6 Chapter six International Banking and Money Market Chapter Objective: • Differentiate between international bank and domestic bank operations and examine the differences of various international banking offices. Chapter Outline • International Banking Services • Types of International Banking Offices • Capital Adequacy Standards • International Money Market
International Banking Services • International Banks do everything domestic banks do and: • Arrange trade financing. • Arrange foreign exchange. • Offer hedging services for foreign currency receivables and payables through forward and option contracts • Offer investment banking services (where allowed). • Borrow or lend in eurocurrency market • Underwrite eurobonds and foreign bonds.
Types of International Banking Offices • Correspondent bank • Banks located in different countries establish accounts in other bank • Provides a means for a bank’s MNC clients to conduct business worldwide through his local bank or its contacts. • Provides income for large banks • Smaller foreign banks that want to do business ,say in the U.S., will enter into a correspondent relationship with a large U.S. bank for a fee
Types of International Banking Offices 2. Representative office • A small service facility staffed by parent bank personnel that is designed to assist MNC clients of the parent bank in dealings with the bank’s correspondents. • No traditional credit services provided • Looks for foreign market opportunities and serves as a liaison between parent and clients • Useful in newly emerging markets • Representative offices also assist with information about local business customs, and credit evaluation of the MNC’s local customers. • It is useful when the bank has many MNC clients in a country
Types of International Banking Offices 3. Foreign Branch • A foreign branch bank operates like a local bank, but is legally part of the parent, not a separate entity. • Subject to both the banking regulations of home country and foreign country. • Reasons for establishing a foreign branch • More extensive range of services (faster check clearing, larger loans) • Foreign branches are not subject to Canadian reserve requirements or deposit insurance • Compete with host country banks at the local level • Most popular means of internationalizing bank operations
Types of International Banking Offices 4. Subsidiary and Affiliate Bank • A subsidiary bank is a locally incorporated bank that is either wholly owned or owned in major part by a foreign parents. • An affiliate bank is one that is only partially owned, but not controlled by its foreign parent. • Both subsidiary and affiliate banks operate under the banking laws of the country in which they are incorporated. • They are allowed to underwrite securities.
Types of International Banking Offices 5. Offshore Banking Center • A country whose banking system is organized to permit external accounts beyond the normal scope of local economic activity. • The host country usually grants complete freedom from host-country governmental banking regulations. • Banks operate as branches or subsidiaries of the parent bank • Primary credit services provided in currency other than host country currency • Reasons for offshore banks • Low or no taxes, services provided for nonresident clients, few or no FX controls, legal regime that upholds bank secrecy • The IMF recognizes the Bahamas, Bahrain, the Cayman Islands, Hong Kong, the Netherlands Antilles, Panama, Singapore as major offshore banking centers
Capital Adequacy Standards • Bank capital adequacy = equity capital and other securities a bank holds as reserves against risky assets • How much bank capital is “enough” to ensure the safety and soundness of the banking system? • Basle Accord 1 (1988): Rules-based approach + VAR • Basle Accord 2 (2003 - 2009) - 3 pillars -min. cap. Requirements -supervisory review process -market discipline • Basle Accord 3 (2010 - 2011) • Strengthens bank capital requirement and introduces new regulatory requirements on bank liquidity and bank leverage
Basle Accord I: minimum bank capital adequacy ratio (rules-based) • Banks involved in cross-border transactions. • Min. Cap. Adequacy = 8% [risk weighted assets] • Tier I Core capital = shareholder equity + retained earnings • Tier II Supplemental capital = internationally recognized • non-equity items • Tier II < 50% total bank capital • Asset Weights: Government obligations = 0%; short-term interbank assets = 20% Residential mortgages = 50%; other assets = 100%
Basle Accord I: Risk-focused Cap. adequacy • 1996 amendment allows banks to use modern portfolio models to specify adequate Cap. Adequacy. • VAR(value-at-risk) = loss exceeded with a specified probability over a specified time period. • 1% chance: maximum loss over 10 days > bank’s capital VAR = (PV)(s)(Z.01)(D1/2) PV = portfolio value; s = standard deviation of return(daily); Z.01 = standard normal value for 1-tail confidence interval; D = days
International Money Market • Eurocurrency is a time deposit in an international bank located in a country different than the country that issued the currency. • Eurodollars are U.S. dollar-denominated time deposits in banks located outside the United States. • Euroyen are yen-denominated time deposits in banks located outside of Japan. • The foreign bank doesn’t have to be located in Europe. • Lower cost structure: • Reserve requirement - NO • Deposit insurance - NO • Rapid growth, especially in the Eurodollar market.
