GLOBAL BANKING ACTIVITIES

Chapter 21

Bank ManagementBank Management, 5th edition.5th edition.Timothy W. Koch and S. Scott MacDonaldTimothy W. Koch and S. Scott MacDonaldCopyright © 2003 by South-Western, a division of Thomson Learning

Global banking business

One clear trend in the evolution of financial institutions and markets is the expansion of activities across national boundaries.

Technology has made it possible to conduct business around the world with relative ease and minimal cost.

Producers recognize that export markets are as important as domestic markets, and that the range of competitors includes both domestic and foreign operations.

Global banking activities…involve both traditional commercial banking and investment banking operations.

U.S. commercial banks now accept deposits, make loans, provide letters of credit, trade bonds and foreign exchange, and underwrite debt and equity securities in dollars and other currencies.

With the globalization of financial markets, all firms compete directly with other major commercial and investment banks throughout the world.

Foreign banks offer the same products and services denominated in their domestic currencies and in U.S. dollars.

Still, it was not always this way.

U.S. banks, although a dominant player in some world markets, have not been considered “large” by international standards

Restrictive branching laws, Restrictions on the types of activities U.S.

banks could engage in, and Other regulatory factors generally meant that

U.S. banks were greater in number, but smaller in size.

U.S. banks, although a dominant player in some world markets, have not been considered “large” by international standards.

Rank Company Name 12/31/1996 1 Bank of Tokyo-Mitsubishi Ltd., Tokyo, Japan $648,161.00 2 Deutsche Bank AG, Frankfurt, Germany 575,072.00 3 Credit Agricole Mutual, Paris, France (2) 479,963.00 4 Credit Suisse Group, Zurich, Switzerland (1) 463,751.40 5 Dai-Ichi Kangyo Bank Ltd., Tokyo, Japan 434,115.00 6 Fuji Bank Ltd., Tokyo, Japan 432,992.00 7 Sanwa Bank Ltd., Osaka, Japan 427,689.00 8 Sumitomo Bank Ltd., Osaka, Japan 426,103.00 9 Sakura Bank Ltd., Tokyo, Japan 423,017.00

10 HSBC Holdings, Plc., London, United Kingdom 404,979.00 17 Chase Manhattan Corp., New York, United States 333,777.00 26 Citicorp, New York, United States (b) 278,941.00

Billions of dollars Source: The AmericanBanker: http://www.americanbanker.com.

By the end of the 20th century, many factors had changed in the U.S. banking system. The Riegle-Neal Interstate Banking and Branching Efficiency

Act of 1994 effectively eliminated interstate branching restrictions in the U.S. such that: by early 1994, there were 10 U.S. banks with 30 interstate

branches. by June 2001, there were 288 U.S. banks with 19,298

interstate branches. U.S. banks were also hampered in their ability to compete

internationally by the Glass-Steagall Act, which effectively separated commercial banking from investment banking. As such, U.S. commercial banks essentially provided two

products: loans and FDIC-insured deposits. In November 1999, the U.S. Congress passed the Gramm-

Leach-Bliley Act, which allowed U.S. banks to fully compete with the largest global diversified financial companies by offering the same broad range of products. The Gramm-Leach-Bliley Act of 1999 repealed restrictions

on banks affiliating with securities firms and modified portions of the Bank Holding Company Act to allow affiliations between banks and insurance underwriters.

By the end of 2000, the largest banking company in the world was Citigroup at just under one-trillion dollars and three of the largest ten banking companies in the world were U.S. banks.

The merger between Citicorp and Travelers created Citigroup, the first diversified financial services company in the U.S.

The merger, however, was not completely permissible at the time it was approved under provisions of the Glass-Steagall Act. The passage of the Gramm-Leach-Bliley Act, made

this merger permissible and thereby allowed Citigroup to legally be the world’s largest banking company.

Citigroup formed a financial holding company under the provisions of the Gramm-Leach-Bliley Act and became one of the first integrated financial services companies engaged in investment services, asset management, life insurance and property casualty insurance, and consumer lending.

Its operating companies include Salomon Smith Barney, Salomon Smith Barney Asset Management, Travelers Life & Annuity, Primerica Financial Services, Travelers Property Casualty Corp., and Commercial Credit.

