5 million for a few
frantic days, the money eventually lands in the right account."2°
It would be interesting to learn how many instances of commercial bank loans
involve financing demand for products made by their major customers. The impres-
sion given by Lewis and Wallich on bond finance in the 1920s was that of a broad
external stimulus to U.S. aggregate demand. A similar impression appears in
connection with the Wall Street Journal's description of the effects of the

recent wave of U.S. bank loans to Mexico; in fact, the following passage

contains the entire mix of curruption, market-making, and loans soon to


31

pecuniary motive for setting up the foreign loan syndication. They could
receive loan fees for setting up the consortium of lenders, and they would
receive this money at the outset. The larger the loan, the greater the
winnings attributable to economies of scale of banking:

Fees for arranging the loans averaged about 1 percent

of their value. The difference between the bank's

cost of funds and the lending rate are expressed as

'spreads,' percentages of the value of the loan--which,

while typically lower for large borrowers, vary a good

deal less than the size of the loan. One percent of a

$200 million loan is $2 million, while 2 percent of a

$100,000 loan is only $2,000. It does not require any-

where near one thousand times the effort expended on a

$100,000 loan to arrange a $200 million loan, and even

if syndication costs should be large, they can be

covered by additional fees assessed “up front" (before

the loan is granted).6
Loan fees can ease the pain of self-deception for the largest banks.

Gwynne's evidence about the lack of knowledge among the bank's mana-

gers for second-line banks can be reinterpreted as a story where they
simply are trying to keep their big depositors happy. Makin's discussion
of the money-center banks "securing" their loans with LDC government
guarantees gives way to the financial advantages of receiving the loan fee.

Inadequate knowledge on the part of either set of bankers becomes a matter of
secondary importance as does the quality of the loans. This places things

a step closer to the case where the bankers rationally may have pushed the
lcans without expecting significant rates of repayment by the borrowers.
Advocates of improved information for the bankers--including access to
"special" information on the internal conditions of specific LDCs possessed

by the World Bank or the IMF--are barking up the wrong tree if the debt

crisis is not due to misinformation on the part of the bankers 68


28

Short of the cynical, but potentially defensible, position that the
bankers intentionally made bad loans, the rational expectations hypothesis
suggests either that there is no debt crisis or, if there is one, it is due
to a stochastic shock. In either case, if loan "pushing" occured, it was
not overlending given the well-reasoned judgments of the lenders. If the
terms were softened to encourage LDC borrowers those terms were consistent
with best estimates of the risks involved--country risk, credit risk, ex-
change risk, etc.--at the time the loan contracts were made initially.

B. Uninformed Bankers

At the opposite pole from rational expectations based explanations for
the debt crisis is the explanation that attributes the situation to poor
judgment by the bankers. Unlike the rational expectations view that the
bankers were as well-informed as possible in making their loans, this per-
spective holds that the bankers operated without adequate knowledge relative
to the available information. Bad loans were made because of carelessness
and insufficient investigation of the circumstances of the borrowers; poor
knowledge led to the current debt crisis.

The explanation can be given a generational cast. The current wave
of bank managers either have forgotten or never were familiar with the
troubled history of LDC loans. The fifty year waves of LDC loans occur
precisely because it takes about that amount of time for the older group of
captains of finance to be entirely replaced with a younger group that is
unaware of the lessons to be learned from the past.

S. C. Gwynne's revelations on the foreign loan business as an employee
of a medium-sized Ohio bank provide some support for this explanation. He

describes his own rise into the trenches as a twenty-five year old front-


could delay the day of reckoning by extending additional credit to foreign

borrowers, but, at that stage, as Max Winkler suggested in his customary

purple prose "the lender becomes a slave to the borrower." !4

At some point when the record of default by foreign borrowers crosses
some intolerable threshold the revulsion set in. The ultimate lenders
will swallow their losses and retreat en masse from the international
capital markets. By the early 1930s it had become virtually impossible
for the less developed countries to float a new issue. Lewis dated the
revulsion from the credit contraction in the United States associated with

15 vallich

the 1929 collapse of share prices on the New York stock exchange.

argued that the worldwide depression of the 1930s was the fundamental

event that brought down the house of cards--simultaneously aggravating the

borrowers’ inability to pay and the lenders' refusal to continue to finance

the debt. '6
In summary, six major features emerge in the literature on the loan

adventures of the 1920s that relate to the loan "pushing" phenomenon:

(1) There was the promotional-cum-persuasion aspect, where the initiative

to borrow comes from the lenders. Borrowers received more than they, them-

selves, conceived as feasible or necessary at the outset. (2) Concomitantly,

there is the implication that there was a surplus of funds that was unable

to seep into normal outlets that made its way into the less developed

regions. This notion is plainly evident in Cleona Lewis' description of

the shift on the part of U.S. promoters from a search for lenders overseas

in the mid-1800s to a search for borrowers overseas during the mid-1920s.

(3) The foreign lending wave involved nepotistic connections and corruption


Lewis's work highlighted another feature of the loan push doctrine-~
the creation of foreign markets for U.S. producers. Lewis found that
numerous overseas loans were arranged for public works projects in the
LDC's of the 1920s and that ". . . big American construction companies
sometimes helped finance public works in foreign countries, sometimes
secured their contracts on a competitive basis after the financing had
been arranged. "9 In general, she concluded that infrastructural "loans

and contracts provided a considerable market for American materials and

ul

services. The stimulus for products of U.S. origin had far-reaching

dimensions:

The roadbuilding contracts, for example, expanded
the demand for American steam shovels and grading
machinery; and also called for cement and asphalt
from the South American and Cuban subsidiaries of
American companies. The building of sanitation,
gas, and waterworks systems called for metal pipes
and plumbing supplies. Railway building called
for steel rails, engines and cars. The execution
of all these contracts gave employment abroad to
a large number of American engineers, and also
called for additional numbers of emp loyees in the
home offices of the companies concerned.

Henry Wallich perceived that, in the aggregate, the expansionary boost to
American production in the 1920s from the Latin loans was sufficiently

large to make the loans a net benefit for the U.S. economy, despite the

subsequent defaults. !

However, from the standpoint of the ultimate lenders of the 1920s,

the bondholders, the situation was unpleasant. As Wallich noted,

. . . it is obvious that by far the heaviest part of the burden, if not

ul3

all of it, rested upon the security holders. The ultimate lenders


7

a reasonable calculation of prospects for efficacious use of their loans
and subsequent repayment. After all the greatest volume of loans were
going to those LDCs that displayed the best prospects for industrial
development. The biggest borrowers were members of what Lawrence Franko has

called the "charmed circle of ten."34

(Also see Table 3 for the ten LDCs
with the largest foreign debt.) Oil price shocks and export commodity

price declines were all events that make for debt service problems for some

of these borrowers, but these are transitory difficulties. The underlying
trend is toward solvency. The bankers' loans were made wisely, i.e.,
rationally, and there is no enduring international debt crisis.

In addition, it is often pointed out, the loss rate on foreign loans
actually is lower for U.S. banks than the loss rate on domestic loans. For
example, in February 1983 testimony before the House Committee on Banking,
Finance and Urban Affairs the Fed chairman, Paul Volcker, reported that

. losses on foreign credits of commercial banks continued to be sub-

stantially lower than on domestic lending... (035

This piece of data
routinely is used to reinforce the impression that the bankers' eagerness
to loan to the LDCs during the 1970s was sensible.

Furthermore, it is argued the bankers can rely upon some natural
safeguards inherent in their approach to lending. Specifically, Laurie
Goodman has placed emphasis on the bankers' capacity to diversify their
lending to reduce the degree of covariance between the various credits they
issue. Goodman, writing shortly before the Mexican peso drama in 1981, was
so optimistic about the effectiveness of diversification that she could
conclude "that the nightmares of bankers, regulators, and journalists of

massive LDC defaults paralyzing the United States banking system are not

warranted on economic grounds . "36


Charles Kindleberger's rhetoric conveys an even more dramatic picture:

+ . . contemplate the enormous external debt of

the developing countries, built up not only since

the rise of oil prices but importantly--a widely

ignored fact--in the several years before that

time, as multinational banks swollen with dollars

tumbled over one another in trying to uncover new

foreign borrowers and practically forced money

on the less-developed countries.

The image of the multinational banks gorged with dollars is consistent
with the second feature of the loan push doctrine--the existence of surplus
funds that eventually gravitate toward unorthodox recipients. Excess
dollars in the late 1960s and early 1970s have been attributed to the
explosive development of the unregulated Euro-currency market. Softening
demand for commercial bank funds by the banks' preferred clients beginning
in 1971, coupled with the growth in the funds the banks wished to make
available to borrowers, led, in this view, to the cultivation of borrowers
from regions customarily ignored. 20 The recycling of OPEC surpluses in
the aftermath of the first major oil price increase is seen as aggravating
the surplus funds condition but not fundamental to the beginnings of the

situation.2!

