Chapter 4

International Banking System

Economic role of Banks

Banking is like any other form of economic activity. Like other economic agents, banks are both dealers and producers. They are dealers, in the sense that they bring together lenders and borrowers, and they are producers as they transform raw base money or cash issued by the government into more convenient checks or demand deposits, which have greater security than cash, and also they transform short-term deposits into longer-term loans. In the process they do the financial intermediation and maintain liquidity in the system. Risk reduction

In their role as dealers, bankers help to reduce risk in the economy. There are two types of risk: the more familiar default risk and the less familiar withdrawal risk. In reducing these risks, banks make their profits. Let us consider default risk. A would-be supplier of credit, or lender-creditor, wishes to make a loan, in order to earn interest on excess cash-balances. The creditor may search out prospective borrowers from among the public. But the creditor must evaluate the individual risks of default. Further, to the normal costs of acquiring information, there is the higher risk of concentrating the loan with one or a few individuals. Because of this, the creditor would charge a high interest rate on this loan, in order to compensate for the risk. By going to a bank, with a long-standing reputation and a diversified portfolio of assets, the creditor markedly reduces the risk of any default on the loan. The rate of interest should be lower in this case. Intermediation and Interest-Rate Expectations

Banks do financial intermediation as they transform short-term deposits into longer-term assets or loans. Typically, short-term deposits are less risky for depositors, and so they require a lower rate of interest. Longer-term loans, on the other hand, offer borrowers a lower risk of withdrawal, so borrowers will be willing to pay a higher interest rate to the bank. For this reason, banks usually transform short-term liabilities (deposits) into longer-term assets (loans).

The banks generally borrow short to finance long term assets and use this leverage to earn the spreads which accrue to them as income. They borrow short through a sequence of, say, two one-period deposits, offering rates r1 now and expected rate r2 next period. Again, the banks can borrow long. On the lending side, the bank can offer a two-period loan at an interest rate I, or it can extend a sequence of two one-period loans at interest rates i1 now, and expected interest rate i2 next period.

The time management of both deposits and credit portfolio will depend on the difference between the short term interest and long term ones. The business of the banks is the quantum of spreads that is defined as the difference between the average returns from the created assets and average costs of deposits. International Banking Operations

International banking operations are essentially to facilitate the movement of goods across the political boundary of countries. Banking system came along with the development of money as an institution. As civilization narrowed down the social distances and mankind learned about the benefits of exchanging commodities across political boundaries, the presentday international trade developed. The transaction of commodities across countries required financial intermediation in the international level and thus international banking business was born. What started with movement of gold and silver across countryborders became ultimately an efficient institution of international transfer of not only yellow metal but the currencies of sovereign countries. In this way the emergence and growth of international banking is closely interwoven with the development of international trade and international capital movement.

The above gives the general perspective of the growth of international banking. But there are many aspects of this development. From a historical standpoint, the recent growth of international banking can be regarded as a reversion to the situation before World War I when European banks dominated the world capital market. During the period 19401960 regulatory control on capital flow and convertibility of the currencies reduced the importance of international banking. From 1960 onwards globalization of capital market started and the emergence of surplus in petrodollars in the seventies gave the much needed liquidity to the international banking business. The latter has been characterized by an increasing turnover in international trade, a phenomenal increase in the international flow of capital and also an increasing flow of funds from the banks to nonbank sectors. To understand the causative factors properly the literature has attempted to identify the factors supporting the internationalization of banking business. Thus factors like nonfinancial multinational corporations, the proximity to customers abroad, the competitive advantage with better information technology and the benefits due to international diversification have been mentioned in the literature in the contexts when these become relevant (Nandi , 1996). These factors along with other forces of globalization have established the huge international financial architecture which rule the international financial market today. The theoretical studies mentioning the factors helping the expansion of international banking are important, but in today's scenario the major business of international banks is based on international trade , international transfer of capital and money and derivatives.

