International Finance Outline
I. Introduction
A. Elements of international financial transaction
1. Types of Financial Intermediation
– Indirect Finance
o Banks (liability to depositors) transmitting money from Savers to
Borrowers
– Direct Finance
o Securities firms (no liability) connecting issuers (notes, bonds, equity) to
investors
2. Cross-Border International Transactions
a) NY Bank lending to German Co.
b) NY Company issuing securities to German Investors
3. Non Cross-Border Transactions
a) NY bank lending Euros to a U.S. Co
b) NY bank in London (branch or sub) making Pound loan to U.K. Company (Duffy and
Chung do not regard it as international)
c) Japanese Co. Issuing Securities to U.S. investor in Tokyo
– the U.S. wants to protect people wherever they are and would extend the reach of our
securities laws to even U.S. investors located abroad
B. Evolution of international financial markets
– International Lending of Banks (1982)
o Japan 11% (lending to non-residents in foreign currency)What changes
between 1982 and 2002, most significant in Japan, lending in foreign
currency is much more to non-residents than residents and loans in dollars
in Japan has fell, reasoning: in 1982 there was a lot of regulations of the
Yen (exchange controls), they lent in dollars because of lower regulation
of the Yen
o USA 17% (lending to non-residents in home currency)
o A long-term policy in which federal reserve discourages making foreign
currency loans inside the United States
o UK 72% (lending to non-residents in foreign currency)
o 1982 – U.S. Greatest % of International Assets, 2002 – Germany
– Off Shore Banking Centers
o Functional (London) or booking (Bahamas)
– Move from banks as providers of capital to securities and capital markets
C. Costs and benefits of international finance
II. International Aspects of U.S. Securities Regulation
A.
–
–
–
–
Internationalization of U.S. Securities Market
More Foreign Securities held
More Foreign Listing on NYSE
More Foreign Issues
Greater U.S. Global Equity Market Cap
1. Reasons why Foreign Companies List
– Bonding to higher disclosure standards
o Siegel disputes this because he says there is no enforcement of regulations
against foreign firms
B. U.S. Treatment of Foreign Issuers
– Much fewer causes of action against foreign v. domestic issuers
a)
–
–
–
Obstacles to Foreign Issuers in Public Offerrings
No exit from ’34 Act (if more than 300 U.S. shareholders)
Disclosure Costs
Corporate Governance
o Sarbanes-Oxley
– Distribution Restrictions
b) April 2003 settlement for Independent Research Analysts
o Separate research and investment banking
o Analyst compensation cannot be based on investment banking revenues
and cannot be determined by investment bankers
o Analysts can’t go on roadshows
o Research reports must disclose that company may seek to do business with
covered firms
– Result: may be less research by investment banks BUT ONLY APPLIES TO U.S.
FIRMS
– Note: the rules do apply to foreign firms issuing securities in the U.S. but not abroad
c) 2003 IPO Pricing and Allocation
– Prohibit underwriters from allocating IPO stock to certain individuals
– PROHIBITIONS DO NOT APPLY OUTSIDE OF THE U.S>
o U.S. firms will not follow restrictions in distributions abroad of
unregistered offerings
o Unlike analyst rules, U.S. firms are not implementing these rules globally
for unregistered offerings
o U.S. firms may follow restrictions (but foreign firms will not) for foreign
part of global offering (offering both in U.S. and abroad)
d)
–
–
–
–
–
–
2002 Sarbanes-Oxley and Stock Exchange Treatment of Foreign Issuers
CEO and CF) certifications of financial statements – Fully applicable
Independent audit committee – Limited exemptions
Outside auditor independence – Less stringent overall
Stock Exchange requirements – Exemption with disclosure of differences
Attorney Obligations – Fully Applicable
Continuous and Improved Disclosure – Fully Applicable
e) Regulation FD
– Prevents companies from just giving analysts info, must disclose publicly too
– Does not apply to Foreigners AT ALL (legislation did not require it and SEC didn’t
do it either) It was a different environment, 2000 was much different than 2002-3. If
it was written today it would be enforced against foreign firms.
– International companies get better than National treatment
o No private liability
o Only covers reckless violations
o Only covers communications by “senior” officials
o Does not apply to communications made in connection with most
registered securities offerings
o Only applies to “material” non-public info
o Does not apply to “confidential” communications
f) Should we impose more onerous disclosure requirements for foreign issuers than
apply to domestic issuers?
– It is harder to enforce rules against foreign firms
– How about stricter disclosure rules? But no matter what the rule is how can you
enforce the truth? Tougher auditing?
– What would be the effect of these rules?
o Retaliation, other countries complain even when they get national
treatment (SOX)
g) Ways to get around U.S. requirements
– Private Placement -- We have long had Private Placements, what changed in 1990
was to develop a secondary market for private placements (see slide)
o Rule 144A Offering
 Either to QIB’s
 An Investment Bank, which then resells to QIB’s
 Then there is private, secondary QIB Market

one system is PORTAL. Only QIB can trade within the
system, creating a more liquidity market
o Information requirement for non-34 Act reporting companies without
12g3-2(b) exemption
o 10 (b)-5 and 17 (a) liability (Parmalat)
 Parmalat issued bonds under 144A, SEC tried to find fraud liability
of Parmalat and/or underwriter, this has sent a shiver through the
market this was supposed to be the market was less regulated
o Look up British Aerospace: bond spreads
o Can be made more attractive: QIB definitions, No information for nonreporting, non-exept users, Reduce liability, clarify due diligence
– Home Country Rules: MJDS
o Just Canadian, get to issue stock on U.S. markets with their own
disclosure, accounting rules
o Have to be real Canadians
o Get U.S. Fraud liability
o Supplemental disclosures required
o U.S. Auditor Independence
o U.S. GAAP reconciliation
o Sarbanes-Oxley applies
o Prett much the same, very little change
o Should be extended?
 Scott says major Concerns
– ADRs
o Ownership interest (negotiable certificate) in securities deposited with a
depositary by issuer/holder. Most foreign issues listed in U.S. and 144A
trade in this form.
 For our purposes, ADR’s may make trading of foreign shares more
attractive but if they are public you are subject to public
registration requirements and if it is a private placement you still
have the same requirements (registration rules are exactly the
same), ADR’s are totally subject to full U.S. regulation
o Juts make the trading of public or privately uissued shares in foreign firms
more attractive
 Traded, cleared and settled in U.S. markets (cheaper, more
relaibile)
 More accurate pricing of foreign issues (liquidity), this is general
effect of U.S. listing
 Dividens/interest paid in dollars
 Corporate action reports in English
o Foreign Exchange Risk
 Direct Risk: If foreign currency price drives U.S. dollar price
(depends where most trading)
 Indirect Risk: Earnings of Japanese corporation can be affected by
Yen/$ rate, this is independent of trading
C.
–
–
–
Regulation S: U.S. Control of Securities Offerings Abroad
U.S. Issuer issuing on Foreign Market
Foreign Issuer issuing to U.S. Investor
Laws say that unless there is a specific exemption by SEC both the transactions
would be subject to SEC regulation if U.S. investors are involved (this is the officially
SEC interpretation of the ’33 Act)
– Regulations S sets out the terms of the exemption under certain conditions:
a) Regulation S: General Conditions for Exemption
– Offshore transaction
o Buyer is or reasonably believed to be abroad, or
o Sale on physical trading floor of an established foreign exchange (normal
primary distribution are off exchanges)
– No “Directed Selling” in U.S.
– Re-read Regulation S
b) Regulation S
– Does not allow U.S. Investors to participate in primary offshore markets of foreign
issues
o After flowback restrictions end (0-40 says to 1 year after issue), U.S.
investors can freely trade foreign securities in secondary market abroad on
foreign exchanges
o Scott Proposal
 Provides for use of offshore markets to achieve uniform rules on
disclosure and distribution
 Drop regulation S for foreign issuers
 Minimum disclosure required
 Allow Foreign Issuers to sell directly in U.S.
 Does not want initially for U.S. issuers, more possibility of
undermining SEC U.S. regs. (U.S. issuers would just go abroad)
D. International Efforts
a) IOSCO Disclosure Rules
– Adopted by U.S. in 1999: Revised Form 20-F for foreign issuers
– Harmonizes basic business data but not materiality, business segments, forwardlooking statements, GAAP reconciliation, distribution and enforcement
b) International Accounting Standings
– E.U. scheduled to adopt in 2005 but European banks oppose derivative rules on markto-market accounting
o Derivatives are instruments kept off the balance sheet, issue how you
would account for their value on the balance, in the U.S. we keep the
value to market (if it goes down it is loss in income); this mark-market
accounting creates volatility.
o
– Should U.S. adopt?
o May also be derailed by bank pressure on mark-to-market rules for
derivatives
o EU may prohibit U.S. firms from using U.S> GAPP in EU offerings if
U.S. does not permit foreign firms to use IAS in U.S. offerings
c) Alternatives for Use of Foreign Reulatory System
– Portable reciprocity: issuer can select law of any country (Choi-Guzman)
– EU’s proposed equivalence test: allow issuer to issue under home-country rules
where such rules are :equivalent”” to those of U.S.
III. International Aspects of U.S. Banking Regulation
A. The Operations and Importance of Foreign Banks
– Importance of Foreign Banks in the U.S.
o 5.2% of offices
o 20% of Assets
o 25% of Loans
B. Systemic Risk: A Major Concern of Regulation
– One bank failure starts a chain reaction through
o Interbank deposits – placements v. clearing
o Payment system
o Imitative Runs
– Foreign banks can create the same systemic risks
o Subsidiaries just like U.S. Bank
o Branches
 Interbank deposits
 Extremely rare that there would be clearing problem, US
banks do not give clearing accounts to foreign banks
 US banks do lend to foreign banks, however, but not a
greater risk than domestic lending, also the exposure is
pretty small (1% overall)
 Payments system
 The major players in the CHPS system are foreign banks,
who clear dollar payments through the CHPS system so
foreign branches add risk here, but there have been
incredible improvements so the risk is quite minimal;
 Imitative runs
 People distinguish between foreign and domestic banks

