International Banking, Debt, and Risk Chapter 20 International Banking, Debt, and Risk

Topics to be Covered Eurocurrency Market Origins of Offshore Banking International Banking Facilities Offshore Banking Practices International Debt IMF and IMF Conditionality Role of Corruption Country Risk Analysis

Eurocurrency Market Eurocurrency Market—is the deposit and loan market for foreign currencies. Banks that accept deposits and make loans in the Eurocurrency market are called Eurobanks. The term Eurocurrency or Eurobank is a misnomer since it refers to offshore banking and is not limited to Europe.

Origins of Offshore Banking The Eurodollar market started in the late 1950s when European banks began accepting deposits in U.S. dollars. Why and how did this market get started? The reserve-currency status of the dollar was an important factor. Some communist countries were the earliest source of dollar deposits held in Europe. Eurobanks developed as a result of profit considerations.

Offshore Banking (cont.) Offshore banking has grown rapidly over the past decades because Eurobanks are essentially unregulated. Eurobanks can offer narrower spreads than U.S. banks (the “spread” is the difference between the deposit and loan interest rates).

Eurobank vs. U.S. Bank Spreads Refer to Figure 20.1 Eurobanks are able to offer a lower rate on dollar loans and a higher rate on dollar deposits than U.S. banks. Eurodollar transactions are considered riskier to U.S. residents compared to domestic dollar transactions in the U.S.

FIGURE 20.1 Comparing U.S. and Eurobank Spreads

LIBOR London Interbank Offered Rate (LIBOR)—the interest rate at which large London banks make deposits or lend to each other. In the Eurodollar market, loan interest rates are quoted as percentage points above LIBOR. LIBOR is fixed daily for the British pound, Canadian dollar, Danish krone, euro, U.S. dollar, Australian dollar, New Zealand dollar, Japanese yen, and Swiss franc.

LIBOR and the 2008 Black Swan Event See Global Insights 20.1 Black swan event – the occurrence of a rare event that was not expected to happen. The increase in credit risk associated with failing banks led to a rise in LIBOR. TED spread – the difference between the 3-month LIBOR and the 3-month U.S. T-bill interest rate.

International Banking by Countries Refer to Figure 20.2 Foreign assets held by banks, by country The U.K. banks account for the largest share of foreign assets, primarily cross-border total claims. Interbank claims are deposits held in banks in other countries.

FIGURE 20.2 TED Spread

International Banking Facilities In December 1981, the Federal Reserve permitted U.S. banks to engage in Eurobank activity on U.S. soil. International banking facilities (IBFs) are international banking divisions of onshore U.S. banks. The loans and deposits of IBFs are kept separate from the rest of the U.S. bank’s business because IBFs are not subject to reserve requirements, interest rate regulations, or FDIC deposit insurance premiums.

Offshore Banking Practices Because of the importance of interbank transactions, gross deposits at Eurobanks overstate the actual amount of activity of these banks in intermediating funds between nonbank savers and nonbank borrowers. To measure the amount of credit actually extended by Eurobanks, the net size of the market is determined by subtracting interbank activity from total deposits. Refer to Tables 20.1, 20.2, and 20.3 for an example.

TABLE 20.1 Company X Deposits $1 Million in Eurobank A

TABLE 20.2 Eurobank A Deposits $1 Million in Eurobank B

TABLE 20.3 Eurobank B Lends $1 Million to Company Y

Effects of Eurodollar Market Eurodollars are not spendable money, but are money substitutes such as time deposits in a bank. In countries without efficient money markets, access to a competitive Eurodollar market may reduce the demand for domestic money as residents shift funds to the offshore market and earn profit. If the Eurodollar market encourages more international capital flows, then central banks need to engage in more sterilization operations to achieve their domestic monetary policy.

Characteristics of Eurobanks Eurobanks are just like domestic banks in terms of maximizing spreads and managing risk. Deposits are for fixed terms ranging from days to years, mostly for less than six months. Eurocurrency deposits are similar to domestic banks’ certificates of deposits. Eurocurrency loans can range up to 10 years or more. Large loans are generally made by syndicates of Eurobanks.

International Debt Petrodollars—are Eurodollar deposits arising from the trade surpluses of OPEC nations. In turn, the Eurobanks lent these petrodollars to developing countries. Refer to Table 20.4 External debt of developing countries during the debt crisis period.

TABLE 20.4 External Debt/Export Ratios during International Debt Crisis Period (Average gross external debt as a percentage of exports of goods, services, and private transfers)

International Debt (cont.) Debtor countries such as Argentina and Brazil borrowed more to service their outstanding debt and/or rescheduled or renegotiated the terms of the loans. Paris Club—meetings of creditor governments (typically Western industrialized countries) with debtor nations. The debtor must first apply for a standby credit arrangement with the IMF before the meeting is held.

Debt/Equity Swap Debt/Equity Swap—involves an exchange of a developing country’s debt for an ownership or equity position in a business in the debtor country. The use of debt/equity swaps has stimulated the growth of a secondary market where creditor commercial banks may sell their developing country debt.

IMF Conditionality The International Monetary Fund (IMF) has been an important source of funding for debtor countries with repayment problems. IMF Conditionality refers to the IMF pre-conditions which require borrowers to adjust their economic policies to reduce balance of payments deficits and improve the chance of debt repayment. These conditions involve macroeconomic targets such as money supply growth and the budget deficit.

IMF The IMF is a multinational organization of over 180 countries. Its objective is to provide short-term loans to countries with temporary balance of payments disequilibria (if the countries agree to certain IMF conditions). IMF policy is determined by member countries’ votes. Voting power is based on a country’s quota or financial contribution to the IMF. The U.S. has the most votes since its quota accounts for almost 18% of the total fund.

The Role of Corruption Research shows that there is a negative relationship between the level of corruption in a country and the country’s growth and investment. Corruption thrives in countries where government policies create economic distortions or imperfect markets. The more competitive a country’s markets, the fewer the opportunities for corruption. In the late 1990s, both the IMF and World Bank began including anticorruption policies as part of their lending process.

Country Risk Analysis Country Risk—refers to the overall political and financial situation in a country and how these conditions may affect the ability of the country to repay its debts. Country risk analysis involves the evaluation of both qualitative and quantitative factors.

Qualitative or Political Risk Factors Splits between different language, ethnic, and religious groups that undermine stability. Extreme nationalism and aversion to foreigners that may lead to preferential treatment of local interests and nationalization of foreign holdings. Unfavorable social conditions, including extremes of wealth. Conflicts in society evidenced by demonstrations, violence, and guerilla war. The strength and organization of radical groups.

Quantitative or Economic Factors External debt as a % of GDP or exports International reserve holdings relative to imports Export level and diversity Economic growth

TABLE 20.5 Country-Risk Rankings

TABLE 20.5 Country-Risk Rankings (cont.)

FIGURE 20.3 Deposit Banks’ Foreign Assets, by Country