Federal Deposit Insurance Corporation
 

FDIC
 

Banking
 Review
 1998
 

Vol. 11, No. 3
 

Financial Deregulation

in Japan

Financial Deregulation

in Japan

International Risk

Exposures

International Risk

Exposures

Recent

Developments

Recent

Developments
Table of Contents

FDIC
 

Banking


Review
 

1998
 

Volume 11, No. 3
 

Chairman

Donna Tanoue

Division of Research

and Statistics,

Director

Wm. Roger Watson 

Deputy Directors

Barry Kolatch
 

Steven A. Seelig
 

Editor

Steven A. Seelig

Editorial Committee

Jack T. Reidhill
 

Detta Voesar
 

Managing Editor

Detta Voesar

Editorial Secretary

Cathy Wright

Design and Production

Geri Bonebrake 

The views expressed are

those of the authors and do

not necessarily reflect official positions of the Federal

Deposit Insurance Corporation. Articles may be

reprinted or abstracted if

the FDIC Banking Review

and author(s) are credited.

Please provide the FDIC's

Division of Research and

Statistics with a copy of any

publications containing reprinted material.

Single­copy subscriptions

are available to the public

free of charge. Requests for

subscriptions, back issues

or address changes should

be mailed to: FDIC Banking

Review, Office of Corporate

Communications, Federal

Deposit Insurance Corporation, 550 17th Street, N.W.,

Washington, DC 20429.

Financial Deregulation in Japan

by Valentine V. Craig Page 1

This article examines the financial problems facing Japan for much of

the past decade and describes the reforms proposed to address them. It

then surveys the results of Britain's Big Bang, the model for Japanese

financial deregulation. The article concludes with a discussion of the

probable effects of Japanese Big Bang.

Assessing International Risk Exposures of U.S.

Banks

by Timothy Curry, Christopher Richardson, 

and Robin Heider Page 13

The authors analyze recent trends in both the direct and indirect risks

associated with the international lending activities of U.S. banks.

Recent Developments Affecting Depository

Institutions

by Lynne Montgomery Page 31

This regular feature of the FDIC Banking Review contains information on

regulatory agency actions, state legislation and regulation, and articles

and studies pertinent to banking and deposit insurance issues.
Financial Deregulation in Japan

Financial
 

Deregulation
 in Japan
 

by Valentine V. Craig*

On November 11, 1996, Japanese Prime

Minister Ryutaro Hashimoto unveiled a plan to

reform Japanese financial institutions and markets by the year 2001. The plan, which consisted of

dozens of proposals, was called "Big Bang," an analogy

to the decade­earlier British effort to reform its securities industry and capital markets. The goal of Japanese

Big Bang, as enunciated by the prime minister, was to

create a "free, fair and global" financial system-free,

in that it would operate according to market principles

rather than regulatory prescriptions; fair, in that it

would be transparent and reliable; and global, in that it

would be sophisticated and internationally respected.

Japan is the largest creditor nation in the world. It is

the world's second­largest economy (after the United

States) and accounts for the world's second­largest insurance market. It has nine of the ten largest banks (in

terms of loans outstanding) in the world. Its citizens

enjoy the world's highest per capita income, and they

contribute to one of the highest rates of savings in the

world. However, the nation has been facing severe financial problems for much of the past decade. This article begins by examining these problems and

describing the reforms proposed to address them. It

then surveys the results of Britain's Big Bang, the model for Japanese financial deregulation. It ends by discussing the probable effects of Japanese Big Bang. 

Japan's Financial Problems

Japan's financial industry and markets are suffering

from a constellation of problems caused, to a large extent, by government protection and excessive regulation. These problems include inadequate investment

choices and returns, inefficient and noncompetitive financial institutions, and underdeveloped financial markets that both fail to meet international standards for

performance and are characterized by weak financial

reporting and lack of transparency. Because of these

problems, the country faces a potentially serious pension fund shortfall, a banking crisis, and a lack of respect for Japanese financial markets and currency. 

Looming Pension Shortfalls: Inadequate

Investment Choices and Returns

The government hopes to stave off a serious pension

fund situation by expanding the number of investment

vehicles available to the population and by increasing

returns to savers. 

The portion of the population approaching retirement age is much larger in Japan than in other industrialized nations. In 2007, an estimated 21 percent of

the Japanese population will be over 65 compared with

15.5 percent now. It is projected that by 2025 there will

be 61 Japanese pensioners for every 100 workers. The

comparable projection for the United States is 49 retirees per 100 workers. According to a study by the

Organization for Economic Cooperation and Development (the OECD), assuming the current Japanese retirement age and level of worker contributions and

returns, government debt attributable to pensions will

rise from approximately 25 percent of GNP in 2000 to

* Valentine V. Craig is a Chartered Financial Analyst in the FDIC's

Division of Research and Statistics.

1
FDIC Banking Review

300 percent of GNP in 2030.1 Japanese firms are not

required to report pension liabilities on their balance

sheets, but by some estimates, Japanese firms will have

to spend 25 percent of profits on pension contributions

by the year 2000.2 These demographics explain

Japan's resistance to international calls for tax cuts to

spur its economy. The pending pension problem is severe, and returns to investors must improve dramatically for the country to avoid consuming a large portion

of its economy with retirement payments.

This pension fund crisis appears paradoxical, as the

amount of Japanese savings is huge. Japanese gross national savings represent approximately 30 percent of

GDP, or approximately one­third of the world's savings.3 However, most of this money has been funneled

into low­yielding savings accounts. More than anywhere else in the developed world, Japanese investors

have relied on savings accounts (offered by either

Japanese domestic banks or the Japanese Postal

System) as their primary investment vehicles.

Approximately 60 percent of Japanese liquid assets are

in bank accounts, compared with approximately 25

percent in the United States.4 And unfortunately for

Japanese savers, returns on bank or Postal System savings have historically been very low because of government policies that subordinated the needs of the banks

and savers to the needs of Japanese industry. After the

Second World War, Japanese industry needed cheap

capital to restart itself, and this cheap capital was subsidized through government restrictions on where money could go and what yields it could earn. 

Banking Crisis: Inefficient and

Noncompetitive Financial Institutions

Government protection and excessive regulation

have also resulted in inefficient and noncompetitive

Japanese financial institutions, with the banks especially disadvantaged by government policy.5 The

post-World War II government policy referred to

above, to promote Japanese industry at the expense of

savers and intermediaries, kept bank profitability low

in return for shifting risk from banks to the government. The banks funneled money cheaply to industrial firms that desperately needed funding to rebuild

after the war-and in return for restricted or "appropriate" profits, the banks received protection from

competition at home and abroad, and a tacit guarantee

of a bailout should problems arise. 

Japanese banks are currently saddled with bad loans

and, having been protected for so long, have not been

able to compete profitably in the new global arena.

Japanese investment firms and insurance companies

were also heavily regulated and protected from competition. Most securities firms have not made a profit in

years; and the insurance companies, although not required to report the same kind of asset­quality information as the banks, are believed by many analysts to

be much worse off financially than the banks. 

Underdeveloped Financial Markets

The third major financial problem for Japan is that

the nation's financial markets are relatively underdeveloped. Because of a variety of prohibitions, restrictions, and taxes, Japanese capital markets have not

kept pace with other world markets and have, in fact,

deteriorated greatly over the past decade. During the

late 1980s, monthly trading volumes in Tokyo and

New York were approximately equal; today Tokyo's

volume is approximately 20 percent of New York's,

with approximately 70 percent fewer shares traded

now in Tokyo than during 1988. Not only has the volume of foreign shares traded on the Tokyo Exchange

declined substantially, but the exchange's percentage

of domestic shares traded has declined as well.

Approximately 18 percent of total trade in Japanese equities is now done in London, a threefold increase in

the past five years.6 One­third of the Nikkei 225 stock

futures business is conducted from Singapore.7

Moreover, the number of foreign companies listed with

Tokyo has dropped by approximately one­half over the

past five years. 

The underdevelopment of Japanese capital markets

has both foreign and domestic consequences. Even

though Japan is the world's largest creditor nation, its

underdeveloped capital markets have dissuaded foreign investors from holding yen. Thus, the exchangerate risk for Japanese businesses, particularly Japanese

banks, has increased. The banks are particularly sensitive to the weakness in the yen because much of their

foreign lending is done in dollars and accounted for in

yen. As the dollar has strengthened relative to the yen,

the yen­amount of loans outstanding has increased,

forcing the banks to set aside more capital to meet the

1 "A Suitable Case for Treatment," The Economist (June 28, 1997): 9.

2 Ibid., 12.

3 "A Giant Sucking Sound," The Economist (August 23, 1997): 53.

4 "The Asian Tigers May Falter, but the Japanese Lion Is the Worry," The

New York Times (November 13, 1997), D2.

5 "A Time of Crisis," FDIC Banking Review 11, no. 2 (1998): 9-17.

6 "A Big Bang in Slow Motion," Financial Times (December 10, 1996), 21.

7 "Japanese Finance," The Economist (June 28, 1997): 1-18.

2
Financial Deregulation in Japan

minimum reserve requirements of the Bank for

International Settlements. 

From a purely domestic point of view, the underdevelopment of the capital markets has made borrowers

overdependent on banks. In the United States, bank

loans account for less than 10 percent of corporate

funding, but in Japan the figure is approximately 60

percent, according to estimates by Salomon Smith

Barney.8 Bank borrowers (for the most part Japanese

corporations) certainly benefited handsomely from the

low interest rates on bank borrowings, but at the same

time they became overly dependent upon the banks

for their capital needs, a potentially serious problem

when the banks are in crisis, as they are today. 

Weak and Opaque Financial Reporting 

Westerners complain of a lack of transparency and

materiality in the financial reporting of Japanese firms.

Parent­only reporting has served to obscure the financial and legal position of Japanese parent firms. Even

in the case where the parent is not legally responsible

for its subsidiaries' debt, refusal to honor the subsidiaries' debt can result in a parent's failure. This was

brought home recently in the case of Daido Concrete,

which refused to honor its shido nenshoes (letters of

awareness) for its subsidiaries' borrowings and was

then brought down by the concerted action of its

banks, which refused to roll over the parent's shortterm borrowings. Extensive financial arrangements

and obligations among firms in a keiretsu9 are also common in Japan and may be very material to the health of

a member firm, but are generally not reported.

Japan has neither the laws nor the infrastructure to

deal with financial problems of the magnitude it faces

today. For instance, Japanese firms often pledge the

same collateral repeatedly for different loans, and when

the borrower defaults, there is no legal procedure for

settling the claims of the different lenders. Japanese

law also makes it very difficult for banks to foreclose on

bad loans. Nor does a professional infrastructure exist

to promote Western ideas of transparency. With just

over 12,000 accountants in Japan (the United States,

whose economy is twice the size of Japan's, has 470,000

Certified Public Accountants), 710 bank examiners

(the United States has approximately 7,000), and a very

small judiciary, much financial reporting and enforcement of rules necessarily rests on the honor system. 

Proposed Solution: Big Bang

The dozens of reform proposals presented by Prime

Minister Hashimoto in late 1996 were the response to

these pressing financial problems. The proposed reforms are discussed in this section according to the

breakdown used by the Ministry of Finance:

� reforms to increase choice for investors and

borrowers; 

� reforms to encourage Japanese financial institutions to become more efficient and competitive; 

� reforms to encourage better functioning of

Japanese financial markets; and 

� reforms to establish rules for fair and transparent financial operations and a reliable regulatory framework. 

The initial plan called for these reforms to be implemented on a staggered basis over a five­year period.

Most of the proposals have been passed by the Diet,

and many have already been implemented. 

Increasing Choice for Investors and
 

Borrowers 

To improve investor choice, Big Bang authorizes

new financial instruments and new powers for

Japanese financial institutions and removes controls on

foreign exchange. 

New Financial Instruments and Powers

Banks and securities firms are now permitted to deal

in over­the­counter securities derivatives. Previously,

there was uncertainty as to whether using them constituted gambling and was therefore banned by Japanese

law. Beginning in July 1997, brokerages were allowed

to sell options on individual stocks on the Tokyo and

Osaka stock exchanges-previously this had been permitted only on indices. Banks are now authorized to

engage in over­the­counter trading of derivatives related to securities and commodities, and asset­backed securities are being authorized to improve liquidity. 

More choice was also given to investors and savers

with the introduction of asset management accounts in

October 1997; previously, postal or bank savings accounts were the main alternatives open to Japanese

savers. Additionally, banks and insurance companies

8 "Landmark Deals Indicate the Scale of Change," Financial Times (July

14, 1998), 3.

9 A keiretsu is a grouping of businesses held together by cross shareholdings

and a common economic purpose. Keiretsu groupings typically consist of

a large commercial bank at the center, with trust banks, insurance companies, and trading, construction, finance and real­estate companies as

other members.

3
FDIC Banking Review

have been authorized to enter the investment trust

(mutual fund) sales business indirectly by renting

space to investment companies, and they will be permitted to sell these trusts themselves in December

1998. It is expected that banks will eventually be authorized to sell long­term fire insurance and credit life

insurance related to housing loans.

Removal of Controls on Foreign Exchange

Controls on foreign exchange have been largely removed. On April 1, 1998, the Foreign Exchange and

Foreign Trade Control Act was amended, and among

other changes, Japanese nonbank companies and individuals were allowed to open financial accounts in institutions in foreign countries and to deal directly with

overseas banks and brokerages. Additionally, the monopoly that licensed banks and securities firms had on

the foreign­exchange business was lifted. The foreignexchange business was opened to nonbanks, and licensing requirements were removed.

Improving Efficiency and Competitiveness

of Financial Institutions

The Big Bang reforms have created a different competitive structure for financial institutions by authorizing competition through financial holding companies.

The reforms are also stripping away many of the protected powers enjoyed by the different kinds of financial firms and will allow for broad­based competition; in

particular, foreign entities are being allowed to compete more freely with Japanese firms. All of these reforms designed to increase competition will necessarily

increase investor choice as well. 

Competition through Holding Companies

Initially, competition among the different sectors of

the Japanese financial industry is being channeled

through a holding company structure. Holding companies had been outlawed since the end of the war, but

the Japanese Diet has repealed (subject to some restrictions) its general ban on them. The walls between

banks and securities firms have been removed through

the use of area­specific subsidiaries. It is planned that

beginning in April 2000, insurance companies will be

able to enter the banking, trust, and securities businesses through subsidiaries; in December 1998, securities companies will be able to enter the insurance

business; and in April 2001, banks will be able to enter

the insurance business. Head­to­head competition

(not through a holding company structure) by the different financial sectors is to be decided on at a later

date.

Removal of Monopoly Power and Other
 

Industry Protections
 

A major thrust of Big Bang is to abolish the monopoly powers enjoyed by each of the three sectors of the

financial industry in Japan: banks, securities firms, and

insurance companies. 

Reforms particularly relevant to banks. Some of

the reforms particularly relevant to banks are mentioned above: the removal of the licensed bank and securities firms' monopoly on foreign exchange, and the

opening up of the distribution of mutual funds to

banks and insurance companies. In addition, bank securities affiliates have been allowed to trade convertible bonds, warrants, stock options, and futures, and

will be allowed to broker cash equities. 

Reforms particularly relevant to securities firms.

Independent investment groups organized as investment advisors (Western­style fund managers), including foreign firms, will be allowed to compete more

freely for Japan's $2 trillion pension fund business.

Also, as already mentioned, since October 1997, securities firms have been allowed to offer asset management

accounts-multi­purpose securities accounts which

can be used to make payments and settlements. Fixed

commissions on securities sales are being gradually

abolished, first on transactions of more than 50 million

yen; by the end of calendar year 1999, fixed stock commissions will be completely eliminated. Commission

rates on securities transactions in Japan have been

among the highest in the world. Requirements mandating the specialization of securities firms are also being abolished, so that the firms will be allowed to

diversify; and a simplified registration system will replace the long process needed for licensing new brokerage firms. Finally, the securities transaction tax and

the exchange tax will be reduced in December 1998

and may be totally abolished in 1999. 

Reforms particularly relevant to insurance companies. Detailed restrictions on pension fund investments are being replaced with general requirements of

prudence. According to the previous "5­3­3­2 Rule," 50

percent of pension fund assets had to be invested in assets that guaranteed a return of principal (bonds primarily, or cash); not more than 30 percent of assets could be

in domestic equity; not more than 30 percent in foreign

equity; and no more than 20 percent in property. In addition, insurance premiums will be deregulated.

4
Financial Deregulation in Japan

Improving the Functioning of Financial

Markets

A number of the Big Bang reforms are designed to

make Japanese securities markets more like other global capital markets. Restrictions on off­exchange trading for listed securities will be abolished in December

1998, and the ban on broker trading of unlisted and unregistered stocks has already been lifted. Measures are

being taken to improve the liquidity of the over­thecounter market (JASDAQ); and in cross­border capital

transactions, requirements for permission and prior notification have been abolished for external settlements

and capital transactions.

