International Banking

August-December 2013

Facilitator: Wajahat A Qureshi

Introduction & Overview

Banking transactions crossing national boundaries
Cross border lending
All claims of domestic banks offices on foreign residents Claims of foreign banks offices on local residents Claims of domestic banks offices on domestic residents in foreign currency

Similar classification of deposits Eurodollar Bonds

Role & Function

International Banking plays an important role in facilitating:
Foreign trade--Import & Export International Finance International Payment Transfers

Low marginal costs, advantage of having knowledge and experiencing of managing in the domestic markets, prestige, growth, reduction in risk, etc. may be the major motivating factors behind the banks decision of entering into the international markets

Products & Services

Commercial banking--branch banking, and other services conventionally offered by domestic banks, like accepting deposits and lending

Trade Finance--financing imports and exports

Corporate Finance and other investment banking products & services Foreign Exchange & Foreign Currency Hedging-using derivatives and structuring customised solutions

Types of International Banks

Subsidiary & Affiliate Bank
Subsidiary is normally a wholly or majority owned entity incorporated locally Affiliate bank is a partially owned entity, without having control

Foreign Branch
Operates like a local bank, legally part of the parent, and not a separate entity Subject to regulations of both home country and foreign country

Types of International Banks

Offshore Banking Unit/Centre
Opened in countries where establishment of such entities regulatory structure allows/facilitates

Involve operations beyond the normal scope of economic activity Completely free from host country banking regulations Usually operates as branch or subsidiary Providing services in currency other than the currency of host country Tax free or low tax environment, minimal regulations, ability to offer services to non-resident clients, are the major reasons for establishing OBU/OBC Bahrain, Cayman Islands, Hong Kong, Singapore, Bahamas, Panama, EPZ, are a few examples

Types of International Banks

Representative Office
Established to assist with information of local customs and develop and/or further strengthen relationship with multinational customers, who may have operations in home country May also be used to explore prospects for setting up a full service facility--by acquiring a local entity or establishing one

Types of International Banks

Correspondent Bank
Offering services to banks, located cross border, in settling their claims/receipts in that particular currency Banks located in different countries establish accounts in other banks Accounts used to settle trade payments and transfers

Financing International Trade

One of the core international banks functions performed by

Different payment methods used in facilitating international trade:

Clean Payments/Advance Payments Letters of Credit Documentary Collections

May also be facilitated instruments like Guarantees

using

non-funded

Financing International Trade

Clean/Advance Payment
Minimal involvement of banking channels, except for effecting funds transfer

Based on mutual trust--between importer and exporter

Exporter may effect shipment without receiving funds, or Importer makes an advance payment, and receives the shipment afterwards Shipping and title documents handled directly by the trading parties

Financing International Trade

Clean/Advance Payment (Contd....)
Two types:
Advance Payment
Exporter receives the value of goods to be shipped, in advance, and then effects the shipment, thus zero risk but may accept lower price--Time value of money and risk mitigation

Open Account
Importer receives the shipment/goods and documents directly from the exporter and then makes the payment, as per the agreed terms No risk to importer; High risk to exporter--non payment, rejection, etc.; May get a higher price due to these risks and delayed payment

Financing International Trade

Letter of Credit
A written undertaking by the Issuing Bank (Importer s bank); On behalf of its customer--the Applicant (Importer); Promise to effect payment in favour of the Beneficiary (Exporter); A stated sum of money; Within a prescribed time limit; and Against stipulated documents

Satisfies Exporters desire for cash payment and Importers desire for credit

Financing International Trade

Letter of Credit (Contd...)
Underlying principle--Banks deal in documents and not goods
If the documents, on the face, are in accordance with the terms and conditions of the L/C, bank is liable to effect the payment, regardless of the fact that the actual shipment received is not as per agreed between the buyer and the seller International Chamber of Commerce (ICC) issues standardised/agreed upon rules, definitions and practices governing L/Cs--called UCP for Documentary Credits (Version 600 effective July 2007 currently available and in practice) ICC has also issued and regularly updates the standard terms used in international trade--International Commercial Terms (INCOTERMS)

