How factors in creditor countries affect secondary market prices for developing country debt

Bank loans to many developing countries trade at a discount on the secondary market. These discounts are typically assumed to reflect only the repayment prospects of the borrower country. But the authors demonstrate that factors in the creditor countries have a major impact on secondary market prices. Their empirical investigation suggests a systematic relationship between secondary market prices and the size distribution of banks' portfolios. There is a strong negative correlation between discounts in the secondary market and U.S. banks' heavy exposure to developing country debt. It is estimated that every US$4 billion increase in a large bank's exposure to a country reduces the discount 10 to 15 cents on the dollar. The authors find that discounts and total bank capital are positively correlated over time : a US$8 billion increase in the capital of the largest U.S. banks increases discounts by nearly 25 cents on the dollar. They explain their results with a simulation model of a representative bank with minimum capital requirements, flat-rate deposit insurance, and limited liability. The bank's portfolio adjustment decision involves trading risky foreign loans in the secondary market or making short-term domestic loans. The model yields a negative relationship between the banks' exposure to developing countries and discounts in the secondary market.