1. International Banking Regulatory Framework Session 2

2. International Banking Introduction (1) International banks work in the Interbank Market. International Banking comprises of— – Correspondent Banking; – Resident Representatives; – Bank Agencies; – Foreign Branches; – Foreign Subsidiaries & Affiliates; – Consortium Banks.

3. International Banking Introduction (2) Bank lending is ‘international’ when it is cross-border. Most of the times lending can also be cross- currency. International banks lend on the following basic criteria— 1. The Resident of the Bank; 2. The Resident of the Borrower; 3. The Currency Denomination of the Loan.

4. International Banking Introduction (3) Since international banking activities take place between parties that are not in the same country, the international banks are exposed to regulations of the host country as well as the country in which borrowers are located. To aid the banks operating internationally from dual regulations, a need to regulate the international banking system was felt and implemented.

5. International Banking BANKING REGULATIONS

6. International Banking What are Banking Regulations? Bank Regulations are a form of government regulations which subject banks to certain requirements, restrictions and guidelines.

7. International Banking Objectives of Bank Regulations The objectives of bank regulations, and the emphasis, varies between jurisdiction. The most common objectives are: – Prudential—to reduce the level of risk bank creditors are exposed to (that is, to protect depositors); – Systemic Risk Reduction—to reduce the risk of disruption resulting from adverse trading conditions for banks causing multiple or major bank failures; – Avoid Misuse of Banks—to reduce the risk of banks being used for criminal purposes, e.g. laundering the proceeds of crime; – To Protect Banking Confidentiality; – Credit Allocation—to direct credit to favored sectors.

8. International Banking General Principles of Bank Regulations (1) Banking regulations can vary widely across nations and jurisdictions. The general principles of bank regulation throughout the world are— 1. Minimum Requirements; 2. Supervisory Review; 3. Market Discipline.

9. International Banking General Principles of Bank Regulations (2) 1. Minimum Requirements Requirements are imposed on banks in order to promote the objectives of the regulator. The most important minimum requirement in banking regulation is maintaining minimum capital ratios.

10. International Banking General Principles of Bank Regulations (3) 2. Supervisory Review Banks are required to be issued with a bank license by the regulator in order to carry on business as a bank, and the regulator supervises licensed banks for compliance with the requirements and responds to breaches of the requirements through obtaining undertakings, giving directions, imposing penalties or revoking the bank’s license.

11. International Banking General Principles of Bank Regulations (4) 3. Market Discipline The regulator requires banks to publicly disclose financial and other information, and depositors and other creditors are able to use this information to assess the level of risk and to make investment decisions. As a result of this, the bank is subject to market discipline and the regulator can also use market pricing information as an indicator of the bank’s financial health.

12. International Banking Instruments & Requirement of Bank Regulations The instruments & requirements of bank regulations are— – Capital Requirement; – Reserve Requirement; – Corporate Governance; – Financial Reporting & Disclosure Requirements; – Credit Rating Requirement; – Large Exposures Restrictions; – Related Party Exposure Restrictions; – Activity & Affiliation Restrictions; – Payments Systems Requirements.

13. International Banking REGULATION, DEREGULATION & RE- REGULATION (INTERNATIONAL MONETARY SYSTEM)

14. International Banking The international banking system is underlined by procedures, customs, instruments and organizational setting that provides a workable multilateral payment arrangement among different countries. The evolution of international monetary system from the Gold Standard to the Louvre Accord had a profound impact on the international banking developments. Introduction

15. International Banking There are varied reasons for regulating international banking. The following are the basic reasons— – The volume of financial flows is much higher than the trade flows. – In virtually all developed markets, banking industry is heavily regulated than any other commercial or industrial sector. The prudential rational, which is the backbone of bank regulation, is heavily dependent on the monetary rationale. Need for Regulation of International Banking (1)

16. International Banking – Banks are inherently unstable owing to their intermediary function, because it implies a high gearing, or ratio of debt to equity. In the early stages of banking, lending and depository functions were largely separated. But subsequently, the fusion of these two functions led to the reduction in capital adequacy for banks across the world. Therefore, common norms on the capital adequacy for banks world wide became imperative. Need for Regulation of International Banking (2)

