Financial Institutions ch. 15

Risk Evaluation

1. An analysis of both the borrower and borrower's country is done by the bank's foreign lending and economic departments. 2. Evaluation involves a statistical analysis of the country's political and economic risks. 3. A financial analysis of the borrower is also conducted. 4. If the cost of doing the analysis internally is prohibitive, outside sources exist but they tend not to be as reliable. 5. The higher the cost of gathering information, the higher the loan rate, reflecting the increased risk due to unreliable information or lack of information.

Foreign Banks in the U. S.

1. Can establish federally chartered branches. 2. Must have FDIC insurance on deposits up to $100,000. 3. Other foreign banking institutions can opt for FDIC insurance.

Risks in International Lending

1. Credit risk - the risk of default. 2. Country risk - related to the political stability, laws, and regulations of the foreign country. a. Expropriation b. Nationalization c. Change of government 3. Currency risk - risk of currency value changes and exchange controls.

International Banking Facilities (IBFs)

1. Fed permitted IBFs beginning December 1981. 2. May be established by a U.S. chartered depository institution, a U.S. branch or agency of a foreign bank, or a U.S. office of an Edge Act Corporation. 3. They represent the balance sheet of the aggregated foreign assets and liabilities of the establishing institution. 4. They are not subject to U.S. banking regulations. a. Deposits over $100,000 can be accepted from non U.S. residents or other IBFs. b. Deposits generated can be used to make foreign loans only.

The Regulatory Framework

1. Federal Reserve Act of 1913 - allowed federally chartered branches outside the U.S. 2. Amendment to Federal Reserve Act (1916) - agreement corporations permitted. 3. Edge Act (1919) - federally chartered corporations for international banking. 4. National banks permitted equity investments in foreign bank stock (1966). 5. Bank Holding Company Act Amendments of 1970 - regulated international activities of bank holding companies. 6. International Banking Act of 1978 - extended federal regulation to foreign banks operating in the United States. 7. The DIDMCA of 1980: a. expanded Fed control over foreign banks. b. permitted U.S. banks to establish international banking facilities. 8. In July, 1988, the Bank for International Standards (BIS) worked out enhanced bank capital adequacy standards (effective in 1992) between leading economic nations.

The Edge Act (1919)

1. Federal Reserve Act of 1913 permitted foreign branches. 2. Agreement corporations were legalized in 1916. 3. Details of the Edge Act a. Banks able to create federally chartered subsidiaries located in the U.S. (Edge Act corporations). b. Participate in international banking c. Could make equity investments d. Able to compete with European banks e. Grew in number and activities after WW II

Recent Activity in U.S. International Banking

1. Growth slowed in the early 1970s a. U. S. regulations limiting the outflow of funds to foreign countries were eliminated. b. Smaller banks could not compete with larger international operations. 2. International lending increased in 1974. a. OPEC increased oil prices. b. Oil producers and oil importers had surplus/deficit funds flow to invest or finance. 3. While fewer U.S. banks operate overseas, they have a larger network of global affiliates in the form of branches, overseas offices, and most importantly through correspondent banks. 4. Since the 1990s, fewer, but larger U.S. banks are operating globally. Two of the largest banks in the world are U.S. banks - Citigroup & Bank of America.

Growth of Foreign Banks

1. High growth after mid-1970s until 1990. [See Exhibit 15.5 - 15.7] 2. Japanese banking growth dominated the world in the late 1980's and made significant inroads into west coast U.S. markets. 3. The slowing down of the Japanese equity markets, increased scrutiny by regulators, increased international capital adequacy standards, and the increased merger activity among large U.S. banks have all slowed down the growth of foreign banks in the U. S.

The Reasons for Growth in U.S. International Banking

1. Increased expansion of U.S. trade and foreign markets. 2. Growth of multinational corporations. 3. U.S. government regulation limited cash outflows out of the U.S. 4. Need to finance petroleum-induced deficits in foreign countries.

Managing Risk: How Banks Reduce Country Risk

1. International Finance Corporation (IFC) creates loan syndications to private borrowers in high-risk countries. 2. Banks take part of loan and risk, not all with loan participations.

International Banking

1. International banking dates back to the rise of international trade. 2. Great Britain dominated international finance until after WW II. 3. American banks entered international finance after 1914.

Correspondent Banks

1. It is a relationship with foreign banks to provide international banking services, similar to those that banks have in the domestic environment. 2. These include accepting drafts, honoring letters of credit, furnishing credit information, collecting and disbursing international funds, and investing funds. 3. No permanent personnel are allowed in the foreign country.

Foreign Branches

1. Legal branches of domestic parent banks providing full range of banking services in foreign country. 2. Foreign deposits are included in the required reserves calculations at home. 3. They are subject to both the host nation's regulations and the U.S. regulations. 4. Despite the cost of establishing a branch, they generate world-wide name recognition for the parent bank.

