International banking lesson 07

62 International Banking LESSON 7 ORGANISATIONAL FEATURES OF MULTINATIONAL BANKING CONTENTS 7.0 Aims and Objectives 7.1 Introduction 7.2 Correspondent Banking 7.3 Resident Represent

62

International Banking LESSON

7

ORGANISATIONAL FEATURES OF MULTINATIONAL BANKING

CONTENTS

7.0 Aims and Objectives 7.1 Introduction

7.2 Correspondent Banking 7.3 Resident Representatives 7.4 Bank Agencies

7.5 Foreign Branches 7.6 Foreign Subsidiaries and Affiliates 7.7 Consortium Banks

7.8 Problems of Multinational Banking 7.9 Analysis and Control of Foreign Portfolio Risk 7.10 Let us Sum up

7.11 Lesson End Activity 7.12 Keywords 7.13 Questions for Discussion 7.14 Suggested Readings

7.0 AIMS AND OBJECTIVES

After studying this lesson, you should be able to understand:

z Various formal and informal ways of banks linked together

z Problems in multinational banking

z Different type of risks faced by banks

7.1 INTRODUCTION

International banks are linked together in various formal and informal ways from simply holding account with each other correspondent accounts - to common ownership These and other forms of banking organisation are described below

7.2 CORRESPONDENT BANKING

An informal linkage between banks in different countries is set up when banks maintain correspondent accounts with each other Large banks have correspondent relationships with banks in almost every country in which they do not have an office

of their own The purpose of maintaining foreign correspondents is to facilitate international payments and collections for customers The term "correspondent" comes from the mail or cable communications that the banks used for settling

63 Organisational Features o

customer accounts Today, these communications have largely been replaced by

SWIFT messages, and the settling between banks occurs via CHIPS For example, if a

US Company wants to pay a Canadian supplier, it will, ask its US bank which will

communicate with its Canadian correspondent bank via SWIFT The Canadian bank

credits the account of the Canadian firm, while US Company's bank debits its account

The US and Canadian banks then settle through CHIPS Correspondent banking

allows banks to help their customers who are doing, business abroad, without having

to maintain any personnel or offices overseas This relationship is primarily for

settling customer payments, but it can extend to providing limited credit for each

other's customers and to setting up contacts between local business people and the

clients of the correspondent banks

f Multinational Banking

7.3 RESIDENT REPRESENTATIVES

In order to provide their customers with help from their own personnel on the spot in

foreign countries, banks open overseas business offices These are not banking offices

in the sense of accepting local deposits or providing loans The primary purpose of

these offices is to provide information about local business practices and conditions,

including the creditworthiness of potential customers and the bank's clients The

resident representatives will keep in contact with local correspondent banks and

provide help when needed Representative offices are generally small, they have the

appearance of an ordinary commercial office rather than a bank

7.4 BANK AGENCIES

An agency is like a full-fledged bank in every respect except that it does not handle

ordinary retail deposits The agencies deal in the local money markets and in the

foreign exchange markets, arrange loans, clear bank drafts and checks, and channel

foreign funds into financial markets Agencies are common in New York; for

example, Canadian and European banks keep busy offices there, with perhaps dozens

of personnel dealing in the short-term credit markets and in foreign exchange

Agencies also often arrange long-term loans for customers and act on behalf of the

home office to keep it directly involved in the important foreign financial markets

Check Your Progress 1

Define the following:

1 Correspondent Banking

………

………

2 Bank Agency

………

………

7.5 FOREIGN BRANCHES

Foreign branches are operating banks like local banks, except that the directors and

owners tend to reside elsewhere Generally, foreign branches are subject to both local

banking rules and the rules at home, but because they can benefit from loopholes, the

extra tier of regulations is not necessarily onerous The books of a foreign branch are

incorporated with those of the parent bank, although the foreign branch will also

maintain separate books for revealing separate performance, for tax purposes, and so

on for local authorities The existence of foreign branches can mean very rapid check

64

International Banking clearing for customers in different countries, because the debit and credit operations

are internal and can be initiated by fax or electronic mail This can offer a great advantage over the lengthy clearing that can occur via correspondents The foreign branch also offers bank customers in small countries all the service and safety advantages of a large bank, which the local market might not be able to support There would probably be far more extensive foreign branch networks of the large international banks were it not for legal limitations imposed by local governments to protect local banks from aggressive foreign competition Britain has traditionally been liberal in allowing foreign banks to operate and has gained in return from the reciprocal rules that are frequently offered On the other hand, until the 1980 Bank Act was passed, opening of foreign bank subsidiaries within Canada was prohibited, and branches of foreign banks are still not allowed The United States selectively allows foreign banks to operate