– Should host or home central bank serve as lender of last resort for a foreign bank’s
branch or sub in the U.S.?
o A failure won’t effect US banking system as much is one reason against
host country protection (see above)
o Argument for home country is that they regulate/follow the bank, they can
evaluate better whether the failure is rational
o Host country has more host currency (counter argument)
o What if home country is asleep?
o Don’t want to let banks know exactly when the central bank will be lender
of last resort, moral hazard of banks being less careful
C. Safety and Soundness
– Concern: Avoid deposit insurance payouts and uninsured depositor losses that result
from failure
o Public funds if insurance premium not enough
o Prospect of systemic risk
– Regulation
o Ex-ante: examination, capital requirements, activity restrictions (e.g.
limitations on loans to single borrowers, or commercial activities)
o Ex-post: Dealing with failed banks
o More important for subsidiaries or branches?
 More concerned with foreign branches because we are not sure
they are solidly backed.
 There was time that the FDIC protected foreign branches too, but
now we don’t insure foreign branches but branches can exist if
they take deposits above $100,000. We ban foreign branches from
taking deposits of less than 100K from any U.S. citizen without
FDIC insurance. Less than 100K has to be subsidiary. From
deposit insurance loss point of view, there is less concern with
foreign branches because we don’t even insure them.

– BCCI
o One bank in Luxembourg one in Cayman Islands, would give each other
worthless loans when the examiners appear
o The lesson is that a structure where it is not clear who is in charge of the
safety and soundness off the bank is not a good idea
o Mr. Assistor: pretend to take a loan and give it to the deadbeat debtor to
trick the examiners
o Concern with solvency of foreign banks
 Subsidiaries: of bank owners
 Branches: of bank itself
o Need for foreign bank entry/exit controls (branches particularly—U.S.
adopts after BCCI)
o Need for effective supervisors (Luxembourg had no examiners—U.S.
requires after BCCI)
o Need for lender of last resort (Abu Dhabi—no formal requirement)
o Need consolidated supervision for overview (U.S. adopts after BCCI)
 Who is the overall regulator?
 Holding company incorporation (e.g. Luxembourg)
 Major Business
 College approach: This is how things are structured now, a
lead regulator with a college of interested countries.
o Role of home versus host country (Basel); home country cannot easily
inspect branches
o Secrecy: How does consolidated supervisor get information on operations
in Nassau?
– Daiwa
o 10th largest Japanese bank with 2 branches in NY, NY Dawia Trust Co.
 Principal NY branch loses $1.1 billion from trading, concealed
1984-1995, discovered in 1995
 $97 million loss in Trust Company from Concealed Trading
o Why does U.S. care about NY branch or Trust company losses?
o Were U.S. penalties reasonable? This bank was not going to fail, no where
near it, yet all these penalties were implemented
 Plea bargain on criminal charges for $340mm in fines (charged
with $1.3 billion)
 Criminal convictions (hail and fines) of branch manager and rogue
trader
 All Daiwa operations in U.S. terminated (sold to Sumitomo)
 Point: The whole system depends on cooperation, the Fed
examiners have to be able to rely on promises made by foreign
banks, host regulators have to cooperation otherwise the whole
system falls apart. When misinformation is propagated by banks
the

D. Deposit Insurance
E. Activities
– We are worried about bank failure, we don’t want them to engage in risky activities,
limit what they can do in order to lessen the risk.
o This is the lesson from 30’s, all the banks failed because they were
involved in risky securities trading.
1. Pre-1999
– Non-banking subs of Bank Holding Cos. Limited acitivites
o No commercial
o Limited insurance (no underwriting)
o Securities: Limited in principle, extensive in practice
– Other Countries allow universal banking
2. GLB
– Allows Financial Holding Companies to Engage in Activities which are Financial in
Nature
o Bank subs
 Some securities business
 No insurance underwriting
 No merchant banking
o Non-Bank subs
 Can do securities-dealing and underwriting
 Can do insurance
 Can do merchant banking
– Result of all this has been to eliminate much of the differentiation of U.S. and foreign
banks, it actually helps bank organization reduce risk due to a diversified portfolio in
case banking market is struggling
IV. International Rules in Banking
1. Basle Concordats
a) Allocation of Authority Between Home and Host Countries for Subsidiaries and
Branches of Foreign Banks
b) Capital Accord
– Why do gov’t regulate Capital Adequacy?
o Prevent bank failure by providing a cushion for losses (or reduce bailout
costs)
o Reduce moral hazard for owners by making sure they have substantial
capital at risk
o Insure fair competition
o
– What is capital?
o Assets-Liabilities = Capital
o How can a failed bank have capital that is 10% of assets moments before it
fails?
 We have no market value for loans, the banks say they are worth
100, but they are actually worth 70
 Most of the assets of banks are not market-priced
– What is the competitive impact of capital ratios?
o Having less capital requirements means you can make larger loans 
more profit
– Basel Accord: Do bank capital standards adequately deal with credit risk?
o Promulgated in 1988 by G10 countries through Basel Committee
 EU adopts a similar direcdtive extending to more countries
 Many other countries adopt: de facto international standard
o Agreement of central bankers—not a treaty: the federal reserve had
adequate authority under existing law to translate into regulation
o Minimum standards for international banks (no official definition of
international bank, but not aimed at local, rural banks) and implemented
differently in each country (U.S. and EU apply to all banks; U.S. to
holding companies)
o What is capital under Basle Accord?
 As implemented in U.S.
 Tier I capital
o Equity and near equity
 4% of risk weighted assets
 Tier II capital: Limited to 100% of Tier I
 Total capital:
o 8% of risk-weighted assets
o (if Tier I is 4%, Tier II must be 4% and total is 8%)
 Note: banks and (FHCs) may hold more than minimum to
qualify for expanded activities and lower levels of
supervision under prompt-corrective action standards, p.3.,
as well as for competitive and buisiness judgment reasons
o Risk Weighted Assets
 9% Cash and loans to OECD governments
 20% Short-term claims on non-OECD banks
 Residential mortgage loans (secured)
 All other loans
 Problems: Very crude, doesn’t measure risk accurately
 Banks will incentivized to lend to the most risk borrower in
each category
 During Asian crisis, part of the problem is short-term debts,
banks for arbitrage reasons expose themselves to more risk
than is represented here
 Residential mortgage loans (secured), why should they be
different secured commercial loans which are at 100%?
This was a political play by U.S. negotiators.

o Bank Captial Nears 8%, has do something
– Basel II: proposals to amend the Accord
o Overview
 Minimum regulatory capital charge
 Standardized approach (default)
o Banks use rating agencies to classify borrowers,
then Basel specifies risk weights
o Unrated borrowers: 100%
o Loans with mortgage: residential, 50%; commercial
100%
 Internal Ratings-Based (IRB approach)
o Regulators let sophisticated banks rate risk



Foundation Approach: Basel sets
components of many parameters
Advanced approach: banks set more
components
Parameters
 Probability of default
 Extent of loss given default
 Amount at risk
 Maturity: assume maturity of 3 years
 Parameters “map on” to risk-weights

