CHAPTER 15
INTERNATIONAL BANKING
CHAPTER OVERVIEW AND LEARNING OBJECTIVES

One of the major economic functions of the banking industry has been to facilitate
international trade by providing guarantees, credit, and a reasonably priced system in which
all businesses may easily participate in international trade. These are analyzed in this chapter.

In this chapter, the evolution, growth and regulation of the global practices of U.S. banking
are discussed.

The various organizational forms that U.S. banks use and their origin are discussed.

Risks involved in international lending are also identified and described.
CAREER PLANNING NOTE: PREPARING FOR YOUR GLOBAL BUSINESS
ACTIVITIES
In many college business courses, the international perspective is a chapter at the end of a text, seldom
assigned, and not likely to be covered in depth. Most professors have little international perspective, and
the place on the syllabus for "international" indicates it. Often there is a required "international business"
course that students take because accrediting bodies tell you to. Overall, some business schools still do a
poor job of preparing you for your likely contact with internationals, foreign business activity, etc.
You then are partially responsible for some preparation toward your near-certain global business activity.
The world is "shrinking" and many businesses world now have international competition, subsidiaries, or
customers. Your preparation can involve a number of general areas:
1.
Extend your foreign-language study. Some courses include cultural and institutional
materials of specific countries.
2.
Take a course in international finance, international economics, or trade. These are
usually "meaty" courses with some lasting benefits.
3.
As a finance major take a course in international business, but do not major in it at the
undergraduate level. Stay in finance, economics or accounting, or a functional area.
Multinational firms seldom hire entry-level people for international assignments. They
put their trained people with special skills (language or cultural knowledge) in those
assignments.
4.
If you have an interest, look for an opportunity to intern or tour in a foreign country.
If international business/finance is of interest to you, hone your language and cultural knowledge skills in
college, accept a challenging domestic entry-level position, and look for an opportunity to later transfer to
international activities. If you're not interested, don't worry. International activities or knowledge
193
requirements will come to you in time, right when you are least prepared for it! College is the best place
to prepare for the inevitable!
THE WALL STREET JOURNAL
In “Money & Markets” section there is a discussion and analysis of the foreign exchange markets.
Reading this column daily will provide considerable insights as to what influences the supply and demand
for foreign exchange and the prices or rates that follow. Everything from trade, financial flows, and
central bank involvement to speculation and expectations are involved in foreign-exchange transactions.
The "Currency Markets" section lists the recent spot prices of U.S. dollar and foreign exchange rates,
along with quotations associated with the previous business day's trading in foreign exchange futures,
options, futures options, and other foreign exchange index options. Note the "Key Currency Cross Rates"
table, listing the value of major currencies relative to other currencies, not just to the U.S. dollar. Reading
the "World Markets" articles, Section A, and the "Foreign Exchange" analysis daily for a term is as
effective as any international business course you will ever take!
TOPIC OUTLINE AND KEY TERMS
I.
Development of International Banking
A.
International Banking
1.
2.
3.
B.
The Edge Act (1919)
1.
2.
3.
C.
International banking dates back to the rise of international trade.
Great Britain dominated international finance until after WW II.
American banks entered international finance after 1914.
Federal Reserve Act of 1913 permitted foreign branches.
Agreement corporations were legalized in 1916.
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
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).
194
D.
The Reasons for Growth in U.S. International Banking
1.
2.
3.
4.
E.
Recent Activity in U.S. International Banking
1.
2.
3.
4.
II.
Increased expansion of U.S. trade and foreign markets.
Growth of multinational corporations.
U.S. government regulation limited cash outflows out of the U.S.
Need to finance petroleum-induced deficits in foreign countries.
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.
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.
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.
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. [See
Exhibit 15.2]
Regulation of Overseas Banking Activity
A.
Domestic U.S. Banking
1.
B.
Foreign Banks in the U. S.
1.
2.
3.
C.