Eurocurrency Market • This is an external banking system that runs parallel to the domestic banking system. • Most Eurocurrency transactions are interbank transactions in the amount of $1,000,000 and up. • Banks seek deposits and make loans to other Eurobanks. - loan interest rate is the interbank offered rate. - interbank deposit interest rate is the interbank bid rate. • Common reference rates include • LIBOR = London Interbank Offered Rate • PIBOR = Paris Interbank Offered Rate • SIBOR = Singapore Interbank Offered Rate • New reference rate for the euro • EURIBOR = rate at which interbank time deposits of € are offered by one prime bank to another.
Eurocredits • Short- to medium-term loans of Eurocurrency to corporations, governments, nonprime banks or international organizations. • Loans are often too large for one bank to underwrite; a syndicate of banks share the risk of the loan. • Adjustable rate - Rollover 3-6 mo. Example 6.1 • On Eurocredits originating in London, the base rate is LIBOR + X% based on the creditworthiness of the borrower.
Forward Rate Agreements • An interbank contract that involves two parties, a buyer and a seller. • The buyer agrees to pay the seller the increased interest cost on a notional amount if interest rates fall below an agreed rate. • The seller agrees to pay the buyer the increased interest cost if interest rates increase above the agreed rate. • Forward Rate Agreements can be used to: • Hedge assets that a bank currently owns against interest rate risk. • Speculate on the future course of interest rates.
Euronotes and Eurocommercial Papers • Euronotes • Short-term notes underwritten by a group of international investment banks or international commercial banks (facility). 3-6 months • They are sold at a discount from face value and pay back the full face value at maturity. • Interest rate usually less than syndicated Eurobank loans. (i.e. LIBOR + 1/8%) • Bank receives a small fee for underwriting. Euro Commercial Papers • Unsecured short-term promissory notes issued by corporations and banks. 1-6 months. • Placed directly with the public through a dealer. • Eurocommercial paper, while typically U.S. dollar denominated, is often of lower quality than U.S. commercial paper—as a result yields are higher. • Eurocommercial paper market size - 2006 = $635 billion
International Debt Crisis • Some of the largest banks in the world were endangered when loans to sovereign governments of some less-developed countries. • At the height of the crisis, third world countries owed $1.2 trillion. • Like a great many calamities, it is easy to see in retrospect that: • It’s a bad idea to put too many eggs in one basket, especially if: • You don’t know much about that basket.
Debt-for-Equity Swaps • As part of debt rescheduling agreements among the bank lending syndicates and the debtor nations, creditor banks would sell their loans for U.S. dollars at discounts from face value to MNCs desiring to make equity investment in subsidiaries or local firms in the LDCs. • A 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.
Sell $100m LDC debt at 60% of face $60m $80m in local currency Redeem LDC debt at 80% of face in local currency $80m in local currency Debt-for-Equity Swap Illustration International Bank LDC firm or MNC subsidiary Equity Investor or MNC LDC Central Bank
Japanese Banking Crisis • The history of the Japanese banking crisis is a result of a complex combination of events and the structure of the Japanese financial system. • Japanese commercial banks have historically served as the financing arm and center of a collaborative group know as keiretsu. • Keiretsu members have cross-holdings of an another’s equity and ties of trade and credit. • The collapse of the Japanese stock market set in motion a downward spiral for the entire Japanese economy and in particular Japanese banks. • This put in jeopardy massive amounts of bank loans to corporations. • It is unlikely that the Japanese banking crisis will be rectified anytime soon. • The Japanese financial system does not have a legal infrastructure that allows for restructuring of bad bank loans. • Japanese bank managers have little incentive to change because of the Keiretsu structure.
The Asian Crisis • This crisis 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 by providing businesses with a full range of products and services. • This led to domestic price bubbles in East Asia, particularly in real estate. • Additionally, the close interrelationships common among commercial firms and financial institutions in Asia resulted in poor investment decision making. • The Asian crisis is only the latest example of banks making a multitude of poor loans—spurred on no doubt by competition from other banks to make loans in the “hot” region.