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International Banking System and Global Money Flows Sukumar Nandi Indian Institute of Management Lucknow

Money and currency are very strange things. They keep going up and down and no one knows why. You want to win but you lose no matter how hard you try. [ Abbot Gilles de Muises of Tourani ]

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 longstanding 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

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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 r 1 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 present-day 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 country-borders 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 1940-1960 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 petro-dollars 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 non-bank sectors. To understand the causative factors properly the literature has attempted to identify the factors supporting the internationalization of banking business. Thus factors like non-financial 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).

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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

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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 negativ