7.6 FOREIGN SUBSIDIARIES AND AFFILIATES

A foreign branch is part of a parent organisation that is incorporated elsewhere A foreign subsidiary is a locally incorporated bank that happens to be owned either completely or partially by a foreign parent Foreign subsidiaries do all types of banking, and it may be very difficult to distinguish them from an ordinary locally owned bank Foreign subsidiaries are controlled by foreign owners, even if the foreign ownership is partial Foreign affiliates are similar to subsidiaries in being locally incorporated and so on, but they are joint ventures, and no individual foreign owner has control (even though a group of foreign owners might have control)

7.7 CONSORTIUM BANKS

Consortium banks are joint ventures of the larger commercial banks They do not have

a distinct collective legal identity They can involve a half Dozen or more partners from numerous countries They are primarily concerned with investment, and they arrange large loans and underwrite stock and bonds Consortium banks are not concerned with taking deposits, and they deal only with large corporations or perhaps governments They will take equity positions - part ownership of an investment - as well as make loans, and they are frequently busy arranging takeovers and mergers

7.8 PROBLEMS OF MULTINATIONAL BANKING

z Financial imbalances in governmental budgets as well as in balance of payments These have had a considerable impact on interest and exchange rates; they have exacerbated banker's risks

z Excessive lending to fragile economic sectors (e.g real estate, agriculture or energy projects in the USA) or to countries (e.g relatively high credit exposure, whether contracted by East European or by Latin American or by South-East Asian countries) Such over-lending has been an important source of losses to a great number of banks

z The globalisation of the banks' activities, and the introduction of financial innovations (e.g financial 'futures', 'securitisation' of debt, 'junk' bonds, etc.)

z The issues at stake call for a formidable imaginative effort in various directions

z Rethinking the basic goals of monetary authorities and the desired role of international banking institutions Are distinctions among the functions and the scope of services that can be offered by different financial institutions to be set tightly, or would a measure of inter competition be advantageous to consumers and growth?

65 Organisational Features o

z Could grave errors of judgment in the financial intermediation process be averted?

This is an area of concern to both bank executives and monetary authorities How

far personnel training can and corporate structure fend-off such errors?

f Multinational Banking

z Ascertaining the basic factors of economic instability and designing realistic

mechanisms of effective protection against disasters and crises

z Sizing up the importance of funds that can be lent directly by banks against those

that should be intermediated by them (and financed by other institutions or by

private savers) with no risk to banks' viability

z Should the movement toward the interpenetration of national financial markets or

the integration of international financial markets be further facilitated? The

consequences of such a development have to be well-thought-out

z Coupled with this growing globalisation is the increase of various risks involved

The authorities in different countries are required to co-operate on the regulation

and policy levels to deal with this problem

z Also to ensure the efficiency and safety of the world financial system, more

efforts crossing international borders to do business have to be put into the

consolidation of settlement systems, and the construction of an effective safety

net

z All financial transactions are completed only after settlement has been finalised

(with securities transactions, the transfer of securities is linked to this), an increase

in transaction volume means an increase in settlement volume This is done by

transfers of current deposit accounts at the central bank which is responsible for

its home currency, but this must be conducted during the bank's normal business

hours (There is a problem with this in that while transactions are increasingly

being done round the clock, their settlements are ultimately restricted by the

existing business hours of the central bank for each currency)

z As a logical consequence of this situation, the number of settlements and the

amount involved become enormous, the transaction details become complex and

the speed at which the-settlements are handled becomes inevitably faster than the

speed of the transactions themselves

z If a participant becomes unable to pay such large amount due to a problem of

credibility or for some operational reason, the other participant, who was

expecting to receive the sum in question, would in turn become unable to pay and

the problem would spread This is becoming a real risk for the private central

settlement system carries a “systematic risk”-successive defaults would make the

settlement system itself go bankrupt Also, the central system run by the central

banks, which allows daylight overdrafts and deposits, generates daily colossal

sums of credit extension In this way central settlement system in the major

countries, not to mention the United States which handles the key currency

settlements, are exposed to an increasingly enormous credit risk which is

becoming increasingly tough due to the huge increase in volumes and speed of

settlements in recent years

Check Your Progress 2

Define the following terms:

1 Foreign branches

………

………

2 Consortium banks

………

………

66

International Banking 7.9 ANALYSIS AND CONTROL OF FOREIGN

PORTFOLIO RISK

Broadly speaking, major banks classify their risks according to the following categories (in descending order of importance):

(1) by country of exposure;