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.
Can establish federally chartered branches.
Must have FDIC insurance on deposits up to $100,000.
Other foreign banking institutions can opt for FDIC insurance.
The Regulatory Framework
1.
2.
3.
4.
5.
Federal Reserve Act of 1913 - allowed federally chartered branches outside the
U.S.
Amendment to Federal Reserve Act (1916) - agreement corporations
permitted.
Edge Act (1919) - federally chartered corporations for international banking.
National banks permitted equity investments in foreign bank stock (1966).
Bank Holding Company Act Amendments of 1970 - regulated international
activities of bank holding companies.
195
6.
7.
8.
D.
Allowable Banking Activities
1.
2.
III.
International Banking Act of 1978 - extended federal regulation to foreign
banks operating in the United States.
The DIDMCA of 1980:
a.
expanded Fed control over foreign banks.
b.
permitted U.S. banks to establish international banking facilities.
In July, 1988, the Bank for International Standards (BIS) worked out
enhanced bank capital adequacy standards (effective in 1992) between leading
economic nations.
Traditionally, more activities have been permitted for U.S. banks operating in
foreign countries to enhance competitiveness.
a.
Security underwriting
b.
Equity investments
Restraints are kept on:
a.
U.S. foreign bank subsidiaries owning non-financial businesses.
b.
control of foreign companies.
Delivery of Overseas Banking Services [See Exhibit 15.3]
A.
Representative offices
1.
2.
3.
B.
Shell Branches
1.
2.
3.
4.
C.
Set up to conduct limited inter-bank money market transaction rather than retail
public branches.
Tend to do foreign exchange transactions and limited loan participation in
Eurocurrency markets.
Pay no local taxes and generally operate in relatively stable political
environment.
Tend to have state-of-the-art communications to operate and conduct transactions
in any global market.
Correspondent Banks
1.
2.
3.
D.
Set up to assist parent bank customers in a particular country.
Cannot accept deposits, make loans, transfer funds, accept drafts, transact in the
international money markets, or commit the parent bank to loans.
Can provide information and assist parent bank’s clients in their banking and
business contacts in the foreign country.
It is a relationship with foreign banks to provide international banking services,
similar to those that banks have in the domestic environment.
These include accepting drafts, honoring letters of credit, furnishing credit
information, collecting and disbursing international funds, and investing funds.
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.
196
2.
3.
4.
E.
Edge Act Corporations
1.
2.
F.
2.
Subsidiaries - separately owned (entirely or in part) by a U.S. bank, bank holding
company, or an Edge Act corporation.
Affiliates - small ownership (non-controlling) interest in foreign bank by U.S.
bank.
International Banking Facilities (IBFs)
1.
2.
3.
4.
IV.
These are federally chartered subsidiaries of U.S. banks engaging in international
activities not permitted to domestic banks.
May participate in international banking and non-banking activities including
investing in foreign equities.
Foreign Subsidiaries and Affiliates
1.
G.
Foreign deposits are included in the required reserves calculations at home.
They are subject to both the host nation’s regulations and the U.S. regulations.
Despite the cost of establishing a branch, they generate world-wide name
recognition for the parent bank.
Fed permitted IBFs beginning December 1981.
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.
They represent the balance sheet of the aggregated foreign assets and liabilities of
the establishing institution.
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.
International Lending
A.
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.
2.
Pricing
a.
The interbank rate in London is called the LIBOR or London
Interbank Offer Rate.
197
b.
c.
d.
B.
3.
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.
4.
Collateral
a.
Most international credits are unsecured.
b.
Most business borrowers have high credit ratings.
c.
Borrowing countries pledge their "full faith and credit."
Risks in International Lending
1.
2.
3.
C.
Credit risk - the risk of default.
Country risk - related to the political stability, laws, and regulations of the
foreign country.
a.
Expropriation
b.
Nationalization
c.
