UNIT 6: INTERNATIONAL BANKING

Contents
6.0 Aims and Objectives
6.1 Introduction
6.2 Bank Migration to Foreign Countries
6.3 Global Bank Regulations
6.4 Uniform Global Regulations
6.5 Global Bank Competition
6.6 Competition for Investment Banking Services
6.7 Impact of Eastern European Reform
6.8 Risks of Euro Bank
6.9 Default Risk
6.10 Exchange Rate Risk
6.11 Settlement Risk
6.12 Interest Rate Risk
6.13 Combining All Types of Risk
6.14 Reducing Bank Exposure to LDC Debt
6.15 Use of Brady Plan to Reduce LDC Debt Exposure
6.16 Country Risk Assessment
6.17 Overall Rating
6.18 Country Risk Ratings
6.19 Use of Discriminant Analysis to Assess County Risk
6.20 Summary
6.21 Answers to Check Your Progress Questions
6.22 Model Examination Questions

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6.0 AIMS AND OBJECTIVES

The specific objectives of this chapter are to:

 Describe key regulations that have reduced competitive advantages of banks
in particular countries,
 Describe the risks of international banks,
 Describe bank solutions to the international debt crisis, and
 Describe how banks assess country risk when they consider lending funds to
foreign countries.

6.1 INTRODUCITON

International banking has received more attention in recent years for three reasons. First,
banks are increasingly establishing subsidiaries and branches in foreign countries.
Second, banking regulations in many countries have loosened, allowing easier entry or
access to banking markets. Third, international lending has become a major issue as a
result of the international debt crisis that continues to plague many large banks.

6.2 BANK MIGRATION TO FOREIGN COUNTRIES

Because of historical barriers against interstate banking, some U.S commercial banks
were better able to achieve growth by penetrating foreign markets. It is somewhat ironic
that the New York banks historically had branches in Taiwan and Hong Kong but not in
New Jersey or Connecticut. If full-fledged interstate banking had been allowed
throughout the years, large U.S commercial banks would probably have concentrated
more on the U.S markets. As it was, international markets were their primary sources of
growth. Their international business is normally corporate oriented rather than consumer
oriented.

The most common method for U.S commercial banks to expand is through establishing
branches, full-service banking offices that can compete directly with other banks located
in a particular area. Attempts by U.S. banks to establish foreign branches are subject to

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Federal Reserve Board approval. Among the factors considered by the Board are the
bank’s financial condition and experience in international business.

The U.S bank presence is larger in the United Kingdom than in any other foreign country.
Deposits in foreign branches of U.S. banks are not insured by the vide loans but cannot
accept deposits or provide trust services.

Since 1913, Edge Act Corporations have been established in the United States by banks
to specialize in international banking and foreign financial transactions. These
corporations are not constrained by existing regulations against interstate banking. They
can accept deposits and provide loans, as long as these functions are specifically related
to international transactions.

During the 1960s and 1970s, numerous banks established subsidiaries in the
Eurocurrency market in response to the lack of regulations. The absence of reserve
requirements and deposit insurance fees allowed banks to improve their profit margins.
In addition, the absence of interest rate ceilings on deposits allowed banks to more
aggressively compete for deposits. The Eurocurrency market is currently served by large
banks from several different countries.

International business allows firms to diversify among various economies so that their
performance is less dependent on economic onditions of any single country. This is the
motive for many U.S. commercial banks establishing branches around the world. Such
international diversification of loans is thought to reduce the impact of a U.S. recession
on the risk of U.S. bank loan portfolios. Furthermore, the establishment of branches
allows a bank to do business face to face with subsidiaries of U.S. –based multinational
corporations. The global expertise of some of the larger U.S. banks distinguishes them
from the small and medium banks and enables them to dominate business by attracting
the large corporations.

While U.S. banks have entered non-U.S. markets, non-U.S. bank have also entered U.S.
markets. Initially, they entered primarily to serve the non-U.S. corporations that set up

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subsidiaries in the United States. Because this still serves as their primary function, they
concentrate on corporate rather than consumer services.
The number of foreign bank offices in the United States has consistently increased over
time. More than one-third of all foreign bank offices in the United States are from Japan,
Canada, the United Kingdom, and France. Almost half of these offices are located in
New York, where many of the foreign-owned corporations conduct business. As an
example of non-U.S. bank involvement in the United States, Japanese banks use the U.S.
market as a source of funds during periods of tight credit in Japan. Japanese banks also
increase their business in the United States when Japanese-U.S. trade increases, which
suggests how international banking is dependent on international trade activity.