The Euromarket is the structure perceived as lying at the
heart of these developments. The growth of the Euro-currency market since
the start of the 1970s has been accompanied by a shift in the asset base
of the participating banks away from corporate lending toward sovereign
lending.22

Specifics on nepotistic-corruption elements in contemporary loan making
are harder to detail than the facts that surfaced in the 1920s. But

former banker S. C. Gwynne's confessional exposé on his own involvement in


23

dollars to sell, regardless of the exchange rate. The commercial banks
threatened to hold off new loans to the Mexican government until they
received interest from private sector borrowers. But the banks’ threat was
a consequence of their fear that they would have to label many of their
private sector loans to Mexican borrowers as nonperforming. By February
1983 the commercial banks had put together the largest syndication in
financial history--a syndicate of 500 commercial lenders--to provide $4.8

billion in loans for 1983 to permit the financing of the prior interest

obligations. 52

This was rol] over in its highest form. The quid pro quo
commercial banks demanded by the commercial banks was harsher terms on
refinancing the Mexican government's own debt. The government, according
to the banks, did not want to contract for more than one point above LIBOR
(which was at 15% in early 1983), but the banks insisted upon 14% above
L1Bor.°3

Bankers are loath to report any of their loans as nonperforming, which
would require them to record them on a nonaccrual basis. It is easier for
them to avoid such reports on foreign loans due to the nature of the exist-

ing regulatory arrangements .°*

The banks have interpreted the prevailing
regulations as meaning that they can record interest on loans although
the interest remains unpaid. The banks assert that this is legitimate
under existing rules as long as they “believe the loans are well-secured
and in the process of collection. "> Of course, the banks are largely
free to determine whether or not a particular loan is "well-secured and

in the process of collection." Only very recently is there any evidence

that the comptroller of the currency and the Federal Reserve Board have


International Finance Discussion Papers

Number 253

February 1985

LOAN PUSHING: DOCTRINE AND THEORY

by

William Darity, Jr.

NOTE: International Finance Discussion Papers are preliminary materials
circulated to stimulate discussion and critical comment. References in
publications to International Finance Discussion Papers (other than an
acknowledgment by a writer that he has had access to unpublished materials)
should be cleared with the author or authors.


46

In summary, there is ambiguity about the scope of the moral hazard
problem. The FDIC's insurance capability does not preclude the collapse
of second line banks. It does preclude collapse of the large money-center
banks. However, this guarantee does not extend to job security for the large
bank officials nor the asset position of the large bank stockholders.

The Fed's lender-of-the-last resort capability carries no similar
repercussions for senior bank officials. Perhaps this was the true reason
for the bankers’ "surprise" (if, indeed, they were surprised by the Fed's
post 1979 actions): the Fed's adamant disinflationary stance undercut
"insurance" they had counted on when loans were contracted initially. The
Fed would not "validate" the debts as long as it steered a course away
from inflation. Temporarily, the Fed still could lend to the debtor nation
directly as it did for Mexico.

As noted above, foreign loans possess a unique advantage, given the
ability and willingness of the IMF to supervise nations whose governments
encounter difficulties in making loan payments. Reliance upon the IMF as
an insurance agent on foreign loans involves a high degree of brinksmanship
on the part of the commercial banks. Not only must the banks believe that
the IMF's conditions for new lending are the correct ones, but they also
must believe that LDC regimes can contain the political reaction of their
citizens to national debt peonage that often is aggravated when the Fund
comes on the scene. 27
G. Finance Capital

The final approach explaining the debt crisis to be considered here
emerges from the implications of Rudolf Hilferding's views on the secular

consequences of competition under capitalism. Hilferding argued that


10

In summary, there are two contrasting views of banking practice. The
first view is advanced by Irving Friedman which treats the banks as the
passive actors. The second view appears in the quasi-anecdotal histories
of the bond finance episode of the 1920s. Here the bankers are viewed
as the active agents, literally covering the globe to find new borrowers.
This second view finds echoes in some of the literature that attempts to
assess the current international debt crisis.

It is the latter view--inclusive of the six features identified above
as components of a broader loan push doctrine--that is the object of inquiry
of this paper. In the section that follows an attempt will be made to
give rigorous meaning to the idea of loan pushing. After that, the concept
of loan pushing will be considered in the context of competing explanations
of the current international debt crisis. A final section will provide an

overview of the issues raised in the paper and present some conclusions.

THE CONCEPT OF "PUSHING" LOANS

The loan "push" doctrine was depicted in the previous section as a
complex of attributes. But the specific act of "pushing" or "forcing"
loans requires elaboration. Obviously, it does not mean that bankers force
officials in LDCs to accept loan contracts at gunpoint. The act of pushing
a loan must involve the structure of incentives offered to potential
borrowers--incentives that are out of step with the risk characteristics
possessed by the borrowers.

For Brimmer, pushing loans involves a drastic softening of terms
relative to the expectations of the potential borrowers. When the Euro-

currency banks turned their attention toward the developing countries,


go bad:
In the late 1970s salad days when the 011 looked
inexhaustible, the [Mexican] government's develop-
ment plans focused on massive capital projects that
were heavily dependent on imported materials; steel
mills, oi] installations and electrical power plants
were prominent. Imports soon began rising at a
faster rate than exports, and the deficit in trade
and services grew.
Much of the investment went to notoriously ineffi-
cient state-owned agencies and companies. That led
to wasted money. Corruption drained further resources.
Allegations of corruption at Pemex alone run into
billions of dollars. The architect of its expansion,
Jorge Diaz Serrano, is in jail awaiting trial on
charges of fraud.26
As for the fifth and sixth features of the loan push story that are
apparent in the stories of the 1920s--initially continued lending to sup-
port unstable borrowers and then revulsion on the part of the borrowers--
the former response has been more in evidence with respect to major borrow-
ing nations. The situation in the 1980s is more difficult to interpret than
that of a half-century earlier because of the existence of both multi-
national institutions and national institutions in the developed countries
that play an active role in international financial markets. These include
the IMF, the World Bank, and the central banks in the West, especially the
U.S. Federal Reserve Board. Would the revulsion have taken hold on a wide
scale already if these institutions had not prompted further syndications
to continue to provide credit to these nations during their current period
of difficulty? On the other hand, would the banks be able to maintain as
hard a line on the terms for reschedulings and new credits if not for the
existence of the IMF and its austerity program for troubled debtor nations?”
Suffice it to say that the world is not yet at a stage where creditors have

withdrawn en masse from the international credit markets.


56.
57.

58.

59.

60.

59

their earnings’ impact. At the end of 1976, a few U.S. multinational
banks reported nonperforming foreign loans at levels almost as high as
those for domestic borrowers. While much more information is needed
to assess the source of international lending problems, it is clear
that loan loss experience is an inadequate measure of foreign lending
prudence."

Daniel Hertzberg and S. Karene Witcher. "New U.S. Rules On Latin Debt
To Affect Banks." Wall Street Journal. June 19, 1984, p. 3.

Ibid., p. 3.

For example, Manufacturers Hanover with heavy exposure in Latin America
experienced a major "battering" of its stock in 1984, well before the
regulators took steps to encourage more stringent accounting practices.

Thomas 0. Enders and Richard P. Mattione. "Latin America: The Crisis
of Debt and Growth." Brookings Discussion Papers in International
Economics. The Brookings Institution. December 1983, p. 24.

Enders and Mattione also argue that the situation was made worse by the
failure of the Latin debtor nations’ regimes to engineer an "adjustment"
ta their balance of payments difficulties. "Adjustment" is a euphemism
for the austerity of reducing consumption and imports. Of course, this
leaves open the issue of who will bear the burden of "“adjustment"--the
wealthier strata of the debtor nation or the poor. There are sound
reasons for believing that the brunt will be felt by the poor when such
"adjustments" are enacted--particularly after a "successful" visit by
an IMF mission.

Richard S. Dale. "Country Risk and Bank Regulation," The Banker. Vol.
133:685, March 1983, p. 46.

Makin, op. cit., p. 142 observes, "The argument for diversification was
compelling--but not, it turned out, compelling enough to overcome two
very serious problems. First, it overlooked the ability of governments
to spend more than they have no matter how much they have. In this
case governments proved to be wasteful intermediaries between banks and
projects, out of carelessness or incompetence and sometimes out of down-
right dishonesty. Second, it forgot that the diversification argument
relates only to the stability of earnings, not their level. The sad
truth is that if a world recession--like the one that began in 1981--
unites with waste to produce a widespread negative rate of return, it
does not help much to have diversification to thank its being a stable
negative return instead of a volatile negative one. The debts still
cannot be repaid." (emphasis in original).

See Jeffrey Sachs. "The Current Account and Macroeconomic Adjustment
in the 1970s," Brookings Papers on Economic Activity. 1981 and
Michael Bruno and Jeffrey Sachs. "Adjustment and Structural Change
in the World Economy," NBER Working Paper No. 852, 1982.



42

Since Minsky seems to view these long waves culminating in near-manic
lending booms as occuring cyclically, they are events that repeat themselves

periodically.

The upswings in chronological time appear to be relatively
long from a business cycle perspective--perhaps forty to fifty years. But
if Minsky has detected the periodicity in these events, why have the bankers
failed to do so? Why do they repeat the overlending practices that have
contributed to major downturns in past? Why have they not learned from the
mistakes of the 1920s, for instance?

