Chapter 6 Banking and Money Markets

Management 3460 Institutions and Practices in

International Finance

Fall 2003Greg Flanagan

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Chapter Objectives The student will be able to:

Describe the banking systemThe IMFCentral banksThe Bank of International Settlements

(BIS)Commercial banks—domestic International banking services

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The student will be able to:

List and discuss the different international banking services.

List and discuss the reasons for international banking services.

Explain capital adequacy and the reasons for it.Explain the calculation of Value at Risk

(VAR)

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The student will be able to:

Explain the international money marketDescribe the creation of eurocurency.

Explain the supply and demand of loanable funds.

Differentiate theInterbank offered rates: LIBOR; SIBOR; PIBOR; EURIBOR.

Eurocredits, Euronotes, Euro commercial paper.

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Banking System The World Bank

“Not a bank, but rather a specialized agency.” The IMF

promoting international monetary cooperation; facilitating the expansion and balanced growth of

international trade; promoting exchange stability; assisting in the establishment of a multilateral system of

payments; and making its resources available (under adequate

safeguards) to members experiencing balance of payments difficulties

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Banking System More generally, the IMF is responsible for

ensuring the stability of the international monetary and financial system—the system of international payments and exchange rates among national currenciesIMF Videos

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Banking System Bank of International Settlements BIS Central Banks

Bank of Canada• FX market intervention• Foreign exchange reserves stood at US$37.2 billion

at the end of 2002,

• up from US$34.2 billion at the end of 2001, primarily owing to a revaluation resulting from the appreciation of the euro against the U.S. dollar.

Commercial banks—domestic

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Banking System

Domestic commercial bankssupervised by central bankprovide retail services and productsinvesthold depositsmake loans

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Banking System

Assets Liabilities

Deposits:

Loans:

+$1000

Cash:

+$1000

+$900 +$900

$1000$1000Balance

10% reserves

$1900$1900Balance

$100

-$900

Bank A

A single bank only lends out its excess reserves.

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Banking System

+$900

Assets Liabilities

Deposits:

Loans:

Cash:

+$900

+$810 +$810

$900$900Balance

10% reserves

$1710$1710Balance

$90

-$810

And so on to Bank C and Bank D….

Bank B

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Banking System

+$1000

Assets Liabilities

Deposits:

Loans:

Cash:

+$1000

+$9,000 +$9,000

$10,000$10,000Balance

10% reservesAll Commercial Banks

Money has been created!

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Banking System

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).

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The World’s 50 Largest Banks Bank Country Equity Assets Net Income

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The World’s 50 Largest Banks Bank Country Equity Assets Net Income

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The World’s 50 Largest Banks Bank Country Equity Assets Net Income

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Reasons for International Banking

PrestigeRegulatory AdvantageWholesale Defensive StrategyRetail Defensive StrategyTransactions CostsGrowthRisk Reduction

Greater stability of earnings due to diversification

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Types of International Banking Offices

Correspondent BankRepresentative OfficesForeign BranchesSubsidiary and Affiliate BanksEdge Act BanksOffshore Banking Centers International Banking Facilities

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Correspondent Bank

A correspondent banking relationship 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.

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Representative Offices

A representative office is 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.

Representative offices also assist with information about local business customs, and credit evaluation of the MNC’s local customers.

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Foreign Branches

A foreign branch bank operates like a local bank, but is legally part of the 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

domestic banks to expand overseas.

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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.

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Edge Act Banks

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

The Edge Act was a 1919 amendment to Section 25 of the 1914 Federal Reserve Act.

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Offshore Banking Centers

An offshore banking center is 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.

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Offshore Banking Centers

The IMF recognizes as major offshore banking centersthe BahamasBahrainthe Cayman IslandsHong Kongthe Netherlands AntillesPanamaSingapore

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“Shell” Branches

Shell branches need to be nothing more than a post office box.

The actual business is done by the parent bank at the parent bank.