Today, the product offerings of Citigroup are similar to that of Deutsche Bank in Germany Prior to the merger between Citibank and Travelers,

however, Citibank’s product line was more limited. Outside the U.S., Citibank was able to offer a

diversified set of products using an Edge Act corporation. Edge Act corporations are domestic subsidiaries of

banking organizations chartered by the Federal Reserve.

All “Edges” are located in the United States and may be established by U.S. or foreign banks and bank holding companies, but are limited to activities involving foreign customers.

They can establish overseas branches and international banking facilities (IBFs) and own foreign subsidiaries.

Foreign banks operating through their American banking offices have also aggressively pursued U.S. business.

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Domestic total assets Domestic total depositsForeign owned total assets Foreign owned total deposits

The growth in market share of U.S. offices of foreign banks in total loans and business loans.

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Domestic total loans Domestic business loansForeign owned total loans Foreign owned business loans

The largest U.S. banks with significant international operations.

$ Mill % TA $ Mill % TACitibank NA, New York NY 452,343 98,899 208,024 46.0% 121,901 157,462 34.8% 277J PMorgan Chase Bk, New York NY537,826 160,102 120,371 22.4% 135,872 39,022 7.3% 612Bank of America NA, Charlotte NC 551,691 334,909 56,634 10.3% 287,364 20,867 3.8% 4,350Fleet NA Bk, Providence RI 187,949 110,148 22,316 11.9% 102,956 19,737 10.5% 1,709Bank of New York, New York NY 78,019 28,786 27,024 34.6% 19,822 16,879 21.6% 362Bank One NA, Chicago IL 161,023 81,020 26,358 16.4% 76,440 4,991 3.1% 804MBNA America Bk NA, Wilmington DE43,066 26,187 1,448 3.4% 18,733 4,123 9.6% 3First Union NB, Charlotte NC 232,785 135,276 12,473 5.4% 118,053 3,479 1.5% 2,143State Street B&TC, Boston MA 65,410 12,137 26,718 40.8% 4,519 1,402 2.1% 1Wachovia Bk NA, Winston-Salem NC71,555 42,684 3,627 5.1% 45,434 807 1.1% 790Keybank NA, Cleveland OH 71,526 40,010 2,721 3.8% 54,047 785 1.1% 980PNC Bk NA, Pittsburgh PA 62,610 44,079 2,307 3.7% 39,072 777 1.2% 735Mellon Bk NA, Pittsburgh PA 27,813 9,947 4,949 17.8% 6,269 548 2.0% 346Bank of Hawaii, Honolulu HI 10,493 5,621 1,369 13.0% 5,312 495 4.7% 78Northern Trust Co, Chicago IL 32,758 10,380 9,424 28.8% 11,331 397 1.2% 1National City Bk, Cleveland OH 39,214 20,464 1,007 2.6% 31,022 154 0.4% 353Wells Fargo Bk NA, San Francisco CA140,675 73,644 5,433 3.9% 93,799 20 0.0% 939Wells Fargo Bk MN NA, Minneapolis MN52,428 26,311 7,459 14.2% 34,277 1 0.0% 169

Domestic Offices

# of US BranchesName

Total Assets

Domestic Offices

Foreign Offices Foreign OfficesNet Loans and leasses:Deposits Held in:

The largest “foreign owned” banks operating in the U.S.