6.3 GLOBAL BANK REGULATIONS

Although the division of regulatory power between the central bank and other regulators
varies among countries, each country has a system for monitoring and regulating
commercial banks. Most countries also maintain different guidelines for deposit
insurance. Differences in regulatory restrictions can allow some banks a competitive
advantage in a global banking environment.

Canada’s banks tend to be subject to fewer banking regulations than U.S. banks. Gor
instance, Canadian banks can expand throughout Canada, allowing the larger Canadian
banks to control much of the market share. Canadian banks are also not as restricted as
U.S. banks on investment banking activities, and therefore control much of the Canadian
securities industry. Recently, Canadian banks have begun to enter the insurance industry.

European banks tend to have much more freedom than U.S. banks in the offering of
investment banking activities such as underwriting corporate securities in fact, many
European branches of U.S. banks provide investment banking services in Europe that
would not be allowed in the United States. European banks have penetrated the
insurance industry in recent years by acquiring numerous insurance companies. Many
European banks are allowed to invest in stocks.

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Japanese commercial banks have some flexibility to provide investment banking services,
but not as much as European banks. Perhaps the most obvious difference between.
Japanese and U.S. bank regulations is that Japanese banks are allowed to use depositor
funds to invest in stocks of corporations. Thus, Japanese banks are not only creditors, but
are also shareholders of firms. The Japanese government has recently eased banking
regulations on interest ceilings and lending activities.

6.4 UNIFORM GLOBAL REGULATIONS

The globalization of markets and other financial services is motivated by the

standardization of some regulations around the world. Three of the more significant
regulatory events allowing for a more competitive global playing field are (1) the
International Banking Act, which placed U.S. and foreign banks operating in the United
States under the same set of rules, (2) the Single European Act, which placed all
European banks operating in Europe under the same set of rules, and (3) the uniform
capital adequacy guidelines, which forced banks of 12 industrialized nations to abide by
the same minimum capital constraints. A discussion of each of these key events follows.

Uniform Regulations for Banks Operating in the United States . A key act related to
international banking was the International Banking Act (IBA) of 1978, designed to
impose similar regulations across domestic and foreign banks doing business in the
United States. Prior to the Act, foreign banks had more flexibility to cross state lines in
the United States than U.S.-based banks. The IBA required foreign banks to identify one
state as their home state so that they would be regulated like other U.S.-based banks
residing in that state. The stock prices of money center banks increased in response to
the announcement Regional banks did not experience a significant stock price reaction.
This may have resuited from provisions in the IBA that would allow foreign bank to
become more competitive in the united States at the retail level. Such provisions are of
more concern to regional banks than wholesale-oriented money center banks and could
offset any favorable consequences of other IBA provisions on regional banks.

Uniform Regulations Across Europe.

Europe. One of the most significant events affecting the
international banking markets is the Single European Act, which was phased in

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throughout the European Economic Community (EEC) countries. The following are
some of the more relevant provisions of the Act for the banking industry.

 Capital can flow freely throughout European.

 Banks can offer a wide variety of lending, leasing, and securities activities in the
EEC.
 The regulations regarding competition, mergers, and taxes are similar throughout
the EEC.
 A bank established in any one of the EEC countries has the right to expand into
any or all of the other EEC countries.

As a result of the Single European Act, a common market has been established for 12
European countries. One of the key objectives of the Act is to facilitate the free flow of
capital across countries in order to enhance financial market efficiency. To this end, the
Act eliminated capital controls imposed by individual European countries on services
such as deposit taking, lending, leasing, portfolio management advice, and credit
references.

European banks are already consolidating across countries. Efficiency in the European
banking markets will increase as banks can more easily cross countries without concern
about concern about country-specific regulations that prevailed in the past.

Another key provision of the Act is that banks can enter Europe and receive the same
banking powers as other banks there. Similar provisions are allowed for non-U.S. banks
that enter the United States.

