Chapter 20 - International Banking and the Future of Banking and Financial Services

CHAPTER 20
INTERNATIONAL BANKING AND THE FUTURE OF BANKING AND FINANCIAL
SERVICES
Goal of the Chapter: The purpose of this chapter is to learn the different types of services
international banks offer to their customers and to discover the various forms of organizational
structures; a bank may adopt to conduct international business.
Key Topics in This Chapter

Types of International Banking Organizations

Regulation of International Banking
Foreign Banking Activity in the United States
Services Provided by International Banks
Managing Currency Risk Exposure
Challenges for International Banks in Foreign Markets
The Future of Banking and Financial Services
Chapter Outline

I. Introduction
II. Types of International Banking Organizations
A. Representative Offices
B. Agency Offices
C. Branch Offices
D. Subsidiaries
E. Joint Ventures
F. Edge Act Corporations
G. Agreement Corporations
H. International Banking Facilities (IBFs)
I. Shell Branches
J. Export Trading Companies (ETCs)
III. Regulation of International Banking
A. Goals of International Banking Regulation
B. U.S. Banks Activities Abroad
C. Expansion and Regulation of Foreign Bank Activity in the United States
1. The International Banking Act of 1978
2. The Foreign Bank Supervision Enhancement Act of 1991
D. New Capital Regulation for Major Banks Worldwide
IV. Services Supplied by Banks in International Markets
A. Making Foreign Currencies Available to Customers
B. Hedging Against Foreign Currency Risk Exposure
1. Forward Contracts
2. Currency Futures Contracts
C. Other Tools for Reducing Currency Risks

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1. The Development of Currency Options

2. Currency Swaps
D. Supplying Customers with Short- and Long-Term Credit or Credit Guarantees
1. Note Issuance Facilities
2. Europaper
3. Issuing and Managing Depository Receipts
E. Supplying Payments and Thrift (Savings) Instruments to International Customers
1. Payments Services
2. Savings (Thrift) Services
F. Underwriting Customer Note and Bond Issues in the Eurobond Market
G. Protecting Customers against Interest Rate Risk
1. Interest-Rate Swaps
2. Interest-Rate Caps
3. Financial Futures and Options
H. Helping Customers Market Their Products through Export Trading Companies
V. Challenges for International Banks in Foreign Markets
A. Growing Customer Use of Securities Markets to Raise Funds in a More Volatile and
Risky World
B. Developing Better Methods for Assessing Risk in International Lending
1. International Loan Risks
2. Possible Solutions to Troubled International Loans
3. International Loan Risk Evaluation Systems
C. Adjusting to New Market Opportunities Created by Deregulation and New
International Agreements
1. Opportunities Created by NAFTA and CAFTA
2. Opportunities in the Expanding European Community
3. Opportunities in Asia as Barriers Erode
VI. The Future of Banking and Financial Services
A. Convergence
B. Consolidation
C. Survival of Smaller Community Financial-Service Institutions
D. Reaching the Mass Media
E. Invasion by Industrial and Retailing Companies
F. The Wal-Mart Challenge
G. Fighting for Ultimate Survival in a Global Financial System
VII. Summary of the Chapter
Concept Checks
20-1. What organizational forms do international banks use to reach their customers?
There are various forms of organizations that banks use to set up offices internationally. These
forms include representative offices, agency offices, branch offices, subsidiaries, joint ventures,
Edge Act corporations, agreement corporations, IBFs, shell branches, and ETCs. Representative
offices generally do not provide conventional banking services but serve as a channel to market
the services supplied by the home office and identify new customers, while branch offices