Domestic Offices

Foreign Offices

HSBC Bank USA, Buffalo NY 84,230 37,067 21,153 3,194 HSBC Holdings PLC, LONDON NA 100 440 19Lasalle Bank NA, Chicago IL 54,731 24,963 4,226 0 ABN Amro, AMSTERDAM NA 100 122 2Bankers Trust Co, New York NY 42,678 11,423 10,000 253 Taunus Corporation, NEW YORK NY 100 4 14Standard Federal Bk NA, Troy MI 42,088 19,702 624 0 ABN Amro, AMSTERDAM NA 100 385 2Union Bk of CA NA, San Francisco CA 35,591 26,518 3,305 1,041 Bank of Tokyo-Mitsubishi, TOKYO NA 66 286 6Banco Popular De PR, San Juan PR 20,477 11,459 190 10,306 Popular Inc., SAN JUAN PR 100 2 204Harris T&SB, Chicago IL 19,673 9,498 1,708 151 Bank of Montreal, MONTREAL NA 100 57 2Allfirst Bk, Baltimore MD 17,762 12,758 545 249 Allied Irish Banks Limited, DUBLIN NA 100 270 2RBC Centura Bk, Rocky Mount NC 13,732 7,388 273 0 Royal Bank of Canada, MONTREAL NA 100 241 1Bank of The West, San Francisco CA 13,412 9,212 N/A 0 Bancwest Corporation, HONOLULU HI 44 193 0United CA Bk, San Francisco CA 10,524 8,285 428 0 Sanwa Bank, Limited, OSAKA NA 100 121 1First Hawaiian Bk, Honolulu HI 8,682 5,691 463 364 Bancwest Corporation, HONOLULU HI 44 56 6Firstbank PR, San Juan PR 8,143 4,117 N/A 0 First Bancorp, SAN JUAN PR 100 1 49Banco Santander PR, Hato Rey PR 7,656 4,811 0 0 Banco Santander S .A., SANTANDER NA 80 1 72TD Waterhouse Bk NA, Jersey City NJ 6,069 5,546 N/A 0 TD Waterhouse Holdings, Inc., NEW YORK NY 80 2 0Israel Discount Bk of NY, New York NY 6,021 2,112 2,094 415 Israel Discount Bank Limited, TEL-AVIV NA 100 7 1Westernbank Puerto Rico, Mayaguez PR 5,887 3,214 N/A 0 W Holding Company, Inc., MAYAGUEZ PR 100 1 35Banco Popular North America, New York City NY5,606 4,761 0 0 Popular Inc., SAN JUAN PR 100 98 0Safra NB, New York NY 5,010 2,548 320 875 SNBNY Holdings Limited, MARINA BAY NA 99 2 1Banco Bilbao Vizcaya Argenta, San Juan PR 4,801 2,971 N/A 0 BBVAPR Holding Corporation, SAN JUAN PR 100 1 61Bank of Tokyo Mitsubishi TC, New York NY 4,337 1,491 1,310 46 Bank of Tokyo-Mitsubishi, TOKYO NA 100 1 1Bank Leumi USA, New York NY 4,082 1,496 1,800 169 Bank Leumi Le-Israel B.M., TEL-AVIV NA 99 8 1R-G Premier Bk of PR, San Juan PR 3,963 2,115 N/A 0 R&G Financial Corporation, SAN JUAN PR 100 1 25Doral Bk, San Juan PR 3,486 1,528 N/A 0 Doral Financial Corporation, SAN JUAN PR 100 1 26Laredo NB, Laredo TX 2,349 2,029 N/A 0 Incus Co. Ltd., ROAD TOWN NA 71 24 0

# of Foreign

BranchesTotal

Assets

Deposits Held in: Loans in Frgn

Offices Top Holding CompanyName

% Foreign Owned

# of US Branches

Universal banking model

Universal banking is the conduct of a variety of financial services such as: trading of financial instruments; foreign

exchange activities; underwriting new debt and equity issues; investment management, insurance; as well as extension of credit and deposit gathering

Universal banks have long dominated banking in most of continental Europe. Universal banks engage in everything from insurance to investment banking and retail banking— similar to U.S. banks prior to the enactment of

the Banking Act of 1933 and Glass-Steagall provisions and now post the passage of the Gramm-Leach-Bliley Act of 1999

Three events changed the historical development of banking in the united states.

1. The first was the stock market crash of 1929 and the following Great Depression. Many people blamed the banks and the universal

banking activities for the problems although there is no strong evidence to link the speculative activities of banks with the crash.

2. The second was the enactment of the Banking Act of 1933 and the Glass-Steagall provision, which separated commercial banking from investment banking activities.

3. The third was the rising importance of the federal government in financial markets.

Prior to these events, the U.S. banking system operated more of less under a

universal banking system.

The advantages of universal banking…risk diversification and expanded business opportunities.

A universal bank can spread its costs over a broader base of activities and generate more revenues by offering a bundle of products.

