Download Chapter 1 Introduction

Management 3460
Institutions and Practices in
International Finance
Fall 2003
Greg Flanagan
Chapter 6
Banking and Money Markets
Chapter Objectives
The student will be able to:
Describe the banking system
The IMF
Central banks
The 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 market
Describe 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 currencies
IMF 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 banks
supervised by central bank
provide retail services and products
invest
hold deposits
make loans
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Banking System
Bank A
Assets
Cash:
Liabilities
10% reserves
Deposits:
+$1000
$100
+$1000
Loans:
Balance
+$900
+$900
-$900
$1000
$1900
$1000
$1900
A single bank only lends out its excess reserves.
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Banking System
Bank B
Assets
Cash:
Liabilities
10% reserves
Deposits:
+$900
$90
+$900
Loans:
Balance
+$810
+$810
-$810
$1710
$900
$1710
$900
And so on to Bank C and Bank D….
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Banking System
All Commercial Banks
Assets
Cash:
Liabilities
10% reserves
Deposits:
+$1000
+$1000
Loans:
Balance
+$9,000
+$9,000
$10,000
$10,000
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
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Equity
Assets
Net Income
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The World’s 50 Largest Banks
Bank
Country
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Equity
Assets
Net Income
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The World’s 50 Largest Banks
Bank
Country
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Equity
Assets
Net Income
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Reasons for International
Banking
Prestige
Regulatory Advantage
Wholesale Defensive Strategy
Retail Defensive Strategy
Transactions Costs
Growth
Risk Reduction
Greater stability of earnings due to
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diversification
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Types of International
Banking Offices
Correspondent Bank
Representative Offices
Foreign Branches
Subsidiary and Affiliate Banks
Edge Act Banks
Offshore 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
centers
the Bahamas
Bahrain
the Cayman Islands
Hong Kong
the Netherlands Antilles
Panama
Singapore
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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
= $24.64M
The probability of loss greater than this is1%
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Money Markets
Supply
Interest
rate
S2
i*
i**
Demand
Q* Q**
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Loanable funds
(Eurocurrency)
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International Money Market
Eurocurrency is a time deposit in an
international bank located in a country
different than the country that issued the
currency.
i.e. Eurodollars are US$-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 Market
Most Eurocurrency transactions are
interbank transactions in the amount of
$1,000,000 and up.
Common reference rates include
LIBOR the London Interbank Offered
Rate
PIBOR the Paris Interbank Offered Rate
SIBOR 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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Eurocredits
Eurocredits 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
rate35 is LIBOR.
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Forward Rate Agreements
An 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 Agreements
Bank 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 Agreements
Example: 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
= $1,234.57
1.0125
Bank pays this as the SR > AR
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Euronotes
Euronotes 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 Paper
Unsecured 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
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yields
are higher.
Oct 23, 2003