The literature abounds in the exploration of the causative link in the development of international banking, but not many studies are found testing the theory empirically. There have been several studies which attempt to measure empirically the role of the different factors behind the growth of the US banks in the international fields (Nandi, 1996). Determinants of International Banking Activity

In today's world no country can afford to be autarkic either in the field of international trade or in international banking. But the latter is subject to much more restrictions in almost all the countries compared to the former. What determines the growth of international banks in the domestic banking sector of a particular country? Analytically we can proceed as follows:

Since international trade is closely related to international banking, volume of international trade (imports and exports together) is a determinant of the growth of international banking and the relationship is direct. Assuming that no specific restrictions are imposed on the operation of foreign banks so far as their operations are concerned in international banking vis--vis the practice of international banking done by home country's banks, it can be said that an increase in the turnover of international trade should have positive impact on the growth of international banking. Alternatively, the ratio of export to gross domestic product can be taken as the explanatory variable. This alternative formulation can be tested.

Foreign direct investment has been cited as an important determinant for the expansion of international banking. In fact, the presence of international banks facilitates the inflow of foreign capital and it is expected that the increase in foreign direct investment should have a positive impact on the growth of international banking.

Banking service as a commodity is supposed to have positive income elasticity. As national income is growing, demand for banking service should increase. To what extent the increase in income will help the growth of foreign banking activity in domestic soil depends on the preference of the consumers and also the participation of the foreign banks in the trade, both domestic and international, of the host country. If we take per capita income as the explanatory variable for the growth of international banking activity, then the growth of per capita income may facilitate the growth of international banking in the host country on the assumption that foreign banks have complementary role in the domestic banking structure.

The growth of domestic deposit should have influence on the activity of foreign banks. But in many countries the foreign banks are not allowed to create a domestic deposit base, though this facility is crucial for the increase in business. Foreign banks often face difficulties in the creation of domestic deposit base even when it is allowed, as the cost of the maintenance of deposits may be too high compared to business. Many foreign branches of Indian banks operating abroad have not created the domestic deposit base for this reason.

An increase in domestic deposit is supposed to have positive influence on the deposit mobilization of all banks including the foreign banks. That helps the building up of the asset portfolio. To what extent deposit mobilization will affect the activities of foreign banks depends on the competition between domestic banks and the foreign banks in the host country. Foreign banks prefer the creation of a domestic deposit base in the domestic currency as this helps in the expansion of business. Many countries do not allow the foreign banks to create a domestic base, as the latter is perceived to help the foreign bank to mount an attack on the domestic currency.

Again, the exchange rate changes affect the activities of the foreign banks. An increased volatility of the exchange rate increases the risk factor in international banking, and unless this aspect is properly taken care of, this acts negatively so far as the growth of international banking is concerned. We are to understand that the balance- sheet of the foreign banks in the head office is in their mother currency. If Indian rupee appreciates vis--vis their mother currency, that would show a good results in their foreign operations.

An index of activity of foreign banks may be their aggregate asset structure, though the number of branches may be another indicator. Some studies take both. We find that the expansion of international banking in a country depends on several factors like importance of trade in GDP, the dynamism of the exchange rates, the deposit base and some others as explained in earlier paragraphs. The literature also examines the quantitative strength of different variables using an econometric model (Nandi, 1996). We will pursue here another type of international banking activity which is conducted in offshore areas and specially tax-haven locations.

Offshore Banking and Tax-Haven Centers

Offshore banking initially started in offshore regions but in its current avatar it has nothing to do with its geographical indications. It is more as a type of banking sharply different from traditional type and it is operational even from some important centers like New York and London, though jurisdiction varies in offshore operations. Also it is a fact that major businesses in offshore type of banking are done from offshore areas like Hong Kong, Singapore, Bahamas etc. Offshore banking comes under the category of external and Eurocurrency banking when we find the following:

Currency ( location of the bank ( residence of the borrower / depositor

The above characterizes the international banking practice when an Indian citizen deal with Korean won in a bank at Hong Kong. Offshore banking is conducted out of primary financial centers such as London, New York, Chicago, Tokyo and also secondary centers such as the centers in the Caribbean and the Asia-pacific region. The primary financial centers benefit from a strong industrial base on which the money requirements of the customers depends, while the secondary sectors derive their importance from the proximity of the economies which are either the source of a large financial resources or have substantial independent requirements for financial services.