Diversification, in turn, reduces risk. insurance companies, investment banks and

other suppliers of financial services are moving toward building financial conglomerates

The GLB Act repealed Glass-Steagall and allows U.S. banks to operate in the business of commercial banking, investment banking, and insurance. Although there are many restrictions, U.S.

banks are allowed to compete with foreign banks on an equal footing for the first time since the passage of the Glass-Steagall Act,

Disadvantages of universal banking…inherent conflict of interest

A universal bank might use pressure tactics to coerce a corporation into using its underwriting services or buy insurance from its subsidiary by threatening to cut off credit facilities.

It could force a borrower in financial difficulties to issue risky securities in order to pay off loans.

A universal bank could also abuse confidential information supplied by a company issuing securities as well. One area of the new GLB Act that has

received significant attention is that of privacy protection

Formation and development of the European Community (EC) will provide new opportunities for U.S. Banks.

By abolishing trade restrictions, the EC exposes European banks to outside competition.

In order to increase their competitive advantage, many banks are looking into merging with banks from other countries.

Today, most of Europe uses a unified currency, the Euro.

Organizational structures in international markets

Head office International divisions or departments are

operated as a part of the head office's organizational structure, with the division managers reporting to senior management (supervisory function).

Representative office International office which does not conduct

normal banking business but simply represents the corporation, with the purpose of promoting the corporation's name and developing business to be funneled to the home office (exploratory function).

Foreign offices

Foreign branch A legal part of the home bank which is subject

to the laws and regulations of the host nation Shell office

Does not conduct business with local individuals; serves as a conduit for Eurodollar activities that originate in the head office

Full-service branch Performs all the activities of domestic banks

Foreign Subsidiary Foreign banks or non-bank corporations

acquired by domestic commercial banks or bank holding companies; distinct from the parent bank and performs the same functions as the domestic banks

Edge act and agreement corporations

Edge Act corporations: Domestic subsidiaries of banks chartered by

the Federal Reserve which may be established by U.S. or foreign banks and are limited to activities involving foreign customers.

Agreement corporations: State-chartered equivalents of Edge Act

Corporations.

International banking facilities

Subparts of banks that are created to conduct international business without the cost and effort of avoiding regulatory requirements through shell units.

Exist as a set of accounting entries on the books of the parent company.

Export trading companies

Companies that are acquired by banks and are organized and operated principally for purposes of exporting goods and services produced in the U.S. by unaffiliated persons.

Agencies of foreign banks

Parts of foreign banks that can offer only a limited range of banking services (cannot accept transactions deposits from U.S. residents or issue CDs) with the primary purpose of financing trade originating from firms in their own country.

International financial markets

International markets have evolved to facilitate funds flow in international exchange of goods and services and to reduce the risk of doing business outside the home country.

The Eurocurrency market

Eurocurrency: A deposit liability in any currency except that

of the country in which the bank is located. Eurobank:

Bank that issues Eurocurrency claims.

Eurodollars

Arise when a Eurobank accepting the deposit receives a dollar claim on the U.S. bank from which the funds were transferred.

Eurobanks will redeposit the Eurodollar proceeds in another bank until the funds are given out as a loan by one of the banks.

The initial Eurodollar deposit is accepted at the base rate called LIBOR (London Interbank Offer Rate).

Each redeposit and the final loan will then be priced at a markup over LIBOR.

The Eurobond market

Bonds issued in the international Euromarket, underwritten by an international banking syndicate, not subject to any one country's securities laws, and denominated in any major national currency.

Floating-rate Note: Issued in denominations as low as $5,000 with

maturities ranging from two to five years, carrying interest rates that vary with LIBOR.

Eurocredits…term loans priced at a premium over LIBOR, with the rate floating every three or six months in most cases, thereby reducing the mismatch between asset and liability maturities

Eurocredits are created to overcome interest rate risk.

International lending

International operations generate a considerable portion of earnings for money center banks Citigroup earns about two-thirds of their

earnings globally. International lending, however, carries risks

not associated with domestic lending Country risk

…default risk associated with loans to borrowers outside the home country

Foreign exchange risk …the current and potential volatility in earnings and stockholders’ equity due to changes in foreign exchange rates.

Short-term foreign trade financing…international trade and international trade financing are considerably more complex than simply dealing with trading partners within the same country

To facilitate trade, someone must enter the transaction and assume the risk that the importer may not pay.

