OTC derivatives played important role in Asian crisisIn a contribution to a leading economics journal, Prof. JanKregel highlights the role played by derivatives, particularlyover-the-counter (OTC) derivatives, in the Asian financialcrisis. OTC derivatives, which are structured to clients'particular needs by banks which themselves assume little risk,hamper efficient capital allocation and prudent riskassessment. The volatility generated by the use of suchinstruments necessitates the need for financial-sector reform.by Chakravarthi Raghavan
GENEVA: While not all the difficulties created by volatilecapital flows in Asia were due to the increased use ofderivative instruments or structured derivative packages byforeign banks, they did play an important role in theunexpected declines and excessive volatility of currency andasset markets in Asia during the crisis, according to Prof. JanKregel.In an article on derivatives and global capital flows in theOxford Journal of Economics November 1998 issue devoted to theAsian crisis, Kregel (who at that time was teaching at BolognaUniversity, but is now on the staff of UNCTAD) points to fourpuzzles in the East Asia crisis that have caused surprise, andsuggests that the understanding or explanation lies in thewidespread use of structured over-the-counter (OTC)derivatives.Puzzling elementsThere are at least four puzzling elements in the Asian crisis,he says:First, after the Latin America debt crisis of 1982,developing countries were encouraged to increase reliance onnon-bank lending, in particular FDI, and the instance of suchflows to a number of Asian economies was used as an example ofthe greater stability of such lending. Yet the Asian crisisseems to have been precipitated by the reversal of short-termprivate bank lending which had come to dominate capital flowsto the region.Second, capital flows to Asia have been used as an exampleof the benefits of international capital markets in directingresources to the most productive uses. Yet in the aftermath ofthe crisis, it appears that total returns on equity investmentsin Asia have been lower than in most other regions throughoutthe 1990s.Third, in a number of Asian countries, the majority ofinternational lending was between foreign and domestic banks.It has been suggested that the major cause of the crisis isunsafe lending practices by Asian banks, due to inadequatenational prudential supervision.But the developed-country lenders were large global banks,employing highly sophisticated risk-assessment procedures,which continued to lend well after the increased risks in theregion had become apparent.This shows that even the most sophisticated operators in theglobal financial markets have difficulties in assessing risk,and that the Asian country regulators were no more successfulin imposing prudent limits than those in most advancedcountries.Finally, private portfolio and FDI flows were consideredto be preferable to syndicated bank lending because they werethought to segregate the problem of foreign exchangeinstability from asset market instability.... Yet, the linkagebetween the collapse in exchange rates and that in equitymarkets appears to have been even closer in Asia than in otherexperiences of financial crises.One explanation offered for the crisis in foreign markets,Kregel notes, is that a large proportion of foreign borrowingby corporations was unhedged because of expectations of stablecurrency rates, and when these were disappointed, there was ascramble for foreign currency to repay the debts and thiscreated the massive market imbalance and collapse of foreignexchange markets.And the absence of generalized hedging in foreign exchangemarkets has been interpreted to mean that financial derivativescontracts played no role in the crisis - a view reinforced byreferences to the IMF study that global hedge funds were notactive catalysts in the Asian crisis.However, points out Kregel, the quarterly reports (fourthquarter of 1997 and first quarter of 1998) of US money centrebanks suggest that most of their initial losses have beenrelated to derivative-based credit swap contracts. And at leastin the case of US banks, such derivative contracts played somerole in the flow of funds to Asia and thus in the instabilityof such flows. There is also evidence that the German andFrench banks were also involved in derivatives trading in theregion.Over-the-counter derivativesThe standard derivative contracts - such as forwards, futuresand options - are used for hedging risks. Foreign currencyforwards remain the province of bank foreign exchange dealers.Most basic futures and options contracts are standardized andtraded in organized, regulated markets. But banks also offerderivative contracts to their clients in the "over-the-counter"market. These are not derivatives on organized markets, butrather individually tailored, often highly complex,combinations of standard financial instruments, packagedtogether with derivative contracts designed to meet particularneeds of clients. Such contracts involve very little directlending by banks to clients, and generate little net interestincome to the banks. They are often executed through specialpurpose vehicles - specialized investment firms that areseparately capitalized and thus, in terms of the Basle capitaladequacy requirements, need little or no capital or areclassified as off-balance-sheet items, involving no direct riskexposure of the bank. They generate, though, substantial feeand commission income - with the bank committing none of itsown capital, but serving as an intermediary matching borrowersand lenders.The major objective of active, global financial institutionsis thus no longer the maximization of profits by seeking thelowest-cost funds and channelling them to areas of highestrisk-adjusted return, but rather maximizing the amount offunds intermediated to maximize fees and commissions, thusmaximizing the rate of return on bank capital. This means ashift from continuous risk assessment and risk monitoring offunded investment projects that produce recurring flows ofinterest payments over time to the identification of riskless"trades" that produce large, single payments, with as much ofthe residual risks as possible carried by purchasers of suchpackages. This process has been accelerated by the introductionof risk-weighted capital requirements.This has resulted in banks coming to play a declining rolein the process of efficient international allocation ofinvestment funds, but serving to facilitate this process bylinking primary