Why Offshore Finance Centre a Preferred Destination

In some situations very small nations with good infrastructures and strategic locations create offshore financial centres (OFC) as a matter of policy to attract foreign capital so as to invest the same for the growth of domestic economy. These countries hardly known outside the region have escaped the agony of poverty through this process of foreign capital investment.

During last two decades many OFCs have been created as part of the developing countries efforts to initiate economic growth in their small domestic markets through the provisions of international financial services. These OFCs are classified alon a spectrum of notional OFC to functional OFCs. While the former provide minimal financial services other that simply being a jurisdiction in which nameplate operation of the companies can be established, the latter provide a wide range of value added services. Notional OFCs are costless to establish, and for that competition among tiny states is tough, and it contributes little to the economic development of the region.

The functional OFC require elaborate infrastructure like communication, airport, labour force and all these call for large investment. As a result the region experiences over all economic growth and the real economies surrounding the region are benefited through backward and forward linkages. The OFCs, with support from the local government, offer a large number of services to the potential investors in their banking system and these are :

excellent communication links with the outside world

absence of any tax burden [ or even when tax exists, it is bare minimum]

non existence of any treaty to exchange tax information with other countries

predominant use of major world currencies

no exchange control

the facility to disguise the ownership of corporate vehicles through the use of nominee directors and bearer shares

no reporting requirements for companies like annual reports

no system of supervision of companies such as Annual General Meetings.

Maintenance of secrecy and confidentiality

The list is long and the main idea is to give all facilities to the foreign investors so that OFC can earn money by selling confidentiality.

A small sub-category of offshore banks exists in the tax-haven areas like Cayman Island, Nassau, Bahamas, Bahrain, Monaco, Andorra etc. All offshore centers have the common denominators of customer confidentiality, very low taxes on offshore business and an absence of foreign exchange control. However, the activities in the centers vary depending on location, convenience to other financial markets, legal and accounting matters and communications. Some of the specialized services are the following: company formation and management, administrative services for "paper' branch and subsidiary banks, portfolio management for trusts, Euro- bond underwriting and placement, incorporation and management of captive insurance companies, ship registration, storage and transshipment of merchandise etc. Thus in today's world of globalization the offshore centers have assumed great significance.

One should be clear about the difference between a tax haven and offshore centers. A tax haven is a jurisdiction with a high level of banking and commercial secrecy through which businesses or individuals can hold assets and earnings and move the same to other places and different jurisdictions with little or no tax impact. While many offshore financial centers are tax havens, many are not. These two are different and this should not be confused. Perhaps the governments in the countries creating the offshore financial centers would like to state that these centres operate in tax efficient zones and these are created to derive benefits of large scale movement of finance capital.

Capital flight and so called money laundering are two phenomena from which the developing countries suffer most. The offshore financial centers in tax haven regions are often the conduit for the large scale transfer of funds. The mechanism of transfer and volumes have been studied in the literature (Nandi, 1999 ).

Panama: an Offshore Center

Panama is an independent republic with no exchange control and a very liberal tax laws. It is bilingual, as both English and Spanish languages are used here. It has a very good infrastructure both in air transport and telecommunications. There are a large number of local and foreign financial institutions and also a large spectrum of legal and accounting expertise. The banking secrecy is protected by various laws. There is no tax on offshore business and its legal system is well established. Panama has a long tradition in commercial banking and offshore business. The legal system is liberal in the incorporation of companies, Eurocurrency business, banking secrecy and private banking. The huge amount of capital deposited in the banks here are often used in the domestic investment. Also the fees generated in the business and the small level of taxes facilitate the generation of income and employment. Of course, a large amount of cash of doubtful origin pass through the OFCs like Panama and this is part of international money laundering nexus.