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generally offer a full line of banking services acting as a local office of a large full-service
providing corporation. Agency offices are more complete than representative offices which both
accept deposits and extend credit. Subsidiaries are separate legal entities that are owned by a
banking firm, while joint ventures are shared business operations usually jointly owned by a
foreign bank or bank holding company and a domestic firm, sharing both profits and expenses.
Edge Acts are operated inside the United States by both domestic and foreign banks and must, by
regulation, devote the bulk of their service activities to providing international banking services
to offshore customers. Agreement corporations are similar to Edge Acts providing bulk of their
services to international customers. IBFs are international banking facilities located in U.S.
territory that reflects transactions carried out on behalf of international customers. Both foreign
and domestic U.S. banks may operate these computerized sets of account records known as IBFs.
Shell branches are merely offshore offices that record the receipts of deposits and other
transactions of a banks international operations. They are usually formed by banks to escape the
burden of regulations in their home country. Finally, ETCs are export trading companies that
provide trade financing, export insurance coverage, research into markets abroad, and other
similar services needed by businesses exporting goods and services abroad.
20-2. Why are there so many different types of international organizations in the financial
institutions sector?
Different organizational forms are used for several reasons. These different organizational forms
often serve different functions. The form of institution is usually selected based on a banks goals
and objectives which may include profitability, cultural fit, availability of qualified personnel,
operating costs, among others. Also, the laws in one country may restrict or prohibit the use of a
particular type of organizational form. Additionally, there may be tax advantages of one form
over another as also there may be differing abilities to raise capital and other funds.
20-3. What are the principal goals of international banking regulation?
The principal goals of international banking regulation include:
1. protecting the safety of depositor funds,
2. promoting stable growth in money and credit,
3. protecting a nation against loss of its foreign currency reserves,
4. restricting the outflow of scarce capital, and
5. protecting domestic financial institutions and markets from foreign competition.
20-4. What were the key provisions of the U.S International Banking Act of 1978 and the
International Lending and Supervision Act of 1983?
The U.S. International Banking Act of 1978 brought foreign banks operating in the United States
under federal regulation for the first time. It required all foreign banks operating in the United
States to secure a federal license, abide by the laws of the states in which the bank is registered,
and subjected them to same reserve requirements as a domestic bank in case their deposits
exceeded $1 billion. The International Lending and Supervision Act of 1983 required American
banks to restrict the size of fees charged for rescheduling payments on loans made overseas in

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order to avoid excessive burdens on debtor countries, report their foreign loan exposures to bank
examiners, and hold adequate reserves to protect depositors against possible losses on foreign
loans.
20-5. Explain what the Basel Agreement is and why it is so important.
The Basel Agreement is a negotiated agreement between bank regulatory authorities in the G-20
economies as well as some of the other major financial centers like Singapore and Hong-Kong to
set common capital requirements for all banks under their jurisdiction. The importance of the
Basel Agreement is twofold:
(1) to strengthen international banks, thereby strengthening public confidence in them, and
(2) to remove important inequalities in banking regulation between nations that contribute to
competitive inequalities between banks.
20-6. Describe the principal customer services supplied by international banks serving foreign
markets.
The principal customer services supplied by international banks are:
(1) making foreign currencies available to customers
(2) helping customers hedge their currency risk exposure through the use of forward contracts,
currency futures contracts, currency options, currency swaps, and other financial derivative
instruments,
(3) supplying customers with short and long-term credit or credit guarantees,
(4) supplying payments and thrift (savings) instruments to international customers,
(5) underwriting customer note and bond issues in the Eurobond market,
(6) protecting customers against interest rate risk, and
(7) helping customers market their products through export trading companies.
20-7. What types of risk exposure do international banks strive to control in order to aid their
customers?
International banks strive to control currency risk exposure and interest rate risk exposure in
order to aid their customers.
20-8. What is an NIF? A DR?
A note issuance facility (NIF) is a medium-term credit agreement between an international bank
and its larger corporate and governmental customers, where the customer is authorized to
periodically issue short-term notes, each of which usually comes due in 90 to 180 days, over a
stipulated period (such as five years). International banks pledge to either buy up any notes not
bought by other investors or grant supplemental loans.
A depository receipt or DR is a negotiable instrument representing an ownership interest in the
stock or debt securities of a foreign institution. This instrument usually arises when a broker
purchases securities issued by a foreign entity and delivers them to a custodian who, in turn,
instructs a depository bank to issue DRs representing the securities. Through the use of a DR, the

