International Financial Management (Chapter 11) PDF

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This document is Chapter 11 of a textbook titled "International Financial Management." It covers various aspects of international banking, including international banking services, types of international banking offices, and the Eurocurrency market. Topics such as the international debt crisis and global financial crisis are also discussed.

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PART FOUR Page 305...

PART FOUR Page 305 OUTLINE 11 International Banking and Money Market 12 International Bond Market 13 International Equity Markets 14 Interest Rate and Currency Swaps Copyright © 2023. McGraw-Hill US Higher Ed ISE. All rights reserved. 15 International Portfolio Investment Page 306 World Financial Markets and Institutions PART FOUR PROVIDES a thorough discussion of international financial institutions, assets, and marketplaces, and develops the tools necessary to manage exchange rate uncertainty. CHAPTER 11 differentiates between international bank and domestic bank operations and examines the institutional differences of various types of international banking offices. International banks and their Eun, Cheol, et al. International Financial Management, McGraw-Hill US Higher Ed ISE, 2023. ProQuest Ebook Central, http://ebookcentral.proquest.com/lib/wuww/detail.action?docID=7235286. Created from wuww on 2024-10-15 19:36:56. clients constitute the Eurocurrency market and form the core of the international money market. CHAPTER 12 distinguishes between foreign bonds and Eurobonds, which together make up the international bond market. The advantages of sourcing funds from the international bond market as opposed to raising funds domestically are discussed. A discussion of the major types of international bonds is included in the chapter. CHAPTER 13 covers international equity markets. The chapter begins with a statistical documentation of the size of equity markets in both developed and developing countries. Various methods of trading equity shares in the secondary markets are discussed. Additionally, the chapter provides a discussion of the advantages to the firm of cross-listing equity shares in more than one country. CHAPTER 14 covers interest rate and currency swaps, useful tools for hedging long-term interest rate and currency risk. CHAPTER 15 covers international portfolio investment. It documents that the potential benefits from international diversification are available to all national investors. Copyright © 2023. McGraw-Hill US Higher Ed ISE. All rights reserved. Eun, Cheol, et al. International Financial Management, McGraw-Hill US Higher Ed ISE, 2023. ProQuest Ebook Central, http://ebookcentral.proquest.com/lib/wuww/detail.action?docID=7235286. Created from wuww on 2024-10-15 19:36:56. CHAPTER 11 International Banking and Money Market Page 307 Copyright © 2023. McGraw-Hill US Higher Ed ISE. All rights reserved. Eun, Cheol, et al. International Financial Management, McGraw-Hill US Higher Ed ISE, 2023. ProQuest Ebook Central, http://ebookcentral.proquest.com/lib/wuww/detail.action?docID=7235286. Created from wuww on 2024-10-15 19:36:56. CHAPTER OUTLINE International Banking Services The World’s Largest Banks Reasons for International Banking Types of International Banking Offices Correspondent Bank Representative Offices Foreign Branches Subsidiary and Affiliate Banks Edge Act Banks Offshore Banking Centers International Banking Facilities Capital Adequacy Standards International Money Market Eurocurrency Market Eurocredits Forward Rate Agreements Euronotes Eurocommercial Paper CME SOFR Futures Contracts International Debt Crisis The Problem Debt-for-Equity Swaps The Solution The Asian Crisis Global Financial Crisis The Credit Crunch Impact of the Financial Crisis Summary Copyright © 2023. McGraw-Hill US Higher Ed ISE. All rights reserved. Key Words Questions Problems Internet Exercises Mini Case: Detroit Motors’ Latin American Expansion References & Suggested Readings Appendix 11A: Eurocurrency Creation Appendix 11B: MBS, SIV, CDO, and CDS Eun, Cheol, et al. International Financial Management, McGraw-Hill US Higher Ed ISE, 2023. ProQuest Ebook Central, http://ebookcentral.proquest.com/lib/wuww/detail.action?docID=7235286. Created from wuww on 2024-10-15 19:36:56. WE BEGIN OUR discussion of world financial markets and institutions in this chapter, which takes up four major topics: international banking; international money market operations, in which banks are dominant players; the international debt crisis; and the global financial crisis. The chapter starts with a discussion of the services international banks provide to their clients. This is appropriate since international banks and domestic banks are characterized by different service mixes. Statistics that show the size and financial strength of the world’s largest international banks are presented next. The first part of the chapter concludes with a discussion of the different types of bank operations that encompass international banking. The second part begins with an analysis of the Eurocurrency market, the creation of Eurocurrency deposits by international banks, and the Eurocredit loans they make. These form the foundation of the international money market. Euronotes, Eurocommercial paper, and forward rate agreements are other important money market instruments that are discussed. The third part of the chapter offers a history of the severe international debt crisis of some years ago and the dangers of private bank lending to sovereign governments. The chapter concludes with a lengthy discussion of the recent global financial crisis. Copyright © 2023. McGraw-Hill US Higher Ed ISE. All rights reserved. Eun, Cheol, et al. International Financial Management, McGraw-Hill US Higher Ed ISE, 2023. ProQuest Ebook Central, http://ebookcentral.proquest.com/lib/wuww/detail.action?docID=7235286. Created from wuww on 2024-10-15 19:36:56. International Banking Services