CH 11: International Banking and Money Market

International Banking (IB) Services

Do everything domestic banks do, and:

• Trade financing

• Foreign exchange

• Offer hedging services for foreign currency receivables and payables through forward and option contracts

• Offer investment banking services

Reasons for International Banking:

Low Marginal cost

• Managerial and marketing knowledge is developed at the home country and can be used abroad.

Knowledge advantage

• Foreign bank subsidiaries can draw on the parent banks knowledge of personal contacts and credit investigations for use in the foreign market

Home nation information services

• Local firms in a foreign market may be able to obtain more complete information on trade and financial marks in the MN bank’s home nation.

Prestige

• Very large MN banks have high prestige, which can be attractive to new clients

Regulatory advantage

• MN banks are often not subject to the same regulations as domestic banks.

Wholesale defensive strategy

• Banks follow their multinational customers abroad to avoid losing their business at home and abroad

Retail defensive strategy

• MN banks also compete for retail services such as travelers checks and the tourist and foreign business market

Transactional costs

• Mn banks may be able to circumvent government currency controls.

Growth

• Foreign markets may offer opportunities for growth not found domestically

Risk reduction

• Greater stability of earnings with diversification

International banks facilitate the imports and exports of their clients by arranging trade financing. Additionally, they serve their clients by arranging for foreign exchange necessary to conduct cross-border transactions and make foreign investments.

• In conducting foreign exchange transactions, banks often assist their clients in hedging exchange rate risk through forward and options contracts.

• Generally, IB trade for their own account too.

• Major distinguishable features from DB are the types of deposits they accept and loans and investments.

• Frequently members of international loan syndicates, participating with other international banks to lend large sums to MNCs needing project financing and sovereign Gov needing funds for economic development.

Depending on regulations, an IB may participate in the underwriting of Eurobonds and foreign bonds.

IB frequently provide consulting services and advice to their clients. Areas in which IB has expertise on is:

• Exchange hedging strategies

• Interest rate and currency swap financing

• International cash management services

Banks that do provide the most of these services are called Universal banks or full-service banks.

London Brexit has negatively affected their full service centers. Concern for the future of free flow of goods.

Types of International Banking Offices

Correspondent Bank

Exists when two banks maintain deposits with each other.

Correspondent banking allows a bank’s MNC client to conduct business worldwide through his local bank or its correspondents.

Correspondant banks services also include assistance with trade financing, such as honouring letters of credit and accept drafts drawn on the correspondent bank.

• MNC needing foreign assistance foreign local financing for one of its subsidiaries may rely on its local bank to provide it with a letter of introduction.

Beneficial: A bank can service its MNC clients at a very low cost and without the need of having personnel physically located in many countries.

Disadvantage: Banks clients may not receive the level of service through the correspondent bank that they would if the bank had its own foreign facilities to service its clients.

Representative Offices

Small service facility staffed by parent bank personnel that is designed to assist MNC clients of the parent bank in dealings with the banks correspondents.

Also assist with information about local business customs and credit evaluation of the MNC’s local customers.

Foreign Branches

Operates like a local bank, but is legally part of the parent.

• Subject to both the banking regulations of home country and foreign country.

• Can provide a much fuller range of services than a representative office.

Branch banks are the most popular way for U.S banks to expand overseas.

Branch bank loan limits are based on the capital of the parent bank, not the branch bank. Consequently, a branch bank will likely be able to extend a larger loan to a customer than a locally chartered subsidiary bank of the parent.

The books of a foreign branch are part of the parent banks books. Thus, a branch bank system allows customers to much faster check clearing than does a correspondent bank network because the debit and credit procedure is managed internally within one organization.

Many branches are operated as shell branches in offshore banking centers.

Subsidiary and Affiliate Banks

A Subsidiary bank is a locally incorporated bank wholly or partly owned by a foreign parent.

An Affiliate bank is one that is partly owned but not controlled by the parent.

U.S parent banks like foreign subsidiaries because they allow U.S banks to underwrite securities.