Improving Transparency and

Accountability and Providing a

Regulatory Framework 

A number of the reforms improve the transparency

and accountability of Japanese institutions and markets. Implementation of these reforms is necessary if

the goals of the other reforms (better choice, more efficient institutions, and more respected financial markets) are to be achieved. 

Japan has adopted a "prompt corrective action" system under which banks are required to classify loans

into one of four credit categories (healthy loans, loans

requiring close attention, potentially unrecoverable

loans, and unrecoverable loans); to establish loss reserves; and to write off bad loans according to a set

schedule. As part of this system, a new method for calculating capital adequacy ratios for banks, with specific corrective measures, was to have been adopted in

April 1998. The corrective measures were postponed

for a year, however, for banks engaged exclusively in

domestic lending. The new standards require that internationally active banks with less than 8 percent capital prepare a management improvement plan (the

threshold is 4 percent for banks engaged in domestic

business only); internationally­active banks with capital below 4 percent are required to implement specific

corrective measures (the threshold is 2 percent for

banks engaged in domestic business only); and all

banks with capital below 0 percent are required to suspend operations. Regulators will be empowered to

shut down banks that do not meet capital reserve requirements.

Also, the classification of nonperforming loans was

changed and strengthened in April 1998 to include

those with interest arrears of more than three months

(the previous requirement had been six months).

Additionally, loans whose rates had been lowered and

restructured are now considered bad loans. Outside

auditors are empowered to examine the classifications

and can force banks to adjust them if the auditors find

them unrealistic. 

In April 1999, the consolidated method of reporting

will replace parent­only reporting. This change is intended to improve the reporting of corporate activities;

it will also be needed, now that holding companies

have been authorized. Additionally, in the year 2000

Japan plans to change its accounting standards to conform more closely to international accounting standards

as set forth by the International Accounting Standards

Committee (IASC). Mark­to­market of securities and

derivatives investments will be reported at that time.

And after the liberalization of foreign­exchange markets in April 1998, an ex post facto reporting system for

capital flows was created. 

Various measures are being undertaken to protect

investors and to ensure a fair playing field. Fair­trading

rules are being promulgated to cover new financial

products. Penalties for insider trading abuses are being

strengthened, and the existing civil dispute system is

being improved. The Securities and Exchange

Surveillance Commission is being strengthened to improve its systems for inspection, surveillance, and punishment. Measures to reduce settlement risk will be

undertaken.

The government infrastructure is being enhanced to

support increased surveillance and reporting. The

Financial Supervisory Agency (FSA) opened in July

1998. Independent of the Ministry of Finance, it reports to the new Financial Revitalization Commission

(which reports directly to the Prime Minister). The

FSA is charged with supervising the financial sector, including banks, securities firms, insurance companies,

and some nonbank lenders. It is also empowered to

close insolvent lenders, issue and revoke financial licenses, arrange mergers, and direct the Japanese

Deposit Insurance Corporation (DIC) to pay depositors of failed banks. 

The DIC, started in 1971 before Big Bang, reports to

the FSA. It collects premiums on bank deposits and

insures deposits of failed banks. It was recently

strengthened in response to the banks' bad­loan problems. In 1996, it was granted authority to purchase the

assets and deposits of failed institutions and to represent depositors in court proceedings. In 1998, in response to recent large failures, the Deposit Insurance

Act was amended, providing 17 trillion­yen of government funds for bank assistance through the end of

5
FDIC Banking Review

March 2001. In October 1998, the Diet approved an

additional 43 trillion­yen banking package to recapitalize and restructure the sector: 25 trillion­yen for capital injections into institutions, and 18 trillion­yen for

the establishment of bridge banks and the purchase of

financial institutions' assets. Earlier measures in this

bill requiring the banks to provision against losses were

dropped. 

Two agencies were created to deal specifically with

bad loans resulting from the failure of the jusen

(real­estate lenders) and other Japanese financial institutions. In 1996, the Housing Loan Administration

Corporation (HLAC) was created, and the Tokyo

Kyodo Bank was restructured into the Resolution and

Collection Bank, modeled after the U.S. Resolution

Trust Corporation. Under new legislation, these two

entities will be merged into the Resolution and

Collection Organization. The new organization is

charged with maximizing the recovery on nonperforming loans. 

London's Big Bang: Changes Wrought

The model for the Japanese deregulation effort was

London's Big Bang. British Big Bang officially took effect on October 26, 1986, but the chain of events that

led to it began in 1979 when controls on foreign exchange ended. The removal of these controls resulted

in a flight of British money out of the country as British

businesses (in particular), seeking higher returns, invested in overseas securities. For these transactions

they primarily used cheaper foreign securities firms.

Because fixed­commission rates had been abolished in

the United States four years earlier, the U.S. firms were

cheaper competitors and the recipients of much of this

new business. Furthermore, many U.S. firms, which

had established London offices for their Eurobond

business, branched out and began to trade securities of

large­capitalization British firms on the London

Exchange. In addition, some British financial institutions, rather than using the London Stock Exchange

for their transactions, began to trade British securities

on the New York Stock Exchange as American

Depository Receipts (ADRs), again for reasons of price. 

One of the first reforms of Big Bang was the removal

of restrictions on London Stock Exchange membership. British law did not require separation among the

securities business, investment banking, and commercial banking, but London Stock Exchange (LSE)

membership restrictions effectively maintained such

separation, protecting member firms from competition.

The abolition of these restrictions in March 1986 allowed outsiders, including foreign banks and securities

firms, to become members of the London Stock

Exchange or to purchase members. 

Also ended were fixed commissions on securities

transactions. This reform allowed British brokers to

compete with one another and with international competitors on price. Restrictions requiring separation of

the two types of British securities firms-jobbers (firms

that traded on their own account and made markets in

securities) and brokers (firms that acted only as agents

for a commission) were also abolished. Previously, a

firm could be either a jobber or a broker, and brokers

were required to use jobbers even if they could match

both buy and sell orders. 

The bond market was also opened up to all interested parties. Twenty­nine firms were immediately

granted licenses (18 survived through the end of 1996),

whereas until then, one firm had issued bonds and two

others had dominated trading.10

Finally, an electronic quote­driven trading system

replaced an order­driven trading system. Under the

earlier system, brokers matched buy and sell orders

provided by jobbers. Under the new system-the

Stock Exchange Automated Quotations (SEAQ)-system, similar to the NASDAQ in the United States twoway firm­competing quotes caused marketmakers to

risk their own capital. 

Increased Efficiency, Improved Liquidity,

and Lowered Cost

With the entry of new competition into the London

securities market, efficiency and liquidity in these markets increased and the cost for institutional trades decreased. In 1991, five years after the introduction of

Big Bang, capacity had increased by 500 percent, total

costs had increased 200 percent, and fees were halved.

By 1991, 25 marketmakers in equities and 18 in bonds

had replaced the handful of jobbers that previously

provided this function.11 With improved liquidity,

spreads were cut approximately in half; commissions

almost disappeared in the wholesale markets.12 The

new market for gilts functioned effectively and provided a liquid market for investors, the government, and

the Bank of England, with much of the growth in this

market coming from foreign investors. Institutional in10 "The Morning Ten Years After," The Economist (October 26, 1996): 91.

11 "Five Years Since Big Bang," The Economist (October 26, 1991): 23.

12 Norman S. Poser, International Securities Regulation, London's "Big

Bang" and the European Securities Market, Little, Brown and Company,

Boston, 1991, 68.

6
Financial Deregulation in Japan

vestors were big winners. Commissions on large, heavily traded shares fell dramatically. Additionally, brokers

on large transactions were often able to receive prices

better than those offered on the SEAQ. By 1989, 45

percent of deals (by volume) were done at prices better than the best SEAQ quotes.13

London: A World Financial Center

Big Bang financial deregulation is generally credited

with propelling London into its position as the major

European financial center. Three years after Big Bang,

there were 521 banks in London, and the city was the

center of the Eurobond market, responsible for issuing

65 per cent of all Eurobonds.14 Within five years of Big

Bang's passage, roughly as much trading in foreign equities as in domestic equities was conducted in

London. London had become Europe's leading stock

market: approximately half of the transactions in large

French and Italian shares and a quarter of the trades in

German shares were done through London, as well as

90 percent of all global cross­border transactions. Also

in 1991, more than 600,000 people worked in finance

and business services in London, approximately

100,000 more than in New York.15 In 1996, ten years

after Big Bang, London surpassed Frankfurt and Paris

as Europe's leading financial center. London is the

world's largest swap trader, it arranges more international mergers than any other city in the world, and it is

home to the largest foreign­exchange and international

insurance markets in the world.16

Consolidation in the Financial Industry

Improvements in efficiency, liquidity and cost came

about largely as a result of consolidation in the financial

industry. Deregulation of fixed commissions resulted

in much tighter margins and a decline in the profitability of securities firms. The decline in profitability, in

turn, led to the demise of many small or medium­sized

British securities firms. By February 1987, over half of

the 200 LSE member firms had merged or been acquired.17 Capital was in great demand, and for the

most part foreign firms provided it. British merchant

banks and brokers had insufficient capital to compete

according to international standards and were unsophisticated in the use of capital. They were also technologically backward, and this deficiency hurt their

competitiveness. 

The previously deregulated U.S. firms, particularly

the bond trading firms, proved to be formidable competitors. U.S. and other foreign institutions bought up

British jobbers, brokers, and merchant banks.

Attempting to stay competitive, British brokers

merged with jobbers, merchant banks bought both jobbers and brokers in order to compete with investment

banks, and commercial banks bought securities firms

to provide capital to businesses. 

Too­�asty Entry into the Market

Afraid of missing out on the seemingly limitless opportunities, firms (many of them foreign) rushed into

the London market, acquiring and merging with local

firms. Not all of these acquisitions and mergers made

good business sense. Many of them were not well

thought out and were executed in great haste and at inflated cost. Many acquiring firms underestimated the

difficulties of integrating different corporate cultures

and overestimated the extent of the market. The result was severe overcapacity in professional personnel

and capital. And the timing for an increased stock market presence could not have been worse. The worldwide stock market crash of October 1987 added to

overcapacity, as existing markets shrank. In all, 7 of the

32 marketmakers that entered the equities market after Big Bang, and 9 of the 27 new marketmakers in

bonds, had left by 1991. Moreover, at the same time

that London was experiencing a general overcapacity

in personnel and capital, clearing and settlement functions were deficient because of inadequate computerization and inexperienced back­office personnel. In the

years immediately following Big Bang, settlement

problems accounted for approximately half of all losses

from dealing in British securities.18

Many of the mergers formed in the aftermath of Big

Bang were later annulled at great cost. A notable failure at the time was Citibank's purchase of the British

broker Scrimgeour Vickers, which Citibank subsequently sold at a substantial loss. In many cases, firms

that remained independent had a comparative advantage. Not until 1990 did profitability return to London,

brought back by increased volume, a good market, and

more new issues.19

13 "Five Years Since Big Bang," The Economist (October 26, 1991): 23.

14 Poser, 75.

15 Norman S. Poser, International Securities Regulation, London's "Big

Bank" and the European Securities Market, 1992 Supplement, Little,

Brown and Company, Boston, 1992, 3.

16 "The Morning Ten Years After," The Economist (October 26, 1996): 91.

17 Poser, International Securities Regulation, 1991, 32.

18 "London's Certified Lunacy," The Economist (March 11, 1989).

19 Poser, 1992 Supplement, 20.

7
FDIC Banking Review

Conflicts of Interest and Insider Trading

As barriers were removed, new conflicts of interest

arose. The British Securities and Investment Board

(SIB) reported that in the three years after Big Bang,

unauthorized trading resulted in losses of at least 15

million British pounds.20 No Chinese walls were in

place to protect investors,21 nor was there a strong regulatory apparatus, like the Securities and Exchange

Commission in the United States. For the most part,

securities regulation in Britain had consisted of selfregulation via the London Stock Exchange.22 The

post­reform conglomeration of banks, brokers, and jobbers made insider trading easier, and no infrastructure

existed to police the industry effectively. 

Japan's Big Bang Reforms: 

Likell Outcome

Outcomes similar to those that occurred in Britain,

both the positive and the negative, can be expected to

occur in Japan if Big Bang proceeds as planned.

Improved returns and more vibrant institutions and markets, as well as the closure of domestic firms, initial overcapacity, and increased fraud are likely. However, there

remain implementation and enforcement problems, and

certain unaddressed problems, that stand in the way of

the full attainment of the stated Big Bang goals.

Improved Returns, and More Vibrant
 

Financial Institutions and Markets
 

Over the long run, the Big Bang reforms should result in greater competition, which should produce increased choice and returns and more vibrant financial

institutions and markets. Japanese investors and savers

should be able to earn global rates of return, with the

result that looming Japanese pension shortfalls are lessened. In terms of helping to heal Japan's domestic

banking crisis, the proposed reforms should enable the

nation's banks (and securities firms and insurance companies) to become more efficient and competitive. In

the short run, however, increased international competition will probably exacerbate their problems. Finally,

given such a large economy and the problems afflicting

other Asian financial centers, with decreased government intervention and increased transparency

Japanese financial markets should once again become

internationally significant.

Closure and Consolidation of Financial

Institutions

As in Britain, the withdrawal of protections and the

increase in competition will require consolidation in

the Japanese financial industry, with all the attendant

pain and dislocation. According to some analysts, if Big

Bang succeeds, a third of Japanese financial institutions

will disappear through mergers and closings.23

Japanese banks, securities firms, and insurance companies are expected to fare differently under deregulation, with the banks and insurance companies likely to

have a more difficult time during the adjustment period.

Prospect for Banks 

Burdened with high costs, low demand, old debt,

and new competition, the banks are particularly vulnerable as Big Bang reforms unfold. Morgan Stanley

Dean Witter estimates the net capital of the 19 largest

banks at August 1998 at an approximate negative $7.6

billion, after bad loans are written off.24 There are simply too many banks, so that even with current competition and protection, many are unprofitable. Once

more attractive investment alternatives are available

and financial activities become more transparent, many

Japanese investors are expected to reduce their dependency upon the banks and the Post Office and to invest

in the Japanese stock market and overseas capital markets. This has already begun to happen. In 1993,

Japanese households owned virtually no foreign securities; today, Japanese households own approximately

$685 billion in offshore investments, much of it invested in U.S. savings bonds.25 This capital outflow occurred despite onerous tax­reporting requirements for

cross­border capital transactions and despite higher tax

rates applied to nondomestic bank and postal savings

accounts. 

To deal with new competition, banks will need to restructure. Already some banks, particularly the larger

ones, have begun to dispose of bad loans and are entering into arrangements to securitize and sell real­estate loans in international markets. They will also have

to raise deposit interest rates to attract depositors.

20 Ibid., 1.

21 "Chinese wall" refers to the forced separation in a firm of investment

banking and its trading and investment research functions to eliminate

the use of insider information.

22 Big Bang was followed ten days later by the Financial Services Act,

which, for the first time in England, introduced a comprehensive system for regulating financial services.

23 Jesper Koll of J. P. Morgan and Co. quoted in "Two Japans, The Gulf

Between Corporate Winners and Losers Is Growing," Business Week

(January 27, 1997): 24-28.

24 "Japanese Bank Crisis Said to Be Worsening," The Washington Post

(September 9, 1998).

25 "Flight of Savings," The London Daily Telegraph (August 9, 1998), 4.

8
Financial Deregulation in Japan

Loan demand from strong businesses will weaken, as

these stronger borrowers are better able to access the

capital markets for their funding needs. Weaker, smaller companies, used to subsidized lending rates, will remain as borrowers. To prosper in this environment,

banks will need to price risk into the lending decision,

and as businesses are forced to pay interest rates in line

with their risk profiles, marginal businesses will fail. 

The banks that remain in business will need to develop new financial products to replace lending. Again,

this process has begun: Japanese banks and securities

companies are beginning to compete for pension fund

money management and mutual fund sales. Commercial banks have also been entering the bond business, gaining a market share of 60 percent in the year

ending March 1997, up from 36 percent a year earlier.26

On the whole, the larger banks are expected to weather the transition better than medium and small banks. 

In Britain, foreigners rushed in to purchase British

banks, but this is unlikely to occur in Japan, where the

banks are saddled with huge debts and are still expensive. Instead, many foreign financial institutions that

already have a presence in Japan are expected to expand internally. Others will form alliances, partnerships, and ventures with Japanese banks. Although

U.S. banks have been cutting their exposure to

Japan-it fell nearly 19 percent in the first quarter of

1998-foreign banks have done well overall, as

Japanese consumers and corporations have flocked to

these banks' relative safety. Citibank, for instance, currently reports more than half a million customers and

more than one million accounts in Japan.27

Prospect for Securities Firms

Japanese small and medium­sized securities firms

are also not expected to compete very well in the new

deregulated environment. As the major beneficiaries

of regulated commissions and other government protections, they are high­cost, low­tech producers and are

weak in mutual funds, asset management, derivatives,

and research. Commissions have accounted for at least

half of the revenue of many smaller brokers. Almost all

of the second­tier brokers suffered losses last year.

