CHAPTER 21 International Banking Chapter Objectives Describe

CHAPTER 21 International Banking

Chapter Objectives Describe key regulations that reduced competitive advantages of banks in particular countries n Describe the risks of international banks n Describe bank solutions to the international debt crisis n Describe how banks assess country risk when they consider lending funds to foreign countries n

International Expansion n Banks go global for several reasons Diversify among economies to become less dependant on a single country’s conditions l Do business face-to-face with multinational corporations and their subsidiaries l n International expansion by U. S. banks U. S. bank regulations limited interstate banking l Expansion and growth via international banking l

International Expansion n How U. S. banks expand overseas Establish branches l Must first receive approval of the Federal Reserve Board in the U. S. l U. S. banks’ presence largest in the U. K. l Deposits in foreign branches are not insured l Agencies are an alternative that can make loans but not accept deposits or provide trust services l

International Expansion n Non-U. S. banks expand into the United States and focus on corporate rather than consumer banking Provide service to the subsidiaries of non-U. S. corporations l 1913 Edge Act creates corporations that specialize in banking and foreign transactions allowing loans and accepting deposits only if specifically related to international transactions l

Global Bank Regulations Countries have a system of monitoring and regulating commercial banks n Division of regulatory power between the central bank and other regulators varies among countries n Canada l Europe l Japan l

Global Bank Regulations Standardizing the rules with uniform regulations helps globalize the financial system n Playing field leveled by three regulatory changes n The International Banking Act requiring all banks within the U. S. follow the same rules l Single European Act l Uniform capital adequacy guidelines l

Global Bank Regulations n Uniform regulations for banks operating in the U. S. International Banking Act of 1978 l Prior to the Act, foreign banks had more flexibility to cross state lines l Forced foreign banks to identify one state as their home state l

Global Bank Regulations Uniform regulations across Europe from the Single European Act of 1987 n Capital can flow freely throughout Europe n Banks can offer a wide variety of lending, leasing and securities activities in Europe n Regulations regarding competition, mergers and taxes are similar throughout Europe n Banks established in one European country have the right to expand into any or all other European countries n

Global Bank Regulations Uniform capital adequacy guidelines n Prior to 1988 standards differed around the world n This difference gave some a comparative advantage n 12 industrial countries agreed to standard guidelines in 1988 n Risk-weighting means higher capital for riskier assets n

Global Bank Competition n U. S. bank expansion in foreign countries is driven by several factors Locations where U. S. multinationals are expected to expand l Areas benefiting from expansion due to free trade agreements l Goal of the banks is to offer diverse services to meet all the banking needs of corporate customers l

Global Bank Competition Non-U. S. bank expansion in the United States n Japanese banks developed an extensive presence in the U. S. n Offer competitive corporate loans l Lower fees for letters of credit l Have a low cost of capital so can take on ventures U. S. banks would not l High saving rate in Japan provides deposit funds for global expansion l

Global Bank Competition Impact of the Euro on bank expansion n Introduction of a single currency stimulated bank expansion n Simplifies transactions to deal in one, rather than several currencies l Customers can more easily compare service costs l Expansion via acquisition to capture economies of scale l

Global Bank Competition for investment banking services n Banks compete to provide a variety of services n Swaps l Foreign exchange l Investment banking l u. Underwriting u. Brokerage n Banks expand both geographically and their product and service lines to capture economies

Impact of Eastern European Reform on Global Competition n Banks helped facilitate the trend toward privatization Provide direct loans to businesses l Act as underwriters on bonds and stocks l Provide letters of credit l Provide consulting services l u. International trade u. Mergers u. Other corporate activities

Risks of Multinational Banks Combining All Types of Risk

Risks of Multinational Banks n Credit risk exists for U. S. banks making foreign loans because they may have less information than for domestic loans Regulations for the disclosure of financial information differ among countries and are not as strict as in the U. S. l Ratios and industry norms differ among countries so benchmarking is difficult l

Risks of Multinational Banks n Managing credit risk May solve the problem by lending to large corporations or government l Performance of each branch in a particular country linked to the performance to that country’s economy l u. Diversify within a country across industries u. Diversify throughout the bank across countries

Risks of Multinational Banks Exchange rate risk n Banks may agree to accept payment in a currency other than the currency in which the loan is denominated n Convert funds received into the currency customers want to borrow n Assets and liabilities denominated in different currencies n Net out exposure n

