INTERNATIONAL FINANCE
Session 9
International banking
Main text books :
Bourget, Figliuzzi, Zenou, Monnaies
et systèmes monétaires, 9e édition, Bréal, 2002
J.C. Baker, International
Finance, Prentice Hall, 1998
Internet sources :
Bank
- what is it?
Asian
banking systems
Banking
Digest
BIS
Publications and Statistics and BIS
Publications and Statistics - Banking Statistics
The
New Basel Capital Accord
World
Economist- daily news and current events
United States'
Largest Banks
http://www.worldbanknews.com/
The World
Bank Group
Regulation
K - International Banking Operations
What is a bank ?
The largest US banks
The balance sheet of a bank
-
Non issueing bank
-
Issueing bank
The various liabilities items
The various assets items
-
Fixed assets
-
Commercial loans
-
Letters of credit
-
Real estate loans
-
Residential mortgages
-
Municipal bonds
-
Government securities
-
Treasury securities
-
Cash
Cooke ratios
Reserves on the assets side
How do banks participate in the "creation" of money
Tracing a deposit on our checking account
Securization (in French : Titrisation)
A sight draft
The circuit of a banker's acceptance
An overview on banking :
(source : An Overview on Banking)
I. Banks and
Banking
II. The Revolution in the Banking
Business
III. Types of Banks
IV. Banks and Development Finance
V. Managing Bank Risks
VI. Bank Supervision
I. BANKS AND BANKING: What is a
bank? What is its business?
Banks are institutions which help people and businesses manage
their money.
The business of banking refers to taking deposits and
making loans.
BANKS AND BANKING: How banks
create money?
Banks keep primary and secondary reserves.
Primary reserves are cash deposits due from other banks and the
reserves required by the central banking system. Secondary
reserves are securities banks purchase in the open market which
may be sold to meet short-term cash needs. These securities are
usually government bonds. The amount of deposits a bank must keep
on reserve is regulated by law. Any excess of the required amount
is excess reserves. It is the excess reserves that create money.
(See also Heilbronner & Thurow, Economics explained,
Prentice-Hall)
BANKS AND BANKING: How do banks
make profit?
Banks make profit or loss in three ways:
- Interest Spread: They make money from what they
call the spread, the difference between the interest rate
they apply for deposits and the interest rate they
receive on the loans they make.
- Fees: They earn fees from customer services such
as checking accounts, financial counseling, and loan
servicing.
- Trading profits: from buying and selling
securities to capitalize on movements in interest rates,
exchange rates or equity prices.
BANKS AND BANKING: A short
history of banking
The first American banks appeared in the early 18th century to
provide currency to colonists who needed means of exchange.
Originally, banks only made loans and issued notes for money
deposited. Checking accounts appeared in the 19th century, the
first of many new bank products and services. These now include
credit cards, automatic teller machines, NOW accounts, individual
retirement accounts, home equity loans, and other financial
services.
II. THE REVOLUTION IN THE BANKING
BUSINESS: Diversification of Products and Services
Bank products and services have diversified over the years.
Banks can now venture fully into the financial industry from
stock markets to mortgage and project financing to insurance. The
banking environment of the 90s is highly competitive and
the traditional lines between the basic banking and other
financial services is continually blurring.
THE REVOLUTION IN THE BANKING
BUSINESS: Structure and Functions of a Modern Bank
1. Basic Commercial Banking
- Deposit-taking
- Funding the bank
- Originating new loans
2. Corporate Finance and Brokerage
Activities of Universal Bank
- Underwriting new equity bond issues
- Brokerage business
- Corporate Advisory services
3. Investment Management
- Investment Managements
- Trust Services
4. Internal Bank Management
- Managing Assets (loan portfolio, liquid securities, etc.)
- Managing Risks (credit risk, interest rate risk, etc.)
- Financial Control (Accounting)
- Tax Management
- Managing legal responsibilities (documentation)
- Chief Executives Office
THE REVOLUTION IN THE BANKING BUSINESS: Online
Banking
Online Banking: What is it?
Online system allows customers to plug into a host of banking
services from a personal computer by connecting with the
banks computers over the telephone wires. By virtue of
technology, banking becomes easier for the average consumer.
ONLINE BANKING: Advantages
- Consumers can use their computers and a
telephone modem to dial in from home or any site where
they have access to a computer.
- The services are available seven days a
week, 24 hours a day.
- Transaction are executed and confirmed
quickly, although not instantaneously. Processing time is
comparable to that of an ATM transaction.
- The range of transactions is fairly broad.
Customers can do everything from simply checking on an
account balance to applying for a mortgage.
ONLINE BANKING: Disadvantages
- One has to know how to operate the
computer in order to avail of the conveniences of online
banking.
- Investment of time upfront can be
formidable. The data entry is necessary before the
numbers can be massaged and managed successfully. Online
bill payment is an example of an effort that requires
setting up which leads to ultimate convenience.
- Switching software or banks can mean
re-entry of data, although internet-based systems are
less affected by this.
