Bretton Woods under pressure

By 1961, the plans adopted at the Bretton Woods Convention of 1947 were succeeding beyond anyone’s expectation, proving that Keynes was right. Unfortunately, Keynes was also right in his prediction of a world monetary crisis. It was brought on by a lack of sufficient currency (US dollars) in world circulation to support rapidly expanding international commerce. The solution to this crisis lay in the hands of the Kennedy Administration, the US Federal Reserve Bank and the Bank of International Settlements. The world needed more US dollars to facilitate trade. The US was faced with a dwindling gold supply to back such additional dollars. Printing more dollars would violate the gold standard established by the Bretton Woods agreements. To break the treaty would potentially destroy the stable core at the centre of the world’s economy, leading to international discord, trade wars, lack of trust and possibly to outright war.

The crisis was further aggravated by the fact that the majority of the dollars then in circulation was not concentrated in the coffers of sovereign governments, but rather in the vaults or treasuries of private banks, multi-national corporations, private businesses and individual personal bank accounts. A mere agreement or directive issued by governments among themselves would not prevent the looming crisis. Some mechanism was needed to encourage the private sector to willingly exchange their US dollar currency holdings for some other form of money.

The problem was solved by using the framework of a forfeit finance - a method used to underwrite certain import/export transactions which relied upon the guarantee or aval (a form of guarantee under Napoleonic law) issued by a major bank in the form of either documentary or standby letters of credit or bills of exchange which are then used to assure an exporter of future payment for the goods or service provided to an importer. The system was well established and understood by private banks, governments and the business community world wide. The documents used in such financing were standardised and controlled by international accord, supported by well-established international law and, best of all, administered by the members of the International Chamber of Commerce (ICC) headquartered in Paris. There would be no need to create another world agency to monitor the system if already-approved and readily available documentation, laws and procedure provided by the ICC were adopted. The International Chamber of Commerce is a private, non-governmental, world-wide organisation, that has evolved over time, into a well-recognised, organised, respected and, most of all, trusted association. Its members include the world’s major banks, importers, exporters, merchants and retailers who subscribe to the well-defined conventions, bylaws and codes of conduct. Over time, the ICC has hammered out pre-approved documentation and procedures to promote and settle international commercial transactions.

In the ICC and forfeit systems lay the seeds of a resolution to the looming crisis. Recycling the current number of dollars back into world commerce would solve the problem by avoiding the printing of more US dollars and would leave the Bretton Woods Agreement intact. If currency - dollars - could be drawn back into circulation through the private international banking system and redistributed through the well known “bank ripple effect”, no new dollars would need to be printed, and the world would have an adequate currency supply. The private international banking system required an investment vehicle which could be used to access dollar accounts, thereby recycling substantial dollar deposits. This vehicle would have to be viewed by the private market to be so secure and safe that it would be comparable with US Treasuries which had a reputation for instant liquidity and safety. Given the “newness” of whatever instrument might be created, the private sector would prefer to exchange their dollars for a “proven” instrument: US Treasuries, but selling new Treasury issues to the world would not solve the problem. In fact, it would exacerbate the looming crisis by taking more dollars out of circulation. The world needed more dollars in circulation.

The answer was to encourage the most respected and creditworthy of the world’s private banks to issue a financial instrument, guaranteed by the good faith and credit of the issuing bank, with the spectre of support from the central banks, IMF and Bank of International Settlements. The world’s private investment and business sector would view new investments issued in this manner as “safe”. To encourage their purchase over Treasuries, the investor yield on the new instruments would have to be superior to the yield on Treasuries. If the instruments could be viewed as both safe and providing superior yields over Treasuries, the private sector would purchase these instruments without hesitation.

The crisis was prevented by encouraging the international private banking sector to issue letters of credit and bank guarantees, in large denominations, at yields superior to US Treasuries. To offset the increased “costs” to the issuing banks due to the higher yields accompanying these prime bank instruments, banking regulations within the countries involved were modified in such a way as to encourage and/or allow the following:

Reduced reserve requirements via off-shore transactions.
Support of the programme by the central banks, World Bank, IMF and Bank of International Settlements.
Off-balance sheet accounting by the banks involved.
Instruments to be legally ranked “para passu” (on the same level) with depositors’ funds.
The banks obtaining these depositor funds would be allowed to leverage these funds with the applicable central bank of the country of domicile in such a way as to obtain the equivalent of federal funds at a much lower cost. When these “leveraged funds” are blended with all other accessed funds, the overall blended rate cost of funds to the issuing bank is substantially diminished, thus off-setting the high yield given to attract the investor with substantial funds to deposit.

The bank instruments offered to investors were sold in large denominations (often $100 million) through a well-established and very efficient market mechanism, substantially reducing the cost of accessing the funds. The reduced costs offset the higher yields paid by the issuing banks.

Multi-use instrument

Major commercial banks soon came to realise that these instruments could serve as more than a “funds recycling and redistribution tool”, as originally envisioned. For the issuing bank, they could provide a means of resolving two of the bankers’ major problems: interest rate risks over the term of the loan, and, disintermediation of depositor funds. Bankers, now for the first time, had available a reliable method of accessing large amounts of money in a very cost-efficient manner. These funds could be held as deposits at a predetermined cost over a specific period of time. This new system to promote currency redistribution had also given private banks a way to pass on to third parties the interest rate and disintermediation risks formerly borne by the bank.

The use of these instruments providing instant liquidity and safety has worked amazingly well since 1961. It is one of the principal factors which has served to prevent another financial crisis in the world economies.

In recent years, smaller banks not ranked among the top 100 have been issuing their own instruments. Considering the dollar volume and the number of instruments issued daily, the system has worked extremely well. There have been few instances where a prime bank has had financial problems. In all cases, the central bank of the G-10 country concerned and the Bank of International Settlements have moved quickly to financially stabilise the bank, insuring its ability to honour its commitments. Funds invested in these instruments rank para passu with depositor’s accounts, and as such, their integrity and protection are considered by all the institutions involved as fundamental to a sound international banking system.

Losses have occurred, however, to speculators investing in these instruments in the foreign exchange and futures market, where their profits lay in the gamble that world- wide interest rates would move in such a way as to bring them profits by either going long or short on leveraged funds. These losses were incurred, however, due to the speculative way in which the instruments were used, not due to the integrity of the instruments themselves.

The prime bank instruments programme designed under the Kennedy Administration is still used very effectively to assist in recycling and redistributing currency to meet the world’s demand for commerce.