International banks can be characterized by the types of services they provide that distinguish them from domestic banks. Foremost, international banks facilitate the imports and exports of their clients by arranging trade financing. Additionally, they serve their clients by arranging for foreign exchange necessary to conduct cross-border transactions and make foreign investments. In conducting foreign exchange transactions, banks often assist their clients in hedging exchange rate risk in foreign currency receivables and payables through forward and options contracts. Since international banks have the facilities to trade foreign exchange, they generally also trade foreign exchange products for their own account. The major features that distinguish international banks from domestic banks are the types of Page 308 deposits they accept and the loans and investments they make. Large international banks both borrow and lend in the Eurocurrency market. Additionally, they are frequently members of international loan syndicates, participating with other international banks to lend large sums to MNCs needing project financing and sovereign governments needing funds for economic development. Moreover, depending on the regulations of the country in which it operates and its organizational type, an international bank may participate in the underwriting of Eurobonds and foreign bonds. Today banks are frequently structured as bank holding companies so that they can perform both traditional commercial banking functions, the subject of this chapter, and also engage in investment banking activities. International banks frequently provide consulting services and advice to their clients. Areas in which international banks typically have expertise are foreign exchange hedging strategies, interest rate and currency swap financing, and international cash management services. All these international banking services and operations are covered in depth in this and other chapters of the text. Not all international banks provide all services, however. Banks that do provide most of these services are commonly known as universal banks or full-service banks. The World’s Largest Banks Exhibit 11.1 lists the world’s 30 largest banks ranked by total assets. The exhibit shows total assets, net income, and market value in billions of U.S. dollars. The exhibit indicates that 9 of the world’s 30 Copyright © 2023. McGraw-Hill US Higher Ed ISE. All rights reserved. largest banks are from China, 5 are from the United States, 4 are from Canada, 2 each are from France, India, and Japan, and 1 each is from Australia, Brazil, Italy, Russia, Switzerland, and the United Kingdom. EXHIBIT 11.1 The World’s 30 Largest Banks (in billions of U.S. dollars, as of March 2021) Rank Bank Country Total Assets Net Income Market Value 1 ICBC China 4,914.7 45.8 249.5 2 China Construction Bank China 4,301.7 39.3 210.4 3 Agricultural Bank of China China 4,159.9 31.3 140.1 Eun, Cheol, et al. International Financial Management, McGraw-Hill US Higher Ed ISE, 2023. ProQuest Ebook Central, http://ebookcentral.proquest.com/lib/wuww/detail.action?docID=7235286. Created from wuww on 2024-10-15 19:36:56. Rank Bank Country Total Assets Net Income Market Value 4 Bank of China China 3,731.4 27.9 116.7 5 Mitsubishi UFJ Financial Japan 3,406.5 5.2 69.7 6 BNP Paribas France 3,044.8 7.6 79.1 7 HSBC Holdings United Kingdom 2,984.2 4.0 120.3 8 Bank of America United States 2,832.2 17.9 336.3 9 Credit Agricole France 2,399.5 2.6 41.0 10 Sumitomo Mitsui Financial Japan 2,256.8 4.9 48.9 11 Wells Fargo United States 1,959.5 7.4 181.5 12 Postal Savings Bank of China China 1,736.2 9.3 112.4 13 Bank of Communications China 1,635.8 11.1 47.9 14 TD Bank Group Canada 1,358.6 9.1 120.6 15 Royal Bank of Canada Canada 1,308.2 8.8 135.0 16 China Merchants Bank China 1,278.5 14.1 192.8 17 Intesa Sanpaolo Italy 1,226.7 3.7 53.3 18 Shanghai Pudong Development China 1,215.7 8.5 47.4 19 Industrial Bank China 1,207.2 9.7 66.5 20 UBS Switzerland 1,125.8 6.5 57.3 21 Bank of Nova Scotia Canada 911,2 5.1 75.3 22 Commonwealth Bank Australia 816.2 5.7 120.7 23 Bank of Montreal Canada 761.8 4.1 59.4 24 State Bank of India India 638.1 3.1 40.8 25 US Bancorp United States 553.4 6.1 86.9 26 Truist Bank United States 517.5 4.9 77.8 27 Sberbank Russia 486.9 10.4 85.7 28 PNC Financial Services United States 474.4 8.4 75.8 29 Itau Unibanco Holdings Brazil 389.7 3.7 48.5 30 HDFC Bank India 233.6 4.1 105.9 Source: Compiled from The Global 2000, www.forbes.com. From Exhibit 11.1, one might correctly surmise that the world’s major international Page 309 Copyright © 2023. McGraw-Hill US Higher Ed ISE. All rights reserved. finance centers are New York, Tokyo, Paris, and increasingly Toronto, Beijing, and Shanghai. London, New York, and Tokyo, however, have by far been the most important international finance centers because of the relatively liberal banking regulations of their respective countries, the size of their economies, and the importance of their currencies in international transactions. These three financial centers are frequently referred to as full-service centers because the major banks that operate in them usually provide a full range of services. However, because of Brexit and the associated lack of clarity concerning the future free movement of goods, services, and people across European Union member state borders, London’s importance appears diminished. Eun, Cheol, et al. International Financial Management, McGraw-Hill US Higher Ed ISE, 2023. ProQuest Ebook Central, http://ebookcentral.proquest.com/lib/wuww/detail.action?docID=7235286. Created from wuww on 2024-10-15 19:36:56. Reasons for International Banking The opening discussion on the services international banks provide implied some of the Page 310 reasons why a bank may establish multinational operations. Rugman and Kamath (1987) provide a more formal list: 1. Low marginal costs—Managerial and marketing knowledge developed at home can be used abroad with low marginal costs. 