lenders and final borrowers. This means thatthe efficient allocation of funds to the highest risk-adjustedrate of returns depends on an assessment of risks and returnsby the lender.But the role of most derivative packages is to mask theactual risk involved in an investment, and to increase thedifficulty in assessing the final return on funds provided.As a result, certain types of derivatives may increase thedifficulties faced by private capital markets in effecting theefficient allocation of resources. And by making investmentevaluation more difficult for primary lenders, they create alsodifficulties for financial market regulators and supervisors.Circumventing prudential restrictionsMost institutional investors in the US do not face unlimitedinvestment choices, but are limited to investing in assets witha minimum of risk represented by the investment-grade creditrating on the issue. They are precluded from risks such asforeign exchange risks or foreign credit risks.This means that a large proportion of professionally managedinstitutional investment funds cannot invest in emergingmarkets or in particular asset classes such as foreignexchange."Structured derivative packages, created by globalinvestment banks, have often provided the means to circumventthese restrictions."Some of these packages, Kregel explains, might involve USgovernment agency dollar-denominated structured notes with theinterest payments, or the principal value, linked to an indexrepresenting some foreign asset, such as the Thai baht/dollarexchange rate, and derivative contracts enabling a Thai bank toget below-market-rate funds, US investors above-market returns,and the banks fees and commissions for arranging the trade, butwith no commitment of capital.Kregel points out that it is virtually impossible (in suchcontracts) for the US investor to evaluate the use of funds bythe Thai bank, and there is little incentive for the US bank todo so: for, once the structured note issue is sold, the foreigncredit and exchange risks are borne by the US investor, who isnot only subverting prudential controls, but in all probability evaluating the return without any adjustment for foreignexchange risk, even if that risk is recognized as such."There is thus little economic interest or possibility forthe market to assess either the risk or the returns of theinvestment, and thus no incentive for market agents to act soas to ensure that capital is allocated globally to those usesproviding the highest risk-adjusted rates of return."Kregel explains the use of OTCs for "credit enhancement" inlending and investing in Mexico for Brady bonds and J PMorgan's use of them for the issuance of Aztec bonds in 1988,and more recently investment banks applying this principle toother types of developing-country debt to enable USinstitutional investor funds to invest in emerging-market debt,earning above-market interest rates, with no risk to theintermediary "unless the bank was required to guarantee toconvert interest payments (in local currency) into dollars, anda risk only if the foreign currency were to becomeinconvertible - not a devaluation risk but a risk that thecurrency could not be sold at any price."Kregel comments that this provides one possible explanationwhy so much effort was made to prevent Mexico from suspendingconvertibility in 1994, and notes that structures similar tothat used in Mexico were used in Asia as well as Latin America.The structured note and the credit-enhanced Brady structureswere used to move funds from developed to developing countries,despite the existence of prudential regulatory barriers.Kregel notes that information about the various derivativesis not easy to come by, but some of the litigations between UScentre banks like JP Morgan and some Korean counter-partiesthrow some light.And in the case of Thailand, the profits from derivativesand current revaluations far exceed the total amounts owed fortraditional lending. This suggests that a majority of thefunds that entered Thailand were linked to derivativecontracts. For Korea, the profit figures were well over halfthe amount of total lending, leading to a similar conclusion. And in Indonesia, they are roughly two-thirds.Thus, in all the three countries that had to seek IMFsupport, derivatives sold by US banks to domestic institutionsappear to have played as large a part as traditional financingactivities.The Kregel article was contributed in April 1998, and thusmakes no reference to the evolution of the financial crisisafter that date - its spread to Russia and Latin America, andthe scandal in the US itself of the Long-Term CapitalManagement Fund (LTCM) and its operations and collapse, and theNew York Federal Reserve-engineered rescue of the LTCM.But some of Kregel's views on OTC derivatives and their rolein Asia, and banks assuming no real risks except when acurrency becomes inconvertible, may perhaps explain the howlsraised in Washington and elsewhere against Malaysia and itsdecision in September to make the ringgit non-convertible andimpose capital controls.The strong criticism of Malaysian controls possibly reflectsworries and fears that Indonesia and other developing countriesmight follow the Malaysian example, if there is no quickturnaround in their economies under the IMF conditionedprogrammes.Capital controlsIn the OJE, in other articles, Prof. Robert Wade and othersin fact advocate capital controls and restrictions.Wade argues that capital account convertibility bringseconomic policy in developing countries under the influence ofinternational capital markets - and a small number of countryanalysts and fund managers in New York, London, Frankfurt andTokyo.Even if free movement of capital leads to efficiency inallocation of capital and as such maximizes returns to capitalworldwide, "governments have much more than the interests ofthe owners of capital in view - or ought to have.... They wantto maximize the returns to labour, to entrepreneurship, totechnical progress and to maximize them within their ownterritory rather than somewhere else; they want to providepublic goods that contribute to the good life.""Only blind faith in the virtues of capital markets couldlead one to think that maximizing the returns to capital andpromoting development goals generally coincide," Wade adds.But regional economists like Prof. Jomo Sundaram of theUniversity of Malaya believe that capital controls can avert acrisis but not overcome it. Currency measures in Malaysia werenecessary to regain control over monetary policy and kill theoverseas