Download Global Banking Activities

Bank Management, 6th edition.
Timothy W. Koch and S. Scott MacDonald
Copyright © 2006 by South-Western, a division of Thomson Learning
Global Banking
Activities
Chapter 14
William Chittenden edited and updated the PowerPoint slides for this edition.
Global banking business
 One clear trend in the evolution of financial
institutions and markets is the expansion of
activities across national boundaries.
 Technology has made it possible to conduct
business around the world with relative ease
and minimal cost.
 Producers recognize that foreign markets
are as important as domestic markets, and
that competitors includes both domestic and
foreign operations.
Global banking activities
…involve both traditional commercial
banking and investment banking
operations.




U.S. commercial banks now accept deposits,
make loans, provide letters of credit, trade
bonds and foreign exchange, and underwrite
debt and equity securities in dollars and other
currencies.
With the globalization of financial markets, all
firms compete directly with other major
commercial and investment banks throughout
the world.
Foreign banks offer the same products and
services denominated in their domestic
currencies and in U.S. dollars.
It was not always this way.
U.S. banks, although a dominant player in
some world markets, have not been
considered “large” by international
standards
 Restrictive branching laws,
 Restrictions on the types of activities U.S.
banks could engage in, and
 Other regulatory factors generally meant that
U.S. banks were greater in number,
but smaller in size.
Ranking of World Banking Companies
Prior to Full Enactment of Riegle-Neal
Interstate Banking and Branching
Efficiency Act, 1996
Rank
1
2
3
4
5
6
7
8
9
10
17
26
Company Name
Bank of Tokyo-Mitsubishi Ltd., Tokyo, Japan
Deutsche Bank AG, Frankfurt, Germany
Credit Agricole Mutual, Paris, France (2)
Credit Suisse Group, Zurich, Switzerland (1)
Dai-Ichi Kangyo Bank Ltd., Tokyo, Japan
Fuji Bank Ltd., Tokyo, Japan
Sanwa Bank Ltd., Osaka, Japan
Sumitomo Bank Ltd., Osaka, Japan
Sakura Bank Ltd., Tokyo, Japan
HSBC Holdings, Plc., London, United Kingdom
Chase Manhattan Corp., New York, United States
Citicorp, New York, United States (b)
12/31/1996
$648,161.00
575,072.00
479,963.00
463,751.40
434,115.00
432,992.00
427,689.00
426,103.00
423,017.00
404,979.00
333,777.00
278,941.00
Billions of dollars
Source: The AmericanBanker: http://www.americanbanker.com.
By the end of the 20th century, many
factors had changed in the U.S. banking
system.
 The Riegle-Neal Interstate Banking and Branching Efficiency
Act of 1994 effectively eliminated interstate branching
restrictions in the U.S. such that:
 by early 1994, there were 10 U.S. banks with 30 interstate
branches.
 by June 2001, there were 288 U.S. banks with 19,298
interstate branches.
 U.S. banks were also hampered in their ability to compete
internationally by the Glass-Steagall Act, which effectively
separated commercial banking from investment banking.
 As such, U.S. commercial banks essentially provided two
products: loans and FDIC-insured deposits.
 In November 1999, the U.S. Congress passed the GrammLeach-Bliley Act, which allowed U.S. banks to fully compete
with the largest global diversified financial companies by
offering the same broad range of products.
 The Gramm-Leach-Bliley Act of 1999 repealed restrictions
on banks affiliating with securities firms and modified
portions of the Bank Holding Company Act to allow
affiliations between banks and insurance underwriters.
World Rankings of Financial Companies
(by Assets), 2003 and 2004
2003
Rank
1
2
3
4
5
6
7
8
9
10
…
14
16
Mizuho Financial Group, Tokyo
Citigroup Inc., New York
Allianz AG, Munich
UBS AG, Zurich
HSBC Holdings PLC, London
Deutsche Bank AG, Frankfurt
2003
$1,286,782
1,264,032
1,127,655
1,115,904
1,031,287
1,006,306
2004
#N/A
1,484,101
#N/A
#N/A
#N/A
#N/A
Credit Agricole, Paris
BNP Paribas, Paris
ING Group NV, Amsterdam
Sumitomo Mitsui Financial Group, Tokyo
988,659
983,826
979,585
868,430
#N/A
#N/A
#N/A
#N/A
JPMorgan Chase & Co., New York*
Bank of America Corp., Charlotte, N.C.*
770,912
736,445
1,157,248
1,112,035
Today, the product offerings of large US
banks are similar to those of other
international banks
 Prior to the merger between Citibank and Travelers,
Citibank’s product line was more limited.
 Outside the U.S., Citibank was able to offer a
diversified set of products using an Edge Act
corporation.