17. International Banking – The widespread branch network of banks exposes them to widespread withdrawal of funds by depositors. Owing to their high financial leverage banks can be described as ‘conditionally’ solvent, the condition being that depositors do not collectively exercise their collateral right of withdrawal and thereby forcing banks into insolvency. This may result in a solvency problem, as the victim bank tries to unload essentially unmarketable assets. Need for Regulation of International Banking (3)

18. International Banking – The financial condition of a bank is not readily determinable even by analysts with sophisticated techniques at their disposal because crucial risk parameters such as quality of the loan portfolio cannot be assessed on the basis of published accounts or other publically available information. Even if the information is available, it may become redundant or outdated since banks cannot adjust their risk profile in a short span of time. Sometimes well doing banks also fall victim to ill-founded rumors. This lack of transparency may deteriorate the bank’s financial condition, as they would not be able to take advantage of certain situations. Need for Regulation of International Banking (4)

19. International Banking – So an urgent and genuine need was felt to regulate information flow among the banks that are operating internationally. The above mentioned reasons prompted the banks world over to demand for a regulation common to all of them. Need for Regulation of International Banking (5)

20. International Banking The actual process of regulation started on 5 th July 1991 under the aegis of the Bank of England (BOE) with the closure of Bank of Credit & Commerce International (BCCI) and its subsidiaries. Coordinated action was taken by the BOE in 60 countries to close down the activities of BCCI as well as its subsidiaries in different countries. The effect of the closure of this bank brought a sea of changes in the domestic supervisory practices of overseas banks. The Process of Regulation (1)

21. International Banking The following rules were devised. Host countries should have the following in place— – The Central Bank of the country should extended on-site supervision. – The Central bank should devote more resources to search for fraud, if any. – A duty has to be imposed on auditors to report suspicious of fraud or malpractice of the bank. – Overseas banks are subject to a full-scope review by reporting accountants on an annual basis. The Process of Regulation (2)

22. International Banking – Minimum criteria for authorization should be strictly interpreted. – The Central bank would have the explicit power to refuse or revoke authorization on the grounds that the applicant or bank cannot be effectively supervised because of the group’s structure. – Cooperation and coordination between the banks and other non-regulatory bodies should be enhanced. BOE also focused on issues like setting up supervisory standards (subject to independent monitoring), enhancing international supervisory cooperation and devising bank secrecy provisions. The Process of Regulation (3)

23. International Banking These issues when implemented facilitated banks in different countries to be compared with their counterparts in other countries. However, international banking system had to take care of certain legal issues before implementing the systems in a full fledged manner. The Process of Regulation (4)

24. International Banking Many legal problems crop up in international banking transactions because such transactions inevitably impinge upon the laws of more than one country. Firstly, two systems of law are applicable, and in most cases even more than two are applicable. The presence of different currencies and exchange rates complicates international banking operations. In most cases a third party based in a different country may guarantee the loan. Legal Issues (1)

25. International Banking This thwarts free transactions between the parties as and when required. For instance, a syndicated loan agreement may impinge upon the laws of at least a dozen different countries, depending upon the geographical make-up of the bank syndicate. Whenever a court handles a case in a particular country that contains a foreign element, principles of private international law or conflict of laws come into operation. Legal Issues (2)

26. International Banking The principles of private international law can be enumerated as follows— i. To ascertain whether a court has jurisdiction to determine the case before it. ii. To identify which system of law the court will apply to the fact of the case before it. iii. To determine whether the court will recognize or enforce a judgment obtained in a foreign court. Legal Issues (3)

27. International Banking In the case of domestic banking transactions, since the rights and obligations of the various parties are normally determined by the local systems of law under which they contract, the question of predictability does not arise. Whereas in the case of international banking, it would be crucial to structure the transaction documentation within a legal framework. A balance can be struck by selecting both the systems, of law, which govern the substantive aspects of the transaction, and the court, which has jurisdiction to resolve dispute that may arise, if any. Legal Issues (4)

28. International Banking REGULATORY ARBITRAGE

29. International Banking The gaps that arise either deliberately or unintentionally as a result of regulations, give rise to arbitrage opportunities in banking. Two developments have taken place under this— 1. Euro-Currency; and 2. Offshore Banking Units. Birth of Offshore Banking