2. Knowledge advantage—The foreign bank subsidiary can draw on the parent bank’s knowledge of personal contacts and credit investigations for use in that foreign market. 3. Home country information services—Local firms may be able to obtain from a foreign subsidiary bank operating in their country more complete trade and financial market information about the subsidiary’s home country than they can obtain from their own domestic banks. 4. Prestige—Very large multinational banks have high perceived prestige, liquidity, and deposit safety that can be used to attract clients abroad. 5. Regulation advantage—Multinational banks are often not subject to the same regulations as domestic banks. There may be reduced need to publish adequate financial information, lack of required deposit insurance and reserve requirements on foreign currency deposits, and the absence of territorial restrictions. 6. Wholesale defensive strategy—Banks follow their multinational customers abroad to prevent the erosion of their clientele to foreign banks seeking to service the multinational’s foreign subsidiaries. 7. Retail defensive strategy—Multinational banking operations help a bank prevent the erosion of its tourist and foreign business markets from foreign bank competition. 8. Transaction costs—By maintaining foreign branches and foreign currency balances, banks may reduce transaction costs and foreign exchange risk on currency conversion if government controls can be circumvented. 9. Growth—Growth prospects in a home nation may be limited by a market largely saturated with the services offered by domestic banks. 10. Risk reduction—Greater stability of earnings is possible with international diversification. Offsetting business and monetary policy cycles across nations reduces the country-specific risk a bank faces if it operates in a single nation. Copyright © 2023. McGraw-Hill US Higher Ed ISE. All rights reserved. Eun, Cheol, et al. International Financial Management, McGraw-Hill US Higher Ed ISE, 2023. ProQuest Ebook Central, http://ebookcentral.proquest.com/lib/wuww/detail.action?docID=7235286. Created from wuww on 2024-10-15 19:36:56. Types of International Banking Offices The services and operations of international banks are a function of the regulatory Page 311 environment in which the bank operates and the type of banking facility established. Following is a discussion of the major types of international banking offices, detailing the purpose of each and the regulatory rationale for its existence. The discussion moves from correspondent bank relationships, through which minimal service can be provided to a bank’s customers, to a description of offices providing a fuller array of services, to those that have been established by regulatory change for the purpose of leveling the worldwide competitive playing field.1 Correspondent Bank The large banks in the world will generally have a correspondent relationship with other banks in all the major financial centers in which they do not have their own banking operation. A correspondent bank relationship is established when two banks maintain a correspondent bank account with one another. For example, a large New York bank will have a correspondent bank account in a London bank, and the London bank will maintain one with the New York bank. The correspondent banking system enables a bank’s MNC client to conduct business worldwide through his local bank or its contacts. Correspondent banking services center around foreign exchange conversions that arise through the international transactions the MNC makes. However, correspondent bank services also include assistance with trade financing, such as honoring letters of credit and accepting drafts drawn on the correspondent bank. Additionally, a MNC needing foreign local financing for one of its subsidiaries may rely on its local bank to provide it with a letter of introduction to the correspondent bank in the foreign country. The correspondent bank relationship is beneficial because a bank can service its MNC clients at a very low cost and without the need of having bank personnel physically located in many countries. A disadvantage is that the bank’s clients may not receive the level of service through the correspondent bank that they would if the bank had its own foreign facilities to service its clients. Representative Offices Copyright © 2023. McGraw-Hill US Higher Ed ISE. All rights reserved. A representative office is a small service facility staffed by parent bank personnel that is designed to assist MNC clients of the parent bank in dealings with the bank’s correspondents. It is a way for the parent bank to provide its MNC clients with a level of service greater than that provided through merely a correspondent relationship. The parent bank may open a representative office in a country in which it has many MNC clients or at least an important client. Representative offices also assist MNC clients with information about local business practices, economic information, and credit evaluation of the MNC’s foreign customers. Foreign Branches Eun, Cheol, et al. International Financial Management, McGraw-Hill US Higher Ed ISE, 2023. ProQuest Ebook Central, http://ebookcentral.proquest.com/lib/wuww/detail.action?docID=7235286. Created from wuww on 2024-10-15 19:36:56. A foreign branch bank operates like a local bank, but legally it is a part of the parent bank. As such, a branch bank is subject to both the banking regulations of its home country and the country in which it operates. U.S. branch banks in foreign countries are regulated from the United States by the Federal Reserve Act and Federal Reserve Regulation K: International Banking Operations, which covers most of the regulations relating to U.S. banks operating in foreign countries and foreign banks operating within the United States. There are several reasons a parent bank might establish a branch bank. The primary one is that the bank organization can provide a much fuller range of services for its MNC customers through a