Even the larger Japanese securities firms have not

done well. Of the "Big Four" houses, Yamaichi was

bankrupted last year, and the earnings of the remaining

three-Nomura, Daiwa, and Nikko-plunged during

the first quarter of 1998 as trading volumes and commissions were eroded by foreign competition.28 The

bigger firms are expected to do better, however, as they

are not as dependent on commissions and have good

research capabilities.

Foreign competition is much fiercer in the securities

industry than in banking and insurance, where foreigners still account for only a small portion of Japanese

business. Foreign securities firms have made great

progress in developing their securities, fund management, and investment banking business. At the end of

1997, foreign securities firms accounted for a third of

the turnover on Tokyo's stock exchange. The previous

year they accounted for approximately a quarter of total business.29 They have drawn their customers both

from overseas and from Japan, with many Japanese investors having switched their business to foreign securities firms after scandals were exposed at the big four

Japanese firms. 

Mutual fund sales represent a potentially large market for foreign investment firms. Currently, mutual

fund investments account for only 4 percent of Japan's

household savings. In June 1998, the foreign share of

this market increased from 2 percent to 7 percent.30

The foreign firms have also excelled in pension fund

management. Money managed by all investment advisory firms increased approximately one­third from

1996 to 1997; although from a very small base, the

amount managed by foreign firms increased by 80 percent.31 Two years after its entry into the investment

trust business in Japan, Goldman Sachs was managing

$6 billion; after a four­month presence, Merrill Lynch

was managing $2.5 billion; and after 17 months in

Japan, Alliance Capital had $5 billion under management.32 However, foreign firms have achieved perhaps their greatest success in investment banking,

where they have enjoyed great success in raising foreign capital for Japanese businesses, underwriting new

issues, selling Japanese companies' cross­share holdings, and managing derivatives. 

Although no Japanese securities firm has been purchased outright by a foreign firm, several major foreign

firms have established relationships with them. For instance, Barclays established a joint venture with the

26 "Japanese Securities Firms: Once There Were Four," The Economist

(September 27, 1997): 80.

27 "Japan's Down, Citibank's Up," U.S. News and World Report (September 7, 1998): 34-37.

28 "Competition Hits Japan's Brokers," Financial Times (July 16, 1998), 41.

29 "Rich Pickings for the Gaiijin," The Economist (May 16, 1998): 83.

30 "Financial Big Boys of the West Go on a 'Dating Frenzy,'" Financial

Times (August 12, 1998), 21.

31 Ibid.

32 "Finance Firms Hope to Strike Gold in Japan," Star Tribune (June 5,

1998), 1D.

9
FDIC Banking Review

third­largest Japanese securities firm, Nikko; and

Travelers Group recently purchased a 25 percent stake

in Nikko, effectively taking over its investment banking and international operations. Merrill Lynch acquired a national retail network with its purchase of 30

Yamaichi branches and its hiring of 2,000 of Yamaichi's

laid­off staff. To ward off foreign competition,

Japanese securities firms have also been undertaking

cooperative arrangements with other Japanese financial entities. 

Prospect for Insurance Companies

Prospects for the insurance industry will not be clear

until more is known about which protections are

waived for this industry. Many of these decisions have

been postponed to the turn of the century. However,

the life insurance industry in Japan is in serious trouble-according to some analysts, the industry as a

whole is insolvent. Low interest rates, cancelled policies, and a bad stock market have hurt the industry

badly. Additionally, insurance firms have been big

lenders to brokerages and banks, so financial problems

in those industries will be felt by the insurance companies as well.

The opening up of the asset management business

to other participants-previously the almost exclusive

territory of the insurance companies and trust bankswill further affect this fragile industry. Life insurers

currently manage approximately one­third of the assets

of corporate Japanese pension funds. The returns on

these pension funds have been very low, even by

Japanese standards. New disclosure laws will require

these investments to be reported at market value in

April 1999, and it is expected that the movement of

pension fund money away from the insurance companies will then accelerate. The competition is not just

from foreign firms; Japanese securities companies and

banks have also expressed an interest in developing

their asset management business. 

Some foreign interest has been expressed in

Japanese insurers. GE Capital entered a joint venture

with Toho Life to develop and distribute Western insurance products. Putnam, the fifth­largest U.S. mutual fund family, has entered into an agreement to

manage approximately $700 million for Nippon Life,

focusing on non­Japanese securities, and to develop

products for Nippon Life's pension clients.

Overcapacity

Deregulation of the British securities markets resulted in an influx of foreign firms, resulting in initial

overcapacity and lowered profitability. Many foreign

entrants sustained substantial losses for a number of

years, and many chose to leave the market. Similarly,

over the past several years, foreign businesses have

been rushing into Japan in what one observer has

likened to "a financial dating frenzy."33 Foreign financial firms would be wise to learn the lessons of British

Big Bang and think twice before committing themselves to a large presence in Japan on the basis of unrealistic earnings expectations. 

Increased Fraud

As the British experience also shows, another unwanted development likely to result from financial

deregulation is increased fraud. And much like the

British a decade ago, the Japanese do not appear to

have the infrastructure necessary to support transparency and to discourage fraud. As mentioned previously, there are approximately 12,000 accountants in

Japan, 710 financial examiners (the FSA is requesting

an increase of approximately 15 percent in FY 1999),

and a small judiciary; and the country is significantly

more low­tech than most other developed countries.

Additionally, the Japanese underworld, the yaku�a, is

reportedly deeply involved in the Japanese banks' baddebt problem. A lesson from both the British experience and the U.S. savings­and­loan experience is that

deregulation must be accompanied by supervision, but

this will not be easy to do in Japan.

Implementation and Enforcement

Most of the Big Bang legislation has been passed,

and many of the reforms have been implemented.

Especially on the first three goals of Big Bang-increased choice, increased competition, and vibrant financial markets-a great deal has been accomplished.

New financial instruments and powers have been introduced, controls on foreign exchange have been

largely removed, many industry protections have been

removed, and competition has been allowed through a

holding company structure. Foreign businesses have

been allowed to compete more freely. These reforms

are not likely to be turned back. 

In the area of increased financial industry transparency and accountability, however, less progress has

been made in Japan. The new minimum capital ade33 "Financial Big Boys of the West Go on a 'Dating Frenzy,'" Financial

Times (August 12, 1998), 21.

10
Financial Deregulation in Japan

quacy requirements have been postponed for most

banks until 1999, and Japan's accounting standards are

not slated to conform to international accounting standards until the year 2000. Even if and when these standards are brought into conformance, potentially serious

deficiencies exist that could seriously undermine these

reforms. As mentioned previously, no adequate infrastructure (or culture) currently exists in Japan to enforce increased financial reporting and to question the

accuracy of reported financial results. For instance, one

need not be a skeptic to question the validity of bank

loan classifications based on self­assessment, the current reporting mechanism. And, the new minimum

capital adequacy requirements will be mere windowdressing without realistic loan classifications. Auditing

by respected external auditors is essential for investor

confidence, and at this point in time, there is no such

capability in Japan. Unfortunately, without investor

faith in firms' reported financial positions, the other Big

Bang goals-investor choice, competition, and financial market respect-are undermined. 

The very dire situation of the banks and probably of

the insurance companies, a deepening recession, and

recent political upheaval also bring into question the

ability and willingness of the government to stand

aside and let market forces determine financial winners

and losers. The government's commitment to full disclosure and accountability and to a reliance on unfettered market forces has been unclear in the light of

some recent actions: the postponement of the new

capital adequacy requirements for some banks; the

adoption of accounting gimmicks for banks and insurance companies;34 the pressure exerted by the government on an unwilling Sumitomo Bank to acquire the

long­suffering Long Term Credit Bank; and calls during the summer by some leading politicians for shortterm controls on capital flows. A bill was recently

passed providing an additional 43 trillion­yen to recapitalize and restructure the banking sector. However,

strict provisioning requirements were dropped from

the bill, and it is not at all clear at this time whether the

authorities will require the banks to restructure in a

meaningful way or whether this capital infusion will

represent only a temporary bailout and a continuation

of "business as usual." 

Deregulating the nation's financial institutions will

be very difficult because deregulation will affect not

only Japan's financial institutions and businesses (how

they are financed and operated) but also basic Japanese

values. In a deregulated, competitive environment,

business practices in Japan will have to change. If capital is to earn global returns, there can be no more

cheap money for well­connected marginal businesses-keiretsu loyalties and the concept of lifetime employment will need to be modified substantially, if not

jettisoned. Changing such basic Japanese values will

be difficult and painful. 

Unaddressed Problems

There are also problems that have not been addressed by the Big Bang proposals but that cannot be

ignored. The Big Bang proposals do not deal with the

role of the world's biggest bank, the Japanese Post

Office, which holds approximately $2 trillion in savings

and over $800 billion dollars in life insurance policies.

It pays no taxes or deposit insurance premiums; it is not

required to hold reserves against losses; it is fully guaranteed; and its time deposits are more liquid than those

of banks. The existence of this huge publicly financed, risk­free competitor to banks and insurance

companies must be addressed to ensure a level playing

field for financial participants. 

Japanese tax policy, too, must be examined. The

government is instituting consolidated reporting,

which will provide an incentive for mergers between

profitable and unprofitable firms, and it may totally

abolish securities transaction taxes. However, preferential taxation on bank and postal savings accounts

needs to be addressed. Bank and postal savings accounts are currently taxed at a flat 20 percent rate,

whereas other investment income is subject to a maximum capital gains and interest tax of 65 percent.

Furthermore, after foreign currency controls were removed, onerous tax reporting requirements were instituted for cross­border capital transactions. If the tax

treatments for different investment alternatives remain

substantially different, the effect of removing foreignexchange restrictions and increasing the investment

options for investors will be limited.

Additionally, many decisions about the deregulation

and opening up of the insurance industry have been

postponed for action until later. Government behavior

toward the insurance industry will have a substantial

effect on the outlook for Japanese deregulation.

Conclusion

Big Bang financial reform holds much promise as a

way to alleviate the Japanese problems of inadequate

34 New rules allow banks and insurance companies to inflate their balance

sheets by booking some stocks at cost, and real estate at current value.

11
FDIC Banking Review

investment return and choice, underdeveloped financial markets that do not meet international standards

for performance, and nontransparent financial reporting. Over the long run, these reforms should also make

Japanese financial institutions more efficient and competitive. Over the short run, however, they will quite

possibly exacerbate the problems of these institutions,

in particular, the banks and insurance companies. As

the history of British Big Bang shows, not all the results

of deregulation are benign. Deregulation and increased competition can be expected to lead to the closure of marginal financial firms; and the three

groups-banks, securities firms, and insurance companies-will vary in their capacity to weather the new

competition. Recently, foreign financial firms in these

markets have been doing well, but at some point the

increased competition may lower returns for all participants. Also, if the British model holds, conflicts of interest will increase-an outcome for which the

Japanese appear to be unprepared. Finally, although

much of the legislation authorizing these reforms has

been passed, and many have been implemented, in the

area of transparency and accountability it is not clear

that the government is willing or able to make great

changes in the short run. A lack of an enforcement infrastructure, a banking crisis, a deepening recession,

and political dissension may prevent or weaken the

necessary implementation or enforcement of these reforms. 

12
International Risk Exposures of U.S. Banks

Assessing International
 

Risk Exposures of
 

U.S. Banks
 

by Timothy Curry, Christopher Richardson, and Robin Heider*
 

The debt crisis of the early 1980s was a critical

period for the largest U.S. international banks.

Several of these institutions verged on insolvency because of their international lending exposure

and the potential for massive defaults by the lessdeveloped countries (LDCs). Had one or more of

these institutions failed, the stability of the entire U.S.

financial system could have been jeopardized. Policies

adopted by bank regulatory officials, along with assistance from international lending organizations, managed to prevent the failure of any large U.S. banks and

to otherwise contain the crisis.1 However, it took almost a decade for the international banks to clean up

their balance sheets, rebuild capital levels, and resume

international lending. 

Loan losses incurred by banks in overseas lending

during the 1980s and in other periods reflect the credit risks associated with such activity. Bank supervisors

keep a close watch on this exposure by requiring the

U.S. banking organizations that are engaged in international lending to file quarterly disclosure reports. In

recent decades, with the integration of the regional

and global economies, bank supervisors have also become concerned with indirect, or "secondary," risks.

Secondary risk refers to increased probability of loan

defaults because of trade­based economic linkages between nations. If the economies of two or more nations are linked by trading relationships, then adverse

economic events in one nation may spill over to, and

compound problems for, that nation's trading partner(s); and these secondary effects can, in turn, influence the ability of borrowers in these nations to repay

loans to third parties like U.S. banks. 

Foreign lending risk therefore has at least two components, direct and indirect, and to identify the true

magnitude of the exposure, one cannot take a piecemeal approach. This article examines recent trends in

both the direct and the indirect risks associated with

the international lending activities of U.S. banks. The

first section defines the components of foreign lending

and surveys trends since 1982 in loan volume, risk exposure, and lending organizations; trends in foreign

lending claims, by borrower and by maturity; and

trends in the direction of foreign lending. The next

section looks at secondary, or indirect risk, and the international trading relationships of the United States

and of the countries to which U.S. banks have extended the largest dollar amounts of loans. The final part

summarizes the data presented and draws conclusions

about risks to U.S. foreign lenders in the near future. 

* Timothy Curry and Christopher Richardson are financial economists and

Robin Heider is a research assistant in the FDIC's Division of Research

and Statistics. The authors would like to thank Jack Reidhill, John

O'Keefe, Steven Seelig, Peter Elmer, Gary Fissel, Kathleen James, Louis

Scalza, and Christopher Spoth for helpful comments and suggestions.

1 U.S. bank regulators granted forbearance to the international banks with

respect to the provisioning for future losses and other matters.

Forbearance was the only practical solution at the time, for otherwise

some of the large banks would have been insolvent. In addition, the international lending organizations like the World Bank and International

Monetary Fund provided funds to developing nations to facilitate debt

reduction. Part of these funds were used to repay bank creditors. For a

discussion of these issues, see Seidman (1993) and Curry (1997).

13
FDIC Banking Review

Trends in Foreign Lending 

Foreign lending has at least three components.

First, "cross­border" lending is the dollar­denominated loans booked at the U.S. offices of American banks

and extended outside the boundaries of the United

States. These loans can be made to other commercial

banks, private nonbank borrowers, or various governments and agencies. For example, Citibank, NY,

might book a credit payable in U.S. dollars to a Mexican corporation headquartered in Mexico City. Crossborder lending entails considerable risks besides

borrower default risk because lenders also have to consider the effects of local currency devaluations in

terms of U.S. dollars. As the conversion rate of the local currency into dollars deteriorates, the weight of the

debt service payments of the loans increases because

foreign borrowers have to earn more units of the local

currency to meet their dollar­denominated debt payments. Loan defaults caused by collapsing exchange

rates have been associated with most international financial crises, including that of the early 1980s and the

current Asian and Russian crises.

Second, international banks also engage in "localcurrency" lending, which consists of loans that branches or subsidiaries of U.S. banks in a foreign country

extend in the domestic currency. In contrast to crossborder lending, this type of activity does not involve

direct exchange­rate risks for the borrower.2 For example, when Citibank's branch in London extends

loans in the local currency (pounds), they are considered local­currency loans rather than cross­border

loans. The interest and principal payments on these

loans are made in pounds and thus are not affected by

fluctuations in the exchange rate.

Third, existing loan commitments to foreign borrowers are counted as foreign lending because commitments are contractual pledges by a financial

institution to extend funds at some future date, even

if the funds have yet to be disbursed. 

In this article, "total foreign lending" refers to all

three categories combined, and the degree of international lending risk is usually expressed as a function of

a common measure, such as total capital or assets of

the lending institutions.3

The rest of this section discusses trends in (a) loan

volume, risk exposure, and lending organizations; (b)

the nature of foreign lending claims; and (c) the direction of foreign lending.

Loan Volume, Risk Exposure, and 

Lending Organizations 

Historically, cross­border lending followed international trading relationships, with large commercial

banks pursuing opportunities generated by the expansion of multinational corporations. For decades this

trend was reflected in the global expansion of U.S.,

Japanese, and European banks. More recently, there

have been other incentives for international lending:

world economic growth, the expansion of world trade,

and the emergence of developing economies.

Financial institutions with the necessary capital and

technical skills have moved globally to take advantage

of these opportunities, and large U.S. commercial

banks have been at the forefront of such lending activities. 

Foreign lending by U.S. banks declined during

most of the 1980s and early 1990s in response to that

period's LDC debt and other crises, all of which significantly eroded bank capital.4 For example, between 1982 and 1992, such lending decreased from

$520 billion to $398.7 billion (table 1). In 1993, as

these banks recovered and recapitalized, they resumed lending; and over the next five years outstanding loans and commitments increased significantly,

peaking in 1997 at $703.3 billion, for an annual compound rate of growth of 12 percent over this period.