market in ringgit (especially in Singapore). Butcapital controls are a means and not an end in itself, andcould be messy and discourage FDI as well, he adds.The full contours of the LTCM and its operations in the USare yet to come out fully - the involvements of various banksand bank regulators (in the US and Europe, and their failures),and the LTCM rescue, justified by the Federal Reserve asnecessary to safeguard the financial system but viewed by manyothers as US crony capitalism and an attempt to bury themistakes of the regulators.The LTCM has forced regulators, under prodding fromCongress, to sit up and take note of such funds and theiroperations. But even when trying to respond to Congress, the USregulators are fighting their own turf battles: there are threeof them - the US Federal Reserve, the Securities and ExchangeCommission and the Commodities and Futures Trading Commission -and each has a constituency that uses its campaign financingto line up Congressional support too.But many of the arguments of the US and of the IMF againstover-regulation and controls, and why hedge funds cannot becontrolled or regulated (since they will shift their operationsto offshore centres, like the Cayman Islands, and thus escapesupervision) don't really stand up to much scrutiny.After all, Mr. George Soros or Mr. Meriwether of the LTCMand his like may locate their funds in offshore centres, butthey and their staff won't go and live in these places withtheir families and send their children to school there. Theoffshore centres will only be "name-plate" funds andenterprises, in fact run from desks in the US, UK and so on.Two schools of thoughtThere are two schools of thought in the US: one that advocatesthat derivatives traded on regular markets, and OTCs (whosedaily turnover is not over a trillion dollars), need to beregulated and controlled in the same way new drugs are by theUS Food and Drug Administration: each one needs prior approvaland clearance before being put on the market.The other approach is for regulators to give clearinstructions to the banks on the extent of risks they will beallowed and not allowed, and rely on their internal oversightsystems. If these systems are found to have failed, then thebanks will be forced to set aside heavy capital adequacyrequirements.But either way, it will only safeguard the interests of thefinancial and money centres, not the host developing countries.For the latter to be served, any reform or any new financialarchitecture must be seen not in separate compartments, dealingwith financial and trading systems, but together in one piece.The starting point for this, to ensure that their voices areheard and accommodated, is not to treat "trading in widgets asthe same as trading in dollars", adapting the title of a recentarticle by Prof. Jagdish Bhagwati.Developing countries may not be able to block changes at theIMF, but they can do so at the WTO (and use the consensusprocess to reject accords). They might regain some bargainingleverage at the WTO by not ratifying the 1997 financialservices accord, and insisting on changes in the financialservices agreements or, at the minimum, their being enabled torewrite their schedules with new conditions under which thedictum for foreign financial services operators would be thatthey can do only what they are specifically permitted to do,and anything not allowed would be illegal.This would not be an issue of market vs. command economy -but rather one of following the Anglo-Saxon or Napoleonic law.In the financial sector at least, the market theology needs tobe modified to the effect that any new activity notspecifically authorized would need specific approval, and theoperators would face penalties if they try to get around theregulations or help local enterprises to do so.And the home countries of these banking and financialservices enterprises should be able to raise disputes on behalfof their enterprises at the WTO only if they undertakesupervisory and regulatory obligations to ensure that theirmain offices will obey host-country rules and regulations - inthe same way the US wants countries of origin to track andcontrol production and exports of narcotic drugs. (Third World Economics No. 202, 1-15 February 1999)This article was originally published in the South-North Development Monitor (SUNS) No.4348, of which Chakravarthi Raghavan is the Chief Editor.OTC derivatives played important role in Asian crisisIn a contribution to a leading economics journal, Prof. JanKregel highlights the role played by derivatives, particularlyover-the-counter (OTC) derivatives, in the Asian financialcrisis. OTC derivatives, which are structured to clients'particular needs by banks which themselves assume little risk,hamper efficient capital allocation and prudent riskassessment. The volatility generated by the use of suchinstruments necessitates the need for financial-sector reform.by Chakravarthi Raghavan
GENEVA: While not all the difficulties created by volatilecapital flows in Asia were due to the increased use ofderivative instruments or structured derivative packages byforeign banks, they did play an important role in theunexpected declines and excessive volatility of currency andasset markets in Asia during the crisis, according to Prof. JanKregel.In an article on derivatives and global capital flows in theOxford Journal of Economics November 1998 issue devoted to theAsian crisis, Kregel (who at that time was teaching at BolognaUniversity, but is now on the staff of UNCTAD) points to fourpuzzles in the East Asia crisis that have caused surprise, andsuggests that the understanding or explanation lies in thewidespread use of structured over-the-counter (OTC)derivatives.Puzzling elementsThere are at least four puzzling elements in the Asian crisis,he says:First, after the Latin America debt crisis of 1982,developing countries were encouraged to increase reliance onnon-bank lending, in particular FDI, and the instance of suchflows to a number of Asian economies was used as an example ofthe greater stability of such lending. Yet the Asian crisisseems to have been precipitated by the reversal of short-termprivate bank lending which had come to dominate capital flowsto the region.Second, capital flows to Asia have been used as an exampleof the benefits of international capital markets in directingresources to the most productive uses. Yet in the aftermath ofthe crisis, it appears that total returns on equity investmentsin Asia have been lower than in most other regions throughoutthe 1990s.Third, in a