CHAPTER 15
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GLOBALIZATON,
INTERNATIONAL BANKING,
AND FOREIGN-EXCHANGE RISK
Chapter 15
1
LEARNING OBJECTIVES
To understand …
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Globalization of banking and the FSI
Differences among international money,
capital, and currency markets
Delivery system of international banking
ALM in a global context
Role of foreign banks in the U.S.
Chapter 15
2
Chapter Theme
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Following the international-debt crisis
and the collapse of communism,
globalization and international banking
were on the rebound in the 1990s
11 September 2001 changed the world
but how its aftermath will affect
globalization and international banking
remains to be seen
Chapter 15
3
The Information Revolution
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In the Twilight of Sovereignty, Walter Wriston
wrote:
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The perception of what constitutes an asset, and
what it is that creates wealth is shifting
dramatically. Indeed, the new source of wealth is
not material, it is information, knowledge applied
to work to create value. The pursuit of wealth is
now largely the pursuit of information to the
means of production (p. xii).
Chapter 15
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Three Aspects of the
Information Revolution
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The relationship between countries and
power, and how in today's information age it
is difficult to act alone either politically or
economically
The reduction of the importance of middle
managers to businesses as information
technology replaces paper pushers
The reduction of the importance of natural
resources in favor of knowledge (although it
is difficult to measure) as a country's major
source of power
Chapter 15
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Consolidation in the
International Arena
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Deutsche Bank's acquisition of Bankers Trust
of New York in 1999
Hong Kong & Shanghai Banking Company's
(HSBC) acquisition of Republic New York
Corporation in 2000
Royal Bank of Canada's acquisition of Centura
Bank (NC) in 2001
Citigroup's acquisition of Grupo Financiero
Banamex-Accival (Banacci) in 2001
Chapter 15
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The Evolution of Money, International Banking,
Monetary System, and Globalization
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Box 15-1 (p. 510) provides a long
(1000-2001) of this process
Important update: 11 September 2001,
“The Attack on America” and the
subsequent “War on Terrorism”
Chapter 15
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Globalization, Americanization,
and First-Mover Advantages
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Reasons why U.S. financial-services firms
dominate world markets.
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1. They operate in highly competitive domestic
markets, which serve to sharpen skills and
stimulate innovation
2. English is the language of banking and finance
3. Sophisticated information technology and
modern tools of risk management are the
modus operandi of U.S. financial-services firms
Chapter 15
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Reasons (continued)
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4. The modern U.S. regulatory environment
has been conducive to financial innovation and
tends to react to change (e.g., the Gramm-LeachBliley Act of 1999) rather than be proactive with
prohibitions as it was in the 1930s.
5. The acceptance by U.S. governments,
businesses, households, and educators of free
capital markets as efficient allocators of
financial resources
6. A U.S. culture that encourages and rewards
competitive spirit, innovation, and hard work
Chapter 15
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Americanization?
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The globalization of banking and
financial services can be viewed as
nothing more than the
Americanization of these activities,
which reaffirms the view of Wriston and
others that innovativeness and the
ability to adapt to change are keys to
leadership in the information age
Chapter 15
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First-Mover Advantages
(Tufano [1989])
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Cost of innovative investment-banking
products
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1. Legal, accounting, regulatory, and tax
advisors
2. Computer systems for pricing and
trading
3. Capital and personnel to support
market-making
4. Educating issuers, investors, and traders
Chapter 15
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What’s the Advantage?
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A larger market share compared to imitative
rivals, where in a globalized finance
marketplace the potential gains are even
larger
Tufano concludes that innovators enjoy
lower costs of underwriting, trading, and
marketing. Rather than use these cost
advantages to charge "monopoly prices",
Tufano finds that they garner market share
by pricing products below those of imitative
followers
Chapter 15
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Reputational Capital
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Investment banks stake their firms'
reputations on the success or failure of
innovative new products. By being
innovative, they signal to clients that
their intangible and unique assets are
still productive and worthy of their
reputations.
Chapter 15
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The GLB Act (1999) and
Bancassurance
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Banking and insurance have been comingled outside the U.S., especially in
Europe for years where it's called
"bancassurance". Since the passage of
the Gramm-Leach-Bliley (GLB) Act of
1999 such integration also has been
permitted in the U.S. and is exemplified
by the Citicorp-Travelers Group merger
into Citigroup
Chapter 15
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Potential Market Advantage
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Cross-selling: selling more products top
the same customer base
Size: potential economies of scale lead
to lower cost per transaction
Diversification: more stable income
stream allows refinancing at lower cost,
which increases capital productivity
Chapter 15
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The Role of Bank Size
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Size is important but how it is measured
has changed
Old standard: Total assets (Japanese
banks dominated)
New standard: Market capitalization
and adequacy of bank capital on a riskadjusted basis (U.S. banks dominate)
Chapter 15
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The LDC Debt Crisis in
Retrospect
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The adage, “A rolling loan gather no
loss,” proved incorrect in this case
Thrust: “Countries don’t go bankrupt!”