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denomination of a foreign security can be converted to the currency of the country where the
receipts are being issued, thereby reducing the currency risk for international investors.
20-9. Of what benefit might NIFs and DRs be to international banks and their customers?
Both NIFs and DRs provide fee income to international banks, and allow the banks to offer
additional services to their customers. NIFs provide credit guarantees for customers' borrowings
in the open market. A DR makes it easier for a foreign business borrower to sell its securities in
the global market place. Moreover, an investor usually can recover his or her funds more quickly
by liquidating DRs than by attempting to sell a foreign-issued security.
20-10. What are ETCs? What services do they provide, and what problems have they
encountered inside the United States?
An ETC is an export trading company usually owned and operated by large banks. The purpose
of these ETCs is to research foreign markets, identify firms in those foreign markets that could
distribute products, and then provide or arrange the funding, insurance, and transportation
needed to move goods to market.
20-11. What do the terms Europaper and Eurobonds refer to? Why are these instruments
important to international banks and to their customers?
Europapers consist of commercial papers issued by multinational corporations in the
international markets to finance their short-term credit needs. Eurobonds, on the contrary, are
longer-term debt securities issued by companies in global financial markets. Both these
instruments are issued by the companies outside the country of their origin and are denominated
in currencies other than currencies of their home country. These instruments allow companies
that are unable to crack their domestic markets due to lower credit ratings, to issue foreign
currency denominated debt. In addition, Eurobonds are also used by many companies to finance
their foreign investments. International banks often underwrite these securities to earn fee-based
incomes. Additionally, they also buy these securities to support the funding needs of their
customers.
20-12. What types of tools have international banks developed to help protect themselves and
their customers against currency and interest rate risk? How does each tool accomplish its
purpose?
Two of the most popular tools to hedge against currency risk include forward contracts and
currency futures contracts. While forward contracts are customized contracts, currency futures
contracts are standardized instruments. Both of these instruments allow for buying or selling a
currency at a predetermined price at a specified point in time, and can be used to take a longhedge or a short-hedge position, depending on the need. Typically an importer who will have to
buy foreign currency at a later date may enter into a long-hedge while an exporter who expects to
receive a foreign currency denominated payment in future may enter into a short-hedge to protect
himself against the exchange rate risks. Thus, it can help in protecting the customer from risks
arising due to changes in the exchange rate.

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Banks also frequently use currency options to hedge exchange rate risks. Currency options give
the buyer the right but not the obligation to buy or sell a currency at a predetermined price, thus
giving the customer the chance to benefit from possible gains in the exchange market. Currency
swaps on the other hand, allow two parties to exchange cash flows in one currency with cash
flows in a different currency at a specified price on or before a terminal date. This can help a
company match the currencies of their inflows and outflows and thereby help reduce the risk of
losses due to exchange rate movements.
Tools used to protect against interest rate risks include interest rate swaps and financial futures
and options, which work similar to their currency counterparts. Additionally, banks also offer to
impose caps (maximum rates) on loans, thus protecting the customer from increases in interest
costs due to rise in interest rates.
20-13. This chapter focuses on several major problem areas that international banks must deal
with in the future. What are these problem areas?
The major areas that international banks must deal with in the future are:
1. Growing customer use of securities markets to raise funds in a more volatile and risky
world.
2. Developing better methods for assessing risk in international lending.
3. Adjusting to New Market Opportunities Created by Deregulation and New
International Agreements.
20-14. What different approaches to country-risk evaluation have international banks developed
in recent years?
New approaches to country risk evaluation developed by international banks in recent years
include:
(1) the checklist approach, which lists economic and political factors believed to be significantly
correlated with loan risk,
(2) the Delphi method, which uses consensus view of various business analysts, economists, and
expert opinions to make an assessment of country risk, and
(3) using market interest rates attached to deposits traded in the Eurocurrency markets to develop
implied risk premium measures for bank loan rates.
Recently advanced statistical models have been used which are based on changes in selected key
variables, including growth of the domestic money supply, the ratio of real investment to gross
national product, and the ratio of a nation's imports to foreign exchange reserves. Many analysts
also follow the Euromoney Index, the Institutional Investor Index as well as the International
Country Risk Guide published by leading financial magazines that can help assess the risk of a
loan in a particular country.
20-15. What different regions around the globe today appear to offer the greatest opportunities
for expansion for international banks? Why do you think this is so?

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The most promising areas for expansion lie in Asia, especially in fast growing countries like
China, India, and South Korea, just to name a few. The large population size of these countries
represents opportunities for international banks, securities dealers, insurance companies, and
other financial service providers alike. Some of these countries are amongst the fastest
developing economies in the world. A rising middle class, higher disposable incomes, reducing
entry barriers, and scores of trade agreements resulting in opening up of the previously closeddoor economies are some of the key reasons to believe that these nations offer the greatest
opportunities for expansion for international banks.
20-16. In looking at the future of the banking and financial-services industry, does it appear
likely that the powerful trends of convergence and consolidation will continue into the future?
Why or why not? Is this likely to occur at the same pace as in the past?
Empirical evidences suggest that convergence and consolidation will continue into the
foreseeable future. Convergence is relatively new in the U.S. and many firms are looking to
expand into new markets because of lower profit potentials in their traditional markets and
possibilities for economies of scope and diversification effects. Consolidation has been a long
run trend and is expected to continue as financial service firms look for economies of scale.
However, these trends may continue at a slower pace in the future. Consolidation is speculated to
have slowed because the best targets have already been taken. Convergence may be slower
because not all of the mergers that have taken place have worked well and financial service firms
may want to be more careful entering into these new markets in the future. Also, these past
trends may not necessarily hold, particularly in the light of recent financial crisis, where a lot of
smaller and lesser diversified companies have performed much better than some of their larger
and well diversified counterparts.
20-17. What appears to be the future of community banking? What significant threats does
community banking seem to face?
The biggest impact on the expansion of large international banks is borne by smaller sized
community banks and credit unions. The future of community banks much depends on the speed
at which these smaller banks adapt to the competition, become more efficient, more cost
conscious, and more customer focused. Although, it is likely that they may well survive and
thrive because economies of scale appear to be modest in banking.
Since, community banks have a relatively narrow menu of services (such as loans, credit cards,
deposits, and investment advice) and do not have global services capacity, they may not be able
to effectively serve all the possible needs of a customer. Presence of a large boutique banks in
such a scenario may attract these customers resulting in loss of business for community banks.
Also, due to increasing mobile population, retaining of customers migrating into distant markets
adds to the threat for community banking.
20-18. Are banking and commercefinancial and nonfinancial firmson a collision course for
the future? What challenges do companies like Wal-Mart pose for small community banks? For
the largest financial firms? For regulation? For ongoing efforts to maintain a safety net to protect
the publics deposits and preserve public confidence in the financial system?

