International Finance - Lecture 2

International Banks
International Banks Lecture 2
Globalization has three causes Countries repealed laws that restricted the free flow of investment between countries Countries are economically growing (before 2007); people and businesses save more, and invests them in international markets Corporations are global Corporations move goods, services, and resources around the world International banks move the money Corporations and international banks go hand to hand International banks - links savers and borrowers from different countries International trade and finance Create new financial securities Circumvent a country's regulations Help with exchange rates Hold inventories of foreign currencies Lower transaction costs Lowers information requirements Increases liquidity of financial markets Liquidity – how fast a financial instrument can be exchanged for cash Currencies and bank accounts are more liquid Houses and cars least liquid Lowers risk of investment Located in financial centers around the world London, New York City, and Tokyo Operates 24 hours every day Offshore markets - banks located in the Bahamas, Cayman Islands, Hong Kong, Singapore, etc. Has few regulations Low tax rates Strong confidentiality laws Wealthy, businessmen, and criminals hide money in offshore accounts Tax evasion Protect money from aggressive tax authorities Protect profits from illegal activities
Becoming An International Bank
1. U.S. Banks Entering Foreign Markets Branching - U.S. bank opens a branch in a foreign country Bank Holding Company - U.S. bank becomes majority shareholder in a foreign bank Edge Act Corporation U.S. bank creates subsidiary Accepts deposits from anywhere Can only grant international loans Exempt from some U.S. bank regulations International Banking Facility (IBF) U.S. bank sets up subsidiary Can only accept deposits or make loans to international market Can conduct business with parent company or other IBFs. Exempt from many regulations and state/local taxes 2. Banks Entering the U.S. market Agency Office - foreign banks can grant loans but not accept deposits from Americans Similar to a non-bank bank Legally not a bank - a bank accepts deposits and makes loans; stop one of the functions Not required to have deposit insurance Foreign Bank Branch - a full bank in the U.S. subject to all laws and regulations U.S. Subsidiary Bank Foreign bank becomes majority shareholder in a U.S. bank Most popular U.S. regulations are so complicated that it is easier to buy a bank that already legally operates.
Exchange Rate Risk
1. Currency exchange rate - ratio of one currency to another Example $1 = 3 rm (Malaysian ringgits) How many U.S. dollars could 6 million ringgits be converted into? Trick - keep the currency units Correct method: 6 million rm ($1 / 3 rm) = $2 million Incorrect method: 6 million rm (3 rm / $1) = 18 million rm ² / $1 Exchange rates change Appreciation - one currency can buy more of another currency Depreciation - one currency can buy fewer of another currency Note - if one currency appreciates, the other currency depreciates Example 1 $1 = 10 rm The U.S. dollar appreciated, because it buys more ringgits. Thus, the ringgit automatically depreciated against the dollar. Example 2 $1 = 2 rm The ringgit appreciated, while the U.S. depreciated Some economists and analysts use the terms strong and weak Example - the dollar is weaker today The U.S. dollars was compared to a basket of foreign currencies, and overall, it lost value again them The basket is strong currencies, such as the Japanese yen, euro, British pound, etc. 2. Exchange rate risk - can cause large losses or gains when transactions and loans are in another country Example Malay bank loans 20 million ringgits to a company in Greece Exchange rate is 1 euro = 4 ringgits Original loan is for 5 million euros, because Greece uses the euro What happens, if exchange rate changes to 1 euro = 2 ringgits? Loan is now worth 10 million ringgits Bank has a substantial loss What happens, if the exchange rate changes to 1 euro = 10 ringgits? Loan is now worth 50 million ringgits Bank has a substantial gain
Financial Instruments
1. How banks can protect themselves from the following: Foreign exchange rate risk Circumvent government regulations Facilitate international trade 2. Use derivatives Primary market - government or a corporation issues a new security, this security is sold in this market Government Investment banks - marketing agent for new securities Dealers Secondary market - investors buy or sell securities in this market Organized exchanges New York Stock Exchange - stocks Chicago Board of Trade - derivatives Kuala Lumpur Stock Exchange - stocks, derivatives, etc. Spot Market Buyer and seller exchange a commodity for money immediately Future prices can fluctuate Derivatives market - contracts for the future exchange of a commodity for a specific date at a fixed price Commodities - currencies, petroleum, coffee, corn, wheat, Eurodollars, stocks, bonds, government bonds, etc. The contract is exchanged between two parties today Buyer and seller locked in a future price today Protect a company from price fluctuations Investors can sell or buy contracts on the secondary markets today Types Futures / Forward Put or Call Options Currency Swaps Credit Default Swaps - a player in the 2008 Financial Crisis Forward transaction - on a particular future date, the commodity is exchanged for a known price Forward contracts are tailored made contracts, usually issued by international banks Example - U.S. bank invests in a Malaysian company Bank can buy forward contracts for future payment If the company makes a payment six months from today, the bank can buy a forward contract today with a fixed exchange rate in six months Investors can sell or buy contracts on the secondary markets Maturities: 1, 2, 3, 6, or 12 months Note - Futures are very similar to a forward; however, futures contracts are standardized; easier to buy/sell on futures markets Currency Swaps Spot against a forward 57% of trades in 2004 A dealer buys currency from a bank on the spot market The dealer sells the same security back to the bank with a forward contract No exchange rate risk Dealer is using currency today and will resell currency tomorrow for a known price Example - a U.S. business invests $1 million in Malaysia for one year He or she buys