Chapter 15 1

CHAPTER 15

GLOBALIZATON, INTERNATIONAL BANKING, AND FOREIGN-EXCHANGE RISK

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LEARNING OBJECTIVES To understand …

Globalization of banking and the FSI Differences among international

money, capital, and currency markets Delivery system of international

banking ALM in a global context Role of foreign banks in the U.S.

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Chapter Theme Following the international-debt crisis

and the collapse of communism, globalization and international banking were on the rebound in the 1990s

11 September 2001 changed the world but how its aftermath will affect globalization and international banking remains to be seen

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The Information Revolution In the Twilight of Sovereignty, Walter

Wriston wrote: The perception of what constitutes an asset,

and what it is that creates wealth is shifting dramatically. Indeed, the new source of wealth is not material, it is information, knowledge applied to work to create value. The pursuit of wealth is now largely the pursuit of information to the means of production (p. xii).

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Three Aspects of the Information Revolution The relationship between countries and

power, and how in today's information age it is difficult to act alone either politically or economically

The reduction of the importance of middle managers to businesses as information technology replaces paper pushers

The reduction of the importance of natural resources in favor of knowledge (although it is difficult to measure) as a country's major source of power

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Consolidation in the International Arena Deutsche Bank's acquisition of Bankers

Trust of New York in 1999 Hong Kong & Shanghai Banking

Company's (HSBC) acquisition of Republic New York Corporation in 2000

Royal Bank of Canada's acquisition of Centura Bank (NC) in 2001

Citigroup's acquisition of Grupo Financiero Banamex-Accival (Banacci) in 2001

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The Evolution of Money, International Banking, Monetary System, and Globalization

Box 15-1 (p. 510) provides a long (1000-2001) of this process

Important update: 11 September 2001, “The Attack on America” and the subsequent “War on Terrorism”

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Globalization, Americanization, and First-Mover Advantages Reasons why U.S. financial-services firms

dominate world markets. 1. They operate in highly competitive

domestic markets, which serve to sharpen skills and stimulate innovation

2. English is the language of banking and finance

3. Sophisticated information technology and modern tools of risk management are the modus operandi of U.S. financial-services firms

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Reasons (continued) 4. The modern U.S. regulatory environment

has been conducive to financial innovation and tends to react to change (e.g., the Gramm-Leach-Bliley Act of 1999) rather than be proactive with prohibitions as it was in the 1930s.

5. The acceptance by U.S. governments, businesses, households, and educators of free capital markets as efficient allocators of financial resources

6 . A U.S. culture that encourages and rewards competitive spirit, innovation, and hard work

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Americanization? The globalization of banking and

financial services can be viewed as nothing more than the Americanization of these activities, which reaffirms the view of Wriston and others that innovativeness and the ability to adapt to change are keys to leadership in the information age

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First-Mover Advantages(Tufano [1989]) Cost of innovative investment-

banking products 1. Legal, accounting, regulatory, and

tax advisors 2. Computer systems for pricing and

trading 3. Capital and personnel to support

market-making 4. Educating issuers, investors, and

traders

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What’s the Advantage? A larger market share compared to

imitative rivals, where in a globalized finance marketplace the potential gains are even larger

Tufano concludes that innovators enjoy lower costs of underwriting, trading, and marketing. Rather than use these cost advantages to charge "monopoly prices", Tufano finds that they garner market share by pricing products below those of imitative followers

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Reputational Capital Investment banks stake their firms'

reputations on the success or failure of innovative new products. By being innovative, they signal to clients that their intangible and unique assets are still productive and worthy of their reputations.

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The GLB Act (1999) and Bancassurance Banking and insurance have been

co-mingled outside the U.S., especially in Europe for years where it's called "bancassurance". Since the passage of the Gramm-Leach-Bliley (GLB) Act of 1999 such integration also has been permitted in the U.S. and is exemplified by the Citicorp-Travelers Group merger into Citigroup

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Potential Market Advantage Cross-selling: selling more products

top the same customer base Size: potential economies of scale

lead to lower cost per transaction Diversification: more stable income

stream allows refinancing at lower cost, which increases capital productivity

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The Role of Bank Size Size is important but how it is

measured has changed Old standard: Total assets

(Japanese banks dominated) New standard: Market

capitalization and adequacy of bank capital on a risk-adjusted basis (U.S. banks dominate)

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The LDC Debt Crisis in Retrospect The adage, “A rolling loan gather

no loss,” proved incorrect in this case

Thrust: “Countries don’t go bankrupt!”

