chapter 11- international banking and money markets

Chapter 11- INTERNATIONAL BANKING AND MONEY MARKETS

World Financial Markets (CH 11-15): Money Markets (CH 11), Bonds (CH 12), Stocks (CH 13) Swaps (CH 14), and Intl. Portfolio Theory (CH 15).

INT'L. BANKING SERVICES

Intl. Banking vs. Domestic Banking - Int'l. Banking Services include providing banking services for clients involved in cross-border commerce/investment (int'l. business/investment), e.g., MNCs, exporters, importers, investors, fund/portfolio managers, etc. Examples: Buy/sell FX, arrange trade financing, hedging services (forward contracts), etc. Int'l. banks borrow/lend in the Eurocurrency market, which is a major part of the Int'l. money market (short term credit < one year). Also, long term financing for MNCs. Merchant Banks/Universal Banking. Banks that offer the banking services of both commercial banks and investment banks, and offer a full range of financial services: Deposits/loans, underwriting bonds and stocks, insurance, consulting, brokerage, etc. "Full service banking," very common in Europe and Japan. Banks in Europe and Japan can own equities, acting as "mutual funds" for depositors. See world's largest 30 banks, page 268, Exhibit 11.1. U.S. has 8/30 vs. 4/30 for Japan, and 4/30 for U.K. U.S. GDP > Japan + France + Germany + U.K. Why??? 1927 - McFadden Act. Prohibited branch banking across state lines. 1933 - Glass-Steagall Act. Separated commercial and investment banking. Both have been recently repealed, but there are still lingering effects of these banking laws on the size of U.S. banks.

World banking centers: N.Y., Tokyo, London, Paris, Frankfurt, Zurich and Amsterdam. NYC/Tokyo/London are the Big Three - "full service centers." TYPES OF INTL BANKING OFFICES 1. Correspondent Banking - Int'l. network of large intl. banks having "correspondent" relationships with other banks around the world (discussed in CH 5). Part of the FX market, to facilitate FX trading. Large banks maintain accounts with banks in other countries. Allows MNCs to conduct business/commerce worldwide. Example: GM may have its main corporate bank account at Chase in Detroit. Chase has correspondent relationship with banks all over the world, to facilitate GM's transactions. GM can engage in

BUS 466: International Finance – CH 11 Professor Mark J. Perry1

worldwide commerce through Chase's correspondent banking relationships. Chase can service GM's banking needs without having Chase branches all over the world. 2. Representative Office. Small banking service facility in a foreign country, to provide better service for MNCs, e.g. credit evaluation of GMs foreign customers. Example: Chase may have a representative office in Toronto, London, Tokyo to assist GM, Ford, etc. (Chase has operations in 50 countries). 3. Foreign Branch Bank. Example, Chase opens a full service branch bank in Toronto or London, subject to FRS regulations and the regulations of the foreign country. Advantages: a. Fuller range of banking services vs. representative office b. Faster check clearing c. Large loans since the branch bank is part of the parent company, subject to the loan limits of the parent companyd. Foreign branch banks are NOT subject to some FRS requirements such as FDIC and reserve requirements, more competitive e. Easiest way for US banks to expand overseas. More than 1000 U.S. foreign branch banks worldwide, mostly in Europe especially U.K. Foreign branch banks in U.S. (500-600), same requirements as for U.S. banks such as: a. FDIC and reserve requirements b. No investment banking activities - brokerage, underwriting 4. Offshore Banking Centers. Bahamas, Bahrain, the Cayman Islands, the Netherlands Antilles, Panama, Hong Kong (full service), Singapore (full service). Started in 1960s to allow U.S. banks to participate in the growing Eurodollar market, without having to set up operations in Europe. U.S. bank will set up a foreign branch bank or operate a subsidiary (locally incorporated bank owned by US bank). Offshore banking countries generally offer: minimal banking regulations (no FDIC, low/no reserve requirements), banking secrecy laws, low taxes. Offshore banks are usually the largest and most reputable international banks, contrary to popular opinion about "offshore banking," (shady or weak banks). See page 272, Exhibit 11.2, for a summary of organizational structure. CAPITAL STANDARDS The Bank for Int'l. Settlement (BIS) - Central bank for clearing int'l. transactions. Established int'l. capital adequacy standards in 1988 (Basel Accord) for the G-10 plus Luxembourg, due to concerns about bank failures in U.S., S&L crisis, etc. Banks engaged in cross-border transactions maintain a minimum capital (net worth) ratio of 8% (equity/assets must be 8% or more, of risk-adjusted assets) to protect against bank failure.