The Asian crisis, which broke out in mid­1997, chilled

the fervor for new lending to the point that in the first

quarter of 1998, loans and commitments remained unchanged. Furthermore, in response to the crisis, lending to certain nations (including, among others,

Thailand, Indonesia, the Philippines, and Malaysia)

has plummeted.

2 The lender still faces exchange­rate risks, however, when converting the

interest and principal payments on the loans back into U.S. dollars. To

protect themselves against potential currency fluctuations, most lenders

that are engaged in local­currency lending enter into foreign­exchange

contracts to hedge potential losses.

3 The analysis of foreign lending does not consider all risks associated with

international lending by U.S. banks. For example, off­balance­sheet risks

such as derivative contracts also represent potential drains on the capital

of lending banks but are not considered here because data are lacking.

Similarly, loans to investment funds that engage in international investments, or loans to domestic corporations that engage in international trade

also represent risks to U.S. banks but are not considered in this analysis.

Finally, third­party guarantees represent another potential source of risk.

4 The collapse of commercial real­estate markets during the late 1980s and

early 1990s significantly diminished bank capital by causing heavy loan

losses and, in many cases, bank failures.

14
International Risk Exposures of U.S. Banks

Table 1

Foreign Lending by U.S. Commercial Banks, Year-end 1982-1998

($Billions)

1982 1987 1992 1997 1998a

All U.S. Banks (number) 171 184 150 109 107

Total Capitalb $ 70.6 $ 129.2 $ 182.0 $ 342.9 $ 356.2

Total Assets 1,261.0 1,633.0 1,767.5 3,257.8 3,389.6

Cross­Border Loans 353.3 267.3 197.1 333.9 325.4

Total Commitments 87.3 76.3 72.8 105.3 101.6

Total Cross-Border Lending 440.6 343.7 269.9 439.2 426.9

Percent of Capital 624% 266% 148% 128% 120%

Percent of Assets 35% 21% 15% 13% 13%

Local­Currency Loans and Other Claimsc 79.4 136.4 128.8 264.1 277.0

Total Foreign Lending 520.0 480.1 398.7 703.3 703.9

Percent of Capital 737% 372% 219% 205% 198%

Percent of Assets 41% 29% 23% 22% 21%

Money-Center Banks (number)d 9 9 8 6 6

Total Capitalb $ 29.0 $ 51.5 $ 74.9 $ 122.5 $ 123.9

Total Assets 588.0 626.0 667.2 1,298.8 1,337.3

Cross­Border Loans 205.3 162.9 123.6 234.0 237.2

Total Commitments 69.1 60.2 60.8 79.7 75.0

Total Cross-Border Lending 274.4 223.1 184.4 313.7 312.2

Percent of Capital 946% 433% 246% 256% 252%

Percent of Assets 47% 36% 28% 24% 23%

All Other Large Banks (number)e 15 13 11 7 7

Total Capitalb $ 13.5 $ 23.9 $ 29.4 $ 70.0 $ 72.5

Total Assets 253.0 284.0 278.8 677.5 704.5

Cross­Border Loans 67.3 44.7 34.5 65.9 59.2

Total Commitments 10.5 10.5 7.4 11.1 12.1

Total Cross-Border Lending 77.8 55.2 41.9 77.0 71.4

Percent of Capital 577% 231% 142% 110% 98%

Percent of Assets 31% 19% 15% 11% 10%

All Other Reporting Banks (number) 147 162 131 96 94

Total Capitalb $ 28.1 $ 53.8 $ 77.6 $ 150.3 $ 159.7

Total Assets 420.0 723.0 821.4 1,281.5 1,347.8

Cross­Border Loans 80.6 59.7 38.9 34.0 28.9

Total Commitments 7.7 5.6 4.7 14.5 14.4

Total Cross-Border Lending 88.4 65.3 43.7 48.5 43.3

Percent of Capital 314% 121% 56% 32% 27%

Percent of Assets 21% 9% 5% 4% 3%

Source: FFIEC, Country Exposure Reports.
 

aMarch 31, 1998.
 

bTotal capital includes equity, subordinated debentures, and reserves for loan losses. 

cData on local­currency loans were not available for the individual groupings but only for the aggregate. Thus, the combined data for the individual groupings contain only the total cross­border lending and commitments and do not add up to the "total foreign lending" panel for all banks.

dFor year­end 1997 and March 1998, the "money­center banks" category includes Bank of America, Bankers Trust, Chase Manhattan, Citicorp, First

Chicago, and J. P. Morgan.

eFor year­end 1997 and March 1998, the "other large banks" category includes BankBoston Corp, Bank of New York Co., Corestates Financial Corp, First

Union Corp, NationsBank Corp, Republic NY Corp, and State Street Corp.

15
FDIC Banking Review

U.S. banks' overall risk exposure to foreign lending

also declined for most of the 1980s through 1992. At

year­end 1982, at the outbreak of the LDC debt crisis,

the concentration of foreign loans and commitments

on the balance sheets of U.S. banks represented over

seven times capital and 41 percent of total assets. This

ratio fell during the next decade as new commitments

declined and delinquent loans were written off.5 By

year­end 1992, the total of loans to capital was only approximately 30 percent of what it had been in 1982.

This downward trend continued, slowly, over the next

five years, as U.S. banks were recapitalized. By March

31, 1998, the total capital at risk was still relatively

modest in comparison with what it had been at the

start of the 1980s (table 1).

Foreign lending is dominated by large money­center banks, and this domination has increased over

time. As of March 31, 1998, money­center banks accounted for $312.2 billion of the $426.9 billion in crossborder loans and commitments by U.S. banks (table

1). This market share has been steadily increasing in

recent years, going from 62 percent of total foreign

lending in 1982 to 73 percent as of March 31, 1998 (figure 1). The money­center banks have also had substantially more capital and assets at risk than all other

foreign lending banks, leveraging almost 2.5 dollars of

loans for each dollar of capital and holding 23 percent

of total assets in foreign loans as of the same date. But

Figure 1

"The market shares of the money-center banks have

been increasing in recent years." Percent

100

80

60

40

20

0

1982 1987 1992 1997 1998*

Year-end

Money-Center Other Large All Other

Banks Banks Reporting Banks

Source: Federal Financial Institutions Examination Council (FFIEC),

CountryExposure Reports.

* March 31, 1998.

while the money­center banks' risk exposure has been

increasing since 1992, the levels are modest in comparison with what they were at the outbreak of the

debt crisis in 1982, when foreign lending represented

946 percent of capital and 47 percent of total assets for

these banks. 

Unlike the money­center banks, the "other large

banks" (super­regionals) and "all other reporting

banks" have cut back foreign lending both in terms of

the absolute volume of loans on their books and as a

percentage of capital and assets devoted to such lending. For example, the super­regionals' foreign loans

outstanding declined slightly from $77.8 billion at

year­end 1982 to $71.4 billion at the end of the first

quarter of 1998. Furthermore, their foreign lending

declined from 577 percent of capital and 31 percent of

assets at year­end 1982 to 98 percent of capital and

only 10 percent of assets as of March 31, 1998 (table 1).

The "other reporting banks" that have been involved

in foreign lending have also cut back from the business but much more dramatically. As of March 31,

1998, these banks carried almost 50 percent fewer foreign loans on their books than in the early 1980s, and

the group's international lending amounted to only 27

percent of its capital and 3 percent of its assets. 

Nature of Foreign Lending Claims

Characteristics of foreign loans granted by U.S.

banks over the 1982-1998 period: 

� Borrower

The data show that over the 1982-1998 period, U.S

bank foreign lending to other bank intermediaries (interbank market) declined relative to lending to other

groups. U.S. bank loans to the banking sector have

been trending downward since the early 1980s, with

the market share for this type of loan declining from 53

percent of total cross­border lending in 1982 to 32 percent in 1998 (figures 2 and 3). The cross­border interbank market consists of loans to various parties,

including local financial institutions, correspondent

banks, and, in some instances, branches or subsidiaries

of the parent bank. These loans are typically unsecured, although secured lending also occurs through

5 Citicorp was the first U.S. bank to take a loss on its foreign lending portfolio. It wrote off approximately $3.3 billion of international loans in 1987,

and shortly thereafter most other major U.S. banks that engaged in international lending followed suit. See Curry (1997), 208.

16
International Risk Exposures of U.S. Banks

Figure 2
 

"U.S. bank cross-border lending has been increasing
 

to the private nonbank sector and declining
 

to the banking sector in recent years."
 $Billions

300

200

100

0

1982 1987 1992 1997 1998*

Year-end

Private Nonbank Banks Public

Borrowers Borrowers

Source: FFIEC, CountryExposure Reports.

* March 31, 1998.

Figure 3

"Increased U.S. bank lending to the different

foreign sector borrowers is reflected in the

changing market shares of the groups."

Percent

100

80

60

40

20

0

Year-end

Private Nonbank Banks

Borrowers

Source: FFIEC, Country Exposure Reports.

* March 31, 1998.

1982 1987 1992 1997 1998*

Public

Borrowers

the "repo" or repurchase market (overnight or term

loans collateralized by pledged securities). The recent

shift away from the interbank market is explained primarily by the declining risk/reward trade­offs, as reflected in the narrowing spreads on interbank loans

relative to other types of lending. 

As lending to the interbank market has declined,

direct loans to private nonbank borrowers have captured an increasing share of cross­border lending,

growing from 29 percent in 1982 to 39 percent in 1998

(figure 3). Increases in the flow of bank funds to the

private nonbank sector are linked, in part, to (a) active

privatization programs in several nations and regions,

including (among others) Mexico, Argentina, Brazil,

and Eastern Europe; (b) continued economic expansion and capital investment in Asia through the mid1990s; and (c) accelerating economic reforms in China

and elsewhere. Increases in private­sector loans may

have also resulted from greater direct access to privatesector borrowers, as U.S. banks have maintained a substantial international presence in various countries

over time with branch offices and subsidiaries.6

Loans to public institutions, or "sovereign" debt,

includes obligations of the federal, state, and local governments and governmental agencies. This type of

lending, too, has been growing in recent years. For example, the market share accounted for by lending to

public institutions has increased from 18 percent of total U.S. cross­border lending in 1982 to 29 percent in

1998. In addition, in sharp contrast to the absolute decline in U.S. bank lending to the private sector during

the first quarter of 1998 as the Asian financial crisis

deepened, lending to public institutions increased

more than 6 percent. This growth in sovereign debt

reflects the increasing concern over default risk from

private­sector loans, a concern that has prompted

many lenders to shift new credits to institutions

backed by the government or international organizations.

� Maturity

Figures 4 and 5 display trends in the maturity distribution of outstanding foreign loans by U.S. banks.

Short­term credits, or those with maturities of less

than one year, still dominate U.S. international lending. Most of these credits are trade­related transactions associated with the financing of imports or with

third­party export credits. The proportion of total

lending accounted for by short­term loans remained

fairly constant over the 1987-1997 period at approxi6 For example, as of year­end 1997, the six money­center banks operated

580 foreign branch offices, excluding foreign subsidiaries, and all U.S.

banks engaged in international lending operated 907 branch offices.

17
FDIC Banking Review

Figure 4

"International lending by U.S. banks has been

dominated by short-term loans."

$Billions

300

200

100

0

S

*

1982

<1 Year

ource:

March

1987

FFIEC, Cou

31, 1998.

1992 1997

Year-end

1-5 Years

ntry Exposure Reports.

Figure 5

1998*

>5 Years

"Market shares of foreign loans by U.S. banks with
 

maturities of less than one year
 

have been resonably stabile over time but
 

increased during the first quarter of 1998."
 Percent

100

80

60

40

20

0

Year-end

<1 Year 1-5 Years >5 Years

Source: FFIEC, Country Exposure Reports.

* March 31, 1998.

mately 69 percent but increased during the first quarter of 1998 by approximately 4 percentage points (figure 5). This change represented a natural response to

the problems in Asia and elsewhere, as lenders sought

to lessen default risk by restricting longer­term loans. 

1982 1987 1992 1997 1998*

The high proportion of international lending accounted for by short­term credits is explained by commercial bank preferences for international traderelated finance, concerns over default risk, and a number of structural factors related to regional trends and

changes in the underlying status of developing­country debt positions. In general, most international

banks have preferred to extend short­term trade credit, especially to developing countries, as opposed to

medium­ or long­term credit. This is especially true

for lending to Latin America, where creditor banks

took severe losses in the wake of the 1980s debt crisis.

Other reasons for the high level of outstanding shortterm loans include: (a) the bunching of residual maturities of long­term loans falling due, (b) debt sales or

write­offs of loans with maturities greater than one

year, or (c) debt conversions. The shift is also due to

the entry into the capital markets of nations from

Eastern Europe and Central Asia, many of which

could contract funds only for short durations.7

In the past, when emerging nations wanted to raise

long­term funds, they relied more on syndicated bank

loans than on bond issues. Bond issuance was minimal

because investors generally lacked information about

developing­country borrowers, and few emerging

countries had high­enough credit ratings to enable institutional investors to purchase their bonds. In contrast, many commercial banks had long­established

relationships with developing­country borrowers, having provided them with short­term financing over the

years. These relationships, coupled with knowledge

of local economic conditions, often enabled the banks

to extend their loans to unrated or speculatively rated

borrowers. Moreover, syndicated bank financing is

easily tailored to the requirements of the borrower.8

The typical foreign term loan consists of an intermediate­ to long­term syndicated credit with a floating­rate contract. The interest rate is usually tied to

the London Interbank Offering Rate (LIBOR) and

reprices approximately every three to six months.

Syndicated lending can be highly profitable to the

banks that originate the loans because, in addition to a

variable interest rate that offers some protection when

interest rates go up, these loans carry fees for the

7 Bank for International Settlements (1998).

8 While syndicated loans have been the primary source of funds for emerging nations, an increasing number of developing countries have been

gaining access to the bond and equity markets in recent years. This access has reduced the share of total emerging­nation borrowings that originate with commercial banks. 

18
0

International Risk Exposures of U.S. Banks

banks that manage and participate in the loans.

Typically, the managers of the loan receive a fee representing 3 to 11⁄4 percent of the total loan amount.

This is divided among the loan managers, with the

largest share going to the lead bank-the bank that

won the syndication rights for the loan. Banks party to

the offering also receive a participation fee, which generally ranges from 1⁄4 to 11 percent of the total loan

value.9 This fee is usually split among all the banks

participating in the loan, with largest shares going to

the banks that assumed the greatest risk or largest participations. Because the managing banks generally

have the largest shares in a loan, they usually receive

the largest percentage of the participation fee, in addition to the management fee.10

Figures 4 and 5 show that intermediate­term lending in the one­ to five­year range is accounting for a

slightly decreasing portion of longer­terms credits, declining from 19 percent in 1982 to 16 percent in 1997.

Longer­term syndicated credits with maturities

greater than five years captured some market share

from the intermediate ranges, increasing from approximately 10 percent in 1982 to 15 percent at the end of

1997. But with the current crises in various parts of the

world, the amount of longer­term loans on the books

of the U.S. banks decreased during the first quarter of

1998, with the market share of total lending accounted

for by this category declining to 12 percent, the lowest

level since 1982. 

Direction of Foreign Lending 

The direction of bank lending has changed considerably during the past several decades. The geographic regions with the largest share of cross­border

lending by U.S. banks are listed in table 2. As of

March 31, 1998, the greatest exposure of the large

banks was in Western Europe, which accounted for

$177.7 billion, or 42 percent of total cross­border lending. Latin America and the Caribbean nations (excluding Mexico) rank second with $91.4 billion, or 21

percent. East Asia is the third­largest destination for

U.S. loans with $63.9 billion, or 15 percent, followed

by Canada and Mexico with $40.7 billion, or approximately 10 percent. U.S. bank loans to Eastern

European nations (including Russia) increased significantly during the 1990s in response to those countries'

economic reforms and now account for $22.9 billion, or

5.4 percent. Miscellaneous other regions account for

the balance. 

Table 2 also lists outstanding loans and commitments to individual nations. The majority of credits is

highly concentrated among the developed nations,

with the five largest recipients (United Kingdom,

Germany, Mexico, Brazil, and France) accounting for

$142.7 billion, or almost 33.4 percent of total lending

as of March 31, 1998. The next five largest (Japan,

Canada, Cayman Islands, the Netherlands, and Argentina) account for an additional $81.5 billion, or 19.1

percent of the total. The next five (Italy, Korea,

Russia, Hong Kong, and Switzerland) account for an

additional $49.7 billion, or 11.6 percent.