Commercial banks fulfill this role through bankers acceptance financing.

Trading partners must also have the opportunity to convert one currency into another, which creates a demand for foreign exchange services as well.

Bankers acceptance…A time draft that represents a guarantee under which the accepting bank agrees to remit the face value of the draft at maturity. Acceptances are attractive because a bank substitutes

its credit rating for that of the importer.

Bankers Acceptance financing of U.S. Imports…a bankers acceptance is created, discounted, sold, and paid at maturity

Direct international loans…originate from international departments of domestic banks, Edge Act corporations, credit offices of foreign branches and subsidiaries.

Credit extended to less-developed countries (LDCs) has exhibited a poor repayment history and many of the banks have chosen to withdraw from lending to these countries after a large number of default incidents that took place in the 1980s.

Banks prefer to have foreign exposure in the form of equity investments rather than long-term, constantly renegotiated loans to foreign central banks.

Credit analysis of foreign loans

Credit analysis for international loans follow the same procedures adopted frequently for domestic loans: evaluation of the required loan amount, use of proceeds, source and timing of expected payment, availability of secondary collateral

sources.

Foreign exchange activities

Because different countries use different monetary units, traders must be able to convert one unit into another.

Foreign exchange markets are where these monetary units are traded. Foreign exchange

…currency other than the monetary unit of the home country

Exchange rate…the price of one currency in terms of another currency.

Risks unique to international lending:

Foreign exchange risk…the current and potential risk to earnings and stockholders’ equity arising from changes in foreign exchange rates

Country risk …default risk associated with loans to borrowers outside the home country

Economic risks …quantifiable economic and business risks (mostly examined under regular credit analysis).

Political (sovereign) risks …the likelihood that foreign governments will unilaterally alter their debt service payments, regardless of the formal repayment schedule

Foreign Exchange: …currency other than the monetary unit of the home country

Exchange Rate…price of one currency in terms of another currency.

Spot Market:…market for exchange of currencies for immediate delivery.

Forward Market…market for transactions that represent a commitment to exchange currencies at a specified time in the future at an exchange rate determined at the time the contract is signed.

Foreign exchange risk …current and potential risk to earnings and stockholder’s equity arising from changes in foreign exchange rates

Found when changing exchange rates affect a bank’s cash inflows differently than cash outflows associated with positions denominated in different currencies

Changes in values of foreign currency positions (buying and selling foreign currencies for their own account) due to changing foreign exchange rates is price risk

Example: Foreign exchange risk

Commerce Bank’s (CB) home country is Poland and home currency is the zloty. 1. current (spot) exchange rate is $1 = 150 zlotys. 2. Commerce Bank:

1. $1,000 in loans2. $250 in liabilities denominated in U.S. dollars3. assets are worth 150,000 zlotys4. liabilities are worth 37,500 zlotys at the

prevailing exchange rate. If the exchange rate moved to $1 = 160 zlotys,

1. assets increase in value by 10,000 zlotys,2. liabilities increase by 2,500 zlotys. 3. the bank’s equity would rise by 7,500 zlotys.

Example (continued): Foreign exchange risk

If the exchange rate moved to $1 = 140 zlotys, 1. assets decrease in value by 10,000 zlotys, 2. liabilities decrease by 2,500 zlotys3. the bank’s would see stockholders’ equity

decrease by 7,500 zlotys These same exposures exist for off-balance

sheet commitments and guarantees when counterparties effect the at risk transactions or activities.

Managing foreign exchange rate risk

A bank’s risk managers analyze aggregate foreign exchange risk by currency.

A bank’s net balance sheet exposure in currency j (NEXPj) is the amount of assets minus the amount of liabilities denominated in currency j: NEXPj = Aj – Lj

whereAj = assets denominated in currency j,Lj = liabilities denominated in currency j.

If NEXPj > 0, the bank is long on currency j and if NEXPj < 0, the bank is short currency j.

Gain/Loss in a position

The bank will lose if: it is long a currency (NEXPj > 0) and the

currency depreciates in value (the currency buys less of another currency).

if it is short a currency (NEXPj < 0) and the currency appreciates in value (the currency buys more of another currency).