Example: A bank has the following assets with the assigned weights: Asset Weight $100m T-Bills 0% $100m Short term loans 20% $100m Mortgages 50% $100m Long Term Loans 100% Therefore, the bank has $170m in risk-adjusted assets (.20 x $100m) + (.50 x $100m) + ($100m), and needs to have 8% equity against these assets, or $13.6m in equity (.08 x $170m). Overall, they have only 3.4% equity ($13.6 / $400m) when assets are not risk-adjusted. They need to hold 8% equity against risky, long-term loans, but only 4% against mortgages, 1.6% against short-term loans, and 0% against treasury bills. New Basel II standards are being discussed now, to take effect in 2006. INTERNATIONAL MONEY MARKET Eurocurrency or Eurodollars- Core of intl. money market. Eurocurrency is a time deposit (CD) of one year or less, in an intl. bank, issued in a currency other than the domestic currency. Examples: U.S. dollar time deposit in a U.K., German, Japanese or Mexican bank, Euro time deposit in U.S., U.K. or Japanese bank, Yen time deposit in French or Canadian bank, etc. "Eurodollar" is a misnomer, deposits don't have to be in Europe and the deposits don't have to be in dollars, e.g. Yen deposit in a Mexican bank. Eurodollar market started in 1950s as a way for Soviet Union to avoid political risk, having dollar deposits in U.S. banks frozen or expropriated. Market grew because of cost advantages of Eurodollar deposits vs. U.S. deposits. Eurodollar deposits are NOT subject to reserve requirements or FDIC. $1m deposit in U.S. bank: Bank would have to maintain reserves of $100,000 at 10% reserve ratio, and pay FDIC (as much as $2300/year). If the $1m was at a foreign branch outside the U.S., no FDIC and no reserve requirement. Eurocurrency has grown tremendously, and operates as an external banking system parallel to the domestic banks, both seeking deposits and making loans.

Eurocurrency markets are at the wholesale (interbank) level, minimum amounts of $1m, time deposits for 1-12 months. Example: Bank A in France has $1m of funds to lend for one year, but no retail loan customers. Bank B in Germany has a borrower who needs $1m but the bank has no funds available. Bank B borrows $1m from Bank A for one year, in a Eurocurrency transaction. London is the int'l. money market center, and the interest rate for Eurocurrency deposits is know as LIBOR (London Interbank Offered Rate), recently about 5.3% LIBOR for one-year Eurodollar