Counterthrust: “But bankers who lend
to them do!”
Chapter 15
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How a Rolling Loan Can
Gather Loss
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10-year loan at 10% with a $100 million
balloon payment
After a decade of borrowing to keep the
loan current, what’s the total
indebtedness?
$1,000,000(1.1)10 = $259,370,000
Chapter 15
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Brady Bonds
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The Brady plan offered creditor banks three
alternatives:
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1. They could convert their loans to marketable bonds with a
face value equal to 65 percent of the original par value of
the loan -- a "haircut" of 35 percent
2. They could convert the loans to collateralized bonds with
a coupon rate of interest of 6.5 percent, which amounted to
an interest-rate reduction or a rate haircut
3. They could lend additional funds to allow debtor nations
to attempt to keep their loans current -- the old "rollingloan-gathers-no-loss strategy", which the banks had already
disproved as a solution and were not about to accept it
Chapter 15
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Globalization and Systemic
Risk
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Systemic credit risk focuses on the default risk of all
firms in the economy. If contagion exists, then the
default of one firm leads to the collapse of the
economy. Contagion in banking occurs when a
deposit run at one bank spreads to other banks,
resulting in a liquidity crisis for the financial system.
The new Basel Accord's call for a capital requirement
for bank operating risk highlights the regulatory
concern about this component of systemic risk arising
from globalized and integrated financial systems.
Chapter 15
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The Objectives of Central
Bankers
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1. Foster macroeconomic stability
2. Maintain safe-and-sound financial
institutions that can take advantage of
stability while exploiting the advantages
of new technological advances
Chapter 15
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Greenspan’s Recommendation
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The way to attempt to control systemic risk is not to
attempt to suppress market forces and technological
change but to attempt to use technology to contain
it. To achieve this goal for individual institutions,
technology can be used to develop better riskmanagement systems, improve internal controls
(absent in the collapse of Barings Bank and the
derivatives debacles involving Bankers Trust), and to
increase the efficiency and safety of the payments
system (i.e., move closer to real-time settlement).
Chapter 15
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A World Safety Net Supported
by the U.S.
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To protect against a meltdown of the
financial system, central banks have
adopted what Greenspan calls
"catastrophic financial insurance
coverage," which in the U.S. is the
federal safety net of FDIC deposit
insurance, the Fed as lender of last
resort, and TBTF
Chapter 15
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Delivery Systems of
International Banking
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Correspondent banking
International departments
Participations/loan syndications
Representative offices
Foreign branches (preferred method)
Edge Act and Agreement Corporations
International Banking Facilities (IBF)
Offshore Banking Centers and Units
Chapter 15
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Financial Profile: Foreign vs.
Domestic Banking (% of assets, 12-31-00)
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Item
Interest income
Interest expense
NII
PLL
Noninterest inc.
Noninterest exp.
Net income
Memo:
“Burden”
Number of banks
All U.S. Banks
6.86%
3.59
3.27
0.47
2.45
3.46
1.14
Foreign Offices
7.82%
6.13
1.69
0.33
2.72
2.76
0.94
-1.01
8,315
-0.04
162
Chapter 15
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Conclusions from the Profiles
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Based on foreign offices compared to
domestic operations
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NIM is lower (“bad”)
PLL is lower (“good”)
Burden is lower (“good”)
ROA is lower (“bad”)
Chapter 15
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Foreign Banks in the U.S.
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Form
Branches
Sub. Banks
Agencies
Edges
Rep. Offices
Total
In NY
Number
Assets ($B)
283
901.9
84
314.4
70
39.2
6
3.0
203
0.0
646
1258.5
300 (46%) 912.5 (73%)
Chapter 15
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Banks from 7 Countries Hold
83% of the Assets ($1 trillion)
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Rank order
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1.
2.
3.
4.
5.
6.
7.
Germany ($218.9B)
Japan ($209.9)
Netherlands ($145.8)
France ($144.7)
Canada ($142B)
United Kingdom ($133.2)
Switzerland ($55.6)
Chapter 15
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International Banking and
Money Markets
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The Eurocurrency Market and LIBOR
A Eurocurrency is a claim (e.g., time deposit)
in that currency held by a nonresident of the
currency’s country of origin. Since the
Eurodollar is the major Eurocurrency, it is a
U.S. dollar claim arising from a
dollar-denominated deposit, note, or bond
held by a nonresident of the United States
The Eurocurrency markets began in the late
1950s and early 1960s as a byproduct of the
"Cold War".
