Lecture International finance: An analytical approach (3/e): Chapter 6 - Imad A. Moosa

Chapter 6 - The Eurocurrency market and international banking. After reading the material in this chapter, you should be able: To define the Eurocurrency market, to identify Eurocurrencies and Eurocurrency banking centres, to identify reasons for the growth of the Eurocurrency market,…

Chapter 6

The Eurocurrency Market and

International Banking

Objectives

• To define the Eurocurrency market

• To identify Eurocurrencies and Eurocurrency banking centres

• To identify reasons for the growth of the

Eurocurrency market

(cont.)

Objectives (cont.)

• To identify the main features of Eurobanking

• To illustrate the determination of the bid-offer spread and the risk premium in Eurocurrency deposit rates

• To describe international banking

The Eurocurrency market

• The market is comprised of banks that accept term deposits and make short-term loans in

short-currencies other than that of the country in which

they are located

Prerequisites for Eurocurrency

centres

• Political stability

• Favourable environment for international finance

• Good telecommunications system

• Favourable time zone

• High quality of life

Eurocurrency centres

• European centres: London, Luxembourg, Paris,

Zurich and Frankfurt

• Centres outside developed countries: the Bahamas, Dubai and Hong Kong

• North America and Japan: International Banking

Facilities (IBFs) and the Japan Offshore Market

(JOM)

Evolution and growth

• The market started in the 1950s.

• In 1957, the Bank of England introduced tight

controls

• In 1958, European currencies were made convertible

(cont.)

Evolution and growth (cont.)

• The rise of oil prices in the 1970s produced huge

financial surpluses for oil-exporting countries These surpluses were deposited at Eurobanks

(cont.)

Evolution and growth (cont.)

• Eurobanks are efficient because:

 they are not subject to regulations, such as Regulation Q, interest equalisation tax

 no reserve requirements

 economies of scale

Features of Eurobanking

• International banking encompasses Eurobanking

• Liabilities are time or call deposits

• Eurobanks cannot create deposits by writing claims

against themselves

(cont.)

Features of Eurobanking (cont.)

• Eurobanks accept deposits and make loans in a

variety of currencies

• A Eurobank is often a branch of an international bank

• There are no formal restrictions on entry

(cont.)

Features of Eurobanking (cont.)

• Transactions are large

• The geographical spread is very wide

• The market is not subject to the regulatory measures

of the local authorities

(cont.)

Features of Eurobanking (cont.)

• The market is dominated by interbank operations

• Participants include multinationals and central banks

• Eurobanks do not have to hold reserves against

deposits

Determination of the bid-offer

spread in interest rates

• The bid rate is determined by the demand by market makers and the supply of price takers

• The offer rate is determined by the demand by price takers and the supply of market makers

Interest rate determination

Q Q

The risk premium

• Only borrowers of high quality can borrow at the offer rate quoted by market makers

• Others have to pay a risk premium

Risk premium associated with quality borrowers

Reasons for the emergence of

international banking

• Meeting the needs of foreign subsidiaries

• Participation in the FX market

• Circumventing capital controls

• Provision of custodial services

Traditional activities

• Export-import finance

• Buying and selling foreign exchange

• Provision of foreign loans

New activities

• Dealing in Eurocurrencies

• Syndicated Eurocredit

• Investment banking

Innovative activities

• Innovative financing

• Global money market

• Managing the loan portfolios of developing countries

• Private banking

The organisational set-up

Correspondent banks

• When a bank has no branch in a particular country it uses a foreign bank located in that country to settle transactions on its behalf

Representative offices

• A representative office is established by a bank in

another country with the primary task of providing

information about business conditions in that country

Bank agencies

• A bank agency is similar to an ordinary commercial bank, except that it does not handle ordinary

deposits

• Its function is to deal in money and FX markets,

arrange loans and clear cheques

Foreign branches

• If the volume of international business of the

customers of a bank is large enough, it may be

viable to open a branch in another country

• Branches are subject to regulation by the home and host governments

Foreign subsidiaries and affiliates

• These are banks established in another country and owned solely or jointly with other parties

• Unlike branches, they do not have the name of the bank

• The degree of control is greater in the case of a

subsidiary

Consortium banks

• Joint ventures established by large international

banks to deal with large companies and

governments

Global banks

• A global bank takes deposits and offers loans and

other banking services in a variety of national

markets through local presence