30. International Banking Euro-currency markets came into existence in the early 1950s when the Soviet Union allegedly fearing that the United States might block its dollar reserves, decided to deposit its dollars in a Soviet owned Paris bank, Banque Commerciale Pour. They evolved from the concept of euro-dollars (the dollars held with a bank outside USA). Later many other reasons prompted the growth of euro-currency markets. Euro-Currency Markets

31. International Banking The currency of denomination is separated from its country of jurisdiction. Euro­currency banking is not subject to domestic banking regulations like—deposit insurance fee, reserve requirements, interest restrictions, etc. Due to the absence of certain regulations, they are able to offer cheap and efficient services as compared to its domestic competitors. Salient Features of Euro-Currency Markets (1)

32. International Banking Broadly, the market comprises of three segments— i. The banks accept deposits mostly on short-term basis. ii. Lend funds for medium and long-term loans. iii. Raise funds on behalf of international borrowers by issuing bonds, etc. The major participants in the market are commercial banks. They enter the market both as depositors and lenders. Salient Features of Euro-Currency Markets (2)

33. International Banking They accept deposits and lend to corporate who are in need of funds. Corporations are other players in the market who raise loans. Not only the foreign corporations, but even the domestic firms with more international activities rely on the euro- currency loans when the credit conditions become tight and the interest rates are high. Simply put firms engaged in international business enter the market to meet their euro-currency requirements. Salient Features of Euro-Currency Markets (3)

34. International Banking Offshore banking units normally comprise sub-offices of multinational banks set-up to freely transact in international currencies especially with non-residents. The motivating force behind such transactions is usually the high rates of interest on deposits and loans, coupled with cost effective services. Offshore banking units offer attractive rates of interest as they are generally exempted from all types of fiscal levies and monetary controls. Offshore Banking Units (1)

35. International Banking The main feature, of an offshore center is the physical presence of a banking unit, which undertakes the bulk of everyday transactions. They also serve as an important link for global markets thus facilitating channeling of funds from major international financial centers to borrowers at other centers. Since, offshore centers cannot act as close substitutes to one another, it is not possible to close down an offshore banking unit even if certain concessions are withdrawn and the location center becomes less attractive. Offshore Banking Units (2)

36. International Banking The main pre-requisites for setting up a successful offshore banking center are political and economic stability. Some of the fundamental pre-requisites are: – The existence of a major domestic financial market. – A team of experienced, expert support specialists in the field. – A well-defined background of statutory laws. – A system free from restrictions and currency fluctuations, at least as far as non-resident transactions are concerned. – An efficient, highly developed, cost-effective telecommunication network. Pre-Requisites for Setting an Offshore Banking Center (1)

37. International Banking – The capability of leasing exclusive channels of communication for assessing international data and carrying out treasury operations. – The presence of regulatory and fiscal incentives such as “no obligation” system for maintaining reserves with the Central Bank. – The absence of withholding tax on depositors interest income and income tax. Pre-Requisites for Setting an Offshore Banking Center (2)

38. International Banking BASEL CONCORDAT

39. International Banking The case of prudential regulation applies to a banks international activities as it does to their domestic operations. After the Herstatt Crisis in 1974, formal regulations were set-up to coordinate international regulatory arrangements. Introduction

40. International Banking Losses caused by unauthorized foreign exchange dealings were particularly high in the initial stages of floating exchange regime, which began in 1973. The risk of default by the counter party in a spot foreign exchange transaction was highlighted for the first time by the Herstatt collapse. Herstatt Crisis (1)

41. International Banking In the Herstatt case, German Marks were sold to Herstatt on June 24, 1974 by at least dozen banks. Settlement was due in dollars on June 26. On that date the selling banks instructed their correspondent banks in Germany to debit their mark accounts and deposit their funds in the Lande Central Bank, the clearing house operated by the Bundesbank. The funds were then credited to Herstatt. The selling banks expected to receive dollars on the same day through London or New York clearing houses. Herstatt Crisis (2)

