International Banking Final PDF

Financial intermediaries and market roles: to provide a mechanism where funds are transferred and allocated to productive opportunities Financial system: a set of institutions that permit exchange of funds - Firm, regional, and global levels - Banks, insurance companies, stock exchanges Fina...

Financial intermediaries and market roles: to provide a mechanism where funds are transferred and allocated to productive opportunities Financial system: a set of institutions that permit exchange of funds - Firm, regional, and global levels - Banks, insurance companies, stock exchanges Financial sectors: help money move from savers to prospective buyers - To pay for college, to buy a house, etc. Financial markets: negotiate loans, fund projects, investments, pursue return on assets - Borrowers -- deficit units, financial liabilities, prefer long term and lowest cost (interest rate) - Lenders -- surplus units, risk of default and assets drop in value, aim to minimize cost, prefer high liquidity, short term-high return preference - Investors Without borrowing there would be less developed economies, businesses would be unable to raise funds, they would be unable to invest in equipment and new production plants, they would be unable to own a home, and there would be political instability Direct finance funds from lender/save to borrowers/investors Indirect finance: funds from lender/saver to financial intermediaries, to borrower/investor. - Financial intermediaries are a major source of funds for corporations Types of markets: - Stock markets: where shares are traded - Bond markets: where government or other bonds are traded - Currency market: currencies are bought and sold - Commodity markets: ai, metal, agriculture, or electricity are traded - Futures and option markets: derivatives or objects on present notes are traded Financial markets importance: - Allow funds to transfer - Effectively allocate resources - Improve economic welfare - Increase return and profit on investment - Set firm value - Buy and sell risk Global financial systems: - Regulated entities / international banks and insurance - Regulators - Supervisors - Institutions Evolution of global financial systems: - Gold standard - WWI -- Britian and Germany were in debt and borrowing - Great Depression -- decline in international trade and high tariff rates - WWII -- disruption in global trade - Bretton Woods Conference -- Created IMF and World Bank - International intuitions: - IMF: international balance of member states, lender of last resort - World bank: for developing countries, provides fundings, credit risk, offer favorable terms - Dollar -- proclaimed main reserve currency - GATT -- reduced barriers and integration Financial Institutions: - Depository institutions: banks, credit unions, savings, and loan associations - Accepts (issues) deposits which becomes liabilities (funds) - Makes loans and they become their assets - Insurance companies: collect premiums (payments) from policy holders and pay compensation in case of fire, theft, sickness, etc. - Pension funds: collect from current workers and pay to retired workers - Insurance companies invest in the contributions of securities and real estate becomes their assets - Finance companies: use people's savings to make loans. By selling bonds and commercial paper they raise cash - Security firms: provide access to financial markets - Investment banks - Government sponsored enterprises: - Mortgage and student loans - Loans for farmers and home buyers - Social insurance programs Private institutions: commercial banks, pension, and hedge funds Regional institutions: Eurozone, NAFTA Financial claims: money, deposit accounts, bonds, shares, loans, life insurance Financial intermediaries: minimize direct lending costs and transaction costs (obtaining info, searching, negotiating and monitoring costs) Banks: payment services (organized arrangement for transferring value), deposit/lending, investment, pensions, or insurance, e-banking - provide loans to borrowers and savers - improved allocation of resources - receive interest on loans - makes profit on rate paid for deposits and rate received from borrowers - source of funding is deposits and interest rates - profit from high interest rates - funding goes to loans, investments and fixed assets - difference between assets and liabilities is bank capital/equity - can raise funds with bonds, equity/shares, and retained earnings - Roles: - Size transfer: collect small deposits from savers and transform them into larger loans - Maturity transfer: take funds for short time and transform into medium- or long-term loans -- liquidity risk - Risk transformation: minimize individual risk and diversity into investments or capital for buffer or unexpected losses Bank assets: income earning assets (85%) loans and securities - Must maintain portion of fund