This is virtually the same as asking, why do the bankers fail to dis-
play behavior rooted in rational expectations if the Minsky model provides
an accurate picture of the structural features of the U.S. economy. Of
course, if holding rational expectations means that they adopt more conserva-
tive lending practices during a long upswing then the process Minsky depicts
would not happen. To maintain the Minsky position it is more satisfying
to establish that the credit cycles could occur even if bankers could fore-
see the adverse consequences of their collective actions.

Minsky tends to argue that the bankers believe their loans would per-
form, but individually they cannot manage the performance of the world
economy. Policy makers, like the Federal Reserve could avert the credit
crunch, but to do so would require reflation of the economy. Further-
more, the bankers and the Fed officials alike are prisoners of the false
doctrines of monetarism which purports to argue that if the Fed maintains
steady money growth the economy will be self-adjusting or self-correcting. 8

The first part of his argument can take on the flavor of the version

of the rational expectations approach that says the bank loans went bad

due to the random shock of the Fed's disinflation policy. Otherwise, if


30

Philippines was prompted by the insistence of one of his bank's key deposi-
tors. Were the senior loan officers who approved the foreign loan that
subsequently went bad acting out of ignorance or self-preservation? Presum-
ably, they managed to retain their major depositor although, eventually,
they had to write-down the loan. To the extent that the depositor was able
to make some sales to the importer in the Philippines, some of the funds
lent abroad may have returned to the bank's balance sheet through the
depositor's own account.

Typically, negotiations were conducted primarily between LDC govern-
ments and the large banks to bring together a wide range of public and pri-
vate sector borrowers in the developing countries and numerous second line

banks in the developed countries. As Makin continues:

But as we've seen with a large number of separate
projects under a government umbrella, the bankers
saved themselves the cost of carefully investi-
gating each project to determine its profitability
and potential to repay borrowing, assuming they
even had the language skills and technical and
regional experience required to do so. Rather,
the bankers could just deal with the governments
guaranteeing these debts, pledging as collateral
their ability to tax their citizens. The pledged
word of a great republic like Brazil is very im-
posing at the time it is given, and somehow it
induced a retroactive belief that governments do
not default their debts.

But of course governments have defaulted in the past, despite the
potential danger of being ousted from the international credit markets.
When reschedulings and refinancing arrangements are made, it plunges
borrower and lender into a murky region where on some interpretations
default de facto might have occurred actually. Makin does suggest in the

next paragraph of his book that the larger banks had a quite reasonable


47

financial institutions, especially banks, would play a growing coordinating
role over industry--that the directors of financial and industrial enter-
prises would overlap to an increasing degree. Over time, the competitive
nature of capitalism would lead to crises arising out of overlending-cum-
overborrowing of a sort quite similar to Minsky's. The periodic downturns
would involve shakeouts that would extinguish smaller businesses and produce
greater concentration in both the financial and industrial spheres. The
stage of finance capital was the era in which this tendency toward concentra-
tion under capitalist competition became urgently visible, 28

It is notable that in the 1930's when thousands of U.S. banks perma-
nently closed their doors the survivors included Citicorp, J. P. Morgan,

Chase Manhattan, and Bank America.29

It also is of interest that, with the
exception of Continental Illinois, the current wave of bank failures has
left the giant money-center banks untouched.

Whereas Hilferding developed his theory of the evolution toward greater
concentration in an analytical environment of pure laissez-faire capitalism,
there are reasons to believe that the contemporary regulatory apparatus
promotes the position of the larger banks. The previous section of the
paper indicated that the FDIC's rescue of Continental Illinois shows that
the big banks can expect a degree of help that will not be given to smaller
banks. This could give the big banks a further advantage in attracting
depositors over the smaller banks and other deposit-accepting financial

institutions. 10

Even if small bank depositors do not pull their funds out
entirely and, instead, diversify by placing their funds with several banks,

this still could hurt the banks that previously held their entire deposits.


29

line loan officer in the Philippines in 1978 after ". . . one and a half
years of banking experience [after joining] the bank as a ‘credit analyst’
or the strength of an MA in English [and after promotion] eleven months

later to loan officer and [assignment] to the French speaking Arab nations

62

[because of my fluency in French] Gwynne adds further that he was not

unique:

I am far from alone in my youth and inexperience. The
world of international banking is now full of aggress-
ive, bright, but hopelessly inexperienced lenders in
their mid-twenties. They travel the world like itinerant
brushmen, filling loan quotas, peddling financial wares,
and living high on the hog. Their bosses are often bright
but hopelessly inexperienced twenty-nine-year-old vice
presidents with wardrobes from Brooks Brothers, MBAs from
Wharton or Stanford, and so little credit training they
would have trouble with a simple retail installment Joan. 63
As for the bosses above these young vice presidents--the senior loan
officers--Gwynne describes them as "pragmatic, nuts-and-bolts bankers

whose grasp of local banking is often profound, the product of twenty or
thirty years of experience [however, they] are fish out of water when it

comes to international lending. "4

According to Gwynne, the senior bankers

had no desire to move into the foreign loan market “but were forced into

it by the internationalization of American commerce; as their local clientele

expanded into foreign trade, they had no choice but to follow them or lose

the business to the money-center banks. "0°
On the face of it, Gwynne's story is one of inadequate information at

all levels of the decision-making apparatus--at least among the second tier

of banks, if not the money-center banks as well. But his story also involves

the market making function of the loans on behalf of the banks' domestic cor- '

porate depositors. As noted above, the loan Gwynne himself arranged in the


in the arrangement of the loans. (4) The loans performed a market-making
function for numerous U.S. producers. The loans created the financial
capacity in the less developed countries to purchase the output of U.S.
enterprises. (5) When concrete evidence of softness in the ability of
the borrowers to meet their obligations became visible, the lenders
initially tried to resolve the situation by continuing to lend. (6) Even-
tually, the lenders withdrew altogether from providing funds (or the period
of revulsion took hold).

These six features all appear in the literature that explores the
foreign loan crisis of the 1980s. However, it should be kept in mind that
unlike the loans of the 1920s, when the commercial banks played an under-
writing function thus transferring the risks of lending onto the shoulders
of the bondholders, the loans made in the 1970s have been made directly by
the banks themselves. This means that the banks and their depositors--
which may be other banks depending upon the structure of interbank rela-
tions--directly share the risks today. For the time being, the question of
why bank loan finance has replaced bond finance in international credit
markets is left aside. !7

The promotional aspect, or the process of creation of borrowers, is
reflected in T. H. Donaldson's nervous warning about the pattern of lending
toward the end of the previous decade:

There is a developing feeling . . . that some banks

are so concerned with finding borrowers--any borrowers--
that they are occasionaly overpersuading countries who
should more sensibly be cautioned against too much
borrowing. If this fear proves justified, the banks
concerned are storing up trouble not only for themselves
and the borrowers involved, but for many other banks and
borrowers who wil suffer from the repercussions of
future problems


20

Especially difficult outcomes to forecast are the effects of tne actions

2” the

of one debtor on others. If one defaults, will others follow suit
game-theoretic literature suggests that it is a devastatingly open-ended
question that only can be given an unequivocal answer if stringent--and

unrealistic--assumptions are employed. 42

Stephen Dubrul Jr.'s observation that ". . . the only certainty in

international finance is uncertainty . . 43

is especially telling. There
is no magic formula that permits the bankers to calculate the real return
on their loans. They are confronted with uncertainty in Keynes' most dis-

turbing sense. “4

The bankers cannot tell what real return will be earned
on capital in the future. They cannot see the future. Their decisions must
be made despite inherently frail prognostications.

It also is interesting to note that.a more careful look at the variable
that Beenstock isolates to support his position--the debt-service ratio--
actually is susceptible to mounting the opposite case. Beenstock probably is
a victim of the date of publication of his manuscript. His data on debt-
service ratios runs up through 1979, but by 1981 the debt-service ratio had
reached 20% for LDCs in general and was climbing. Those ratios were in the
vicinity of Latin American debt-service ratios between 1930 and 1937.45

A recent study by Dooley et al. reinforces how dramatically the debt-
service ratios for LDC borrowers have changed since the publication of
Beenstock's book. While admitting that they "do not know what level of
this ratio is sustainable for any country nor . . . that it is the only

relevant measure of country's debt position," Dooley and his co-authors

contend that ratio of real net interest payments to exports "clearly show


39.

40.

41.

42.

43.

44.

45.

46.

47.
48.

57

Henry Wallich. “How Much Private Bank Lending Is Enough?" in Stephen
Goodman (ed.) Financing and Risk in Developing Countries. New York:
Praeger Publishers, 1978, p. 15.

ITbid., pp. 15-6.

Ibid., p. 16.

See Crawford, op. cit.

Stephen M. Dubrul Jr. “Management of Risk" in Stephen Goodman (ed.).

Financing and Risk in Developing Countries. New York: Praeger
Publishers, 1978, p. 57.

J. M. Keynes. “The General Theory of Employment," Quarterly Journal
of Economics. February 1937, p. 214 emphasis added:

"By 'uncertain' knowledge, let me explain, I do not mean merely to
distinguish what is known for certain from what is only probable.
The game of roulette is not subject, in this sense, to uncertainty;
nor is the prospect of a Victory bond being drawn. Or, again, the
expectation of life is only slightly uncertain. Even the weather
is only moderately uncertain. The sense in which I am using the
term is that in which the prospect of a European war is uncertain,
or the price of copper or the rate of interest twenty years hence,
or the obsolescence of a new invention, or the position of private
wealth-owners in the social system in 1970. About these matters
there is no scientific basis on which to form any calculable proba-

bility whatever. We simply do not know."