Change of government
Currency risk - risk of currency value changes and exchange controls.
Risk Evaluation
1.
2.
3.
4.
5.
D.
Non-bank borrowers pay above the LIBOR.
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.
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.
An analysis of both the borrower and borrower's country is done by the bank’s
foreign lending and economic departments.
Evaluation involves a statistical analysis of the country’s political and economic
risks.
A financial analysis of the borrower is also conducted.
If the cost of doing the analysis internally is prohibitive, outside sources exist but
they tend not to be as reliable.
The higher the cost of gathering information, the higher the loan rate, reflecting
the increased risk due to unreliable information or lack of information.
Risk Management in International Lending
1.
2.
3.
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
Pooling risk - participation loans among banks to spread risk.
Diversification of foreign loan portfolio
198
4.
E.
Managing Risk: How Banks Reduce Country Risk
1.
2.
V.
International Finance Corporation (IFC) creates loan syndications to private
borrowers in high-risk countries.
Banks take part of loan and risk, not all with loan participations.
Foreign Banks in the United States
A.
Growth of Foreign Banks
1.
2.
3.
B.
High growth after mid-1970s until 1990. [See Exhibit 15.5 - 15.7]
Japanese banking growth dominated the world in the late 1980's and made
significant inroads into west coast U.S. markets.
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.
Regulation of Foreign Banks’ U.S. Operations
1.
2.
VI.
a.
Geographical – regional or by country
b.
Industry
c.
Domestic vs. foreign loans
Loan Sales - selling nonperforming loans in the secondary market at a discount.
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.
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.
Future Directions of International Banking
A.
Concern about International Loan Quality
B.
Development of International EFT Networks
199
COMPLETION QUESTIONS
1.
The historical development of international banking is closely related to the development of
international __________.
2.
The __________ Act of 1919 enabled banks to create __________ chartered corporate
subsidiaries to participate in international banking including the making of __________
investments.
3.
International lending includes __________ and __________ risk along with credit risk.
4.
The __________ office is a minimal involvement in international banking in a foreign country,
but a __________ is a full deposit gathering/lending extension of the domestic bank.
5.
International loans, usually made in the __________ market, by a ________ of international
banks, are denominated in ________, and are priced using the ________________(LIBOR).
6.
An IBF (1981) or __________ __________ __________ is a segregated accounting of
international banking operations.
7.
Adequate geographical and industrial __________ is one method of reducing international
lending risk; pooling or _________ loans and third party __________ are other ways for a bank
to reduce its international lending risk.
8.
Foreign banks operating in the United States were brought into competitive equality with U.S.
banks with the 1978 __________ __________ Act.
9.
Banks can reduce foreign lending risk by lending to exporters, who insure their trade credit with
the ____________ _____________ ___________ _______________ (FCIA).
10.
Publications, such as Euromoney, assist the foreign lender by providing an assessment of
_____________ or __________ risk.
TRUE-FALSE QUESTIONS
T
F
1.
U.S. regulators have attempted to separate domestic banking risks and
international banking risks.
T
F
2.
The FDIC is the principal U.S. regulator of international banking activity.
T
F
3.
International banking facilities (IBFs) operate as subsidiaries of bank holding
companies.
T
F
4.
Expropriation and nationalization are two methods of guaranteeing payment of
U.S. bank loans to developing countries.
T
F
5.
Pooling risk entails lending by several banks to a foreign borrower.
200
T
F
6.
American industrial companies followed U.S. bank involvement in foreign
operations.
T
F
7.
Edge Act corporations are federally chartered.
T
F
8.
Representative offices are usually established to coordinate business between
domestic and foreign banks.
T
F
9.
Deposits of foreign branches outside the U.S. are included in the required
reserves calculations at home.
T
F
10.
Pooling and third-party guarantees are two methods of reducing international
currency risk.
T
F
11.
The Edge Act of 1919 permitted U.S. banks to create international banking
facilities.