Types of Letter of Credit

Letter of Credit Types/Terms
Revocable & Irrevocable

Unconfirmed & Confirmed

Sight & Usance Transferrable & Assignment of Proceeds Revolving & Standby

Types of Letter of Credit

Revocable Letter of Credit
Could be revoked by the applicant (importer) anytime without getting consent from the exporter Cancelled and amended anytime before the receipt of documents Not much in use/practice

Irrevocable Letter of Credit

Non-cancellable or amendable without prior consent of the exporter Almost all of the L/Cs currently used are Irrevocable

Types of Letter of Credit

Unconfirmed L/C
Where the credit-worthiness of the L/C issuing bank and country risk is acceptable to exporter All L/Cs are unconfirmed, unless otherwise mentioned

Confirmed L/C
In cases where the exporter has doubts about the credit quality of the L/C issuing bank or is not comfortable with the country risk Requires confirmation from a third bank, usually a sound credit quality international bank or a bank located in the country of exporter

Types of Letter of Credit

Sight L/C
Payment made at the time of presentation of documents Usually made within 1-2 weeks

Usance/Acceptance L/C
Where payment is to be made at a future date, from the presentation of documents L/C issuing bank would confirm the payment date after acceptance of documents by the importer

Types of Letter of Credit

Transferrable L/C
L/C with terms allowing for transfer of credit, partial or whole, to a third party Transferee would become the new beneficiary of the L/C, and would have the privilege to present the documents directly and get the payment--Right to Draw would be transferred

Assignment of Proceeds
Where part or whole of the credit assigned to a third party (Assignee) Assignee would get the entitlement to receive the payment, under the letter of credit, instead of the beneficiary Right to Draw would still remain with the original beneficiary

Types of Letter of Credit

Revolving L/C
Replaces the need for opening more than one L/Cs Single L/C covering more than one shipments Allows for relatively longer period, until maturity, as against a normal L/C
Cumulative--Allowing for roll-over of un-utilised amount Non-Cumulative--Which doesnt allow for roll-overs

Types of Letter of Credit

Standby L/C
Acts as a guarantee to third party, issued on behalf of customer, to ensure payment in case of non-payment by the original obligor Issued with a validity of one year

Used in place/leu of bank guarantee, where it is otherwise legally barred

Certain conditions imposed in Pakistan, on its issuance

L/C Process Flow

L/C Process Flow
Exporter (Seller) sends in Pro-forma invoice to Importer (Buyer)

Importer submits Accepted Pro-forma Invoice, Purchase Order or Contract to Exporter

Importer places application for Letter of Credit with Importers bank Importer s bank sends confirmation of opening of Letter of Credit to Exporters/confirming bank Confirming bank sends copy of Letter of Credit to Exporter Exporter sends order confirmation to Importer

Exporter ships the goods through Air/Sea/Land route

L/C Process Flow

L/C Process Flow (Contd...)
Exporter presents Letter of Credit and export documentation to confirming/own bank for settlement/negotiation/discounting Confirming bank confirms authenticity of L/C and export documents, pays Exporter per terms of the L/C Confirming bank forwards export documents to Importers Bank

Importers bank presents copies of export documents to Importer

Importer pays bank under terms of the L/C Importers bank releases original export documents to the Importer Importer presents original export documents to local customs authorities Customs authorities after verifying the authenticity of documents release goods to the Importer

Documentary Collections
Method of payment whereby Exporter assigns the responsibility of handling export documents to banks, and instructs the banks concerning the release of these documents to the Importer.