Neil J. McMullen. "Historical Perspectives on Developing Nations‘
Debt" in Lawrence G. Franko and Marilyn Seiber (eds.) Developin
Country Debt. New York: Pergamon Press, 1979, pp. 3-16.

McMullen also was an optimist about the LDC debt build-up of the 1970s
based upon a comparison with the conditions of the 1930s. His compari-
sons may have been, like Beenstock's, premature. The only salient
differences between the 1930s and the current situation that McMullen
identified that still applies is the existence of international insti-
tutions that can make concessionary loans and grants, and because of
loan finance instead of bond finance countries with debt problems may
have more alternatives to formal default.

Michael Dooley, William Helkie, Ralph Tryon and John Underwood. "An
Analysis of External Debt Positions of Eight Developing Countries

Through 1990," International Finance Discussion Paper No. 227, Board
of Governors of the Federal Reserve System, August 1983, p. 7.

Ibid., p. 7.
Ibid., p. 7.


64

96. G. Christian Hill, “Lender Beware," op. cit., p. 1 writes: "The FDIC
expects less than 10% of these problem banks [the 650 banks on its
problem-loan list in March 1984] to fail, and even if somewhat more
than 10% collapse, its $15.5 billion insurance fund can absorb the
cost." The FDIC has had to handle 54 bank failures by September 1984,
the largest number since the Depression years. See Tim Carrington and
Daniel Hertzberg. "Money At Risk: Financial Institutions Are Showing
the Strain of a Decade of Turmoil," Wall Street Journal, September 5,
1984, p. 1.

97. For example, Richard Alm “World Debt Crisis Backlash," The Washington
Times, June 27, 1984, p. 3 C reports:

"IMF aid rarely comes without strings. In most cases, the IMF
imposes rigid austerity, a formula that usually includes sharp cut-
backs in budget deficits, an end to consumer subsidies, currency
devaluations, and ceilings on wage rates.

"'They all hit very hard at poor people,’ says Richard Feinberg
of the Overseas Development Council.

"Poor people made poorer often take to the streets, and that's
what frightens Latin America's political leaders. The Dominican
Republic, a Caribbean island nation with a debt of $2.5 billion,
erupted in riots that killed 60 people and injured 200 others in
April after the government raised prices on basic foods to help qual-
ify for renewal of a $450 million IMF loan."

Also see S. Karene Witcher. "As Latin Debtor Nations Prepare to Meet
Political Unrest Becomes A Big Concern," Wall Street Journal, June 19,
1984, p. 33.
98. Rudolf Hilferding. Finance Capital: A Study of the Latest Phase of
Capitalist Development. London: Routledge Kegan Paul, 1981.
(originally published in German in 1910).

99. Sampson, op. cit., pp. 94-109.

100. Dennis Jacobe, research director of the U.S. League of Savings Insti-
tutions, has made just such a point while complaining about the inequity
of the FDIC's rescue policies. See Hertzberg, Carrington, and Andrew,
op. cit., p. 6.

101. Such a shift is described in G. Christian Hill and Edwin A. Finn.
"Confidence Crisis: Big Depositors' Runs On Beleaguered Banks Speed
the Failure Rate," The Wall Street Journal, August 23, 1984, pp. 1, 6.
On p. 6 the authors report, for example, that "Jean Campbell, who
runs a tax service in Sun Valley, California, took out $420,000 of
uninsured deposits held at American Pacific by a client. She is plac-
ing most of the money at Bank of America, the nation’s second-biggest
bank, and Home Savings of America, the second largest thrift."


37

The performance of Manufacturers Hanover's common stock appears to
carry an even stronger relationship to news about its foreign loan port-
folio. A bank with significant exposure in Argentina, it experienced a
moderate decline in mid-1982 falling from about $32 per share to $26.50 per
share. Whether or not the Falkland Islands crisis played a role in the drop
is not clear. This year, however, three Wall Street Journal reporters made
a direct link between rumors about the shakiness of Manufacturers Hanovers'
foreign loans and its equity position. They emphasized the impact of these
rumors in explaining the one day $3.375 drop during May of this year in its
share price to $27.625 per share on heavy trading of 1.3 million shares ./9

Manufacturers Hanover has the largest net exposure to the large Latin
American debtors; Citicorp has the largest absolute exposure (again see
Table 4). But Citicorp has not experienced as severe a stock battering. It
has been suggested that this is due to Citi's strong ability to earn on
its domestic operations which are separate from the Latin debt problem. 22
It also may be the case that Citicorp has been more effective in arranging
reschedulings among its foreign borrowers--especially in Brazil--to maintain
its ability to record high profitability on its Joans .8! In general, lately
the LDC loans seem to be having a depressing effect on the large banks'
equity positions.

The weakness in money-center banks' share prices has been accompanied
by weakness in their earnings. Nineteen major banks reported a loss of
$5.6 million during the second quarter of 1984--the only sector of Ameri-

can business to experience an overall loss during the period. The banks’

earnings position was overwhelmed by Continental Illinois' $1.16 billion


38

negative earnings, a record in the annals of U.S. banking. But removal of
Continental from the picture would still leave the remaining 18 banks with
a 4% decline in net income. The foreign loan factor played a role, par-
ticularly "[s]tricter accounting rules adopted by regulators [that] led
the banks to put significant amounts of Argentinian loans on nonaccrual
status, reducing earnings. "22

It appears that the stock exchange only penalizes the banks through
their decisions about whether to buy or sell bank stock after news surfaces
that the loans are going bad. This news can be "announced" before the
banks actually put the loans on nonaccrual status. Nevertheless, downward
pressure on share prices from LDC loans seems to materialize fairly late in
the game. No such penalties occured when the initial loan commitments were
made throughout the 1970s. If anything bank share prices tended to gain
throughout the previous decade, and it seems that the stock market's reac-
tion to the development loans was favorable at that time.

If the dominant investors follow the fundamentals in judging whether
to bull or bear (or hedge) a stock then they must have been favorably dis-
posed toward the LDC lending boom when it first got underway. They changed
their minds in the 1980s when news came in that suggested that all was not
well with the loans to the developing world. But, evidently, the market
did not forecast that the Latin loans would have an adverse effect on bank
earnings in the 1970s.

If the dominant investors are speculators in Keynes' sense then they
utilize the news to anticipate the actions of other investors rather than

forecast the earnings performance of the banks issuing the securities. In


10.
1.
12.

13.
14,
15.
16.

53

Lewis, Ibid., p. 378.

Lewis offered the examples of (1) Ulen and Company's contract to build
the port works in Colombia, (2) Frederick Snare and Company's financing
of public works contracts in Peru, (3) Warren Brothers road-bui lding
contracts in Argentina, Chile, Colombia, Cuba, and Guatemala, and (4)
Foundation Company building roads, sanitation works and public works

in Peru and Bolivia and public works in Argentina, Chile, and Colombia.
She does not detail the extent to which the contracts were fulfilled
completely.

Ibid., p. 379.
Ibid., p. 379.

Henry Wallich. "The Future of Latin American Dollar Bonds ," American
Economic Review. Vol. 33:2, June 1943.

Wallich (pp. 326-7 emphasis added) observed, "It was pointed out by
Professor Hansen in his testimony before the Temporary National Eco-
nomic Committee that the American prosperity of the 1920's was due not
to any inherent characteristics of our economic system but to the
cooperation of a number of stimulating factors. One of these factors
was the high level of our exports, paid for in part with the proceeds
of our loans. It cannot, of course, be proved that the loans increased
exports by an equal amount. Since, however, most countries had only
limited exchange reserves of their own, insufficient to permit a con-
tinuously passive current balance, a fair presumption exists that the
increase in exports was roughly equivalent to our loans. These addi-
tional exports produced an export multiplier effect and thus tended to
raise national income by a multiple of their own value. From this gross
gain in national income we must of course deduct the losses suffered
through the default of the loans, in order to arrive at the net gain
attributable to the loans. But these losses have been smaller than the
loans themselves, since the defaulted bonds still retain some market.
value. Hence their subtraction from the gross gains, which were larger
than the loan-induced exports (which we have assumed to be equal to
these loans), still leaves a considerable margin of net gain for the
United States." Wallich's comments indicate that foreign lending can
be analyzed in terms of the transfer problem so popular in the pure
theory of international trade.

Ibid., p. 327n. 4.
Winkler, op. cit., p. 88.
Lewis, op. cit., passim.

Wallich, op. cit., pp. 322-3.


26

the statistical evidence cited above on debt service ratios for major LOC
debtor nations, the substantial record of nonperformance on these Joans, and
the obvious failure of the bankers' natural safeguard of diversification
to ensure that their portfolios are comprised of a reasonably balanced mix
of developing nations with positive as well as negative rates of overall
economic growth or net export growth. Second, one can hold that the bankers
made the loans fully expecting the overwhelming majority of them to go bad.
To pursue this intriguing possibility it seems only reasonable to establish
that there is some overall advantage to banks from making bad loans. Finally,
one can argue that the bankers made their decisions based upon expectations
formed rationally, but they were surprised by an unforeseen and unfore-
seeable event that made the loans perform badly.