Counterthrust: “But bankers who lend to them do!”

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How a Rolling Loan Can Gather Loss 10-year loan at 10% with a $100

million balloon payment After a decade of borrowing to

keep the loan current, what’s the total indebtedness?

$1,000,000(1.1)10 = $259,370,000

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Brady Bonds The Brady plan offered creditor banks three

alternatives: 1. They could convert their loans to marketable bonds

with a face value equal to 65 percent of the original par value of the loan -- a "haircut" of 35 percent

2. They could convert the loans to collateralized bonds with a coupon rate of interest of 6.5 percent, which amounted to an interest-rate reduction or a rate haircut

3. They could lend additional funds to allow debtor nations to attempt to keep their loans current -- the old "rolling-loan-gathers-no-loss strategy", which the banks had already disproved as a solution and were not about to accept it

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Globalization and Systemic Risk Systemic credit risk focuses on the default risk of

all firms in the economy. If contagion exists, then the default of one firm leads to the collapse of the economy. Contagion in banking occurs when a deposit run at one bank spreads to other banks, resulting in a liquidity crisis for the financial system.

The new Basel Accord's call for a capital requirement for bank operating risk highlights the regulatory concern about this component of systemic risk arising from globalized and integrated financial systems.

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The Objectives of Central Bankers 1. Foster macroeconomic stability 2. Maintain safe-and-sound

financial institutions that can take advantage of stability while exploiting the advantages of new technological advances

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Greenspan’s Recommendation The way to attempt to control systemic risk is

not to attempt to suppress market forces and technological change but to attempt to use technology to contain it. To achieve this goal for individual institutions, technology can be used to develop better risk-management systems, improve internal controls (absent in the collapse of Barings Bank and the derivatives debacles involving Bankers Trust), and to increase the efficiency and safety of the payments system (i.e., move closer to real-time settlement).

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A World Safety Net Supported by the U.S. To protect against a meltdown of

the financial system, central banks have adopted what Greenspan calls "catastrophic financial insurance coverage," which in the U.S. is the federal safety net of FDIC deposit insurance, the Fed as lender of last resort, and TBTF

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Delivery Systems of International Banking Correspondent banking International departments Participations/loan syndications Representative offices Foreign branches (preferred method) Edge Act and Agreement Corporations International Banking Facilities (IBF) Offshore Banking Centers and Units

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Financial Profile: Foreign vs. Domestic Banking (% of assets, 12-31-00)

Item All U.S. Banks Foreign Offices Interest income 6.86% 7.82% Interest expense 3.59 6.13 NII 3.27 1.69 PLL 0.47 0.33 Noninterest inc. 2.45 2.72 Noninterest exp. 3.46 2.76 Net income 1.14 0.94 Memo: “Burden” -1.01 -0.04 Number of banks 8,315 162

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Conclusions from the Profiles Based on foreign offices compared

to domestic operations NIM is lower (“bad”) PLL is lower (“good”) Burden is lower (“good”) ROA is lower (“bad”)

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Foreign Banks in the U.S. Form Number Assets ($B) Branches 283 901.9 Sub. Banks 84 314.4 Agencies 70 39.2 Edges 6 3.0 Rep. Offices 203 0.0 Total 646 1258.5 In NY 300 (46%) 912.5 (73%)

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Banks from 7 Countries Hold 83% of the Assets ($1 trillion) Rank order

1. Germany ($218.9B) 2. Japan ($209.9) 3. Netherlands ($145.8) 4. France ($144.7) 5. Canada ($142B) 6. United Kingdom ($133.2) 7. Switzerland ($55.6)

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International Banking and Money Markets The Eurocurrency Market and LIBOR A Eurocurrency is a claim (e.g., time deposit)

in that currency held by a nonresident of the currency’s country of origin. Since the Eurodollar is the major Eurocurrency, it is a U.S. dollar claim arising from a dollar‑denominated deposit, note, or bond held by a nonresident of the United States

The Eurocurrency markets began in the late 1950s and early 1960s as a byproduct of the "Cold War".