42. International Banking However, Bankhaus Herstatt was officially declared bankrupt on June 26, 1974. Though the market closed in Germany, foreign exchange was still being traded in New York. In the mean time, Landes Central Bank had credited Herstatt with funds in Cologne, but the latter’s doors were shut before Herstatt’s dollars were credited to foreign banks. Herstatt Crisis (3)

43. International Banking By closing Herstatt before dollar settlements for the day had taken place in New York, the Bundesbank was exposed to a interbank credit risk in spot foreign exchange transactions, of which banks were unaware of before. Subsequently banks all over the world responded by imposing settlement limits on their foreign exchange dealings with one another. Herstatt Crisis (4)

44. International Banking Normally, settlement in case of failure of individual institutions is ensured by eliminating the cash flow shortfall and allowing the losses on the underlying contracts to be dealt with separately through the courts. As an alternative, a Real Time Gross Settlement System (RTGS) is devised, which allows the funds transfer orders to be settled as soon as they have been sent, provided that the sending bank has sufficient cover in its account with the Central Bank. Real Time Gross Settlement System (1)

45. International Banking With this, the exposures become more transparent, and therefore the participant should be in a position to continuously monitor their risk settlement accounts and credit limits, if any. But the gains come at the cost of higher intraday liquid balances and operating outlays for participants. Real Time Gross Settlement System (2)

46. International Banking The disturbances that followed in the wake of Herstatt’s collapse focused attention on the dependence of national banking system and led to the creation of a standing committee of bank supervisors, under the auspices of the Bank for International Settlements (BIS). The Bank for International Settlements (BIS) fulfills the need for an international organization, which fosters international monetary and financial cooperation and serves as a bank for Central Banks. The Bank for International Settlements commenced its activities from 17th May, 1930 in Basel. Basel Committee on Banking Supervision (1)

47. International Banking The Committee on Banking Regulation and Supervisory Practices (Peter Cooke Committee) seeked not to harmonize national laws and practices but rather to inter­link disparate regulatory regimes with a view to ensure that all banks are supervised according to certain broad principles. The initiative taken by the Cooke Committee came to be known as “Basel Concordat” and can be described as the most important cornerstone of international supervisory cooperation. Basel Committee on Banking Supervision (2)

48. International Banking The following key principles were embedded in the original contract— – The supervision of foreign banking establishments is the joint responsibility of parent and host authorities. – No foreign banking establishment should escape supervision. – The supervision of liquidity should be the primary responsibility of the host authorities. – The supervision of solvency is essentially a matter for the parent authority in case of foreign branches and primarily the responsibility of the host authority in case of foreign subsidiaries. – Practical coordination should be promoted by the exchange of information between host and parent authorities and by the authorization of bank inspections by or on behalf of parent authorities on the territory of host authority. Basel Committee on Banking Supervision (3)

49. International Banking Although the Concordat represented a significant step towards greater international supervisory cooperation, it suffered from a number of defects. For example, the Concordat failed to address the question of differing supervisory standards. The failure of the Concordat in some issues led to the Revised Basel Concordat (June 1983). The Revised Basel Concordat replaced the 1975 Concordat and reformulates some of the provisions. Basel Committee on Banking Supervision (4)

50. International Banking It dealt exclusively with the responsibilities of banking supervisory authorities for monitoring the prudential conduct and soundness of the business of banks’ foreign establishments. The new Concordat is ratified by the group of ten countries, and is designed to establish minimum levels of capital for internationally active banks. It aims at an effective cooperation between host and parent authorities by ensuring that no foreign banking establishment escapes supervision. Basel Committee on Banking Supervision (5)

51. International Banking The new Concordat considers the following aspects for the supervision of banks’ foreign establishments— – Solvency: The allocation of responsibilities for the supervision of solvency of banks’ foreign establishments depend upon the type of establishment. The solvency of branches is indistinguishable from that of the parent bank. For subsidiaries, the supervision of solvency is a joint responsibility of both host and parent authorities. For joint ventures, the supervision of solvency is the responsibility of the authorities in the country of incorporation. Basel Committee on Banking Supervision (6)