Banks do not guarantee the payment

Collections are subject to the the Uniform Rules for Collections (URC)

Comes mainly in two types

Documents Against Payment (DP) Documents Against Acceptance (DA)

Documentary Collections
Documents Against Payment (DP)
Documents released to the Importer only after the payment is effected Also known as a Sight Collection or Cash Against Documents (CAD) Less costly than L/C, but carries risk of refusal, commercial and country risks for exporter No credit line/limit required for importer Forward cover/Currency hedging not allowed in Pakistan

Documentary Collections
Documents Against Acceptance (DA)
Documents released acceptance of a draft to the Importer only against

Carries risk of non-acceptance of documents, for exporter

Even after the acceptance by the importer, there is no guarantee for the payment
Beneficial for importer, because of no payment obligation upon receipt of documents

Foreign Exchange Markets

Currency Marketswhere money denominated in one
currency is bought and sold with money denominated in another currency A foreign exchange transaction is an agreement between a buyer and a seller that a fixed amount of one currency will be delivered for some other currency at a specified date

International International Trade and Capital Transactionsfacilitated with the

transfer purchasing power between countries

ability to

Mostly OTC transactions (with no exchange or clearing house, customized trades, etc.) done over phone, through broker, systemReuters, Bloomberg

Foreign Exchange Markets

Participants include Banks, retail customers, other financial institutions, etc. Globally, operations in the foreign exchange market started roughly in 1971, after an apparent failure of Bretton Woods It also Paved the way for floating exchange rate regimes in several countries. In Pakistan, managed float exchange rate mechanism prevailed until 1998, and transformed into Free Float from mid 1998 to early 1999 Over the years, the foreign exchange market has emerged as the largest market in the world

Foreign Exchange Markets

Works almost 24 hour-a-day with no specific location housed in any particular building like an exchange Highly flexible and liquid Exists in SpotValue date 2 business days from the date of transaction, and ForwardValue date beyond Spot Value date means the date of settlement of the transaction Central banks also participate to maintain some sort of control on their currency, especially in terms of its value

Foreign Exchange Markets

Fixed exchange rate is the official rate set by the monetary authorities/central banks Under floating exchange rate, the value of the currency is decided by supply and demand factors Outright ForwardSingle leg sale or purchase transaction maturing at any future date

SwapDual leg transaction, with near leg maturing in spot/forward and the far leg in forward (Ready-Forward, Spot-Forward or Forward-Forward Swap)

Foreign exchange Markets

Foreign Exchange Mechanism

Managed Exchange Rate Dual Exchange Rate

Floating Exchange Rate

Foreign Exchange Markets

Direct & Indirect Quote Home Currency Price of A Foreign Currency--GBP, EUR, AUD, etc. Foreign Currency Price of Home Currency--PKR, MYR, CAD, etc. Price Maker Vs. Price Taker NOP/FEEL

Foreign Exchange Markets

Forward FX
Agreement between two parties for purchase/sale of a specific amount of one currency against another at a predetermined rate and a date in future
Price is worked out using the interest rate differential

May be Fixed for delivery or may carry an option period

Option period provides the buyer/seller with the privilege of takeup/delivery during the specified period Non cancellable, circumstances unless otherwise required under specific

Closed out upon expiry, if remained un-utilized Difference to be settled with payment or receipt to/from the customer

Foreign Exchange Markets

Forward Rate Calculation
3-Month USD Interest Rate = 0.50% P.A & 3-Month PKR Interest Rate = 9.50% P.A USD/PKR Spot Rate = 104 Day-count For USD = Actual / 360 & Day-count for PKR = Actual / 365 Three Month Forward Rate = Spot Rate * (1+PKR Interest Rate * 91/365) / (1+USD Interest Rate * 91/360)

104 * (1 + 0.095 * 91/365) / (1+0.005 * 91/360) = 104 * (0.273 / 0.254)

Based on these calculations 3-Month USD/PKR would be 111.78 Also be presented in percentages--(Forward Premium or Discount / spot rate) * (360/Number of contract days)

