Financial Markets and Institutions A001322735

Michael C Yule

Financial Markets and Institutions

A001322735

19th August 2014

Word Count - 2741

Not including Executive Summary, Introduction and Conclusion

Executive Summary

Globalisation, specifically within financial markets has increased exponentially toward the end of
the 20th century, and will continue to change the dynamics of international markets for the
foreseeable future. In regards to the banking environment, the terms international banking and
global banking are often thought to be interchangeable, however are quite different in their
assumptions. This report will reference both the Argentine and the Asian financial crisiss to
discuss the nuances between international and global banking, and also to critically analyse
global bankings capital flows and the implications to financial markets.

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1.0 Introduction

This report will be divided into two main sections, with the first half of this report conducting a
brief literature review on the 2003 research paper by McCauley (2003)Globalising International
Banking. The US and Europe financial systems will be referenced to discuss the implications of
international banking, while using domestic scenarios to illustrate certain topics.
The second half of the paper will be concerned with corporate capital flows to and from East Asia
since the 1997 crisis, referencing an influential paper by Robert McCauley released by the Bank
for International Settlements in 2003.

2.0 Globalising International Banking

(a) Global banking and international banking are often thought to be interchangeable;
however there is a particularly important distinction between the two terms. As discussed in the
paper by McCauley, R (2003),an international bank uses funds raised in the domestic market, to
finance borrowers in a foreign market. For example, if Westpac Bank were to lend funds in another
country apart from Australia, while using capital domiciled and raised locally - it would therefore be
considered an international bank. Global banks lend funds in a foreign country whilst using capital to
fund the investments which is raised in the same foreign country. Using Westpac Bank again as an
example, if Westpac were to operate in the Maldives, such as lending funds to corporate entities
whilst accepting deposits at the same time in that country, then it would be considered for all intents
and purposes a global bank. An illustrated simple example of the difference between the two terms
described above can be seen in Appendix 1.0.

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(b) From the discussion above, this report will now briefly discuss five scenarios of a US
bank underwritingloans to borrowers in Japan, and will separate these separate scenarios into
either global banking or international banking.

1 The first and most basic scenario would be a US bank accepting USD deposits by
clients in the US, and then using the funds from its balance sheet to supply loans to
clients situated in Japan, such as loans in Yen for residential mortgage purposes. As
the US bank is accepting domestic deposits, however using these funds to finance
dealings in Japan, this would be a typical case of international banking.
2 To further carry on from the basic scenario as described above, the US bank could
also have a subsidiary or affiliate bank, which operated in Japan which only lent
money to borrowers, and did not accept deposits from Japan. This would serve the
same purpose as the scenario described above, however instead of the US bank
dealing directly with the borrowers, cross border deposits into the Japanese affiliate
bank would be made before these funds were lent to borrowers in Japan. This more
complex scenario would still be classified as international banking.
3 The last scenario which can be used to describe a situation of international bankingis
where the US bank operates in the US, however receives deposits in the form of
savings by Japanese clients via cross border transactions from Japan to the US. This
therefore allows the bank to loan funds via further cross border transactions to
Japanese clients directly, without an intermediary affiliate branch from the home
country.
4 With regards to global banking, the US bank could have a fully operational affiliate
branch in Japan, which receives deposits by clients in Yen as well as lending funds to
clients in Yen. As this scenario does not involve any cross border transactions
between both the lenders and the borrowers, this bank would be referred to as a truly
global bank.
5 Delving further into the above scenario with regards to a global banking operation, if
the US affiliate bank operating in Japan was to receive US savers deposits whilst
using these funds to conduct lending operations to Japanese clients, this would be
another case of global banking.