Supervisory Review
 Credit Risk Mitigation (you are actually protected):
Collateral, Derivatives (hedging), Guarantees, Insurance
Netting
 Supervisors evaluate residual risk of each technique
following Basel’s guidelines
 Market discipline (disclosure)
o U.S. Application
 Basel II (advanced) mandatory for 10 banks-FHCs, 10 more may
qualify; rest use Bel I—is this a good approach?
– What are the other possibilities?
o Just let banks use their models, let the market set capital adequacy
o New system which demand that banks issue market symbols tha indicate
their risk
o Only national standards
c) Market Risk
– Capital Adequacy: Market Risk
o Why governments regulate capital for market risk (risk from the change in
value of assets)
 Securities firms and banks underwrite, deal on their own behalf
and trade on behalf of customers
 Market risk, like credit risk can lead to insolvency
o But why do governments care if securities firms fail?
 Firms are linked/connected contractually (derivatives, etc.), if one
fails many might fail, but this a controversial idea
 Customers (as opposed to investors) who use the securities firms to
acquire securities
 Also, securities firms are often part of banks!!! If the securities
firm endangered the bank/holding company its failure could impact
the bank and then bank systemic failure
– U.S. Financial Firms are Subject to 3 Approaches to Market Risk
o Basel Building Block Approach
 Applies to banks’ securities positions (and by Fed to consolidated
US FHCs)

For general risk, hold 8% of the net position in the market,
plus
 For specific risk, hold 8% of the overall gross position, or
4% if the position is well diversified and liquid
o All of your longs go down and all of your shorts go
up
 These add up to capital position
 Observations
o Short risk is greater than long risk (stocks can go to
infinity but never less than 0) which this model does
not account for
o 4% and 8% are pretty random
 Basel II does not deal with market risk
o Models-based regulation
 Basel: alternative for qualifying banks/firms (and by Fed for US
FHCs)
 Regulators set parameters. Banks must:
o Have skilled staff, systems, managers
o Compute Value at Risk (amount of gains and
losses)
o Back test, increasing to 4X VAR if model failed
o The Comprehensive Approach
 SEC: Applies to positions of securities companies, including
securities affiliates of FHCs
 Very conservative approach, multiple haircuts on assets
 Hair cut accounts for how long will it take to trade out
when you go bankrupt (delays causing your assets to
decrease in value)
 What is the logic of the second haircut?
o Shorts are usually the smaller position, this is
basically saying that you are better off if your shorts
are small
d) Operational Risk
o Sept. 11, etc., mistakes, general business risk
o Basel II Approach
 12% of Overall Capital Requirement X Gross Income
 Standardized Approach: 12% of Overall Capital requirement x
gross income of 8 business lines weighted for different risk
 Advanced Measurement Approach: internal models with
parameters
 Credit for risk mitigation through insurance limited to 20%
 Lots of operational risk is insured against why not get full
credit?

Takes time to get insurance, so not rapid enough to be
capital but an 80% discount is pretty extreme

– International Capital Rules:
o Will they survive?
o Crown Jewel of International Regulation
o Move towards models and markets, not international rules in the same
sense
o May they are coming out with a final Basel II proposal

2. International Financial Architecture Initiatives
– Basle Core Principles
3. 1997 General Agreement on Trade in Services (GATS)
– Key Purpose: remove barriers to entry for foreign financial institutions
– Key Principle: most-favored nation (MFN)
V. Payment System
A. Risks and Risk Reduction in Fedwire and CHIPS
1.
–
–
–
–
–
Fedwire
Owned and operated by 12 Fed Reserve Banks
Real Time
Gross Settlement
Overdrafts allowed
“Good” funds
a)
–
–
–
–
Risks
Could take the money back from Receiving Bank if OB does not cover its overdraft
Could prohibit overdrafts
Could require COllatetal
Daylight Overdraft Ceiling:
o Maximum is 2.25 x capital per day and 1.50 capital as a two week average
o Self-assestment of (1) bank credit worthiness (2) operational controls to
control risk in payment sustesm and from customers (3) credit policies and
procedures; and (4) systems/contingency procedure
o Ex-post monitoring
o Special rules for branches of foreign banks:
 Home country subscribes to Basel: capital base is 10% of
worldwide capital
 Home country does not subscribe to Basel: capital base is 5% of
the branch’s liabilities for unsecured overdrafts or 10% of
worldwide capital for secured overdrafts

Makes foreign banks less competitive, Special rules are a result of
Fed’s fear that it will be stuck low on the bankruptcy priority list if
the foreign bank fails. Under US banking laws, by contrast, the
Fed is always repaid.

– Pricing
o 27 BP (.0027) annual rate for an 18 hour day
2. CHIPS
– Until 1998 owned and operated by NYCHA (10 NYC banks)
– As of Feb. 2003 owned by CHIPco., which is owned by the participants and operated
by NYCHA
– 54 participants (majority foreign banks from 30 countries)
– Intra-day continuous bilateral and multilateral net settlement as of 2001
o Humphrey says that 30% of the world’s banks would fail if the biggest net
debtor failed
o
– End of day net settlement
o There is a risk of net settlement
o New CHIPS arrangement
 Prefunded balances based on past acitivity
 Balances cannot go below zero or over two times initial balance
 Payments settled during day by bilateral or multilateral netting
against balances by a balance release algorithm designed to get the
most settlement out of the available balances
 End of day net settlement: unreleased messages expire
 Implications for payment system and bank regulation?
 Safer/almost no system risk
 Don’t seem to cause gridlock (very minor)
 Makes CHIPS more competitive with Fedwire, have to
maintain a balance with CHIPS so lose some opportunity
cost
o Still an issue if Bank Fails and bankruptcy trustee does not respect netting
B. Herstatt Risk
– See German Bank failure
VI. Terrorist Financing
– Money Laundering
o Cash proceeds of the illegal activity must be converted to bank deposits in
order to shrink the hug volumes of cash generated
o Money Launderers must conceal the true ownership and origin of bank
deposits, the proceeds of illegal activity
o Criminals must be able to effect control of their illegally obtained
proceeds
o Diffrernce with Terrorism Financing



Legal-bank transfer
Smaller
Non-major markets
A. Profiling
o Would this profile allow us to identify future terrorists from bank records?
B. Preventive Techniques
o Stopping Payments
 Old Money Laundering Techniques
 Suspicious Activity Reports (SARs) profiling
 Currency Transaction Reports: cash transactions over
$10,000: deter cash conversions and facilitate tracking
 Wire transfer records (Travel rule): facilitate tracking
 New Patriot Act Techniques
 Section 326: Know Your Customer (verify identiies and
check against terrorist lists)
o Lot of opposition to initial proposal in 1999
o Patriot Act regulations are not as intrusive, get the
identity but not the nature of the business
 Section 314(a): Info sharing with law enforcement officials
o Not just applicable to banks
o Lower hurdles on getting customer info
 Section 312: Due Diligence for Private Banking and
Correspondent Accounts
o “Reasonable” Due Diligence required to detect
instances of money laundering or terrorist financing
o If correspondent account is from non-cooperating
country bank must undertake special due diligence
on ownership, security, and see if it is a nested
correspondent accounts
 Section 311
o Certain jurisdictions, institutions or transactions can
be designated by Treaurary Sec. As posing
particular terrorist financing concerns, designation
results in enhanced record keeping requirements
 Will these measures be effective in preventing terrorism?
 Tracking down terrorists after the fact?
 What else could we do?
 Get rid of cash transactions, only electronic money
 Get rid Hawala, i.e. provide incentives for legitimatization
(lower costs of getting a bank account)
 Get rid of correspondent banking (Scott’s idea), no bank
can hold a USD account outside of the U.S.
C. Freezing Assets

