International Risk Management

1. International Risk Management

2. Introduction • This portion of the class covers portions of three different chapters in the book, chapters 15, 16 and 23. • This issue has become increasingly important for FIs due to hedging needs and speculative positions taken to increase income.

3. Background • Globalization of financial markets has increased foreign exposure of most FIs. • FI may have assets or liabilities denominated in foreign currency (in addition to direct positions in foreign currency). • Foreign currency holdings exceed direct portfolio investments.

4. Sources of FX Risk • Spot positions denominated in foreign currency • Forward positions denominated in foreign currency • Net exposure in currency i = (FX assetsi - FX liabi) + (FX boughti - FX soldi) • Net long (+) • Net Short (-)

5. FX Risk Exposure • Could match foreign currency assets and liabilities to hedge F/X risk, but that is not enough • Must also hedge against foreign interest rate risk (by matching durations, for example)

6. Trends in FX • Value of foreign positions has increased • Volume of foreign currency trading has decreased • Causes: • Investment bank mergers • Increased trading efficiency through technological innovation • Introduction of the euro

7. FX Risk Exposure • Greater exposure to a foreign currency combined with greater volatility of the foreign currency implies greater DEAR. • Dollar loss/gain in currency i = [Net exposure in foreign currency i measured in U.S. $] × Shock (Volatility) to the $/Foreign currency i exchange rate

8. FX Trading • FX markets turnover often greater than $1.8 trillion per day. • The market moves between Tokyo, NYC and London over the day allowing for what is essentially a 24-hour market. • Overnight exposure adds to the risk.

9. Trading Activities • Basically 4 trading activities: • Purchase and sale of currencies to complete international transactions. • Facilitating positions in foreign real and financial investments. • Accommodating hedging activities • Speculation.

10. Profitability of FX Trading • For large US banks, trading income is a major source of income. • Volatility of European currencies are declining (due to euro) • Volatility in Asian and emerging markets currencies higher • Risk arises from taking open positions in currencies

11. Foreign Assets & Liabilities • Mismatches between foreign asset and liability portfolios • Ability to raise funds from internationally diverse sources presents opportunities as well as risks • Greater competition in well-developed (lower risk) markets

12. Return and Risk of Foreign Investments • Returns are affected by: • Spread between costs and revenues • changes in FX rates • Changes in FX rates are not under the control of the FI

13. Risk and Hedging • Hedge can be constructed on balance sheet or off balance sheet. • On - balance-sheet hedge will also require duration matching to control exposure to foreign interest rate risk. • Off-balance-sheet hedge using forwards, futures, or options.

14. Interest Rate Parity Theorem • Equilibrium condition is that there should be no arbitrage opportunities available through lending and borrowing across currencies. This requires that 1+r(domestic) = (F/S)[1+r (foreign)] • Difference in interest rates will be offset by the expected change in exchange rates.

15. Multicurrency Positions • Since the banks generally take positions in more than one currency simultaneously, their risk is partially reduced through diversification. • Overall, world bond markets are significantly, but not fully integrated which leaves open the opportunity to reduce exposure by diversifying.

16. Diversification Effects (continued) • High correlations between the bond returns may be due to high correlation of real interest rates over time and/or inflation expectations. ri = rri + iei Nominal return = real return + E[inflation]

17. Sovereign Risk (chapter 16) • In 1970s: • Expansion of loans to Eastern bloc, Latin America and other LDCs. • Beginning of 1980s: • Poland and Eastern bloc repayment problems. • Debt moratoria announced by Brazil and Mexico. • Increased loan loss reserves

18. Introduction (continued) • Late 1980s and early 1990s: • Expanding investments in emerging markets. • Peso devaluation. • More recently: • Asian and Russian crises. • MYRAs • Brady Bonds

19. Credit Risk versus Sovereign Risk • Sovereign Risk -- Governments can impose restrictions on debt repayments to outside creditors. • Loan may be forced into default even though borrower had a strong credit rating at origination of loan. • Legal remedies are very limited. • Need to assess credit quality and sovereign risk

20. Sovereign Risk • Debt repudiation – cancellation of current and future debt obligations • Since WW II, only China, Cuba and North Korea have repudiated debt. • Rescheduling –moratorium or delay in payments of a country or group of creditors in a country • Most common form of sovereign risk.

21. Debt Rescheduling • More likely with debt financing rather than bond financing • Loan syndicates often comprised of same group of Fis probability of agreement increases • Cross-default provisions state that one default constitutes default in entire portfolio • Specialness of banks argues for rescheduling but, incentives to default again if bailouts are automatic

22. Country Risk Evaluation • Outside evaluation models: • The Euromoney Index • The Economist Intelligence Unit ratings – higher the rating greater the risk • Based upon both economic and political risks. • Institutional Investor Index

23. Country Risk Evaluation • Internal Evaluation Models • Statistical models: • Country risk-scoring models based on primarily economic ratios.

24. Statistical Models • Commonly used economic ratios: • Debt service ratio: (Interest + amortization on debt)/Exports • Import ratio: Total imports / Total FX reserves • Investment ratio: Real investment / GNP • Variance of export revenue • Domestic money supply growth

25. Problems with Statistical CRA Models • Measurements of key variables. • Population groups • Finer distinction than reschedulers and nonreschedulers may be required. • Political risk factors • Strikes, corruption, elections, revolution. • Portfolio aspects

26. Problems with Statistical CRA Models (continued) • Incentive aspects of rescheduling: • Borrowers and Lenders: • Benefits • Costs • Stability • Model likely to require frequent updating.