Edge Act Banks

Federally chartered subsidiaries of U.S banks that are physically located in the U.S and are allowed to engage in a full range of international banking activities.

Edge act banks are not prohibited from owning equity in business corporations unlike domestic commercial banks. Thus it is through the Edge Act that U.S parent banks have historically owned foreign banking subsidiaries and held ownership positions in foreign banking subsidiaries and held ownership positions in foreign banking affiliates.

Offshore Banking Centers

Country whose banking system is organized to permit external accounts beyond the normal scope of local economic activity of the country.

Host country usually grants complete freedom from host-country governmental banking regulations

Operate as branches or subsidiaries of the parent bank. The principal features that make a country attractive for establishing an offshore banking operation are virtually total freedom from host country governmental banking regulations.

Low reserve requirements, no deposit insurance, low taxes, to a minor extend strict banking secrecy laws.

The primary activities of offshore banks are to:

• Seek deposits

• Grant loans in currencies other than the currency of the host government.

“Shell” Branches

Need to be nothing more than a post office box.

Actual business is done by the parent bank at the parent bank.

Purpose: Allow U.S banks to compete internationally without the expense of setting up operations “for real”.

International Banking Facilities (IBF)

Separate set of assets and liability accounts that are segregated on the parent’s books.

Captured a lot of the Eurodollar business that was previously handled offshore.

Any U.S bank can have one.

IBF operate as foreign banks in the U.S.

Not subject to domestic reserve requirement on deposits. Nor is FDIC insurance required on deposits.

IBF seeks deposits from non-citizens and can make loans only to foreigners.

Established largely because of the success of offshore banking.

Capital Adequacy Standards

Refers to the amount of equity capital and other securities a bank holds as reserves against risky assets to reduce the probability of bank failure

.The bank of international settlement (BIS) also known the the Basel Accord established a framework for measuring bank capital adequacy for banks in the G10 countries and Luxembourg.

• The BIS is the central bank for clearing international transactions between national central banks. Serves as a facilitator in reaching international banking agreements among its members.

• The Basel accord called for a minimum bank capital adequacy ratio of 8% of risk-weighted assets for internationally active banks.

• The accord dividends bank capital into two categories: Tier 1 Core Capital- Consists of shareholder equity and retained earnings. Tier 2 Supplemental Capital - Internationally recognized non-equity items such as preferred stock and subordinate bonds.

One major criticism: The arbitrary nature in which the accord was implemented. The 8% minimum capital requirement assigned to risk-weighted assets was unchanging regardless of whether the degree of credit risk fluctuated throughout the business cycle.

Focused on credit risk.

Four categories of risky assets:

Government obligations - weighed at 0

Short-term interbank assets- weighed at 20%

Residential mortgages- weighed at 50%

other assets - weighed at 100%

The Basil II is under 3 pillars of capital adequacy:

• Minimum capital requirements - Bank capital is defined as per the 1988 accord, but the minimum 8% capital ratio is calculated on the sum of the banks credit, market, and operational risk.

• Supervisory review process- Designed to ensure that each bank has a sound internal process in place to properly assess the adequacy of its capital based on a thorough evaluation of its risks.

• Effective use of market discipline- Designed to complement the other two. It is believed that public disclosure of key information will bring greater market discipline to bear on banks and supervisors to better manage risk and improve bank stability.

Traditional bank capital standards protect depositors from traditional credit risk, but they may not be sufficient protection from derivative risk.

The Basel II Accords has been endorsed by central bank governors and bank supervisors in the G10 countries.

** The key variables the bank must estimate are the probability of default and the loss given default for each asset on their books.

International Money Market

Eurocurrency is a time deposit in an international bank located in a country different than the country that issued the currency.

Example: Eurodollars are U.S dollar-denominated time deposits in banks located abroad.

Euroyen are yen-denominated time deposits in banks located outside of Japan.

**The foreign bank doesn’t have to be located in Europe.

The Eurocurrency market is an external banking system that runs parallel to the domestic banking system of the country that issued the currency.