Chapter 15
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London Interbank Offered
Rate (LIBOR)
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LIBOR is the base or anchor rate in the Eurocurrency
market
It represents the rate at which leading multinational
banks in London are willing to lend to each other
A LIBOR reference rate exists for each Eurocurrency
(e.g., Eurodollars, Euromarks, and Euroyen)
Since other world financial centers have their own
interbank offer rates, we have the Tokyo Interbank
Offered Rate (TIBOR), and the Singapore Interbank
Offered Rate (SIBOR), and the EURO Interbank
Offered Rate (EURIBOR)
Chapter 15
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BBA Quotes and Practices
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The British Bankers Association (BBA) reports the
average LIBOR for dollar deposits in the London
market based on quotations at 16 major banks for
maturities of one month, three months, six months,
and one year. Although these four terms are the
standard ones, maturities ranging from overnight to
several years are available.
Markup pricing exists but the premiums on interbank
deposits or placements are relatively small because
the costs and risks are minimal
Chapter 15
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Eurodollar Loans:
Pricing and Fees
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More costly to administer and typically more risky;
thus, they require a larger markup
Floating-rate basis, with adjustments made every
three-to-six months, depending on the maturity of
the underlying liability instrument (time deposit)
Commitment fees, which are an integral part of
Eurocurrency pricing arrangements and subject to
competitive pressures, typically range in size from
0.25 to 0.50 percent, with payment required at the
time the commitment is made
Chapter 15
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Borrowing and Lending Rates
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The rate at which major banks in
London are willing to borrow funds from
each other, as opposed to lend to each
other, is the London Interbank Bid Rate
or LIBID. The spread between LIBOR
and LIBID represents the "bid-ask
spread" for surplus Eurodollar deposits.
The bid rate (LIBID) is the lower of the
two rates
Chapter 15
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Important Characteristics of
the Eurocurrency Market
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It’s a wholesale market in which large CDs are the
basic liability instrument, with loan participations
frequently used to facilitate denomination
intermediation into large loans
The international and domestic money markets are
competing sectors in the global market for financial
assets and liabilities
It is an unregulated market not subject to restrictions
such as reserve requirements or deposit-insurance
fees, which makes the international-banking sector
particularly attractive to U.S. banks because they are
more heavily regulated than other banks
Chapter 15
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Characteristics (continued)
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It is more competitive than domestic financial
markets, resulting in thinner profit margins and
interest spreads because deposit rates must be
higher and loan rates lower to compete with
domestic financial institutions
The risk analysis required in Eurocurrency markets is
more complex because of foreign-exchange risk and
foreign-country risk, factors that are not critical in
domestic financial markets. In Eurocurrency markets,
however, it is possible to separate these risks
On balance, Eurocurrency markets link the various
currencies and countries of the world into a global
financial market
Chapter 15
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The Foreign-Exchange Market
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The FX or forex market exists because of trade
between countries with different currencies. That is,
exporters prefer not to hold foreign currencies; they
want to be paid in their national currency
Quotations for major exchange rates are available in
daily publications such as The Wall Street Journal or
from major financial institutions
Quoted FX rates are wholesale ones for amounts of
$1 million or more as traded among major banks.
Retail transactions typically provide fewer units of
foreign currency per dollar. Box 15-4 (p. 533)
provides a primer on FX
Chapter 15
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The FX Market
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Large commercial banks, domestic and
foreign, dominate the FX market
To provide foreign-exchange services to their
customers, these banks take a position (i.e.,
hold inventories) in the major currencies of
the world
In addition to providing for customers’ foreign
currency needs in either the spot or forward
markets, banks trade for their own account in
the FX market
Chapter 15
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The European Monetary
System (EMS) and the Euro
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Created in 1979 to establish monetary
stability in Europe and to promote economic
and political unification for the European
Union
Important EMS FX provisions
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Created a common unit of account, the European
Currency Unit or ECU, which later was replaced by
the Euro, began circulating on January 2002
Established an exchange-rate mechanism (ERM)
and procedure for collectively linking and
managing the exchange rates of the EMU member
countries
Chapter 15
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European Central Bank
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A third important development coming
out of the EMU was the establishment
of the European Central Bank (ECB).
Its task is to control the supply of
money and credit for the EMU
countries, which have rendered their
monetary sovereignty to the ECB
Chapter 15
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The Euro Parity-Grid System
(Set on January 1, 1999)
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One Euro equals
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13.7063 Austrian schillings
1936.27 Italian lira
40.3399 Belgian francs
40.3399 Luxembourg francs
5.94573 Finnish markkas
2.20371 Netherlands guilders
6.55975 French francs
200.482 Portuguese escudos
1.95583 German marks
166.386 Spanish pesetas
0.787564 Irish pounds
340.750 Greek drachmas
Chapter 15
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The Euro (continued)
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The Euro floats against currencies
outside the EMU
The Euro exchange rate against the
USD began at 1.0653 in 1999 but by
2000 it had dropped to 0.9232 USD per
Euro. By May 14, 2001, the Euro's slide
had continued to 0.8743 although it
had reached 0.9376 in January 2001
Chapter 15
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Hedged Cost of Funds
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Consider the following information for Alpha
Company, which can borrow in Japan or the
United States
Money market costs: 5% in USD and 2% in
yen
FX market:
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Spot = 122 yen/USD
One-year forward = 119 quoted and 120 expected
Chapter 15
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Analysis
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On the surface, borrowing appears cheaper in
Japan. However, until we account for
changes in the yen-USD exchange rate, we
cannot know the effective cost of borrowing
For example, the expected change in the
value of the yen is 1.64% [= (122-120)/122].