Representative offices

1. Set up to assist parent bank customers in a particular country. 2. Cannot accept deposits, make loans, transfer funds, accept drafts, transact in the international money markets, or commit the parent bank to loans. 3. Can provide information and assist parent bank's clients in their banking and business contacts in the foreign country.

Shell Branches

1. Set up to conduct limited inter-bank money market transaction rather than retail public branches. 2. Tend to do foreign exchange transactions and limited loan participation in Eurocurrency markets. 3. Pay no local taxes and generally operate in relatively stable political environment. 4. Tend to have state-of-the-art communications to operate and conduct transactions in any global market.

Foreign Subsidiaries and Affiliates

1. Subsidiaries - separately owned (entirely or in part) by a U.S. bank, bank holding company, or an Edge Act corporation. 2. Affiliates - small ownership (non-controlling) interest in foreign bank by U.S. bank.

Domestic U.S. Banking

1. The motives for domestic banking regulation are: a. bank safety and financial soundness and stability. b. bank competition - performance. c. banking business is "special" and kept separate (arms length) from other types of business activities.

The Decade of Expansion (1960s)

1. The number of U.S. banks with foreign branches increased rapidly. [See Exhibit 15.1] a. The 1960s began with just 8 banks with 131 branches and about $3.5 billion in overseas assets. b. By 1970, the number had risen to 79 banks with 532 branches. c. The number of banks peaked in 1985 at 162, while the number of branches continued to grow until 2000 when it peaked at 998. d. Attrition in the number of banks and branches since 2000 is the natural consequence of mergers between large, multinational banks (51 banks and 640 branches in 2006).

Regulation of Foreign Banks' U.S. Operations

1. The passage of the International Banking Act of 1978 made U.S. banks more competitive with foreign banks operating in the United States. a. Allow federal chartering of foreign banking facilities. b. Limit ability of foreign banks of accepting interstate deposits. c. Fed may impose reserve requirements on foreign banks. d. FDIC insurance required on domestic retail deposits in U.S. based foreign banks. e. Foreign banks permitted to form Edge Act corporations. f. U.S. based foreign banks were made subject to non-banking prohibitions of U.S. bank holding companies. 2. In addition, the Foreign Bank Supervision Enhancement Act (FBSEA) was passed in 1991 to give the Federal Reserve Bank the authority to oversee the activities of foreign institutions in the U.S.

Edge Act Corporations

1. These are federally chartered subsidiaries of U.S. banks engaging in international activities not permitted to domestic banks. 2. May participate in international banking and non-banking activities including investing in foreign equities.

Risk Management in International Lending

1. Third-party help a. Guarantees by governments or their central banks b. Guarantees by organizations outside the foreign country i) Foreign Credit Insurance Association (FCIA) ii) U.S. Export-Import Bank (EXIM bank) iii) Overseas Private Investment Corporation (OPIC) iv) Private insurance company guarantees 2. Pooling risk - participation loans among banks to spread risk. 3. Diversification of foreign loan portfolio a. Geographical - regional or by country b. Industry c. Domestic vs. foreign loans 4. Loan Sales - selling nonperforming loans in the secondary market at a discount.

Allowable Banking Activities

1. Traditionally, more activities have been permitted for U.S. banks operating in foreign countries to enhance competitiveness. a. Security underwriting b. Equity investments 2. Restraints are kept on: a. U.S. foreign bank subsidiaries owning non-financial businesses. b. control of foreign companies.

Future Directions of International Banking

A. Concern about International Loan Quality B. Development of International EFT Networks

Characteristics of International Loans

While similar to domestic loans in some aspects, they are also different in the following areas: 1. Funding a. International loans can be denominated in almost any major currency, but the U.S. dollar is the most common. b. The average international loan is larger with large, multinational firms and sovereign countries as borrowers. c. Most large international loans are funded in the Eurocurrency market, i) International banks issue time deposits and make short or intermediate-term loans. ii) Banks often lend to each other in the interbank market.

Collateral

a. Most international credits are unsecured. b. Most business borrowers have high credit ratings. c. Borrowing countries pledge their "full faith and credit."

Syndicated

a. Several banks usually participate in funding the loans, thus spreading the risk to banks and providing the large amounts of funds needed by the borrower. b. One or more lead bank(s) package the loan arrangement.

Pricing

a. The interbank rate in London is called the LIBOR or London Interbank Offer Rate. b. Non-bank borrowers pay above the LIBOR. c. The interest rate paid to time deposits and the rate charged borrowers will be tied to the interest rate levels of the country and currency used to denominate the deposit and loan. d. Lending rates are fixed for the stated credit period (usually a month) but change (float) with the LIBOR at the beginning of each (rollover) period.