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(c) In the research paper by McCauley, Ruud &Wooldridge (2003), a graph is referencedin
regards to the ratio of local claims against foreign claims - of foreign banks operating within the US
between 1983 and 2001. It is important to note that with ratios, a ratio compares two quantities and
is basically a shorthand reference to show the relationship between two variables. Without an
understanding on what the difference between the two variables means, a ratio is useless. (Bazley and
Hancock 2013) The ratio that this paper will refer to is LC/CC.
Where LC = Local Claims CC = Cross Border Claims

Referring once again to the data found in the research paper by McCauley, Ruud &Wooldridge
(2003), at the end of 2001 US Banks cross border claims were 548 Billion, while their respective
local claims were 385 Billion. The ratio for these figures would then be:
385 / 548 = .702

This ratio means that for every dollar of cross border claims, there is roughly 70 cents of local claims.
Different values would therefore be expected when these ratios are calculated by using international
banks figures, and global banks figures. As a global bank raises funds in the same market as it
operates within to ultimately lend the funds to borrowers, less cross border claims would be expected
than international claims. A global banks ratio calculation could be such that local claims are 500
billion, and cross border claims are 450 billion, providing the following ratio:
Global Bank 500 / 450 = 1.11

For an international bank, the local claims are expected to be smaller than international claims as the
bank would be using cross border claims to fund lending activities in the foreign country, either
directly or through an affiliate. International banks local claims could be 100 billion, where their
cross border claims could be 500 Billion. Therefore the ratio that would be expected for an
international bank would be:
International Bank 100 / 500 = .20

To conclude, an international bank would be expected to have a low ratio (closer to zero),where a
truly global bank would be expected to have a ratio equal or higher than 1, which has been illustrated
above.

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(d) Many changes happened both domestically and globally in the banking industry in the
1980s, which fundamentally changed the financial landscape that we witness today.McCauley,
Ruud &Wooldridge (2003) state that the overall shift from international to global banking reflects
changes both in banks strategies and in the constraints they face. The five main reasons for the
noticeable shift are briefly explained below;

1 As banks prefer an equal balance sheet, such as the same amount of credits to the amount
of debits in simplistic terms, this causes a natural rise in assets and liabilities in foreign
markets to ensure the balance sheet remains strong.
2 Since the 1980s the rise of global banking compared to international banking is also
thought as a risk management strategy for banks. If Westpac was to look into entering a
foreign market, which is also inherently risky - creating a sound balance sheet (equal
amounts of assets and liabilities) minimises the systematic risks of that particular foreign
market.
3 From the various crises in the 1980s from multiple international economies, banks have
moved towards global banking as opposed to international banking. Global banking
reduces foreign exchange risk as well as political risk for the rest of the banks operations
as it is raising as well as lending funds within the same market and microeconomic
environment.
4 Since the early 1990s there has also been a large increase in mergers and acquisitions by
many financial institutions, which this paper suggests some of this movement would be a
result of the crises and deregulation throughout the same period. As many financial
institutions were distressed, and policies were relaxed for foreign ownership of banks, this
increased the M & A activity in many countries. McCauley, Ruud &Wooldridge (2003)
stated cross-border mergers and acquisitions reached a record level of 8% of world GDP
during the late 1990s.
5 Another reason for the migration from global to international banking is the liberalisation
and deregulation of many financial markets across the world. Over the past two decades,
many countries have moved away from relatively closed and administered financial
systems to more open ones (McCauley, Ruud &Wooldridge 2003) Due to these policy
changes, foreign bank ownership restrictions have been loosened allowing banks to
become truly international banks.

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(e) The European financial landscape is different to other financial landscapes for multiples
reasons, though this report will mainly refer to the explanations discussed in the paper by
McCauley, Ruud &Wooldridge (2003). One reason that the paper states is that Europe is a large
complex geographical area with many countries that host extremely large financial institutions,
creating a high amount of cross border transactions within Europe.

The obvious and large answer to the reason as to why Europe is an exception within the migration
from global to international banking is due to the Euro. In January 1999 the conversion rates
wereirrevocably fixed for the former national currencies of the participating member statesand
henceforth, a single monetary policy was instituted for the euro area. (Tsujimura & Tsujimura 2009)
With one currency for many countries and individual economies, there is virtually no exchange rate
risk therefore there is less of an actual need for financial institutions to move into other countries
within the Eurozone.