Even some European savings institutions are affected by more uniform regulations across
European countries. Savings institutions throughout Europe are now evolving into full-
service institutions, expanding into services such as insurance, brokerage, and mutual
fund management.

The European Commission has been empowered to make rules and regulations uniform
across member countries. This task becomes very complicated when dealing with goods

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and services provided by 12 deferent countries. The commission has switched to a
simplified approach where any product approved under one country’s national laws can
be sold in any other member country. This strategy shifts the burden of regulatory
restrictions to the home country of the firm’s European headquarters.

Commercial banks in one member country will be able to do business in the other 11
countries without having to conform to country-specific restrictions that previously
existed. However, the oligopolistic nature of the industry in some European countries
will still represent a significant bank to foreign banks. The banking industry in France,
Great Britain, and Germany is dominated by just a few banks.

Uniform Capital Adequacy Guidelines Around the World. Before 1987, capital
standards imposed on banks varied across countries, which allowed some banks to have a
comparative global advantage over others. As an example, consider a bank in the United
States that is subject to a 6 percent capital ratio that is twice that of a foreign bank. The
foreign bank could achieve the same return on equality as the U.S. bank by generating a
return on assets that is only one-half that of the U.S. bank. In essence, the foreign bank’s
leverage measure (assets divided by equity) would be double that of the U.S. bank, which
would offset the low return on assets. Given these conditions, foreign banks could accept
lower profit margins while still achieving the same return on equity. This affords them a
stronger competitive position. In addition, growth is more easily achieved, as a relatively
small amount of capital is needed to support an increase in assets.

Some analysts would counter that these advantages are somewhat offset by the higher
risk perception of banks having low capital ratios. Yet, it the governments in those
countries are more likely to back banks that experience financial problems, banks with
low capital may not necessarily be too risky. Therefore, some non-U.S. banks had
globally competitive advantages over U.S banks with out being subject to excessive risk.
In December 1987, 12 major industrialized countries attempted to resolve the disparity by
proposing uniform bank standards. In July 1988, central bank governors of the 12
countries agreed on standardized guidelines. Briefly, capital was classified as either Tier
1 capital (which is primarily retained earnings or funds obtained from issuing stock) or
Tier 2 capital (which includes loan loss reserves and some forms of long-term debt). Tier

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1 capital must be at least 4 percent of risk-weighted asset. The use of risk weightings on
assets implicitly caused a higher capital ratio for riskier assets, because those assets were
assigned lower weights. Off-balance sheet items were also accounted for so that banks
could not circumvent capital requirements by focusing on services (such as letters of
credit and interest rate swaps)that are not explicitly shown on a balance sheet. Even with
uniform capital requirements across countries, some analysts may still contend that U.S.
banks are at a competitive disadvantage because they are subject to different accounting
and tax provisions. Nevertheless, the uniform capital requirements represent significant
progress toward a more level global field.

6.5 GLOBAL BANK COMPETITION

As the markets for loans and other financial services become more integrated, banks from
any given country are recognizing that their main completion may be foreign banks. U.S.
banks have always had a competitive advantage in technology, such as devising new
products and services. For example, U.S. banks are advanced in their creation of interest
rate swaps and currency swaps. They also dominate the market for selling packaged
loans.

U.S. Bank Expansion in Foreign Countries. U.S. banks have recently established
foreign subsidiaries wherever they expected more foreign expansion by U.S. firms, such
as in Southeast Asia and Eastern Europe. In the last few years, expansion has been
focused on Latin America As a result of the North American Free Trade Agreement
(NAFTA), several U.S. banks, including Bankers Trust, Chase Manhattan, and Chemical
Bank planned to expand their business in Mexico. These banks can help finance the
ongoing expansion by U.S-based corporations that are establishing subsidiaries in
Mexico. They can also benefit from the increased international trade by offering
banker’s acceptances and foreign exchange services. If Mexico’s economy strengthens
as a result of the NAFTA, because the NAFTA may lead to a broader trade agreement
with many Latin American countries, many U.S. banks are also considering expansion
throughout these countries.