VII.
LAFB:
 Why did they set up the investment bank in London?
 Dollar accounts held outside of the U.S. (Eurodollars), the
hope was it would be outside the jurisdiction of the U.S.
 Higher interest rates are higher in London, because the cost
of bank in NY is higher, no reserve requirements in
London, Federal Reserve bank requires a reserve deposit,
there are interest rate ceilings in the U.S.
 Do all transfers go through the U.S.? Why was this
important to the case? Court says if you pay in cash you
don’t have to go through NY. In theory is it even possible
to pay $300MM in cash? Well they could just buy it. Or
they could through correspondent banks.
 Libyans win the case in the English court, court says they
need pay Libya $300MM. Could the U.S. prevent BT from
complying with the decision of the English court? If so,
why didn’t it? What happens in BT doesn’t pay. Libya can
foreclose on the assets if they don’t pay up. What are the
assets of a bank? Well, you have loans which are being
repaid, Libya could get these.
 Eventually the U.S. let BT give them the $$, after BT
pleaded that they didn’t want anymore trouble.
 Lessons for terrorist freezes?
o Big lesson is that all freezes need to be multilateral
to be truly effective
 Where would terrorist funds be distributed once they were
unfrozen? Here they go to Libya.
Foreign Exchange Regimes
A. Functions of an exchange rate regime
– Value currencies against each other (in order to promote trade/capital exchange)
– Allow a country to adjust its economy (or prices) when its trade with other countries
is not in balance
B. The extremes: fixed and floating regimes
– Governments: fixed rates
o Fixed rates will always automatically result in adjusting trade imbalances
o But countries may want to avoid adjustment
– Market: floating rates
o Also an automatic adjustment
 Rules: Governments do not intervene except to smooth the markets
 Key point: the surplus country will feel the brunt of the adjustment
o How governments impede adjustment to keep exports high (central bank
that effects the amount of the currency by buying and selling treasury bills
in massive amounts)
 Reduce demand
 Lower Interest Rates
 Buy Sterling
 Increase Supply
 Lend more money
 Sell currency for sterling
– Interest Rate Parity Theorem
o There is a direct relation between the interest rates in 2 countries and the
exchange rate of their currencies
o A rising interest rate in country A and no change in B will mean that A’s
currency will attract investors and increase in value against B’s currency
– Capital Controls
o Some governments control the flow of capital into and out of their
country, have eroded but may still be a tool to deal with FX crises (IMF
more sympathetic)
– Exchange Rates in Headlines
o Japan Buys Massive Amounts of Dollars for Yen (January 2004, $70
billion), FT 3-4-2004, Op Ed – the Yen weakens so there can be more
Japanese exports, major macroeconomic problem has been DEFLATION
(banks don’t want to make loans because it is harder to make money,
inhibiting economic growth), this might result in some price increases
 What do they do with the all $ they buy? They are going to buy
massive quantities of US treasury bonds, what will be the impact
of that? A good effect on US economy, Alan Greenspan might be
happy.
 What about the effect on our national debt (we owe
Japanese a lot more money), lots of leverage by Japanese
gov’t (if they sell US interest rates go up)
o Dollar Weakness Deters Transatlantic M&A, FT, 3-1-2004, American’s
stocks are worth less in pounds/euros because of depreciated $$, decreases
whom is acquiring whom not really merger activity in general
o Greenspan Warns About Yuan Float, WSJ, 3-2-2004, China has lot of
growth but a troubled banking system (no capital, banks might be going
bankrupt), the Chinese would have to remove capital control, which would
result in a bank runs (convert Yuans to $ accounts), which would result in
a panic
 There is also a current fear of inflation because of the 9% growth,
in order to peg to the dollar they will need to buy dollars which
will result in inflation (fixed rates contribute to inflation?)
C. What regime should countries have today?
– A country that issues its own currency revceives income from doing so
– Floating the best?
VIII. European Monetary Union
– Shift to a single monetary and FX policy but Preservation of Separate Fiscal Policies
– FX rates set irrevocably in 1999, National currencies disappear by 6/01/02
– One monetary policy set by the ECB
– Governing institutions include heads of state, council of finance ministers, ECB, and
national central banks
– Costs
o States lose FX and monetary policy tools as adjustment techniques
o Separate Fiscal policies will lead to inflation if Stability Pact ineffective
 Spending is left national authorities (individual countries spending
with one central bank conducting monetary policy and interest
rates), individual countries export the costs of inflation to other
countries by undisciplined spending
o
– Benefits
o Reduced transaction costs on FX
o Integration of financial markets (but don’t need single currency for this)
o Better inflation control in inflation-control countries
– Stability pact
o If fiscal debt (taxes v. spending) is greater than 3% get fines, purpose is to
control inflation
o Not currently being enforced against France and Germany
– ESCB
o ECB Council makes ECB policy (12 Central Bank Governors + President
+ 6 Ex. Board Members)
o 12 National Central Banks IMPLEMENT policy
o Independent but perhaps not effective, unwilling to use interest rate policy
(effectiveness and independence are two major concerns)
– Transition Problems
o Loans made in another currency at a different rate, once Euro Implmented
should rate be changed?
– Will the euro fall apart?
o High fiscal deficits of some countries impose unacceptable adjustment
costs (ECB higher interest rates)
o Loss of value of the euro against other countries causes consumer/investor
revolt
o Fear of a country’s withdrawal from EMU and a subsequent
redenomination, triggers a banking crisis
 This situation is the opposite (country leaving the Euro)
 May need to honor Euros even though they have
redenominated

This country might be euro-rized just like some Latin
American countries are dollarized (undermining the
redenomination), people will exchange DM to euro,
making withdrawal basically impossible
– Article 3 of 235 Regulation
o The intro of the euro shall not have the effect of altering any term of a
legal instrument or of discharging or excusing performance
o NY propagated the same regulation
– EU Internal Market
A. Securities Market
1. EU Pop and Listings Directives
– The basic idea: single EU market for EU-wide securities offerings
o Home country disclosure rules with minimum standards
 For securities on exchanges, Listings Particular Directive
 Limits on Regulatory Arbitrage: Listings
 Must list first in country of registered office
 For public offerings (of unlisted securities), POP Directive
 Limits of Regulatory Arbitrage: Unlisted Public Offerings
o Local enforcement
o Why is there scant use of these directives?
 See slide on Offshore Markets – investors just go offshore
 European countries have nothing like SEC regulation S, they may
have some prohibitions on the advertising of the offerings in their
territories (don’t have an ideally efficient market because there are
restrictions on whether people know about the offerings)