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London Interbank Offered Rate (LIBOR) LIBOR is the base or anchor rate in the

Eurocurrency market It represents the rate at which leading

multinational banks in London are willing to lend to each other

A LIBOR reference rate exists for each Eurocurrency (e.g., Eurodollars, Euromarks, and Euroyen)

Since other world financial centers have their own interbank offer rates, we have the Tokyo Interbank Offered Rate (TIBOR), and the Singapore Interbank Offered Rate (SIBOR), and the EURO Interbank Offered Rate (EURIBOR)

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BBA Quotes and Practices The British Bankers Association (BBA) reports

the average LIBOR for dollar deposits in the London market based on quotations at 16 major banks for maturities of one month, three months, six months, and one year. Although these four terms are the standard ones, maturities ranging from overnight to several years are available.

Markup pricing exists but the premiums on interbank deposits or placements are relatively small because the costs and risks are minimal

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Eurodollar Loans:Pricing and Fees More costly to administer and typically more

risky; thus, they require a larger markup Floating‑rate basis, with adjustments made every

three-to-six months, depending on the maturity of the underlying liability instrument (time deposit)

Commitment fees, which are an integral part of Eurocurrency pricing arrangements and subject to competitive pressures, typically range in size from 0.25 to 0.50 percent, with payment required at the time the commitment is made

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Borrowing and Lending Rates The rate at which major banks in

London are willing to borrow funds from each other, as opposed to lend to each other, is the London Interbank Bid Rate or LIBID. The spread between LIBOR and LIBID represents the "bid-ask spread" for surplus Eurodollar deposits. The bid rate (LIBID) is the lower of the two rates

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Important Characteristics of the Eurocurrency Market It’s a wholesale market in which large CDs are the

basic liability instrument, with loan participations frequently used to facilitate denomination intermediation into large loans

The international and domestic money markets are competing sectors in the global market for financial assets and liabilities

It is an unregulated market not subject to restrictions such as reserve requirements or deposit‑insurance fees, which makes the international‑banking sector particularly attractive to U.S. banks because they are more heavily regulated than other banks

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Characteristics (continued) It is more competitive than domestic financial

markets, resulting in thinner profit margins and interest spreads because deposit rates must be higher and loan rates lower to compete with domestic financial institutions

The risk analysis required in Eurocurrency markets is more complex because of foreign‑exchange risk and foreign‑country risk, factors that are not critical in domestic financial markets. In Eurocurrency markets, however, it is possible to separate these risks

On balance, Eurocurrency markets link the various currencies and countries of the world into a global financial market

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The Foreign-Exchange Market The FX or forex market exists because of trade

between countries with different currencies. That is, exporters prefer not to hold foreign currencies; they want to be paid in their national currency

Quotations for major exchange rates are available in daily publications such as The Wall Street Journal or from major financial institutions

Quoted FX rates are wholesale ones for amounts of $1 million or more as traded among major banks. Retail transactions typically provide fewer units of foreign currency per dollar. Box 15-4 (p. 533) provides a primer on FX

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The FX Market Large commercial banks, domestic and

foreign, dominate the FX market To provide foreign‑exchange services to

their customers, these banks take a position (i.e., hold inventories) in the major currencies of the world

In addition to providing for customers’ foreign currency needs in either the spot or forward markets, banks trade for their own account in the FX market

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The European Monetary System (EMS) and the Euro Created in 1979 to establish monetary

stability in Europe and to promote economic and political unification for the European Union

Important EMS FX provisions Created a common unit of account, the European

Currency Unit or ECU, which later was replaced by the Euro, began circulating on January 2002

Established an exchange-rate mechanism (ERM) and procedure for collectively linking and managing the exchange rates of the EMU member countries

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European Central Bank A third important development

coming out of the EMU was the establishment of the European Central Bank (ECB). Its task is to control the supply of money and credit for the EMU countries, which have rendered their monetary sovereignty to the ECB

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The Euro Parity-Grid System (Set on January 1, 1999) One Euro equals

13.7063 Austrian schillings 1936.27 Italian lira 40.3399 Belgian francs 40.3399 Luxembourg francs 5.94573 Finnish markkas 2.20371 Netherlands guilders 6.55975 French francs 200.482 Portuguese escudos 1.95583 German marks 166.386 Spanish pesetas 0.787564 Irish pounds 340.750 Greek drachmas

