CHAPTER 21 International Banking

Chapter Objectives n 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

International Expansion n Banks go global for several reasons l 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 n International expansion by U.S. banks l U.S. bank regulations limited interstate banking l Expansion and growth via international banking

International Expansion n How U.S. banks expand overseas l 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

International Expansion n Non-U.S. banks expand into the United States and focus on corporate rather than consumer banking l 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

Global Bank Regulations n 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 l Canada l Europe l Japan

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

Global Bank Regulations n Uniform regulations for banks operating in the U.S. l 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

Global Bank Regulations n 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

Global Bank Regulations n 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

Global Bank Competition n U.S. bank expansion in foreign countries is driven by several factors l 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

Global Bank Competition n Non-U.S. bank expansion in the United States n Japanese banks developed an extensive presence in the U.S. l 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

Global Bank Competition n Impact of the Euro on bank expansion n Introduction of a single currency stimulated bank expansion l 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

Global Bank Competition n Competition for investment banking services n Banks compete to provide a variety of services l Swaps l Foreign exchange l Investment banking 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 l Provide direct loans to businesses l Act as underwriters on bonds and stocks l Provide letters of credit l Provide consulting services u International trade u Mergers u Other corporate activities

Risks of Multinational Banks Credit Risk Exchange Rate Risk Settlement Risk Interest Rate Risk 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 l 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

Risks of Multinational Banks n Managing credit risk l 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 u Diversify within a country across industries u Diversify throughout the bank across countries

Risks of Multinational Banks n 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

Risks of Multinational Banks n 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

Risks of Multinational Banks n 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

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

International Debt Crisis n 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 1980s because the LDC’s dependence on export earnings n Strong dollar also hurt LDCs in the early 1980s because their loans were denominated in dollars n Countries simultaneously defaulted

International Debt Crisis n Commercial banks with LDC debt in the 1980s faced a crisis and had to decide between two alternatives l 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 n Banks and countries formed groups to negotiate

International Debt Crisis n 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 l Selling LDC loans l Using debt-for-equity swaps l Boosting loan loss reserves

International Debt Crisis n 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

Asian Crisis n Impact of bank lending on the Asian crisis l 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

Asian Crisis n 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

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

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 l 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

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

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

Exhibit 21.2 Determining Country Risk Ratings

Exhibit 21.3 Converting Grade Into Country Rating

Country Risk Assessment n Discriminant analysis is used to examine country risk l 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