branch office than it can through a representative office. For example, branch bank loan limits are based on the capital of the parent bank, not the branch bank. Consequently, a branch bank will likely be able to extend a larger loan to a customer than a locally chartered subsidiary bank of the parent. Additionally, the books of a foreign branch are part of the parent bank’s books. Thus, a branch bank system allows customers much faster check clearing than does a correspondent bank network because the debit and credit procedure is managed internally within one organization. Another reason a U.S. parent bank may establish a foreign branch bank is to compete on a Page 312 local level with the banks of the host country. Branches of U.S. banks are not subject to U.S. reserve requirements on deposits and are not required to have Federal Deposit Insurance Corporation (FDIC) insurance on deposits. Consequently, branch banks are on the same competitive level as local banks in terms of their cost structure in making loans. Branch banking is the most popular way for U.S. banks to expand operations overseas. Most branch banks are in Europe, in particular the United Kingdom. Many branch banks are operated as “shell” branches in offshore banking centers, a topic covered later in this section. The most important piece of legislation affecting the operation of foreign banks in the United States is the International Banking Act of 1978 (IBA). In general, the act specifies that foreign branch banks operating in the United States must comply with U.S. banking regulations just like U.S. banks. In particular, the IBA specifies that foreign branch banks must meet the Fed reserve requirements on deposits and make FDIC insurance available for customer deposits. Subsidiary and Affiliate Banks A subsidiary bank is a locally incorporated bank that is either wholly owned or owned in major part by a foreign parent. An affiliate bank is one that is only partially owned but not controlled by its foreign Copyright © 2023. McGraw-Hill US Higher Ed ISE. All rights reserved. parent. Both subsidiary and affiliate banks operate under the banking laws of the country in which they are incorporated. U.S. parent banks find subsidiary and affiliate banking structures desirable because they are allowed to underwrite securities. Foreign-owned subsidiary banks in the United States tend to locate in the states that are major centers of financial activity, as do U.S. branches of foreign parent banks. In the United States, foreign bank offices tend to locate in the highly populous states of New York, California, Illinois, Florida, Georgia, and Texas.2 Edge Act Banks Eun, Cheol, et al. International Financial Management, McGraw-Hill US Higher Ed ISE, 2023. ProQuest Ebook Central, http://ebookcentral.proquest.com/lib/wuww/detail.action?docID=7235286. Created from wuww on 2024-10-15 19:36:56. Edge Act banks are federally chartered subsidiaries of U.S. banks that are physically located in the United States and are allowed to engage in a full range of international banking activities. Senator Walter E. Edge of New Jersey sponsored the 1919 amendment to Section 25 of the Federal Reserve Act to allow U.S. banks to be competitive with the services foreign banks could supply their customers. Federal Reserve Regulation K allows Edge Act banks to accept foreign deposits, extend trade credit, finance foreign projects abroad, trade foreign currencies, and engage in investment banking activities with U.S. citizens involving foreign securities. As such, Edge Act banks do not compete directly with the services provided by U.S. commercial banks. The IBA permits foreign banks operating in the United States to establish Edge Act banks. Thus, both U.S. and foreign Edge Act banks operate on an equally competitive basis. Edge Act banks are not prohibited from owning equity in business corporations, unlike domestic commercial banks. Thus, it is through the Edge Act that U.S. parent banks have historically owned foreign banking subsidiaries and held ownership positions in foreign banking affiliates. Since 1966, however, U.S. banks can invest directly in foreign banks, and since 1970, U.S. bank holding companies have been permitted to invest in foreign companies. Offshore Banking Centers A significant portion of the external banking activity takes place through offshore banking centers. An offshore banking center is a country whose banking system is organized to permit external accounts beyond the normal economic activity of the country. The International Monetary Fund has recognized the Bahamas, Bahrain, the Cayman Islands, Hong Kong, Panama, and Singapore as major offshore banking centers. Offshore banks operate as branches or subsidiaries of the parent bank. The principal features Page 313 that make a country attractive for establishing an offshore banking operation are virtually total freedom from host-country governmental banking regulations—for example, low reserve requirements and no deposit insurance, low taxes, a favorable time zone that facilitates international banking transactions, and, to a minor extent, strict banking secrecy laws. It should not be inferred that offshore host governments tolerate or encourage poor banking practices, as entry is usually confined to the largest and most reputable international banks. The primary activities of offshore banks are to seek deposits and grant loans in currencies other than the currency of the host government. Offshore banking was spawned in the late 1960s when the Federal Reserve authorized U.S. banks to establish “shell” branches, which needs to be nothing more Copyright © 2023. McGraw-Hill US Higher Ed ISE. All rights reserved. than a post office box in the host country. The actual banking transactions were conducted by the parent bank. The purpose was to allow smaller U.S. banks the opportunity to participate in the growing Eurodollar market without having to bear the expense of setting up operations in a major European money center. Today there are hundreds of offshore bank branches and subsidiaries, about one-third operated by U.S. parent banks.3 Most offshore banking centers continue to serve as locations for shell branches, but Hong Kong and Singapore have developed into full-service banking centers that now rival London, New York, and Tokyo. International Banking Facilities Eun, Cheol, et al. International Financial Management, McGraw-Hill US Higher Ed ISE, 2023. ProQuest Ebook Central, http://ebookcentral.proquest.com/lib/wuww/detail.action?docID=7235286. Created from wuww on 2024-10-15 19:36:56. In 1981, the Federal Reserve authorized the establishment of International Banking Facilities (IBFs). An IBF is a separate set of asset and liability accounts that are segregated on the parent bank’s books; it is not a unique physical or legal entity. Any U.S.