The position that the debt crisis is the outcome of a random shock is

most fully developed by Sachs and Bruno.©°

They place special emphasis
on the oil price shock and its effects as the key random event that sent
the borrowing nations into arrears on their debt payments. They have not
selected the most satisfactory surprise, however, (1) since it would be
difficult to support the view that the second oil price boost of 1978 and
1979 was a "shock" and (2) since loan portfolio diversification was inten-
ded to cope with just such an eventuality.

A superior candidate may be the Fed's maintenance of a stringent
disinflationary policy. A case can be made that no one--including the

bankers--expected the Federal Reserve to stick by its tight money guns so

intently. The economists attached to the Fisherian theory of interest


27.

28.
29.
30.
31.

32.

33.
34,

35.

36.

37.

38.

56

See, e.g., "A War of Nerves Over Latin Debt," Business Week. June 18,
1984, pp. 20-1.

Brimmer, op. cit., p. 17.
Charles Kindleberger, correspondence dated July 6, 1984.
Ibid.

A simple explanation for the commercial banks’ movement toward LOC
borrowers could be the claim that the elasticity of loan demand by center
borrowers is much greater than the elasticity of demand by borrowers
from the periphery with respect to the terms. Therefore, a point is
reached on a phase of loan expansion when the commercial banks perceive
that they will have to make unacceptably large reductions in the terms
to continue lending at the center. But the Kindleberger view has the
banks having to accept softer terms at the center for any reason, in-
cluding central bank monetary policy.

Michael Beenstock. The World Economy in Transition. London: George
Allen and Unwin, 1983.

Ibid., p. 122.

Lawrence G. Franko. "Debt, Trade, and the Prospects for World Economic
Growth," in L. G. Franko and Marilyn Seiber (eds.). Developing
Country Debt. New York: Pergamon Press, 1979, p. 292.

Paul Volcker. "How Serious Is U.S. Bank Exposure?" Challenge. Vol.
26:2, May-June 1983, p. 13.

Laurie Goodman. "Bank Lending to Non-OPEC LDCs: Are Risks Diversi-
fiable?" Federal Reserve Board of New York Quarterly Review. Vol.
6:2, Summer 1981, p. 20.

Charles Kindleberger. "Debt Situation of the Developing Countries in
Historical Perspective" in Stephen Goodman (ed.). Financing and
Risk in Developing Countries. New York: Praeger Publishers, 1978,
p. 6.

Jofl Metais. "Less Developed Countries' Rising Indebtedness and the
Lender of Last Resort in International Context" in C. P. Kindleberger
and Jean-Pierre Laffargue. Financial Crises: Theory, History, and
Policy. Cambridge: Cambridge University Press, 1982.

Metais (p. 222) contends that the 1970s constitutes the fifth wave of
lending to the "backward" regions. He (p. 234n.2) identifies the
periods 1817-1825, 1860-76, 1900-14, and the 1920's as the four previous
waves. "Unfortunately," Metais (p. 222) concludes, "they all ended in
widespread defaults." Some of the same countries were involved in the
lending booms in the latter three waves--1900-1914, 1920s, and 1970s:
Argentina, Brazil, Egypt, Mexico, Spain, and Turkey.


102.

103.

104.
105.

106.

65

Tim Carrington. "U. S. Agencies Want Nations's Banks to Disclose
More Data on Problems," Wall Street Journal, August 22, 1984,
p. 27.

See Willene A. Johnson. “Bank Size and U.S. Bank Lending to Latin
America," FRBNY Quarterly Review, Vol. 8:3, Autumn 1983, pp. 20-1 and
Willene A. Johnson. "U.S. Bank Lending to Latin America:, The Implica-
tions of Bank Size," Federal Reserve Bank of New York Research Paper
No. 8320, January 1984, p. 33. Johnson suggests that the smaller
banks can pull back more easily because they hold a larger proportion
of short term claims on LDCs. Her work is the most detailed on
differences in lending to Latin borrowers by banks of different sizes.

See Jane D'Arista, op. cit., p. 63.
See Johnson, op. cit.

A. W. Coats has told me that he considers the Baring Crisis in the
1890s to be an exception to this general principle.


applications from a private business in Brazil and in Chad would be on an
equal footing--or the application from the Chadian enterprise will not be
dispensed with simply because the business is in Chad. The banks are
passive actors in the game. The borrowers must take the initiative. The
Chadian firm only would stand no chance of consideration if it failed to
submit a loan application.

The doctrine of loan pushing is the antithesis of Friedman's picture.
Bankers as loan pushers become active door-to-door salesmen, albeit in
pinstripe suits. They persuade borrowers to agree to credits although the
borrowers had no thoughts of borrowing at all or, at least, not such large
amounts. Moreover from this perspective in euphoric times banks will sell
loans to borrowers in regions they customarily leave alone.

The idea that banks force loans on borrowers emerges in the litera-
ture exploring financial flows in the 1920s from lenders in the United
States to borrowers in Germany and Latin America. Max Winkler's provoca-
tive exposé on the underwriting practices of U.S. banks with respect to
foreign bonds provided some remarkable anecdotes illustrative of Joan
pushing. Winkler described a Bavarian hamlet that was reported to be seek-
ing $125,000 to improve the town's power station. He reported further:

How could a loan of so small an amount be offered

to the American investor who had by now learned

to ‘invest' by the tens and hundreds of millions?

After much persuasion, the mayor of the town in

question was convinced of the desirability of con-

tracting a larger loan. The result was a $3,000,000

issue, successfully sold in the American market .2
Winkler adds that after the necessary additions were made to the power
plant, the balance was used "towards . . . various projects . . . ordinarily

termed non-productive. "3


45

removal of Continental Chairman David Taylor, as well as other senior
Managers, and their replacement by officials selected by the FDIC. Conti-
nental's stockholders also would take a bath. In addition to the plunge
in Continental stock they already had weathered, they "could lose the
largest share of some $2.2 billion in equity [when] the Government takes
over. "94

In the case of Continental, as in the case of Franklin National ten
years earlier, the regulators protected the depositors. In fact, fora
bank that had experienced a run so severe that perhaps as much as two-
thirds of its $30 billion in deposits had been removed since May, the FDIC
promised to protect depositors of sums larger than its $100,000 legal
vimit. 9

Although individual bank officials are not free from jeopardy when
loans sour, the bank as a going enterprise is protected from failure. To
be precise, a large money-center bank is protected from failure, particularly
those with intricate inter-bank deposit arrangements. The Continental rescue
was outright, unlike the still unsettled demise of Penn Square Bank. The
Continental rescue seems to provide a clear signal to the larger banks--and
their depositors, inclusive of other large banks--that they will continue to
exist regardless of the decisions of their present array of senior managers.
As least, such security exists up to the limits of the FDIC's insurance

96 Even in the case of exhaustion of the FDIC's funds, the Fed could

fund.
step in and substantially expand the reserves of the private banks. Of
course, as Minsky has stressed this would mean the Fed would have to accept

the inflationary consequences of such a move.


43

the Fed had continued an easy money policy the debt crisis may never have
materialized. For Minsky, the cyclical fluctuations are characteristics of
the unregulated capitalistic economy; appropriate regulation will eliminate
the cyclical swings. ‘
Without regulation, competitive pressure among the banks leads them to
extend loans to less and less well-secured borrowers. Even if there are
lessons to be learned from past lending booms, the profit wars of today
place an insuperable impetus on the commercial banks to increase their
assets through new lending. If it fails to "keep up," a bank must accept
a lower rate of return than its competitors during the long upswing as the
price paid for greater stability in its performance. °9
Finally, it is worth noting--especially in light of the section that
follows--that certain regulatory policies might aggravate overlending. If
the Fed, for example, performs its lender of the last resort function without
any major quid pro quo from the rescued financial institution, it only would
serve to encourage others to continue making injudicious loans:
If lender-of-last-resort interactions are not
accompanied by regulations and reforms that
restrict financial market practices, then the
intervention sets the stage for the financing
of an inflationary expansion, once the ‘animal
spirits’ of business people and bankers have
recovered from the transitory shock of the crisis
that forced the lender-of-the-last resort activities
in the first place.

