With Debt Reserves, Banks Bite Only Half the Bullet

“A brat with guts,” Fortune magazine dubbed Citicorp chairman John Reed after he said that Citicorp was bolstering its bad-loan reserves to 25% of what it is owed in the Third World.

As if to prove that Citicorp wasn’t the only one with guts, bank after large U.S. bank followed suit. Chase. Security Pacific. The Bank of Boston. Even Bank of America, which, conventional wisdom had it, didn’t have the financial strength to be so gutsy. As a result, the five largest U.S. banks had unprecedented second-quarter losses totaling nearly $7 billion.

On the sidelines, most financial analysts interpreted the banks’ moves as a plus for their negotiation position vis-a-vis the debtor nations. The new cushion of reserves, it was argued, removed the debtors’ one good trump card in any negotiation with the banks: the threat of default. Now that Citicorp and others had already taken the hit to their earnings, even the $100-billion debtors, Mexico and Brazil, could not scare the banks into debt relief. “It’s a crummy world out there,” Reed announced, as if to be clear that the banks were not adding to their reserves to make life easier for the debtor nations.

But here again the conventional wisdom is wrong. The banks’ actions have shifted the terms of the debate toward the debtors.

Until now, the creditors have relied on a series of myths to argue their case. Myths held that a buoyant and barreling world economy would pull debtors out of their bind. Myths underpinned the creditors’ argument that the debt crisis wasn’t really a crisis, but only a temporary liquidity problem. And myths were employed to explain that the loans were and always would be worth 100 cents on the dollar. In one swift move Citicorp shattered them all, saying that “pessimism” about the world economy--and, by inference, pessimism that the liquidity lapse would pass--led it to reclassify its loans at 75 cents to the dollar.

With this dose of reality replacing the myths, a new stage in the resolution of the debt crisis is beginning. Since 1985, Treasury Secretary James A. Baker III has promised that compliant Third World debtors--those adhering to Reaganomic formulas of privatization and free-market economics--would get their reward: more private bank loans. Citicorp, making it clear that the debt-ridden Third World is no longer on the list of profitable places for new loans, emerges as the coroner of the Baker Plan.

Citicorp, Chase, Bank of America and the others have proved that a managed write-down need not break the banks. The financial community has long held out the bogyman of global financial collapse to clinch the argument against debt relief. Now we see that a significant portion (somewhere between one-third and one-quarter) of what the Third World owes U.S. banks can be written off without precipitating anything close to financial collapse--and without leaving American taxpayers holding the bill. In other words, no direct government bail-out is necessary. Rather, the banks, which privatized the benefits of Third World lending, can afford to privatize the costs. As for the debtors, such write-offs would in many cases drop their debt-service payments to below 20% of export earnings, freeing up substantial resources for domestic development.

A further plus from the write-downs was that they helped “level the playing field” between banks of different creditor countries. Previously, U.S. banks argued that debt relief would put them at a competitive disadvantage versus German, French and Swiss banks (with 30% to 40% of their Third World debt in reserves). Soon most of these banks will face the Third World with large and roughly equivalent reserves.

Finally, Citicorp’s move immediately preceded another big event in financial circles: the resignation of Paul A. Volcker as Federal Reserve Board chairman. However coincidental, the timing was fortuitous. One of the Baker Plan’s architects, Volcker was instrumental in extending its life. His journeys around the globe to twist the arms of debtors and bankers alike have become the stuff of legend. But his replacement, Alan S. Greenspan, lacks the clout and the international experience to continue to patch up a disintegrating structure.

In sum, the banks have opened the doors for debt relief, but only on their side of the ledger. Debtor nations continue to be bled as if they owed the face value of their debts. When and whether more of them will respond by unilaterally reducing debt payments is uncertain; their fear of retaliation remains high.

The challenge before Western governments, which have regulatory authority over their private banking systems, is to help translate the banks’ step toward realism in the debt debate into actual relief for the desperate economies of the Third World. For its part, Washington should move quickly to induce banks into debt relief by giving them incentives to pursue different approaches to reducing their Third World loan exposure, from interest-rate relief to principal write-down.

In other words, more guts are in order.