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It is very likely that financial and non-financial firms may be on the collision course in the
future. Nonfinancial companies have been exploring several avenues for expanding their current
beachhead in the financial-services industry for decades and this may be become the biggest
competition in the future. Wal-Mart, with numerous neighborhood stores offers limited array of
financial products at competitive pricing. Availability of financial products with the daily needs
under one roof is turning out to be very convenient for consumers and poses a serious threat to
smaller banks business. Currently, American laws segregate financial and nonfinancial firms to
protect financial firms from affiliations with more risky ventures. It is possible that banks
affiliated with industrial firms may make unprofitable loans to the parent company leaving them
vulnerable to losses and potential bankruptcy. Also, losses from the industrial firm could be
transferred to the banking firm. These potential losses could therefore, have serious
consequences for the deposit insurance system designed to protect small depositors. It may
possibly force the government to subsidize losses in industrial firms through their bank affiliates.
There are strong laws in place today to prevent this from happening but some firms are
continuously looking for ways around regulations because of the profit potential in this huge
market.
Problems and Projects
20-1. Pacific Trading Company purchased Canadian dollars yesterday in anticipation of a
purchase of electric equipment through a Canadian supply house. However, Pacific was
contacted this morning by a Japanese trading company that says equipment closer to its
specifications is available in 48 hours from an electronics manufacturer in Osaka. A phone call to
Pacifics bank this morning indicated that another of the banks customers, a furniture importer
located in San Francisco, purchased a comparable amount of yen in order to pay for an incoming
shipment from Tokyo, only to discover that the shipment will be delayed until next week.
Meanwhile, the furniture company must pay off an inventory loan tomorrow that it received 30
days ago from Toronto-Dominion Bank.
Which of the instruments described in this chapter would be most helpful to these two
companies? Construct a diagram that illustrates the transaction you, as an international banker,
would recommend to these two firms to help solve their current problems.
A San Francisco importer with yen needs Canadian dollars to retire a loan taken out with a
Toronto bank. In this case Pacific Trading Company and the import firm in San Francisco need
to agree on a currency swap of yen for Canadian dollars. At the termination of the swap Pacific
Trading Company will need to return yen to the importer who will reciprocate with a counterpayment of Canadian dollars.

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20-2. Arts Sporting Goods ordered a shipment of soccer equipment from a manufacturer and
distributor in Munich. Payment for the shipment (which is valued at $3.5 million U.S.) must be
made in Euros that have changed in value in the last 30 days from 0.6423 euros/$ to 0.6673
euros/$. If this trend is expected to continue, would you as Art's banker recommend that this
customer use a currency futures hedge? Why or why not?
Since the payment by Arts needs to be made in euro, the firm will need to purchase euro. Given,
the value of euro relative to dollar has weakened in the last 30 days, and the trend being expected
to continue, the firm will need to spend lesser amount of dollars to buy euros in future.
Therefore, Arts does not need to hedge this position.
20-3. Pinochio Corporation will import new wooden toys from a French manufacturer this
week at a price of 200 Euros per item for eventual distribution to retail stores. The current Eurodollar exchange rate is 0.6423 Euros per U.S. dollar. Payment for the shipment will be made by
Pinochio next month, but Euros are expected to appreciate significantly against the dollar.
Pinochio asks its bank, Southern Merchants Bank, N.A., for advice on what to do. What kind of
futures transaction could be used to deal with this problem faced by Pinochio? Futures contracts
calling for delivery of Euros next month are priced currently at 0.6418 Euros per dollar and are
expected to be priced next month at 0.6012 Euros per dollar.
The risk of a rising euro can be hedged by a long hedge in currency futures transactions.
Pinochio's bank could assist its customer by brokering a purchase of Euro futures contracts on
the Chicago Mercantile Exchange, where Pinochio agrees to take delivery of euros next month at
a fixed price of 0.6418 euros per U.S. dollar. This will lock-in the purchase price of euros for
Pinochio. The following month, close to the payment date, the purchased futures contracts will
be squared off by selling the futures contracts at the market price, which is expected to be 0.6012
Euros per dollar. The resulting profit from the purchase and subsequent sale of Euro futures will
help offset the loss to Pinochio due to purchase of euros at a higher spot market price.
20-4. Watson Hardware Corporation regularly ships tools to the United States to retail outlets
from its warehouse in Stuttgart, Germany. Its normal credit terms call for full payment in U.S.