– November 2003 Directive
o Harmonize disclosure standards
o Prospectus in language customary in international finance
o Change in Eurosecruties-sales to institutions exempt, but resales to public
are not
o Private placements and shelf registration
o Enforcement by home country
o Non-EU issuers; equity and small debt offerings subject to rules of
country in which make first offering, large debt offerings, pick jurisdiction
for each offering
o Plus: continuous material disclosure forced by Market Abuse Directive of
January 2003 (but only quarterly disclosure of material events under
Transparency Directive)
o Actually makes off-shore offerings easier, you can sell off-shore securities
to qualified investors (change in the exemption)
o Right now you can sell to individual investors (as long as you qualify for
the Eurosecurities exemption), under this directive only if you provide
common prospectus
o Original scheme also did not cover resale of privately placed securities (no
common prospectus requirements)
o Very important to see what happens to offshore markets, is the easing of
certain restrictions within territories lead to marketing.
2. Eurosecurities
o Multiple state underwriters
o Distribution in state other than issuer’s
o Sold to credit institutions, e.g. banks
a) Exemption
o If no generalized campaign of advertising or canvassing (defined by each
host state) then exempt from minimum EU disclosure standards
B. Firm Regulation
1. Investment Services Directive
– Basic Provisions
o Single license: if authorized in any member state, investment firm may
operate in another (minimum prudential standards)
o Home state services (if services on agreed list)
o Host state “rules of conduct”, e.g. custody of securities
o Forum shopping limited by definitions of “home member state”
– Key Securities Markets Provisions
o Direct EU wide access for banks and securities to all exchanges (not just
through subsidiaries)
o Block trading exception to normal prompt price reporting for exchanges
(Article 21)
o Trading only on regulated markets
 Market for specified securities
 On list of market’s home state
 Function regularly
 Regulated by home state as to
 Operations
 Access
 Trading rules
 Transparency (block exception)
o When Member States can require (Can France require French investors to
trade French Company on Paris Bourge rather than SEAQ?) Need to ask
whether SEAQ a regulated market? They are just allowed to limit it to a
regulated market, can’t just randomly limit only to France.
 If investor resident of member state
 Investment firm carries out transactions in member state
 Securities dealt with on regulated market in member state
 Investor may waive
– Directive on “Financial Instruments Markets,” November 2002 ((change in regulation
of firms)
o Abolition of requirement for trading on “regulated markets”
o Specific rules for regulated markets:
 Admission, suspension and removal of instruments from trading
 Legitimizing of more lightly regulated MTFs (electronic
communication networks, ECNs)
 Controls on internalization
 Best execution requirements
 Pre-trade transparency (publish order books or quotes)
 Prompt-reporting of trades (except for large blocks)
C. Banking Markets
1. The Second Banking Derivative (SBD)
– Single license
– Home state services (if on agreed on list, Annex A)
o Can German Bank offer Insurance if not permitted in France? Will France
change its law?
 Can German bank offer this service in France? (depends if it is on
agreed list)
 Will France change its law if it is on the agreed list? Probably,
don’t want to give German firms a comparative advantage over
French firms.
 Home country regime converge and harmonize rules as host state
want their own firms same authorizations as other member-state
firms.
o
– The BCCI problem
o How does/caqn the UK protect UK depositors in branch of Greek bank
against failure?
 CAD
 Minimum supervisory requirements
 Consolidated supervision and information exchange
 Political coordination
 Deposit insurance (home insurance levels with “topping up”
option)
– Has SBD created a single banking market?
o Bank of England says that mostly what has happened is conversion from
subsidiaries to branches. But Branches are able to operate off its
worldwide capital, under the prior regime each subsidiary was subject to
capital requirement. Good for depositors and for banks so it is not trivial.
– Should there be EU regulation of banking or securities firms?
– If so, in separate agencies or a single agency?
D. Transatlantic Financial Market
– Regulatory Issues
o Sarbanes-Oxlwy Remaining issues: PCAOB requirements for foreign
auditing firms, no exit under ’34 ACT
o IAS for U.S. and U.S. GAAP for EU
o Basel Accord differences
o EU Financoal Conglomerates Directive: U.S. holding companies must be
subject to equivalent regulatoion
o Ability of EU stock exchanges to establish U.S> screens
o Others: data protection, privacy and takeovers
– Existing Process: Informal Financial Markets Dialogue: U.S. (Treasury, SEC and
Fed) and EU commission
– Principles of Resolving
o Harmonization
o Home country control
o Equivalence
o Convergence
– Is there a will for closer cooperation? Is this a technical or political issue?
IX. Stock Market Competition
A. What Stock Markets Compete Over
– Listings: listing fees
– Trading: increases member firms’ revenue
o Commissions on NYSE, spread on NASDAQ
– Regulatory fees (20% of NYSE fees)
– Market Date fees
1. Order v. Quote Stock Markets
– Pure Order Market: Central matching of customer orders
o Market orders; at last best quoted price, e.g. if sell at market, get last best
bid
o Limit order: at specified price, e.g. 1000
o Cost includes commissions, can include access fees
– Pure Quote Market: Dealer quotes prices
o Ask price (Ap): price at which dealer will sell, e.g. 100
o Bid price (Bp): price at which dealer will buy, e.g. 99
o Spread: Ap-BP, e.g. 1
o Cost can include access fees
– Spreads
o SEC methodology
 2 * (Transaction price – Posted spread Midpoint)
B. Competition: The Relevant Terms
– Liquidity: investors want to be able to sell at a reasonable price without moving the
market. The deeper the market, the more assured they are of being able to do so.
– Transparency: Price and Trade Reporting
o Investors want to know what the prices (orders and quotes) and what they
have been trades)
o Block Traders want to be able to unload their blocks without counter
parties knowing that price of the pieces
o NYSE and NASDAQ: all trades reported within 30 seconds (delay trade
completion)
o LSE large block trades up to 5 day delay
– Regulation: How do Circuit Breakers Affect Competition?
o Note: SEC/US wants them
o But do investors want them?
C. Fragmentation of U.S. Markets
– 1975 Congressional Mandate to SEC: develop an integrated national market system
for U.S. exchanges
o Goal: increase liquidity, give retail investors access to the best price
– SEC initiatives for all exchanges:
o Tape consolidating price & volume of every trade
o Composite quote system identifies national best bid and offer prices
(NBBBO)
o Intermarket trading system (ITS), so brokers could route orders to market
with the best prices automatically
o New Problems: ECN free riders, internal matching (within broker/dealers)
and pay for order flow (order goes to market that pays for it)
– 1976: NYSE Rule 390 prohibited members from effecting any trade in NYSE listed
stock as principal or agent off the Exchange (prevents fragmentation but maintains
monopoly)
– 1980: SEC let members effect OTC trades (NASDAQ) in securities listed on NYSE
after 4/26/79
o But for “covered stock” listed before 4/26/79
 Members cannot make in-house OTC agency crosses (as brokers)
 NYSE: in-house crosses are not in the auction, which gives
access to the best price
 Members cannot as dealers buy or sell OTC against an agency
order
– Fragmentation of U.S. Markets: End of 390
o NYSE has abolished Rule 390. Members can effect even OTC trades in
covered securities
o SEC fears this reform will insulate members’ customers from price
improvement, isolations parts of total public order flow
– Reducing U.S. Fragmentation: SEC Options
o Markets and brokers disclose details of trade executions an order routing
(this only option adopted)
 Investors can decide which to use: spreads down 40% after
implementation
o Broker/dealers make internal cross trades and pay for order flow only at a
price better than NBBO (NYSE proposal)
o Markets must satisfy first order or quote that improved on NBBO before
executing other trades at that price
o National system links all markets, has strict price/time priority (a central
limit national order book, CLOB)
 Big invest banks’ proposal
– New SEC National Market System Proposal
o Trade Through: under existing rules, markets receiving order must send it
to market with better price, e.g. if Market A receives bid order of 100 nd
has ask of 100, must send to Market B with ask of 99
 SEC proposal permits “fast” (automated) receiving market to
execute, e.g. “trade through” better price of (non-automated)
market if fast market price is close, e.g. for orders over $100 with 5
cents, or if investor opts out of best price on a transaction-bytransaction basis
 Fast market must still send to another fast market with better price
 Cost of implementation may be $1 billion
o Access: Any market with 5% of trading in stock must display BBOs and
allow all market participants to access those orders at de minimis charge,
$0.001 per share (change in Regulation ATS)
o No sub-penny pricing
o Date fees: New system for dividing revenue from supply of quote and
trade date (more emphasis on BBO, currently just based on volume)
D. Competition in Europe
1.
–
–
–
Key Trends
Trading system convergence
Enhanced cross-border competition
Consolidation: economies of scale, advent of euro
o Mergers
 EURONEXT 2000
 Failed LSE-Duetsche Merger
 Regulation of trading in London under U.K. rules,
Regulation of Trading Germany Under German Rules
 Did Regulatory problems prevent the merger?
o Not zero-sum game: Cross-listings may increase total trading and reduce
issuers’ cost of capital
– EU Directive on “Financial Instruments Markets” (11/02)
o Abolition of requirement for trading on “regulated markets”
o Specific rules for regulated markets: admission, suspension and removal
of instruments from trading
o Legitimizing of more lightly regulated MTFs (ECNs)
o Controls on internalization
o Best execution requirements
o Pre-trade transparency (publish order books or quotes)
o Prompt reporting of trades (except for large blocks)
X. Japanese Financial Markets
A. Historical Background
– Dominance of banks over capital markets
– In the 1980s, banks lost customers due to competition and started to invest in stocks
and real estate, Nikkei went up to 39,000
o Banks depending on customers to pay loans based upon inflated collateral
– Massive shifts of value from their own balance sheet to capital markets
– Capital markets wants to enter into territory of other segments, engineered legal
reform
– 1992/1993 legislation providing a process of dismantling boundaries, e.g. The one
that prevented banking to enter securities and vice versa
– Regulators with mandate to policing boundaries became vulnerable
o Financial scandals
–
B. Reform of Japanese Financial System
– Internal and external forces of change
o Shifts in capital supply/demand factors – 1970’s
o Yen-Dollar Accord 1980’s
 Increasing exposure to global market forces
o Bubble economy – 1980’s
1. Reform movement
o Financial scandals – 1991
o Financial System Reform Legislation – 1992
o US-Japan Financial Services Agreement – 1995
o Big Bang – 1996
2. Big Bang Goals and Means
o Mobilize savings and other capital
 The FSA laid the foundation for big bang, the goal was to mobilize
the billions of dollars locked into savings account, release these
savings to provide capital for capital market and capital growth
o Re-channel capital into revitalized world-class capital markets to meet
needs of aging society and of new industries
o Create “free,” “fair,” and “global” markets
 Free - driven by market mechanism
 Fair - investor responsibility, transparent, law-based market
regulation
 Global-international legal, accounting and supervisory standards
 Swift disposition of huge overhang of bank NPSs
o Implementation of Big Bang Program
 1998 Big Bang legislative package
 Creation of Financial Supervisory Agency
o Consequences of Big Bang
 Capital markets: implemented quickly that within two years
(legislative package passed fulfilling most goals of reconstructing
structure of capital markets
 New supervisory infrastructure established
– Was big bang a success?
o Institutional flop: Liberate market – unfair competition with state
institutions (postal saving system has deposit takers and insurance takers)
that undermine
 Did regulators operate on a free, fair and global standards?
o Results of big-bang are unrealized, infrastructure is there. There is also a
legal framework what could develop a market for corporate control (M&A
market) which is important for both banking and capital markets and
disposition of non-performing loan
 Disciplining effect
 Pricing mechanism for
o What progress?
 Winners and losers
 Stock market
 Financial service providers
 Investors and savers
3. The NPL Problem
– HUGE: could vastly exceed total bank capital
– Increasing because of new bad loans to old bad borrowers: in fact, increasing faster
than write-offs
o The bigger problem is the non-performing borrowers (why are the
customers failing?), political problem link between the bad borrowers and
the political establishment, Use of financial engineering to conceal bad
loans
– Cover up techniques by foreign banks
– Available Public Funds: for capital injection, $125B (Deposit Insurance Corporation,
DIC); for purchase of bad loans, $9B (Resolution and Collection Corporation (RCC)),
bonds, purchased very little in past due to no loss policy
o More than enough to buy loans at market value
o Not nearly enough to buy loans at face value (to preserve bank capital),
need to appropriate more money (politically unacceptable to LDP)
– New injection of public funds would be wasted unless lending practices change
– RCC understaffed, 2400 employee versus US RTC, 8000, and fewer skills
4. Capital Adequacy
– Banks likely have negative real capital: state capital 3-2002, $271B (assuming $355B
in NPLs), a little over 8%
o If valued loans correctly: NPLs could be $1.3T and banks would have
negative capital
o If marked stock to market probably under 8% with official NPL numbers:
Nikkei at below 8000 on 3/10/03 and cross-shareholdings overvalued—
must mark-to-market since last year
o If eliminated deferred tax assets (value tax loss carry forwards), half of big
banks’ Tier I capital, around $67B
– Paralyzes new lending, falling for 44 months
– Share selling requirement: must lower shareholding to no more than Tier I capital by
9-2004, will require $40B sell off (will lower state capital by recognizing some
unstated losses) – LDP calls for delay
– BOJ share purchase plan, $8-16B (if purchase at market, will further decrease stated
capital by triggering additional unrealized losses); purchased about $8 billion as of 310-03
– Access of banks to public capital market in doubt: Mizuho, largest Japanese bank
cancels $1.3 billion international share offer in 3-2003, but raises $9.3 billion from
3500 Japanese corporations
– Restoring capital adequacy probably requires huge injection of public funds (again
would be wasted with existing lending practices)
5. Corporate Restructuring
– Lack of restructuring may be as serious as NPL problem: leaves potentially
productive assets in unproductive use: hard to measure cost to economy
– Mechanisms of corporate restructuring have not worked: no good data on degree
o Bank required work-outs (done little, done more)
o RCC engineered restructurings (done little, until recently could not incur
losses)
o Court bankruptcies (obstructed by shareholder, employee rights)
– Need better bankruptcy procedures combined with process for putting bad loans in
hands of creditors that insist on restructuring or bankruptcy – foreign funds could be
important part of solution
o E.g. Merrill buys $843 million in bad loans from UFJ (Japan’s 4th largest
banl, merger of Sanwa, Tokai and Toyo) in early 2003
6. Ownership
– Banks now owned by Japanese shareholders (often cross-shareholding groups) and
government (preferred stock with future conversion to common, owns about 20-60%
of equity of top 4 banks due to past capital infusion)
– More public injection of funds would increase government ownership: nationalized
banking system
– Foreign ownership (nationalism issue)
o Shinsei Bank; consortium purchases LTCB, 10th largest (a
o Aozoea Bank *(former Nihon Credit bank) acquired by US consortium by
Cerberus
o 2003: Goldman Sachs buys $1.3 billion in preferred shares of Sumitomo
Mitsui (increase SMFG capital by .43%)
o Step in right direction? Better management and less responsive to political
pressue to save “zombies”
– Megamerger policy questionable: Mizuho (Dai-Ichi Kangyo, Fuji, IBJ): poorer
management and less incentive to deal with bad loans, Resona govt. takeover
7. Deposit Insurance
– April 2003 was scheduled removal of unlimited guarantee of demand deposit
accounts and substitution of 10 million ceiling ($84K)
– FS advocated sticking to schedule as key element in regulatory reform of limiting
moral hazard
– Deregulation schedule enacted at time (1999) one expected bad loan/bad bank
problem to have been cleaned up
– Koizumi decided that unlimited guarantee would be kept for “settlement” accounts,
a/k/a/ DDAs—recognizes real threat of run on banks (but have survived some smaller
bank failures), capital flight or best vast expansion of postal savings system (to which
reforms did not apply)
– Deposit insurance premiums ongoing burden on underwater banks
8. Post Savings System
– Largest financial institution in Japan, $240T in assets; take deposits, purchases
government bonds and finances government entities
– Distorts competition with private banking sector, and has its own huge bad loan
problem (financed government banks whose own portfolio of NPLs is estimated to be
enormous)
– Golden parachute for bureaucrats
– May be needed as haven for depositors in fear of bank failure (privatization
legislation introduced in spring 2002, but no action)
9. Role of FSA
– Split from MOF in 1998 to take over regulatory power (but ex-MOF staffer), at same
time BOJ became independent of MOF
– End of 2002 shift in leadership from Yanagisawa (67) to Heizo Taekenaka (51) who
is also Economy Minister: generation shift
– Constantly underestimated NPLs (disturbing reports about pressures on analysts),
issue about competence of examiners
– Little or no informal contact with regulates in post-scandal environment; leads to poor
policy
– Fragmented alaphet soup of agencies (MOF, FS, DIC, RCC and Securities and
Surveillance Committee)
XI. Eurocurrency Loans and Eurobonds
A. Euromarkets and National Regulation
1. Eurocurrency
– A deposit in a currency other than that of the bank’s country of residence
o Absence of home country (U.S. for dollar) regulations like reserve
requirements or deposit insurance, often lower tax, no power of currency
country to freeze
o Higher rate on deposits, lower all-in costs of funds
o Eurorccurency rates are offshore interbank deposit rates
 London Interbank Offer Rate (LIBOR) is the rate a London bank
offers to pay other banks for their deposits with it
– Eurobonds
o Bonds issued and largely sold outside the domestic market of the currency
in which they are denominated
– International Bonds
o Bonds issued, and largely sold, in one country outside the domestic
currency in which they are denominated
– Global bonds
o Bonds issued and sold in several countries simultaneously
B. Syndicated Eurocurrency Loans: Key Terms
– Banks in syndicate lend to a borrower medium term at prevailing euromarket interest
rates
– Special features
o Large amounts
o Smaller participations
o Speed in completion
o Flexible drawdown with commitment fee
o Many possible currencies
o Medium term maturities (e.g., 5 years) with 1,3, 6 month rollover (and
repricing) of advances, and
o Floating interest rate, using LIBOR as the base rate plus a margin (or a
spread)
o Borrower default on any other loan can trigger default of current loan
 How well does this protect the banks?
 Protects them for not being able to collect while a borrower
is going bankrupt
 But once it is invoked, you are owed the entire loan and
you are stuck with a huge debt problem before you had the
problem but not a formal default. Works in an individual
situation but hard to invoke when a country/system is
collapsing.
o Risk Allocation: Banks and Borrowers Adverse Change