III. TYPES OF BANKS
- Commercial Banks
- take deposits, make loans
- There are two forms, namely:
- Retail Banking - caters the individuals
- Corporate Banking - caters to companies
and government
- Investment Bank or Merchant Banks
- issue bonds
- invest in equity of a company
- not allowed to take deposits
- Universal Banks
- can perform both commercial and investment bank
functions
- Since the Gramm-Leach-Bliley Act was passed by
Congress on Nov 4, 1999, and signed by Pres. Clinton
on Nov 12, 1999, ("the most significant banking
legislation in the US in 60 years"), Commercial
banks are allowed to establish ties with Investment
banks, and Insurance companies
- Mortgage Banks
- make loans for building houses
- take deposits
- Brokerage House
- buys equity for other people
- 3 main operations:
- buying and selling of equity
- buying and selling of bonds
- buying and selling or currencies
OTHER TYPES OF BANKS
- Thrift Banks
- Specializes in real estate
lending, particularly loans for single-family
homes and other residential properties.
- Can be owned by shareholders or by
their depositors and borrowers. These
institutions are referred to as
thrifts because they originally
offered only savings accounts or time deposits.
- May now offer checking accounts or
demand deposits and make business and consumer
loans as well.
- Credit Unions
- Cooperative financial institutions
formed by groups of people with a common bond.
- Pool of members fund form
the deposit base
- Credit unions are non-profit
institutions that seek to encourage savings and
make excess funds within the community available
at low cost to its members.
IV. BANKS AND DEVELOPMENT FINANCE
What is development finance?
Development finance refers to long-term financial
intermediation that includes raising long term funds, and
extending long term loans for financing projects and development
programs; and providing advisory and non-lending financial
services to sustain success of projects financed.
Types of Development Finance
Activities
- Project finance involving project promotion, appraisal,
monitoring and supervision
- Financial services to support long term lending such as
leasing, insurance, brokerage, working capital financing
- Venture capital financing
- Guarantee funds
- Investment banking
- Entrepreneurial development financing and micro lending
- Privatization and restructuring
- Mergers and acquisitions
- Capital market development
- Free based development activities
- Client training and advisory services (to improve quality
and reduce risk of projects)
Financial Institutions Doing
Development Finance
- Development banks and other policy support and
term-lending financial institutions
- Universal banks (with commercial banks facilities)
investment banks
- Rural and agricultural banks
- Micro credit institutions
- Cooperatives, housing development agencies
- Trade development banks
- Other similar institutions
V. MANAGING BANK RISKS: Why banks
fail?
- Macroeconomic problems leading to
enterprise failure
- Sudden changes in market conditions such
as devaluation, natural disaster or stock market crash
- Errors in judgment or market strategy by
bank management
- Internal management disputes or labor
problems
MANAGING BANK RISKS: Why banks
fail?
- Inexperienced staff operating in new fields
- Violation of regulations
- Connected lending to shareholders, managers or bank staff
- Imprudent lending and asset acquisition
- Poor internal accounting records
- Poor bank supervision
MANAGING BANK RISKS: Three Main
Risks
- Credit Risk. The risk that the interest
and principal on a loan will not be paid in a timely
manner.
- Interest Rate Risk. The risk that a
mismatch in the maturity structure of the fixed interest
liabilities and assets of the bank will result in an
unexpected loss if market interest rates fluctuate in an
unanticipated way.
- Liquidity Risk. The risk that the bank
will run short of liquid funds (i.e., cash) to meet
short-term obligations, even though the bank has a
surplus of assets that could be sold given sufficient
time and effort.
MANAGING BANK RISKS: Sources and
types of risks
- Balance Sheet/Financial Risk
- Credit Risk
- Liquidity Risk
- Interest Rate Risk
- Leverage Risk (Capital Structure)
- Financial Services/Delivery Risk
- Operational Risks
- Technological Risks
- Product Innovation Risks
- Strategic Risks
- Environment Risk
- Economic Risks
- Competitive Risks
- Regulatory Risks
MANAGING BANK RISKS: Risk
Management Policy
- Risk Appetite. A bank must know its own
tolerance for risk
Risks of financial loss
versus
Risk of opportunity loss
- Strategy. A bank must have a strategy to
achieve its risk/return targets and to effectively manage
the desired level of risk.
- Policy Framework. A risk management
strategy involves establishing a policy framework for
making decisions in a consistent and timely manner to
take the greatest advantages of business opportunities
and yet keep risks at manageable level.
- Evaluation Skills. A bank should choose
to take on the risks it can effectively price and manage,
and having decided to take a certain risk, must be
prepared to monitor and manage that risk.
MANAGING BANK RISKS: Principle of
Risk Management
Identifying and evaluating exposures
- Understanding the banks resources
- Anticipating potential sources of losses or accidents
- Measurement of risks
- Forecasting of future losses
Control
- Coordination of risk control across banking divisions
- Incentives for reducing risks
- Monitoring the effectiveness of risk control procedures
Risk Financing
- Use of all available resources
- Maintenance of a catastrophe strategy
- Allocation of risk financing costs across bank divisions
Administration
- Executive responsibility and commitment
- Clear risk management policy and structure
- Targets and objectives
- Cross bank communications of risk control policies
VI. BANK SUPERVISION: Defined
Bank Supervision, in its broadest
sense, is a system that government uses to help ensure the
financial system remains stable, safe, and sound.