sources (liabilities) - As noninterest earning reservices: coins + currency, deposit balance at central bank Examples: - Checks: debit transfers, written requests, debit the creditors account - Credit transfers: customer tells bank to transfer funds to beneficiary's bank account - Standing orders: customer tells bank to pay fixed amount at regular intervals - Direct debits: supplier requires customer to pau regular foxed amounts over time after providing good/service - Plastic cards: not payment methods, to identify customer and create payment - Credit cards: pre-arranged credit limits, attracts interest if not paid off in time - Debit cards: issued by bank, withdraw direct from account obtain cash from ATM - Check guarantee cards: needs identification and details of card on check for guaranteeing payment - Travel and entertainment cards: business related expenses, repayment at end of month, no interest-free credit Deposit and lending services: - Current/checking account: no/low interest mainly for payments - Time/savings account: for a period of time predetermined or variable interest - Consumer loans/mortgages: banks to retail customers, no collateral, short-medium time frame Investment, pension, and insurance services: - Investment products: company stocks or savings bonds, mutual funds, gold, overlap with savings products - Pension and insurance protects policy holders from adverse events, provides retirement income, offered via bank distinguishable from public state pension - E- banking: e-money digital alternative to cash, remote payments Asymmetric information risks: - Generates adverse selection - One party has relevant info the other doesn't have - Financial intermediaries reduce the problem - Reduces moral hazard -- when one party has superior info and uses it against the other - Not everyone has the same inform - Do not have perfect info - Some have 'inside' info - To limit asymmetry: credit checking and scoring proves good risk and no history of debt or unpaid loans Economic imbalances: imports are greater than exports Global imbalances: more assets than other countries Economic interdependence: happens due to specialization Rate of retention: how much credit can be created out of original deposit Credit multiplier: ratio of change in deposits to change in level of deposits Central bank: controls amount of money circulating - Buys and sells government bonds in open markets - Increase or decreases reserve to modify credit multiplier - Interest rate control (foreign exchange) Open market operations: central bank buy or sells securities - Influences money supply - Fed uses to manipulate interest loans - Buying/selling securities, add/take money, lower/raise rates, loans easier/harder to obtain, increase/decrease economic activity Reserve requirements: number of funds a bank holds in reserve - To increase or decrease money supply and influence interest rates Interest rates: impact amount a bank loans, Central Bank may change or require collateral - High interest rates reflect greater economic growth, FED raises rates to slow expansion, stronger economy means more consumers seek loans Deregulation: removing controls that protect financial institutions or liberalization of financial markets - Used to improve competition of sector - Effects: - Loosening banking lows and advance tech encouraged consolidation process - New tech intensified competition and improved ability to adjust prices and terms - Barriers between bank and nonbank institutions disappeared leads to rise in universal banking activity Reregulation: implementing new rules, restrictions or controls, to minimize adverse effects with excessive competition from deregulation Financial innovation: creating and popularizing new financial instruments and tech to differentiate their product and services - New business processed, increased efficiency, market expansion - New credit, deposit, insurance, leasing Commercial banks: take deposits, checking and debit services, provide business, CD's, and savings accounts, earn profits on a 'spread' - Provides personal and mortgage loans and earns income from interest - Largest and most common bank, oldest and most diversified - Key operators in retail banking - Bank- creditor, public- debtor - Income: earned by spread between paid interest on deposits and interest earned on loans = net income - NI = Il -- Id - Assets= liabilities + capital - Assets= loans, securities, earning assets, cash - Liabilities = owes, deposits - Capital = net worth, difference between assets and liabilities - Capital: - Bank capital: financial cushion, protects from risk - Common stock -- corporate equity ownership, the stockholder can share in profits of company, can vote - Preferred stock -- share capital, properties of equity and debt instruments, hybrid instrument - Retained earnings -- cumulative net earnings or profits after paying dividends - Cumulative income or loss -- unrealized gains and losses reported in equity on balance sheet - Management: - Liquidity, liability, capital management - Strive to earn solid profits - Maintain low exposure - Maintain high liquidity -- liquid assets like treasury bills - Liquidity management: banks to make profitable loans they would turndown otherwise, very risky, bank assets have longer maturities than liabilities - If interest rates quickly rise, banks could suffer - Withdrawals are high and bank is unable to meet liabilities - Liabilities: high cash withdrawals cause solvent banks to have liquidity issues - Assets: high loan defaults customers unexpectedly draw lines of credit - To avoid problems bank can hold liquid assets, the more liquid the asset the lower rate of return, bank could be more profitable with less liquid funds - liquidity risk tradeoff = high liquidity -- low risk -- low return - Liquidity indicators: - loans/assets = high ratio -- low liquidity - securities/assets = high ratio -- high liquidity - demand deposits/total deposits = high ratio -- bank need to maintain more liquidity - Liquidity GAP = Net liquid assets -- volatile liabilities Cash assets: - Vault cash: coins and currency, meet publics demand and reserves required - Deposits with FED: meet reserves required and checks - Deposits with other banks: correspondent banking-smaller banks maintain deposits in larger banks in return for services - Ie, check collection, investment counsel, transaction in foreign currency Investment banks: help set up IPO's, debt financings, negotiate mergers and acquisitions, facilitate corporate reorganization - Acts as a broker or advisor - Helps to raise funds through issue of stock or debt (bonds) - To finance growth by borrowing - Investors- creditor, company-debtor - Income from fees charged for providing services International Banks: national borders and different currencies - Traditional foreign banking: nonresidents in domestic currency - Eurocurrency banking: wholesale foreign exchange transactions with residents and non-residents Depository Institutions: channel funds from savers to borrowers CB Liabilities: - Transaction deposits: a bank deposit with dull and immediate liquidity, no delays and waiting, ex) checking account - Non transaction deposits: cannot be withdrawn or transferred with checks, telephone, or transfers - Time/term deposits: guaranteed interest rate locked amount of time - Savings deposits: interest paid on money in account access to money when needed - Non borrowing deposits: - Borrowing from CB: discount loans and window interest at discount rate - Borrowing from other banks' excess reserve: overnight loans between banks pay interest at federal fund rate Discount window: central bank lending to help commercial banks manage short-term liquidity - Refer to FED interest rate, for short term loans or future cash flows in discounted cash flow analysis Discount loan: lender discounts interest and charges before giving to borrower. Borrower pays back whole amount (principal) and charges+interest Overnight loan: loan bank makes to another bank in a short amount of time Real estate loans: collateral property, mortgage, securitization bundles loans into packages Business loans: regular installment loans, lines of credit -- compensating balance Auto loans: installment loans, secured by value of vehicle Overdraft: allows customers to withdraw even with no funds Market securities: unrestricted financial instrument brought or sold on public stock exchange or bond exchange When finding good lending opportunities: - 'buy' federal funds - Issue negotiable CD's - Certificated of deposits = CD's - Guaranteed, cannot be redeemed before maturation date - Sold in highly liquid secondary markets - Low risk -- low interest security - Issue repurchases agreements or bonds - Short term to sell securities, to buy them back at a higher price - Borrow Eurodollars - USD denominated deposits overseas, not regulated by the FED, higher interest rates - Obtain funds through commercial paper market - CP's are unsecured, short term debt instruments issued by corporation to finance accounts payable, inventories, and meeting short term liabilities Risk: quantity and quality of risk/likelihood of default difficult to quantify due to diversification Default risk: borrowers don't repay loans Interest rate risk: changes in interest rate, mismatching maturities of assets and liabilities. To measure use: - GAP Analysis: best technique, difference between interest rate sensitive assets and liabilities over a time period. Rate sensitive if cash from asset or liability changes with the interest rate. GAP = RSAssets - RSLiabilties - Duration Analysis: average life of an asset's cash flow rather than maturity Liquidity risk: depositor withdraw funds Foreign exchange risk: exchange rates change Market risk: adverse movements in level or