-chartered depository institution, a U.S. branch or subsidiary of a foreign bank, or a U.S. office of an Edge Act bank may operate an IBF. IBFs operate as foreign banks in the United States. They are not subject to domestic reserve requirements on deposits, nor is FDIC insurance required on deposits. IBFs seek deposits from non-U.S. citizens and can make loans only to foreigners. All nonbank deposits must be nonnegotiable time deposits with a maturity of at least two business days and be of a size of at least $100,000. IBFs were established largely because of the success of offshore banking. The Federal Reserve desired to return a large share of the deposit and loan business of U.S. branches and subsidiaries to the United States. IBFs have been successful in capturing a large portion of the Eurodollar business that was previously managed offshore. However, offshore banking will never be eliminated because IBFs are restricted from lending to U.S. citizens, while offshore banks are not. Exhibit 11.2 summarizes the organizational structure and characteristics of international banking offices from the perspective of the United States. EXHIBIT 11.2 Organizational Structure of International Banking Offices from the U.S. Perspective Type of Bank Physical Location Accept Foreign Deposits Make Loans to Foreigners Subject to F Domestic bank U.S. No No Correspondent bank Foreign N/A N/A Representative office Foreign No No Foreign branch Foreign Yes Yes Subsidiary bank Foreign Yes Yes Affiliate bank Foreign Yes Yes Edge Act bank U.S. Yes Yes Offshore banking center Technically Yes Yes Foreign International banking facility U.S. Yes Yes Copyright © 2023. McGraw-Hill US Higher Ed ISE. All rights reserved. Eun, Cheol, et al. International Financial Management, McGraw-Hill US Higher Ed ISE, 2023. ProQuest Ebook Central, http://ebookcentral.proquest.com/lib/wuww/detail.action?docID=7235286. Created from wuww on 2024-10-15 19:36:56. Capital Adequacy Standards A concern of bank regulators worldwide and of bank depositors is the safety of bank deposits. Page 314 Bank capital adequacy refers to the amount of equity capital and other securities a bank holds as reserves against risky assets to reduce the probability of a bank failure. In a 1988 agreement known as the Basel Accord, after the Swiss city in which it is headquartered, the Bank for International Settlements (BIS) established a framework for measuring bank capital adequacy for banks in the Group of Ten (G-10) countries and Luxembourg. The BIS is the central bank for clearing international transactions between national central banks, and serves as a facilitator in reaching international banking agreements among its members. www.bis.org This is the official website of the Bank for International Settlements. It is quite extensive. One can download many papers on international bank policies and reports containing statistics on international banks, capital markets, and derivative securities markets. There is also a link to the websites of most central banks in the world. The Basel Accord called for a minimum bank capital adequacy ratio of 8 percent of risk-weighted assets for internationally active banks. The accord divides bank capital into two categories: Tier I Core capital, which consists of shareholder equity and retained earnings, and Tier II Supplemental capital, which consists of internationally recognized nonequity items such as preferred stock and subordinated bonds. Supplemental capital could count for no more than 50 percent of total bank capital, or no more than 4 percent of risk-weighted assets. In determining risk-weighted assets, four categories of risky assets are each weighted differently. More risky assets receive a higher weight. Government obligations are weighted at zero percent, short-term interbank assets are weighted at 20 percent, residential mortgages at 50 percent, and other assets at 100 percent. Thus, a bank with $100 million in each of the four asset categories would have the equivalent of $170 million in risk-weighted assets. It would need to maintain $13.6 million in capital against these investments, of which no more than one- half, or $6.8 million, could be Tier II capital. The 1988 Basel Capital Accord primarily addressed banking in the context of deposit gathering and lending. Thus, its focus was on credit risk. The accord was widely adopted throughout the world by national bank regulators. Nevertheless, it had its problems and its critics. One major criticism Copyright © 2023. McGraw-Hill US Higher Ed ISE. All rights reserved. concerned the arbitrary nature in which the accord was implemented. The 8 percent minimum capital requirement assigned to risk-weighted assets was unchanging regardless of whether the degree of credit risk fluctuated throughout the business cycle, regardless of whether the bank was in a developed or a developing country, and regardless of the types of risks in which banks were engaged. Bank trading in equity, interest rate, and exchange rate derivative products escalated throughout the 1990s. Many of these products were not even in existence when the Basel Accord was drafted. Consequently, even if the accord was satisfactory in safeguarding