Organization of Effective Bank
Supervision
- A Central Bank is the heart of a financial
sector; most central banking law accord the bank the
responsibility for the sectors soundness. Thus,
bank supervision is a common function of Central Banks.
- In some countries, the Ministry of Finance holds
control over virtually all aspects of the financial
sector, with main powers related to banking vested in the
Minister.
- A third option is to have an independent agency,
responsible to the Parliament or the President, to
conduct bank supervision. This could include a deposit
insurance corporation which takes primary responsibility
for supervision.
- With its complex banking system, the United States
conduct supervision through its Central Bank (Federal
Reserve), its Ministry of Finance known as the Treasury
Department through the Comptroller of the Currency, and
its independent agency for deposit insurance known as the
Federal Deposit Insurance Corporation.
Approaches to Bank Supervision
Four (4) basic approaches:
- Information disclosure
- Self-regulation through
- internal audit and control
- external auditors
- Board audit committees
- Government bank examination (implicit guarantee of
deposits)
- Deposit guarantee scheme (explicit guarantee of deposits)
Main Objectives of Bank
Supervision Systems
- To ensure the banking sector is healthy
to promote and enhance economic growth.
- To protect depositors who
have placed their funds in banks.
Principles of Bank Supervision
Why banks should be regulated?
- Monetary policy: the power to create
money
- Credit allocation: the channel of credit
and investment
- Competition & Innovation: to prevent
cartels
- Prudential regulation: depository of
private savings; operators of payments mechanism;
vulnerability to collapse
Bank Examination Activities
- Determine financial position of bank and quality of
operations
- Assess bank management quality
- Ascertain compliance with laws and regulations
- Test accuracy of books, accounts and records
- Verify bank asset quality
Verification of Asset Quality
Includes complete review of credit policy such as:
- proportion of loans to sectors/individuals
- types of securities acceptable to the bank
- procedures to be followed in valuation
- margin of advance
- credit appraisal methodology
- credit monitoring and recovery
- aging of loans, suspension of interest and loans
provisioning
C.A.M.E.L. Test
- Capital adequacy
- Asset quality
- Management depth &
competence
- Earnings level
- Liquidity
Possible Remedial Measures by
Central Bank
- Directing that the problem be remedied, with follow-up
inspections
- Impose fines to the bank or person responsible
- Moral suasion by publishing the misdemeanor
- Restrictions on branching, or loans growth, or
investments
- Call for capital increase
- Assume control of the bank
- Merge or consolidate the bank with stronger bank
- Liquidate the bank
Levels of Supervision &
Control of Banks
- AT THE MANAGEMENT LEVEL:
Chief Executive Decisions
- Mix sources of funds (Treasury
Department)
- Scale Issues -- How large should the bank
become?
- Organizational Issues -- Narrow or wide
focus in terms of lines of businesses? Niche vs
full-service banking?
- Technological Issues -- What methods
should be used to produce and distribute the banks
services?
- Use of Funds (Loan Department and Credit
Risk Committee)
- Pricing Decisions -- How much can be
charged for the banks services? Does the price
cover the risks and direct costs of providing the
services?
- Marketing Issues -- How should the bank
market and sell its services?
- Resource Issues -- How will the bank
attract talented employees? How should the bank pay its
employees?
Levels of Supervision &
Control of Banks
- AT THE BANK LEVEL
- Monitoring of results of project financed vis-à-vis the
financial return and development criteria of the project.
- Monitoring of the sources and application of funds to
avoid mismatch.
- Impact of environmental, political, social and foreign
exchange risks
Levels of Supervision &
Control of Banks
- AT THE NATIONAL LEVEL
Regular Central Bank measures for banks and financial
institutions
- Other measures to ensure bank stability
Levels of Supervision &
Control of Banks
- BY THE NATIONAL DEVELOPMENT AUTHORITY OR EQUIVALENT
- Total employment generated
- Contribution to national revenue
- Enhancement of the environment
- Improvement in standard of living
- Others
The balance sheet of a bank
An example (made up) : The "First
Mulibank" Balance Sheet
Bank regulation
An application of the Basle Accord Bank Capital
Standards
The Bank for International Settlements (Basle,
Switzerland)
Bank risks :
Credit risk (Mexico defaulted in 1982)
Market risk (Unexpected general market
prices and interest rates changes)
Exchange rate risk
Operational risk (Example : Nick Leeson
at Barings Singapore in 1995 ; Kobe earthquake...)
Legal risk
Liquidity risk
Settlement risk (The "Herstatt"
risk)
Other specific risk
The specificities of international
banking
Large international banks are like MNC's. They are confronted
with specific problems and risks related to dealing with many
different currencies, in different political environments.