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dollars for the hardware it ships within 90 days of the shipment date. However, Watson must
convert all U.S. dollars received from its customers into Euros in order to compensate its local
workers and suppliers. Watson has just made a large shipment to retail dealers in the United
States and is concerned about a forecast just received from its local bank that the U.S. dollar-euro
exchange rate will fall sharply over the next month. The current Euro-U.S dollar exchange rate is
0.64 Euros per dollar. However, the local banks current forecast calls for the exchange rate to
rise to 0.70 Euros per dollar, so that Watson will receive substantially less in euros for each U.S.
dollar it receives in payment. Please explain how Watson, with the aid of its bank, could use
currency futures to offset at least a portion of its projected loss due to the expected change in the
Euro-dollar exchange rate.
This situation can be addressed with the use of a short hedge in currency futures contracts.
Anticipating a decline in the dollar's purchasing power in terms of Euros, Watson, working
through its bank, can sell 90 day dollar futures contracts. Then, on or before the expiration date
of these contracts, Watson, with its bank's assistance, will purchase dollar futures contracts at a
lower price. Thus, a profit will result from this short hedge to help offset the potential loss from
converting dollar payments into Euros.
20-5. Johanna International Mercantile Corporation has made a $15 million investment in a
stamping mill located in northern Germany and fears a substantial decline in the Euro's spot price
from $1.56 to $1.50, lowering the value of the firm's capital investment. Johanna's principal U.S.
bank advises the firm to use an appropriate option contract to help reduce Johanna's risk of loss.
What currency option contract would you recommend? Explain why the contract you selected
would help to reduce the firms currency risk .
Johanna International can purchase a put option on euro at a price close to the current spot value
of $1.56 per euro. Thus, if the dollar per euro rate drops to $1.50 as feared, the firm can purchase
euros at $1.50 from the market and deliver those at $1.56 per euro by exercising the put option
contract. The resulting profit will help to offset Johanna's loss due to a decline in the
investments value.
20-6. Ebi International Bank of Japan holds U.S dollar denominated assets of $475 million and
dollar-denominated liabilities of $469 million, has purchased U.S. dollars in the currency
markets amounting to $75 million, and sold U.S. dollars totaling $50 million. What is Ebis net
exposure to risk from fluctuations in the U.S. dollar relative to the banks domestic currency?
Under what circumstances could Ebi lose if dollar prices change relative to the yen?
Net currency exposure for Ebi International bank can be calculates as:
Dollar denominated assets - Dollar denominated liabilities (Dollars bought - Dollars sold) .

or $475 - $469 - $75 - $50 $31 million.

Since the bank has a net long position in dollar, the bank stands to lose if the value of U.S. dollar
falls relative to Japanese yen.
20-7. Suppose that Canterbury Bank has a net long position in U.S. dollars of $12 million,
dollar denominated liabilities of $125 million, U.S dollar purchases of $300 million, and dollar
sales of $220 million. What is the current value of the banks dollar-denominated assets?
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Suppose the U.S. dollars exchange value rises against the pound. Is Canterbury likely to gain or
lose? Why?
Net currency exposure for Canterbury Bank is be calculates as:
Dollar denominated assets - Dollar denominated liabilities (Dollars bought - Dollars sold) .
or $12 Dollar denominated assets - $125 ($300 - $220)
Therefore, dollar denominated assets for the bank is worth $57 million

Since Canterbury has a net long position in U.S. dollars, the bank stands to gain if the value of
U.S. dollar appreciates relative to pound.

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