In conclusion, different countries with diverse cultural and political environments as well as a
different currency create a need for banks to move from international institutions to global
institutions.

(f) As stated by McCauley, Ruud &Wooldridge (2003), transfer risk in the broadest sense is the
risk that the borrower of the funds will not be able to pay in the domestic currency in which the main
bank operates within, or the same currency in which the bank conducts most of it operations in. Once
again referring to Westpac Bank, when mortgages are provided to domestic clients within Australia,
there is no transfer risk involved, as the borrowers will pay back principal and interest in the same
currency as to which the loans were lent in, the AUD.

In regards to country risk, this is risk that there will be a change in the legal or economic landscape in
which the organization is operating in such as company taxes or change of government. Country risk
is more broadly referred to as Political Risk. Country Risk in summary this paper concludes can be
thought as the risk of unpredictable business conditions caused by national polices and conditions.

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(g) The Argentine crisis is still debated today, and many extensive academic literature
reviews on the implications of the Argentine crisis are available. Between the years of 1999 and
2001, Argentina entered a deep economic crisis, facing economic recession and catastrophic bank
failure. (Setser, B, Gelpern, A 2006) As the Argentine Peso was continuing to devalue against the
US, and other major currencies across the globe, the Argentine government had to decide upon a
strategy to attempt to halt the countries move into the shadows of bankruptcy. (Frenkel 2002)

As seen in Appendix 2.0, the risk of Argentinean debt rose sharply at the end of 2001 and at the start
of 2002 Argentina decided to remove the chains, which pegged the Peso to the USD. This has some
major implications for global markets as well as the Argentinian economy. As uncertainty increased
along with bond prices while the Peso depreciated against the USD, global banking strategies had to
adapt. Appendix 3.0 illustrates the depreciation of the Peso against the USD during this time.
Banks operating within the Argentina suddenly had to deal with exchange rate risk, and a large
decrease in the value of any assets denominated in Pesos. To explain further, Argentinian banks
would lend in USD however accept Pesos bank as cash flows for the debt.This put extreme pressure
on international and domestic banks, with domestic financial institutions suffering a catastrophic bank
runs in 2001.

As global banks suffered large looses from the outflow of capital and loss of liquidity in the
Argentinian Banking system, many had to write down losses in the billions of dollars.The
Argentinian crisis of the early 21st century was a systematic, multidimensional dilemma that caused
extremely large losses in the global banking sector.

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3.0 Capital Flows in East Asia since the 1997 crisis

(a) The East Asian crisis in hindsight as concisely described by McCauley, R (2003) was
caused by an abrupt withdraw of funds, causing a decline in asset prices and creating pressure on the
financial sector within East Asia.
As a result of the crisis causing the net surplus of capital within East Asia, there has been an
inflow of funds aiming to purchase high risk capital in Asia, and an outflowof funds seeking low
risk capital to foreign countries from the late 1990s. (McCauley, R 2003) This has helped create
financial stability in the global financial system and promote economic growth.

Economies and nations across the worldseek free flowing capital movements to be able to restructure
their risk profile, derive the most utility from their capital while also being able to raise debt and issue
capital. As countries with more mature economies such as the United States and Europe typically
have lower growth prospects than emerging economies in many Asian countries, large amounts of
capital flow into emerging markets seeking opportunities that are just not available domestically.

During the late 1990s there was a shift towards higher saving rates for households as well as
companies within South East Asia, due to a decline in general business investment and a higher
rate of savings that caused a reversal of the large deficit to a net surplus of reserve funds. Once
again referring to the research paper by McCauley, R (2003), the main beneficiary of the net surplus
during this time was the United States as it was suffering from a ballooning current account deficit.

