Lesson 11: Banking in the International Economy

Upon completion of this lesson, you should be able to do the following:

  • Explain why banks enter the international markets.
  • Describe how U.S. banks enter into foreign markets.
  • Describe how foreign banks enter the United States banking sector.
  • Explain how banks circumvent government regulations by using international financial instruments.
  • Describe the problems of regulating international banks.

Introduction

This lesson deals with international banking. International banking links savers and borrowers from different countries around the world and is essential for international trade and finance. However, international banks cross country boundaries, making it difficult for a government in one country to regulate its bank's business in another country. For example, Citibank has branches and subsidiaries in many countries around the world. It is difficult for the U.S. government and the Fed to regulate and monitor all the bank's activities. Then countries like the Bahamas and Switzerland have strong confidentiality laws. If the regulatory agency believes the bank is participating in risky investments, the regulatory agency can have a difficult time getting bank records and information from banks located in the Bahamas and Switzerland.

Purposes of International Banking

International banks are similar to domestic banks. International banks help people and businesses who are engaged in international trade and finance. For example, Compaq enters into a contract with a firm in Hong Kong to buy memory chips. Compaq goes to an international bank, where the bank gives a short-term loan for the memory chip purchase. The bank can also help with the currency exchange rates.

International banks have three benefits.

  1. International banks accept deposits from savers and lend to borrowers. The savers and borrowers do not have to be located in the same country.

  2. International banks can lower transaction costs by lowering information costs, increasing the liquidity of financial markets, and lowering the risk of investments.

  3. Regulation of international banks can stimulate financial innovation by creating new financial instruments, more so than domestic banks.

International banks tend to be concentrated in countries that are financial centers in the world, such as New York City, Tokyo, and London. International banks are also located in places that have offshore markets. An offshore market has little regulations, low tax rates, and strict banker-customer confidentiality laws. The leading offshore markets are the Bahamas, Hong Kong, and Singapore.

U.S. Banks Entering the Foreign Field

Banks in the United States have four methods to become an international bank.

  1. Branching - the U.S. bank opens a bank branch in a foreign country. These branches accept deposits and make loans. U.S. banks tend to open branches in financial centers around the world. The bank branches help the bank transfer money around the world.

  2. Edge Act corporation - the U.S. bank sets up a subsidiary. The subsidiary can accept deposits from U.S. residents and foreigners, but can only grants loans for international business activity, such as finance international trade and deal with foreign exchange. The subsidiary is exempt from some U.S. banking regulations and the Federal Reserve has to approve the Edge Act corporation.

  3. Bank holding company - the U.S. bank buys and controls the majority of shares of the foreign firm. The Fed requires the international bank to acquire an interest in a foreign firm that is "closely related to banking."

  4. International banking facility (IBF) - an international banking facility cannot conduct domestic banking businesses. The IBFs accepts deposits from foreigners and make loans to foreigners. The IBFs cannot conduct any type of business within the United States except with its parent company or with other IBFs. The IBFs are exempt from many government regulations and are also exempt from local and state taxes. The Fed encourages U.S. banks to use this method for engaging in the international markets. An IBF is very similar to an Edge Act Corporation.

Foreign Banks Entering the U.S.

There are three ways foreign banks can enter the banking market in the United States.

  1. Agency office - the agency office cannot accept deposits from U.S. residents, but it can make loans to them. The agency office does not take deposits, so it is similar to a nonbank bank. The agency office is not subjected to U.S. banking laws and does not have to carry FDIC insurance. The agency office receives it funding from foreign depositors and investors.

  2. Foreign bank branch - this is a full fledge bank that accepts deposits and makes loans. The foreign bank branch is subjected to the U.S. bank regulations.

  3. U.S. subsidiary bank - the foreign bank buys stock of a U.S. bank to become the majority shareholders. The foreign bank controls the U.S. bank and the bank is called a subsidiary. Many foreign banks use subsidiaries to enter the U.S. banking market.

Exchange Rate Risk

International banks are subjected to foreign exchange rate risk. The exchange rate risk is very similar to the interest rate risk, which was discussed at the end of Lesson 9. The international bank has to keep the exchange rate in mind when accepting deposits and granting loans.

  • For example, the international bank accepts $1 million from depositors in the United States. The bank grants a loan to a business in Russia for $1 million. However, the bank has to convert the U.S. dollars into Russian rubles, because the ruble is the legal currency in Russia. If the exchange rate is $1 for 1,000 rubles, then the Russian business receives 1 billion rubles ($1 million X 1,000). What if the exchange rate changes? Then the international bank is subject to an exchange rate risk. The bank could gain or lose from exchange rate changes.  Let the exchange rate change to $1 for 2,000 rubles. When the Russian business pays back its 1 billion-ruble loan, the bank gets only $0.5 million, because the exchange rate moved against the bank (1 billion rubles / 2,000). This example does not include an interest rate and the bank experienced a major loss. The international banks may hedge against foreign exchange rate risk by using financial futures and options for foreign currencies.

International banks can increase the liquidity of foreign-exchange markets. Banks buy and sell foreign currencies to help bank customers in international transactions.

  • One method to lower transaction costs and reduce the exchange rate risk is for a banks to use a currency swap. A currency swap is the exchange of debt instruments denominated in different currencies. For example, Intel wants to build a factory in Germany, while Volkswagen wants to build a new factory in the United States. Intel needs German marks, while Volkswagen needs U.S. dollars for these investments. These companies are well known within their own countries and can borrow on more favorable terms. Intel takes a loan from a U.S. bank, while Volkswagen takes a loan from a German bank. Now Intel and Volkswagen can exchange their loans. Intel has deutchmarks to build a factory in Germany, while Volkswagen has U.S. dollars to build a factory in the United States.

