CHAPTER SIX

INTERNATIONAL BANKING
6.1 Introduction
Internationalization of banks is not a new phenomenon. The history of international
banking starts with the “banks” of ancient times, moves to the rise of the Italian
merchant-bankers in the late Middle Ages. In 1913 there were approximately 2,600
branches of foreign banks worldwide. International banking has been and still is
closely linked to the development of world trade, the process of urbanization, and the
rise of the nation-state. Over time, innovations in financial instruments,
telecommunications, information technology, organization innovation and the growing
sophistication of customers have also meant a dramatic transformation in the conduct
of banking business and client relationships in international banking.
International banking refers to the activities of providing financial services (banking) to
clients (both institutional and individual) located in many different countries. It
involves activities of banking transactions crossing national boundaries. This
encompasses a wide range of activities, including transactions with foreigners and
domestic residents relating to deposits and lending in domestic and foreign currencies,
facilitating foreign currency transactions and foreign exchange risk hedging,
participating in international loan syndications, and facilitating international trade
finance for clients. International financial services enable the smooth operations of
companies in the global arena. International trade is made possible through such
services by international wire transfer and foreign currency exchange.
International banking is the process in which financial institutions allow foreign
clients-both companies and individuals-to use their services. Perhaps the most talked-
about international banks are located in Switzerland. It offers services to clients across
the globe. International banking operations are essential to facilitate the movement of
goods across the political boundary of countries. Let us see the definition of
international banking provided by various authors as follows:
Any financial transformation that has a cross currency/country. (Scholten,
1991)
A bank that owns and controls banking activities in two or more countries.
(Casson, 1990)
Operating a bank in, and conducting banking operations that derive from, many
different countries and national systems. (Robinson, 1972)
A financial corporation which acquires deposits and initiated loans from offices
located in more than one country. (Gray and Gray, 1981)
A multinational bank having branches in one or more foreign countries. (Cho,
1985)
International operating bank has the following characteristics from the definition:
a) Assets and/liabilities other than in the home country and/or home country
currency.
b) Rights and/or claims other than in the home country/currency, part of which is
c) Issued and collected outside the home country.
Page 1
The major incentives/reasons to internationalize banking business are
considered hereunder:
1) Client- Banks go abroad to serve their domestic customers who have gone abroad.
a. Domestic banks in foreign countries may be poorly equipped to serve the
branches set up by the entering firms. It triggers an incentive for banks to
internationalize if the financial innovation and sophistication in the foreign
country lags behind that of the home country.
b. Banks follow their domestic customer abroad to reduce the likelihood that
they might lose their business to host-country banks. Ceteris paribus this
likelihood increases if the financial sophistication of the host country is
greater than that of the home country.
c. Banks follow their customer abroad to further exploit the internationalization
advantage built up in the home country, providing mutual added benefits for
both bank and firm.
2) Perception of market: Entering new geographical markets when a bank feels the
boundaries in the home market are stretched or has limited further opportunities is
an intuitive incentive, especially for banks with a small home market. The
perception of what constitutes a market changes when banking customers from the
home market demand certain products, part of which cannot be generated in the
home market. Good example is Euromarkets. Eurocurrencies are deposits of major
currencies with banks physically situated outside the home market of the currency
(such as deposits of USD with banks outside the US financial centers). Economic
and political integration effectively change boundaries of a market too (such as
engagement of European banks in international activities after WWII).
3) Spread: For most banks the net interest income earned on loans (spread) is the
main source of income. Profiting from higher spreads elsewhere is then a powerful
motive. Spreads can also be interpreted as cost differentials, and relative cost
differentials can be exploited by trade benefiting both domestic and foreign banking
market. The law of comparative advantage, in terms of cost, can be explained here.
For financial intermediation, this advantage is visible through the loan-deposit
spread. A lower spread would suggest more efficient financial intermediation. Banks
in countries with relatively low spreads have an incentive to establish foreign
activities because they have developed low cost technologies for intermediation.
Thus, spreads can serve as a push factor on the cost side (exploitation of low cost
technology) but simultaneously as a pull factor on the earnings side earning higher
spreads elsewhere.
4) Difference in economic structure: the structure, and growth rate of the domestic
economy compared to foreign economies is hypothetically an incentive to
internationalize. Difference in economic structure and financial system can be
exploited; the existence of different economic cycles, as well as different
demographics. Differences in economic growth are a driver for internationalization
activities; higher economic growth in foreign countries implies theoretically a lower

Page 2
 level of provisioning for bad loans, an increase in loans and a stronger capitalization
of the balance sheet. On average, economic growth and GDP per capita are positive
drivers for bank profitability.