bank depositors from traditional credit risks, the capital adequacy requirements were not sufficient to safeguard against the market risk from derivatives trading. For example, Barings Bank, which collapsed in 1995 due in part to the activities of a rogue derivatives trader, was a safe bank by the Basel capital adequacy standards. Eun, Cheol, et al. International Financial Management, McGraw-Hill US Higher Ed ISE, 2023. ProQuest Ebook Central, http://ebookcentral.proquest.com/lib/wuww/detail.action?docID=7235286. Created from wuww on 2024-10-15 19:36:56. Given the shortcomings of the 1988 accord, a 1996 amendment, which went into effect in 1998, required commercial banks engaging in significant trading activity to set aside additional capital under the 8 percent rule to cover the market risks inherent in their trading accounts. By this time, Operational risk, which includes such matters as computer failure, poor documentation, and fraud, was also becoming evident as a significant risk. This expanded view of risk reflects the type of business in which banks now engage and the business environment in which banks operate. In 1999, the Basel Committee proposed a new capital accord. In June 2004, after an extensive consultative process, the new capital adequacy framework commonly referred to as Basel II was endorsed by central bank governors and bank supervisors in the G-10 countries. Page 315 Basel II is based on three mutually reinforcing pillars: minimum capital requirements, a supervisory review process, and the effective use of market discipline. The new framework sets out the details for adopting more risk-sensitive minimum capital requirements that are extended up to the holding company level of diversified bank groups. With respect to the first pillar, bank capital is defined as per the 1988 accord, but the minimum 8 percent capital ratio is calculated on the sum of the bank’s credit, market, and operational risks. The second pillar is designed to ensure that each bank has a sound internal process in place to properly assess the adequacy of its capital based on a thorough evaluation of its risks. For example, banks are required to conduct meaningful stress tests designed to estimate the extent to which capital requirements could increase in an adverse economic scenario. Banks and supervisors are to use the results of these tests to ensure that banks hold sufficient capital. The third pillar is designed to complement the other two. It is believed that public disclosure of key information will bring greater market discipline to bear on banks and supervisors to better manage risk and improve bank stability.4 Throughout the global financial crisis that began in mid-2007, many banks struggled to maintain adequate liquidity. The crisis illustrated how quickly and severely liquidity can crystallize and certain sources of funding can evaporate, compounding concern related to the valuation of assets and capital adequacy. Prior to the onset of the financial crisis, banks built up significant exposures to off-balance- sheet market risks that were not adequately reflected in the capital requirements of Basel II. Several banking organizations experienced large losses, most of which were sustained in the banks’ trading accounts. These losses did not rise from actual defaults, but rather from credit agency downgrades, widening credit spreads, and the loss of liquidity. In July 2009, the Basel Committee on Banking Supervision finalized a package of proposed enhancements to Basel II to strengthen the regulation and supervision of internationally active banks. This package of enhancements is referred to as Basel 2.5. The proposed enhancement to Pillar 1 called Copyright © 2023. McGraw-Hill US Higher Ed ISE. All rights reserved. for increasing the minimum capital requirement to cover illiquid credit products in the trading account; complex securitizations, such as asset-backed securities and collateralized debt obligations; and exposures to off-balance-sheet vehicles. Pillar 2 proposals called for more rigorous supervision and risk management; more specifically, the proposals called for clear expectations for the board of directors and senior management to understand firm-wide risk exposure. Pillar 3 proposals called for enhanced disclosure requirements for securitizations and off-balance-sheet vehicles to allow market participants to better assess the firm’s risk exposure. Basel 2.5 was due to be implemented by January 1, 2012 and that schedule was largely met by most Basel Committee member jurisdictions. Building on Basel 2.5, the committee announced on September 12, 2010, work on a third accord, Basel III, designed to substantially strengthen the regulatory capital framework and increase the quality of Eun, Cheol, et al. International Financial Management, McGraw-Hill US Higher Ed ISE, 2023. ProQuest Ebook Central, http://ebookcentral.proquest.com/lib/wuww/detail.action?docID=7235286. Created from wuww on 2024-10-15 19:36:56. bank capital. Under Basel III, Tier I capital is redefined to include only common equity, retained earnings (i.e., eliminating non-redeemable, non-cumulative preferred stock), and capital instruments with no fixed maturity. Tier II capital is redefined to include subordinated debt and loan-loss reserves. Tier I capital is increased to 4.5 percent. Additionally, the committee introduced a 2.5 percent capital buffer that can be drawn down in periods of financial stress. The 2.5 percent buffer brings Tier I capital to 7 percent and total capital to 10.5. These reforms were scheduled for implementation on January 1, 2019. In addition, global systemically important banks are required to have higher loss absorbency capacity to reflect the greater risks these banks pose to the financial system. Copyright © 2023. McGraw-Hill US Higher Ed ISE. All rights reserved. Eun, Cheol, et al. International Financial Management, McGraw-Hill US Higher Ed ISE, 2023. ProQuest Ebook Central, http://ebookcentral.proquest.com/lib/wuww/detail.action?docID=7235286. Created