International Banking

International Banking 21

Chapter Objectives • Describe key regulations that reduced competitive advantages of banks in particular countries • Describe the risks of international banks • Describe bank solutions to the international debt crisis • Describe how banks assess country risk when they consider lending funds to foreign countries

International Expansion • Banks go global for several reasons • Diversify among economies to become less dependant on a single country’s conditions • Do business face-to-face with multinational corporations and their subsidiaries • International expansion by U.S. banks • U.S. bank regulations limited interstate banking • Expansion and growth via international banking

International Expansion • How U.S. banks expand overseas • Establish branches • Must first receive approval of the Federal Reserve Board in the U.S. • U.S. banks’ presence largest in the U.K. • Deposits in foreign branches are not insured • Agencies are an alternative that can make loans but not accept deposits or provide trust services

International Expansion • Non-U.S. banks expand into the United States and focus on corporate rather than consumer banking • Provide service to the subsidiaries of non-U.S. corporations • 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 • Countries have a system of monitoring and regulating commercial banks • Division of regulatory power between the central bank and other regulators varies among countries • Canada • Europe • Japan

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

Global Bank Regulations • Uniform regulations for banks operating in the U.S. • International Banking Act of 1978 • Prior to the Act, foreign banks had more flexibility to cross state lines • Forced foreign banks to identify one state as their home state

Global Bank Regulations • Uniform regulations across Europe from the Single European Act of 1987 • Capital can flow freely throughout Europe • Banks can offer a wide variety of lending, leasing and securities activities in Europe • Regulations regarding competition, mergers and taxes are similar throughout Europe • Banks established in one European country have the right to expand into any or all other European countries

Global Bank Regulations • Uniform capital adequacy guidelines • Prior to 1988 standards differed around the world • This difference gave some a comparative advantage • 12 industrial countries agreed to standard guidelines in 1988 • Risk-weighting means higher capital for riskier assets

Global Bank Competition • U.S. bank expansion in foreign countries is driven by several factors • Locations where U.S. multinationals are expected to expand • Areas benefiting from expansion due to free trade agreements • Goal of the banks is to offer diverse services to meet all the banking needs of corporate customers

Global Bank Competition • Non-U.S. bank expansion in the United States • Japanese banks developed an extensive presence in the U.S. • Offer competitive corporate loans • Lower fees for letters of credit • Have a low cost of capital so can take on ventures U.S. banks would not • High saving rate in Japan provides deposit funds for global expansion

Global Bank Competition • Impact of the Euro on bank expansion • Introduction of a single currency stimulated bank expansion • Simplifies transactions to deal in one, rather than several currencies • Customers can more easily compare service costs • Expansion via acquisition to capture economies of scale

Global Bank Competition • Competition for investment banking services • Banks compete to provide a variety of services • Swaps • Foreign exchange • Investment banking • Underwriting • Brokerage • Banks expand both geographically and their product and service lines to capture economies

Impact of Eastern European Reform on Global Competition • Banks helped facilitate the trend toward privatization • Provide direct loans to businesses • Act as underwriters on bonds and stocks • Provide letters of credit • Provide consulting services • International trade • Mergers • Other corporate activities

Risks of Multinational Banks Credit Risk Settlement Risk Exchange Rate Risk Combining All Types of Risk Interest Rate Risk

Risks of Multinational Banks • Credit risk exists for U.S. banks making foreign loans because they may have less information than for domestic loans • Regulations for the disclosure of financial information differ among countries and are not as strict as in the U.S. • Ratios and industry norms differ among countries so benchmarking is difficult

Risks of Multinational Banks • Managing credit risk • May solve the problem by lending to large corporations or government • Performance of each branch in a particular country linked to the performance to that country’s economy • Diversify within a country across industries • Diversify throughout the bank across countries

Risks of Multinational Banks • Exchange rate risk • Banks may agree to accept payment in a currency other than the currency in which the loan is denominated • Convert funds received into the currency customers want to borrow • Assets and liabilities denominated in different currencies • Net out exposure