Structural changes in economic and financial structure can also be an important

incentive to internationalize, for example transition from an industrial society to a
service oriented society implies a shift in the structural composition of financial
savings and investments patterns.
5) Regulation: (De)regulation, domestic or foreign, has always been a strong incentive
to internationalize. Regulation should be considered in terms of:
(a) Domestic country regulation as incentive for banks to internationalize- regulatory
biases between countries, freedom of supervision than in the home country,
exchange control, taxation (double), monetary policy, application of a reserve
requirement, ceilings on interest rates, entry in the market and the relationship
between different financial activities.
(b) Regulation controlling the entry and conduct of foreign banks in the host country-
such as regulation to govern the entry of firms: a barrier to entry in the market, or
regulation to govern relationships between different financial activities: the
influencing of market conduct. The regulation can result in a generic (through its
macroeconomic policy, monetary policy…) or specific regulation.
(c) International regulation, and
(d) Deregulation and privatization
6) Historical and cultural determinants: Geographic proximity, a shared common
language, administrative system and culture are factors to enter the market. The
use of the same language facilitates the transfer of knowhow and could help the
process of integration within the organization, when foreign expansion is achieved
by acquiring local banks.
7) Market power and concentration: An increase in concentration of banking
activities can limit expected earnings growth a bank can achieve. An increase in
domestic market share might be difficult to achieve because of the higher market
shares of other banks; earnings growth is then more easily achieved outside the
home country in markets where domestic limitations do not apply. On the other
hand, because some banks are more efficient or successful than others, they tend
to gain more market share leading to a higher concentration ratio. Such ratio is a
sign of efficiency. Then, banks could have incentive to exploit this efficiency further
outside the home country.
8) Risk/Return diversification: this stems from investment theory, taking advantage
of the low correlation between withdrawals by depositors and the loans extended.
As a result the risks and costs of organizing financial intermediation activities
through banks are expected to be lower than if these are achieved through open
markets. Available empirical research suggests that some types of geographically
diversified organizations are likely to improve their risk-expected return trade off.
Page 3
 Further, risk diversification can also be achieved by acquiring foreign activities not
related to financial intermediation or by acquiring activities as purely financial
investments. But, portfolio theory as an incentive is a more ex-post reasoning.
9) Financial systems: financial system, financial development, and
internationalization are intertwined. Financial systems can be: bank oriented,
market oriented and government/institution directed. With market oriented (like US
and UK), the allocation process is mainly determined by market prices, and a
substantial part of the banks’ main activities is performed by capital markets.teh
price mechanism plays a central role, allowing banks to securitize their loans but
also forcing them to compete strongly. With bank oriented financial systems (like
Germany and France), the price process still is important, but the bank itself also
plays an important part in the allocation process. Finally, in government/institution
directed system (such as Japan), banks can be instrumental in achieving the
government’s objectives. It is promoted by government. Thus, such difference might
be an incentive for banks to internationalize.