Idea is that if any of the lender’s costs rise (new law/treaty) then
that additional cost is paid for by the borrower or the borrower can
pre-pay
o Risk allocation between Lead Manager and Participating Banks
 The lead manager functions:
 Locates borrower
 Assembles participating banks
 Negotiates terms, contract
 Would the other banks have recourse against Citi?
 Fraud?
o Can’t override Fraud in K under common law
o Should it apply to these items?
 See language in the contract
o Gross negligence or willful misconduct
o Not liable for borrower’s statements, performance
or creditworthiness
o Not liable for accuracy of the agreement or loan
notes
 The standard now assumes arm’s length relation only
 Can you have a market if the lead managers are held liable?
 Remember, Citi lose reputational interest even if they are
not held financially liable, but people have short memories

C. Eurobonds: Withholding Tax
– Eurobond market started because U.S. would tax interest received from a foreign debt
issuer at a higher rate, but the market continued to grow even after the tax was
eliminated (IET)
– Withholding Tax
o Until 1984, the U.S. imposed a withholding tax on interest paid by U.S.
issuers on bonds issued to foreigners (opposite of IET)
o Intended to make sure foreigners who were required to pay U.S. tax, did
so
o Example: $100 interest payment. If withholding tax is 25%, foreigners get
$75 in interest
o Use of the Euorbond Market to Avoid taxes
 U.S. Company create a sub which issues a Eurobond abroad and
then gives parent the proceeds in the form of loan
o Use of grossing up to counteract withholding tax
 Call provision: Issuer can avoid higher interest payments by
calling bonds at specified price (often par)
o U.S. Withholding Taxes Today
 No withholding taxes on debt (30% on dividends, often reduced to
at least 15% by treaty)