from wuww on 2024-10-15 19:36:56. International Money Market Eurocurrency Market The core of the international money market is the Eurocurrency market. A Eurocurrency is a time deposit of money in an international bank located in a country different from the country that issued the currency. For example, Eurodollars are deposits of U.S. dollars in banks located outside of the United States, Eurosterling are deposits of British pounds sterling in banks outside of the United Kingdom, and Euroyen are deposits of Japanese yen in banks outside of Japan. The prefix Euro is somewhat of a misnomer, since the bank in which the deposit is made does not have to be located in Europe. The depository bank could be located in Europe, the Caribbean, or Asia. Indeed, as we saw in the previous section, Eurodollar deposits can be made in offshore shell branches, or IBFs, which are merely a separate set of asset and liability accounts segregated on the U.S. parent bank’s books. An “Asian dollar” market exists, with headquarters in Singapore, but it can be viewed as a major division of the Eurocurrency market. The origin of the Eurocurrency market can be traced back to the 1950s and early 1960s, when the former Soviet Union and Soviet-bloc countries sold gold and commodities to raise hard currency. Because of anti-Soviet sentiment, these Communist countries were afraid of depositing their U.S. dollars in U.S. banks for fear that the deposits could be frozen or taken. Instead they deposited their dollars in a French bank whose telex address was EURO-BANK. Since that time, dollar deposits outside the United States have been called Eurodollars and banks accepting Eurocurrency deposits have been called Eurobanks.5 The advent of the common euro currency on January 1, 1999, among the 11 countries of the European Union making up the Economic and Monetary Union creates some confusion as to whether one is referring to the common euro currency or another Eurocurrency, such as Eurodollars. Because of this, it is starting to become common practice to refer to international currencies instead of Eurocurrencies and prime banks instead of Eurobanks. The Eurocurrency market is an external banking system that runs parallel to the domestic banking system of the country that issued the currency. Both banking systems seek deposits and make loans to customers from the deposited funds. In the United States, banks are subject to the Federal Reserve Regulation D, specifying reserve requirements on bank time deposits. Additionally, U.S. banks must pay Copyright © 2023. McGraw-Hill US Higher Ed ISE. All rights reserved. FDIC insurance premiums on deposited funds. Eurodollar deposits, on the other hand, are not subject to these arbitrary reserve requirements or deposit insurance; hence, Eurobank operating costs are less. Because of the reduced cost structure, the Eurocurrency market, and in particular the Eurodollar market, has grown spectacularly since its inception. The Eurocurrency market operates at the interbank and/or wholesale level. The majority of Eurocurrency transactions are interbank transactions, representing sums of $1,000,000 or more. Eurobanks with surplus funds and no retail customers to lend to will lend to Eurobanks that have borrowers but need loanable funds. The rate charged by banks with excess funds is referred to as the interbank offered rate; they will accept interbank deposits at the interbank bid rate. The spread is generally 20 basis points for the USD and 10 to 30 basis points for other currencies. Rates on Eun, Cheol, et al. International Financial Management, McGraw-Hill US Higher Ed ISE, 2023. ProQuest Ebook Central, http://ebookcentral.proquest.com/lib/wuww/detail.action?docID=7235286. Created from wuww on 2024-10-15 19:36:56. Eurocurrency deposits are quoted for maturities ranging from one day to one year; however, more standard maturities are for 1, 3, 6, and 12 months. Exhibit 11.3 shows sample Eurocurrency interest rate quotations. Appendix 11A illustrates the creation of Eurocurrency. EXHIBIT 11.3 Eurocurrency Interest Rate Quotations: January 5, 2022 Short Term One Month Three Months Euro −0.65 to −0.35 −0.67 to −0.37 −0.74 to −0.44 − Sterling 0.45 to 0.55 0.58 to 0.68 U.S. Dollar 0.11 to 0.31 0.07 to 0.27 0.08 to 0.28 Japanese Yen −0.10 to 0.00 −0.10 to 0.10 −0.10 to 0.10 Source: The Financial Times, January 6, 2022. London has historically been, and remains, the major Eurocurrency financial center. As such, Page 316 most people have heard of the London Interbank Offered Rate (LIBOR), the reference rate in London for Eurocurrency deposits. To be clear, there was a LIBOR for Eurodollars, Euro–Canadian dollars, Euroyen, and even euros. In other financial centers, other reference rates were used. LIBOR has been called by some “the most important number in finance.” As a benchmark, the daily setting of LIBOR for various tenors was used by banks, securities houses, and investors to set payments annually on at least $450 trillion in the international money, derivatives, and capital markets around the world. However, because of trading practices during and after the Global Financial Crisis (discussed later in this chapter) by some market participants in setting the daily benchmarks, that some considered fraudulent, LIBOR’s U.K. and U.S. regulators and administrator decided to transition away from LIBOR to other reference rates. Beginning on January 1, 2022, a new series of reference rates, known collectively as Alternative Risk- Free Rates (RFRs), went into effect for the various Eurocurrencies. These rates are representative of actual market transactions, a feature missing from the previous rate benchmarks. Exhibit 11.4 specifies several of the new RFRs for the major Eurocurrencies. EXHIBIT 11.4 Alternative Risk-Free Rates Currency (Symbol) RFR Copyright © 2023. McGraw-Hill US Higher Ed ISE. All rights reserved. U.S. Dollar (USD) Secured Overnight Financing Rate (SOFR) Sterling (GBP) Sterling Overnight Index Average (SONIA) Euro (EUR) Euro