Foreign Exchange Markets

FX/Currency Swap
An FX swap is a contract to buy an amount of currency for one value date at an agreed rate, and to simultaneously resell the same amount of currency for a later value date, also at an agreed rate, to the same counter party Essentially a Funding or Money Market Transactions-Involves Borrowing/Lending of the Underlying Currencies No Exchange Rate Risk Concept of Implied Interest Rate Covered Interest Arbitrage Borrow PKR or USD (any foreign currency) using swap by realizing arbitrage opportunity

International Banking Crisis

Real Estate Bubbles and Financial Crisis

Housing Bubble Burst, after it peaked in 2006 Causing real-estate backed assets prices to plummet Damaging Financial Institutions Balance Sheets and P & L holding such assets Liquidity Evaporated, Credit tightened due to deteriorating financial conditions

International Banking Crisis

Affected Exposure Limits (Among Counterparties) and Impacted Banks Liquidity & Balance Sheet Management Resulting in Global Economic slowdown High Risk, Complex Financial Products, Failure of Regulators & Credit Rating Agencies, Conflicts of Interest, Market Self Discipline and Investors Greed could be considered the possible reasons for the crisis

Risks in International Banking-Liquidity & Liquidity Risk Management

Liquidity Risk Defined

Probability of loss arising from a situation where:

There will not be enough cash (or cash equivalents) to meet the need of borrowers or depositors Sale of illiquid assets yield a value lesser than their fair value Illiquid assets will not be sold at the time it is needed, due to lack of demand/buyers Availability of funds to meet all known and unknown commitments

In the right currency In the right place At the right time

Liquidity & Liquidity Risk Management

Funding Liquidity

Ability of an institution to arrange funding for its assets when it is needed Refers to funding of long term assets with short term liabilities

Market Liquidity

An assets ability to get liquidated without causing a significant movement in the price and with minimum loss of value TFCs, Pak Eurobonds, Dubai Government Sukuk, Other emerging market Sukuk and bonds

Funding and Market Liquidity

Both are closely related to each other Inability to generate funding could affect the market liquidity

The dealer would find it hard to fund high margin instruments, affecting the market liquidity of such instruments

Liquidity & Liquidity Risk Management

Liquidity Vs. Solvency

Liquidity refers to cash and instruments that can be converted into cash to meet the business requirements Solvency refers to a firms ability to meet its obligations as these become due

Liquidity relates more to short term business strategy while Solvency is something related to the firms overall health

The Treasury Function

Functions like a heart in the human body

Funds flow in, from units with surplus, and flow out to units with deficit
Local currency (LCY) and FX Customer facilitation--with profitability objective

Interest Rate Risk management

Liquidity & Funds management Fund Transfer Pricing

Medium to long term Investment

The Treasury Function-Organizational Design

Generic Design has Treasury as a separate group headed by a direct report
May contain different departments depending on the size and complexity of the function FX desk--Dealing with the foreign exchange exposure Buying from exporters and selling to importers; market maker--dealing with the interbank Money Market--To deal with the short term liquidity issues Placing surplus liquidity and managing shortfalls Equity Desk--Dealing with investments in the equity market, Margin Financing, CFS, etc. Derivatives Desk--To deal with structuring and trading of derivatives like FRA, IRS, Currency Options, etc. Corporate Desk--Treasurys Face With The Customer deals with customer requirements for various solutions

The Treasury Function

Key Functions/Activities
Liquidity & Funding LCY

Call/Clean Borrowing/Placement
Investment in T Bill & PIB Repo/Reverse Repo

FX
Balance Sheet Management/ALM Interest Rate Risk Management Market & Liquidity Risk Management

The Treasury Function

Supporting Roles
Middle Office Reporting line with Risk or Operations May act as Risk Watchdog or support to Operations

Monitoring and reporting of treasury positions and risk limits

Profit reconciliation Back Office/TROPS

Processing and settling Inter-bank deals initiated at Front Office

Dealing with branches for placement (record keeping) of their LCY and FX deposits Generating position related MIS Maintaining Nostros