Edge Act corporations are domestic subsidiaries of
banking organizations chartered by the Federal
Reserve.
 All “Edges” are located in the United States and
may be established by U.S. or foreign banks and
bank holding companies, but are limited to
activities involving foreign customers.
 They can establish overseas branches and
international banking facilities (IBFs) and own
foreign subsidiaries.
50.0%
95.0%
45.0%
90.0%
40.0%
85.0%
35.0%
80.0%
30.0%
75.0%
Domestic total assets
Foreign owned total assets
Domestic total deposits
Foreign owned total deposits
25.0%
70.0%
20.0%
65.0%
15.0%
60.0%
10.0%
55.0%
5.0%
50.0%
0.0%
Percent of total foreign owned
100.0%
19
7
19 3
7
19 4
7
19 5
7
19 6
7
19 7
7
19 8
7
19 9
8
19 0
8
19 1
8
19 2
8
19 3
8
19 4
8
19 5
8
19 6
8
19 7
8
19 8
8
19 9
9
19 0
9
19 1
9
19 2
9
19 3
9
19 4
9
19 5
9
19 6
9
19 7
9
19 8
9
20 9
0
20 0
0
20 1
0
20 2
0
20 3
04
Percent of total domestic assets or deposits
Comparison of Market Share Data for U.S.
Offices of Domestically and Foreign-Owned
Commercial Banks in the United States: Total
Assets and Deposits, 1973–2004
50.0%
95.0%
45.0%
90.0%
40.0%
85.0%
35.0%
80.0%
30.0%
75.0%
25.0%
70.0%
20.0%
65.0%
15.0%
60.0%
10.0%
55.0%
Domestic total loans
Domestic business loans
Foreign owned total loans
Foreign owned business loans
50.0%
5.0%
0.0%
Percent of total foreign owned
100.0%
19
7
19 3
7
19 4
7
19 5
7
19 6
7
19 7
7
19 8
7
19 9
8
19 0
8
19 1
8
19 2
8
19 3
8
19 4
8
19 5
8
19 6
8
19 7
8
19 8
8
19 9
9
19 0
9
19 1
9
19 2
9
19 3
9
19 4
9
19 5
9
19 6
9
19 7
9
19 8
9
20 9
0
20 0
0
20 1
0
20 2
0
20 3
04
Percent of total domestic loans or business loans
Comparison of Market Share Data for U.S.
Offices of Domestically and Foreign-Owned
Commercial Banks in the United States: Total
Loans and Total Business Loans, 1973–2004
The largest U.S. banks with significant
international operations.
Bank
Holding Company
Citibank NA, New York, NY
Citigroup Inc., NEW YORK NY
JPMorgan Chase Bk NA, Columbus, OH
J.P. Morgan Chase & Co., NEW YORK NY
Bank of America NA, Charlotte, NC
Bank of America Corporation, CHARLOTTE
NC
MBNA America Bk NA, Wilmington, DE
MBNA Corporation, WILMINGTON DE
Wachovia Bk NA, Charlotte, NC
Wachovia Corporation, CHARLOTTE NC
Bank of New York, New York, NY
Bank of New York Co, Inc., NEW YORK NY
Fleet NB, Providence, RI
Bank of America Corporation, CHARLOTTE
NC
Capital One Bk, Glen Allen, VA
Capital One Financial Corp, FALLS CHURCH
VA
Union Planters NB, Memphis, TN
Regions Financial Corp, BIRMINGHAM AL
Comerica Bk, Detroit, MI
Comerica Incorporated, DETROIT MI
Keybank NA, Cleveland, OH