It is important to mention that the net capital outflows from East Asia to more advanced economies
are not without criticism. This includes capital flowing from generally poorer, emerging economies
that have a higher growth rate and faster population growth compared to the economies the capital is
flowing to, such as the United States and even Australia. (McCauley, R 2003) It is argued that the net
capital outflows to other countries withthe United States in particular, only deepens the Bond market
and financial system of receiving economies and fails to strengthen the Asian bond market,
suggestinga cost to South East Asia.

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Referring to the graph shown inAppendix 4.0 , taken from a comprehensive paper byKawai,
Masahiro & Takagi(2008) the amount of private capital inflows to emerging countries more than
halved after the crises of 1997, from around 3% of GDP to just over 1% of GDP. While capital
inflows were subdued during and well after the crisis, a large account surplus of over 200 billion
dollars in 2002 and the United States suffering an economic slowdown, explains the change shown in
the graph. While not in the scope of this paper, if the United States had not been suffering an account
deficit during the Asian crisis and was not able to act as a global bank as such accepting capital
from South East Asia, where would the Asian economy be today?

Deregulation of the Chinese capital accounts and liberalisation of the Chinese Renminbi with other
international markets will be a very much interesting development, and this paper suggests is much
needed in regards to the capital outflow scenario China is experiencing. Discussion of the expected
changes for the RMB as well as the South East Asian economyis not in the scope of this paper
however is expected to become an important topic for many years to come.

(b) Efficient national markets, which are well integrated throughout the different countries
and financial systems across the globe, create opportunities for countries to either take on, or
transfer specific risk on their balance sheet.As Takatoshi I, et al (1999) state in their publication,
capital flows to the Asian region provide an interesting case study in economic development and
growth.

Countries, just like investors seek to exchange risk anddepending on many different factors this
can involve mitigating unwanted risk or seeking more risk usually as a result of higher expected
returns. Free and efficient capital markets enable global markets to create more balanced and
diversified capital accounts.

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Capital flows between East Asia and other economies across the world strengthen national and
corporate balance sheets and certainly provide resilience in the face of economic crises for the
following reasons:

1 At a macroeconomic level, capital flows enable countries to fund welfare-enhancing

current account imbalances (for example, for productive investment or consumption
smoothing). (IMF 2012) This means that East Asia can use surplus funds to invest in
other markets with a different risk profile, as well as assisting other economies to
correct balance sheet mismanagement or misalignment with national targets and
needs.
2 Particularly for East Asia, the liquidity of the national balance sheets have improved,
as the net surplus has allowed the economies within the region to pay back debts and
accumulate liquid assets, such as riskier equity investments from other countries,
namely the United States. (McCauley, R 2003)
3 Once again referring to the influential paper by McCauley, R (2003), the largest form of
inflows into China especially has been foreign direct investment. Foreign direct
investment strengthens the broader economy and supports much needed funding for
emerging economies, supporting the growth in the South East Asian region.Foreign direct
investment was also crucial in some situations where domestic Asian banks struggling
with sufficient capital adequacy, and foreign flows from across the world into the South
East Asian economy was, and still is crucial for banks striving to remain viable.
4 While South East Asia has been attracting foreign direct investment and higher yield risk
while paying back debts and accumulating liquid assets, it has in effect used the global
financial markets to improve liquidity within the economy and deleverage its balance
sheet. (Crockett 2002)

To summarise, a liquid and efficient global financial system increases efficiency in the allocation
of savings to investment and consumption expenditures. (Hunt, B & Terry, C 2011) As the South
East Asian countries are expanding and looking for investment funds, more mature economies
and investors across the world, which have an appetite for sometimes-higher risk investments in
emerging economies, are able to move funds into these investments that benefit both parties.

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4.0 Conclusion

This report concludes that the terms global and international banking are dissimilar and has
provided some clear examples in the history of international banking to confirm the fundamental
assumptions. The East Asian Crisis was also used to discuss the benefits of the net capital flows
from East Asia to the rest of the worlds financial markets.