But tax 1% x number of years to maturity, if bonds issued in bearer
form, unless
 Interest payable outside U.S.
 Legend indicates bond subject to U.S. tax
 Sold under “arrangement reasonably designed” to ensure
securities not sold or distributed to U.S. persons
 Sub cannot be used to avoid bearer bond restrictions since there is
no exemption from this tax treaty
o January 2003 EU Withholding Tax Plan
 2001-03: Negotiate tax information sharing with major financial
centers (Switzerland, U.S. and others in Europe)
 1/2003: EU countries and Switzerland to withhold tax on crossborder interest payments to individual EU investors (15% now,
20% in 2007, 35% in 20130), transfer 75% to home country
 Example: Eurodollar bond issued by U.K. company (could
be sub of U.S. company) pays $100 interest to German
investor, investor only receives $85.
 1/2010: only share information, not withhold tax, if Aus/Bel/Lux
OK
D. The Future of the Euromarkets
– Maughan predicated that globalization will integrate domestic financial markets,
removing barriers that created the euromarkerts, and possibly eliminating them
XII.
Futures and Options
A. The Mechanics of Futures
1. Definition
– A contract to buy or sell an asset at a set time in the future for a price agreed now, at
time of contract, both parties must perform.
o Long: promise to buy the asset at future date, expect price to rise above
agreed price
o Short: promise to sell the asset at a future date, expects price to fall below
agreed price
– Derivative markets have mushroomed in the last decade, mostly used to hedge risk on
an underlying asset
o Government has been skeptical of derivatives – it is useful because it
reduces risk but seems like there are more productive use of resources
 You have concentration of these positions in very few firms,
potential for systemic risk (Freddie Mac/Fannie Mae)
2. Exchanges and Clearing Houses
– Design the contract
– Make trading rules
– Act as counterparty (to give certainty), so set members’ minimum capital and margin
accounts (to reduce risk to exchange)
o Everybody position is with the exchange not with each other, exchange
has got both obligations to perform
3. Margins
– Parties must maintain margin on the contract and there is a margin call if their
position worsens to maintain certain protection
– Members are responsible to the exchange if customers do not meet margin calls on
their proprietary positions
– Members must also meet margin calls on their proprietary positions
– Members may have intra-day calls, an, if positions endanger their own or customers’
capital, “super” margin calls
– Under the current system how could the exchange get into trouble: more than 5%
change in price in one day (solution: intraday margin calls), maybe they enter into an
offsetting contract if there is an actual default – limit their exposure -–
B. Barings
1. What happened?
– Authorized activities
o Inter-Exchange Arbitrage of Nikkei 225 Futures Contract
– Unauthorized activities:
o High risk trades in proprietary accounts
o Misreported customer trades and said they were proprietary (which require
less margins)
o Unhedged futures, Nikkei options
o Ignored clients’ instructions, manipulated accounts he managed
o Did not hedge SIMEX side of BSJ arbitrage, or pass back to them margins
SIMEX returned to him, reported non-existent intra-day margin calls;
reported paper profits; hid losses in secret account 88888
o Misreported trades to SIMEX and Barings HQ, using his control over back
office
o Lied to SIMEX; reported fictitious trades to SIMEX to underrepresent
BSJ’s positions; delinked secret a/c from London HQ computer
– What did Leeson get from this?
o Bonuses by showing a profitable Singapore office
2.
–
–
–
–
Why didn’t Barings Not Catch Leeson?
Organizational Chaos (unclear who was reporting to who, etc.)
Let him Reconcile the accounts
They didn’t understand the product
External monitors/auditors fell down
– Was there any regulation by SIMEX?
o They were the counterparty to every transaction and then never checked
out their own risk (auditing Leeson), but should exchanges really doublecheck work supposed to being done by auditors?
– Was there any regulation by BOE?
o They were the lead regulator of the holding company but this was
subsidiary
o They were not supposed to be regulating securities (pre-FSA)
– Exposure limit: how much an entity could be exposed: SIMEX was the performer, but
Barings never lost because of exposure they lost because Leeson made bad contracts
– SIMEX and Barings
o Barings’ share on SIMEX
o See slide about Total Volume and Nikkei 225 Contracts accounted for by
Barings
– What danger did Leeson’s fraud pose to SIMEX?
o Losses would exceed the margins, credit-risk
o But did SIMEX lose money on this?
 If Barings is failing SIMEX protects itself by taking out the
opposite position (check this), but during this period of closeout (9
days, it doesn’t really take this long) the market went up so they
actually made $36MM which had to pay to Barings
 Why did the market go up?
o Singapore Monetary Authority bought a lot of
Nikkei 225 to manipulate the market, they had an
incentive to protect themselves (they were in charge
of regulated SIMEX)
o Result
 There is risk for SIMEX as well as Barings, but they found a way
to get out, which probably is not reproducible
– Were SIMEX’s rules adequate?
o Raise the margin requirements (make them less competitive)
o How about higher margin requirements just for those with high exposure?
3. Aftermath: The Need for Regulators Around the World to Cooperate
– 1995 Windsor Declaration calls for exchange regulators to cooperate
– 1996 Declaration implements information sharing
o Regulator A may ask Regulator B (in another country) about big changes
in exchange member’s equity, customers’ or proprietary margin fees, or
contract positions that are a large share of total open interest
o Regulator B will use “reasonable efforts” to get the data
o Regulator A will not let data be used from competitive advantage or
violate confidentiality rules
o Is this sufficient cooperation among supervisors to protect against more
problems like Barings
– Types of Action to protect against an even more serious Barings Crisis
XIII.
Swaps
A. Currency Swaps
– At the end of the term the swap is undone (Issuer A gets $40MM back and Issuer B
gets $5 Yen back)
– Why would an Issuer swap currency?
o Funding cost advantage
o Hedging/Speculation on particular currency
o Unable to issue bonds in a particular currency due to regulation
 Couldn’t you do this through the EuroYen market?
 Cheaper cost of funding
B. Interest Rate Swaps
– Reasons bank would enter Interest rate swap
o Hedging
o Lower the cost of funds
o Did Bank A reduce its funding costs by entering into this transaction?
(Bank A’s market cost of floating rate funding is assumed to be Libor)
o Analysis of Bank A’s Savings
 Direct Cost (to bondholders): (10)
 Swap Cost (to Swap Bank) (Libor)
 Swap Revenue from Swap Bank 10 1/2%
 Net cost == Libor – ½%
 Cost Savings: Libor – (Libor – ½) = ½%
 Is this just magic?
o Well there is now additional risk that the
counterparty will default (even though it is AAA)
o speculation
– Swap bank wants the party with the better credit rating to “win” the swap, reduces
their credit risk
– Futures/Options v. Swaps
o If Bank A wants to hedge or speculate on interest raters, why use swaps
rather than futures/options?
o One difference is maturity (longer-term maturity need to go the swaps
market)
o More customization on the swaps market
o Counterparty is risk is lower for an exchange
o Liquidity, the future exchanges are better?
– How would you compare the risk for banks on interest rate swaps to being in the
lending business?
o A way to gauge how concerned regulators should be about banks
participating in swaps:
o Counterparty is usually AAA, this is more secure than normal creditors
(lower credit risk)
o Higher market risk with swaps? Maybe not, because if bank is paying
floating rate on liabilities and received fixed rate lending, they have
market risk
o No easy answer to this.
C. Credit and Market Risks
– Credit risk: financial ability to perform the contract
– A has market risk and they don’t care about performance. (the risk has come to bear
even though this is really a loss
D. Disclosure
E. Credit Derivatives
– Banks buy protection for a loan from a dealer
– Protect against default of x, obviously, but what other reasons – speculation (shorting
X), hedging an obligation to pay someone else
– Why would Dealer sell protection?
o Speculation
– This is all very like an insurance company scheme
o They are not subjected to insurance industry regulations, it is all designed
to avoid insurance regulations, whether they should or not is another
question
– Issue: when must dealer (seller of protection) make the payment to the Bank (Buyer
of Protection)
– Bank has credit risk on the Company loan
– Bank also has credit risk on the swap
F. Capital Requirements
– Has credit risk been eliminated? Should capital requirements be reduced/eliminated
then? Not that simple, still some credit risk – both the company and dealer might
default. How are capital requirements determined? Some function of the loan and the
dealer.
– Capital effect: The cost of the hedge fund) is less because they don’t have to
subscribe to Basel as the banks do, insurance companies have some regulation but not
the level of Basel, banks very expensive to be the dealer. Bottom line: Capital
requirements determines who participates in swap market
– Special rules for Credit Derivatives
o Current Basel I and Basel II standardized approach: risk-weight of the
seller of protection
o Original Basel II standardized proposal: assets covered by CDs have a risk
weight that is weighted average of the obligot’s risk weight (debtor on
loan) and the protection seller’s risk weight
o Basell II for IRB approach: banks set risk weights based on own estimates
of PD and LGD
– What qualifies as default/credit event? Debate over how much restructuring is
required for a credit event
o Some restructuring not been provided for in the original terms of the
obligation
o Be a result of a deterioration in the obligor’s creditworthiness (based on
creditor change or market change)
– Incentives:
o Banks that make a loan and get credit protection -- they may try to get a
credit event if rates increase or obligors creditworthiness decreases
o How about a deductible to decrease this incentive?
– Who bears the risk ultimately when there is credit event triggering default?
o Dealer could be hedged – last man standing – the entity/person not hedged
(who are these people? Orange County? German Banks?) We’re