Keycorp, CLEVELAND OH
PNC Bk NA, Pittsburgh, PA
PNC Financial Services Group, PITTSBURGH
PA
MB Financial Bk NA, Chicago, IL
MB Financial, Inc, CHICAGO IL
Bank of Hawaii, Honolulu, HI
Bank of Hawaii Corporation, HONOLULU HI
State Street B&TC, Boston, MA
State Street Corporation, BOSTON MA
Northern Trust Co, Chicago, IL
Northern Trust Corporation, CHICAGO IL
National City Bk, Cleveland, OH
National City Corporation, CLEVELAND OH
California Cmrc Bk, Century City, CA
Citigroup Inc., NEW YORK NY
Irwin Union B&TC, Columbus, IN
Irwin Financial Corporation, COLUMBUS IN
Total
Rank
Assets ($ by $
Billions) loans
Loans
%
$ Billions
Foreign Domestic
Loans
Loans
Deposits
$ Billions Rank by
$ Billions
Foreign
$
% Foreign Domestic
Loans
deposits Deposits Deposits
Number of Branches
$ Billions
Foreign
Deposits Domestic Foreign
$694.529
1
54.47%
$174.27
$208.47
1
72.89%
$124.43
$334.57
272
300
$967.365
2
9.61%
$330.85
$35.19
2
28.94%
$367.87
$149.85
589
158
$771.619
3
4.47%
$365.67
$17.10
3
17.10%
$439.07
$90.60
4,334
123
$58.269
5
35.40%
$20.56
$11.27
16
8.88%
$29.71
$2.90
3
1
$389.963
6
5.15%
$188.88
$10.26
7
7.53%
$252.66
$20.57
2,611
21
$92.138
7
28.07%
$26.04
$10.16
5
36.68%
$41.48
$24.03
362
12
$218.740
8
7.38%
$104.75
$8.35
8
13.41%
$126.10
$19.53
1,562
103
$29.047
9
27.50%
$13.24
$5.02
18
15.83%
$12.23
$2.30
1
0
$33.133
10
16.25%
$19.04
$3.70
31
0.58%
$22.40
$0.13
729
0
$52.078
12
4.50%
$39.10
$1.84
21
3.07%
$40.51
$1.28
356
2
$86.062
14
2.03%
$66.74
$1.38
11
14.80%
$50.59
$8.79
920
3
$73.809
15
2.82%
$42.18
$1.22
15
5.66%
$49.87
$2.99
729
8
$4.927
16
18.66%
$2.59
$0.59
32
0.00%
$3.70
$0.00
36
0
$9.815
17
9.86%
$5.42
$0.59
24
9.30%
$6.86
$0.70
74
17
$90.268
18
11.28%
$4.07
$0.52
4
70.69%
$16.52
$39.84
2
2
$37.044
19
4.72%
$10.04
$0.50
9
64.81%
$8.61
$15.87
19
2
$52.975
23
0.65%
$41.96
$0.27
13
19.14%
$22.58
$5.34
344
2
$1.976
24
32.82%
$0.50
$0.25
27
17.38%
$1.45
$0.30
2
0
$4.870
25
5.71%
$3.82
$0.23
33
0.00%
$3.06
$0.00
22
0
Largest Foreign Owned Banks Operating in the US:
Foreign Office Deposits, Loans and Branches, 2004
Deposits Held in:
Rank
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
Bank
Top Level Holding Company
HSBC Bk USA NA, Wilmington, DE
HSBC Holdings PLC, London NA
Lasalle Bank NA, Chicago, IL
Stichting Prior ABN Amro Hdg, Amsterdam NA
Manufacturers & Traders TC, Buffalo, NY
Allied Irish Banks Limited, Dublin NA
Union Bk of CA NA, San Francisco, CA
Mitsubishi Tokyo Finl Group, Tokyo NA
Standard Federal Bk NA, Troy, MI
Stichting Prior ABN Amro Hdg, Amsterdam NA
Bank of the West, San Francisco, CA
BNP Paribas, PARIS NA