F. Moral Hazard

The previous observation by Minsky succinctly identifies the moral

hazard problem. To the extent that lenders perceive that there are insti-

tutions willing to "insure" their operations they may become more willing


13

TABLE 2

INTEREST RATE SPREADS (OVER LIBOR) ANG “HATURITIES
ON EURCCURRENCY CREDITS TO SELECTED MAJGR DEBTOK NATIONS, 1975-1981

ARGENTINA 197594 197604 197794 197894 197994 198094 198194

SPREAD -- 1.88 1.58 88 76 -63 1.09
MATURITY -- 4.00 9.14 11.05 10.43 - 7.65 7.33
BRAZIL 197594 197694 197794 197894 197994 198094 198194
SFREAD 1.72 1.95 2.20 1.26 72 1.79 2.14
MATURITY 6.80 5.71 7.76 11.52 12.03 8.87 8.00
CHILE 1975Q4 197694 197794 197804 197994 198094 198194
SPREAD - -- 1.93 1.10 92 +93 1.01

MATURITY - -- 4.33 9.57 9.80 7.30 5.06
MEXICO 197594 197694 197794 197894 197994 198094 198104
SPREAD 2.00 2.05 1.88 +91 -69 -90 60
MATURITY 4.76 5.97 7.00 7.93 8.84 6.96 5.41

KOREA 197504, 197694 1977Q4 197804 197994 19804 198194
SPREAD 1.47 1.63 1.75 95 -69 52 +63
RATURITY 3.50 5.32 7.00 9.34 9.61 7.52 7.46
PCILAND 197594 197694 197794 197804 197904 198094 198194
SPREAD 1.50 1.50 - -- -83 1.13 --

MATURITY 6.00 7.00 - -- 3.00 3.00 -

VENEZUELA 197594 19764 19774 1978Q4 197994 198004 198194
SPREAD -- 1.63 1.63 1.35 -- -68 --

MATURITY -- 5.90 6.00 5.70 -- 5.00 --

Interest rate spreads are calculated as percent per annum.
Maturities are calculated as numbers of years.

Source: Memorandum prepared by Rodney H. Mills, Jr. entitled "Spreads and
Maturities on Eurocurrency Credits--Fourth Quarter 198] and Two-Year
Review" Board of Governors of the Federal Reserve System, March 3, 1982.


20.

21.

22.

55

This perspective is apparent in the remarks of such disparate observers
as then Federal Reserve Board Governor Andrew Brimmer in "International
Capital Markets and the Financing of Economic Development" in Addresses,
Essays, Lectures of Andrew Felton Brimmer Vol. 13 Washington, D.C.:
Federal Reserve Library 1973 p. 17, Cheryl Payer "Will the Government
Bail Out the Banks?" The Bankers Magazine Vol. 160: No. 2 Spring 1977

p. 84, and Stephen I. Davis The Management Function in International
Banking New York: John Wiley and Sons 1979 pp. 19-20. Brimmer, for
example observed "The main explanation [for the sharp rise in bank lending
to the LDC's] appears to lie in the abundant supply of funds to the Euro-
dollar market and the failure of demand for loans from borrowers in
developed countries to keep pace with the expansion in credit availa-
bility." And further: ". . . the Euro-currency banks (especially in
London) began to push loans to the developing countries with considerable
vigor. '

In his Westerfield address delivered at Atlanta University on October 25,
1973--prior to the bite of the first oil "shock"--Brimmer, Ibid., p. 15,
said that the seeds already had been sown for an international debt
crisis: ". . . there was a growing awareness in the late 1960s and early
1970s that the developing countries as a group, had incurred very large
foreign debts and were faced with heavy debt service requirements in the
years ahead." As early as 1969, Brimmer (p. 16) noted, that a Commission
on International Development headed by Lester Pearson warned about diffi-
culties posed for short and long term debt management problems for LDCs.
The World Bank in its World Debt Tables: External Public Debt of LDCs
December 15, 1974 (p. xvii) reported that by the late 1960s and the

early 1970s several countries already were “unable to continue meeting
their debt servicing obligations." These included Chile, Ghana, India,
Indonesia, Pakistan, Peru, and Turkey seeking debt relief on a multi-
lateral basis and Afghanistan, Egypt, and Yugoslavia seeking relief on

a bilateral basis.

Davis, op. cit., pp. 23-5.

Davis provides estimates that indicate that from the end of 1974 to the
end of 1977 banks in the Group of Ten countries and Switzerland raised
their net exposure in Brazil by 335%, in Mexico by 317%, in South Africa
by 197%, in the Soviet Union by an astonishing 8457% (although the
initial base was negligible), in Poland by 284%, and in Peru by 285%.

S. C. Gwynne. “Adventures in the Loan Trade." Harper's, Vol. 267:1600,
September 1983, pp. 22-6. ~

Ibid., pp. 25-6.

Ibid., p. 26.

Steve Frazier. "Oil's Lure Led Mexico and Banks Into Payment Woes,"
Wall Street Journal. May 15, 1984, p. 32 emphasis added.


61

75. Ibid., p. 16.

76. The Latin American debt far exceeds the indebtedness of any other
region of the Third World. For example, by mid-1984 the total debt
of the Latin nations was estimated to be greater than $230 billion
when compared with the estimated debt of about $50 billion for all
of Africa's nations. This does not mean that the situation in terms
of debt management is any easier for the African countries. The
smaller magnitude of the African debt removes the leverage the Latin
nations possess to threaten the formation of a debtor's cartel. for
several African nations debt service ratios exceed those of Mexico
and Brazil. Plus virtually all African nations have severe balance
of payments problems. See Clifford D. May. "Africa's Debts Appear
More Troublesome Than Others." The New York Times, July 1, 1984,

p. E 3.

77. Lee Berton "Early Warnings: Long Before the 'Run' at Continental
I]linois Bank Hinted of Its I11s," The Wall Street Journal, July 12,
1984, p. 20 reports:

". . . Continental's loans--the main assets at the Chicago institution
are of poorer quality than its competitors’, the banks' most recent
financial reports show. At the end of the 1984 first quarter, for
instance, Continental's nonperforming loans--those 90 days or more
Past due on interest and principal--were 7.7% of its total loans,
compared with 2.7% for the 14 money-center banks. Continental's loan-
loss reserves rose to 1.32% of its total loans at the end of the
quarter from 1.21% at the end of 1983 and 1.11% [at] the end of 1982."
Berton also quotes bank accountants as describing Continental as being
“notorious in the industry for ‘shooting craps' by lending to com-
panies that other banks avoided." The bank's customers had included
“once-ailing Chrysler Corp. International Harvester, and Braniff
International Corp.," but it still was hesitant to raise its loan-loss
reserve significantly. In fact, between 1975 and 1981 it lowered the
reserve from 1.34% to 0.87% while other money-center banks typically
maintained a 1% figure. Continental also had a remarkable record in
lagged writeoffs. After the 1982 shut down of Oklahoma City's Penn
Square Bank "by Federal regulators, Continental charged off only 4.5%
and classified only 15.1% of its Penn Square loans as nonperforming
{while] Chase Manhattan Corp. had by then charged off 21.2% and classi-
fied 35.4% as nonperforming, and Seafirst Corp. had charged 4.4% and
classified 27.3% as nonperformers."

78. "Troubled Nations Hold 11% of Foreign Loans by Continental I]linois,"
Wall Street Journal, November 29, 1982, p. 12.

79. Daniel Hertzberg, Tim Carrington, and John Andrew. "Confidence Game:
Large Banks Are Hit By New Set of Rumors and Stock Prices Fall,"
Wall Street Journal, May 25, 1984, p. 1.

By the end of 1983 Manufacturers Hanover had $6.5 billion in loans to
the four largest Latin borrowers which amounted to 284% of its share-
holders equity. In addition, Hertzberg, Carrington, and Andrew report


15

institutions they find creditors clamoring for their attention. The wall-

flowers become the belles of the dollar ball.

THEORIES OF THE DEBT CRISIS AND "PUSHING" LOANS

Both the concept and the doctrine of loan "pushing" fit with varying
degrees of ease within the folds of various theories of the current inter-
national debt crisis. Theories to be given critical consideration here are
those that rely upon (1) the rational expectations hypothesis, (2) unin-
formed bankers, (3) a principal-agent dilemma, (4) an over-borrowing
thesis, (5) the Minsky financial instability hypothesis, (6) the moral
hazard problem, and (7) the evolutionary tendency toward concentration

under the regime of finance capital.

A. The Rational Expectations Hypothesis

Explanations of the massive build-up of indebtedness in less developed
countries compatible with the belief that bankers possess rational expec-
tations (or stochastic perfect foresight) either treat the growth in
periphery debt as no object for alarm or due to unforeseeable shocks. The
first view, in effect, says that the debt crisis is not really a crisis
after all. The second view says that the bankers were surprised and that
the surprises could not have been prevented since they were purely random
events.

Michael Beenstock is perhaps the premier exponent of the first view. 22
Beenstock's "transition theory" says that the LDCs are now becoming the
major global industrial centers. Deindustrialization in the center ‘and
industrialization in the periphery--particularly in the so-called newly-

industrializing countries (NICs)--has meant (autonomous?) shifts in the


Loan Pushing: Doctrine and Theory
William Darity, Jr.

INTRODUCTION: THE LOAN PUSH DOCTRINE

Debt woes on a global scale compel attention simultaneously to a host
of ongoing unresolved theoretical problems for economists. The problems
broadly include the appropriate theory of the firm, the appropriate theory
of banking behavior, the proper analysis of the formation of contracts,
the correct treatment of the formation of individual and market expecta-
tions, and the nature of trade cycles and financial crises. Along the
fragile precipice of international credit arrangements these problems
surface flush red with high drama--a world of big banks, smaller banks, multi-
national guardian institutions, allegations of neoimperialist conspiracies,
borrowing governments of questionable competence and incorruptibility, and
persistent poverty among the masses of the populations of many of the
borrowing nations.