volatility of market prices of interest rate instruments, equities, commodities, or currencies - Increase in asset trading creates a need for management systems Country risk: funds or assets in foreign country cannot be mobilized to home country Management risk: employee activities Credit risk: borrower fails to meet terms, difficult to quantify, loans are largest source - Could arise from: individual creditors, transactions or risk in portfolio - Ex) transactions, trades, bonds, settlements, guarantees, foreign exchange transactions Retail lending: accurate credit decision - Maximize loan value, minimize default risk - Assess risk-return tradeoff of a loan Pricing a loan: profitable loan rate = risk free rate/ profitability of default Interest rate charged on a loan: promised return on loan = base lending rate + market premium / balance requirement times negative reserve requirement Impacts on loans expected return: - Interest rate - Fees - Credit risk premium - Collateral backing - Non-price terms (conditions and clauses) Loan portfolio: - Diversify -- different economy sectors, geographic locations, industries, maturities - Reduces impact of failure through unsystematic risk Risk Adjusted Return on Capital = Revenues -- costs -- losses / total equity capital - Asses where to allocate more capital Value at Risk = market value x price movement x pm per \$1 - Principal portfolio measure of market risk - Potential loss on portfolio from market movements Historical method- worst to best historical returns Variance -- Covariations method -- assumes stock return has mean of 0, estimate of expected return and standard deviation VaR= normal distribution x standard deviation Summery: Commercial banks raise funds through deposit and use funds to grant loans Banks earn interest rate spread on deposit and loan rates, earning service fees too If banks low on reserve, borrows from FED at discount rate or borrow from bank at RED rate Loans are most income earning asset Banks must hold non-interest earning legal reserves like currency and deposit at FED Smaller banks maintain deposits in larger banks in returns for service Banks bundle real estate loans into packages and issue securities based on these packages to investors -- securitization Banks become insolvent if: total assets are less than total liability or negative net worth Low liquidity = high risk = higher return Aggressive liability management = dangerous - Banks assets usually have longer maturities than liabilities - If interest rates rise, banks can suffer Capital is cushion -- protection from insolvency - High bank capital ratio -- lower insolvency risk -- lower rate of return Simplified Financial intermediaries/market role: mechanisms where funds are transferred and allocated to their most productive opportunities Well-functioning financial sector is necessary for a well-functioning economy Financial intermediaries are major sources of funds for companies Financial markets: stocks, bonds, currency, commodity, future, options - Transfers funds, productive allocation, improves economic welfare, increase return on investment, buy and sells risk Financial institutions: depository, insurance, pension funds, finance companies, security firms, government sponsored entities Banks = borrowers, deficit units Lenders = surplus units Financial claims: in the form of any financial assets, money, bonds, loans, etc. Lender requirements: low risk and low cost, high return and liquidity, short term Borrower requirements: long term, lowest cost Roles of banks: size, maturity and risk transformations Asymmetric information: not the same or perfect information, one side may have inside information Adverse selection: one party has information the other doesn't Moral hazard: one party has superior information M0= notes, coins, e-deposits M1= M0 + checkable deposits M2= M1 + money market, savings accounts, time deposits M3 = M2 + repos, money market funds, bonds under 2 years Deposits have shorter maturity than loans Net interest income line = Iliabilities - Ideposits, size of spread shows profitability Credit multiplier: used by central bank to control amount of money circulating, change in deposits to change in reserves Central bank raises money through open markets, reserves, and interest rates Open market mechanism: buy and sell government bonds to meet liabilities incase of withdrawals Reserve requirements: amount of money a bank holds to meet liabilities incase of withdrawals Main source of funds for banks is customer deposits - Raise funds by issuing bonds and equity, savings from past profits, and deposits - Banks collect deposits compared to other financial institutions Banking services: payment, deposits/lending, investment/pension/insurance, e-banking Commercial banks: take deposits, provide checking and debit account services, provide loans - Oldest and most diversified financial