number of Asian countries, the majority ofinternational lending was between foreign and domestic banks.It has been suggested that the major cause of the crisis isunsafe lending practices by Asian banks, due to inadequatenational prudential supervision.But the developed-country lenders were large global banks,employing highly sophisticated risk-assessment procedures,which continued to lend well after the increased risks in theregion had become apparent.This shows that even the most sophisticated operators in theglobal financial markets have difficulties in assessing risk,and that the Asian country regulators were no more successfulin imposing prudent limits than those in most advancedcountries.Finally, private portfolio and FDI flows were consideredto be preferable to syndicated bank lending because they werethought to segregate the problem of foreign exchangeinstability from asset market instability.... Yet, the linkagebetween the collapse in exchange rates and that in equitymarkets appears to have been even closer in Asia than in otherexperiences of financial crises.One explanation offered for the crisis in foreign markets,Kregel notes, is that a large proportion of foreign borrowingby corporations was unhedged because of expectations of stablecurrency rates, and when these were disappointed, there was ascramble for foreign currency to repay the debts and thiscreated the massive market imbalance and collapse of foreignexchange markets.And the absence of generalized hedging in foreign exchangemarkets has been interpreted to mean that financial derivativescontracts played no role in the crisis - a view reinforced byreferences to the IMF study that global hedge funds were notactive catalysts in the Asian crisis.However, points out Kregel, the quarterly reports (fourthquarter of 1997 and first quarter of 1998) of US money centrebanks suggest that most of their initial losses have beenrelated to derivative-based credit swap contracts. And at leastin the case of US banks, such derivative contracts played somerole in the flow of funds to Asia and thus in the instabilityof such flows. There is also evidence that the German andFrench banks were also involved in derivatives trading in theregion.Over-the-counter derivativesThe standard derivative contracts - such as forwards, futuresand options - are used for hedging risks. Foreign currencyforwards remain the province of bank foreign exchange dealers.Most basic futures and options contracts are standardized andtraded in organized, regulated markets. But banks also offerderivative contracts to their clients in the "over-the-counter"market. These are not derivatives on organized markets, butrather individually tailored, often highly complex,combinations of standard financial instruments, packagedtogether with derivative contracts designed to meet particularneeds of clients. Such contracts involve very little directlending by banks to clients, and generate little net interestincome to the banks. They are often executed through specialpurpose vehicles - specialized investment firms that areseparately capitalized and thus, in terms of the Basle capitaladequacy requirements, need little or no capital or areclassified as off-balance-sheet items, involving no direct riskexposure of the bank. They generate, though, substantial feeand commission income - with the bank committing none of itsown capital, but serving as an intermediary matching borrowersand lenders.The major objective of active, global financial institutionsis thus no longer the maximization of profits by seeking thelowest-cost funds and channelling them to areas of highestrisk-adjusted return, but rather maximizing the amount offunds intermediated to maximize fees and commissions, thusmaximizing the rate of return on bank capital. This means ashift from continuous risk assessment and risk monitoring offunded investment projects that produce recurring flows ofinterest payments over time to the identification of riskless"trades" that produce large, single payments, with as much ofthe residual risks as possible carried by purchasers of suchpackages. This process has been accelerated by the introductionof risk-weighted capital requirements.This has resulted in banks coming to play a declining rolein the process of efficient international allocation ofinvestment funds, but serving to facilitate this process bylinking primary lenders and final borrowers. This means thatthe efficient allocation of funds to the highest risk-adjustedrate of returns depends on an assessment of risks and returnsby the lender.But the role of most derivative packages is to mask theactual risk involved in an investment, and to increase thedifficulty in assessing the final return on funds provided.As a result, certain types of derivatives may increase thedifficulties faced by private capital markets in effecting theefficient allocation of resources. And by making investmentevaluation more difficult for primary lenders, they create alsodifficulties for financial market regulators and supervisors.Circumventing prudential restrictionsMost institutional investors in the US do not face unlimitedinvestment choices, but are limited to investing in assets witha minimum of risk represented by the investment-grade creditrating on the issue. They are precluded from risks such asforeign exchange risks or foreign credit risks.This means that a large proportion of professionally managedinstitutional investment funds cannot invest in emergingmarkets or in particular asset classes such as foreignexchange."Structured derivative packages, created by globalinvestment banks, have often provided the means to circumventthese restrictions."Some of these packages, Kregel explains, might involve USgovernment agency dollar-denominated structured notes with theinterest payments, or the principal value, linked to an indexrepresenting some foreign asset, such as the Thai baht/dollarexchange rate, and derivative contracts enabling a Thai bank toget below-market-rate funds, US investors above-market returns,and the banks fees and commissions for arranging the trade, butwith no commitment of capital.Kregel points out that it is virtually impossible (in suchcontracts) for the US investor to evaluate the use of funds bythe Thai bank, and there is little incentive for the US bank todo so: for, once the structured note issue is sold, the foreigncredit and exchange risks are borne by the US investor, who isnot only subverting prudential controls, but in all probability evaluating the return without any adjustment for