Deutsche Bk TC Americas, New York, NY
Deutsche Bank Aktiengesellsc, Frankfurt NA
Banco Popular De PR, San Juan, PR
Popular Inc., San Juan PR
Harris T&SB, Chicago, IL
Bank of Montreal, Montreal NA
RBC Centura Bk, Rocky Mount, NC
Royal Bank of Canada, Montreal NA
UBS Bk USA, Salt Lake City, UT
UBS AG, Zurich NA
Firstbank PR, San Juan, PR
First Bancorp, San Juan PR
Westernbank Puerto Rico, Mayaguez, PR
W Holding Company, Inc., Mayaguez PR
TD Waterhouse Bk NA, Jersey City, NJ
Toronto-Dominion Bank, Toronto NA
Doral Bk, San Juan, PR
Doral Financial Corporation, San Juan PR
First Hawaiian Bk, Honolulu, HI
BNP Paribas, Paris NA
Banco Popular North America, New York City, NY
Popular Inc., San Juan PR
Israel Discount Bk of NY, New York, NY
Israel Discount Bank Limited, Tel-Aviv NA
Banco Santander PR, San Juan, PR
Banco Santander S.A., Santander NA
R-G Premier Bk of PR, San Juan, PR
R&G Financial Corporation, Hato Rey PR
Bank of Tokyo Mitsubishi TC, New York, NY
Mitsubishi Tokyo Finl Group, Tokyo NA
Bank Leumi USA, New York, NY
Bank Leumi Le-Israel B.M., Tel-Aviv NA
Banco Bilbao Vizcaya Argenta, San Juan, PR
Banco Bilbao Vizcaya Argenta, Bilbao NA
Oriental B&TC, San Juan, PR
Oriental Financial Group Inc, San Juan PR
Safra NB, New York, NY
SNBNY Holdings Limited, Marina Bay NA
Number of Branches:
Percent
Total Domestic Foreign Domestic Foreign Foreign
Assets Offices Offices Offices Offices Ownership Domestic Foreign
$138.30
Loans Held in:
$57.66 $23.62
$81.52
$2.90
100
0
0
$63.73
$30.30
$7.44
$36.38
$0.00
100
126
2
$52.41
$31.11
$4.23
$38.03
$0.10
22
740
3
$47.49
$38.72
$2.59
$28.58
$1.48
61
312
6
$39.13
$18.58
$1.71
$21.49
$0.00
100
273
2
$38.77
$24.04
$1.05
$26.65
$0.00
99
296
2
$33.34
$8.57
$6.42
$8.95
$0.03
100
4
14
$23.80
$13.49
$0.26
$0.06 $13.22
100
2
203
$21.49
$12.30
$1.68
$11.45
$0.08
100
54
2
$18.38
$9.38
$1.36
$11.28
$0.00
99
263
1
$17.56
$14.91
NA!
$7.21
NA!
64
1
0
$15.50
$7.93
$0.20
$9.35
$0.11
100
1
56
$14.20
$6.22
NA!
$6.02
NA!
100
2
48
$11.52
$9.33
NA!
$0.02
NA!
95
2
0
$11.19
$3.37
NA!
$2.71
NA!
100
1
36
$10.61
$7.07
$0.59
$5.10
$0.38
99
56
7
$10.23
$7.10
$0.00
$7.15
$0.00
100
99
0
$8.40
$3.53
$1.49
$2.21
$0.32
100
6
1
$8.24
$4.77
$0.00
$5.59
$0.00
60
1
66
$7.57
$3.44
NA!
$4.02
NA!
100
1
32
$6.32
$1.42
$0.77
$1.68
$0.00
100
1
1
$5.70
$3.26
$1.25
$2.27
$0.16
97
11
1
$5.54
$2.55
NA!
$3.11
NA!
100
1
45
$4.13
$1.08
NA!
$0.78
NA!
100
1
24
$4.12
$2.51
$0.82
$1.30
$0.35
99
2
1
Three events changed the historical
development of banking in the united states.
1.
The first was the stock market crash of 1929 and
the following Great Depression.