While there are some perceived negative benefits of South East Asia being a net exporter of
capital to other economies, the benefits that this provides such as consumption smoothing and
balance sheet management - this report suggests outweigh any criticism. The emerging
liberalisation of the Chinese Renminbi is an interesting topic that will be researched for many
years to come to further analyse capital flows between South East Asia and the rest of the world.

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5.0 References

Bazley, M and Hancock, P 2013, Contemporary Accounting, 8th edn, Cengage Learning Australia (ISBN:
9780170223294)

Cardoza, G, Daz, J, & ngel, A 2006, 'Institutional Determinants of the Argentinean Crisis: A Systemic Approach',
Latin American Business Review, 7, 1, pp. 1-32, Business Source Complete, EBSCOhost, viewed 17 July 2014.

Crockett, A. 2002 SpeechCapital flows in East Asia since the crisis. Bank for International Settlement, 11 October
2002. www.bis.org/speeches/sp021011.htm Viewed 14 August 2014

Frenkel, R 2002, 'Argentina: A Decade of the Convertibility Regime', Challenge (05775132), 45, 4, pp. 41-59,
Business Source Complete, EBSCOhost, viewed 7 August 2014

Hunt, B and Terry, C 2011, Financial Institutions and Markets, 6th edn, Cengage Learning (ISBN: 9780170188449)

International Monetary Fund 2012 'The Liberalization and Management of Capital Flows: An Institutional View
Working Paper http://www.imf.org/external/np/pp/eng/2012/111412.pdf Viewed 9 August 2014

Kawai, Masahiro, and Shinji Takagi. 2008. A Survey of the Literature on Managing Capital Inflows. ADBI
Discussion Paper 100. Tokyo: Asian Development Bank Institute. Available: http://www.adbi.org/discussion-
paper/2008/03/27/2514.managing.capital.inflows.lit.survey Viewed 10 August 2014

Robert N McCauley, Judith S Ruud and Philip D Wooldridge 2003 Globalising International Banking Bank for
International Settlements Quarterly Review March 2002, pages 41-51.

Robert N McCauley 2003 Capital Flows in East Asia since the 1997 Crisis Bank for International Settlements
Quarterly Review June 2003, pages 41-56.

Setser, B, & Gelpern, A 2006, 'Pathways Through Financial Crisis: Argentina', Global Governance, 12, 4, pp. 465-
487, Business Source Complete, EBSCOhost, viewed 17 July 2014

Takatoshi Ito, Kathryn M. Dominguez, Moeen Qureshi, Zhang Shengman, Masaru Yoshitomi 1999 International
Capital Flows: Capital Flows to East Asia. University of Chicago Press. (p. 111 190)

Tsujimura, K, & Tsujimura, M 2009, 'The consequences of the introduction of the euro: a nested mixed-effects
analysis of the international banking positions', Empirical Economics, 37, 3, pp. 583-597, Business Source
Complete, EBSCOhost, viewed 9 August 2014

Van de Wiel, I 2013, The Argentine Crisis 2001/2002. Rabobank Economic Report. Economic Research
Department. August 23 2013 Rabobank Website https://economics.rabobank.com/publications/2013/august/the-
argentine-crisis-20012002-/ Viewed 14 August 2014

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6.0 Appendices

Appendix 1.0 International and Global Banking

International Bank Example

Australian Deposits Westpac Bank Maldives Borrowing

Global Bank Example

Maldives Deposits Westpac Bank Maldives Borrowing

situated in Maldives

Appendix 2.0 Country Risk of Argentinean Bonds

Cardoza et al, 2006

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Appendix 3.0 Depreciation of the Peso against the USD

Van de Wiel, I 2013

Appendix 4.0 Private Capital Inflows Emerging Countries 1981-2006

Kawai, Masahiro, and Shinji Takagi. 2008

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