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International banking is not solely concentrated on foreign loans. To illustrate the
diversity in international banking services consider the case of
Citicorp. Some of the key services offered by Citicorp to firms around the world include
foreign exchange transactions, forecasting, risk management, cross-border trade finance,
acquisition finance, cash management services, and local currency funding. Citicorp not
only serves large multinational corporations such as The Coca-Cola Company, Dow
Chemical, IBM, and Sony, but also small firms that need international banking services.
By spreading itself across the world, Citicorp can typically handle the banking needs of
all of a multinational corporation’s subsidiaries.

Non-U.S. Bank Expansion in the United States.

States. Non-U.S. banks have been more
aggressive in penetrating the U.S. market. Japanese banks have a very significant
presence in the United States. They control about 25 percent of the California market.
One major reason for their growth is very competitive corporate loans. They also have
been known to provide letters of credit for lower fees than those charged by U.S. banks.
Another reason for their growth is a relatively low cost of capital, which allows them to
take on more ventures that might not be feasible to U.S. banks. Furthermore, the high
savings rate of the Japanese banks allows for substantial growth in deposits in Japan,
which may then be channeled to support operations in the United States.

6.6 COMPETITION FOR INVESTMENT BANKING SERVICES

A variety of financial services in addition to loans have become globalized, in which

there is competition between financial institutions from numerous countries. Some of the
more obvious examples of global participation are in such services as foreign exchange,
swaps, and such investment banking services as under writing and brokerage. Some
commercial banks were initially able to offer a complete range of services by establishing
subsidiaries in countries with fewer regulations.

One of the most common examples of commercial banks’ circumventing regulations by

migration to other countries is in the securities industry. In most non-U.S. countries,
commercial banks can participate in such securities activities as underwriting and full-
service brokerage. In the United States, securities and banking activities continue to be

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somewhat separated, although commercial banks in the United States have recently been
allowed some underwriting and brokerage privileges. Non-U.S. commercial banks are
more able to diversify across services products because of fewer regulatory barriers. U.S.
banks have attempted to diversify across products by establishing subsidiaries in foreign
markets. However, this is an inconvenient approach for smaller banks that would prefer
to focus on region of the United States. In addition, the U.S. restrictions prevent U.S.
commercial banks from fully capitalizing or economic of scale in securities activities.

Since 1988, the barriers between securities and traditional banking activities have
diminished, allowing U.S. commercial banks to behave more like non U.S. banks. In
1988 some money center banks in the United States filed applications requesting that
specific subsidiaries be allowed to underwrite and deal in corporate debt. In January
1989, the Federal Reserve Board approved the applications contingent on specific
requirements, including the requirement that the revenues from debt underwriting be
limited to 5 percent of the bank subsidiary’s total revenues. The generation of tee income
from underwriting has become more desirable since the more stringent capital
requirements have been imposed. Underwriting allows banks to boost their revenues
without signigicantly altering their asset size. Therefore, growth into the underwriting
business will not necessarily require an increase in the required capital. The underwriting
activities by banks could also lead to closer relationships with corporat clients and allow
than to facilitate mergers and acquisitions for additional fee income.

International Debt Crisis

At any given point in time, some countries may be experiencing strong economic growth
while others are stagnant. This is a primary reason for limiting the total percentage of
loans to any one country. Yet, the 1980 and 1982 recessions affected all countries. To
the extent that countries trade with each other, economies alemtegrated. The stagnant
economies in Europe and the United States adversely affecred each other in the early
1980s, and exporting volume declined. Furthermore, their demand for exports from less
developed countries (LDCs) decreased. Because many LDC economies are highly
dependent on their export business, the recession in the United States and Europe hand a
dramatic impact. In addition, the market price of oil was reduced because of the oil glut

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at that time. Consequently, the oil-exporting LDCs were generating less revenue that
anticipated. As a result of the recession and declining oil prices, borrowers residing in
many LDCs (governments and corporations) were not generating enough case to repay
their loans

The debt problems of the LDCs were adversely affected by the strengthening dollar
during the early 1980s. Many of the loans provided to LDCs were denominated in U.S.
dollars. As the dollar strengthened, more of the LDCs currency was needed to make
payments. In addition, the interest rates in the early1980s were at their peak, exceeding
20 percent in 1981. The high market interest rates, combined with the strengthening U.S.
dollar, caused the effective (exchange rate-adjusted) interest rate on previous loans to be
30 percent or more.

