8:59 AM Feb 27, 1997

BIS WARNING ON RISKS IN INTERNATIONAL MARKET PLACE

Geneva 27 Feb (Chakravarthi Raghavan) -- No one - investors, banking and financial intermediaries, managers of investment funds, and above all public authorities opening up markets or rushing into market place - would be able to claim later of unawareness of the risks to themselves, the institutions, countries and economies.

In reporting new issuance of international securities, breaking all previous records, and the proliferation of structures involving repackaging of assets and/or use of derivatives, the Bank of International Settlements (BIS) has posed the question "whether the risk and return characteristics of complex structures, as well as the liquidity of underlying assets, have all been properly assessed, particularly in the case of new entrants to the international market-place".

The BIS, whose immediate turf and concern is the banking system of the BIS reporting countries, has thus voiced concern over what might be "untried techniques and instruments of financial risk management".

Separately, this week, the Chairman of the US Securities and Exchanges Commission (SEC), and the Chairman of the US Federal Reserve, have voiced their concerns about the irrationality in the market.

Alan Greenspan, in testimony to the US Senate, sounded again his warning of December last about the 'irrationality' of equity prices in the US market, being way above what would be justified on the basis of earnings and expectations, and cautioned that in view of its rousing 'inflationary expectations' might force the Federal Reserve to raise US interest rates.

The SEC Chairman, Arthur Levitt, on the previous day, in a speech at Boston, announced tighter regulation of US mutual funds (which now manage some $3500 bn of assets on behalf of individuals) obliging them to make the investment risks clearer to the investors. Levitt noted that new investors are being drawn to the market and they are not as informed as they should be, with most having experienced only a bull market of the last decade. Levitt warned that these new investors may act precipitously and carelessly to a downturn and "at great cost to themselves and to the markets".

The BIS not-so-explicitly-stated worry is that the banks -- now engaged in old banking business and also in international securities and derivatives, (and insurance in some jurisdictions) -- in raising money and doing business to earn profits, but without adequate risk weighting for capital adequacy purposes -- may suddenly find themselves facing the effects of such risk, and set off a chain reaction affecting the banking system.

The BIS report, its quarterly regular commentary and statistics on recent "International Banking and Financial Market Developments", reports that ample liquidity, subdued inflation, widespread efforts at fiscal consolidation and the progress towards a European Monetary Union (EMU) have combined to create a favourable climate in the international financial markets.

With limited scope for a further substantial reduction in interest rates in the major fixed income markets, investors' search for higher returns led to a broadening in the focus of activity to include more "exotic" sectors in terms of currencies, signatures and instruments.

In testing new products and exploring new niches, investors showed a willingness to take greater market and credit risks. Financial institutions were particularly active - diversifying their funding sources, restructuring their balance sheets and raising capital on an unprecedented scale through increasingly complex instruments.

When seen in relation to the more moderate pace of expansion of net international bank credit recorded last year, the growing buoyancy of securities issuance by financial intermediaries may have represented more a shift in structure of risk management, both on and off-balance- sheet, than a genuine increase in the financing of the real economy.

The report shows that international bank lending by BIS reporting banks to outside area countries in the third quarter rose of 19965 rose to $34.7 billion (compared to 28.1 bn in the second quarter, and 32.9 bn in the same period of 1995).

But this brisk pace masked a sharp cutback in credit flows to Asia - a trend already apparent towards end of second quarter). There were pronounced falls in lending to Korea and Thailand, the two major bank debtors and with a high proportion of short-term debt, due among others also to reassessment of lenders' strategies.

There was also a slowdown in bank lending to China, Malaysia and the Philippines. But credit flows to Indonesia gathered momentum. There was also an increase in bank credit to corporate sector in Latin America.

While Asian countries have somewhat reduced their reliance on short-term banking funds, private sector borrowers in Latin America have diversified away from the international securities markets in favour of bank loans.

There has also been a resumption of bank lending to Middle East countries, where rise in oil prices eased the financial pressures on the oil producers and triggered a recovery in regional bank activity.

The international securities markets were at the centre of these developments -- with new debt issuance breaking all previous records in the fourth quarter with a total of $163.6 billion.

While fund-raising activity of financial institutions accounted for twothirds of this amount, the search of international investors for higher yields increased their willingness to move down the credit spectrum and lengthen duration, opening new financing and refinancing opportunities for a broadening range of borrowers.

The accompanying reduction in risk premia, in turn, boosted the demand for securities involving the repackaging of assets and/or use of derivative features.

In fact most new issues in the international securities markets, during the period under review, incorporated one or both these elements.

(Interestingly, Greenspan has said in his testimony that the reduction in risk premia could have contributed to expectations of very strong earnings, but viewing this as a rational one)

The report brings out that in the efforts of international investors to obtain enhanced returns and moving down the credit spectrum to explore new market niches, there was an increase in the number of currencies used -- with Argentine pesos, Croatian kunas and Icelandic kronurs being used in new issues.

The Asset-backed securities (ABSs), and offering higher returns than assets of comparable credit standing, the financial institutions have been provided with new opportunities for restructuring balance sheets, economising on capital and maximising income.

There has also been a pervasive use of derivatives - featuring a widening array of debt issues - in the search of investors for higher returns. A large number of subordinated issues launched by financial institutions offered attractive margins over benchmark rates - in exchange for various optional elements and/or equity like features.

These options -- such as calls and step-ups -- were often resold by underwriters in the secondary market to reduce borrowers' cost of funds.

All these, and ongoing attempts at enticing investors through progressive incorporation of more complex features, and even finer distinction between debt and equity characteristics, culminated in December in the introduction of a preference share issue incorporating call, step-up, perpetual and non-cumulative clauses.

[A call option is one enabling purchase or sale at a future date at a fixed price. A step-up is one taking account of discontinuity in interest rates. Both could provide a high future profit, at a relatively smaller higher purchase price now, if prices go up, but could also mean losses for the institutions, if the market turns.]

Aside from their derivative features, many of these capital-raising instruments offer a number of additional benefits to both issuers and investors. For issuing banks, they provide an opportunity to exploit discrepancies between the tax and regulatory treatment of capital. For investing banks an important incentive is their low risk weighting for capital adequacy purposes, although this is somewhat offset by higher market and credit risks.

In assessing these developments, BIS says that these raise three important issues:

* Firstly, with recent international debt issues incorporating increasingly complex derivative features, it can be asked whether the associated risk and return characteristics are adequately appreciated by investors.

The difficulties faced by rating agencies in evaluating such structures and the reduced market liquidity of the underlying issues by rating agencies provide some indication of the extent of the problems involved.

* Secondly, the large number of issues exploiting the discrepancies arising from differences in the treatment of capital for regulatory and tax purposes may have created inefficiencies in the global allocation of capital.

* Thirdly, the buildup of positions resulting from the strong fund-raising activity of financial institutions and inter-penetration of securities and derivatives markets have considerably reduced market transparency.

This is likely to have made some of the traditional monetary and debt aggregates less relevant in assessing real-side developments.