In pursuit of various aspects of all these problems, this paper focuses
in depth on a particular controversy that has arisen in the midst of the
international debt crisis--the controversy over the extent to which multi-
national banks are responsible for the current situation. The claim that
the commercial banks “pushed"--in some sense--loans on the less developed
countries constitutes the indictment. Proponents of the loan push notion
suggest that the banks have engaged in self-victimization by making absurd
lending decisions by advancing credit to foreign borrowers who have less
than a prayer of making repayment.

This view of bank lending lies at an opposite pole from the view
articulated by Irving Friedman. Friedman depicts banks as waiting for
applications for loans from around the world and evaluating each loan indi-

vidually on its merits regardless of its country of origin. | Thus, a priori,


36

Consider the recent experience of the large U.S. banks with significant
exposure to the four largest Latin American borrowing nations (see Table 4/6
The case of Continental Illinois obviously comes to mind. Its domestic loans,
of an unusually low quality pushed the bank over the edge. But there is
evidence to suggest that its Latin loans generally were (unofficially) in the
nonperforming category.’7 As of late 1982, 11% of its foreign loan portfolio

was devoted to Argentina and Mexico, amounting to 3% of the bank's total assets

of $37.57 billion.’8

Even before the crushing mid-1984 run on Continental
by its major institutional depositors its share prices began a long decline.

Its common stock eventually dropped from $25 per share to below $4 per share.

TABLE 4
THE MAJOR U.S. LENDERS TO LATIN AMERICA

Outstanding loans (Dec. 31, 1983)*
Millions of dollars

Percent of

Mexico Brazil Argentina Venezuela Total Assets
Manufacturers Hanover $1,915 $2,130 $1,327 $1,084 10.0%
Citicorp 2,900 4,700 1,090 1,500 7.6
Chase Manhattan 1,553 2,560 775 1,226 7.5
Chemical N.Y. 1,414 1,276 370 776 7.5
J. P. Morgan 1,174 1,785 741 464 7.2
Bankers Trust N.Y. 1,286 743 230** 436 6.7
BankAmerica 2,741 2,484 300** 1,614 5.9
Wells Fargo 655 568 100** 279 5.9
Continental Illinois 699 476 383 436 4.7
First Chicago 870 689 NA NA 4.3

*Excluding local currency loans **Estimated NA=not available
DATA: KEEFE, BRUYETTE & WOODS INC.

SOURCE: Business Week. June 18, 1984, p. 21,


24

begun to attempt to "clarify" the accounting rules to tighten the conditions
under which banks can continue to report interest on loans that is 90
days overdue as if it has been received. °°

What may be a more difficult management problem for the money-center
banks than avoiding writing down their earnings on Latin debt is preventing
their stocks from being ravaged on the securities market. Investors may
simply look through the accounting gambits and make a negative judgment
about the earnings position of the banks due to doubts about their LDC
Toans.°” The question remains whether or not investor reaction js a
sufficient disciplining force to rein in excessive lending by the commercial
banks. The issue will be treated in greater depth below when the principal-
agent dilemma approach to the international debt crisis is examined. To the
extent that the current crisis is an authentic index of fundamental weakness
in the international financial system, the investor response only appears to
have an ex post impact--after the loans already have been made that even-

tually become nonperforming.

The bankers' natural safeguards--such as diversification which is given
such an enthusiastic endorsement by Goodman--certainly has not proven
effective during this episode of lending to the LDCs. The banks made a
special effort to lend to non oil exporting LDCs and oil-exporting LDCs
simultaneously, ostensibly to cover themselves regardless of what happened
to petroleum prices. Additional increases in oil prices would hurt the
balance of payments position of the non-oil exporting LDCs, but enhance
the ability of the oil exporters to repay their loans. Decreases in oil

prices would have the opposite effect.


Long-term lending to non-OPEC LDCs began to grow
rapidly, albeit from a small base, in the late
1960s. This growth accelerated in the 1971-73
period, as banks began aggressively to seek new
lending outlets by offering narrow spreads on
syndicated credits and attractive terms on other
types of loans . . . [T]he volume of lending
mushroomed after the quadrupling of oil prices
in 1973-74.

Laurie Goodman. "Bank Lending to
Non-OPEC LDCs: Are Risks Diversi-

fiable?" FRBNY Quarterly keview.
Summer 1981, p. 15.

The present signs suggest that the bankers of the
world are bent on suicide.

John Maynard Keynes. "The Consequences
to the Banks of the Collapse of Money

Values (Aug. 1931)" in Essays in’

Persuasion. New York: W. W. Norton &
Company, 1963, p. 178.


48

Already, the shift is on toward the transfer of deposits from smaller banks

to larger banks. 101

Although the FDIC's rescue operation for a large bank
that fails can lead to dismissal of bank officials, the demonstration effect
can have great benefits for the large banks that are still solvent. The
policy can induce a shift in depositors toward them, enhancing concentration
of bank resources.

Regulatory proposals now under consideration to increase disclosure
may have a differential effect with respect to banks of different sizes.
In terms of domestic loans the "large banks whose shares are publicly traded
already disclose considerable information through the Securities and Exchange
Commission's reporting system" while the smaller banks would have to surrender
new information that they fear could subject them to runs by an already

panicky public. 02

The larger banks, with a larger proportion of their
portfolio in foreign loans, potentially can preserve the illusory quality
of those loans more easily than the smaller banks can with their problem
domestic loans.

It already has been shown that the large money-center banks have a clear
gain in the foreign loan business from the large fees they obtain for
arranging a syndication. When nervousness about LDC loans sets in smaller
banks tend to be the first to seek to pull back. 03 The larger banks have
an incentive to keep the second-line banks involved in new lending efforts
to extract the loan fees .'4 But if they cannot keep them involved they
still can take over some of the smaller banks' claims when the latter pull
out from providing funds to a country having payments difficulties .!05

One can speculate that the larger banks absorb these claims from those in


32

Keynes explained the manic lending of 1920s by the failure of the
bankers to sensibly forecast the future. The bankers, in Keynes'
view, were partially the victims of bad advice from his fellow economists
who, he continued to argue throughout the 1930s, were misleading practical

men with policy recommendations rooted in unsound theory. ©9

The bankers
also were, Keynes argued, victims of their own penchant for conventions--
conventions that paved a path to ruin:

A sound banker, alas! is not one who foresees

danger and avoids it, but one who, when he is

ruined is ruined in a conventional and ortho-

dox way along with hjs fellows, so that no one

can really blame him
Better to go down doing what everyone believes a banker should be doing,
than to stay afloat by being a maverick in the world of high finance. For
Keynes the bankers were prisoners of custom and habit which propelled them
onto unwarranted lending sprees from which they eventually recoiled only
to deepen their peril. They “pushed" loans--low quality loans--because that
was the conventional thing to be doing at the time.

Like virtually all of Keynes' hypotheses this one is intriguing, but
it, too, leaves several important questions unanswered: Who sets the con-
vention of the moment? How is it recognized as such, so that the herd
follows? If, in fact, there are profit advantages in not following the
convention, why does it remain so attractive to follow it to assure that, if
failure comes, it comes only "in a conventional and orthodox way"? Or, if
the profit advantages from unconventional and unorthodox behavior are
supremely uncertain, then why not follow the convention--since to do other-

wise holds no assurances of success? In the latter case the bankers are not

"blind" to the future and mere victims of their own habitual behavior. They


4]

E. The Financial Instability Hypothesis
Hyman Minsky recently has begun the extension of his financial insta-

bility hypothesis to the foreign loan push of the 1970s. 84

The financial
instability hypothesis mandates that the credit mechanism of capitalistic
economies is inherently prone to breakdown, contributing directly to

recurrent cyclical downturns. 85

Cast in the context of a long-wave analysis,
Minsky contends that long periods of prosperity lead lending institutions

to extend credits to borrowers with increasingly weaker financial positions.
Profit-seeking enterprises that receive new credits are more leveraged than
their predecessors in the borrowing game and more vulnerable to being unable
to repay their debts when a decline occurs in after-tax profits. Older
borrowers taking on additional credit, at least in part to refinance previous
debt obligations, acquire less sturdy financial postures. Eventually a
dropoff in after-tax profits occurs, and businesses fail to meet their Payment
commitments. The lenders subsequently retreat from extending additional
credit. The credit crunch that supplants the prior credit boom propagates

a generalized fall in investment, income, and employment.

It is convenient to graft a new set of borrowers onto the Minsky model,
specifically foreign borrowers in developing countries. They become the
object of attention of lenders to a greater degree as the long upswing
advances. This group of borrowers may, from the time their loans first are
contracted, possess speculative or Ponzi finance positions. These positions
are the most dangerous to sustain in a Minsky world. °6 The longer the
duration of a cyclical upturn, the larger the proportion of businesses and,

now, foreign governments, who come to hold these more dangerous positions.