foreignexchange risk, even if that risk is recognized as such."There is thus little economic interest or possibility forthe market to assess either the risk or the returns of theinvestment, and thus no incentive for market agents to act soas to ensure that capital is allocated globally to those usesproviding the highest risk-adjusted rates of return."Kregel explains the use of OTCs for "credit enhancement" inlending and investing in Mexico for Brady bonds and J PMorgan's use of them for the issuance of Aztec bonds in 1988,and more recently investment banks applying this principle toother types of developing-country debt to enable USinstitutional investor funds to invest in emerging-market debt,earning above-market interest rates, with no risk to theintermediary "unless the bank was required to guarantee toconvert interest payments (in local currency) into dollars, anda risk only if the foreign currency were to becomeinconvertible - not a devaluation risk but a risk that thecurrency could not be sold at any price."Kregel comments that this provides one possible explanationwhy so much effort was made to prevent Mexico from suspendingconvertibility in 1994, and notes that structures similar tothat used in Mexico were used in Asia as well as Latin America.The structured note and the credit-enhanced Brady structureswere used to move funds from developed to developing countries,despite the existence of prudential regulatory barriers.Kregel notes that information about the various derivativesis not easy to come by, but some of the litigations between UScentre banks like JP Morgan and some Korean counter-partiesthrow some light.And in the case of Thailand, the profits from derivativesand current revaluations far exceed the total amounts owed fortraditional lending. This suggests that a majority of thefunds that entered Thailand were linked to derivativecontracts. For Korea, the profit figures were well over halfthe amount of total lending, leading to a similar conclusion. And in Indonesia, they are roughly two-thirds.Thus, in all the three countries that had to seek IMFsupport, derivatives sold by US banks to domestic institutionsappear to have played as large a part as traditional financingactivities.The Kregel article was contributed in April 1998, and thusmakes no reference to the evolution of the financial crisisafter that date - its spread to Russia and Latin America, andthe scandal in the US itself of the Long-Term CapitalManagement Fund (LTCM) and its operations and collapse, and theNew York Federal Reserve-engineered rescue of the LTCM.But some of Kregel's views on OTC derivatives and their rolein Asia, and banks assuming no real risks except when acurrency becomes inconvertible, may perhaps explain the howlsraised in Washington and elsewhere against Malaysia and itsdecision in September to make the ringgit non-convertible andimpose capital controls.The strong criticism of Malaysian controls possibly reflectsworries and fears that Indonesia and other developing countriesmight follow the Malaysian example, if there is no quickturnaround in their economies under the IMF conditionedprogrammes.Capital controlsIn the OJE, in other articles, Prof. Robert Wade and othersin fact advocate capital controls and restrictions.Wade argues that capital account convertibility bringseconomic policy in developing countries under the influence ofinternational capital markets - and a small number of countryanalysts and fund managers in New York, London, Frankfurt andTokyo.Even if free movement of capital leads to efficiency inallocation of capital and as such maximizes returns to capitalworldwide, "governments have much more than the interests ofthe owners of capital in view - or ought to have.... They wantto maximize the returns to labour, to entrepreneurship, totechnical progress and to maximize them within their ownterritory rather than somewhere else; they want to providepublic goods that contribute to the good life.""Only blind faith in the virtues of capital markets couldlead one to think that maximizing the returns to capital andpromoting development goals generally coincide," Wade adds.But regional economists like Prof. Jomo Sundaram of theUniversity of Malaya believe that capital controls can avert acrisis but not overcome it. Currency measures in Malaysia werenecessary to regain control over monetary policy and kill theoverseas market in ringgit (especially in Singapore). Butcapital controls are a means and not an end in itself, andcould be messy and discourage FDI as well, he adds.The full contours of the LTCM and its operations in the USare yet to come out fully - the involvements of various banksand bank regulators (in the US and Europe, and their failures),and the LTCM rescue, justified by the Federal Reserve asnecessary to safeguard the financial system but viewed by manyothers as US crony capitalism and an attempt to bury themistakes of the regulators.The LTCM has forced regulators, under prodding fromCongress, to sit up and take note of such funds and theiroperations. But even when trying to respond to Congress, the USregulators are fighting their own turf battles: there are threeof them - the US Federal Reserve, the Securities and ExchangeCommission and the Commodities and Futures Trading Commission -and each has a constituency that uses its campaign financingto line up Congressional support too.But many of the arguments of the US and of the IMF againstover-regulation and controls, and why hedge funds cannot becontrolled or regulated (since they will shift their operationsto offshore centres, like the Cayman Islands, and thus escapesupervision) don't really stand up to much scrutiny.After all, Mr. George Soros or Mr. Meriwether of the LTCMand his like may locate their funds in offshore centres, butthey and their staff won't go and live in these places withtheir families and send their children to school there. Theoffshore centres will only be "name-plate" funds andenterprises, in fact run from desks in the US, UK and so on.Two schools of thoughtThere are two schools of thought in the US: one that advocatesthat derivatives traded on regular markets, and OTCs (whosedaily turnover is not over a trillion dollars), need to beregulated and controlled in the same way new drugs are by theUS Food and Drug Administration: each one needs prior approvaland clearance before being put on the market.The other approach is for regulators to give clearinstructions to the banks on the extent of risks they will beallowed and not allowed, and rely on their internal