SUNS  4348 Friday 18 December 1998



FINANCE: OTC DERIVATIVES PLAYED IMPORTANT ROLE IN ASIAN CRISIS

Geneva, 16 Dec (Chakravarthi Raghavan) -- While not all the difficulties created by volatile capital flows in Asia were due to the increased use of derivative instruments or structured derivative packages by foreign banks, they did play an important role in the unexpected declines and excessive volatility of currency and asset markets in Asia during the crisis, according to Prof. Jan Kregel.

In an article on derivatives and global capital flows in the Oxford Journal of Economics November issue devoted to the Asian crisis, Kregel (who at that time was teaching at Bologna University, but is now on UNCTAD staff) points to four puzzles in the East Asia crisis that have caused surprise, and suggests that the understanding or explanation lies in the wide-spread use of structured over-the-counter (OTC) derivatives.

There 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 on non-bank lending, in particular FDI, and the example of such flows to a number of Asians was used as example of the greater stability of such lending. Yet the Asian crisis seems to have been precipitated by the reversal of short-term private bank lending which had come to dominate capital flows to the region.
Second, capital flows to Asia have been used as an example of the benefits of international capital markets in directing resources to the most productive uses. Yet in the aftermath of the crisis, it appears that total returns on equity investments in Asia have been lower than in most other regions throughout the 1990s.
Third, in a number of Asian countries the majority of international lending was between foreign and domestic banks. It has been suggested that the major cause of the crisis is unsafe lending practices by Asian banks, due to inadequate national prudential supervision.

But the developed country lenders were large global banks, employing highly sophisticated risk-assessment procedures, who continued to lend well after the increased risks in the region had become apparent.

This shows that even the most sophisticated operators in the global financial markets have difficulties in assessing risk, and that the Asian country regulators were no more successful in imposing prudent limits than those in most advanced countries.

Finally, private portfolio and FDI flows were considered to be preferable to syndicated bank lending because they were thought to segregate the problem of foreign exchange instability from asset market instability.... Yet, the linkage between collapse in exchange rates and equity markets appears to have been even closer in Asia than in other experiences of financial crises.

One explanation offered for the crisis in foreign markets, Kregel notes, is that a large proportion of foreign borrowing by corporations was unhedged because of expectations of stable currency rates, and when these were disappointed there was a scramble for foreign currency to repay the debts and this created the massive market imbalance and collapse of foreign exchange markets.

And the absence of generalized hedging in foreign exchange markets has been interpreted to mean that financial derivatives contracts played no role in the crisis - a view reinforced by references to the IMF study that global hedge funds were not active catalysts in the Asian crisis.

However, points out Kregel, the quarterly reports (4th quarter of 1997 and first quarter of 1998) of US money centre banks, suggest that most of their initial losses have been related to derivative-based credit swap contracts. And at least in the case of US banks, such derivative contracts played some role in the flow of funds to Asia and thus in the instability of such flows. There is also evidence that the German and French banks were also involved in derivatives trading in the region.

The standard derivative contracts are used for hedging risks - such as forwards, futures and options. Foreign currency forwards remain the province of bank foreign exchange dealers. Most basic futures and options contracts are standardised and traded in organized, regulated markets. But banks also offer derivative contracts to their clients in 'over-the-counter' (OTC) market. These are not derivatives on organized markets, but rather individually tailored, often highly complex,
combinations of standard financial instruments, packaged together with derivative contracts designed to meet particular needs of clients. Such contracts involve very little direct lending by banks to clients, and generate little net interest income to the banks. They are often executed through special purpose vehicles - specialized investment firms that are separately capitalized, and thus in terms of the Basle capital adequacy requirements, need little or no capital or are classified as off-balance-sheet items, involving no direct risk exposure of the bank. They generate though substantial fee and commission income - with the bank committing none of its own capital, but serving as intermediaries matching borrowers and lenders.

The major objective of active, global financial institutions is thus no longer the maximisation of profits by seeking the lowest cost funds and channelling them to highest-risk adjusted return,  but rather in maximising amount of funds intermediated to maximise fees and commissions, thus maximising the rate of return on bank capital.