  • Another way for U.S. banks to protect themselves from exchange rate risk is by keeping all of its loans in terms of U.S. dollars, when they engage in international transactions.

The international bank can reduce the information costs in international trade. If a U.S. store wants to import coffee from Costa Rica, the exporter in Costa Rica has no information about the U.S. store's credit worthiness. If the exchange of coffee for money occurs in the future, the U.S. store does not know what the future exchange rate will be. There is an information problem and an international bank can use a banker's acceptance. The U.S. store deposits money at its international bank. The bank guarantees payment by issuing a banker's acceptance and sends a letter of credit to the exporter in Costa Rica. If the U.S. store bankrupts, the exporter in Costa Rica still gets his money. If the firm does not deposit money at the bank and the bank guarantees payment, then the bank still has to pay the exporter in Costa Rica. When the exporter in Costa Rica exports the coffee to the U.S., the exporter deposits his letter of credit at his bank. The exporter's bank will contact the U.S. store's bank and make payment arrangements. There is a secondary market for banker's acceptances, so these securities are liquid. International banks lower transaction and information costs and reduce the risk in international finance.

After World War II, the U.S. dollar became the international transaction currency. An international transaction currency is the preferred currency used in negotiating transactions in the international financial markets. For example, all transactions in the market for oil is done entirely in U.S. dollars. One financial innovation that occurred in the international market was the rise of Eurodollars. A new Eurodollar is created when a bank deposit in the United States is transferred to a foreign bank. The foreign bank keeps the account in terms of the dollar. The account is not converted to the local currency. The Eurodollars were created by the Soviet Union. The Soviet Union was accumulating U.S. dollars, but was afraid to hold them in a U.S. bank, so they convinced European banks to hold these dollar deposits.

Eurodollars helped circumvent laws that restricted bank activities. In the United States, banks originally could not pay interest on checking accounts. In Britain, banks originally could not grant loans outside of Britain. Eurodollars allowed these banks to circumvent these laws. U.S. banks could borrow Eurodollars instead relying on deposits while British banks could lend outside of Britain by using Eurodollars. Eurodollars were so successful, causing many of these regulations to be repealed. The U.S. dollar still dominants the Eurodollar market. Most international banking business is conducted through the Euromarkets. These markets are essentially unregulated and include all financial markets that are denominated in U.S. dollars and are located outside of the United States.

Eurodollars are not limited to only Europe. During the 1970s, Organization of Petroleum Exporting Countries (OPEC) were successful in reducing the production of petroleum, causing the price of oil to increase. The high oil prices caused a large inflow of U.S. dollars into the OPEC nations and OPEC became the largest source of Eurodollars. Currently, Japan and South Korea also have large deposits in U.S. dollars.

Many other financial instruments were created from Eurodollars, which are Euroloans and Eurobonds. The principal and interest payments are denominated in U.S. dollars. For example, Europe can grant a loan to Russia, using a Euroloan. All terms of the loan are in dollars and Russia has to pay the loan back in dollars. Europe is protected from changes in the ruble-dollar exchange rate. The exchange rate risk is completely passed onto Russia. Euroloans can be unusually large often in billions of dollars. Therefore, several international banks may cooperate together to grant such a large loan. This cooperation is referred to as loan syndication. One large loan is spread out among several banks and one bank will manage the loan and earns a management fee.

During the 1980s, several developing countries threaten to default on their Euroloans. The loan default would cause a global banking crisis in the industrialized countries. This threat prompted twelve countries including the United State to meet in Basel to discuss capital requirements. The committee and agreement of the 12 countries are named after the city, Basel. These countries wanted to reduce risky international banking activities by ensuring banks had enough capital. If an international bank suffered losses, having enough capital would help the bank to survive. It was difficult to implement the Basel agreement, because each country has different regulations and different accounting standards. The Basal agreement set common capital standards for banks engaged in currency swaps, financial futures, and options.

Leaders of central banks and finance ministries continue to push for coordination and restrictions on deposit insurance. Deposit insurance in the United States insures up to $100,000 for each individual. In other countries, the deposit insurance is not as generous. Currently, U.S. banks pay modest premiums only on domestic deposits. If U.S. banks have to pay deposit insurance on all accounts including foreign accounts, then their premiums will increase. Coordination of an international deposit insurance will also be difficult. First, many regulatory agencies in other countries lack the monitoring power of the FDIC. Second, only 3 countries in Europe: Netherlands, Spain, and United Kingdom, have laws requiring the government to step in and fund the deposit insurance if the insurance premiums cannot cover all accounts when a bank fails.

After the debt crisis during the 1980s, central banks met and discussed their roles of being the lenders of last resort during a banking crisis. They concluded they should concentrate on the financial stability of their own domestic banks. However, there is one problem. Many banks are linked internationally to other banks abroad. If there is an international banking crisis, how do the central banks intervene?

Government regulatory differences among countries are likely to diminish in the future and regulations may decline. Bank holding companies and financial innovation allow banks to circumvent regulations and enter spheres of new business activity. In the future, bank holding companies will offer a broad range of financial services. The type of services a bank holding company can offer will depend on the legal tradition of the country where the bank holding company wants to do business. Banks will be subjected to more restrictions in the United States, while regulations are less stringent in Europe and Japan.

 

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