oversightsystems. If these systems are found to have failed, then thebanks will be forced to set aside heavy capital adequacyrequirements.But either way, it will only safeguard the interests of thefinancial and money centres, not the host developing countries.For the latter to be served, any reform or any new financialarchitecture must be seen not in separate compartments, dealingwith financial and trading systems, but together in one piece.The starting point for this, to ensure that their voices areheard and accommodated, is not to treat "trading in widgets asthe same as trading in dollars", adapting the title of a recentarticle by Prof. Jagdish Bhagwati.Developing countries may not be able to block changes at theIMF, but they can do so at the WTO (and use the consensusprocess to reject accords). They might regain some bargainingleverage at the WTO by not ratifying the 1997 financialservices accord, and insisting on changes in the financialservices agreements or, at the minimum, their being enabled torewrite their schedules with new conditions under which thedictum for foreign financial services operators would be thatthey can do only what they are specifically permitted to do,and anything not allowed would be illegal.This would not be an issue of market vs. command economy -but rather one of following the Anglo-Saxon or Napoleonic law.In the financial sector at least, the market theology needs tobe modified to the effect that any new activity notspecifically authorized would need specific approval, and theoperators would face penalties if they try to get around theregulations or help local enterprises to do so.And the home countries of these banking and financialservices enterprises should be able to raise disputes on behalfof their enterprises at the WTO only if they undertakesupervisory and regulatory obligations to ensure that theirmain offices will obey host-country rules and regulations - inthe same way the US wants countries of origin to track andcontrol production and exports of narcotic drugs. (Third World Economics No. 202, 1-15 February 1999)This article was originally published in the South-North Development Monitor (SUNS) No.4348, of which Chakravarthi Raghavan is the Chief Editor.a contribution to a leading economics journal, Prof. JanKregel highlights the role played by derivatives, particularlyover-the-counter (OTC) derivatives, in the Asian financialcrisis. OTC derivatives, which are structured to clients'particular needs by banks which themselves assume little risk,hamper efficient capital allocation and prudent riskassessment. The volatility generated by the use of suchinstruments necessitates the need for financial-sector reform.by Chakravarthi Raghavan
GENEVA: While not all the difficulties created by volatilecapital flows in Asia were due to the increased use ofderivative instruments or structured derivative packages byforeign banks, they did play an important role in theunexpected declines and excessive volatility of currency andasset markets in Asia during the crisis, according to Prof. JanKregel.In an article on derivatives and global capital flows in theOxford Journal of Economics November 1998 issue devoted to theAsian crisis, Kregel (who at that time was teaching at BolognaUniversity, but is now on the staff of UNCTAD) points to fourpuzzles in the East Asia crisis that have caused surprise, andsuggests that the understanding or explanation lies in thewidespread use of structured over-the-counter (OTC)derivatives.Puzzling elementsThere are at least four puzzling elements in the Asian crisis,he says:First, after the Latin America debt crisis of 1982,developing countries were encouraged to increase reliance onnon-bank lending, in particular FDI, and the instance of suchflows to a number of Asian economies was used as an example ofthe greater stability of such lending. Yet the Asian crisisseems to have been precipitated by the reversal of short-termprivate bank lending which had come to dominate capital flowsto the region.Second, capital flows to Asia have been used as an exampleof the benefits of international capital markets in directingresources to the most productive uses. Yet in the aftermath ofthe crisis, it appears that total returns on equity investmentsin Asia have been lower than in most other regions throughoutthe 1990s.Third, in a number of Asian countries, the majority ofinternational lending was between foreign and domestic banks.It has been suggested that the major cause of the crisis isunsafe lending practices by Asian banks, due to inadequatenational prudential supervision.But the developed-country lenders were large global banks,employing highly sophisticated risk-assessment procedures,which continued to lend well after the increased risks in theregion had become apparent.This shows that even the most sophisticated operators in theglobal financial markets have difficulties in assessing risk,and that the Asian country regulators were no more successfulin imposing prudent limits than those in most advancedcountries.Finally, private portfolio and FDI flows were consideredto be preferable to syndicated bank lending because they werethought to segregate the problem of foreign exchangeinstability from asset market instability.... Yet, the linkagebetween the collapse in exchange rates and that in equitymarkets appears to have been even closer in Asia than in otherexperiences of financial crises.One explanation offered for the crisis in foreign markets,Kregel notes, is that a large proportion of foreign borrowingby corporations was unhedged because of expectations of stablecurrency rates, and when these were disappointed, there was ascramble for foreign currency to repay the debts and thiscreated the massive market imbalance and collapse of foreignexchange markets.And the absence of generalized hedging in foreign exchangemarkets has been interpreted to mean that financial derivativescontracts played no role in the crisis - a view reinforced byreferences to the IMF study that global hedge funds were notactive catalysts in the Asian crisis.However, points out Kregel, the quarterly reports (fourthquarter of 1997 and first quarter of 1998) of US money centrebanks suggest that most of their initial losses have beenrelated to derivative-based credit swap contracts. And at leastin the case of US banks, such derivative contracts played somerole in the flow of funds to Asia and thus in the instabilityof such flows. There is also evidence that the German andFrench banks were also involved in derivatives trading in theregion.Over-the-counter