This means a shift from continuous risk assessment and risk monitoring of funded investment projects that produce recurring flows of interest payments over time to the identification of riskless 'trades' that produce large, single payments, with as much of the residual risks as possible carried by purchasers of such package. This process has been accelerated by the introduction of risk-weighted capital requirements.

This has resulted in banks coming to play a declining role in the process of efficient international allocation of investment funds, but serving to facilitate this process by linking primary lenders and final borrowers. This means that the efficient allocation of funds to the highest risk-adjusted rate of returns depends on an assessment of risks and returns by the lender.

But the role of most derivative packages is to mask the actual risk involved in an investment, and to increase the difficulty in assessing the final return on funds provided.

As a result, certain types of derivatives may increase the difficulties faced by private capital markets in effecting the efficient allocation of resources. And by making investment evaluation more difficult for primary lenders, they create also difficulties for financial market regulators and supervisors.

Most institutional investors in the US do not face unlimited investment choices, but are limited to invest in assets with a minimum of risk represented by the investment-grade credit rating on the issue. They are precluded from risks such as foreign exchange risks or foreign credit risks.

This means that a large proportion of professionally managed institutional investment funds cannot invest in emerging markets or in particular asset classes such as foreign exchange.

"Structured derivative packages, created by global investment banks, have often provided the means to circumvent these restrictions."

Some of these packages, Kregel explains, might involve US government agency dollar denominated structured notes with the interest payments, or the principal value, linked to an index representing some foreign asset, such as Thai baht/dollar exchange rate, and derivative contracts
enabling a Thai bank getting below-market rate funds, and US investors with above-market returns, and the banks with fees and commissions for arranging the trade, but with no commitment of capital.

Kregel points out that it is virtually impossible (in such contracts) for the US investor to evaluate the use of funds by the Thai bank, and little incentive for the US bank to do so: for, once the structured
note issue is sold, the foreign credit and exchange risks are borne by the US investor, who is not only subverting prudential controls, but in all probability evaluating the return without any adjustment for foreign exchange risk, even if that risk is recognized as such.

"There is thus little economic interest or possibility for the market to assess either the risk or the returns of the investment, and thus no incentive for market agents top act so as to ensure that capital is allocated globally to those uses providing the highest risk-adjusted rates of return."

Kregel explains the use of OTCs for 'credit enhancement' in lending and investing in Mexico for Brady bonds and J.P.Morgan's use of it for issue of Aztec bond in 1988, and more recently investment banks using this principle to other types of developing country debt to enable US institutional investor funds being invested in emerging market debt, earning above-market interest rates, with no risk to the intermediary "unless the bank was required to guarantee to convert interest payments (in local currency) into dollars, and a risk only if the foreign currency were to become inconvertible - not a devaluation risk but a risk that the currency could not be sold at any price."

Kregel comments that this provides one possible explanation why so much effort was made to prevent Mexico from suspending convertibility in 1994, and notes that structures similar to that used in Mexico were used in Asia as well as Latin America.

The structured note and the credit-enhanced Brady structures were used to move funds from developed to developing countries, despite the existence of prudential regulatory barriers.

Kregel notes that information about the various derivatives are not easy to come by, but some of the litigations between US centre banks like JP Morgan and some Korean counter-parties throw some light.

And in the case of Thailand, the profits from derivatives and current revaluations far exceed the total amounts owed for traditional lending. This suggests that a majority of the funds that entered Thailand were linked to derivative contracts. For Korea, the profit figures were well over half the 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 IMF support, derivatives sold by US banks to domestic institutions appear to have played as large a part as traditional financing activities.

The Kregel article was contributed in April 1998, and thus makes no  reference to the evolution of the financial crisis after that date - its spread to Russia, Latin America, and the scandal in the United
States itself, of the Long Term Capital Management Fund and its operations and collapse, and the New York Federal Reserve engineered rescue of the LTCM.

But some of the Kregel views on OTC derivatives and their role in Asia, and banks having no real risks except when a currency becomes inconvertible, may perhaps explain the howls raised in Washington and elsewhere against Malaysia and its decision in September to make the ringgit non-convertible, and impose capital controls.

