The Banking Industry (International) Chapter 14 pt. 2 The Banking Industry (International)

Objectives To become familiar with trends and current situations in important non-Hong Kong banking markets. To understand the role of banks in facilitating international trade and finance.

Largest International Banks: 2001 Mishkin and Eakins

Banking System Framework In the post-war era, there were three basic systems of banking regulation. Universal Banking (prevalent in Continental Europe: France, Germany, Switzerland). Bank Holding Companies (prevalent in UK & Commonwealth countries). Strict Commercial Banking (once prevalent in US & Japan)

Universal Banking Universal banks do all sorts of financial activities in one company. Banks are free to engage in banking, securities, real estate, insurance…. All businesses done under 1 legal entity. Banking business fully shares risks. Banks Own Securities and may have representatives on board of major borrowers. Advantages: Banks ownership of securities enables close monitoring/ One stop shopping allows banks to build strong relationships with borrowers.

Bank Holding Companies Bank holding companies have a corporate structure in which a parent company owns many subsidiaries in different financial industries. Subsidiaries engage in banking, securities, real estate and insurance business. Subsidiaries are separate legal entities so the bankruptcy of one does not mean losses for the other. Losses at one subsidiary do result in losses for shareholders of the holding company. Banks mostly protected from risk of sister companies. Advantages: Protects depositors & bank capital from market risk. One stop shopping can help build relationships.

Strict Commercial Banking In this regime, banks are engage in only commercial banking (taking deposits and making loans). Banks are completely independent companies. Banks may not be part of a corporation that also runs investment banks, insurance etc. In USA, banks could not own equities. In Japan, banks did own equities. Advantages: Banks protected from stock market risk. In both Japan and USA, system has switched to bank holding companies.

A Look at Banking Systems Around the World In this section, we examine changes in large banking markets around the world. USA Japan People’s Republic of China

U.S. Banking System: Past Prior to 1980, U.S. banking system was heavily regulated along a number of dimensions. Banks were strictly commercial banks and could not participate in investment banking, insurance, mutual funds, other financial industries. Banks were restricted to operation in 1 state (California, New York, etc.). As a result, USA has many small banks.

Evolution of the US Banking System US Banking system becoming closer to UK style commercial banking. Banks have used holding companies to consolidate across state lines. Number of banks is shrinking through Mergers. Banks are now able to set up brokerages and sell mutual funds. In 1999, banks were allowed to be a part of holding companies that own insurance and investment banks.

Japanese Main Banking Japanese banking characterized by long term relationship described as Main Banking. A company’s main bank will be the sole provider of the bulk of its external finance. Virtually all companies had a main bank which closely monitored borrowers for long periods. Many banks are at the center of industrial groups called Keiretsu. Keiretsu bank is the main bank of the companies in the group. Bank owns shares of the stock of Keiretsu companies. Keiretsu companies own shares in the bank.

Japanese Banking System: Past Japan banks were restricted to commercial banking, but could own equity securities. Japanese central bank had an official policy of not allowing bank failures. Prior to 1990’s, not much need for a lender of last resort. In 1990’s, Japanese banking system suffered large losses due to collapse of equity prices and, most importantly, default on many loans to property speculators. Many banks closed or nationalized.

The Big Bang and Beyond As in the US, liberalization of financial markets has produced new competition for banks and a declining market share of external finance for banks. Banks searching for new clients financed real estate speculation during 1980’s. Over the course of the 1990’s, many loans went bad jeopardizing bank balance sheets. In 1998, announced a further financial liberalization nicknamed the Big Bang. Part of this allowed for bank holding companies and direct sales of mutual funds and insurance by banks.

Rising problem of non-performing loans

Characteristics of Japanese Financial Intermediation Consolidation of City Banks: Banking industry had been dominated by 8 nation-wide “city” banks. (Dai-Ichi, Fuji, and IBJ combine to for Mizuho) (Bank of Tokyo-Mitsubishi combine) (Sumitomo-Mitsui combine) Sanwa and Toyo bank combine to form UFJ

Characteristics of Japanese Financial Intermediation Banking firms ignore consumer credit. Stand-alone consumer credit firms are major players in financial intermediation. JapanPost takes bank deposits. These deposits can often be superior to deposits at banks in terms of liquidity and interest rates and are perceived as safer.

Distribution of Assets: Japan Source: McKinsey Global Institute

Chinese Banking System Dominated by Four State Owned Deposit Money Taking Banks (Industrial and Commercial, Construction Bank, Agricultural Bank, Bank of China) (Deposit Money Bank) Other types of banks: Joint-Stock Commercial Bank (CITIC Industrial Bank, Bank of Communications, Everbright) City Commercial Bank (Bank of Shanghai, Bank of Beijing, Bank of Tianjian) Credit Cooperatives (Collective Banks – Urban and Rural) Policy Banks (Export Import Bank, China Development Bank)

Distribution of Assets: PRC Source: Mckinsey Global Institute

Characteristics of China’s financial market. Bank lending (especially by big 4) has traditionally been channeled to State Owned Enterprises (SOE’s) for policy reasons rather than traditional profit. SOE sector is declining. As a result, many of the loans made by Chinese banks go bad. Some argue that credit analysis is improving rapidly in China.