derivativesThe standard derivative contracts - such as forwards, futuresand options - are used for hedging risks. Foreign currencyforwards remain the province of bank foreign exchange dealers.Most basic futures and options contracts are standardized andtraded in organized, regulated markets. But banks also offerderivative contracts to their clients in the "over-the-counter"market. These are not derivatives on organized markets, butrather individually tailored, often highly complex,combinations of standard financial instruments, packagedtogether with derivative contracts designed to meet particularneeds of clients. Such contracts involve very little directlending by banks to clients, and generate little net interestincome to the banks. They are often executed through specialpurpose vehicles - specialized investment firms that areseparately capitalized and thus, in terms of the Basle capitaladequacy requirements, need little or no capital or areclassified as off-balance-sheet items, involving no direct riskexposure of the bank. They generate, though, substantial feeand commission income - with the bank committing none of itsown capital, but serving as an intermediary matching borrowersand lenders.The major objective of active, global financial institutionsis thus no longer the maximization of profits by seeking thelowest-cost funds and channelling them to areas of highestrisk-adjusted return, but rather maximizing the amount offunds intermediated to maximize fees and commissions, thusmaximizing the rate of return on bank capital. This means ashift from continuous risk assessment and risk monitoring offunded investment projects that produce recurring flows ofinterest payments over time to the identification of riskless"trades" that produce large, single payments, with as much ofthe residual risks as possible carried by purchasers of suchpackages. This process has been accelerated by the introductionof risk-weighted capital requirements.This has resulted in banks coming to play a declining rolein the process of efficient international allocation ofinvestment funds, but serving to facilitate this process bylinking primary lenders and final borrowers. This means thatthe efficient allocation of funds to the highest risk-adjustedrate of returns depends on an assessment of risks and returnsby the lender.But the role of most derivative packages is to mask theactual risk involved in an investment, and to increase thedifficulty in assessing the final return on funds provided.As a result, certain types of derivatives may increase thedifficulties faced by private capital markets in effecting theefficient allocation of resources. And by making investmentevaluation more difficult for primary lenders, they create alsodifficulties for financial market regulators and supervisors.Circumventing prudential restrictionsMost institutional investors in the US do not face unlimitedinvestment choices, but are limited to investing in assets witha minimum of risk represented by the investment-grade creditrating on the issue. They are precluded from risks such asforeign exchange risks or foreign credit risks.This means that a large proportion of professionally managedinstitutional investment funds cannot invest in emergingmarkets or in particular asset classes such as foreignexchange."Structured derivative packages, created by globalinvestment banks, have often provided the means to circumventthese restrictions."Some of these packages, Kregel explains, might involve USgovernment agency dollar-denominated structured notes with theinterest payments, or the principal value, linked to an indexrepresenting some foreign asset, such as the Thai baht/dollarexchange rate, and derivative contracts enabling a Thai bank toget below-market-rate funds, US investors above-market returns,and the banks fees and commissions for arranging the trade, butwith no commitment of capital.Kregel points out that it is virtually impossible (in suchcontracts) for the US investor to evaluate the use of funds bythe Thai bank, and there is little incentive for the US bank todo so: for, once the structured note issue is sold, the foreigncredit and exchange risks are borne by the US investor, who isnot only subverting prudential controls, but in all probability evaluating the return without any adjustment for foreignexchange risk, even if that risk is recognized as such."There is thus little economic interest or possibility forthe market to assess either the risk or the returns of theinvestment, and thus no incentive for market agents to act soas to ensure that capital is allocated globally to those usesproviding the highest risk-adjusted rates of return."Kregel explains the use of OTCs for "credit enhancement" inlending and investing in Mexico for Brady bonds and J PMorgan's use of them for the issuance of Aztec bonds in 1988,and more recently investment banks applying this principle toother types of developing-country debt to enable USinstitutional investor funds to invest in emerging-market debt,earning above-market interest rates, with no risk to theintermediary "unless the bank was required to guarantee toconvert interest payments (in local currency) into dollars, anda risk only if the foreign currency were to becomeinconvertible - not a devaluation risk but a risk that thecurrency could not be sold at any price."Kregel comments that this provides one possible explanationwhy so much effort was made to prevent Mexico from suspendingconvertibility in 1994, and notes that structures similar tothat used in Mexico were used in Asia as well as Latin America.The structured note and the credit-enhanced Brady structureswere used to move funds from developed to developing countries,despite the existence of prudential regulatory barriers.Kregel notes that information about the various derivativesis not easy to come by, but some of the litigations between UScentre banks like JP Morgan and some Korean counter-partiesthrow some light.And in the case of Thailand, the profits from derivativesand current revaluations far exceed the total amounts owed fortraditional lending. This suggests that a majority of thefunds that entered Thailand were linked to derivativecontracts. For Korea, the profit figures were well over halfthe amount of total lending, leading to a similar conclusion. And in Indonesia, they are roughly two-thirds.Thus, in all the three countries that had to seek IMFsupport, derivatives sold by US banks to domestic institutionsappear to have played as large a part as traditional financingactivities.The