The strong criticism of Malaysian controls possibly reflect the worries and fears that Indonesia and other developing countries might follow Malaysian example, if there is no quick turnaround in their economies under the IMF conditioned programmes.

In the OJE, in other articles, Prof Robert Wade and others in fact advocate capital controls and restrictions.

Wade argues that capital account convertibility brings economic policy in developing countries under the influence of international capital markets - and a small number of country analysts and fund managers in New York, London, Frankfurt and Tokyo.

Even if free movement of capital lead to efficiency in allocation of capital and as such maximise returns to capital worldwide, "governments have much more than the interests of the owners of capital in view - or ought to have.... They want to maximise the returns to labour, to entrepreneurship, to technical progress and to maximise them within their own territory rather than somewhere else; they want to provide public goods that contribute to the good life."

"Only blind faith in the virtues of capital markets could lead one to think that maximising the returns to capital and promoting development goals generally coincide," Wade adds.

But regional economists like Prof. Jomo Sundaram of Malaysia University believe that capital controls can avert a crisis but not overcome them.
Currency measures in Malaysia were necessary to regain control over monetary policy and kill the overseas market in ringgit (specially in Singapore). But capital controls are a means and not an end in itself, and could be messy and discourage FDI as well, he adds.

The full contours of the LTCM and its operations in US are yet to come out fully -- the involvements of various banks and bank regulators (in the US and Europe and their failures) and the LTCM rescue, justified by the Federal Reserve as necessary to safeguard the financial system but viewed by many others as US crony capitalism and attempt to bury the mistakes of the regulators.

The LTCM has forced regulators, under prodding from the Congress, to sit up and take note of such funds and their operations. But even when trying to respond to Congress, the US regulators are fighting their own turf battles: there are three of them -- the US Federal Reserve, the Securities and Exchanges Commission and the Commodities and Futures Trading Commission, and each has a constituency that uses its campaign financing to line up Congressional support too.

But many of the arguments of the US and of the IMF against over-regulation and controls, and why hedge funds cannot be controlled or regulated (since they will shift their operations to off-shore
centres, like Cayman islands, and thus beyond supervision) don't really stand much scrutiny.

After all Mr. George Soros or Mr. Merriweather of the LTCM and his like may locate their funds in off-shore centres, but they and their staff won't go and live in these places with their families and send their children to school there. The off-shore centres will only be 'name-plate' funds and enterprises, in fact run from desks in the US, UK and so on.

There are two schools of thought in the US: one that advocates that derivatives traded on regular markets, and OTCs (whose daily turnover is not over a trillion dollars), need to be regulated and controlled in the same way new drugs are by the US Food and Drug Administration: each one needs prior approval and clearance before being put on the market.

The other approach is for regulators to give clear instructions to the banks on the extent of risks they will be allowed and not allowed, and rely on their internal oversight systems. If these systems are found to have failed, then the banks will be forced to set aside heavy capital adequacy requirements.

But either way it will only safeguard the interests of the financial and money centres, not the host developing countries. For the latter to be served, any reform or any new financial architecture must be seen not in separate compartments, dealing with financial and trading systems, but together in one piece.

The starting point for this, and to ensure that their voices are heard and accommodated, is to adapt the title of a recent article by Prof. Jagdish Bhagwati, is not to treat "trading in widgets as the same as trading in dollars".

Developing countries may not be able to block changes at the IMF, but they can do so at the WTO (and use the consensus process to reject accords). They might regain some bargaining leverage at the WTO by not ratifying the 1997 financial services accord, and insist on changes in the financial services agreements or at the minimum enable them to rewrite their schedules with new conditions under which the dictum for foreign financial services operators would be that they 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 to be modified that any new activity not specifically authorised would need specific approval, and the operators would face penalties if they try to get around the regulations or help local enterprises to do so.

And the home countries of these banking and financial services enterprises should be able to raise disputes on behalf of their enterprises at the WTO only if they undertake supervisory and
regulatory obligations to ensure that their main offices will obey host country rules and regulations - in the same way the US wants countries of origin to track and control production and exports narcotic drugs.