52. International Banking – Liquidity: The host authority has responsibility for monitoring the liquidity of the bank’s establishment in its country. The parent authority has responsibility for monitoring the liquidity of the banking group as a whole. In case of subsidiaries, primary responsibility for supervising liquidity is with the host authority. – Foreign Exchange Operations and Position: There is a joint responsibility of parent and host authorities. Host authorities should be in a position to monitor the foreign exchange exposure of foreign establishments in their territories and should inform themselves of the nature and extent of supervision of these establishments being undertaken by parent authorities. Basel Committee on Banking Supervision (7)

53. International Banking It is a protocol formalized by the banks for International Settlements to regulate and control the Capital Adequacy of Banks. It is a new standard for the measurement of different types of risks in banks, and for the allocation of capital to cover those risks. It was published by the Basel Committee of G10 Central Banks. What is Basel Exactly?

54. International Banking History of Basel (1) It is a product of deliberations by the Central bankers from around the world, under the auspices of the Bank of International Settlements (BIS) in Basel, Switzerland. It aims at producing uniformity in the way banks and banking regulators approach risk management across national borders The Basel Committee was established by the Central Bank Governors of the G-10 countries. The catalyst for this committee was the failure of the German Bank, Herstatt, in 1974. On June 26,1974, German regulators forced this troubled bank into liquidation.

55. International Banking History of Basel (2) To respond to the cross-jurisdictional implication of such financial disasters, the Basel Committee introduced a Capital Measurement System in 1988, called Basel Capital System. This System provided for the implementation of a Credit Risk Management Framework. Two fundamental objectives lie at the heart of the Committee’s work. Firstly, that the new framework should serve to strengthen the soundness and stability of the international banking system. Secondly that the framework should be fair and have a high degree of consistency in its application to banks in different countries with a view to diminishing an existing source of competitive inequality among international banks.

56. No standardised rules on capital adequacy for banks. Rules depend on bank regulators of individual countries. No rules in some countries. 1988 Basel set rules for credit risk only 1996 Basel add rules for market risk 2004 Basel II rules for credit, market & operational risks 1996 Amendment Credit RiskCredit + Market Risks Credit + Market + Operational Risks July 1988 Basel Capital Accord Finalisation of Revised Framework Implementation of Revised Framework Pre Basel The Basel Evolution (1)

57. International Banking In the Pre Basel I, there are no standardised rules on capital adequacy for banks. Rules depend on bank regulators of individual countries. There are no rules in some countries. In July 1998, the BIS issued the capital accord which is known as Basel which sets rules for credit risk only. In 1996, the BIS made an amendment in the Basel and added rules for market risk along with the credit risk. In 2004, the Basel Committee issued a new Basel Accord (Basel II) for the New Capital Adequacy Framework to replace the 1988 one, which includes rules for credit, market and operational risks. The Basel Evolution (2)

58. International Banking The Basel I focused on the total amount of bank capital, which is important in reducing the risk of bank insolvency and the potential cost of a bank’s failure for depositors. Building on this, the new framework was designed to improve safety and soundness in the financial system by placing more emphasis on banks’ own internal control and management, the supervisory review process, and market discipline. Although the new framework’s focus is primarily on internationally active banks, its underlying principles intend to be suitable for application to banks of varying levels of complexity and sophistication. Basel II (1)

59. International Banking The new framework provides approaches, which are both more comprehensive and more sensitive to risks than the Basel I, while maintaining the overall level of regulatory capital. Capital requirements that are more in line with the underlying risks will allow banks to manage their businesses more efficiently. Basel II (2)

60. International Banking CAPITAL ADEQUACY RATIOS

61. International Banking Credit management is the challenging functional area in a commercial bank. It calls for expert handling, assessing risk exposure at every stage and securing adequately the safety of funds exposed. In-spite of best efforts there can be no full proof safety standards, resulting in the unpreventable emergence of periodical sticky or overdue credit. Introduction (1)

62. International Banking Credit management is therefore a continuous search for more secure De-risking (effective risk- management) Standards, and Asset­Liability Management Strategies. Such risk-management expertise built and implemented helps at not eliminating risk altogether, but minimizing the same. Risk Management and Asset-Liability Management Strategies are gaining attention in Pakistan. Introduction (2)

