Global Financial Services

1
Global Financial Services

• Outline
• Why and how U.S. banks engage in international
  banking
• Foreign banks in the U.S.
• International lending
• Foreign exchange markets

2
Why and how U.S. banks engage in international
banking

• Why engage in international banking?
• Serve the needs of their customers (imports and
  exports, foreign production operations, etc).
• Profit motive of opening new markets.
• Global diversification.
• Prestige of having offices in important financial
  centers around the world.

3
Why and how U.S. banks engage in international
banking

• How do they engage in international banking?
• Correspondent banks (large banks and foreign
  banks in the U.S.) providing international
  banking services.
• Foreign branches (full- or limited-service).
• Representative offices (quasi sales office with
  no loans or deposits).
• Foreign affiliates (ownership in part or whole of
  a foreign financial service firm).
• Edge Act offices (subsidiaries of national banks
  with offices in U.S. or abroad devoted to
  international trade).
• International banking facilities or IBFs
  (accounting system in a bank for deposits and
  loans of foreigners with tax and reserve
  requirement benefits).

4
Foreign banks in the U.S.

• International Banking Act of 1978
• Allows foreign banks to operate offices in the
  U.S. without reciprocity of U.S. banks being
  allowed to operate in foreign countries.
• An agency under this Act is a foreign bank or
  office that can provide credit and clear checks
  but cannot take deposits of U.S. citizens.
  Primarily used for foreign trade.
• A branch is similar to an agency but it can
  accept deposits of U.S. citizens if for the
  purpose of carrying out transactions in foreign
  countries. The branch can do almost anything
  that the parent bank can do.
• An investment company cannot accept deposits but
  can make loans and equity investments (note do
  not confuse with a domestic investment company of
  mutual fund).
• A subsidiary is a U.S. bank that is owned by a
  foreign bank.
• A finance company can be owned and operated by a
  foreign financial organization.

5
International lending

• Syndicated loans
• Large loans that enable borrowers to obtain large
  amounts of funds and lenders can diversify their
  credit risk. Lead bank can earn fee income for
  management services.
• Two types of syndicated bank loans
• Agreement between borrower and each lender.
• Participation loans involving a lead bank that
  organizes a group of managing banks, who can
  refer information to other potential
  participating banks.
• Loan pricing
• LIBOR plus a certain number of points (also SIBOR
  in Pacific basin or Singapore interbank offered
  rate).
• Commitment fees, underwriting fees, foreign
  taxes, etc.

6
International lending

• Letters of credit
• Import letters of credit are issued by a bank in
  favor of a firm in most cases. An export letter
  of credit is issued by a foreign bank to a firm
  in the U.S.
• The letter of credit is a document from a bank
  that says it will pay the exporter when the
  conditions in the letter are met. In effect, the
  banks credit is substituted for the importer.
  The importer pays the issuing bank a fee for its
  services. Some important documents are
• Bill of Lading (title to the merchandise)
• Invoice (goods description, price, quantity,
  etc.)
• Certificate of origin (country goods come from)
• Inspection certificate (independent third party)
• Draft or bill of exchange (drawn by exporter or
  importers bank for amount due as stated in the
  letter of credit -- payable immediately or at
  some later (i.e.,sight and time drafts,
  respectively . When the issuing bank accepts the
  draft, a bankers acceptance is created. The bank
  can sell this security in the financial
  marketplace. Both bank and importer are liable
  to pay the note.)

7
International lending

• Letters of credit
• Confirmed letters of credit involve the
  exporters bank, which further guarantees that
  the funds will be paid under the terms of the
  credit. Two banks further reduces credit risk.
• Collection (via correspondent banks and foreign
  branches to facilitate the clearing process)
• Clean collections (i.e., no documents attached,
  such as travelers checks and money orders)
• Documentary collections (i.e., exporter sends
  documents to their bank for collection and bank
  forwards documents to importers bank for
  payment). Unlike an irrevocable letter of
  credit, the exporters payment is an obligation
  of the importer, rather than the bank issuing a
  letter of credit.

8
Foreign exchange markets

• Foreign exchange (FX)
• Interbank market of money center banks and major
  foreign banks.
• Foreign exchange brokers facilitate currency
  trading.
• Exchange rates can be direct (U.S./foreign
  currency) or indirect (foreign currency/U.S.).
• Cross rate is the rate at which (say) euros and
  yen can be exchanged using dollars
• Cross-rate euro/yen (/euro)(/yen) euro/yen
• Buyer and seller agree to an exchange on the
  value date.
• Spot market, as well as futures market and
  forward market transactions (not standardized,
  not traded on an organized exchange, and
  privately negotiated).
• Annual forward rate (as a premium or discount
  relative to the spot rate)
• (F - S) x 100/S x 365/n, where F is the
  forward rate, S is the spot rate and n is the
  number of days to maturity.
• Example
• (0.1735/franc - 0.1726/franc) x
  100/0.1726/franc x 365/90
• 2.11 (premium over the spot rate)

9
Foreign exchange markets

• Foreign exchange risks
• Exchange rate risk due to open (long) or short
  positions. If a bank buys and sells equal
  amounts of a currency, it has a net covered
  position. To control this risk, use hedging
  techniques and dollar limits on positions and
  customers.
• Interest rate risk due to mismatches in the
  maturity structure of the banks foreign exchange
  position. As interest rates change, the value of
  currencies can change.
• Arbitrage by buying assets in one market and
  selling them immediately in another market to
  profit from price differences in the two markets.
  Interest rate parity (or covered interest
  arbitrage) normally keeps interest rate and
  foreign exchange rate values in equilibrium with
  one another in different countries.
• p (F - S)/S, which says that the premium or
  discount is related to the forward rate
  (/foreign currency) and spot rate (/foreign
  currency).
• p N - L, where N is the short-term interest
  rate in the U.S., and L is the short-term
  interest rate in the foreign country.

10
Foreign exchange markets

• Foreign exchange risks
• Credit risk associated with the counterparty
  (bank or broker) failing to meet its obligations.
  Settlement risk is a type of credit risk wherein
  one party makes transfer of payment and then the
  other party goes bankrupt.
• Country risk is broadly defined to include
  economic, social, and political risks.
• Sovereign risk occurs when a national government
  defaults on debts.
• Transfer risk is related to problems in
  converting domestic currency into foreign
  exchange due to government controls or other
  reasons.