ringgits on the spot market today He can buy a forward contract today, so when he cashes out ringgits on a future date, he can exchange them for a known exchange rate Forward-Forward Swap $3.2 trillion market in April 2007 A firm and a dealer have two forward contracts with each other Exchange of two separate cash flows A dealer sells a forward contract for a specific currency to a firm and the firm simultaneously sells a contract to the dealer for the opposite currency with the same maturity Similar to a loan with collateral from the dealer Example Intel wants to invest in Malaysia, while the Malaysian dealer wants to invest in the United States A Malaysian dealer sells Intel ringgits on a future date and Intel sells U.S. dollars to the Malaysian dealer. Exchange of two forwards contracts Intel could get a loan from a U.S. bank while the Malaysian dealer gets a loan from a Malaysian bank Could get more favorable terms, because companies are well known within their country Note - similar to a U.S. dollar liquidity swap Example - a European Central Bank requests U.S. dollars from the Federal Reserve Both central banks enters into forward-forward swaps Federal Reserve lends U.S. dollars to the European Central Bank, and the European Central Bank gives the loan equivalent in euros as collateral European Central Bank repays loan in U.S. dollars and gets its euros back 3. International Trade and Finance Banker’s Acceptance - bank guarantees payment to foreign exporter Example Malaysian store wants to buy coffee from Indonesia The coffee company does not know the credit worthiness of the Malaysian store owner Malaysian store owner deposits money into international bank International bank guarantees payment and sends letter of credit to the Indonesian coffee company The coffee company can now export coffee to Malaysia and deposits letter of credit into his bank The Malaysian bank sends electronic payment to Indonesian bank Lowers transaction cost International bank guarantees payment and is liable once banker’s acceptance is created Banker’s Acceptances can be sold on the secondary markets for a discount Eurodollars - banks keep accounts denominated in U.S. dollars outside of the U.S. Financial innovation created by the Soviet Union USSR accumulated U.S. dollars from selling petroleum They wanted to hold U.S. dollars but not in U.S. banks Afraid of seizure from U.S. gov. Convinced European banks to hold accounts in U.S. dollars Eurodollars allowed banks to circumvent regulations British banks could not lend outside of Britain U.S. banks could not pay interest on checking accounts Checks – document that allows bank transfers U.S. banks could borrow Eurodollars and pay interest British banks could lend outside of England, using Eurodollars Federal Reserve (i.e. U.S. central bank stop publishing the M3 definition of the money supply in 2006 M3 definition contains Eurodollar Countries are worried about the U.S. debt and trade deficits Euroloans and eurobonds - the repayment of loans is denominated in U.S. dollars U.S. bank grants a loan to a Malaysian business The repayment of principal and interest is denominated in U.S. dollars The exchange rate risk is forced upon the borrowers Note - if the exchange rate changes too much, then the borrower could default on the loan In our case, the ringgits depreciates significantly against the dollar, then the Malaysian company defaults, if it business accepts ringgits and converts them to U.S. dollars
Regulatory Oversight
1. U.S. dollar became the international transaction currency after World War II Preferred currency to negotiate international transactions Petroleum market denominated in U.S. dollars. Several developing countries threaten to default on their Euroloans during 1980s Could trigger a global banking crisis in the industrialized countries. Twelve countries, including the United States met in Basel, Switzerland to discuss capital requirements Basel agreement Ensure banks had enough capital to survive a financial crisis Avoid massive profit losses. Set common capital standards for banks engaged in currency swaps, financial futures, and options. Central banks discuss their roles of being the lenders of last resort during a banking crisis. They would concentrate on the financial stability of their own domestic banks. Banking crisis in one country can spread and trigger a banking crisis in another. One central bank cannot contain a financial crisis 2. Many countries were deregulating their financial markets as the 2008 Financial Crisis struck the world economy. The United States, Ireland, Spain, and many countries experienced a strong real estate bubble Real estate bubble ended in 2007 World economy entered a recession in 2007 Businesses lay off many people Unemployed could not find jobs. Unemployment rate soared Some people stopped paying their mortgages Banks stopped granting new mortgages New housing construction stopped Housing prices began falling as the banks foreclose on houses that are losing value. The U.S. government response Identical to many other countries The U.S. government purchased preferred stock in the largest banks in the United States Banks gained new funds. U.S. government started ownership in a business The Federal Reserve bought many of the toxic mortgage loans from the banks Remove the bad debt from their books. Toxic loan is a bank granted a mortgage to a family or person with no credit history or poor credit First loans to go bad as the 2007 Great Recession started Called subprime loans before the financial crisis because banks earned enormous profits. Federal Reserve rapidly expanded the money supply to offset the declines in the U.S. economy. Granted trillions of dollars in emergency loans to the U.S. banks. Federal Reserve became the lender of the last resort for the developed world. Central banks from Britain, European Union, and Japan can borrow U.S. dollars from the Federal Reserve through the U.S. dollar liquidity swap. A U.S. dollar liquidity swap is a central bank can borrow U.S. currency from the Federal Reserve by giving its own currency as collateral. On the maturity date, the central bank repays its loan in U.S. dollars, and the Fed returns the currency. Similar to a forward-forward transaction. Government regulations and regulatory differences among countries will diminish Avoid an economic crisis like the 2008 Financial Crisis.