In August 1982, Mexico’s government announced that it was unable to pay on its debt,
and several LDCs followed Mexico’s lead. Many of these LDCs that were unable to pay
their bank debt were from South America, as identified in Exhibit 20.1. This event
becomes known as the international debt crisis (IDC). The effects of the IDC continued
throughout the 1980s and into the 11990s. Commercial banks that provided loans to
LDCs did not anticipate that several governments would simultaneously announce their
inability to repay loans. The situation was Intensified by a plea of some of the
governments of addition fund to rescue them from economic disaster .this put the bankers
on the spot. They were already being criticized for being too aggressive with their
lending. Now they were forced to decide between two alternative action :(1) provide
additional loan and incur the risk that these loans as well as well as previous loans would
never be paid back and (2) reject the LDC’s request for additional funds, realizing that
the LDC’s would then likely be unwilling to repay their existing loans

The negotiating power of LDCs was enhanced because they as a group, announced their
inability to repay loans. If a single LDC had defaulted, the leading commercial bank
would not have been as concerned. However, when several LDCs simultaneously are
unable to repay loans, banks are not as willing to write off loans at once. They instead
search for a long –term economic rescue plan that may someday allow for repayment.

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The commercial bank also had more negotiating power as a group. The LDCs may not be
as concerned with threats of a single commercial bank (if certain conditions of the loan
agreement are not met), because there are other banks with which the LDCs could do
business in the future. But if all lending bank as a group require the LDCs to meet certain
conditions of not following through are more severe.

Negotiations between the commercial bank, LDCs and the international .monetary fund
(IMF) were held in 1963. The IMF participated, because one of its main function is to
promote international business. If negotiations between commercial banks and the LDCs
had broken down, international trade between the developed countries and the LDCs
would have been significantly reduced in November 1983 the IMF Funding Bill was
passed to provide additional funding to those LDCs that could meet specified economic
goals. The goals differed for each LDC.

Historically, loan rescheduling allowed for a short –term delay of loan repayments, such
as one or two years. This had only a slight impact on the cash flows of lending banks.
however, it dose not allow the borrowers mush time to cure their financial problems. The
financial problems of the LDCs were so severe that banks were forced to offer multiyear
rescheduling .this strategy offered governments of LDCs a long –term period for curing
their financial problem, but also forced the bands to be more patient in receiving their
loan repayments.

The ability of debtor nations to cover their debt depends on their ability to export and to
attract foreign investments. Since they are unable to attract foreign investment when
their existing debt level is perceived to be high the must rely on exports. Given that may
countries have this same goal in mind they cannot all attain it some countries can be net
exporters only if others are willing to be net importers.

6.14 REDUCING BANK EXPOSURE TO LCD DEBT

Nine money center bands make up more than 60 percent of the total US bank exposure to
troubled LCDs. Although the exposure is concentrated within a small group of banks,

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these nine banks are the largest. The failure of even a single mo0ney center bank could
potentially result in a panic within the financial system.

To reduce exposure during the international debt crisis, banks utilized the following
strategies:
 Selling LDC loans
 Debt-equity swap
 Boosting loan

Selling LDC loans. Many commercial banks in the unite sates and other countries
attempted to sell a portion of their LDC loans in the secondary market .some middle
Easter and European banks sold their entire Latin American loan portfolio . Many banks
were willing to sell the loans cheaply and incur the loss immediately. The probability of
loan repayment can be assessed by reviewing the discounts on LDC loans sold in the
secondary market.

Debt-Equity swaps.
swaps. An alternative method of reducing exposure LDC loans is the debt-
equity swap, in which a bank swaps the debt in exchange for some assets owned by the
borrower. As an example, Citicorp swapped claims on Chile’s debt in exchange for an
equity investment in Chile’s gold mining. Chase Manhattan Corporation, First Chicago
Corporation, and other banks have exchanged Peruvian debt for Peruvian exports. Many
swaps have been conducted through nonblank multinationals. U.S. based multinationals,
including General Electric and Chrysler, purchased LDC loans at a discount in the
secondary market and then exchanged the debt for companies or other assets owned by
the borrower.