27. Mechanisms for Dealing with Sovereign Risk Exposure • Debt-equity swaps • Example: • Citibank sells $100 million Chilean loan to Merrill Lynch for $91 million. • Merrill Lynch (market maker) sells to IBM at $93 million. • Chilean government allows IBM to convert the $100 million face value loan into pesos at a discounted rate to finance investments in Chile.

28. Multi Year restructuring agreements MYRAs • Aspects of MYRAs: • Fee charged by bank for restructuring • Interest rate charged • Grace period • Maturity of loan • Option features • Concessionality

29. Other Mechanisms • Loan Sales • Bond for Loan Swaps (Brady bonds) • Transform LDC loan into marketable liquid instrument. • Usually senior to remaining loans of that country.

30. Geographic Diversification Chapter 23 • Although many FIs can diversify domestically, the benefits to global diversification are available only to large firms. This chapter explores the potential risk-return advantages and disadvantages of international expansion and the trends toward globalization of FI franchises. As countries such as the U.S. expand, some countries, Japan in particular, are contracting their overseas operations.

31. Global and International Expansions • Three ways to establish global presence • Sell financial services from domestic offices to foreign customers • Sell financial services through a branch, agency, or representative office in foreign customer’s country • Sell financial services through subsidiary company in foreign customer’s country.

32. Global Expansion of FIs • U.S. insurance companies and securities firms recent expansion • 12 banks in the world with over 50 percent of assets in foreign countries • No single country dominates • Japanese banks absent in spite of their size

33. U.S. Banks Abroad • J.P. Morgan/Chase have had offices abroad since beginning of century. • Major growth began in 1960s • Overseas Direct Investment Control Act, 1964. • Offshore funding and lending in dollars forged beginnings of the Eurodollar market. • Assets of U.S. bank activities abroad increased from $353.8 billion in 1980, to $745 billion in 2001. Declined in percentage terms.

34. Factors Encouraging U.S. Bank Expansions Abroad • Dollar as international medium of exchange • Effects of Euro • Political risk • Encouraged flows to U.S. branches and subsidiaries in Cayman Islands and Bahamas. • USA Patriot Act of 2001 prohibited services to shell banks and increased focus on money laundering

35. Factors Encouraging U.S. Bank Expansions Abroad • Domestic activity restrictions • Fed regulations permitting banks to engage in activities permitted by foreign host. • Diversification benefits. • Technology and communications improvements • CHIPS • Decreasing operating costs

36. Factors Deterring Expansion • Capital constraints • BIS 2001 reforms • raise capital requirements for loans to non-OECD sovereigns rated below B- • raise capital requirements for loans to OECD countries rated below AA- • zero risk weights for OECD countries rated above AA-

37. Factors Deterring Expansion • Emerging markets problems • Increased caution due to Korea, Thailand, Indonesia despite improved regulatory environment (NAFTA, for example). • WTO reduction of barriers to global expansion • China as a recent noteworthy example

38. Factors Deterring Expansion • Competition • During 1990s, extensive competition from Japanese banks • Japan had 9 of the 10 largest banks • European Community Second Banking Directive resulted in significant consolidation of European banks.

39. Foreign Banks in the U.S. • Organizational form • Subsidiary • Branch • Agency • Edge Act Corporation • Representative Office

40. Trends and Growth • Rapid expansion of foreign banks in U.S. • In 1980, foreign banks had assets of $166.7 billion (10.8 percent of total U.S. bank assets) • 1992, $514.3 billion (16.4 percent) • 1994, $471.1 billion (13.8 percent) • Retrenchments due to several factors including competitive and regulatory effects. • Recent growth in foreign bank operations in U.S.

41. Regulation of Foreign Banks in U.S. • Prior to 1978, foreign branches and agencies were licensed mostly at state level. • No access to discount window • No direct access to Fedwire/fed funds markets • No FDIC coverage

42. Regulation of Foreign Banks in U.S. (post 1978) • Passage of International Banking Act, 1978 • National treatment to level the playing field • Accelerated expansion of foreign banks in U.S. • Japanese bank entry into California, and subsequent sales notable

43. Regulation of Foreign Banks • Foreign Bank Supervision Enhancement Act 1991, increased federal control. • Triggered by three events: • collapse of BCCI • issuance of $1 billion in unauthorized letters of credit to Iraq by Atlanta agency of Banca Nazionale del Lavoro • unauthorized taking of deposit funds by U.S. representative of Greek National Mortgage Bank of New York.

44. Features of FBSEA • Fed’s approval required for entry • Closure under control of Federal Reserve • Daiwa Bank ordered to cease operations. • Examination by Fed • Deposits: Only foreign subsidiaries with FDIC coverage can take deposits under $100,000. • Activity powers: restricted to activities permitted to federal branch.

45. Advantages to International Expansion • Risk diversification • Economies of scale • Innovations • generate extra returns from selling new products abroad. • Funds source • Customer relationships • Regulatory avoidance

46. Disadvantages • Information/monitoring costs • Example: differences in accounting standards • Nationalization/expropriation. • Fixed costs may be high • Tokyo real estate prices for example.