T
F
12.
U.S. bank regulators allow U.S. banks overseas to engage in all banking activities
allowed by the host country.
T
F
13.
Shell branches are developed for international money market transactions
without contact with the public of the host country.
T
F
14.
Sovereign loans to less developed countries are usually rescheduled rather than
foreclosed.
T
F
15.
Until the passage of the International Bank Act of 1978, foreign banks enjoyed
substantial operating advantages over domestic banks.
MULTIPLE-CHOICE QUESTIONS
1.
A U.S. bank loan to a Mexican manufacturer payable in pesos accepts which risks?
a.
country risk
b.
credit risk
c.
currency risk
d.
all of the above
2.
The U.S. bank above could reduce its risk of loss by
a.
selling participations to other banks.
b.
seeking Mexican government guarantees.
c.
selling pesos in the forward market.
d.
all of the above
3.
All but one of the following relates to rescheduling activities of a troubled sovereign loan:
a.
Shortening the repayment schedule.
b.
The consolidation of several loans into one.
c.
The extension of governmental guarantees to private business debt.
d.
The granting of a grace period, during which no payment is expected.
201
4.
All but one of the following is a reason why American banks expanded their international
activities:
a.
the growth of U.S. based multinational corporations.
b.
the expansion of U.S. world trade.
c.
regulatory restrictions in U.S. banking markets.
d.
the World Bank provided assistance to expand globally.
5.
The Foreign Credit Insurance Association (FCIA) is an organization of U.S. insurance
companies which
a.
insures the foreign lending (trade credit) risk of exporters.
b.
insures the foreign lending (trade credit) risk of importers.
c.
insures bank loans made to developing nations.
d.
assures that foreign exporters will pay their trade credit.
6.
The development of foreign banking activities in the 1960s was prompted by all of the following
U.S. regulations which restricted U.S. capital flows abroad except:
a.
Foreign Direct Investment Program (FDIP)
b.
Agricultural Export Restraint Program (AERP)
c.
Interest Equalization Tax (IET)
d.
Voluntary Foreign Credit Restraint program (VFCR)
7.
International loans priced at or above the LIBOR, are financed by
a.
demand deposits
b.
LIBOR loans
c.
time deposits
d.
foreign exchange
8.
An Edge Act bank may
a.
be located in the United States outside a parent's own state.
b.
own foreign banking subsidiaries.
c.
engage only in international banking activities.
d.
all of the above
9.
U.S. banks reduce their risk of foreign operations by
a.
seeking guarantees from borrowers.
b.
FDIC insurance.
c.
portfolio diversification.
d.
insurance through the International Monetary Fund.
10.
The purpose of the International Banking Act of 1978 was to
a.
return the competitive edge to U.S. banks.
b.
return competitive equality between domestic and foreign banks.
c.
reduce the competitiveness of foreign banks.
d.
none of the above
11.
Unlike the United States, many countries grant their banks the authority for
a.
full merchant banking.
b.
deposit banking.
c.
forming bank holding companies.
d.
lending to foreign companies and countries.
202
12.
All but one of the following is associated with U.S. regulation of international banking?
a.
Federal Reserve Act of 1913
b.
Edge Act of 1919
c.
National Banking Act of 1863
d.
International Banking Act of 1978
13.
Which of the following forms of international banking organization is an extension of a domestic
bank but is located in a foreign country?
a.
foreign branch
b.
shell branch
c.
representative office
d.
international banking facility
14.
International bank lending is characterized by all of the following except that loans
a.
are unsecured.
b.
have floating rates.
c.
are made for relatively small amounts.
d.
are priced relative to the LIBOR.
15.
Which of the following is associated with the currency risk of international lending by a U.S.
bank?
a.
The Spanish borrower is slow to pay the U.S. bank.
b.
The U.S. bank is paid dollars by its foreign borrowers.
c.
A U.S. bank expects to receive an interest payment from a Russian borrower paid in
Rubles.
d.