2.
3.
Many people blamed banks and the universal
banking activities for the problems although there is
no strong evidence to link the speculative activities
of banks with the crash.
The second was the enactment of the Banking Act
of 1933 and the Glass-Steagall provision, which
separated commercial banking from investment
banking activities.
The third was the rising importance of the federal
government in financial markets.
Prior to these events, the U.S. banking
system operated more of less under a
universal banking system.
Formation and development of the
European Community (EC) will provide
new opportunities for U.S. Banks.
 By abolishing trade restrictions, the EC
exposes European banks to outside
competition.
 EC country members have generally agreed
on rules that allow the following:



Free flow of capital across borders
Elimination of customs formalities
Establishment of a common central bank, which
creates the potential for a single currency
Universal banking model
 Universal banking is the conduct of a variety
of financial services such as:

trading of financial instruments; foreign
exchange activities; underwriting new debt
and equity issues; investment management,
insurance; as well as extension of credit and
deposit gathering
 Universal banks have long dominated
banking in most of continental Europe.
Universal banks engage in everything from
insurance to investment banking and retail
banking.
The United States moved away from a universal
banking system in the 1930s because of problems
in separating commerce from finance
 An inherent conflict of interest
 A universal bank might use pressure tactics
to coerce a corporation into using its
underwriting services or buy insurance from
its subsidiary by threatening to cut off credit
facilities.
 Gramm-Leach-Bliley returned the US banking
system to more of a Universal banking
system

Some of the most complicated aspects of
GLB are functional regulation, privacy
provisions, and what banks are allowed to do
versus what the bank’s “financial holding
company” is allowed to do.
Gramm-Leach-Bliley permitted US Bank’s
to Engage in New Lines of Business
 Under the U.S. system, financial holding
companies (FHCs) are distinct entities from bank
holding companies (BHCs).
 A company can form a BHC, an FHC, or both.



The primary advantage to forming an FHC is that
the organizer can engage in a wide range of
financial activities not permitted in the bank or
within a BHC.
Some of these activities include insurance and
securities underwriting and agency activities,
merchant banking, and insurance company
portfolio investment activities.
Activities that are “complementary” to financial
activities also are authorized.
Organizational structures in
international markets
 Head office
 International divisions or departments are
operated as a part of the head office's
organizational structure, with the division
managers reporting to senior management
(supervisory function).
 Representative office
 International office which does not conduct
normal banking business but simply
represents the corporation, with the purpose
of promoting the corporation's name and
developing business to be funneled to the
home office (exploratory function).
Foreign offices
 Foreign branch
 A legal part of the home bank which is subject
to the laws and regulations of the host nation
 Shell office
 Does not conduct business with local
individuals; serves as a conduit for Eurodollar
activities that originate in the head office
 Full-service branch
 Performs all the activities of domestic banks
 Foreign Subsidiary
 Foreign banks or non-bank corporations
acquired by domestic commercial banks or
bank holding companies; distinct from the
parent bank and performs the same functions
as the domestic banks
Edge act and agreement corporations
 Edge Act corporations:
 Domestic subsidiaries of banks chartered by
the Federal Reserve which may be
established by U.S. or foreign banks and are
limited to activities involving foreign
customers.
 Agreement corporations:
 State-chartered equivalents of Edge Act
Corporations.
International banking facilities
 Subparts of banks that are created to
conduct international business without the
cost and effort of avoiding regulatory
requirements through shell units.
 Exist as a set of accounting entries on the
books of the parent company.
Export trading companies
 Companies that are acquired by banks and
are organized and operated principally for
purposes of exporting goods and services
produced in the U.S. by unaffiliated persons.
Agencies of foreign banks
 Parts of foreign banks that can offer only a
limited range of banking services (cannot
accept transactions deposits from U.S.
residents or issue CDs) with the primary
purpose of financing trade originating from
firms in their own country.
International financial markets
 International markets have evolved to
facilitate funds flows in international
exchange of goods and services and to
reduce the risk of doing business outside the
home country.
The Eurocurrency market
 Eurocurrency:

A deposit liability in any currency except that
of the country in which the bank is located.
 Eurobank:

Bank that issues Eurocurrency claims.
Eurodollars
 Arise when a bank located outside the U.S.
accepts a deposit denominated in U.S.
dollars. As such, the bank receives a dollar
claim on the U.S. bank from which the funds
were transferred.
 Such banks typically redeposit the
Eurodollar proceeds in another bank until the
funds are given out as a loan by one of the
banks.
 The initial Eurodollar deposit is accepted at
the base rate called LIBOR (London
Interbank Offer Rate).
 Each redeposit and the final loan will then be
priced at a markup over LIBOR.
The Eurobond market
 Eurobonds are bonds issued in the
international Euromarket, underwritten by an
international banking syndicate, not subject
to any one country's securities laws, and
denominated in any major national currency.
 Floating-rate Note:

Issued in denominations as low as $5,000 with
maturities ranging from two to five years,
carrying interest rates that vary with LIBOR.
Eurocredits
…term loans priced at a premium over
LIBOR, with the rate floating every three or
six months in most cases, thereby reducing
the mismatch between asset and liability
maturities
 Eurocredits are created to overcome interest
rate risk.
International lending
 International operations generate a
considerable portion of earnings for money
center banks

Citigroup earns about two-thirds of the firm’s
earnings globally.
 International lending, however, carries risks
not associated with domestic lending


Country risk
…default risk associated with loans to
borrowers outside the home country
Foreign exchange risk
…the current and potential volatility in
earnings and stockholders’ equity due to
changes in foreign exchange rates.
Short-term foreign trade financing
…international trade and international trade
financing are considerably more complex than
simply dealing with trading partners within the
same country
 To facilitate trade, someone must enter the transaction
and assume the risk that the importer may not pay.
 Commercial banks fulfill this role through bankers
acceptance financing.
 Trading partners must also have the opportunity to
convert one currency into another, which creates a
demand for foreign exchange services as well.
 Bankers acceptance
…A time draft that represents a guarantee under which
the accepting bank agrees to remit the face value of
the draft at maturity.