27

rates were baffled as the real rate of interest on the dollar went from low
and even negative rates to historically unprecedented levels over the
course of the past several years. John Makin, for one, places the onus

of the international debt crisis at the doorstep of the Fed's great success
in bringing down the U.S. inflation rate; he depicts Walter Wriston as

one money-center banker who was "shocked" by the Fed's vigilance:

What remains is to determine what force on earth could
bring to so sudden a stop the music that both borrowers
and lenders had been so pleased to hear and dance to
with such abandon from 1974 to 1981. In two words, it
was Paul Volcker. Again Wriston is the spokesman who
characterizes a transition from the banker's perspective.
Asked in a 1978 interview whether he would welcome any
restrictions on any U.S. lenders or borrowers, Wriston
replied: "I just want the opposite. Let us have their
freedoms." "Which ones?" asked the interviewer. Wriston
replied: "I believe the most important thing the bank
will have to deal with over the next 10 years is not
money policy, because the options are limited and there
isn't much elbow room. [Rather] it's the revolution in
the financial business of America."

Five years later, asked the inevitable “what's gone wrong
now" question in another interview just before the Septem-
ber annual meetings of the IMF and World Bank, Wriston
replied: "We're beat upon the fact that we have imprudent
moments. But I don't know anyone that knew Volcker was
going to lock the wheels of the world. "6!

From this perspective the banks and their borrowers got caught in the
left-hand tail of the rate of return frequency distribution due to the ran-
dom shock created by a surprising commitment to disinflation by the U.S.
central bank. The bankers' lending terms were reasonable, conditional on
their reasonable forecasts of the world economy's direction. Floating rates
on loan contracts tied to reference nominal rates designed to protect the

lenders from high inflation punished the carriers of dollar-denominated

debt as inflation was wrung out of the U.S. economy.


1

Brimmer argued that they reduced the spread between their cost of funds
(LIBOR) and the loan rate they offered LDC borrowers. In addition, in
general, they lengthened the maturities on the loans and substantially
raised the amounts they were willing to tend .28 From Brimmer's perspective,
the commercial banks, in an effort to dispose of their surplus funds in the
periphery, made their terms particularly attractive to LDC borrowers.

The pattern of declining spreads and lengthening maturities is
especially plain between the final quarter of 1975 and the final quarter
of 1979 for both non-OPEC LDCs and OPEC nations at the aggregate level
(see Table 1). It is also plain for the major debtor nations (see Table 2).
Signs of reversal become visible in 1980 and 1981 as repayment difficulties
accelerate and as reschedulings were negotiated on harsher terms than the
initial loans.

The key point in the Brimmer conceptualization of loan pushing is the
implied segmentation of the global financial market between borrowers in
the developed and developing worlds. The commercial banks only turn in a
comprehensive fashion toward the LDCs when loan demand from sources in the
developed world weakens sufficiently for the terms required to bring forth
additional demand to be perceived as unprofitable. To make the new loans
in the countries of the periphery may have necessitated comparatively soft
terms for borrowers there, but those terms still were perceived as adequate
to produce a desired degree of profitability by the lenders.

Kindleberger, while acknowledging that his observation quoted above
about banks "'forcing' loans on the LDCs is a bit hyperbolic," also has
attempted to give precision to loan "pushing." He argues that sharp dif-

ferences exist in opportunities to contract for interest rates across


87.

88.

89.

90.

92.

93.

94.
95.

63

cover its debt obligations by reaping "a ‘bonanza' in the future which
makes the present value positive for low enough interest rates." In
the meantime, it must continually raise “its outstanding debt to meet
financial obligations."

In the late 1970s, Charles Kindleberger, Manias, Panics, and Crashes,
op. cit., passim, adopted a Minsky interpretation of lending bursts
leading to borrower default and a revulsion on the part of the lenders.
He seems to have moved somewhat away from this interpretation lately.

See especially Hyman Minsky, "The Federal Reserve: Between A Rack

and a Hard Place,” Challenge, May/June 1980, pp. 30-6. In personal
correspondence dated July 11, 1984 Minsky wrote the following to me:

"No banker and businessman--not even Continental Illinois and its
clients--entered upon contracts with the expectation that loans would
not perform. But the individual decision makers--even at the scale

of Citicorp--do not have command over system performance. Further-
more, the prevailing conventional wisdom is that the economy is capable
of sustained expansion at stable prices and of course the Captains of
Industry (and Finance) believe in the virtues of Capitalism and consider
anyone pointing out the flaws of capitalism as such as being subversive
or worst. Past crises and depressions are imputed to institutional
weaknesses or policy errors--not any inherent characteristics of our
economy. The 'alibis' for preceding performance shortfalls are believ-
able: for example if you read Friedman and Schwartz's Great Contrac-
tion would you believe that the contraction reflected deep flaws in

Our economy or that it was due to avoidable policy errors by the Federal
Reserve in managing The Money Supply?” (emphasis in original)

My colleague Bobbie Horn suggested this interpretation of the repetition
of overlending in the Minsky model.

Minsky, "The Federal Reserve," op. cit., p. 35.

An instance when the Fed performed such a function was its effort to
protect depositors at the London branch of Franklin National in 1974.
See Minsky, Ibid., p. 32.

See Charles Lipson. "The IMF, Commercial Banks, and Third World Debts,"
in Jonathan David Aronson (ed.). Debt and the Less Developed Countries.
Boulder: Westview Press, 1979, pp. 317-33.

Robert M. Solow. “On the Lender of Last Resort" in C. P. Kindleberger
and Jean-Pierre Laffargue (eds.). Financial Crises: Theory, History,
and Policy. Cambridge: Cambridge University Press, 1982, p. 238.

Stephen Knapp. "The Rescuer of Last Resort," Time, July 30, 1984, p. 88.

Ibid.


49

flight at a reduced price, and the smaller banks must correspondingly write-
down their asset position.

There may be a general principle that emerges here: periods of
generalized crises of liquidity permit the larger banks to gain at the

expense of the weak, 106

Although the larger banks are rivals among them-
selves, in general international debt crises serve them collectively vis-a-vis
the rest by producing the conditions under which they can consolidate their
position. If they are, at least in part, conscious actors in this process,

they may push LDC loans to advance such concentration.

CONCLUSIONS

If bankers possess rational expectations and made loans to LDC bor-
rowers sensibly based upon their best possible forecasts given the available
information, then three options follow in explaining the international debt
crisis. Either (1) there is no crisis--an extremely difficult position to
sustain, (2) the crisis was the product of an unanticipated event--such as
the change in monetary policy that occurred in 1979, or (3) the bankers
knowingly made bad foreign loans.

The third position can be maintained--despite its peculiarly cynical
flavor--if one distinguishes carefully between the potential interests of
the large money-center banks whose shares are publicly traded and the
comparatively smaller banks that are not publicly owned. The latter, it
can be argued, were pressed into the foreign loan business by the efforts
to export abroad by their major depositors. It should be added that larger
banks, through correspondent relationships, can exert leverage to pull

them into foreign loan syndications.


51

prior to the existence of FDIC or the IMF or the World Bank, competitive
pressure ala Minsky may well be a sufficient condition on its own terms to
produce a debt crisis. But the modern regulatory apparatus might make it
easier for the bankers to forget any lessons to be learned from the past.
Only the Minsky approach explicitly offers an explanation that suggests why
waves of lending occur at long intervals.

Loan pushing also is, obviously, consistent with arguments that are
not constrained by the assumption that bankers possess rational expectations.
Inadequate information on the part of the bankers, or the related explanation
that attributes the debt crisis to flaws in the incentives prevailing in the
typical organizational structure of banks both could result in overlending.
But these explanations are less satisfactory because they are rooted in
circumstances that are unlikely to be stable or persistent. Presumably,
bankers themselves would have an incentive to improve their information or to
remedy institutional weaknesses that produce an excessive volume of bad loans--
if, indeed, they are concerned about loan quality.

Regardless, the idea that banks "push loans," in the Brimmer-Kindleberger
sense, is not an unreasonable one. The history of commercial bank lending to
the less developed regions generate a host of instances that conform with the
general characteristics of the loan push phenomenon. A variety of theoretical

approaches provide credible explanations for the phenomenon.


14

borrowers with varying risk characteristics .29 Kindleberger constructs a
position that resembles the implications of the ancient mercantilist doc-
trine of the utility of poverty for the labor supply function; instead,

Kindleberger is concerned with the shape of the supply curve for loanable

funds. Kindleberger writes:

+ + . when interest rates decline sharply for any
reason, lenders look around to make loans at high
interest rates and take greater risks, in a sort
of backward-bending supply curve, to preserve
their old incomes. 30

According to Kindleberger the recent build-up of LDC indebtedness was
triggered by former Federal Reserve chairman Arthur Burns' "cheap money
efforts . . . in the early part of 1971"; this depressed interest rates
in the Euro-dollar market and led the participating banks to chase down
potential borrowers in the LDCs, particularly in Latin America.

Thus, the commercial banks are portrayed as attempting to avert
reductions in their profitability or earnings by shifting toward LOC
borrowers. 3! The banks were unwilling to accept a decline in terms great
enough to achieve full absorption of their loanable funds at the center.
On the other hand, softening the terms for periphery borrowers to a suffi-
cient degree to stimulate their consent to contract for large sums of
indebtedness would still leave the banks with what they considered to be
adequate margins for profitability.

"Pushing," then, amounts to design of loan packages that attract
borrowers who formerly were denied access to international credit markets
altogether or who were, at least, denied such large amounts of funds. The
LDC borrowers' risk characteristics, which presumably were responsible for
their previous exclusion from easy credit terms, remain unchanged. But

suddenly instead of being pariahs for the major international lending