Thus, Alpha probably would have to pay back
the yen borrowing after the yen has
appreciated (USD depreciated)
Chapter 15
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Analysis (continued)
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Is borrowing in Japan a good idea? We can
approximate the borrowing cost by adding the
expected change in the value of the yen to the
interest rate. In this case, Alpha's estimated effective
borrowing cost would be about 3.64%, which is less
than the U.S. rate of 5%
To be more exact, assume that Alpha borrows
$1,000,000 (at the current spot exchange rate of 122
yen/USD) and agrees to pay principal and interest at
the end of one year
Chapter 15
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Analysis (continued)
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The firm will have borrowed 122 × 1,000,000 = 122
million yen and must pay 122,000,000 × (1 + .02) =
124.44 million yen in one year. If the exchange rate
is the expected 120 yen/USD, the dollar outflow is
$1,037,000 (= 124.44/120) and the effective cost of
the borrowing is 3.7% (< 5%). Of course, no
guarantee exists that the 120 yen/USD rate will exist.
If the value of the dollar is as low as 118, then the
dollar outflow is $1,054,600 and the effective (dollar
denominated) cost of the borrowing is 5.46% (> 5%)
Chapter 15
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Analysis (continued)
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Forward markets, which can be used to
eliminate the risk of changing exchange
rates, allow an individual or a firm to
generate known cash flows from
international borrowings and therefore
make valid comparisons
Chapter 15
46
Borrowing and Hedging
Cash Flows
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Assume that Alpha negotiated a forward contract
with an FX dealer bank to buy yen at 119 yen/USD.
With this forward contract, Alpha will pay $1,045,700
in one year regardless of the exchange rate and it
secures an effective cost of borrowing at 4.57% with
no risk. This rate, moreover, is lower than the
domestic borrowing cost of 5%, so the firm is better
off borrowing in Japan. The effective cost of 4.57%
is often referred to as the Hedged Cost of Funds. As
such, it refers to the fact that the risks of exchange
movements have been eliminated
Chapter 15
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Components of the Hedged
Cost of Funds
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The foreign interest rate (e.g., 2% in the example
above)
The forward premium or discounts used to compute
the cash outflows.
In the case where the firm borrows in a foreign
currency at a rate rf with principal and interest due in
one period and a forward premium or discount on the
foreign currency of p, the hedged cost of funds
(domestic currency effective rate), rh, can be
calculated as follows:
(1 + rf) × (1 + p) = (1 + rh)
(15-1)
Chapter 15
48
Hedge Cost of Funds
(concluded)
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In the previous example, the yen is selling at
a (1/119 - 1/122) / (1/122) = 2.52%
premium. Thus, the hedged cost of funds is
(1 + 0.02)(1 + 0.0252) - 1 = 0.0457 =
4.57%. This calculation is only valid for the
most simple loan structure -- principal and
interest in one year. By looking at the actual
cash flows associated with any specific
borrowing, and the forward contracts needed
to hedge the borrowing, we can calculate a
hedged cost of funds
Chapter 15
49
Risk Exposure and Risk
Management
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Country (sovereign credit) risk
Cross-currency risk on an off the
balance sheet
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Net exposure in an FX is:
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NET = [A(FX) - L(FX)] + NTP(FX)
Global ALM
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Risk profiles
Chapter 15
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CHAPTER SUMMARY
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The important international banking markets are the
Eurocurrency, foreign-exchange, and
derivatives markets. The European Monetary
System (EMS) and its currency, the Euro, reflect
"globalization" on a regional scale. Moreover, the
spread of the bancassurance business model from
Europe to other parts of the financial world captures
the growing integration of financial services.
The most popular way for banks, whether domestic
or foreign, to deliver international banking services is
to establish branches
Chapter 15
51
More …

The dominant role that major U.S.
commercial and investment banks have
played in the globalization of the financialservices industry supports the argument that
the phenomenon can be viewed as the
Americanization of world financial markets.
Globalization is, of course, a two-way street
and the U.S. policy of national treatment
of foreign banks has created opportunities for
foreign banks to play a major role in U.S.
banking and financial markets.
Chapter 15
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