Global Financial Services • Outline • Why and how U.S. banks engage in international banking • Foreign banks in the U.S. • International lending • Foreign exchange markets
Why and how U.S. banks engage in international banking • Why engage in international banking? • Serve the needs of their customers (imports and exports, foreign production operations, etc). • Profit motive of opening new markets. • Global diversification. • Prestige of having offices in important financial centers around the world.
Why and how U.S. banks engage in international banking • How do they engage in international banking? • Correspondent banks (large banks and foreign banks in the U.S.) providing international banking services. • Foreign branches (full- or limited-service). • Representative offices (quasi sales office with no loans or deposits). • Foreign affiliates (ownership in part or whole of a foreign financial service firm). • Edge Act offices (subsidiaries of national banks with offices in U.S. or abroad devoted to international trade). • International banking facilities or IBFs (accounting system in a bank for deposits and loans of foreigners with tax and reserve requirement benefits).
Foreign banks in the U.S. • International Banking Act of 1978 • Allows foreign banks to operate offices in the U.S. without reciprocity of U.S. banks being allowed to operate in foreign countries. • An agency under this Act is a foreign bank or office that can provide credit and clear checks but cannot take deposits of U.S. citizens. Primarily used for foreign trade. • A branch is similar to an agency but it can accept deposits of U.S. citizens if for the purpose of carrying out transactions in foreign countries. The branch can do almost anything that the parent bank can do. • An investment company cannot accept deposits but can make loans and equity investments (note: do not confuse with a domestic investment company of mutual fund). • A subsidiary is a U.S. bank that is owned by a foreign bank. • A finance company can be owned and operated by a foreign financial organization.
International lending • Syndicated loans • Large loans that enable borrowers to obtain large amounts of funds and lenders can diversify their credit risk. Lead bank can earn fee income for management services. • Two types of syndicated bank loans: Agreement between borrower and each lender. Participation loans involving a lead bank that organizes a group of managing banks, who can refer information to other potential participating banks. • Loan pricing • LIBOR plus a certain number of points (also SIBOR in Pacific basin or Singapore interbank offered rate). • Commitment fees, underwriting fees, foreign taxes, etc.
International lending • Letters of credit • Import letters of credit are issued by a bank in favor of a firm in most cases. An export letter of credit is issued by a foreign bank to a firm in the U.S. • The letter of credit is a document from a bank that says it will pay the exporter when the conditions in the letter are met. In effect, the bank’s credit is substituted for the importer. The issuing bank pays the seller through the advising (paying) bank. The importer pays the issuing bank a fee for its services. Some important documents are: Bill of Lading (title to the merchandise) Invoice (goods description, price, quantity, etc.) Certificate of origin (country goods come from) Inspection certificate (independent third party) Draft or bill of exchange (drawn by exporter on importer’s bank for amount due as stated in the letter of credit -- payable at sight or at some time after sight. When the issuing bank accepts the draft, a bankers acceptance is created. The bank can sell this security in the financial marketplace. Both bank and importer are liable to pay the note.)
International lending • Letters of credit • Confirmed letters of credit involve the exporter’s bank, which further guarantees that the funds will be paid under the terms of the credit. Two banks further reduces credit risk. • Collection (via correspondent banks and foreign branches to facilitate the clearing process) • Clean collections (i.e., no documents attached, such as travelers checks and money orders) • Documentary collections (i.e., exporter sends documents to their bank for collection and bank forwards documents to importer’s bank for payment). Unlike an irrevocable letter of credit, the exporter’s payment is an obligation of the importer, rather than the bank issuing a letter of credit.
Foreign exchange markets • Foreign exchange (FX) • Interbank market of money center banks and major foreign banks. • Foreign exchange brokers facilitate currency trading. • Exchange rates can be direct ($U.S./foreign currency) or indirect (foreign currency/$U.S.). Cross rate is the rate at which (say) euros and yen can be exchanged using dollars: Cross-rate euro/yen = ($/euro)($/yen) = euro/yen • Buyer and seller agree to an exchange on the value date. • Spot market, as well as futures market and forward market transactions (not standardized, not traded on an organized exchange, and privately negotiated). Annual forward rate (as a premium or discount relative to the spot rate) = [(F - S) x 100/S] x 365/n, where F is the forward rate, S is the spot rate and n is the number of days to maturity. Example: [($0.1735/franc - $0.1726/franc) x 100/$0.1729/franc] x 365/90 = 2.11 % (premium over the spot rate)
Foreign exchange markets • Foreign exchange risks • Exchange rate risk due to open (long) or short positions. If a bank buys and sells equal amounts of a currency, it has a net covered position. To control this risk, use hedging techniques and dollar limits on positions and customers. • Interest rate risk due to mismatches in the maturity structure of the bank’s foreign exchange position. As interest rates change, the value of currencies can change. • Arbitrage by buying assets in one market and selling them immediately in another market to profit from price differences in the two markets. Interest rate parity (or covered interest arbitrage) normally keeps interest rate and foreign exchange rate values in equilibrium with one another in different countries. p = (F - S)/S, which says that the premium or discount is related to the forward rate ($/foreign currency) and spot rate ($/foreign currency). p = N - L, where N is the short-term interest rate in the U.S., and L is the short-term interest rate in the foreign country. The value p is normally a bank due to FDIC insurance, reserves, etc.
Foreign exchange markets • Foreign exchange risks • Credit risk associated with the counterparty (bank or broker) failing to meet its obligations. Settlement risk is a type of credit risk wherein one party makes transfer of payment and then the other party goes bankrupt. • Country risk is broadly defined to include economic, social, and political risks. Sovereign risk occurs when a national government defaults on debts. Transfer risk is related to problems in converting domestic currency into foreign exchange due to government controls or other reasons.