The de facto government of the Ayatollah Khomeini is putting the international banking system to its most severe test in modern times. On Nov. 23, amidst the resounding cheers of thousands of students demonstrators, the Iranian finance minister proclaimed that his country would not repay the billions of dollars borrowed fron non-Iranian private banks. Although precise data on Iran's private foreign debt outstanding will not be known for weeks, preliminary estimates place the figure about $10 billion. Therefore, assuming Iran follows through with its threat, this may be the largest default in financial history.
If the international banking system withstands this onslaught against its credibility, it will emerge stronger and more creditable than ever. If not, it is virtually certain that the entire Third World will suffer the consequence of restricted access to international sources of capital, and the banks themselves will be saddled with stricter regulation of their international activities.
With the extraordinary growth of the Eurocurrency markets during this decade, the private banks have become the single largest source of external funds for the financing of Third World growth and development. Thus Iran's renunciation of its international debts raises questions that have global implications, not only for the private bankers around the world that stand to lose billions, but also for the government of every developing country that uses the international financial marketplace.
At first glance there may be concern that other less-developed-country borrowers will be tempted to follow the Iranian example, thereby placing even greater strain on the international banking system. But, as Iran will soon discover when food and other vital supplies being to disappear, the ramifications of having absolutely no access to international sources of credit will create unimaginable hardships. The leaders of most countries in today's interdependent world understand that it is virtually impossible to survive as a viable sovereign entity without exchanging goods and services with other nations. When a country is denied access to international sources of credit, an outcome that is certain to occur in the Iranian case, it will soon cease to exist. The ayatollah's defiance is tantamount to financial suricide.
But even if other countries eschew Iran's poor example, Third World borrowers have the most to lose from Khomeini's actions. Private bankers will now take a hard look at their overseas operations. In recent years the largest U.S. banks have derived at least 50% of their earnings from international activities, the bulk of which resulted from lending to Third World borrowers. Regardless of the outcome of the Iran crisis, the banking community has been provided with a sobering illustration of the fragile and uncertain nature of its relations with LDC borrowers.
Although even the safest credit risks in the Third World will be scrutinized more carefully than ever before, bankers must not exaggerate the implications of the Iran crisis. Risk analysis will always be an imperfect decision-making tool. No credit evaluation system, regardless of how sophisticated and prudent, is capable of forcasting the future with certainty. The critics, therefore, would be well advised not to hastily reject methods that have served them fairly well in the past. The critics, therefore, would be well advised not to hastily reject methods that have served them fairly well in the past. They should avoid an overreaction that would jeopardize other Third World countries that are as deserving of access to international sources of credit after the Iran crisis as they are before.
An even greater reassessment is likely to come from the regulators. The crisis in Iran is tailor-made for proponents of tighter control of the international lending activities of private banks. For example, a 1977 report by the Senate Foreign Relations Committee raised the frightening specter that the entire international financial system might collapse beneath the weight of one or two defaults, which in turn would have a domino effect on the community of international banks. The report bemoaned the fact that "offshore lending seems to have fallen between the cracks of the U.S. regulatory system," and suggested that some of legislation.
More recently, a congressman introduced a bill stipulating that "the pursuit of reasonable control of the Eurocurrency market is in the enlightened self-interest of evry country." This sentiment, expressed long before events in Iran spilled out the control, suggests that Congress is likely to be against future threats of this kind.
But just as the bankers could not foresee events in Iran or adequately protect themselves against default, no amount of regulation could have spared the financial community the losses that may be incurred. And, contrary to the fears of some doomsday analysts, the international banking system is bearing up remarkably well. The prospect of even one bank -- much less the entire system -- collapsing as a result of the Iranian upheaval appears to be remote.
Banks are compensated to take risks; it is the essence of their business. Regardless of the banker's prudence or the legislator's surveillance, risk will always be an inherent component of lending money. To be sure, as every banker known, the uncertainties in the international arena are greater than they are at home. The possibility of civil war, revolutionary political change or expropriation will invariably make international lending a hazardous undertaking. Losses will occur from time to time in the most heavily regulated banking system. But the fact remains that during this decade U.S. banks have suffered fewer losses from international lending than they have from their domestic activity.
It is also worth remembering that the events in Iran are unprecedented. The odds of another major Third World debtor country renouncing its international private debt in the near future are probably less than the likelihood of a serious confrontation between any of the countries that currently possess an arsenal of nuclearn weapons. This suggests that prior to taking drastic action to correct an allegedly flawed system, bankers and legislators alike should pause and observe how well the current system functions during a period of extreme disruption. The temptation to overreact in this moment of turmoil would be a fruitless as is the behavior of the ayatollah himself.