Acceptances are attractive because a bank substitutes
its credit rating for that of the importer.
Bankers Acceptance
financing of U.S.
Imports
…a bankers acceptance
is created, discounted,
sold, and paid at maturity
Direct international loans
…originate from international departments of
domestic banks, Edge Act corporations, credit
offices of foreign branches and subsidiaries.
 Credit extended to less-developed countries
(LDCs) has exhibited a poor repayment history
and many of the banks have chosen to
withdraw from lending to these countries after
a large number of default incidents that took
place in the 1980s.
 Banks prefer to have foreign exposure
in the form of equity investments rather
than long-term, constantly renegotiated
loans to foreign central banks.
Credit analysis of foreign loans
 Credit analysis for international loans
follow the same procedures adopted
for domestic loans:
 evaluation
of the required loan amount,
 use of proceeds,
 source and timing of expected payment,
 availability of secondary collateral
sources.
Foreign exchange activities
 Because different countries use
different monetary units, traders must
be able to convert one unit into
another.
 Foreign exchange markets are where
these monetary units are traded.
 Foreign
exchange
…currency other than the monetary unit
of the home country
 Exchange rate
…the price of one currency in terms of
another currency.
Risks unique to international lending:
 Foreign exchange risk
…the current and potential risk to earnings and
stockholders’ equity arising from changes in
foreign exchange rates
 Country risk
…default risk associated with loans to
borrowers outside the home country
 Economic risks
…quantifiable economic and business risks
(mostly examined under regular credit analysis).
 Political (sovereign) risks
…the likelihood that foreign governments will
unilaterally alter their debt service payments,
regardless of the formal repayment schedule
Foreign Exchange:
…currency other than the monetary unit of
the home country
 Exchange Rate
…price of one currency in terms of another
currency.
 Spot Market:
…market for exchange of currencies for
immediate delivery.
 Forward Market
…market for transactions that represent a
commitment to exchange currencies at a
specified time in the future at an exchange rate
determined at the time the contract is signed.
Foreign exchange risk
…current and potential risk to earnings and
stockholder’s equity arising from changes
in foreign exchange rates
 Found when changing exchange rates affect
a bank’s cash inflows differently than cash
outflows associated with positions
denominated in different currencies
 Changes in values of foreign currency
positions (buying and selling foreign
currencies for their own account) due to
changing foreign exchange rates indicate
price risk
Example: Foreign exchange risk
 Commerce Bank’s (CB) home country is
Poland and home currency is the zloty.
current (spot) exchange rate is $1 = 150 zlotys.
2. Commerce Bank:
1.
1.
2.
3.
4.
$1,000 in loans
$250 in liabilities denominated in U.S. dollars
assets are worth 150,000 zlotys
liabilities are worth 37,500 zlotys at the
prevailing exchange rate.
 If the exchange rate moved to $1 = 160 zlotys,
1. assets increase in value by 10,000 zlotys,
2. liabilities increase by 2,500 zlotys.
3. the bank’s equity would rise by 7,500 zlotys.
Example (continued): Foreign exchange risk
 If the exchange rate moved to $1 = 140 zlotys,
1. assets decrease in value by 10,000 zlotys,
2. liabilities decrease by 2,500 zlotys
3. the bank would see stockholders’ equity
decrease by 7,500 zlotys
 These same exposures exist for off-balance
sheet commitments and guarantees when
counterparties effect the at risk transactions
or activities.
Managing foreign exchange rate risk
 A bank’s risk managers analyze aggregate
foreign exchange risk by currency.
 A bank’s net balance sheet exposure in
currency j (NEXPj) is the amount of assets
minus the amount of liabilities denominated
in currency j:

NEXPj = Aj – Lj
where
Aj = assets denominated in currency j,
Lj = liabilities denominated in currency j.
 If NEXPj > 0, the bank is long on currency j
and if NEXPj < 0, the bank is short currency j.
Gain/Loss in a position
 The bank will lose if:
 it is long a currency (NEXPj > 0) and the
currency depreciates in value (the currency
buys less of another currency).
 if it is short a currency (NEXPj < 0) and the
currency appreciates in value (the currency
buys more of another currency).
 The gain/loss in a position with a currency is
indicated by:

Gain/Loss in a Position With Currency j
= NEXPj x [spot exchange rate at time t
– spot exchange rate at time t-1]
Example: gain/loss in a position
 Current (spot) exchange rate is $1 = 150
zlotys.
 Commerce Bank (CB) would lose if

long U.S. dollars


the dollar depreciates as indicated by a
movement in the exchange rate to $1 = 140
zlotys.
Loss = [1,000 - 250] x [140 - 150]
= -7,500 zlotys
 CB would gain if
 the dollar appreciates as indicated by a
exchange rate change to $1 = 160 zlotys.
Example: forward markets
 A bank commits to buy 1 million yen, 90 days
forward for $9,804.