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The Euro (continued) The Euro floats against currencies

outside the EMU The Euro exchange rate against the

USD began at 1.0653 in 1999 but by 2000 it had dropped to 0.9232 USD per Euro. By May 14, 2001, the Euro's slide had continued to 0.8743 although it had reached 0.9376 in January 2001

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Hedged Cost of Funds Consider the following information for

Alpha Company, which can borrow in Japan or the United States

Money market costs: 5% in USD and 2% in yen

FX market: Spot = 122 yen/USD One-year forward = 119 quoted and 120

expected

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Analysis On the surface, borrowing appears cheaper

in Japan. However, until we account for changes in the yen-USD exchange rate, we cannot know the effective cost of borrowing

For example, the expected change in the value of the yen is 1.64% [= (122-120)/122]. Thus, Alpha probably would have to pay back the yen borrowing after the yen has appreciated (USD depreciated)

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Analysis (continued) Is borrowing in Japan a good idea? We can

approximate the borrowing cost by adding the expected change in the value of the yen to the interest rate. In this case, Alpha's estimated effective borrowing cost would be about 3.64%, which is less than the U.S. rate of 5%

To be more exact, assume that Alpha borrows $1,000,000 (at the current spot exchange rate of 122 yen/USD) and agrees to pay principal and interest at the end of one year

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Analysis (continued) The firm will have borrowed 122 × 1,000,000 =

122 million yen and must pay 122,000,000 × (1 + .02) = 124.44 million yen in one year. If the exchange rate is the expected 120 yen/USD, the dollar outflow is $1,037,000 (= 124.44/120) and the effective cost of the borrowing is 3.7% (< 5%). Of course, no guarantee exists that the 120 yen/USD rate will exist. If the value of the dollar is as low as 118, then the dollar outflow is $1,054,600 and the effective (dollar denominated) cost of the borrowing is 5.46% (> 5%)

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Analysis (continued) Forward markets, which can be

used to eliminate the risk of changing exchange rates, allow an individual or a firm to generate known cash flows from international borrowings and therefore make valid comparisons

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Borrowing and Hedging Cash Flows Assume that Alpha negotiated a forward contract

with an FX dealer bank to buy yen at 119 yen/USD. With this forward contract, Alpha will pay $1,045,700 in one year regardless of the exchange rate and it secures an effective cost of borrowing at 4.57% with no risk. This rate, moreover, is lower than the domestic borrowing cost of 5%, so the firm is better off borrowing in Japan. The effective cost of 4.57% is often referred to as the Hedged Cost of Funds. As such, it refers to the fact that the risks of exchange movements have been eliminated

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Components of the Hedged Cost of Funds The foreign interest rate (e.g., 2% in the

example above) The forward premium or discounts used to

compute the cash outflows. In the case where the firm borrows in a foreign

currency at a rate rf with principal and interest due in one period and a forward premium or discount on the foreign currency of p, the hedged cost of funds (domestic currency effective rate), rh, can be calculated as follows:

(1 + rf) × (1 + p) = (1 + rh) (15-1)

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Hedge Cost of Funds(concluded) In the previous example, the yen is selling

at a (1/119 - 1/122) / (1/122) = 2.52% premium. Thus, the hedged cost of funds is (1 + 0.02)(1 + 0.0252) - 1 = 0.0457 = 4.57%. This calculation is only valid for the most simple loan structure -- principal and interest in one year. By looking at the actual cash flows associated with any specific borrowing, and the forward contracts needed to hedge the borrowing, we can calculate a hedged cost of funds

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Risk Exposure and Risk Management Country (sovereign credit) risk Cross-currency risk on an off the

balance sheet Net exposure in an FX is:

NET = [A(FX) - L(FX)] + NTP(FX)

Global ALM Risk profiles

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CHAPTER SUMMARY The important international banking markets

are the Eurocurrency, foreign-exchange, and derivatives markets. The European Monetary System (EMS) and its currency, the Euro, reflect "globalization" on a regional scale. Moreover, the spread of the bancassurance business model from Europe to other parts of the financial world captures the growing integration of financial services.

The most popular way for banks, whether domestic or foreign, to deliver international banking services is to establish branches

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More … The dominant role that major U.S.

commercial and investment banks have played in the globalization of the financial-services industry supports the argument that the phenomenon can be viewed as the Americanization of world financial markets. Globalization is, of course, a two-way street and the U.S. policy of national treatment of foreign banks has created opportunities for foreign banks to play a major role in U.S. banking and financial markets.