intermediary - Makes money from interest on loans - Creditor = bank, Debtor = public - Channels funds from savers to borrowers - Assets: what the bank owns, loans, securities, cash assets, earning assets - Liabilities: what the bank owes, deposits, checking and cash, non-deposits: bonds, FED funds - Capital: assets-liabilities=net worth, common/preferred stock, retained earnings, APIC, OCI. Strive to earn profits, maintain low exposure, high liquidity, protects bank from insolvency (cushion) International banking activities: foreign and eurocurrency - Domestic/foreign banks with foreign/domestic residence/currency - Eurocurrency: deposit with bank outside the country in which the currency is dominated - Currency: interest rates higher, rates on loans lower - SWIFT: society for worldwide interbank financial telecommunication, safe and secure transactions, unique ID codes Interbank market: where major banks trade and manage exchange and interest rate risks, private banks mostly, not regulated Spot market: currencies for immediate trade- 2 days Forward market: currencies for future trade- 30,90,180 days Euro bonds: bonds issued in not domestic currency helps organizations raise capital Liquid asset = treasury bills Liquidity tradeoff: - High liquidity has low risk and low return - Low liquidity has high risk and high return Indicators: - Loans/assets = high ratio = low liquidity - Securities/deposits = high ratio = high liquidity - Demand deposits/total deposits = high ratio = bank needs more liquidity Risk types: credit, interest rate, currency, liquidity, market Credit risk: borrower fails to meet obligations (loans) - Strategies: diversification, credit check and scoring, collateral Interest rate risk: mismatch of assets and liability maturities - Measured by GAP analysis and duration analysis (life of cash flows) Liquidity risk: lack of confidence/unexpected need for cash - Bank cannot meet liabilities -- high cash withdrawals or high loan defaults - Risk management -- hold more profitable liquid assets, make more profitable loans Market risk: adverse movement of market prices - Risk management -- RAROC (what needs more capital), UAR (potential loss on portfolio), historical/variance method Loans: most income earning assets If a company hurt their reputation, how would it impact there balance sheet Final Portion Issues in banking: - Investment and financing decision are vital to planning process - Can be measured in sales and profits - Goal to manage assets and liabiltiies, and to maximize profits - Concerns: - Assets -- low risk and diversification - Libailties -- lowest cost possible - OBS -- control exposures Asset liabiltiiy management ALM -- manage assets well while maximizing retunrs on loans and securities - To diversity - Trade off between profit and liquidity - Minimize interest paid on deposits Off Balance Sheet OBS -- fee based business, swaps, foreign exchange, credit, options - Control exposue from OBS transcations - Risk encurred from activities [Financial futures]: contracts to deliver and pay for asset at specific date or price - Usually on t-bonds, CD's, or currencies [Forward contracts]: agreement to exhcnage asset at specific day and price - Highly liquid, private, and non-standard - Paid at maturity - Risk of default [Future contacts]: traded on organized markets, highly liquid, purchase offset by sale - Clearing house -- cash deposit against transaction called intial margin - Margin call -- deposits paid to loosing party daily if losses occur [Options contracts]: the right to buy and sell securities at a set price - Options are standard, can be OTC or exchange traded [Swaps]: agreement to exchange two different forms of payment obligations - Interest rate and currency swaps - To reduce borrowing cost Regulations: setting rules firms abide by - To prevent: - Bank run - Bank contagion -- one fails, rest fail, markets are interconnected - Systematic risk - Safety nets, lender of last resort (CB responsibility) - To ensure stability - Contract -- reduce bad advice, insolvency, and fraud Safety and Soundness regulation - Protection to balance profits to risk - Diversify assets, monitor and survail, guarentee funds, hold capital, - Insurance funds Monetary policy regulation - Minimum required cash held against deposits - CB's require reserves for fincancial intermediation Credit allocation regulation - Support sectors like housing and farming - To hold minimum amount of assets or set rates - Qualified thift lender QTL -- banks to hold 65% of assets in mortgages Investor protection regulation - Protection for investors from insider trading, lack of discloseur Entry and chartering regulation - Change of cost of entry into financial sectors affect firms already in the industry profitability CFPB Consumer financial protection bureau -- protection for consumers from unfair practices Regulators: FED, SEC, OCC Product