Boosting loan loss reserves. Some banks recently reacted to their large LDC debt
exposure by increasing their loan loss reserves. Because income is used to build the loans
loss reserve account, an increase in reserves causes a reduction in reported earnings. In
May 1987, Citicorp announced a $3 billion-dollar increase in loan loss reserves. Over the
Following this strategy.
strategy. These actions signal anticipation that some of the LDC loans
will default or the only a portion of the loans will ultimately be repaid.

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In September 1989 another round of increases in loan loss reserves began for some
money center banks. The most publicized announcement was J.P. Morgan’s increase in
loan loss reserves by $2billion, which boosted its loan loss reserve account to match its
total LDC debt exposure. The total loan loss reserves at other money center banks only
represented between 35 percent and 50 percent of medium and long-term LDC debt.

6.15 USE OF THE BRADY PLAN TO REDUCE LDC DEBT EXPOSURE

Over the period from 1985 to 1988 a plan was endorsed as a means of mitigating the
LDC debt crisis. The plan was based on voluntary actions by lenders to reduce their
exposure. In December 1988, the World Bank proposed a gradual implementation of the
plan, along with its commitment to provide loans to LDCs in place of bank loans and
impose economic reforms on the LDCs. During 1989 the plan gained momentum as the
International Monetary Fund signaled its willingness to replace LDC debt maintained by
banks. In what then became known as the Brady Plan, negotiations between banks and
individual LDCs were encouraged in order to provide banks with the option of having
their debt replace by the World Bank and IMF by trading it in at a discount. In July 1989
banks reached an agreement with Mexico in which they were given the following
options: (1) agree to a 356 percent cut in the principal or interest on loans, or (2) grant
new loans equal to 25 percent of the Mexican loans. Essentially, the trade-off involved
either recognizing losses on previous loans while reducing exposure or increasing
investment in LDCs without incurring immiediate losses. The agreement could improve
Mexico’s position because it reduces the amount Mexico owes on existing debt and
allows for additional loans from banks. In this way Mexico may be more able to improve
its debt servicing, which would enhance investors’ perceptions of Mexican debt
maintained by banks. The agreement between banks and Mexico is encouraging because
it could pave the way for agreements with other countries.

A dilemma involved in resolving the crisis is that if all banks prefer to discontinue loans
to LDCs by writing off all or a portion of existing loans, the LDCs may be unable to
secure adequate financing to improve economic conditions. The LDCs’ only chance to
repay existing loans is by economic reform, which requires more loans. Yet many banks

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may feel that providing additional loans is like “throwing good money after bad.” For this
reason, the use of World Bank and IMF funds to assume commercial bank debt at some
discounted price could help resolve the ongoing crisis.

Although the impact of the international debt crisis is not over, commercial banks are
more prepared to deal with it than they were in the 1980s. The crisis has demonstrated
that diversifying loans among foreign countries does not guarantee low risk and that
loans for foreign governments are not risk-free. These lessons have changed the long-
term planning of commercial banks.

6.16 COUNTRY RISK ASSESSMENT

Banks have historically used country risk analysis for measuring the risk of loans to
foreign governments. County risk assessment systems have recently received more
attention as a result of the international debt crisis. Those banks that were highly exposed
to the loans of the problem LDCs either had a poor country risk assessment system or did
not take their assessment seriously. Although each bank has its own unique assessment
system, most systems involve identifying factors that influence country risk and then
weighting these factors. Some of the factors can be measured in an objective fashion,
while others must be measured subjectively. An effective country before they occur,
allowing banks to avoid lending to those countries or at least to reduce their existing loan
exposure to those contras some of the more important factors that affect country risk are:
 Economic indicators
 Debt management
 Political factors
 Structural factors

Short-term and medium-term models of these four aspects can be developed to determine
an overall short-term ratting for a country and an overall medium-term rating

Economic indicators
 The economic indicator model evaluates the country’s economic environment.
Some of the more relevant factors for this model are

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  Changes in their consumer price index
 Real growth in gross domestic product
 Current account balance divided by exports

A statistical the technique called discriminate analysis can be applied to these and other
economic indicators to determine how they influence debt –repayment problems. This
analysis creates a function that can be used to assign an overall rating to the country’s
economic indicators.