63. International Banking The deregulation of the banking sector has brought with it a number of risks which banks have to face. The 1988 Basel Accord (Basel I) exclusively addresses effective handling of credit-risks. However, the new Basel Accord (Basel II) which was implemented in 2004 covers other mitigated risks also. Introduction (3)

64. Minimum Capital Requirement = 8% of Risk-Weighted Exposures Market RiskCredit Risk Operational Risk Capital Adequacy Ratios

65. International Banking LOAN LOSS PROVISIONING

66. International Banking Introduction According to the Basel Accord, along with the capital adequacy standards, income recognition and provisioning also assume significance. In order to rescue banks from writing-off their non-performing loans, the Basel Accord recognizes the non-performing assets (an asset would be considered non-performing if interest on such assets remains due for a period not exceeding 180 days at the balance sheet date) and provides for the same.

67. International Banking Prudential Norms of Income Recognition and Provisioning (1) While categorization of bank credit-based on risk exposure was provided, it did not provide for risk coverage on account of credit-assets turning non- productive or sticky. It is in this context that prudential norms of income recognition and provisioning for sticky accounts were introduced in 1992 when the RBI considered it essential to accept Basel Committee recommendations for capital adequacy.

68. International Banking Prudential Norms of Income Recognition and Provisioning (2) Interest income should not be recognized until it is realized. An NPA is one where interest is overdue for two quarters or more. In respect of NPAs, interest is not to be recognized on accrual basis, but is to be treated as income only when actually received.

69. International Banking Asset Classification (1) The banks should classify their assets based on weaknesses and dependency on collateral securities into four categories— – Standard Assets: It carries not more than the normal risk attached to the business and is not an NPA. – Sub-standard Asset: An asset which remains as NPA for a period not exceeding 18 months, where the current net worth of the borrower, guarantor or the current market value of the security charged to the bank is not enough to ensure recovery of the debt due to the bank in full.

70. International Banking Asset Classification (2) – Doubtful Assets: An NPA, which continued to be so for a period exceeding two years (18 months, with effect from March, 2001). – Loss Assets: An asset identified by the bank or internal / external auditors or the RBI inspection as loss asset, but the amount has not yet been written off wholly or partly.

71. International Banking Provisioning Norms Based on the asset classification, banks will have to make the following provisioning— – Loss Assets: 100% of the outstanding amount. – Doubtful Assets: 100% for the unsecured portion, and 20% - 50% for the secured portion. – Sub-Standard Assets: 10% of the total outstanding amount. – Standard Assets: As per the current guidelines 0.25% provisioning is to be made.

72. International Banking ASSESSMENT OF COUNTRY/SOVEREIGN RISK

73. International Banking Introduction (1) The country/sovereign risk is the most important risk faced by the banks. From good olden days, banks seldom ignore the country risk analysis in their cross border operations. In many instances, creditors suffered losses due to insufficient information on the debtor’s financial position or/and inability/unwillingness to pay. By doing the country risk analysis, banks analyze the credibility of the borrower, and above all the policies of the country in which he is residing.

74. International Banking Introduction (2) This is imperative because the government policies have a profound impact on the movement of capital across borders. Also any possibility of a change in the government or in the policies of the government can easily invalidate any previous contract and therefore the hope of receiving back the funds starts waning.

75. International Banking What is Country Risk? Country risk refers to the general level of political and economic uncertainty in a country affecting the value of loans or investment in that country. There are various economic factors involved in the country risk analysis.

76. International Banking Factors—Political Risk (1) It refers to the uncertain government action that affects the value of a firm. Most companies believe that greater political stability would mean a safer investment environment. From an economic point of view, political risk refers to the uncertainty over the property rights. Political risk is said to exist if the government expropriates either legal title to property or streams of income it generates. International banks are worried about getting their funds back in such scenarios, as the firms’ earnings would be affected.

77. International Banking Factors—Transfer Risk (2) This encompasses potential restrictions on the ability to remit funds across sovereign borders. These restrictions can result in a price-related decline in the value of the asset, remittance of dividends, debt service on loans, or other fees or royalties for financial products, or other services. Transfer risk also arises from hazards associated with global market conditions and debtor governments policies and performance. Since these also affect the cash flows for a bank, international banks are concerned about the borrowers exposure to these risks.