Risks of Multinational Banks • Risk exists because banks may suffer losses as they settle their transactions • If one participant can not meet their obligations, counterparties will also be unable to meet their obligations • Central banks around the world are examining ways to stop the ripple effect

Risks of Multinational Banks • Interest rate risk is even more challenging for the international bank because of its foreign currency balances • Risk depends on the currency denomination and the interest rates of loans and securities in various currencies • Minimize the risk by matching rate sensitivities of assets and liabilities for each currency

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

International Debt Crisis • Reducing bank exposure to Lesser Developed Countries (LDC) debt is more difficult in an integrated global economy • Stagnant U.S. and European economies hurt LDCs in the early 1980s because the LDC’s dependence on export earnings • Strong dollar also hurt LDCs in the early 1980s because their loans were denominated in dollars • Countries simultaneously defaulted

International Debt Crisis • Commercial banks with LDC debt in the 1980s faced a crisis and had to decide between two alternatives • Provide additional loans and incur the risk of default of new as well as older loans • Reject the request for additional funds and cause default • Banks and countries formed groups to negotiate

International Debt Crisis • Exposure to LDC debt was concentrated in 9 money center banks which, if even one failed, would have caused a panic • Banks reduced their exposure by • Selling LDC loans • Using debt-for-equity swaps • Boosting loan loss reserves

International Debt Crisis • The Brady plan developed between 1985 and 1988 was used to reduce LDC debt problems • The only chance Lesser Developed Countries had as a group to pay off loans was to improve their economic conditions • The plan allowed LDCs the chance to reform their economies • Banks were given the option of trading their loans to the World Bank and IMF

Asian Crisis • Impact of bank lending on the Asian crisis • The Asian crisis was caused in part by banks’ willingness to extend credit in Thailand • Commercial developers in Thailand borrowed without having to show projects were feasible • Debt was at high interest rates and expensive • Economic growth slowed and cash flows could not cover local loans or foreign currency-based loans

Asian Crisis • Spread of loan defaults throughout Asia • Problems caused by a weak economy spread throughout Asia • Currencies weakened and investors withdrew funds • South Korean loans made without adequate credit analysis resulted in defaults

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

Country Risk Assessment • Several factors of country risk including: • Economic indicators • Changes in the consumer price index • Real growth in gross domestic product • Current account balances divided by exports

Country Risk Assessment • Debt management • Debt service and short-term debt divided by total exports • Ratio of total debt to GDP • Short-term debt divided by total debt

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

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

S h o r t - T e r m H o r i z o n M e d i u m - T e r m H o r i z o n W e i g h t e d W e i g h t e d W e i g h t G r a d e G r a d e W e i g h t G r a d e G r a d e Debt management model . 3 8 0 2 4 . 3 7 0 2 1 Economic Indicator model . 3 9 0 2 7 . 2 7 0 1 4 Political rating model . 2 6 0 1 2 . 3 5 0 1 5 Structural rating model . 2 7 5 1 5 . 2 6 0 1 2 7 8 6 2 Exhibit 21.2 Determining Country Risk Ratings

O v e r a l l G r a d e R a t i n g R a t i n g 9 1 – 1 0 0 A A A E x c e l l e n t 8 1 – 9 0 A A 7 1 – 8 0 A 6 1 – 7 0 B B B Satisfactory quality, average risk 5 1 – 6 0 B B 4 1 – 5 0 B 3 1 – 4 0 C C C Low quality, high risk 2 1 – 3 0 C C 1 1 – 2 0 C 0 – 1 0 D Excessive risk Exhibit 21.3 Converting Grade Into Country Rating

Country Risk Assessment • Discriminant analysis is used to examine country risk • Discriminant analysis is a statistical technique used to identify factors that are distinctly different between two groups • Used to try to identify factors that distinguish between countries with and without debt repayment problems

International Banking