Kregel article was contributed in April 1998, and thusmakes no reference to the evolution of the financial crisisafter that date - its spread to Russia and Latin America, andthe scandal in the US itself of the Long-Term CapitalManagement Fund (LTCM) and its operations and collapse, and theNew York Federal Reserve-engineered rescue of the LTCM.But some of Kregel's views on OTC derivatives and their rolein Asia, and banks assuming no real risks except when acurrency becomes inconvertible, may perhaps explain the howlsraised in Washington and elsewhere against Malaysia and itsdecision in September to make the ringgit non-convertible andimpose capital controls.The strong criticism of Malaysian controls possibly reflectsworries and fears that Indonesia and other developing countriesmight follow the Malaysian example, if there is no quickturnaround in their economies under the IMF conditionedprogrammes.Capital controlsIn the OJE, in other articles, Prof. Robert Wade and othersin fact advocate capital controls and restrictions.Wade argues that capital account convertibility bringseconomic policy in developing countries under the influence ofinternational capital markets - and a small number of countryanalysts and fund managers in New York, London, Frankfurt andTokyo.Even if free movement of capital leads to efficiency inallocation of capital and as such maximizes returns to capitalworldwide, "governments have much more than the interests ofthe owners of capital in view - or ought to have.... They wantto maximize the returns to labour, to entrepreneurship, totechnical progress and to maximize them within their ownterritory rather than somewhere else; they want to providepublic goods that contribute to the good life.""Only blind faith in the virtues of capital markets couldlead one to think that maximizing the returns to capital andpromoting development goals generally coincide," Wade adds.But regional economists like Prof. Jomo Sundaram of theUniversity of Malaya believe that capital controls can avert acrisis but not overcome it. Currency measures in Malaysia werenecessary to regain control over monetary policy and kill theoverseas market in ringgit (especially in Singapore). Butcapital controls are a means and not an end in itself, andcould be messy and discourage FDI as well, he adds.The full contours of the LTCM and its operations in the USare yet to come out fully - the involvements of various banksand bank regulators (in the US and Europe, and their failures),and the LTCM rescue, justified by the Federal Reserve asnecessary to safeguard the financial system but viewed by manyothers as US crony capitalism and an attempt to bury themistakes of the regulators.The LTCM has forced regulators, under prodding fromCongress, to sit up and take note of such funds and theiroperations. But even when trying to respond to Congress, the USregulators are fighting their own turf battles: there are threeof them - the US Federal Reserve, the Securities and ExchangeCommission and the Commodities and Futures Trading Commission -and each has a constituency that uses its campaign financingto line up Congressional support too.But many of the arguments of the US and of the IMF againstover-regulation and controls, and why hedge funds cannot becontrolled or regulated (since they will shift their operationsto offshore centres, like the Cayman Islands, and thus escapesupervision) don't really stand up to much scrutiny.After all, Mr. George Soros or Mr. Meriwether of the LTCMand his like may locate their funds in offshore centres, butthey and their staff won't go and live in these places withtheir families and send their children to school there. Theoffshore centres will only be "name-plate" funds andenterprises, in fact run from desks in the US, UK and so on.Two schools of thoughtThere are two schools of thought in the US: one that advocatesthat derivatives traded on regular markets, and OTCs (whosedaily turnover is not over a trillion dollars), need to beregulated and controlled in the same way new drugs are by theUS Food and Drug Administration: each one needs prior approvaland clearance before being put on the market.The other approach is for regulators to give clearinstructions to the banks on the extent of risks they will beallowed and not allowed, and rely on their internal oversightsystems. If these systems are found to have failed, then thebanks will be forced to set aside heavy capital adequacyrequirements.But either way, it will only safeguard the interests of thefinancial and money centres, not the host developing countries.For the latter to be served, any reform or any new financialarchitecture must be seen not in separate compartments, dealingwith financial and trading systems, but together in one piece.The starting point for this, to ensure that their voices areheard and accommodated, is not to treat "trading in widgets asthe same as trading in dollars", adapting the title of a recentarticle by Prof. Jagdish Bhagwati.Developing countries may not be able to block changes at theIMF, but they can do so at the WTO (and use the consensusprocess to reject accords). They might regain some bargainingleverage at the WTO by not ratifying the 1997 financialservices accord, and insisting on changes in the financialservices agreements or, at the minimum, their being enabled torewrite their schedules with new conditions under which thedictum for foreign financial services operators would be thatthey can do only what they are specifically permitted to do,and anything not allowed would be illegal.This would not be an issue of market vs. command economy -but rather one of following the Anglo-Saxon or Napoleonic law.In the financial sector at least, the market theology needs tobe modified to the effect that any new activity notspecifically authorized would need specific approval, and theoperators would face penalties if they try to get around theregulations or help local enterprises to do so.And the home countries of these banking and financialservices enterprises should be able to raise disputes on behalfof their enterprises at the WTO only if they undertakesupervisory and regulatory obligations to ensure that theirmain offices will obey host-country rules and regulations - inthe same way the US wants countries of origin to track andcontrol production and exports of narcotic drugs. (Third World Economics No. 202, 1-15 February 1999)This article was originally published in the South-North Development Monitor (SUNS) No.4348, of which Chakravarthi Raghavan is the Chief Editor.