A U.S. bank holds a mortgage on property in a country in the middle of a civil war.
SUPPLEMENTARY ASSIGNMENT: ISSUES IN INTERNATIONAL BANKING
Research the periodical indexes or look through several issues of bank periodicals with the objective of
identifying a "Current Issue in International Banking." Write a two-page essay identifying the issue, the
cause of the issue, and several proposed alternatives. If you locate several other current issues, list them at
the end of your discussion.
SOLUTIONS TO COMPLETION QUESTIONS
1.
trade
2.
Edge; federally; equity
3.
country; currency or foreign exchange
4.
representative; branch
5.
Eurodollar; syndicate; dollars; London Interbank Offered Rate
6.
international banking facility
203
7.
diversification; participation; guarantees
8.
International Banking
9.
Foreign Credit Insurance Association
10.
country or credit
SOLUTIONS TO TRUE-FALSE QUESTIONS
1.
T
By requiring separate corporate subsidiaries (Edge Act) to operate international
operations. On the other hand, the extensive foreign loan levels held by money center
banks is a domestic challenge to U.S. banks and regulators.
2.
F
The Federal Reserve System.
3.
F
They are merely a separate set of books of a U.S. bank for specific international
activities.
4.
F
They are two risks of lending to businesses operating in foreign countries.
5.
T
Several banks may participate, reducing the risk (and return) for the primary lender.
6.
F
Just the opposite is true. U.S. banks assisted trade development.
7.
T
Versus state chartered.
8.
F
To assist the bank's customers.
9.
T
All foreign-based deposits of foreign branches of U.S. banks are included for the purpose
of calculating required reserves.
10.
F
Two methods of reducing credit risk.
11.
F
The Edge Act of 1919 permitted U.S. banks to create subsidiaries called Edge Act
Corporations, not IBFs.
12.
F
U.S. bank regulators do not allow U.S. banks overseas to engage in all banking activities
allowed by the host country. For example, they are not allowed to own non-financial
corporations.
13.
T
Shell branches are developed for international money market transactions without contact
with the public of the host country.
14.
T
Loans to Less Developed nations are usually rescheduled rather than foreclosed.
15.
T
The passage of the International Banking Act of 1978 made U.S. banks more
competitive with foreign banks operating in the United States.
204
SOLUTIONS TO MULTIPLE CHOICE QUESTIONS
1.
d
Country, credit, and the risk that the peso’s value against the dollar will change is
accepted by the lender.
2.
d
All are risk reduction methods, which also reduces potential return and reduces the
variability of returns on the loans.
3.
a
Shortening the term is not part of rescheduling.
4.
d
The first three are true reasons for American banks’ globalization.
5.
a
Exporters have shipped goods and expect payment in the future. This risk may be
transferred to the FCIA.
6.
b
These capital flow restrictions of the 1960s encouraged U.S. banks to open foreign
branches to raise funds and finance expanding U.S. and foreign businesses.
7.
d
Relatively short-term time deposits, often Eurodollar deposits, provide the funding for
many international loans.
8.
d
An Edge Act corporation is a flexibility option for international banks while maintaining
rather right regulations with domestic banking.
9.
c
Proper diversification reduces total risk.
10.
b
To enhance bank performance in the economy, the Act gave a few "bones" to U.S. banks,
but also tightened regulations in certain areas without choking off incentives for foreign
bank competition.
11.
a
In most nations, banks are allowed to do investment banking or merchant banking
activity without constraints.
12.
c
The National Banking Act of 1863 dealt with domestic bank regulation.
13.
a
A foreign branch serves as an extension of a domestic bank but is located in a foreign
country.
14.
c
International lending take place in a wholesale market implying large transaction sizes.
15.
c
The Russian borrower’s interest payment in Rubles is subject to exchange rate risk, since
the Ruble’s value against the U.S. dollar can change over time.
205