In the US, banks are subject to the Federal Reserve Regulation D, specifying reserve requirements on bank time deposited funds. Additionally, US banks must pay FDIC insurance premiums on deposited funds.

Eurodollar deposits, are not subject to these arbitrary reserve requirements or deposit insurance; hence, they cost less.

The Eurocurrency market operates at the interbank and/or wholesale level.

Eurocredits

Short to medium term loans of Eurocurrency extended by Eurobanks to corporations.

Loans are denominated in currencies other than the home currency of the Eurobank.

Often the loans are too large for one bank to underwrite; a number of banks form a syndicate to share the risk of the loan.

Feature an adjustable rate

Forward Rate Agreements

An interbank contract that involves 2 parties, a buyer and a seller.

• Buyer agrees to pay the sellers the increased interest cost on a notational amount if interest rates fall below an agreed rate.

• Seller agrees to pay the buyer the increased interest cost if interest rates increase above the agreed rate.

Only when deposit and credit maturities are perfectly matched will the rollover feature of Eurocredits allow the bank to earn the desired deposit-loan rate spread.

Uses:

Hedge assets that a bank currently owns against interest rate risk.

Speculate on the future course of interest rates.

Euro notes

Short-term notes underwritten by a group of international investment banks or international commercial banks called a “facility".” Sold at a discount from FV and pay back the full FV at maturity.

Euro Commercial Paper

Unsecured short-term promissory notes issued by corporations and banks.

Placed directly with the public through a dealer.

Typically U.S dollar denominated, is often of lower quality than U.S commercial paper, as a result yields are higher.

Like Euronotes, are sold at a discount from FV.

Eurodollar Interest Rate Futures Contract

Used for hedging short-term U.S dollar interest rate risk.

The underlying asset is a hypothetical $1,000,000 90 day Eurodollar deposit. The contract is cash settled.

London Interbank Offered Rate (LIBOR)

LIBOR is the reference rate in London for Eurocurrency deposits. Has been called “the most important number in finance.” As a benchmark, the daily setting of LIBOR for various tenors was used by banks, securities houses, and investors. HOWEVER, because of trading practices during and after the global financial crisis by some participants in setting the daily benchmarks, that some consider fraudulent, LIBOR’s U.K and U.S. regulators and administrator decided to transition away from LIBOR to other reference rates.

Alternative Risk-Free Rates (RFRs) went into effect for the various Eurocurrencies. representative of actual market transactions, a feature missing form the previous rate benchmarks. Based on overnight wholesale transactions that are unsecured or secured repurchase or “repo” transactions. Backward looking rate.

Euro Interbank Offered Rate is the rate at which interbank deposits of the euro are offered by one prime bank to another in the euro zone.

International Debt Crisis

Debt-for-Equity Swaps

As part of debt rescheduling agreements, Creditor banks would sell their loans for U.S dollars at discounts from FV to MNCs desiring to make equity investment in subsidiaries or local firms in the Less Developed Countries Crisis.

• The LDC central bank would buy the bank debt from a MNC at a smaller discount than the MNC paid, but in local currency.

• The MNC would use the local currency to make pre-approved new investment in the LDC that was economically or socially beneficial to the LDC.

All parties are presumed to benefit.The creditor bank benefits from getting an unproductive loan amount. The LDC benefits in 2 ways: 1) Being able to pay off a “hard” currency loan. 2) new productive investment made in the country, designed to foster economic growth.

The Asian Crisis

Began mid 1997 when Thailand devalued the baht. Followed a period of economic expansion in the region financed by record private capital inflows.

Bankers from the G-10 countries actively sought to finance the growth opportunities in Asia. Providing businesses with a full range of products and services.

Led to domestic price bubbles in East Asia, particularly in Real Estate.

Close interrelationships common among commercial firms and financial institutions in Asia resulted in poor investment decision making.

Global Financial Crisis

The origin of the credit crunch can be traced back to 3 key contributing factors: Liberalization of banking and securities regulation, A global savings glut, and the low interest rate environment created by the Federal Reserve.