Banking System in 2002: (Source: Asian Wall Street Journal) Big Four Banks Official NPL Ratio Industrial & Commercial Bank of China 21.56% Bank of China 18.07% China Construction Bank 11.92% Agricultural Bank of China 30.07%

Importance as a Store of Wealth Chinese savers have limited options for storing their wealth. Bond markets are limited and mutual funds rare. Stock markets not transparent and volatile. Capital account closed. No legal foreign assets. As a result, huge share of savings channeled to the banking sector.

Deposits are major channel for saving in PRC

Banks on the Eve of Reform Problem Banks have limited competition for deposits of Chinese savers. Many loans are made on a non-commercial basis. A large share of loans are non-performing. Policy Response Recapitalization. Asset Management Banks have purchased Yuan 1.4 Trillion worth of bad loans from banks. Transparency. Banks are required to make information about NPL’s public. Foreign Ownership & Competition WTO will allow greater access to Chinese market to foreign financial services companies presenting competition for deposits.

Banking in the International Economy Chapter 16 Banking in the International Economy

Loans by International Banks to the Non-bank Sector by Nationality of Lender, 2004 Germany . . . . . . . . . . . . . . . . . . . . 20.3% Japan . . . . . . . . . . . . . . . . . . . . . 13.0% France . . . . . . . . . . . . . . . . . . . . . . 11.1% United Kingdom . . . . . . . . . . . . . . . . . .10.2% Switzerland . . . . . . . . . . . . . . . . . . 8.4% United States . . . . . . . . . . . . . . . . . 6.9% Netherlands . . . . . . . . . . . . . . . . . . 6.5% Belgium . . . . . . . . . . . . . . . . . . . . 5.2% BIS International Banking Statistics

Multinational Banks.

Credit Risk and Exchange Risk in International Trade International Trade will require some credit risk. Importers promise to pay for goods shipped, but exporters may have little information about the credit-worthiness of importers. Importers often will pay for goods in their home country currencies. Exporters face costs of producing goods in their home country currencies..

Facilitating International Trade

Trade Instruments Bankers Acceptances: Time drafts that establish credit between parties who do not know each other, facilitating international trade. Banks promise to pay exporters at a specific time. Banks collect some fee for making this payment (about .5% of transaction) from importer. Banks can hold or sell bankers acceptance which will require exporter to repay value of the time draft.

Exchange Rate Risk Exchange Rate Forwards: Promise to sell foreign currency at a pre-arranged currency Exporters facing currency risk might seek a forward transaction from bank. They will promise to pay the foreign proceeds from their international trade transaction and bank will promise a certain fixed amount of domestic currency.

International Banking: Lending Prior to 1960’s: international lending was small and mostly sovereign borrowing The UK and Switzerland were the main centers of international banking. During 1970’s: Oil exporting countries achieved large dollar surplus due to high oil prices. U.S. banks recycled loans to developing countries. During the 1980’s and 1990’s: Japanese trade surplus encouraged the entry of Japanese banks into international markets. Over the next 20 years, international lending has risen 10 fold.

Syndicated Euroloans A Euroloan is a loan not made in the currency of the borrower. International bank loans to developing economies are Euroloans. The typical Euroloan is a floating-rate obligation of relatively long maturity with LIBOR as the benchmark rate. Euroloans are usually handled by loan syndication, with each participating bank holding a fraction of a loan.

Why Syndicate? Loan syndication is a way to share risks and take advantage of scale economies on information costs. Lead managers: Some large, international banks specialize in evaluating and monitoring international borrowers. Lead managers find borrowers and share loans with participating banks. Smaller banks might be willing to absorb risks of international lending but not have advantage in evaluating loans.

Syndicated Loans to Emerging Markets Borrowing from international banks can be an important source of funding for emerging markets International lending markets can also be unstable with sudden changes in bank lending. International financial markets can be an important source of macroeconomic instability in emerging markets Example: East Asian Crisis of 1997-1998.

International Bank Lending to

East Asian Crisis

International Lending: Deposits A Eurocurrency deposit is a time deposit or negotiable CD denominated in a currency other than the currency of the location of the bank. Eurocurrency markets were pioneered by British banks that were trying to avoid rules on the use of pounds in international loans. London still the main Euromarket center. Eurocurrency deposits catered to US depositors trying to escape Regulation Q. First Eurocurrency is the Eurodollar.