Figure 6 shows the direction of international lending by U.S banks since 1982 by region. After the debt

crisis erupted in Mexico in August 1982, U.S. banks

started to cut back international lending to almost all

nations. As international lending resumed in the early

1990s, the flow of funds moved rapidly toward

Western Europe during the next five years. Furthermore, this flow continued increasing to Western

Europe in the first quarter of 1998, as the Asian crisis

caused a "flight to quality" in lending. Starting in

1992, funds flowed again to Mexico and the Latin

America/Caribbean area as they recovered from a

decade of slow growth. Loans to East Asian nations,

whose economies were growing, increased rapidly during the early to mid­1990s; after peaking in 1996, loans

to the region dropped precipitously with the outbreak

of the financial and economic crisis there.

Secondary Lending Riskk 

Trade Relationships

In addition to the direct risk of foreign lending, U.S.

banks are subject to secondary risk. Secondary risk

arises from the spread of adverse economic conditions

between countries. Economic theory suggests that adverse economic conditions may be spread between

countries by international trade. The spread of adverse conditions may be between the United States

and its own trading partners, or it may be between the

countries for which U.S. banks have relatively high

lending exposure and their partners, but in either case,

loans by U.S. banks may be at risk.

9 Madrid (1990), 51.

10 Ultimately, the interest­rate spread determines the profitability of a

loan. However, fees can be lucrative when loan amounts are in the hundreds of millions of dollars.

19
FDIC Banking Review

Table 2

Foreign Lending by Region and Nation, March 31, 1998

($Millions)

Total Amount Total Total U.S. Risk Exposure as a

Owed by Borrowing Commitments Cross-Border Percent of U.S.

Region/Nation for New Lending Exposure Foreign Lendinga

Region

Western Europe $ 129,866 $ 47,813 $ 177,679 41.6%

Latin America/Caribbean 73,665 17,721 91,386 21.4

East Asia 50,247 13,673 63,920 15.0

Canada and Mexico 29,204 11,455 40,659 9.5

Eastern Europe 19,873 3,116 22,989 5.4

All Other 22,523 7,776 30,299 7.1

Total $325,378 $101,554 $426,932 100.0%

Nation

1 United Kingdom 35,019 19,009 54,028 12.7%

2 Germany 20,400 4,527 24,927 5.8

3 Mexico 17,378 4,101 21,479 5.0

4 Brazil 19,344 1,975 21,319 5.0

5 France 15,750 5,193 20,943 4.9

6 Japan 15,119 5,663 20,782 4.9

7 Canada 11,826 7,354 19,180 4.5

8 Cayman Islands 13,213 1,491 14,704 3.4

9 Netherlands 9,930 3,655 13,585 3.2

10 Argentina 10,609 2,660 13,269 3.1

11 Italy 10,479 1,165 11,644 2.7

12 Korea 9,194 1,336 10,530 2.5

13 Russia 8,820 743 9,563 2.2

14 Hong Kong 7,681 1,574 9,255 2.2

15 Switzerland 5,653 3,045 8,698 2.0

16 Bermuda 2,504 5,966 8,470 2.0

17 Belgium 6,737 736 7,473 1.8

18 Spain 6,395 977 7,372 1.7

19 Sweden 3,753 3,280 7,033 1.6

20 Australia 4,875 1,386 6,261 1.5

21 Indonesia 4,108 1,146 5,254 1.2

22 Chile 4,764 444 5,208 1.2

23 Singapore 4,025 981 5,006 1.2

24 Norway 3,313 1,572 4,885 1.1

25 Venezuela 3,927 753 4,680 1.1

Source: FFIEC, Country Exposure Reports.
 

aExcluding local­currency loans.
 

Trade flows (exports and imports) are a key mechanism in the transmission of risk among countries because countries closely linked by direct trade are more

likely to transmit economic disturbances-positive or

negative-to each other. Trade relationships tend to

be regional, and evidence suggests that financial market disturbances (for example, currency crises) are

more likely to spread among countries in close geographic proximity that have strong trade relationships.11 Identifying trade relationships can thus be

helpful in identifying possible sources of international

lending risk. 

For example, if the U.S. economy is highly dependent upon a country (or group of countries) for export

11 Glick and Rose (1998) and Eichengreen and Rose (1998) provide recent

evidence that trade relationships are important to the spread of currency crises. Backus, Kehoe, and Kydland (1993), Stockman and Tesar

(1995), and Fernald, Edison, and Loungani (1998) also find high correlations of economic variables among major industrialized countries that

happen to have significant intercountry trade flows.

20
International Risk Exposures of U.S. Banks

Figure 6

"U.S. bank foreign lending to �estern Europe has

been growing rapidly in recent years."

$Billions

200

150

100

50

0

1982 1984 1986 1988 1990 1992 1994 1996 1998*

Year-end

Western Europe

Latin America/

Caribbean

East Asia

Canada and Mexico

Eastern Europe

Source: FFIEC, Country Exposure Reports.

* March 31, 1998.

earnings, adverse economic events in those countries

(such as a recession) may have negative consequences

for the United States in the form of decreased foreign

demand for U.S. goods. These negative consequences

may, in turn, make it more difficult for businesses exporting from the United States to meet their debt

obligations. Conversely, if a foreign country is highly

dependent upon the United States as an export market, adverse economic events in the United States

may decrease U.S. demand for the foreign country's

goods, and to the extent that the decrease in demand

makes it harder for foreign businesses to meet their

debt obligations, the performance of their loans from

the U.S. banks may be impaired.

Of particular importance to the effect of trade fluctuations on foreign lending is the relationship between

where a country lends and where it trades. If a country

lends heavily to and trades heavily with the same

partner, the risk associated with foreign lending may

increase, because in this case the risk component of

foreign lending that is due to fluctuations in trade with

other countries is not as easily offset by domestic

loans. The scenario is akin to, for example, lending

money to a chef to cook meals that you will buy back

from the chef, with the understanding that you will be

the chef's biggest customer and the chef can sell a limited number of meals to other people as well. If you

later decide you don't like the chef's cooking anymore

or you can't afford to continue buying the meals, the

chef will lose sales and may not be able to pay you

back, and both of you lose. However, if you make a

loan to the chef but are only a small portion of the

chef's market, the chef's ability to repay the loan is less

likely to be affected if you decide to stop buying the

meals or are unable to afford them. 

Another significant aspect of trade relationships and

the transmission of risk from one country to another is

that the more trade­dependent a country's economy,

the more sensitive its economic condition and foreign

loan performance are to fluctuations in trade flows and

the terms of trade. Thus, because the United States is

less dependent on trade than most other industrialized

nations (see table 3), the United States is also less susceptible to fluctuations in trade flows or to the events

that cause such fluctuations (for example, changes in

the terms of trade, fluctuations in exchange rates, and

import tariffs). For many other countries, however, exports and imports account for a substantial portion of

GDP, and for these countries, fluctuations in trade

flows can cause significant fluctuations in economic

21
FDIC Banking Review

growth. As table 3 shows, many European and Asian

economies are heavily dependent on international

trade. For example, exports of goods totaled nearly 60

percent of GDP in 1996 for Belgium and Luxembourg12 and more than 25 percent for Korea. All other things being equal, therefore, fluctuations in foreign

trade are more likely to affect economic growth in

these countries than in countries such as the United

States and Japan. 

U.S. Trade Relationships

Even though the United States is less trade­dependent than other industrialized countries, it has grown

more dependent in recent decades. Figure 7 shows

that in 1970 both exports and imports of goods and services totaled less than 6 percent of U.S. GDP, with exports actually greater than imports. Since 1970,

however, U.S. trade dependence has increased, with

exports and imports at approximately 13 and 11.5 percent of GDP, respectively, as of year­end 1996. This

trend suggests that currently international trade has a

potentially greater effect on the performance of U.S.

international loans than it did in 1970.

One can examine international trade at both the regional and the country levels. At the regional level,

U.S. trade is concentrated in North America (Canada

and Mexico) and East Asia. As of year­end 1996,

North America accounted for 30.3 percent of U.S. exports and 28.4 percent of U.S. imports (table 4). East

Asia accounted for 29.1 percent of exports and 37.3

percent of imports. Western Europe is less significant

as a trading partner to the United States, making up

21.9 percent of exports and 19.4 percent of imports in

1996. At the country level, the largest U.S. trading relationships involve Canada, Japan, and Mexico, which

together accounted for more than 41 percent of total

U.S. exports and 43 percent of U.S. imports as of yearend 1996. The next three largest markets for U.S. exports are the United Kingdom, Korea, and Germany,

followed by Singapore, the Netherlands, France, and

Hong Kong (table 5). The ordering of the largest markets for U.S. imports, however, deviates from the ordering of exports after the first three countries: China,

Germany, and the United Kingdom are the next three

largest markets for U.S. imports (after Canada, Japan,

and Mexico), followed by Korea, Singapore, France,

and Italy (table 5).

12 Export and import data were available only for Belgium and

Luxembourg combined.

Table 3

Exports of Goods as a Percent of GDP for
 Major Borrowers of U.S. Banks and for
 Selected East Asian Countries
 (Year-end 1996)

Major Borrowers Exports as a

from U.S. Banks Percent of GDP

Belgium-Luxembourga 59.7%

Netherlands 50.3

Canada 33.5

Korea 26.8

Switzerland 25.9

Argentina 24.7

United Kingdom 22.5

Germany 22.2

Italy 20.7

France 18.8

Mexico 17.7

Spain 17.6

Australia 15.5

Japan 8.9

United States 8.2

East Asia

Malaysia 78.9

Thailand 30.3

Philippines 24.4

Indonesia 21.9

Source: International Monetary Fund.

a Export data are not available for Belgium and Luxembourg separately.

Figure 7

"U.S. exports and imports of goods and services as

a percent of GDP have increased since 1970."

Percent

12

9

6

3

0

Exports as a Percent of GDP

Imports as a Percent of GDP

1970 1980 1990 1997

Source: Haver Analytics.

22
International Risk Exposures of U.S. Banks

Table 4

U.S. Trade Relationships by Region

(Year-end 1996)

Total U.S. Percent of As a Percent

Region ($Millions) Total U.S. of U.S. GDP

Exportsa

North America (Canada and Mexico) $ 189,345 30.3% 2.5%

East Asia 182,044 29.1 2.4

Western Europe 136,895 21.9 1.8

Latin America/Caribbean 35,312 5.6 0.5

All Other 81,477 13.0 1.1

Total Exports $625,073 100.0% 8.2%

Importsb

East Asia $ 306,812 37.3% 4.0%

North America (Canada and Mexico) 233,857 28.4 3.1

Western Europe 159,271 19.4 2.1

Latin America/Caribbean 52,080 6.3 0.7

All Other 70,005 8.5 0.9

Total Imports $822,025 100.0% 10.8%

Source: International Monetary Fund.
 

aExports of goods only.
 

bImports of goods only.
 

Table 5

U.S. Trade Relationships by Country

(Year-end 1996)

Total U.S. Percent of As a Percent

Nation ($Millions) Total U.S. of U.S. GDP

Exportsa

1 Canada $ 132,584 21.2% 1.7%

2 Japan 67,536 10.8 0.9

3 Mexico 56,761 9.1 0.7

4 United Kingdom 30,916 4.9 0.4

5 Korea 26,583 4.3 0.3

6 Germany 23,474 3.8 0.3

7 Singapore 16,686 2.7 0.2

8 Netherlands 16,614 2.7 0.2

9 France 14,431 2.3 0.2

10 Hong Kong 13,956 2.2 0.2

Total Exports $399,541 63.9% 5.2%

Importsb

1 Canada $ 159,746 19.4% 2.1%

2 Japan 117,963 14.4 1.5

3 Mexico 74,111 9.0 1.0

4 China 54,409 6.6 0.7

5 Germany 39,989 4.9 0.5

6 United Kingdom 29,700 3.6 0.4

7 Korea 23,297 2.8 0.3

8 Singapore 20,648 2.5 0.3

9 France 19,196 2.3 0.3

10 Italy 19,001 2.3 0.2

Total Imports $558,060 67.9% 7.3%

Source: International Monetary Fund.
 

aExports of goods only.
 

bImports of goods only.
 

23
FDIC Banking Review

Trade Relationships of Countries �ith

�igh Totals of U.S. Loans

Economic instability in a foreign economy may

pose additional risk to U.S. foreign loans if that country's adverse economic conditions spread to countries

the United States lends heavily to. Suppose, for example, that the economies of the United States and

Indonesia are linked to one another through trade and

bank lending and that Indonesia and Japan are similarly linked. In this case, economic fluctuations in

Japan represent secondary risk to U.S. lending to

Indonesia because economic fluctuations in Japan

may affect the profitability of Indonesian businesses

and, in turn, the performance of U.S. loans to

Indonesia. Thus, a viable means of identifying secondary risks to U.S. lending is to examine the international trade relationships of countries to which the

United States has large lending exposure.

Table 6 shows trade relationships for the 15 nations

with the largest amount of indebtedness to U.S. commercial banks as of December 31, 1997. Columns (1)

and (2) identify the nations and specify each one's

fraction of total U.S. foreign lending. Column (3)

ranks the five most important trading partners of each

of the nations in column (1), and column (4) specifies

the percentage of exports (goods only) going to each of

the five trading partners. As indicated by table 6, most

of the top 15 nations are highly dependent on exports

to the United States. Six of the top 15 nations have

the United States as their largest export market; of

those 6 nations, 2 (Mexico and Canada) send over 80

percent of their total exports of goods to the United

States, while another (Japan) ships almost 27.5 percent

of its total exports to the United States. For another 2

(Switzerland and Argentina), the United States is the

second­largest export market. For the remaining 7 nations, the United States is one of the top 5 export markets.

Table 6 also reveals that, excluding the United

States, the export markets of major U.S. borrowers are

largely regional. The biggest U.S. borrower as of yearend 1997, the United Kingdom, exports mainly to

Germany, France, the Netherlands, and BelgiumLuxembourg, with almost 33 percent of the U.K.'s exports going to these four countries. A similar regional

pattern is evident in other European countries:

Germany, France, Italy, Belgium-Luxembourg, and

Switzerland all export a considerable percentage of

goods to other Western European nations. To a somewhat lesser degree, the regional pattern is also present

in Asia: while exporting heavily to the United States

(27.5 percent), Japan-which represented 9.2 percent

of U.S. foreign lending exposure at year­end

1997-exports mainly to Asian nations, with Korea,

Hong Kong, China, and Singapore as its four nextlargest export markets.

Significant U.S. trade relationships are not limited

to countries with strong lending ties to the United

States; many countries that do not borrow heavily from

the United States nevertheless depend greatly on the

United States as a major export market. Of particular

current interest in this regard are the economies in

East Asia. Most of the developing Asian nations

stricken by the "Asian flu" of devalued currencies,

massive outflows of capital, stock market fluctuations,

and banking sector instability are only moderately indebted to U.S. banks but are still highly dependent

upon the United States as a major export market. As

table 7 shows, the United States is the number­one

export market for Singapore, Thailand, and the

Philippines, and the number­two market for Indonesia

and Malaysia. As the world's economic superpower,

the United States influences foreign economiesthrough trade or financial flows-throughout the

world. 

The patterns of U.S. trade flows and bank­loan

flows suggest that a major threat to U.S. lending to foreign countries is, ironically, a U.S. recession. A U.S. recession would decrease this country's demand for

exports from countries that borrow heavily from it,

thus making it harder for these countries to pay back

their loans to the United States.

Similarly, a major threat to economic stability in

Europe is a recession in Germany. Germany has the

third­largest economy in the world, behind the United

States and Japan. Germany is also much more dependent on international trade than are the United States

and Japan, as its ratio of exports to GDP is 22 percent.

