CD Market Response to the Citicorp Loan-Loss Reserve Decision and the International Debt Crisis of 1987

Article excerpt

CD Market Response to the Citicorp Loan-Loss Reserve Decision and the International Debt Crisis of 1987(*)

On May 19, 1987, Citicorp announced that it would augment its loan-loss reserve by $3 billion to cover potential losses on loans to less-developed countries (LDCs). This event was perceived as a reaction to Brazil's announcement on February 20, 1987, to suspend interest payments on debt held by foreign banks and was a major policy shift in Citicorp's treatment of the LDC debt problem. Within a month, most of the large money-center banks followed Citicorp's decision. The events surrounding these announcements are given in the Appendix to this paper.

The Brazil announcement and Citicorp decision was not the first crisis of its kind. In August 1982, Mexico announced a moratorium on its foreign debt payments that heightened public concern over bank LDC debt exposure. Subsequently, numerous studies analyzed risk-adjusted stock market returns around the date of the Mexican announcement. Schoder and Vankudre [16], Cornell and Shapiro [5], and Smirlock and Kaufold [17] found mixed or insignificant effects. However, Bruner and Simms [4], who examined forty-eight of the nation's largest banks, found significant negative risk-adjusted equity returns following the announcement data.

Recently, the impact of the Citicorp decision has received increased attention in the research literature. Grammatikos and Saunders [8] found positive abnormal returns accrued to shareholders of the largest banks following the Citicorp decision. This conclusion was confirmed by Musumeci and Sinkey [12], who examined the equity returns of the twenty-five largest U.S. banks.

This paper further explores the impact of the Citicorp decision by examining the effect in the large negotiable Certificate of Deposit (CD) market. Examination of this market should be of interest for at least two reasons. First, the equity market studies focus on profitability and the combined effects on both the asset and liability sides of the bank balance sheet, whereas analysis of the CD market focuses specifically on the liability or funding side of the bank. Second, the examination of this market addresses the issue of market discipline. That is, any effects realized in the CD market would indicate the market's ability to reward or penalize banks for unnecessary risk exposure and management of the LDC debt problem. This is a problem that will probably not go away for quite some time. Indeed, only recently (see The Wall Street Journal, September 21, 1989)Chase Manhattan and Manufacturers Hanover increased their loan-loss reserves to over forty-five percent of their LDC exposure. This is well above the 30 percent mark achieved by Citicorp in 1987.

The Citicorp decision to increase loan-loss reserves (LLR) and the money-center and large regional banks that subsequently followed represented a major shift in policy toward the treatment of their LDC debt exposure. A predictable reaction in the financial markets to these decisions is not obvious. Risk premiums in the CD markets could increase if the markets perceived the decision as a signal of increasing loan defaults, which would further strain the financial condition of these banks. On the other hand, CD premia could decline due to a positive market perception of the decision. In this case, the market may perceive the banks to be in a better bargaining position that could lead to more favorable settlement terms in the event that a final resolution is obtained. A positive reaction could also be due to the fact that banks are "facing up" to the LDC debt problem and may consequently reduce some of the uncertainty with respect to the crisis. In a sense, this contrasts with Continental Illinois' reaction to the loan defaults that resulted from its dealings with Penn Square Bank in Oklahoma City in the early 1980s. Uncertainly in the financial condition of Continental grew until May 1984, when a huge deposit run on the bank led to a major liquidity crisis at the bank and a subsequent federal bailout. …