segmentation: - Commercial banking -- deposit taking and lending - Investment banking -- underwriting, issuing, and distributing European banking authority -- integreity, transparency, stabilization, quality, protection, supervision European Central Bank -- ensures banks follow rules from EBA Capital adequacy -- ensures enough capiutal and liquid assets to fulfil obligations when risks are realized - 8% capital ratio Basel I -- risk based capital ration Basel II -- options for credit and operational risk Basel 2.5 -- updated capital requirements on market risk Basel III -- quality, consistency, transparency, higher capital requirements, capital standard measurable Financial crisis -- asset value decline, debts unpayable, liquidity shortage - Panic and bank run - Tulip mania -- asset bubble and crash of tulips - Credit crash of 1772 -- expanding credit led to bank runs Stages: 1. Asset decrease in value and debt increase 2. Financial system fails 3. Breakdown, unable to meet obligations Bubble: rapid escalation of asset prices followed by decrease and crash - Displacement -- new products and low interest rates, anything which gets attention - Boom -- prices rise and people buy assets - Eurphoria -- price skyrockets - Profit taking -- start to sell of with warning of burst - Panic -- drop, supply is greater than demand Governemnt response: lower interest rates, buy back debt and mortgages, bail out companies Vlocker: restricts how banks invest their money Interest rate: amount charged on principal for asset use Bonds: fixed income instrument loan - Unit of corporate debt - Price is inversely coorelated to interest rate - Face valye is how much a bond is worth at maturity - Coupon rate is the interest as a percent paid on face value - Coupon date is when interest payments occur - Lower returns than stocks, can default - Issue of debt securities Corporate bonds: - Issued by company, offer lower interest rates and favorable terms - Issued to raise capital - Investment grade or high yield Municipal bonds: - Issued by states and municipalities Government bonds: - Issued by the government to support government spending - Low risk and low interest - Sold at a discount - Interest payments - Less than 1 year = bill - 1-10 years = note - Greater than 10 years = bond Zero coupon bond: no coupon payments and issued at discount to their par value Convertible bonds: convert debt to equity Callable bondas: called back before maturity to the company Puttable bonds: sold back to company before matuiryt Yeild curves: interest rate compare to maturities, norma, inverted, and flat curves Primary market: new issued Secondary market: already sold in market before, resold at a later date Equity market: shares are issued and traded from primary market to secondard market - Companies get capital - Savers get to invest - Sold in stock exchange and over the counter Initial public offering IPO: offering shares of private corporation to the public, can be considered an exit strategy for investors - Steps: - Proposal, underwrite (agreements), team, documentation, \[board, processing, reporting\], shared issues (recorded as stakeholders equity on balance sheet) Special prupose acquisition company SPAC: - To raise money through IPO to buy another company - They have two years or finds are returned to investors - Takes months compared to IPO which takes 6-12 months - Able to negotiate - Lack of discloseur and regulation Mutual funds: investment vehicle of stocks, bonds, and securities - Gives small investors or individuals access to portfolios at a low price Hedge funds: alternative investments using risky/nontraditional strategies - High fee and high deposits Private equity: investment in non public company usually high net worth individuals SWIFT: assigns members unique ID codes and allows for payments across banks Interbank market: whole sale market where banks trade with each other - Currency exchange mainly - Foreign exchange market - Manage exchange and interest rate risk - Not regulated - Mainly private banks Spot market: immediate currency trade delivery Forward market: future delivery currency exchange Eurocurrency market: transactions with nonresidents or foreign currencies - Short term loans and deposits in foreign currencies - USD in British Bank - Interest rate is usually higher - Rates are lower on eurocurrency loans LIBOR -- Lond Inter Bank Offer Rate: - Average interest rate global banks borrow from each other at EurIBO -- Euro - Average interest rate where eurozone banks offer short term lending Eurobond - Currency other than the one issued in - Help raise capital - Bond issued outside of borders of currencies home country Foreign bond - UK firm issuing bond in USD - Denominated in currency of country receiving bond European centers: 60% of eurocurrency market Outside developed countries : 20% of global market North American and Japan alone are 20%