Moreover, Germany is a major export market for most

Western European nations, including the United

Kingdom, France, the Netherlands, Switzerland, Italy,

and Belgium-Luxembourg (table 6). Germany's trade

statistics strongly suggest that the German economy to

a large extent "drives" Europe. Hence, an economic

downturn in Germany would likely cause economic

problems for many of the countries of the continent

24
International Risk Exposures of U.S. Banks

Table 6

Secondary Risk Exposures of U.S. Banks, All Countries

(Year-end 1996)

(1) (2) (3) (4)

Largest U.S. Percent of Largest Export Exports of Country A

Bank Exposures U.S. Foreign Markets of as a Percent of Its

(Country A) Lendinga Country A Total Exports

1 United Kingdom 10.2% 1 United States 12.1%

2 Germany 11.3

3 France 9.3

4 Netherlands 7.3

5 Belgium-Luxembourg 4.7

2 Japan 9.2 1 United States 27.5

2 Korea 7.1

3 Hong Kong 6.2

4 China 5.3

5 Singapore 5.1

3 Germany 7.4 1 France 10.7

2 United Kingdom 7.9

3 United States 7.7

4 Netherlands 7.3

5 Italy 7.3

4 France 6.1 1 Germany 16.8

2 United Kingdom 9.2

3 Italy 9.0

4 Belgium-Luxembourg 8.2

5 United States 6.0

5 Canada 5.6 1 United States 81.7

2 Japan 3.7

3 United Kingdom 1.4

4 Germany 1.1

5 China 1.0

6 Brazil 4.2 1 United States 19.5

2 Argentina 10.9

3 Netherlands 7.4

4 Japan 6.4

5 Germany 4.4

7 Korea 3.8 1 United States 16.8

2 China 8.9

3 Hong Kong 8.6

4 Singapore 5.0

5 Germany 3.6

8 Netherlands 3.6 1 Germany 25.1

2 Belgium-Luxembourg 11.6

3 France 9.7

4 United Kingdom 8.4

5 Italy 5.2

(continued)

25
FDIC Banking Review

Table 6 (continued)

Secondary Risk Exposures of U.S. Banks, All Countries

(Year-end 1996)

(1) (2) (3) (4)

Largest U.S. Percent of Largest Export Exports of Country A

Bank Exposures U.S. Foreign Markets of as a Percent of Its

(Country A) Lendinga Country A Total Exports

9 Mexicob 3.4 1 United States 83.4%

2 Canada 2.2

3 Japan 1.4

4 Spain 1.0

5 Italy 0.1

10 Switzerland 3.3 1 Germany 23.6

2 United States 9.8

3 Italy 7.8

4 United Kingdom 6.8

5 Japan 4.3

11 Italy 3.2 1 Germany 17.4

2 France 12.5

3 United States 7.4

4 United Kingdom 6.5

5 Spain 5.0

12 Spain 3.1 1 France 20.1

2 Germany 14.5

3 Italy 8.8

4 Portugal 8.6

5 United Kingdom 8.5

13 Belgium�Luxembourgc 2.7 1 Germany 20.4

2 France 17.8

3 Netherlands 13.3

4 United Kingdom 9.0

5 United States 4.1

14 Australia 2.5 1 Japan 19.9

2 Korea 9.5

3 New �ealand 7.2

4 United States 6.4

5 Indonesia 4.0

15 Argentina 2.3 1 Brazil 27.8

2 United States 8.3

3 Chile 7.4

4 Netherlands 5.1

5 Uruguay 3.1

Sources: FFIEC, Country Exposure Reports; International Monetary Fund.
 

a Excluding local­currency loans.
 

b Total exports for Mexico uses the DOTS world total. All other total exports data use the IFS world total.
 

c Commercial bank lending data for Belgium only; exports data for both Belgium and Luxembourg.
 

26
International Risk Exposures of U.S. Banks

Table 7

Secondary Risk Exposures of U.S. Banks, East Asian Countries

(Year-end 1997)

(1)

Largest U.S.

Bank Exposures

(Country A)

(2)

Percent of

U.S. Foreign

Lendinga

(3)

Largest Export

Markets of

Country A

(4)

Exports of Country A

as a Percent of Its

Total Exportsb

Indonesia 1.3% 1

2

Japan

United States

25.9%

13.6

3

4

Singapore

Korea

9.2

6.6

5 China 4.1

Singapore 1.1 1

2

3

4

5

United States

Malaysia

Hong Kong

Japan

Thailand

18.4

18.0

8.9

8.2

5.7

Thailand 1.1 1 United States 18.0

2

3

4

5

Japan

Singapore

Hong Kong

Malaysia

16.8

12.1

5.8

3.6

Malaysia 0.6 1

2

Singapore

United States

20.4

18.2

3

4

5

Japan

Hong Kong

Thailand

13.4

5.9

4.1

Philippines 0.6 1

2

3

4

United States

Japan

Singapore

Netherlands

34.1

18.0

6.0

5.5

5 United Kingdom 4.6

Sources: FFIEC, Country Exposure Reports; International Monetary Fund.
 

aExcludes local­currency loans.
 

bExports of goods only.
 

and, as a result, would limit the profitability of U.S.

loans not only to Germany but to the entire continent.

Similarly in East Asia, the trade flow data suggest

that the greatest threat to the economic stability and

well­being of the region is a prolonged recession in

Japan. The current Japanese recession highlights the

debilitating effect of Japan's economy on the rest of

East Asia. As table 7 shows, Japan is the leading export market for Indonesia (26 percent of exports as of

year­end 1997), the second­largest export market (after the United States) for the Philippines (18 percent)

and Thailand (17 percent), and the third­largest (after

Singapore and the United States) for Malaysia (13 percent). The East Asian corridor has suffered not only

because of trade relations with Japan but also because

systemic structural problems in the Japanese banking

system have all but eliminated the ability of Japanese

banks to provide the credit necessary to spur investment and economic growth in the region-and Japan

has lent heavily to developing East Asian countries.13

13"Available, but incomplete, balance­sheet data compiled by the Bank for

International Settlements (BIS) indicate that as of mid­1997, banking

system exposures to Asian emerging market countries amounted to approximately $260 billion in the European Union (31⁄4 percent of GDP),

$210 billion in Japan (5 percent of GDP), and $40 billion in the United

States (1⁄2 of 1 percent of GDP)" (International Monetary Fund [1998],

25.

27
FDIC Banking Review

Su��ary and Conclusions

Trends in both the primary and secondary risks associated with the international lending activities of

U.S. banks over the 1982-1998 period indicate that

U.S. banks recovered from the heavy losses they incurred on foreign loans during the 1980s debt crisis;

and in the 1990s they resumed international lending.

But while foreign lending grew significantly during

the 1990s, substantial amounts of new capital also

came into the industry. Thus, the amount of risk exposure as reflected in the ratio of foreign loans to total

capital is lower than it was during the early 1980s,

when some of the largest U.S. banks faced the possibility of insolvency because of delinquent cross­border loans. Another way in which foreign lending by

U.S. banks is different in the 1990s is that the moneycenter banks have expanded their domination of these

markets. 

This expansion of the role of money­center banks

has come about for several reasons: the money­center

banks pursue highly competitive pricing strategies,

they have numerous foreign branch offices, they have

the technical expertise to originate such loans, and at

the same time many of the super­regional and other

U.S. banks have cut back their origination of and participation in foreign lending, after incurring heavy

loan losses on developing­country debt during the

1980s. 

Some of the characteristics of foreign loans made by

U.S. banks have also changed. An increasing percentage of these loans is being made to the private nonbank sector and away from the interbank market. The

shift has occurred because active privatization programs under way in many nations, as well as other developments, have increased the demands for

private­sector loans and made them more profitable,

especially with the recent narrowing of interest­rate

spreads on loans in the interbank market. Maturity,

however, has not changed: the maturity of most foreign loans continues to be short term-over 70 percent of total foreign loans are in this category. But the

direction of foreign lending has shifted somewhat:

during the 1990s loans to Western Europe have accounted for an increasing share of total lending.

Lending to the Latin American/Caribbean region resumed after a decade of retrenchment, and loans to

East Asia increased significantly during the 1980s and

early 1990s but declined in the late 1990s, in response

to changing circumstances in Asia. These changing

lending patterns-the heavy concentration of lending

to Western Europe and away from East Asia-may

have reduced overall U.S. bank lending risk during

the 1990s, but the increasing levels of lending to

Mexico, Brazil and other Latin American/Caribbean

region may partially offset the reduction.

In addition to the primary risks of international

lending, bank supervisors have also become concerned about the secondary risks of such lending, risks

that arise when economies are linked by trading relationships. Adverse economic disturbances are transmitted between countries by international trade. The

greater the trading interdependence among countries,

the more likely it is that economic disturbances will be

transmitted, and the higher the probability that one

country's economic problems will affect other countries. Economic problems transmitted through the

trade mechanism affect not only the private nonbank

sector of an economy but also the banking sector, as

trade­related problems such as currency devaluations

and falling exports can increase the incidence of credit risk and loan defaults.

An example of the direct risk is evident in Asia.

The recession in Japan has reduced its import demand

for products from other Asian countries. This in turn

has jeopardized the loans of Japanese banks to exporters in these countries. Although U.S. banks may

be sheltered from this direct risk they nevertheless

may be exposed. Because most Asian nations depend

somewhat upon the Japanese market for export earnings, indirect risk appears to have increased. Thus, a

prolonged recession in Japan is likely to increase the

total risk to banks in the United States. Similarly, because most European nations depend upon the

German market for export earnings, a recession in

Germany would also increase the total risk to banks in

the United States. In today's increasingly international banking environment, when bankers and their supervisors assess the risks associated with the

international lending activities of U.S. banks, they

should be particularly aware of the linkages between

economies.

The largest indirect risk to U.S. international lending, however, is a recession in the United States itself.

The United States is a major export market for most

of the world, and particularly for nations that the

28
International Risk Exposures of U.S. Banks

United States lends heavily to. If the U.S. economy back their loans to the United States. Thus, as interwere to fall into a sustained recession, exports to the national trade and financial linkages grow, weakness in

United States would probably fall. This would make the largest economies increases the risk associated

it harder for many countries around the world to pay with international lending. 

29
FDIC Banking Review

References
 

Backus, David K., Patrick J. Kehoe, and Finn E. Kydland. 1993. International Business Cycles:

Theory vs. Evidence. Federal Reserve Bank of Minneapolis Quarterly Review 17, no. 4:

14-30.

Bank for International Settlements. Various issues. International Banking and Financial Market

Developments. Basle, Switzerland. 

Curry, Timothy J. 1997. The LDC Debt Crisis. In History of the Eighties-Lessons for the

Future. Vol. 1. Federal Deposit Insurance Corporation. 

Eichengreen, Barry, and Andrew K. Rose. 1998. Contagious Currency Crises: Channels of

Conveyance. In Changes in Exchange Rates in Rapidly Developing Countries, edited by T. Ito

and A. Krueger. Forthcoming.

Fernald, John, Hali Edison, and Prakash Loungani. 1998. Was China the First Domino?

Assessing Links between China and the Rest of Emerging Asia. International Finance

Discussion Paper. Board of Governors of the Federal Reserve.

Fissel, Gary. The Anatomy of the LDC Debt Crisis. FDIC Banking Review 91, no. 1: 1-17. 

Glick, Reuven, and Andrew K. Rose. 1998. Contagion and Trade: Why Are Currency Crises

Regional? Working Paper. University of California, Berkeley.

International Monetary Fund. 1998. World Economic Outlook. International Monetary Fund.

Madrid, Paul L. 1990. Overexposed. Investor Responsibility Research Center. Washington,

DC.

Seidman, L. William. 1993. Full Faith and Credit: The Great S&L Debacle and Other Washington

Sagas. Random House. 

Stockman, Alan C., and Linda L. Tesar. 1995. Tastes and Technology in a Two­Country Model

of the Business Cycle: Explaining International Comovements. American Economic

Review 85, no. 1: 168-85.

30
Recent Developments

Recent Developments
 

Affecting Depository
 

Institutions
 

by Lynne Montgomery*
 

REGULATORY AGENCY ACTlONS
 

lnteragency Actions

FFIEC Issues Year 2000 Guidance

On April 10, 1998, the Federal Financial

Institutions Examination Council issued guidance to

help financial institutions prepare testing procedures

to address computer­related problems linked to the

century date change. The Exam Council declared

that testing is the most important phase in Year 2000

preparations. In addition to the institution's own systems, banks and thrifts are required to look at services and products provided by vendors. The Exam

Council outlined the general internal and external

systems that should be examined and also set several deadlines for institutions to meet in the Y2K testing process. The Exam Council explained that

noncompliance with the Y2K guidance and deadlines

could threaten the safety and soundness of the institution. BBR, 4/20/98, p. 634.

New Approach to Evaluating 

Investment Risks
 

The Federal Financial Institutions Examination

Council issued a policy statement on investment

securities and end­user derivative activities, which

requires depository institutions to focus on how combinations of risk affect the institution's overall financial health. The policy statement was published in

the Federal Register on April 23, 1998. The new

approach eliminates three tests that bank regulators

have used since 1992 to measure investment risks.

The banking agencies were concerned that the 1992

policy placed too much emphasis on the type of

instrument involved, rather than the investment's

risk characteristics and how they affected the institution's total risk profile. The new policy statement

emphasizes that senior managers and directors

should understand how the risks of an institution's

investment portfolio affect the entire organization.

The policy statement advises that determining

whether a security or mortgage derivative product is

an appropriate investment depends on a variety of

factors, including the institution's capital level, the

security's effect on the aggregate risk of the portfolio,

and the management's ability to measure and manage the risks. BBR, 4/27/98, p. 668; FIL-45-98, FDIC, 4/28/98.

Regulators Approve Uniform Application

On May 6, 1998, the Conference of State Bank

Supervisors announced that state and federal banking regulators approved a Uniform Interstate

Application/Notice Form. State­chartered banks

operating in more than one state will be permitted to

file a single application with federal and state regulators to set up, relocate, or discontinue a branch, an

automated teller machine, or other place of business.

*Lynne Montgomery is a financial analyst in the FDIC's Division of

Research and Statistics.

Reference sources: American Banker (AB); The Wall Street Journal (WSJ);

BNA's Banking Report (BBR); and Federal Register (FR).

31
FDlC Banking Review

The uniform application will ease the regulatory burden for state­chartered banks. The application was

developed by the State Federal Working Group,

which consists of senior regulators representing the

Federal Reserve Board, the Federal Deposit

Insurance Corporation (FDIC), and the Conference

of State Bank Supervisors. BBR, 5/11/98, p. 756.

Revised Policy on Civil Money Penalties

Effective June 3, 1998, the Federal Financial

Institutions Examination Council issued a revised

interagency policy on the criteria agencies should use

when assessing fines on depository institutions for

violations of laws, regulations, and other misconduct.

The revised joint policy replaces an existing civil

money penalty policy statement, which was adopted

in 1980. The updated policy statement eliminates

unnecessary references to interagency coordination

of civil money penalty proceedings and specifies that

the amount of a fine should be sufficient to deter

future misconduct. The revised policy also requires

federal regulators to consider five statutory factors

when deciding whether to impose fines, including:

the financial resources of the institution; good faith;

the seriousness of the violation; history of previous

offenses; and other factors that may require corrective action. Further, the revised policy lists the type

of violations that may warrant civil money penalties.

BBR, 6/8/98, p. 921.

New Capital Limits for Servicing Assets

The Federal Reserve Board, the Office of the

Comptroller of the Currency (OCC), the FDIC, and

the Office of Thrift Supervision (OTS) issued a final

rule on August 4, 1998, which amends capital adequacy standards for banks, bank holding companies,

and savings associations. The final rule increases the

maximum amount of mortgage servicing assets and

purchased credit­card relationships (PCCRs) that

depository institutions may include in regulatory capital calculations. The final rule increases the Tier 1

capital limit for mortgage servicing assets and PCCRs

from 50 percent to 100 percent of Tier 1 capital. The

rule is effective as of October 1, 1998. BBR, 7/13/98, p.

55-56; FRB-PR, 8/4/98.

New Risk-Based Capital Standards

The Federal Reserve Board, the OCC, the FDIC,

and the OTS amended their risk­based capital standards for banks, bank holding companies and thrifts

regarding the capital treatment of unrealized holding

gains on certain equity securities. These gains have

been reported as a component of equity capital under

U.S. generally accepted accounting principles

(GAAP), but have not been included in regulatory

capital under the banking agencies' capital standards.

The final rule, which is effective October 1, 1998,

permits institutions to include up to 45 percent of the

pre­tax net unrealized holding gains on certain available­for­sale equity securities in supplementary capital (Tier 2). The final rule will make the capital

treatment of these unrealized gains consistent with

the international standards of the Basle Accord. FRBPR, 8/26/98.

Federal Deposit lnsurance Corporation

Tanoue Sworn in as Chairman

Donna A. Tanoue was sworn in as the 17th

Chairman of the FDIC on May 26, 1998. Before her

appointment to the FDIC, Ms. Tanoue was an attorney with the law firm of Goodsill Anderson Quinn &

Stifel in Honolulu. She also served as Hawaii's financial institutions commissioner during the banking crisis in the mid­1980s, where she engineered a rescue

package for Hawaii's underfunded thrift insurance

corporation. Ms. Tanoue replaces FDIC Acting

Chairman, Andrew C. Hove, Jr., who will resume his

position as the agency's Vice­Chairman. PR-35-98, FDIC,

5/26/98.

Semiannual Agenda of Regulations

On April 27, 1998, the FDIC published its semiannual agenda of regulations in the Federal Register to

inform the public of projected new rulemakings, as

well as existing regulations under review and completed rulemakings. Many of the actions are the

result of the FDIC Board's ongoing efforts to reduce

the regulatory burden on banks, simplify rules,

improve efficiency and comply with the Riegle

Community Development and Regulatory

Improvement Act of 1994. The agenda contains 26

regulatory actions. Six actions have been completed

and the others are in various stages of the rulemaking

process. PR-29-98, FDIC, 4/29/98.