The gain/loss in a position with a currency is indicated by: Gain/Loss in a Position With Currency j

= NEXPj x [spot exchange rate at time t – spot exchange rate at time t-1]

Example: gain/loss in a position

Current (spot) exchange rate is $1 = 150 zlotys.

Commerce Bank’s (CB) would lose if long U.S. dollars

the dollar depreciates as indicated by a movement in the exchange rate to $1 = 140 zlotys.

Loss = [1,000 - 250] x [140 - 150] = -7,500 zlotys

CB would gain if the dollar appreciates as indicated by a

exchange rate change to $1 = 160 zlotys.

Example: forward markets

A bank commits to buy 1 million yen, 90 days forward for $9804. This means that after 90 days, the bank pays

$9804 and receives 1 million yen, regardless of movements in exchange rates during the 90-day period.

Forward markets: forward premium.

Forward premium …the forward price of a currency is higher than its spot price, the foreign currency is priced at a premium.

Example: a bank agrees to buy 1 million yen 90 days

forward for 102 yens per dollar. If the spot rate is 105 yens per dollar, the yen

is priced at a forward premium against the dollar.

Forward markets: forward discount.

Forward discount …the forward price of a currency is lower than its spot price, the foreign currency is priced at a discount.

Example: a bank agrees to buy 1 million yen 90 days

forward for 102 yens per dollar. if the spot rate is 100 yens per dollar, the yen

is priced at a forward discount against the dollar.

Relationship between foreign exchange rates and interest rates.

Arbitrage transactions between countries guarantee that interest rate changes produce changes in foreign exchange rates, and vice versa.

If the interest rate differential between securities in two countries falls out of line with the spot-to-forward exchange rate differential, a covered interest arbitrage will take place and investors will make net profits from the series of transactions.

Continuing arbitrage will go on until prices move back into line to eliminate the riskless return from covered interest arbitrage.

Covered interest arbitrage 2. Convert dollars to francs at $1 = 1.7 francs 3. Invest in Swiss securities yielding 10%

000,000,1$0.091

$1,009,000

francs million 1.7(1.7)0.091

$1,090,000

$1,121,776(1.667)

)(1.7)(1.100.091

$1,090,000

francs million 1.87)(1.7)(1.100.091

$1,090,000

1. Borrow dollars at 9% 4. Sell francs for dollars 1 year forward at $1 = 1.667 francs Sample Transaction: Borrow $1,000,000 1. Borrow $1,000,000 at 9%; agree to repay $1,090,000 in one year. 2. Convert $1,000,000 to 1.7 million francs in spot market at $1 = 1.7 francs. 3. Invest 1.7 million francs in 1-year security yielding 10%; will receive 1.87 million francs after 1 year. 4. Sell 1.87 million francs 1 year forward for $1,121,776 at $1 = 1.667 francs. Net profit = $1,121,776 - $1,090,000 = $ 31,776

Foreign exchange rates and interest rates

Covered interest arbitrage …exists when the interest rate differential between securities in two countries is out of line with the spot-to-forward exchange rate differential.

Interest rate parity…exist when covered interest arbitrage profit potential is eliminated.

Interest rate parity implies:

Wherei1: Annual interest rate in Country 1.i2: Annual interest rate in Country 2. s1,2: Spot exchange rate equal to the number of units

of Country 2's currency for one unit of Country 1's currency.

f1,2: One-year forward exchange rate equal to the number of units of Country 2's currency for one unit of Country 1's currency.

1,2

1,21,2

1

12

1,2

1,2

1

2

s

sf

i1

ii

or

1,f

s

i1

i1

The interest rate parity equilibrium condition suggests that:

The forward exchange rate differential, as a fraction of the spot rate, should equal the interest rate differential relative to 1 plus an interest factor to eliminate arbitrage profits.

Example: i1 is 9%, i2 is 10%, and s1,2 is 1.7 as in the previous example, then f1,2 should be equal to 1.7156:

1.7

1.7f

0.091

0.090.10 1,2

GLOBAL BANKING ACTIVITIES

Chapter 21

Bank ManagementBank Management, 5th edition.5th edition.Timothy W. Koch and S. Scott MacDonaldTimothy W. Koch and S. Scott MacDonaldCopyright © 2003 by South-Western, a division of Thomson Learning