78. International Banking Factors—GDP of the Country (3) The GDP forms the lowest common denominator for many of the key factors, which are used to measure the country risk. A careful examination of the components of a country’s GDP and their rate of change reveal about the structure of the economy significantly and therefore, its flexibility to respond to internal and external shocks.

79. International Banking Factors—Inflation (4) A prolonged period of inflation is invariably symptomatic of economic mismanagement. Persistent inflation tends to be associated with low· growth, declining investment and over-valued exchange rate. This in turn leads to loss of competitive spirit, lack of confidence, capital flight and Balance of Payment difficulties. International banks look into the GDP deflator (the broadest and accurate indicator of inflation), the wholesale price and consumer price indexes, and nominal wages of the borrowers country while lending.

80. International Banking Factors—Real Exchange Rates (5) Exchange rates play a vital role in international banking activities, because various currencies are involved in the transactions undertaken by the international banks. The real exchange rate is computed from the nominal exchange rate by taking the inflation also into account. The high real exchange rates devastate domestic industries, which ·are either into exporting or competing against imports. The implications for credit analysis of real exchange rates are less important in the case of local firms selling domestically and facing little or no import competition. But for firms borrowing abroad, banks should consider the real exchange rate before lending.

81. International Banking Factors—Export GDP Ratio (6) A high and rising export-GDP ratio would indicate a greater ability to repay debt. Banks operating internationally should consider other factors like export-commodity concentrations, the geographical concentration of export markets, and the prospects for export growth. Banks should analyze whether the borrowers’ country is able to borrow abroad as long as the rate of growth equals the foreign exchange receipts or exceeds the average interest rate on its external debt.

82. International Banking Factors—Debt Service Ratio (7) One of the most widely used ratios in country-risk analysis is the debt-service ratio which measures the annual repayments of principal and interest as a percentage of foreign exchange receipts. The ratio is influenced by the outlook for exports structure and currency composition of debt. An amortization schedule for the existing medium and long- term debt stock can help the banks decide upon lending.

83. International Banking Factors—Interest Payments to Foreign Exchange Receipts Ratio (8) Given the unstable nature of principal repayments, the ratio of interest payments to foreign exchange receipts is perceived as a better indicator of liquidity for banks, since interest cannot be easily rescheduled. Therefore banks should look into the interest payments to foreign exchange reserves ratio before lending.

84. International Banking Factors—Policies (9) Fiscal Policy: The international banks should assess the fiscal policy of the borrower’s country before lending. Fiscal policy refers to the government policy for dealing with the budget (especially with taxation and borrowing). Monetary Policy: A study about the monetary policy of the Central Bank of the borrower’s country would give the bank an insight into the money supply, and interest rates in the country and their effect on the firms earnings.

85. International Banking Measurement of Country Risk (1) As part of the international banking regulation, a new approach is designed to measure the country risk/exposure. The measurement of country exposure is based on a reporting system for international lending information under the auspices of BIS. The measurement is done on a consolidated bank basis. The loans to each foreign country would be included irrespective of whether made by a bank’s head office or by a branch or affiliate abroad. Each reporting bank in a semi-annual country exposure report, provides information about its foreign claims.

86. International Banking Measurement of Country Risk (2) The claims are segregated by the type of borrower and by maturity. Loan commitments and other contingencies are also detailed. In international lending, the location of the borrower may not coincide with the location of the ultimate country exposure. The country exposure data would enable the examiner— i. To evaluate the amounts, location, maturities, and types of claims a bank has abroad. ii. To evaluate the amounts of claims reallocated to country of ultimate risk. iii. To compare the exposure levels with the bank’s capital and suggest areas for further analysis.

87. International Banking Country Risk Management The objective of Country Risk Management (CRM) system is to enable the bank to balance its exposures in different countries commensurate with the evaluation of the risks. The system rests on two supportive exercises— – Country Risk Evaluation; and – Balanced Distribution of International Asset and Exposures Amongst Various Countries. The two exercises converge in setting country limits within which the exposure needs to be controlled.

88. International Banking The End