Assessment Rates

The FDIC Board of Directors voted to maintain

the current deposit insurance assessment rates for

the Bank Insurance Fund (BIF) and the Savings

Association Insurance Fund (SAIF) through year­end

1998. Insurance premiums for the BIF and the SAIF

32
Recent Developments

range between zero and 27 basis points, depending

on the institution's supervisory rating. The healthiest banks and thrifts pay nothing for deposit insurance. Currently, approximately 95 percent of all

federally insured banks and 91 percent of all federally insured savings associations pay no deposit insurance premiums. Federal law requires the FDIC to

maintain a minimum reserve ratio of 1.25 percent

(reserves as a percent of insured deposits) for both

the BIF and the SAIF. The FDIC estimates that the

BIF reserve ratio will be 1.43 percent and the SAIF

ratio will be 1.45 percent by December 31, 1998. BBR,

5/4/98, p. 705; FIL-66-98, FDIC, 6/19/98.

Bank Failures

The Michigan Commissioner of the Financial

Institutions Bureau closed Omnibank in River

Rouge, Michigan, on April 9, 1998, and the FDIC

was named receiver. The deposits of Omnibank

were assumed by ShoreBank, Detroit, in Detroit,

Michigan, which is a newly chartered bank subsidiary

of Shorebank Detroit Corporation. ShoreBank paid

the FDIC a premium of $154,000 to receive the

failed bank's deposits and to purchase $41.8 million

in assets. In addition, ShoreBank will participate in a

five­year loss­sharing arrangement on approximately

$23.8 million of the assets that it purchased from the

receivership. The FDIC estimates that this transaction will cost the BIF approximately $3.1 million.

Omnibank is the first FDIC­insured failure since

November 1997. PR-24-98, FDIC, 4/9/98.

On July 23, 1998, the Colorado State Bank

Commissioner closed BestBank in Boulder,

Colorado, and the FDIC was named receiver. The

FDIC approved the assumption of the insured

deposits of BestBank by The Pueblo Bank and Trust

Company in Pueblo, Colorado. The Pueblo Bank

also purchased $47.2 million of the failed bank's

assets. The former office of BestBank was reopened

on July 27, 1998, as a branch of Pueblo Bank and

Trust. This was the first bank failure in Colorado

since 1993. PR-50-98, FDIC, 7/25/98.

Montana's Commissioner of Financial Institutions

closed Q Bank of Fort Benton, Montana, on August

7, 1998, and the FDIC was named receiver. The

FDIC approved the assumption of the insured

deposits of Q Bank by Heritage State Bank in Fort

Benton, Montana, which is a newly chartered banking subsidiary of United Financial Corporation in

Great Falls, Montana. Heritage State Bank paid a

premium of $445,000 for the right to receive the

insured deposits and will purchase $2.5 million of the

failed bank's assets. The FDIC estimates the cost of

the transaction to the BIF will be approximately $1.3

billion. Q Bank is the third failure of an FDICinsured bank this year and the first in Montana since

March 1992. PR-54-98, FDIC, 8/7/98.

Simplified Deposit Insurance Rules

On April 28, 1998, the FDIC Board of Directors

approved final revisions clarifying certain aspects of

the deposit insurance regulations. The revised

deposit insurance regulations, which are effective

July 1, 1998, make three significant revisions to the

insurance rules. The revised regulations give the

FDIC more flexibility to insure deposits made by

third­party agents on behalf of account owners. The

regulations also clarify the insurance coverage of living trust accounts and provide a six­month grace

period following the death of a depositor for beneficiaries to restructure inherited accounts in order to

maximize deposit insurance coverage. BBR, 5/4/98, p.

704-705; PR-26-98, FDIC, 4/28/98.

Interstate Banking Interest Charges

The FDIC published a legal opinion in the Federal

Register on May 18, 1998, clarifying how interest

charges are applied when a state­chartered bank

operates across state lines. The FDIC opinion gives

state banks the same flexibility that national banks

have under Section 85 of the National Bank Act,

which permits a bank to charge interest allowed by

its home state to out­of­state borrowers. The opinion

addresses three main issues, including: where interstate state banks are located for purposes of federal

law; which state's interest provisions should govern

the interest charged on the loan; and the need for disclosures to customers regarding which state's law will

cover the loan. PR-33-98, FDIC, 5/13/98; BBR, 5/25/98, p. 851-852.

Midyear 1998 Financial Results

(Unaudited)

The Bank Insurance Fund (BIF) reported $637

million in net income for the first half of 1998, and

the Savings Association Insurance Fund (SAIF)

earned $242 million for the same period. Both funds

closed the second quarter of 1998 with record balances, the BIF with $28.9 billion and the SAIF with

$9.6 billion. The strong results are attributed to the

continuing low numbers of bank and thrift failures.

Revenue for the BIF totaled $858 million for the first

six months ending June 30, 1998, including $827 mil33
FDlC Banking Review

lion in interest on investments in U.S. Treasury securities and $8 million in deposit insurance assessments. The SAIF earned $282 million in revenue,

consisting of $278 million in interest on investments

in U.S. Treasury securities and $4 million in deposit

insurance assessments.

The FSLIC Resolution Fund (FRF) assets in liquidation were reduced by 24 percent, to $1.8 billion.

Federal Financing Bank borrowings for the FRF

were reduced by $492 million, to $357 million, during the six­month period. PR-58-98, FDIC, 8/25/98.

Real-Estate Survey-April 1998

The April 1998 issue of the Survey of Real Estate

Trends continued to report favorable conditions for

residential and commercial real­estate markets. The

survey polled 302 senior examiners and asset managers from the federal bank and thrift regulatory

agencies about developments in their local markets

in the preceding three months. Sixty­three percent

of those surveyed in late April described local housing markets as improving, up from 49 percent in the

January survey. More than half of the respondents

(56 percent) cited better conditions for commercial

markets in the last three months compared to 49 percent in the January survey.

The national composite index was 79 in April, up

from 72 in January and 71 in April 1997. Index scores

above 50 reflect improving conditions, while index

scores below 50 indicate declining conditions.

Every region showed an increase in the index

between January and April. Survey of Real Estate Trends,

FDIC, April 1998.

Real-Estate Survey-July 1998

The July 1998 issue of the Survey of Real Estate

Trends also reported favorable conditions for residential and commercial real­estate markets. The July

survey polled 299 examiners and asset managers.

Sixty­one percent observed that local housing markets had improved during the preceding three

months, compared with 63 percent in the April survey and up from 51 percent in July 1997.

Assessments of commercial market conditions

remained positive in July, although the frequency of

favorable reports was slightly less than three months

earlier. Fifty­two percent reported improvements,

compared with 56 percent in the April survey.

The national composite index was 77 in July, a

slight decrease from the April index of 79, but

improved from the July 1997 index of 74. Survey of Real

Estate Trends, FDIC, July 1998.

Report on Underwriting Practices

The April 1998 issue of the Report on Underwriting

Practices reported that banks' underwriting practices

have weakened during the last year. The weakened

standards are most evident in commercial real­estate

and construction lending; however, the FDIC examiners noted early signs of adverse trends for all major

types of loans. Implemented in early 1995, the survey of underwriting practices is aimed at providing

early warnings of potential problems in underwriting

practices at FDIC­supervised, state­chartered nonmember banks. The focus of the survey is threefold:

material changes in underwriting standards for new

loans, degree of risk in current practices, and specific

aspects of the underwriting standards for new loans.

Report on Underwriting Practices, FDIC, April 1998.

Expedited Application Procedures

The FDIC Board of Directors voted on July 7,

1998, to expedite the processing of applications filed

by well­managed, well­capitalized institutions and to

simplify and streamline its application rules. The

revised Part 303 of the FDIC's rules applies expedited processing procedures to applications for deposit

insurance, mergers, branches, trust powers, stock

buy­backs, and certain international banking activities. The revised rule, which is effective October 1,

1998, reduces regulatory burden for well­managed

institutions and permits the FDIC to focus resources

on applications that present a significant issue or risk.

PR-45-98, FDIC, 7/7/98.

Federal Reserve Board

Phillips Resigns

Federal Reserve Governor Susan Phillips resigned

from her post on the Board of Governors as of June

30, 1998. Ms. Phillips accepted the post of dean in

the School of Business and Public Management at

The George Washington University. Ms. Phillips had

served on the Board of Governors since 1991. BBR,

5/11/98, p. 757.

Interest Rates

The Federal Reserve Open Market Committee

again voted to leave short­term interest rates

unchanged on August 18, 1998. The Federal

Reserve Board has kept the interest rates constant

since March 1997. BBR, 8/24/98, p. 292.

34
Recent Developments

Loan �uality Assessment Pro�ect

In a supervisory letter released on June 30, 1998,

the Federal Reserve Board reported that banks

have eased lending standards for commercial loans

significantly since 1995 in response to intense competition for loan customers. However, the Board

notes that the overall quality of banks' business

loans has not deteriorated greatly, because of strong

economic conditions. The Board's report on lending standards is based on the results of a recent

study, the Loan Quality Assessment Project, which

compared several hundred commercial and industrial loans made in late 1995 with loans made in late

1997. The Loan Quality Assessment Project found

that banks have relaxed the terms of commercial

loans to attract customers by cutting interest­rate

spreads, extending loan maturities, easing collateral

requirements, or waiving financial covenants. FRBPR, 6/30/98; BBR, 7/6/98, p. 5.

Guidance for Assessing IT-Related Risks

The Federal Reserve Board announced that bank

examiners would be required to consider the risks

associated with an institution's use of information

technology when developing safety­and­soundness

assessments under the risk­focused supervisory

process. In an April 20, 1998 letter to all Federal

Reserve-supervised institutions, the Federal

Reserve Board outlined a framework for examiners to

use in evaluating how banks manage their information technology risks, and reiterated its commitment

to continuing examiner training in the information

technology area. The Federal Reserve Board's information technology framework includes five elements: the institution's management processes,

system design and structure, security, and the integrity and availability of the information delivered to

end­users. BBR, 5/4/98, p. 712.

Relaxed Limits on Insurance Sales

As of May 1998, the Federal Reserve Board granted bank holding companies greater flexibility to sell

life insurance and annuity products through their

securities dealer subsidiaries on behalf of affiliated

insurance agencies. The insurance activities may be

conducted only in states that permit insurance sales

under the Bank Holding Company Act, and the

insurance activities must be conducted according to

the federal banking agencies' joint policy on the

retail sales of nondeposit investment products.

Additionally, the bank holding companies must separate the insurance activities from areas in which

insured deposits are accepted. BBR, 7/6/98, p. 20.

Regulation Y

The Federal Reserve Board revised its leverage

capital rules for bank holding companies (Regulation

Y), effective June 30, 1998. The revisions allow the

most highly rated bank holding companies to maintain a minimum Tier 1 leverage ratio of 3 percent,

while requiring all other bank holding companies to

maintain a Tier 1 leverage ratio of 4 percent. The

Tier 1 leverage ratio is defined as the proportion of

core capital to total assets. Before the revisions, all

but the highest­rated bank holding companies were

required to maintain a minimum level of core capital

equal to 3 percent of total assets, plus an additional

100 to 200 basis points. The revised final rule also

provides that higher capital ratios would be required

for bank holding companies that have significant

financial, operational, or managerial weaknesses that

make them more risky. BBR, 6/8/98, p. 920-921.

Regulations H and P

On July 7, 1998, the Federal Reserve Board

announced final revisions to Regulation H, updating and clarifying its procedures for state­chartered

banks to join the Federal Reserve System. The

new Regulation H is intended to reduce the regulatory burden for state banks and replaces the entire

existing regulation, except for the appendices to the

rule, which remain unchanged. Under the new

Regulation H, well­capitalized and well­managed

institutions could qualify for faster consideration of

Federal Reserve membership and branch applications. As part of the process of revising Regulation

H, the Federal Reserve Board rescinded Regulation

P. Regulation P, which was folded into the new

Regulation H, implemented the Bank Protection

Act of 1968 and required federal banking regulators

to establish minimum standards for banks' security

systems. The new Regulation H is effective beginning on October 1, 1998. FRB-PR, 7/7/98; BBR, 7/13/98, p.

49-50.

Regulation DD

On July 27, 1998, the Federal Reserve Board made

final an interim rule amending Regulation DD,

Truth in Savings, regarding the disclosure of the

annual percentage yield (APY). The rule permits

institutions to disclose an APY equal to the contract

interest rate for certain time accounts. The rule

35
FDlC Banking Review

applies only to time accounts with maturities greater

than one year. FRB-PR, 7/27/98.

Office of the Comptroller of the Currency

Comptroller Nomination

The White House announced on July 16, 1998,

that President Clinton intends to nominate Treasury

Undersecretary for Domestic Finance John D.

Hawke, Jr. to be the next Comptroller of the

Currency. If confirmed by the Senate, Mr. Hawke

would succeed Eugene A. Ludwig, who departed

after his five­year term expired in April 1998.

Former OCC Chief Counsel, Julie L. Williams, has

been serving as acting comptroller since April. Mr.

Hawke has served as Treasury Undersecretary for

Domestic Finance since 1995. BBR, 7/20/98, p. 96.

Loan Underwriting Survey

On July 13, 1998, the OCC announced that banks'

commercial lending standards have slipped for the

fourth year in a row, as heavy competition and pressure to increase loan volume are causing banks to

grant more generous concessions to business borrowers. The findings are based on the results of the

OCC's fourth annual survey of national banks' loan

underwriting standards. As a result, the OCC is

implementing a series of new supervisory initiatives

intended to reverse the trend of sliding commercial

and consumer credit practices. The new initiatives

build on existing programs that have already been

implemented to help national banks deal with an

increase in problem loans that could result from an

economic downturn. NR 98-70, aCC, 7/13/98; BBR, 7/20/98, p. 95.

Bank Municipal Securities Dealers

Effective June 29, 1998, the OCC adopted final

revisions to its municipal securities dealers' regulation. The final rule clarifies that national bank subsidiaries, which conduct municipal securities

activities, are subject to the Municipal Securities

Rulemaking Board and must register with the

National Association of Securities Dealers. As a

result, these national bank subsidiaries are exempt

from the OCC's municipal securities dealers' regulation. BBR, 6/1/98, p. 883. 

Bank Can Take Fee for Insurance
 

Referrals
 

On February 27, 1998, the Chief Counsel for the

Office of the Comptroller of the Currency ruled that

a national bank would be permitted to collect a finder's fee for referring bank customers to a group of

independent insurance agencies. The ruling is significant because it allows national banks to collect

fee revenue in addition to their existing authority to

sell insurance as agent. BBR, 4/20/98, p. 651.

New Supervision Handbooks

A new version of the OCC's Large Bank

Supervision handbook was issued on July 22, 1998, in

order to help examiners develop more detailed and

meaningful risk profiles of the nation's largest national banks. The manual, which is aimed at the 80

national banks with assets of more than $1 billion,

applies supervision by risk to all aspects of the supervisory process so that risks are properly assessed and

evaluated across the entire organization, regardless of

its size, complexity or geographic reach. NR-98-75, aCC,

7/22/98.

On August 24, 1998, the OCC issued another new

manual that is designed to help examiners evaluate

the internal control systems that national banks use

to guard against fraud and financial mismanagement.

NR-98-87, aCC, 8/24/98.

Credit-Card Suspension Agreements

In an interpretive letter made available on June

23, 1998, the OCC gave a national bank permission to

enter into credit­card debt suspension agreements. A

suspension agreement states that, in exchange for a

monthly fee paid by the cardholder, the bank will

agree to freeze the cardholder's account for a specified period if certain temporary hardship circumstances occur. During the freeze, the cardholder is

not charged interest, fees, or penalties. BBR, 6/29/98, p. 1066. 

Office of Thrift Supervision

Simplified Rule on ARMs Disclosure

On July 17, 1998, the OTS finalized a rule giving

thrifts two options when disclosing potential interest

payments to borrowers of adjustable­rate mortgage

loans. The OTS's new rule requires thrifts to follow

the provisions of the Federal Reserve Board's

Regulation �. Regulation � requires institutions to

either: (1) provide a borrower with a 15­year historical example showing how interest­rate changes

would affect loan payments and loan balances on a

$10,000 loan, or (2) disclose the maximum interest

rate and payment possible for a $10,000 loan. aTS 98-

50, 7/16/98.

36
Recent Developments

Limits on Repurchase Transactions

The OTS approved a final rule on August 12,

1998, that prohibits reverse repurchase agreements

between savings associations and their nonbank affiliates. In a reverse repurchase agreement, a depository institution buys securities from another party and

agrees to sell them back later at a higher price. The

final rule clarifies that the OTS will treat reverse

repurchase agreements as loans or other extensions

of credit for the purposes of the Home Owners' Loan

Act. Therefore, thrifts will be barred from entering

into these agreements with nonbank affiliates

because reverse repurchase agreements are extensions of credit. Exemptions from the ban are possible if several conditions are met. The final rule takes

effect on October 1, 1998. BBR, 8/24/98, p. 301.

One-Member, One-Vote Rule Adopted

Under a final rule announced by the OTS on

August 27, 1998, mutual depository institutions with

a one­member, one­vote provision in their current

charters will be able to retain that authority when

converting to a federal savings association. In addition, any existing federal mutual savings association

will be able to adopt a one­vote­per­member provision if it desires. The new rule applies to all mutualtype institutions, including credit unions that wish to

become thrifts. The rule expands the range of votes

a federal mutual savings association may allow a

member to cast on issues requiring membership

action from the current 50 to 1,000 votes to 1 to 1,000

votes per member. aTS 98-64, 8/27/98.