deposits, 3.75% LIBOR for one-year Euros, .61% LIBOR for EuroYen, 5.34% LIBOR for EuroSterling (UK), see Exhibit 11.3 on p. 275 and http://www.marketprices.ft.com/markets/currencies/money Two Eurocurrency instruments: Fixed time deposits of 1-12 months with penalty for early withdrawal (90% market) of the market and Negotiable CDs (NCDs), which are saleable in the secondary market if the depositor needs funds early (10% market). See page 276, Exhibit 11.5 for comparison of lending-borrowing spreads. In U.S., banks pay 3.15% to attract (borrow) funds (6-month NCDs) and charge 5.5% to lend funds at prime rate, for a spread of 2.35%. In Eurodollar market, LIBOR is 3.16%, more competitive than U.S. (higher interest rates for CDs). The Eurodollar market is more competitive, spread is .50-1.5%. For example, banks might currently pay about 3.13% on CDs and lend money at 3.63-4.63%. Point: Lending- borrowing spreads are lower in Eurocurrency market, less regulated, more competitive. Result of competition: Some U.S. banks now are forced to lend at sub-prime. See Appendix 11A on p. 290 for an illustration of how Eurodollars are created. INTEREST RATE RISK Banks are exposed to interest rate risk when there is a mismatch (duration) in the maturity of assets and liabilities. Examples: Scenario #1: Assets (loans) have a longer maturity than liabilities (deposits). Assume that avg. loan rate is 8% (lending) and avg. deposit rate (borrowing) is 5%, but avg. loan maturity (5 years) is longer than avg. deposit maturity (30 days). What is bank worried about? Scenario #2: Loans (lending) are short (30 days) at 8%, and deposits (borrowing) are long (2 years) at 5%. What is bank worried about?

Either way, the mismatch in maturities exposes the bank to interest rate risk. An adverse interest rate movement will negatively affect the bank's income. For every $1m in assets/deposits, the 3% interest rate spread generates $30,000 in annual operating income for the bank. Every 1% decline in the spread costs the bank $10,000 in profit, due to interest rate risk. Forward Rate Agreements (FRAs) are interbank contracts for banks to hedge interest rate risk, a huge market ($13 trillion at end of 2001). Example: Bank A has longer asset maturity, and Bank B has longer liability maturity. Bank A is worried about interest rates going up (but will profit if interest rates fall), Bank B is worried about interest rates going down (but will profit if interest rates go up). FRA provides hedge against risk. Summary:


Bank A Bank B MA > ML MA < ML Worried? Int. rising Int. falling Profits Rise Int. Fall Int. Rise If interest rates (3 or 6-month LIBOR) fall below a certain level during a certain period (6 months), Bank A pays Bank B a certain amount. If interest rates rise above a certain level, Bank B pays Bank A a certain amount.

FRAs can also be used by speculators, to try to profit from interest rate movements. Example (simplified, based on Example 11.2): Suppose Bank B has the following balance sheet:

Assets Liabilities Loan $3m Deposit $3m 3-month 6-month 6% 5.75%

In 3 months, the bank is worried about? ________________

If 3-month LIBOR remains at 6%, the bank will have $3m x .06 x 90/360 = $45,000 Int Income

If 3-month LIBOR falls to 5.5%, the bank will have only $3m x .055 x 90/360 = $41,250 Int Income

To protect against interest rate risk of LIBOR __________, the bank could enter into an FRA at 6%:

Long (buy) Proft (%) AR = 6% + + SR - - Loss (%)

Short (sell)

The bank is worried about interest rates ___________ so it would take the ___________ position in a FRA of $3,000,000, and some other party would take the ____________ position.


The buyer (long) agrees to pay to the seller (short) the increased interest cost on a notional amount if interest rates fall below an agreement rate (AR).

The seller (short) agrees to pay to the buyer (long) the increased interest cost on a notional amount if interest rates increase above the AR.

For hedgers, Seller is worried about interest rates ____________ the AR and the Buyer is worried about interest rates _______________ the AR.

Suppose that LIBOR (SR) in three months was 5.5%, the bank would settle the FRA in cash with a ________ of (6 – 5.5% x $3m x 90 / 360) = _________.

That cash profit from the FRA would cover the shortfall in interest income, and would guarantee the bank will get an effective rate of 6% for the second 3-month period. The bank would accept the 5.5% market rate on a new $3m loan and receive only $41,250 in interest income, but would have the cash settlement from the FRA of ________ , for a total of $45,000 interest income.

Actual interest income = ______________Cash settlement from FRA = ______________

Total Income

Suppose that LIBOR (SR) in three months was 6.5%, the bank would settle the FRA in cash with a ________ of (6.0 – 6.5% x $3m x 90 / 360) = _________.