(2) by maturity of the loan; or (3) by nature of loan

There is a general presumption that long-term lending leaves a bank more exposed to risk than do short-term commitments It is also generally considered that loans to finance trade directly add to productive capacity, especially in export or import substituting industries, are less risky than pure domestically oriented loans, for example for real estate or to governments The strategies banks use to manage their portfolio risks revolve around geographical diversification and maturity management The main analytical problems are to measure exposure by country, and then to set so-called “country limits.” It is not straightforward in practice to allocate risk by country There is substantial divergence in the principles of allocation, especially with respect to interbank placements Inter-bank comparisons of country exposure can be made only with extreme caution The estimates most affected are those for exposure

in the industrialised countries and the offshore financial centres There are few interbank placements with banks in developing countries and Eastern bloc countries,

so comparisons for these areas are reliable However to the extent that money centre banks have relent the placements into these areas, the economic principal of allocation

of claims would require appropriate adjustment to the exposure figures

Here, the primary focus is on the quality of the economic policy followed by the government of a country It is viewed as being primarily responsible for inflation and economic growth, or at least for managing them Substantial attention is given to the realism of the policy targets For example, is the government trying to sustain a hopelessly overvalued exchange rate, or trying to accelerate industrial growth behind tariff walls when agricultural productivity and the levels of available skills cannot sustain this? Policies like these are sure to lead to marked calamities at some future date Ultimately the aim is to assess the external financial situation in order to evaluate the ability to service debt Additional short term factors are access to IMF, World Bank, and foreign official credits, and the adequacy of the foreign exchange reserves Banks work on a rule of thumb of three to four months coverage of imports for a satisfactory reserve level

Using this sort of data, the area heads then decides:

1 an overall country exposure limit;

2 a limit for exposure with maturity over one year;

3 general areas in which it is desirable to concentrate future lending

The division here is by nature of borrower and type of activity, for example, loans to governments, loans to banks, loans to private non-banks, and loans to projects generating hard currency versus loans to projects generating local currency It is considered that in most developing countries, the creditworthiness of governments and banks is much higher than that of non banks Also, hard currency generating projects and trade finance are preferred to local projects and general-purpose loans to governments The macroeconomic cost of a banking crisis and of its resolution is often very high Fiscal costs of earlier banking crises in the 1990s ranged between 40% (Norway and Sweden) and 17% (Venezuela) of GDP, even though non-performing loan ratios in most of these banking crises were well below the levels now recorded in Asia Two aspects are important for assessing the macroeconomic

67 Organisational Features of Multinational Banking

cost of a banking crisis First is the degree to which the public's confidence in its

banking institutions can be preserved Loss of such confidence may induce depositors

to withdraw their assets, reducing the level of financial intermediation and the

efficiency with which resources can be allocated If assets are shifted abroad, a

currency crisis may erupt or an existing one may deepen A temporary loss of

confidence in the domestic banking system occurred in Argentina in 1995,

necessitating sharp policy adjustments which contributed to a sizable economic

contraction Similarly, a bank run complicated crisis containment in Indonesia in late

1997 The second important aspect is the extent to which credit may contract during

the crisis Given the crucial role of credit in economic activity, particularly in Asia,

where it is very large relative to GDP, a sharp drop in lending may have significant

macroeconomic effects Even in a sound banking system, the demand for bank credit

would decline as a natural reaction to the lack of investment opportunities after a

boom However, this credit contraction will be more severe when banks are burdened

with large portfolios of non-performing loans made to finance heavy investment in

real assets, as in Asia If banks are closed, even solvent borrowers will lose "their"

bank and will usually find it difficult to gain access to credit from other banks If

banks are kept afloat, they are likely to apply stiffer loan standards and ration credit

Such a credit crunch will further curtail aggregate demand, causing even greater

problems for borrowers and banks Following earlier banking crises real bank credit in

Mexico fell by one-half in two years, while in Finland and Sweden it shrank by over

20% As noted above, bank credit in real terms started to contract in all crisis-hit

economies last year

Rapid credit contraction in the context of a banking crisis raises the question of what

monetary policy can do to offset it Easing the stance of monetary policy would lower

short-term interest rates and probably steepen the yield curve This would help the

situation by stimulating demand, as well as by widening banks' net interest margins

Such a policy was successfully adopted in the United States in the early 1990s It may,

however, be problematic in the small, open Asian economies to ease monetary policy

even more than has been done so far, given the danger that an overly easy monetary

policy stance may trigger renewed disorderly conditions in foreign exchange markets