6.2 Risk Exposure of Banking

The nature of banking is strongly related to the management and control of risks. Risk
here, refers to a danger that an unpredictable contingency can occur that may affect
the bank’s profitability and cash flow. Since foreign countries have varying political
and business environments, users may face several risks when using international
bank services. A bank has many risks that must be managed carefully since it uses
a large amount of leverage. Some of these risks include liquidity risk, sovereign/political
risk, foreign exchange risk, credit risk and operational risk. The following constitute some
of the risks confronting international bankers:
 Credit risk – the danger that a borrower defaults on a debt obligation. It is a risk
that a party to contract fails to fully discharge terms of the contract.
 Liquidity and funding risk- the threat of insufficient liquidity on the part of the bank
for normal operating requirements. It is a risk that asset owner cannot realize the
full market value of the asset when the sale is desired.
 Settlement/payment risk- which is created when one party of a deal pays money or
delivers assets before receiving its own cash or assets, hence exposing itself to a
potential loss and interest rate risk.
 Interest rate risk- the risk that arises from mismatches in both the volume and
maturity of interest-sensitive assets, liabilities, and off-balance sheet items. It is a
risk that occurs due to interest rate changes.
 Sovereign/Country/Political risk- The most important risks are the problem of
sovereign risk. Country risk arises from the economic, social and political
environment of a given foreign country, which could have favorable or adverse
consequences for foreigners’ debt and/or equity investments in that country.
It is a risk in which the political or economic conditions in a particular country
threaten to interrupt repayment of loans or other debt obligations. For example,

Page 4
Ethiopian companies might hesitate when conducting business internationally since
foreign countries may be less stable politically and economically. Situations such as
political unrest, military coups, dictatorships and anti-business groups can create
difficult banking environments in foreign countries.
Country risk is characterized as the possibility that economic, political or social factors
within a country might create a situation in which borrowers in that country would be
unable to service or repay their debts to foreign lenders in a timely manner. Risk in
international banking is generally considered to arise out of the possibility of loan loss
write-offs.
These political issues can make forecasting difficult because Ethiopian companies tend
to lack familiarity with violent political upheaval. Business-friendly countries might
create unfavorable banking conditions or institute tougher banking regulations to
restrict foreign companies from dominating their local business market.
 Foreign exchange or currency risk- the exposure of banks to fluctuations in foreign
exchange rates that affect positions held in a particular currency for a customer or
the bank. Conducting business internationally forces companies to become familiar
with the currency exchange rates. Companies choosing to operate business
locations on foreign soil typically use foreign currency when purchasing materials
and hiring workers at the local facility. Start-up capital may come from the
company's domestic operations prior to the company exchanges it for foreign
currency. If the Birr is stronger than the value of the foreign currency, it will require
more foreign currency to equal the value in Birr. Conversely, if the Birr is weaker
than the foreign currency, gaining an equal-value currency exchange will require
more Birr. Exchange rates may affect profits made in a foreign country when
companies transfer foreign currency to their Ethiopian headquarters.
 Operating risk- a risk arising from losses caused by fraud, failure of internal control,
or unexpected expenses, as in the case of lawsuits.

6.3 Commercial Letters of Credit

International trade risks are inevitable. International traders try to minimize or
eliminate these risks. From a historical perspective the practical method that many
international traders use for this purpose is the letter of credit (L/C).
Letter of Credit is literally a letter that extends a line of credit to an individual or
business entity. A bank on behalf of one of its customers writes it. A letter of credit is a
banking mechanism that allows importers to offer secure terms to exporters.

Letter of Credit is a document of authority for payment of guarantee given by importer

to exporter through banking channel. Importer’s bank undertakes guarantees for
payment on behalf of the importer. It is named a letter because initially the Letter of
Credit was issued manually in a Letter format address by Issuing Bank to Beneficiary
confirming its conditional undertaking to reimburse the Beneficiary.

Page 5
A letter of credit may be a commercial or non-commercial one. When it relates to a
mercantile transaction, i.e., buying and selling of goods, it is called a commercial letter
of credit. When it does not relate to any mercantile transaction but only conveys an
order of opening banker to his overseas correspondent to pay to a third party named in
the order within a specified period of time, against drafts drawn upon him by that
party up to a stated amount, it is non-commercial, and is called circular letter of
credit.
A Commercial Letter of Credit may be defined as an instrument usually issued by a
bank, at the request and for the account of its client, which indicates that the bank
agrees to pay to the named beneficiary a sum of money upon the presentation of
certain documents or written representations stipulated in the Letter of Credit. In other
words, it is a document issued by a bank which provides a guarantee of funding for a
business. It is used particularly in overseas transactions, where a company in one
country wishes to purchase goods or services from a company in another company.
The bank reviews the buyer’s credit and provides a guarantee of payment in case of
default by the buyer. The person receiving the letter of credit is considered the
"beneficiary."
The Letter of Credit provides the most satisfactory method of obtaining payment.
It provides security of payment to the exporter, and enables the buyer to ensure
that he/she receives the goods as ordered and delivered in the way he/she
requires.
The most important function of the L/C is to give confidence to both exporter and
importer through an impartial mechanism that commercial banks with
international banking experience have developed. The letter of credit assures the
exporter that a bank will make payment for goods shipped. It assures the importer
that the exporter will not be paid unless the documentation submitted by the
exporter conforms to the terms and conditions of the letter of credit. A letter of
credit issued by a commercial bank with worldwide banking facilities solves the
financing problem.
Steps of Letter of Credit