Many banks and mortgage lenders lowered their credit standards to attract new home buyers who could afford to make mortgage payments at the current low interest rates, or “teaser” rates that were temporarily set at a low level during the early years of an adjustable-rate mortgage, but would likely reset to a higher rate later on.

**Many of these homebuyers would not have qualified for mortgage financing under more stringent credit standards, or could afford the home at the higher rates.

Subprimer Primer

Subprime mortgages were typically not held by the originating bank making the loan. Instead, they were resold for packaging into mortgage-backed securities (MBSs).

Each MBS represents a portfolio of mortgages, thus diversifying the credit risk that the investor holds.

SIVs

Structured Investment Vehicles (SIVs) have been one large investor in MBS. It is a virtual bank, frequently operated by a commercial bank or an investment bank, and operates off the balance sheet.

Typically, an SIV raises short-term funds in the commercial paper market to finance longer-term investment in MBSs and other asset-backed securities.

• Frequently highly levered, with ratios of 10 - 15 times the amount of equity raised.

• Might earn .25% by having upward sloping since an SIV is a yield.

• Subject to the interest rate risk of the yield curve inverting (short-term rates rising above long-term rates), requiring the SIV to refinance the MBS investment at short-term rates in excess of the rate being earned on the MBS.

• Must contend with default risk. If the underlying mortgage borrowers default on their home loans, the SIV will lose investment value.

Collateralized Debt Obligations (CDOs)

Big investor in MBS.

A CDO is a corporate entity constructed to hold a portfolio of fixed-income assets as collateral. The portfolio of fixed-income assets is divided into different tranches, each representing a different risk class: AAA, AA-BB, or unrelated.

Serve as an important funding source for fixed-income securities. An investor in a CDO is taking a position in the cash flows of a particular tranche, not in the fixed-income securities directly.

• The investment is dependent on the metrics used to define the risk and reward of the tranche. MBS and other asset-backed securities have served as collateral.

Fed Actions

To cool the growth of the economy, The government steadily increased the fed funds target rate at meetings of the Federal Open Market Committee. From a low of 1.00% (2003) to 5.25% (2006).

As a result, mortgage rates increased. Many subprime borrowers found it difficult, if not impossible, to make mortgage payments in a cooling economy, especially when their adjustable-rate mortgages were reset at higher rates.

Default Snowball

When subprime debtors began defaulting on their mortgages, commercial paper investors were unwilling to finance SIVs. Liquidity worldwide essentially dried up.

Many CDOs found themselves stuck with the highest risk tranches of MBS debt.

Lessons

• Credit rating agencies need to refine their models for evaluating esoteric credit risk created in MBSs and CDOs.

• Borrowers must be more wary of putting complete faith in credit ratings.

• Bankers seem to scrutinize credit risk less closely when they serve only as mortgage originators rather than the paper holders themselves.

Summary

**Write in CH Summary when study

International banks facilitate imports and exports by arranging trade financing. They also:

• arrange foreign currency exchange

• assist in hedging exchange rate exposure

• trade foreign exchange for their own account

• Make a market in currency derivative products.

A Eurocurrency is a time deposit of money in an international bank located in a country different from the country that issued the currency. For example, Eurodollars are deposits of U.S dollars in banks outside of the United States. Eurocurrency market is located in London.

Other main international money market instruments: Forward rate agreements, Euro notes, Euro commercial paper, and Eurodollar interest rate futures.

Capital adequacy refers to the amount of equity capital and other securities a bank holds as reserves to reduce the probability of a bank failure.

The international debt crisis was caused by international banks lending more to 3rd world sovereign governments than they should have.

The Asian crisis followed a period of economic expansion in the region financed by record private capital inflows.

The Global financial crisis began in the US in the summer of 2007 as a credit crunch, or the inability of borrowers to easily obtain credit.

• The origin of the credit crunch can be traced back to 3 key contributing factors: liberalization of banking and securities regulation, A global savings glut, and the low interest rate environment created by the Federal Reserve in the earlier part of the decade.