Moreover, very low interest rates, and in turn much reduced carrying costs of bad

loans, may relax pressure for effective financial sector restructuring

To deal with the severe banking crises, several restructuring and recapitalisation

initiatives have been taken in Asia over the last two years A number of common

features have marked the initial stages of these bank restructuring programmes First,

preventing bank runs has usually compelled the authorities to extend guarantees

covering bank deposits and to develop explicit deposit insurance schemes Changes in

the regulatory framework have been a second feature Prudential regulations were

tightened, although in some instances (Malaysia and, to a lesser extent, Thailand)

temporary concessions were made to help banks deal with their acute financial

problems

In addition, asset management corporations were established in most crisis-hit

countries to take over part of the non-performing loan portfolio of financial

institutions Often, the motivation was to lessen the aversion towards new lending

which banks increasingly demonstrated as their preoccupation with the management

of bad debts grew Strategies varied between trying to dispose of the impaired assets

quickly and seeking to avoid fire sales The former strategy was followed in Thailand,

while the latter was adopted in Malaysia

Finally, fears that the forced closure of one bank would precipitate a more systemic

flood of bank insolvencies and aggravate the problem of credit rationing explain why

relatively few banks had been allowed to fail by early 1999 Instead, policies focused

on bank recapitalisation and bank mergers A variety of recapitalisation schemes,

often contingent on shareholder participation or improvements in operational

68

International Banking efficiency and management changes have been put in place over the last year and a

half Where necessary, a number of troubled banks were temporarily taken into state ownership Takeovers of weak banks by larger; less weak banks were also encouraged (as in Korea and Thailand), although the systemic proportions of the banking crises often made it very difficult to find suitable buyers Official attitudes towards takeovers

by foreign banks also becan1e much more favourable In several countries, such as Indonesia and Thailand, barriers to foreign bank ownership were lowered or abolished altogether

In most countries, schemes for addressing bank problems were complemented with initiatives to help viable enterprises restructure their operations and deal with debt servicing obligations made much more onerous by reduced cash flows By early 1999, many of these programmes had not gone far beyond their conceptual stage In part this was because weaknesses in most countries' corporate legislation, in particular bankruptcy procedures, stood in the way of more rapid and effective debt rescheduling and corporate restructuring In part it was also because weakened creditors were not willing to make concessions Progress tended to be greatest in Korea, where an agreement in late 1998 between the government and the five major chaebol (conglomerates) promised rationalisation, greater specialisation of their operations and debt reduction These promises, however; remain to be implemented

7.10 LET US SUM UP

International banks are linked in various formal and informal ways from simply holding account with each other's correspondent accounts - to common ownership These can be of following types:

(i) Correspondent banks (ii) Resident representative (iii) Bank agencies

(iv) Foreign branches (v) Foreign subsidiaries and affiliates (vi) Consortium banks

7.11 LESSON END ACTIVITY

“Consortium banks are joint ventures of the larger commercial banks” Explain this statement with example

7.12 KEYWORDS

Correspondent Banking: An informal linkage between banks in different countries

set up when banks maintain correspondent accounts with each other

Consortium Banks: Joint ventures of the large commercial banks

Multinational banking: Multinational banking refers to the currency and

cross-country facets of banking business

7.13 QUESTIONS FOR DISCUSSION

1 What do you understand by correspondent banking? State the problems of multinational banking

2 Banks classify their risks according to the some categories Explain these categories in detail

3 Analyse the features of multinational banking

Check Your Progress: Model Answers 69

Organisational Features of Multinational Banking

CYP 1

1 An informal linkage between banks in different countries is set up when

banks maintain correspondent accounts with each other Large banks have

correspondent relationships with banks in almost every country in which

they do not have an office of their own

2 An agency is like a full-fledged bank in every respect except that it does

not handle ordinary retail deposits The agencies deal in the local money

markets and in the foreign exchange markets, arrange loans, clear bank

drafts and checks, and channel foreign funds into financial markets

CYP 2

1 Foreign branches are operating banks like local banks, except that the

directors and owners tend to reside elsewhere Generally, foreign

branches are subject to both local banking rules and the rules at home, but

because they can benefit from loopholes, the extra tier of regulations is

not necessarily onerous

2 Consortium banks are joint ventures of the larger commercial banks They

do not have a distinct collective legal identity They can involve half

dozen or more partners from numerous countries

7.14 SUGGESTED READINGS

C Jeevanadam, Foreign Exchange Management

Levi, International Finance

Ian H Giddy, Global Financial Markets

Rupnaryan Bose, Fundamentals of International Banking, Macmillan India Ltd

Vyuptakesh Sharan, International Financial Management, Prentice Hall of India

ICFAI University Press, International Banking

B.K Chauduri, O P Agrarwal, A Textbook of Foreign Trade and Foreign Exchange,

Himalaya Publishing House