First of all, Letter of Credit applicant must be a client of the bank. If a new client
comes in for opening Letter of Credit, he/she has to open an account with Bank first.
The following main steps are pursued to accomplish the process of Letter of Credit
smoothly:
1) Sales Contract between Importer and Exporter- First of all, the Importer and the
Exporter should communicate by any way (it may be by advertisement) and agree
the Exporter sends copy of Proforma Invoice to the Importer and the Importer
signs on proforma invoice. Then importer takes one copy and sends the other
copies to the beneficiary.

Page 6
2) Credit Contract between Importer and Issuing Bank. After the issuing bank checks
all about the Importer, then the bank takes the creditworthiness of the Importer
by opening the Letter of Credit in favor of the Exporter.
3) The Issuing Bank then sends the Letter of Credit through via SWIFT (Society for
Worldwide Interbank Financial Telecommunication) - which supplies secure
messaging services and interface software to wholesale financial entities) for the
Advising Bank in favor of the Exporter.
4) The Advising Bank sends a message for the Exporter about the Letter of Credit.
5) The Exporter starts to load the goods through the port of shipment to send the
goods and collect all necessary documents by handed over the goods. /The
document preparation starts on this step/
6) The Exporter handed over all the documents that collect from the concerned parties
including the Bill of Lading to the Advising Bank for negotiation.
7) After scrutinizing the negotiation documents about their genuinely the Advising
Bank pays the money for the Exporter.

8) The Advising Bank dispatches all documents that it receives from the Exporter by
mail or via SWIFT to the Issuing Bank.
9) The Issuing Bank sends the money to the Advising Bank or if the two banks are
correspondent, the Advising Bank deducts the Letter of Credit amount from the
Issuing Bank’s account.

10) The Issuing Bank handed over the entire necessary documents that it receives
from the Advising Bank to the Importer after the buyer clears the payment.
11) The Importer takes the goods from the custom or port of destination by using the
necessary documents that receives from the Exporter through the Issuing Bank.

Illustrations of Letter of Credit (LC)

a) Application for Import Letter of Credit

In foreign trade, the most popular type of letter of credit is the irrevocable letter of
credit. The import letter of credit has different procedures. As an example assume that
an Ethiopian Importer Company in Addis Ababa requests Awash International Bank
Share Company to open a letter of credit for Chong Exporter Company, located in Hong
Kong, in the amount of Birr 1,000,000.00 covering a shipment of Machinery from Hong
Kong to Addis Ababa. The draft will be paid at sight in Addis Ababa. Upon receiving the
application, the opening bank must examine it carefully and check the credit line and
credit status of the applicant. If the application is consistent with national and
international legal requirements and satisfactory to sides, the importer and the
opening bank sign an agreement to open a Letter of Credit.

Page 7
 b) Application for Export Letter of Credit
Assume the following example for the illustration of Export Letter of credit. An
Ethiopian company engaged in the purchase and sell of television sets arranges to
purchase 10,000 television sets from U.S. Exporter Company Ltd. Located in New York
City. In accordance with the contract, both importer and exporter agree that the
shipment will be financed by a letter of credit confirmed and payable at 90 days after
sight in the amount of $1,000,000.00. The Ethiopian Company asks its bank, Awash
International Bank Share Company. The Ethiopian Company needs to open an
irrevocable credit payable at Citibank, New York with credit confirmed by that bank.
Upon receiving instruction from the Awash International Bank Share Company,
Citibank issues a confirmed irrevocable credit to the beneficiary U.S. Exporter
Company, Ltd.
Letter of Credit Process (The flow in graph)

***The End***

Page 8