This means that after 90 days, the bank pays
$9,804 and receives 1 million yen, regardless
of movements in exchange rates during the
90-day period.
Forward markets: forward premium.
 Forward premium
…the forward price of a currency is higher
than its spot price, the foreign currency is
priced at a premium.
 Example:


a bank agrees to buy 1 million yen 90 days
forward for 102 yen per dollar.
If the spot rate is 105 yen per dollar, the yen is
priced at a forward premium against the
dollar.
Forward markets: forward discount.
 Forward discount
…the forward price of a currency is lower
than its spot price, the foreign currency is
priced at a discount.
 Example:


a bank agrees to buy 1 million yen 90 days
forward for 102 yen per dollar.
if the spot rate is 100 yen per dollar, the yen is
priced at a forward discount against the
dollar.
Relationship between foreign exchange
rates and interest rates.
 Arbitrage transactions between countries
guarantee that interest rate changes produce
changes in foreign exchange rates, and vice
versa.
 If the interest rate differential between
securities in two countries falls out of line
with the spot-to-forward exchange rate
differential, a covered interest arbitrage will
take place and investors will make net profits
from the series of transactions.
Continuing arbitrage will go on until prices
move back into line to eliminate the riskless
return from covered interest arbitrage.
Covered interest arbitrage
2. Convert dollars to francs at $1 = 1.7 francs
 $1,090,000
 1 + 0.09 (1.7) = 1.7 million francs
$1,009,000
= $1,000,000
+
1 0.09
1. Borrow dollars at 9%
3. Invest in Swiss securities yielding 10%
 $1,090,000 
 1 + 0.09 (1.7)(1.10) = 1.87 million francs
$1,090,000 (1.7)(1.10)
= $1,121,776
1 + 0.09
(1.667)
4. Sell francs for dollars 1 year forward at $1
= 1.667 francs
Sample Transaction: Borrow $1,000,000
1. Borrow $1,000,000 at 9%; agree to repay $1,090,000 in one year.
2. Convert $1,000,000 to 1.7 million francs in spot market at $1 = 1.7 francs.
3. Invest 1.7 million francs in 1-year security yielding 10%; will receive 1.87 million francs after 1 year.
4. Sell 1.87 million francs 1 year forward for $1,121,776 at $1 = 1.667 francs.
Net profit = $1,121,776 - $1,090,000 = $ 31,776
Foreign exchange rates and interest rates
 Covered interest arbitrage
…exists when the interest rate differential
between securities in two countries is out of
line with the spot-to-forward exchange rate
differential.
 Interest rate parity
…exist when covered interest arbitrage profit
potential is eliminated.
Interest rate parity implies:
Where
i1: Annual interest rate in
Country 1.
i2: Annual interest rate in
Country 2.
1 + i2  s1,2 
s1,2: Spot exchange rate


=
=
1,
equal
to
the
number
of

1 + i1  f1,2 
units of Country 2's
currency for one unit of
or
Country 1's currency.
f
1,2: One-year forward


f1,2  s1,2
i2  i1
exchange rate equal to

= 
the number of units of
1 + i1  s1,2 
Country 2's currency for
one unit of Country 1's
currency.
The interest rate parity equilibrium
condition suggests that:
 The forward exchange rate differential, as a
fraction of the spot rate, should equal the
interest rate differential relative to 1 plus an
interest factor to eliminate arbitrage profits.
 Example:
 i1
 i2


is 9%,
is 10%, and
s1,2 is 1.7 as in the previous example,
then f1,2 should be equal to 1.7156:
0.10  0.09  f1,2  1.7 

= 
1 + 0.09
 1.7 
Bank Management, 6th edition.
Timothy W. Koch and S. Scott MacDonald
Copyright © 2006 by South-Western, a division of Thomson Learning
GLOBAL BANKING
ACTIVITIES
Chapter 14
William Chittenden edited and updated the PowerPoint slides for this edition.