Risks of Multinational Banks Risk exists because banks may suffer losses as they settle their transactions n If one participant can not meet their obligations, counterparties will also be unable to meet their obligations n Central banks around the world are examining ways to stop the ripple effect n

Risks of Multinational Banks Interest rate risk is even more challenging for the international bank because of its foreign currency balances n Risk depends on the currency denomination and the interest rates of loans and securities in various currencies n Minimize the risk by matching rate sensitivities of assets and liabilities for each currency n

Risks of Multinational Banks n n n Combining all types of risk means managing risk is complex Tradeoffs exist because trying to minimize one of the risks may affect exposure in another area Risks occur as the bank does daily business with multinationals and meets their needs l l Trying to control bank risks means they would not meet customer needs Customers have many choices in this competitive market

International Debt Crisis Reducing bank exposure to Lesser Developed Countries (LDC) debt is more difficult in an integrated global economy n Stagnant U. S. and European economies hurt LDCs in the early 1980 s because the LDC’s dependence on export earnings n Strong dollar also hurt LDCs in the early 1980 s because their loans were denominated in dollars n Countries simultaneously defaulted n

International Debt Crisis n Commercial banks with LDC debt in the 1980 s faced a crisis and had to decide between two alternatives Provide additional loans and incur the risk of default of new as well as older loans l Reject the request for additional funds and cause default l n Banks and countries formed groups to negotiate

International Debt Crisis Exposure to LDC debt was concentrated in 9 money center banks which, if even one failed, would have caused a panic n Banks reduced their exposure by n Selling LDC loans l Using debt-for-equity swaps l Boosting loan loss reserves l

International Debt Crisis The Brady plan developed between 1985 and 1988 was used to reduce LDC debt problems n The only chance Lesser Developed Countries had as a group to pay off loans was to improve their economic conditions n The plan allowed LDCs the chance to reform their economies n Banks were given the option of trading their loans to the World Bank and IMF n

Asian Crisis n Impact of bank lending on the Asian crisis The Asian crisis was caused in part by banks’ willingness to extend credit in Thailand l Commercial developers in Thailand borrowed without having to show projects were feasible l Debt was at high interest rates and expensive l Economic growth slowed and cash flows could not cover local loans or foreign currency-based loans l

Asian Crisis Spread of loan defaults throughout Asia n Problems caused by a weak economy spread throughout Asia n Currencies weakened and investors withdrew funds n South Korean loans made without adequate credit analysis resulted in defaults n

Asian Crisis n Impact on U. S. and European banks had exposure because they made loans in Asia l Bank stocks declined as a result of the losses l

Country Risk Assessment n Several factors of country risk including: l Economic indicators u. Changes in the consumer price index u. Real growth in gross domestic product u. Current account balances divided by exports

Country Risk Assessment n Debt management Debt service and short-term debt divided by total exports l Ratio of total debt to GDP l Short-term debt divided by total debt l

Country Risk Assessment n Political factors are measured subjectively and include a probability for each Destabilizing riots or civil unrest l Increased terrorist activities l Civil war l Foreign war l Government overthrow l

Country Risk Assessment n Structural factors are also measured subjectively Natural resource base l Human resource base l Leadership l n Overall rating Assigns a score between 0 and 100 l Grade assigned for both short and long term l

Exhibit 21. 2 Determining Country Risk Ratings Short-Term Horizon Medium-Term Horizon Weighted Grade . 3 70 21 27 . 2 70 14 60 12 . 3 50 15 75 15 . 2 60 12 Weight Grade Debt management model . 3 80 24 Economic Indicator model . 3 90 Political rating model . 2 Structural rating model . 2 78 62

Exhibit 21. 3 Converting Grade Into Country Rating Overall Grade Rating 9 1– 1 0 0 AAA 8 1– 9 0 A A 7 1– 8 0 A 6 1– 7 0 BBB 5 1– 6 0 BB 4 1– 5 0 B 3 1– 4 0 CCC 2 1– 3 0 C C 11– 2 0 C 0 – 1 0 D Excellent Satisfactory quality, average risk Low quality, high risk Excessive risk

Country Risk Assessment n Discriminant analysis is used to examine country risk Discriminant analysis is a statistical technique used to identify factors that are distinctly different between two groups l Used to try to identify factors that distinguish between countries with and without debt repayment problems l