That cash loss from the FRA would offset the increase in interest income, and would guarantee the bank will still get an effective rate of 6% for the second 3-month period. The bank would accept the 6.5% market rate on a new $3m loan and receive $48,750 in interest income, but would have the cash loss from the FRA of ________ , for a total of $45,000 interest income.

Actual interest income = ______________Cash settlement (payment) for FRA = ______________

Total Income

POINT: If interest rates fall, the bank will make a profit on its FRA to offset the lower interest rate and reduced profits on its new $3m loan. If interest rates rise, the bank will make a loss on its FRA, but will make a higher profit on its new $3m loan. Either way, it locks into a 6% LIBOR rate for the second three month period.

How would the buyer of the FRA be? What about Bank A below? Or speculators.

Assets Liabilities Loan $3m Deposit $3m 6-month 3-month 6.25% 6.00%

Worried about? _________________________


Other intl. fixed income securities that are issued are: Euronotes (3-6 month maturities) unsecured credit, and Eurocommercial paper, mostly dollar-denominated short-term, unsecured debt issued by corporations or banks to the public at 1-6 month maturities. Both are sold on a discount basis. See Exhibit 11.7 on page 279. INTL DEBT CRISIS Five principles of sound bank behavior: 1. Diversify loan portfolio - avoid loans concentrated in one area 2. Expand cautiously into new activities 3. Know your customers 4. Control mismatch between assets and liabilities (interest rate risk)5. Avoid vulnerability of collateral to the same shocks that weaken your borrowers. Intl. debt crisis in the 1980s was because these principles were violated in loans made to the governments of less-developed countries (LDCs). Debt Crisis started in 1982 with Mexico defaulting on $68B of loans, then Brazil, Argentina, 20 other LDCs announced similar problems making payments on debt totaling more than $1T. Countries over-borrowed, took on too much debt. Mexico's debt was almost 60% of GDP, they needed $28B to cover interest expense, or 36% of $78B of GDP. Similar for other LDCs. Source of Debt Crisis: Petrodollars in the 70s from OPEC, led to huge Eurodollar deposits in Eurobanks. Banks needed to find new loan customers with the deposits, found willing borrowers in LDCs looking for funds to finance economic development. Most loans were made in dollars, payable in dollars at variable rates. In 1970s, US inflation surged, int. rates rose, debt payments rose, LDCs had trouble making int. payments. Tight monetary policies in the early 1980s led to recessionary economic conditions, high real interest rates, high nominal rates, more trouble for LDCs. Downward sloping yield curve. See page 280, Exhibit 11.8, list of banks lending to Mexico. "Mexican bailout?," see Milton Friedman article. Why did US banks lend to risky LDCs? 1) Desperate to find borrowers for the Eurodollar deposits. 2) Pressure from Washington, DC to lend to LDCs. Violated Rules #1, 2, 3, 5(Inflation shocks). DEBT-FOR-EQUITY SWAPS Part of loan restructuring for LDCs. Loans were in default, being sold at deep discount. D-E Swap worked as follows: MNC buys debt at discount for $s, sells the loan to the LDC central bank at a


premium for local currency, agreeing to invest proceeds in the LDC. Example: GM or VW would buy a $100m Mexican loan for $60m (40% discount) from a U.S. bank, sell the loan to the Mexican central bank for $80m worth of Mexican pesos. GM/VW has purchased $80m of pesos for only $60m, then they invest $60m in US dollars ($80m in pesos) to expand operations in Mexico. Results: 1. Bank gets rid of the non-performing loan. 2. MNC gets a discount for its FDI. 3. LDC gets rid of "hard currency" loan, which it cannot service with its own currency. 4. LDC gets FDI from a MNC (GM, VW, etc.). See Exhibit 11-9, p. 281.

Updated: April 7, 2023


chapter 11- international banking and money markets

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