National Credit Union Administration

Credit Union Membership Access Act

The Credit Union Membership Access Act was

signed by President Clinton on August 7, 1998. The

Act permits federal credit unions to offer membership to multiple groups of less than 3,000 persons,

and grandfathers all existing members and groups as

of the date of enactment of the bill. Other provisions

impose statutory limits on member business lending

and prompt corrective action requirements on the

NCUA. H.R. 1151 was introduced in 1997 after a

federal appeals court ruled against the National

Credit Union Administration's multiple­group membership policy. The Federal Credit Union Act

requires members of federal employment­based

credit unions to share a common bond. The NCUA

interpreted that requirement to allow multiple fields

of membership, each with its own common bond;

however, the U.S. Court of Appeals for the District of

Columbia Circuit ruled in 1996 that each federal

occupational credit union must share just one common bond. The NCUA appealed to the Supreme

Court, but the Supreme Court also ruled against the

NCUA in February 1998. After the ruling, Congress

quickly initiated the Credit Union Membership

Access Act to give the NCUA relief from the "one

common bond" ruling. NCUA PR, 8/4/98 and 8/7/98; BBR, 8/3/98.

Federal Housing Finance Board

Amended Rule for FHLBank System
 

Membership
 

On April 9, 1998, the Federal Housing Finance

Board approved a rule that will make it easier for

banks with assets of less than $500 million to qualify

for membership in the Federal Home Loan Bank

System. Previous regulations required FHLBank

System members to have at least 10 percent of their

loans in home mortgage loans. A home mortgage

loan for certain combination properties is defined as

a mortgage loan where the appraised value of the residence on the property equals at least 50 percent of

the appraisal value of the entire property. As a result

of this 50 percent test, many institutions found it difficult to make enough home mortgage loans to qualify for membership in the FHLBank System. The

new rule allows institutions with assets of $500 million or less to ignore the 50 percent test for combination properties. The new rule states that

combination property loans will be considered as residential property loans, as long as there is a permanent residential structure that is an integral part of

the property. BBR, 4/13/98, p. 612.

New Financial Disclosure Requirements

On June 24, 1998, the Federal Housing Finance

Board approved a final policy statement expanding

financial disclosures by the Federal Home Loan

Bank System. The final policy statement, Disclosures

in the Combined Annual and Quarterly Reports of the

Federal Home Loan Bank System, requires that the

reports be prepared in a manner that is consistent

with the disclosure requirements of the Securities

and Exchange Commission. The Finance Board also

adopted a final rule requiring that the financial statements of the individual FHLBanks are consistent

with the combined annual and quarterly reports presented by the Finance Board and are provided to the

Finance Board in a timely manner. BBR, 6/29/98, p. 1064.

37
FDlC Banking Review

STATE LEGlSLATlON AND REGULATlON
 

Illinois

On July 30, 1998, Illinois Governor James Edgar

signed the so­called banking industry omnibus bill,

Senate Bill 1528. The legislation will permit statechartered banks in Illinois to compete more efficiently with national banks and insured savings

associations through expanded "wild card" provisions. The legislation also establishes standards for

information sharing between bank affiliate organizations, creates a safe harbor from liability in certain

electronic transactions, and streamlines motor vehicle repossession rules. All aspects of the bill became

effective on July 30, except for the auto repossession

provision which becomes effective January 1, 1999.

BBR, 8/24/98, p. 289.

�ansas

The Kansas legislature approved a bill on May 8,

1998, that requires all banks located in the state that

have nonbank affiliates to file consolidated tax

returns. Both state­ and federally chartered banks

must file consolidated state tax returns or combined

reports with any subsidiaries that own, hold, or manage any portion of their securities portfolios. In

order to keep the Kansas State tax burden in line

with that of other states, the bill also includes a provision to reduce the base tax rate on net income of

banks and savings­and­loan associations. BBR, 5/18/98,

p. 814.

Massachusetts

On May 22, 1998, Massachusetts Acting Governor

Paul Celluci signed legislation that permits statechartered banks to sell insurance and annuity products beginning on September 1, 1998. Massachusetts

is one of the last states to offer this authority to

banks. BBR, 6/1/98, p. 883-884.

Mississippi

Effective July 1, 1998, a new state law permits

Mississippi­chartered trust operations to branch into

other states. The law requires the trust operations to

notify the state banking commissioner before setting

up branches across state lines. Out­of­state trust

operations will be permitted to enter Mississippi

after getting approval from banking regulators in

their home state. American Banker, 6/17/98.

New York

The New York State Banking Board approved

final regulations on June 4, 1998, that allow statechartered banks and trust companies located in

places with populations of 5,000 or less to sell insurance directly to customers. The regulations require

that all credit and insurance transactions be completed separately. In addition, all insurance sold by

banks and trusts will be subject to state Insurance

Department regulations. BBR, 6/15/98, p. 967.

On June 19, 1998, the New York legislature

approved a bill to extend the state's "wild card"

banking law for two more years and expand the scope

of the law to cover thrifts. The state's original wild

card banking law, which was enacted last year, allows

the New York State Banking Board to grant statechartered banks the same powers as federally chartered institutions. It also establishes safeguards to

prevent banks from tying banking and insurance

products together. The latest bill extends the expiration date of the wild card law until September 10,

2000. The new bill also authorizes the New York

State Banking Board to adopt regulations granting

state­chartered thrifts any insurance powers that

have been granted to state­chartered commercial

banks under the wild card law. BBR, 6/29/98, p. 1052.

An additional regulation was published in the

Federal Register on June 24, 1998, which permits New

York State banking institutions to create banking

development districts in areas that have traditionally

been underserved by banks. The districts can be

established through a joint application by a local government and a commercial bank, trust company, or

national bank. BBR, 7/6/98, p. 19.

Oklahoma

On June 5, 1998, a bill was signed that amends

Oklahoma's Consumer Credit Code and allows banks

and other companies to issue credit cards and impose

a variety of fees on the credit­card holders. The new

law, which becomes effective November 1, 1998,

removes legislative limits on credit­card charges and

allows Oklahoma­based companies to charge fees for

membership, transactions, cash advances, documents, and for stopping payments on checks by the

users of the credit cards. The new law gives

38
Recent Developments

Oklahoma businesses an advantage when competing

with out­of­state lenders. BBR, 6/15/98, p. 971.

Texas

In May 1998, the Texas Banking Commissioner

announced that state banks would be allowed to

branch and merge interstate. The announcement was

made in response to a court decision allowing NationsBank Corporation to fold its Texas operations into its

North Carolina headquarters. American Banker, 5/15/98. 

West Virginia

On April 1, 1998, Governor Cecil Underwood

signed a law that permits mobile branch banking in

West Virginia. The law limits mobile banks to a

radius of 30 miles from the bank's permanent main

office or a fixed branch office, and it does not allow

any mobile bank within 2,000 feet of another bank's

main office or branch office. The law became effective on June 12, 1998. BBR, 4/13/98, p. 604.

BANK AND THRlFT PERFORMANCE
 

First-�uarter 1998 Results for

Commercial Banks and Savings

Institutions

Insured commercial banks continued to produce

record profits in the first quarter of 1998, earning net

income of $15.9 billion, which was $621 million higher than the previous record set in the fourth quarter

of 1997. The FDIC attributed much of the increase

in banks' first­quarter earnings to the continued

strong growth in noninterest income, especially from

trust activities and other sources of fees. Revenues

also received a one­time gain from sales of securities

and other assets. Banks' annualized return on assets

(ROA) was 1.26 percent in the first quarter, up from

1.24 percent in the fourth quarter of 1997 and 1.25

percent in the first quarter of 1997. The number of

problem banks decreased from 71 in the fourth quarter of 1997 to 67 in the first quarter of 1998. Problem

banks had assets of $4.8 billion. There were no failures of insured commercial banks in the first quarter.

FDIC BIF­insured mutual savings institutions

earned $2.6 billion in the first quarter of 1998, up by

$178 million from one year earlier. The savings

industry reported an average annualized ROA of 1.03

percent in the first quarter, which matches the ROA

in the first quarter of 1997. The number of problem

thrifts declined to 16 in the first quarter from 21 at

the end of 1997. However, assets of problem thrifts

rose to $2.3 billion from $1.7 billion at year­end 1997.

FDIC Quarterly Banking Profile, First Quarter 1998.

First-�uarter 1998 Results for Thrifts

The nation's thrift industry earned $1.87 billion in

the first quarter of 1998, which was up from $1.66 billion in the fourth quarter of 1997 and $1.73 billion in

the first quarter of last year. Profitability and capital

levels also increased in the first quarter, while troubled assets and delinquent loans decreased. The

equity capital to assets ratio rose to 8.40 percent at

the end of the first quarter, compared with the previous quarter's record of 8.32 percent. All but one of

the OTS­supervised thrifts met or exceeded minimum capital requirements, and 98 percent of the

thrifts were in the highest capital category (well­capitalized) at the end of March 1998. 

The thrift industry's ROA was 0.97 percent in the

first quarter, up from 0.87 in the fourth quarter of

1997. The number of problem thrifts fell to 14 in the

first quarter, down from 18 in the fourth quarter and

30 one year ago. The OTS attributed the strong

financial performance of the thrift industry to an

increased demand for single­family mortgage loans

because of the robust economy and low, stable interest rates. aTS 98-45, 6/3/98.

RECENT ARTlCLES AND STUDlES

A working paper, entitled Capitalization of the Kevin Sheehan, a financial economist in the Division

Bank Insurance Fund, concludes that the current of Research and Statistics at the FDIC. Working Paper

funding arrangement of the Bank Insurance Fund Series, 98-1, FDIC.

(BIF) is sufficient to maintain FDIC solvency,

assuming that the prior history of losses is a good A working paper published in June 1998 by the

indicator of future losses. The study simulates the Swiss­based Bank for International Settlements

BIF's future reserve levels and examines the impli­ (BIS) concludes that the separation of commercial

cations of different assessment rates and required banking and securities activities cannot be justified

reserve ratios. The working paper was written by either on bank safety­and­soundness or conflict­of39
FDlC Banking Review

interest grounds. The paper, entitled Commercial

Banks in the Securities Business: A Review, was written

for the BIS by former Federal Reserve Bank of

Cleveland official Joao Santos. The working paper

notes that the advantages of allowing "universal

banking," both banking and securities services

offered under one roof, include improved information on companies they underwrite and economies of

scope that allow consumers to save time and money

by purchasing an array of financial services from a

single provider. BBR, 7/6/98, p. 37.

The Federal Reserve Bank of Chicago released a

report on April 28, 1998, entitled 1996 CRA Small

Business Lending Profile. The report revealed that

low­ and moderate­income neighborhoods in the

Midwest are receiving a smaller share of small­business loans than their broader metropolitan areas.

The report analyzes data collected under the Community Reinvestment Act and evaluates five metropolitan areas, including Chicago, Des Moines,

Detroit, Indianapolis, and Milwaukee. BBR, 5/4/98, p. 714.

The Federal Reserve Board released a study on

May 29, 1998, which declared that banks' internal

credit risk models will not completely replace international risk­based capital standards any time soon,

but may enhance current supervisory and regulatory

policies. The final report, entitled Credit Risk Models

at Major U.S. Banking Institutions: Current State of the

Art and Implications for Assessments of Capital

Adequacy, concluded that the internal models used to

measure risk and to allocate capital have significant

shortcomings that make them unreliable substitutes

for existing risk­based capital rules. The study states

that difficulties regarding model construction, data

availability, and model validation procedures limit

the use of banks' internal models in the regulatory

process. FRB PR 5/29/98; BBR, 6/8/98, p. 920.

A paper, entitled The Evolution of Bank Lending to

Small Business, concludes that the recent wave of

bank mergers may actually increase the amount of

credit available to small businesses. The paper

reports that mergers among community banks produce larger institutions, which means they may make

larger loans and still remain within government­set

limits on loans to any single borrower. Joe Peek of

Boston College and Eric S. Rosengren of the Federal

Reserve Bank of Boston performed the study. American

Banker, 5/8/98.

Deposit Insurance Reform in the FDIC Improvement

Act: The Experience to Date reports that a 1991 law

meant to restore the industry's health and avoid

banking crises appears to be working. The Federal

Deposit Insurance Corporation Improvement Act

appears to be preventing banks from taking excessive risks and encouraging regulators to sanction

financially troubled institutions. Two economists

authored the paper, George Benston of Emory

University and George Kaufman of Loyola

University. American Banker, 8/28/98.

lNTERNATlONAL DEVELOPMENTS
 

International Deposit Insurance
 

Conference
 

The FDIC sponsored an International Deposit

Insurance Conference in September 1998, in order to

discuss the role of deposit insurance in sustaining

public confidence in the world's banking systems.

The Conference brought together top government

officials from 63 countries, including the leaders of

deposit insurance agencies in more than 20 nations.

PR-61-98, FDIC, 9/1/98.

Deposit Insurance for Russian Banks

In an effort to restore confidence in Russia's banking system, the Central Bank announced plans to

insure deposits held by individuals at commercial

banks. On August 20, 1998, Central Bank Chairman

Sergei Dubinin announced the proposed insurance

plan and stated that it would cover all bank deposits

established before August 1, 1998. The insurance

would work through Russia's largest commercial

bank, Sberbank, in which the government holds a

controlling stake. BBR, 8/24/98, p. 308.

Basle Committee

The Basle Committee on Banking Supervision

announced on April 7, 1998, that they amended their

rules regarding the capital that banks must keep on

hand to cover risk resulting from loans to securities

firms. The changes affect the Committee's 1988

Basle Capital Accord, which is an international agreement that sets minimum capital requirements for

banks. The amendment reduces the risk weight on

a bank's credit exposure for claims on regulated securities firms to 20 percent from 100 percent. The

40
Recent Developments

amendment applies only to claims on regulated securities firms and not holding companies that may own

the securities firms. The Basle Committee on

Banking Supervision is a group of senior supervisors

and central bank officials from nine western

European countries and the United States, Canada,

and Japan. PR-23-98, FDIC, 4/8/98; BBR, 4/13/98, p. 620.

European Union

On April 30, 1998, the European Parliament

approved changes to European Union legislation

involving capital adequacy and solvency requirements for banks, credit institutions, and investment

firms. The changes will be effective upon publication of three new directives. Governments will have

up to 24 months to confirm that their national laws

comply with the new European Union requirements.

The first directive introduces changes to Directive

89/647/EEC, which establishes a solvency ratio for

credit institutions. The second proposal includes

amendments to the 1989 solvency directive, as well

as Directive 77/780/EEC, which sets rules for establishing and operating credit institutions, and

Directive 93/6/EEC on capital adequacy of investment firms and credit institutions. The amendments

to these directives involve updated capital requirements, including requirements for credit risks inherent in derivatives, as well as extending the exchange

of information between European Union bank supervisors and nonbanking supervisory authorities in

third countries. The third directive updates the 1993

capital adequacy directive regarding commodities

and commodity directives. BBR, 5/18/98, p. 828.

Eleven Countries Establish Economic and

Monetary Union

On May 3, 1998, eleven European Union countries

received confirmation that they qualified for the

Economic and Monetary Union. The eleven countries-Austria, Belgium, Finland, France, Germany,

Ireland, Italy, Luxembourg, the Netherlands,

Portugal, and Spain-will convert to a single currency, the Euro, on January 1, 1999. Once the 11 countries convert to the Euro, the legacy currencies will

become denominations of the Euro. Belgium,

France, and Germany will redenominate their existing government debt into Euros. On January 1, 2002,

Euro notes will be issued, and the legacy currencies

will be withdrawn from circulation. BBR, 5/11/98, p. 781;

BBR, 6/8/98, p. 949.

Indonesia

On April 4, 1998, the new Indonesian Bank

Restructuring Agency made its first moves to rebuild

the country's battered banking system by closing

seven small banks and taking control of seven large

banks. The Indonesian Bank Restructuring Agency

was created in January 1998 to repair the country's

banking system. The Wall Street Journal, 4/6/98.

Statement of Cooperation

In April 1998, the Office of Comptroller of the

Currency, the Board of Governors of the Federal

Reserve System, and the Superintendencia de

Bancos de Chile entered into a Statement of

Cooperation that will facilitate the supervision of

financial institutions operating in each other's country. The Statement of Cooperation provides for the

sharing of supervisory information to facilitate the

performance of each agency's duties and to promote

the safe and sound functioning of financial institutions in their respective countries. The arrangement

provides for cooperation during the authorization

process as well as in the supervision of ongoing activities of financial institutions operating in each other's

country. The statement supercedes an earlier one

established between the Superintendencia and the

Federal Reserve in March 1997. NR-98-40, aCC, 4/16/98.

41