Short Term Rate (€STR) Swiss Franc (CHF) Swiss Average Overnight Rate (SARON) Japanese Yen (JPY) Tokyo Overnight Average Rate (TONAR) These RFRs are based on overnight wholesale transactions that are unsecured or secured repurchase or “repo” transactions. Hence, they are representative of risk-free rates, or nearly risk-free rates. On the other hand, Eurocurrency transactions are term transactions of various tenors. The Secured Overnight F inancing Rate (SOFR) was selected as the benchmark replacement for USD LIBOR. SOFR is a broad Eun, Cheol, et al. International Financial Management, McGraw-Hill US Higher Ed ISE, 2023. ProQuest Ebook Central, http://ebookcentral.proquest.com/lib/wuww/detail.action?docID=7235286. Created from wuww on 2024-10-15 19:36:56. measure of the cost of borrowing cash overnight collateralized by U.S. Treasury securities. The New York Federal Reserve Bank publishes daily SOFR data. Its determination is fully transaction-based. The RFRs are backward-looking rates, whereas Eurocurrency transactions require a forward-looking rate applicable to the term of the Eurocurrency deposit. For the USD, the CME Group has developed an algorithm that provides a daily set of forward-looking interest rate estimates for SOFR for various tenors based on market expectations implied from CME SOFR futures contract (which are discussed in detail later in this chapter). CME Term SOFR Reference Rates are provided for terms of 1, 3, 6, and 12 months. They may be licensed for use in cash-market financial products and other derivatives by market participants. Forward-looking term SONIA reference rates have also been developed. Eurocurrency transactions are not risk free and need to be priced at a rate that incorporates a Page 317 term premium to compensate for the risk of default. For borrowing and lending in the Eurodollar market, a term premium of 11 basis points (bps) has been calculated by Bloomberg from analysis of five years of historical data to be a suitable add-on adjustment to the one-month CME Term SOFR rate to account for bank credit risk of a one-month deposit. For a 3-month term, the add-on adjustment is 26 bps; for 6 months, 43 bps; and, for 12 months, 72 bps. In the wholesale money market, Eurobanks accept Eurocurrency fixed time deposits and issue negotiabl e certificates of deposit (NCDs). In fact, these are the preferable ways for Eurobanks to raise loanable funds, as the deposits tend to be for a lengthier period and the acquiring rate is often slightly less than the interbank bid rate. Denominations are at least $500,000, but sizes of $1,000,000 or larger are more typical. Exhibit 11.5 shows the values of international bank external liabilities (Eurodeposits and other Euroliabilities) in billions of U.S. dollars for the years 2017 through the second quarter of 2021. The 2021 column shows that total external liabilities were $27,267 billion and that interbank liabilities accounted for $16,358.1 billion of this amount, whereas nonbank deposits were $10,908.9 billion. Overall, the statistics suggest a low but steady growth in international banking activity since 2017. The major currencies denominating these were the U.S. dollar, the euro, the Japanese yen and the British pound sterling. EXHIBIT 11.5 International Bank External Liabilities (in billions of U.S. dollars) 2017 2018 2019 2020 2021 Q2 Type Liability Copyright © 2023. McGraw-Hill US Higher Ed ISE. All rights reserved. To banks 14,337.4 14,150.6 14,638.6 16,074.5 16,358.1 To nonbanks 8,765.5 8,987.2 9,159.8 10,625.4 10,908.9 Total 23,102.9 23,137.8 23,798.4 26,699.9 27,267.0 Source: Compiled from various issues of International Banking and Financial Market Developments, Bank for International Settlements. Approximately 90 percent of wholesale Eurobank external liabilities come from fixed time deposits, the remainder from NCDs. There is an interest penalty for the early withdrawal of funds from a fixed time deposit. NCDs, on the other hand, being negotiable, can be sold in the secondary market if the depositor suddenly needs his funds prior to scheduled maturity. The NCD market began in 1967 in Eun, Cheol, et al. International Financial Management, McGraw-Hill US Higher Ed ISE, 2023. ProQuest Ebook Central, http://ebookcentral.proquest.com/lib/wuww/detail.action?docID=7235286. Created from wuww on 2024-10-15 19:36:56. London for Eurodollars. NCDs for currencies other than the U.S. dollar are offered by banks in London and in other financial centers, but the secondary market for nondollar NCDs is not very liquid. Eurocredits Eurocredits are short- to medium-term loans of Eurocurrency extended by Eurobanks to corporations, sovereign governments, nonprime banks, or international organizations. The loans are denominated in currencies other than the home currency of the Eurobank. Because these loans are frequently too large for a single bank to handle, Eurobanks will band together to form a bank lending syndicate to share the risk. The credit risk on these loans is greater than on loans to other banks in the interbank market. Thus, the interest rate on Eurocredits must compensate the bank, or banking syndicate, for the added credit risk. On Eurocredits the base lending rate is the specific Eurocurrency Term RFR. The total lending rate on these credits is the sum of three values: Term RFR + Bank Credit Risk premium + X percent, where X is the lending margin charged depending upon the creditworthiness of the borrower. Additionally, rollover pricing was created on Eurocredits so that Eurobanks do not end up paying more on Eurocurrency time deposits than they earn from the loans. Thus, a Eurocredit may be viewed as a series of shorter-term loans, where at the end of each period (generally three or six months), the loan is rolled over and the base lending rate is repriced to current Term SOFR over the next time interval of the loan. Page 318 Exhibit 11.6 shows the relationship among the various interest rates we have discus

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