The Isle of Man : Offshore Financial Centre

The Isle of Man is outside the sovereign jurisdiction of United Kingdom. It is in the centre of Irish Sea and eighty miles away from Manchester. This tiny territory has its own government for the last 1200 years and it has obtained the status of an offshore centre. This island takes pride in its numerous attractions along with its ability of providing a safe tax- free environment for the investors. The well established company laws of the island allow a variety of corporate vehicles including companies limited by guarantee and hybrid companies, and also companies limited by share capital.

Companies that are not owned by the residents of the Isle of Man (IM) and those that conduct their business completely outside the IM, even if they may have an office there, are granted exemption from all IM income taxes. Non- resident companies from other jurisdictions like Panama or Irish non-resident can maintain their base at IM and can apply for IM residency under Part F of Isle of Man Companies Act, and they are eligible for income tax exemption. The ownership of the companies need not be a matter of public record, and this way complete secrecy can be maintained.. The companies can carry on lawful business in any country and in any currency that they desire according to their convenience.

The island has an excellent financial infrastructure, and most banks, accountants and insurance companies are represented there. For example, Ulster Bank (Isle of Man) Limited is a wholly owned subsidiary of Ulster Bank Limited, and the latter is a member of Nat West Group, which is one of the world's largest banking organization. Under the rule of the Financial Supervision Commission responsible for the Depositors Compensation Scheme, deposits are protected up to 75 per cent of the first GBP 20,000 per depositor. The investors are offered several options regarding the opening of account, the variations in minimum amount, minimum withdrawal and interest rate structure. For example, an investor can keep money in fixed deposits, the time may vary from one week to five years at an interest rate which is known in the beginning.

The list is not exhaustive, and some centres within well - established countries are providing the same level of services. Some OFC s are now targets of the Russia's organized crime like Nauru, and the Russian syndicate has evolved an ingenious way of using front organizations to cover Russian connections. The Crime branches of many countries in OECD group are trying to identify the Russian connections because of their potential of wrong- doing. The role of these OFC s in the illegal transfer of money across the globe has been explained in detail in Chapter 14 where money laundering has been explained.

The Fixed-Coefficient Model of the Banking System

The economic position of the banks in the society and their roles in shaping the monetary policy can better be understood with the help of a model. An early model of the banking system, based on a fixed coefficient approach, explains how banks engage in monetary expansion. The model rests on three equations:

R = r D Equation ( 6.1a)C = k D Equation ( 6.1b)MB = R + C

Equation ( 6.1 c)where R represents the reserves of the banking system, C the currency in circulation, D demand deposits, and MB, monetary base, equal to the sum of reserves and currency in circulation. The coefficient r represents the required reserve ratio of bank, with respect to deposits, while k is the ratio of cash to deposits, a ratio determined more by the state of communications and financial technology, as well as custom. For example, the less financially developed an economy is, the greater the need for cash for ordinary payments rather than checks. Substituting the reserve and cash equations in the monetary base definition, one can obtain the following deposit multiplier:

MB = r D + k D

And from this we get

D / MB = 1 / ( r + k)

Equation 6.2With a required reserve ratio of 0.15 and a cash /deposit ratio of .05, for example, the

deposit multiplier is 1/.20, or 5. For every one dollar of monetary base that the government injects into the economy, deposits expand by a factor of 5. This model shows the role that the banking system plays in the money supply process. The government can reduce the money supply either by reducing monetary base, or by changing reserve requirement, since a higher require reserve ratio r will lower the multiplier, and reduce the amount of deposits offered by the banking system.

There is no role of interest rate in the model. Particularly deposit and lending rates can be accommodated in the model as these are important in the functioning of the banking system.

In an expanded model, let us assume that the reserve ratio would depend on the lending rates i, and the discount rate idisc, the rate at which banks can borrow to supplement reserves. Thus the interest rate r would become a function like the following:

R = r (i, idisc), with r1 0

.. ( 6.3) The first negativity implies that higher lending rates would lead banks to keep less reserves. Again, the second positive sign implies that higher discount rates would force banks to hold more reserves so they would not have to borrow from the Central Bank. Similarly, the cash-deposit ratio k would depend on the deposit rate r, or we can write,

k = k(r), with k'