The purpose was to allow U.S. banks to compete internationally without the expense of setting up operations “for real”.

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International Banking Facilities

An international banking facility is a separate set of accounts that are segregated on the parents books.

An international banking facility is not a unique physical or legal identity.

Any U.S. bank can have one. International banking facilities have

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

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Capital Adequacy Standards

Bank capital adequacy refers to the amount of equity capital and other securities a bank holds as reserves.

There are various standards and international agreements regarding how much bank capital is “enough” to ensure the safety and soundness of the banking system.

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Capital Adequacy Standards Traditional bank capital standards may be

enough to protect depositors from traditional credit risk, they may not be sufficient protection from derivative risk.i.e. Barings Bank, collapsed in 1995 from

derivative losses, but looked OK on paper relative to capital adequacy standards.

Value-at-Risk (VAR)

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Value-at-Risk (VAR) BIS Basle Accord

VAR = Portfolio Value X Daily Standard Deviation of return X Confidence Interval factor X SQRT(time horizon)

Portfolio Value is known 99% Confidence Interval factor = 2.326 SQRT 10 day horizon =3.1622 Daily Standard Deviation of return needs to

be estimated

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Value-at-Risk (VAR) Example: Portfolio value = $500M Daily Standard Deviation of return

estimated at .67% $500M X .0067 X 2.326 X 3.1622

= $24.64M

The probability of loss greater than this is1%

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Money Markets

Q*

Interestrate

Loanable funds (Eurocurrency)

Demand

Supply

i*

S2

i**

Q**

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International Money MarketEurocurrency is a time deposit in an

international bank located in a country different than the country that issued the currency.i.e. Eurodollars are US$-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.

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Eurocurrency MarketMost Eurocurrency transactions are

interbank transactions in the amount of $1,000,000 and up.

Common reference rates includeLIBOR the London Interbank Offered

RatePIBOR the Paris Interbank Offered RateSIBOR the Singapore Interbank Offered

Rate

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Eurocurrency Market

A new reference rate for the new euro currency

EURIBOR the rate at which interbank time deposits of € are offered by one prime bank to another.

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EurocreditsEurocredits are short- to medium-term loans

of Eurocurrency.The 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.

Eurocredits feature an adjustable rate. On Eurocredits originating in London the base rate is LIBOR.

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Forward Rate AgreementsAn interbank contract that involves two

parties, a buyer and a seller.The buyer agrees to pay the seller the

increased interest cost on a notational 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.

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Forward Rate Agreements: Uses

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.

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Forward Rate AgreementsBank wishes to hedge a deposit cost over a

time period against a loan return over a different time period.

The Bank will sell a forward rate agreement.Settlement rate–SR Agreement rate–AR The payment equals

Note Amount X (SR-AR) X days/360

1+ (SR X days/360)

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Forward Rate AgreementsExample: A bank has a loan out at 4.5% and is

paying deposits at a lower rate—the spread.Note = $1,000,000 Agreement rate = 4.5%;

Settlement rate = 5%; the forward rate period = 91days (three months)

$1,000,000 X (.05-.045) X 91/360 1+ (.05 X 91/360)$1,000,000 X .005 X .25 1.0125

= $1,234.57

Bank pays this as the SR > AR

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EuronotesEuronotes are short-term notes

underwritten by a group of international investment banks or international commercial banks.

They are sold at a discount from face value and pay back the full face value at maturity.

Maturity is typically three to six months.

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Euro-Medium-Term Notes

Typically fixed rate notes issued by a corporation.

Maturities range from less than a year to about ten years.

Euro-MTNs is partially sold on a continuous basis –this allows the borrower to raise funds as they are needed.

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Eurocommercial PaperUnsecured short-term promissory notes issued

by corporations and banks.Placed directly with the public through a dealer.Maturities typically range from one month to six

months.Eurocommercial paper, while typically U.S.

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