spreading risk but we don’t know if the people bearing it know what they
are doing.
G. Liability for Dealers
1. Dharmala
– Dharmala makes a really bad swap with BT, and then replaces it with an even worse
swap, at the end they owed BT $65MM
– Dharmala makes claim that BT misrepresented and violated Duty of Care
o No liability under English law, would it be actionable under U.S. law?
o U.S. legal standards
 Liability under P&G: BT had duty to disclose “material info to
plaintiff both before the parties entered into the swap transactions
and in their performance and also a duty to deal fairly in good faith
during the performance of swap transactions”
 Would BT be liable under P& G?
 Is this right standard?
 10-b (5)
 Under Section 301 of CFMA, a swap would be a “securitybased” swap, and covered by 10b-5, if any material term of
the swap is based “on price, yield, value, or volatility of
any security or any group or index of securities, or any
interest therein.”
 In our case it was just based on interest rates not based on
value of securities.
XIV. Clearance and Settlement
A. The Basics
1. NSCC
– Matching Trades (capture trade facts)
– Net position calculation and multilateral netting
2.
–
–
–
–
Transfers
DTC transfers securities
Payment for securities through payment system, e.g. Fedwire
Does it matter whether securities and funds are transferred at the same time?
Two levels
o Broker level
o Customer-broker level
– DTCC has risk in the clearing system
o Failure on a party to:
 Pay (price of shares go down)
 Deliver securities (price of shares go up)
 Is the failure is due to the delivering broker (DB)
insolvency, then depends on (1) whether DB becomes
insolvent on T+3 or T+4; (2) whether DB becomes
insolvent before or after the market closes; and (3) whether
DB becomes insolvent before or after paying its mark
(increase in stock value)
o DTCC protects itself against failure to deliver
 Clearing fund to cover potential losses (monthly payments based
on 20 day rolling average of a participants’ portfolio value away
from the stock price)
 Membership requirements
 Third Party Guarantee
 Minimum capital requirements for participants
 Assess member for shortfalls
 Monitor participants’ solvency
B. The G-30 standards
– In effect
o Institutional Comparison on T+1
o Affirmation of Trades on T+2
o Rolling Settlement on T+3
o Central Securities Depository
o Securities Netting
o DvP (delivery v. payment)
o Same day funds
o Securities Lending
o Technical standards for securities messages
– New G-30 Proposals (pp. 15-16)
o Strengthened Interoperable Global Network
 More automation, eliminate paper
 Synchronize timing among networks, e.g. securities with payments
and FX (T or T+1)
 Expand use of central counterparties
 Facilitate securities lending and borrowing to facilitate settlement
o Mitigation of risk
 Financial integrity of providers of clearing and settlement
 Risk management of users
 Final, simulatenous transfers
 Business continuity and disaster recovery
 Plan for failure of systematically important institution
 Enforceability of contracts, legal rights to securities, cash or
collateral (see Hague Convention)
 Closeout netting; validity and valuation
o Improved Corporate Governance
– Are common private standards a good idea?
– Should U.S. go to T+1 (Hong Kong and some other countries have already)?
C. Cross-border linkage
1. Cross Exchange Trade
– US buyer buys 100 IBM shares cross-listed on Tokyo Stock Exchange (TSE) from
Japanese seller. How would this transaction be settled?
o JSCC is a member of DTC, that is the clearing/settlement link
o Cash settlement – buyer pays seller through Japanese payment system
2. Cross Border Trade
– US investor sells 100 Mitsubishi Chemical, listed on TSE, to Japanese buyer
o Seller’s custodian bank is member of JSCC
o Cash settlement – Japanese buyer pays Seller’s custodian bank through
Japanese payment system
D. Euroclear
– System for clearing and settling securities: competes with nation systems
(Clearstream similart)
– Participants hold cash and securities accounts for over 33,000 different debt and
equity securities in multiple currencies with Morgan Guaranty’s Brussels branch
which are “redeposited” by Morgan branch with designated securities depositories, in
effect sub-custodians
– Would Parties want to clear s US Equity Trade through Euroclear rather than DTCC?
o Can clear faster than T+3 (but no automatic capture)
o True DvP
o Centralization of Trades/Cash for different markets
o No contributions to funding of clearing corporation
o Chaining v. Netting
o Securities lending/borrowing easier than in local markets
E.
–
–
–
Rights in Dematerialized and Immobilized Securities
Who has what rights in the securities when there are custodians and sub-custodian?
What law governs the rights?
Hague PRIMA Convention
o Applicable law is that of the location of the intermediary maintaining the
accountant to which the securities are credited—the place of the relevant
intermediary.
o How do we know where the relevant intermediary is?
 Law specified in contract, Article 4, provided intermediary has an
office is contractually specified jurisdiction. If not applicable, then
 Location of office of intermediary which contract specifies is the
office through which intermediary entered into the agreement,
Article 5(1), if not applicable, then
 Law of the place of incorporation of the relevant intermediary,
Aticles 5 (2) and (3)
F.
–
–
–
Future Clearing Arrangements: Europe
20 plus clearing organizations
Vertical silos v. horizontal arrangements
Fragmentation: C&S costs in Europe 7-10 times those of DTCC
o Apples and organges comparison
o Estimate 20% savings if Euroclear and Clearstream merged
o Legal barriers, e.g. Italy and Spain provided only one organization can
hold electronic shares in their countries
o EC Commission proposes fine of Clearstream for discriminating agains
Euroclear – charges it higher prices for clearing and settlement (link)
– Is World Clear the future?
– Is this preferable?
XV.
Offshore Mutual Funds
A. Investment Company Act of 1940
1. Basic Approach
– Requires registration of all funds sold to public (absent exemption); those sold to the
general public (no private placement exemption) must also register under ’33 Act
– Disclosure of investment policies, fees and portfolio
– Rules controlling pyramiding, conflicts of interest, and embezzlement
2. Why Requirement Foreign Investment Companies to Register under ’40 Act?
– Foreign inadequate, must be subject to US Law (or meet the requirements of Section
7 (d))
– Enforcement
a) 7-d requirements
Mutual fund must be separately incorporated
– Managers of funds must be US citizens or residents
o Enforcement problem against Europeans
o Letter of credit (5% holdings of US investors) alternative
o If boards of foreign issuers need not be U.S. why Boards of mutual funds>
– Assets must be in custody of US bank
b) Patter of SEC Action on 7 (d)
– 1960:1973: Permitted foreign funds from Canada, Australia, Bermuda, U.K. and
South Africa to register
– 1973: No further registrations (or applications)
B. Taxation of Offshore Funds
1. Why U.S. investors will not invest in Foreign Funds
– U.S. anti-defferal rules, PFIC (passive foreign investment company) requires taxation
on earnings even if not distributed
o Applies to foreign investment company whose gross income is 75% or
more passive
o Foreign funds usually do not distribute because foreign jurisdictions allow
deferral
o Calculation
 Actual Earnings
 Mark-to-Market
 Pay tax on current net asset value of shares
o Default Rule: When taxpayer sells Fund’s shares, pay gain plus interest
representing value of tax deferral, which is often excessive compared to
actual economic value
2. Why Foreigners Do no Invest in U.S. Funds
– US funds must distribute current realized income (taxable to shareholders) to be
exempt form current tax at fund level, most foreign funds (tax havens) do not have to
do so, so foreigners invest only in them
– Dividends on foreign shareholders subject to 30% withholding taxes (reduced to 15%
by tax treaties)
C. Alternative to U.S. Registration: Mirror and Master Feeder Funds
1. Mirror Funds
– Separate U.S. organized company that invests in the same portfolio (often foreign
securities) as the Foreign Fund
o Is this the equivalent of investing in the Foreign Fund?
o Rebalancing/Synchronization
2. Master Feeder
– U.S. registration of Master-Feeder required
– EU: UCITS prohibits Master/Feeder Structure
D. Hedge Funds
1. What is it?
– Unregistered “private” fund, partnership or corporation
– Limited to 100 U.S. beneficial owners, 3(c)(1) or U.S. qualified purchases (those with
over $5 million in investments), 3(c)(7)
– Different hedge funds have different investment strategies, i.e. they are not all foreign
exchange speculators
– Offshore hedge funds may have more relaxed requirements, e.g. Hong Kong,
Singapore
2. Unregistered funds cannot be sold to retail investors
– Hedge funds cannot be registered given legal constraints on leverage, concentration,
short sales and incentive compensation for advising
– Funds of hedge funds (FOFs) avoid these constraints—if registered under ’40 and ’33
Acts can be sold to anyone, but no incentive fees at FOF level
3.
–
–
–
–
–
–
–
LTCM
Hedge fund which loses 90% of its capital, lenders/counterparties bailout
What role did NY Fed play?
Should hedge funds be required to make more disclosures to investors? How about
bank investors?
Should hedge fund leverage rations be limited?
Should hedge fund advisers be required to register with the SEC?
Changes in bank risk-management?
Systemic Risk Concerns by LTCM:
o Losses for counterparties
o Losses for other investors
o Various debt markets might cease to function, leading to panic
selling/closing out
E. Trading Violations
– Late trading—after 4 p.m. (illegal) and market timing – in and out, day-tot-day
(requires disclosure)
o Dilutes gains of other shareholders
o Has led to penalities and fines from SEC and NY AG Spitzer
– SEC proposes in December 2003 “hard” trade close which would prevent any trades
from being processed after 4 p.m.
o Currently many trades, e.g. pension funds, are entered before 4 but
processed after 4 (processing takes time)
o Late traders abused late processing (entered trade before 4 but cancel after
4 if market moves against them)
– SEC adopts enhanced disclosure requirements on 4/13, 2004 on market timing
– Alternative solutions
o Fair value pricing (update price after market close);
o T+1 pricing (purchase on Day 1 but get closing price on Day 2)
o Exchange-traded funds (ETFs), currently index, might be actively-traded
in future
o Unclear whether same problems with foreign funds