Debt Management
The debt management model evaluates a county’s ability to manager debt. The more
relevant variables for rating debt management include:
 Debt service and short-term debt divided by total exports
 Ratio of total debt to gross domestic product

Short –term debt divided by total debt

Other thing being equal, the debt service and short –term debt are relative to expert or to
gross domestic product, the higher the probability that a country would experience debt-
repayment problems. The ratio of short-term debt to total debt indicates the percentage of
debt principal that must be repaid in the near future. A high percentage could cause cash
flow problems in the near future. In addition, countries with a high percentage are usually
more vulnerable to interest rate movements.

Political Factors
The political rating model is used to measure governmental characteristics and political
stability. The political factors are generally measured subjectively and include the
following
 Probability of destabilizing riots or civil unrest
 Probability of increased terrorist activities
 Probability of civil war
 Probability of foreign war
 Probability of government overthrow

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Each factor can be assigned a probability ranging from 1 (extremely likely) to5
(extremely unlikely).

Structural Factors
The structural rating model measures socioeconomic conditions. Some of the more
important structural factors are.
 Natural resource base
 Human resource base
 Leadership
These factors are also subjectively rated.

6.17 OVERALL RATING

Each of the four models can assign a score between 0 and 100, and the overall rating is
determined by weighing the importance of the models. An example of how the overall
rating is determined is shown in Exhibit 20.2. Note that a grade is assigned for both the
short-and medium-term horizons. The grades for this hypothetical example were higher
for the short term. Economic indicators were thought to be more important in the short-
term horizon, while the political rating was more important for the medium-term horizon,
while the political rating was more important for the medium-term horizon.

The overall numerical grade for each horizon can be converted into a rating based on
Standard and Poor’s rating system on securities. The country’s short term horizon
received a rating of A, while its medium-term horizon received a grade of BBB (see
Exhibit 20.3)

6.18 COUNTRY RISK RATINGS

Institutional Investor magazine surveys international bankers to obtain country credit
ratings and discloses the average rating for each country. Recent country risk ratings of
various European and Latin American countries are shown in Exhibit 20.4. in general, the

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industrialized countries have relatively high ratings, while the ratings in less developed
countries in Eastern Europe and Latin America are lower.

6.19 USE OF DISCRIMINATE ANALYSIS TO ASSESS COUNTRY RISK

Discriminate analysis is useful for identifying factors that are distinctly different between
two groups. As a popular technique for country risk assessment, discriminate analysis
attempts to identify factors that distinguish between countries experiencing debt-
repayment problems and countries not experiencing such problems. Once these factors
are known, they can be closely monitored.

The factors hypothesized to discriminate between two groups must first be identified and
then numerically measurable. The factors are then measured by historical data.
Discriminate analysis generates a discriminate function that determines not only which
factors distinguish between the two groups but also the type of influence each factor has.

Short-term horizon Medium-term Horizon

Weighted Weighted
Weight Grade Grade Weight Grade Grade
Debt management model 3 80 24 3 70 21
Economic indicator model 3 90 27 2 70 14
Political rating model 2 60 12 3 50 15
Structural rating model 2 75 15 2 60 12
78 62

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Exhibits 20.3 conversion of country’s Grade in to a rating
Overall
Grade
Rating Rating
91-100 AAA Excellent
81-90 AA
71-80 A
61-70 BBB Satisfactory quality, average risk
51-60 BB
41-50 B
31-40 CCC Low quality, high risk
21-30 CC
11-20 C
0-10 D Excessive risk

Research by Morgan’ used discriminating analysis to assess the influence of variables on

the likelihood that a country would need to reschedule its loan repayments. Morgan found
the following characteristics of countries whose loan payments were rescheduled:
 Their total debt to exports ratio was relatively high.
 Their proportion of floating-rate loans (relative to total loans) was relatively high
 Their real growth rate in gross domestic product (GDP) was relatively low.

Although descriminant analysis is useful for identifying characteristics that distinguish

countries that rescheduled loans from those that did not, its accuracy in predicting
rescheduling depends on whether those characteristics continue to have a similar impact
on rescheduling. For example, using Morgan’s results, one would expect that country
with a greater proportion of floating-rate lawns would have a higher probability of
experiencing loan-repayment problems. However if interest rates were do decrease in the
future, countries with a greater proportion of floating-rate loans might be favorably
affected.

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Check your progress
1. What was the purpose of the International Banking Act (IBA)?
…………………………………………………………………………………………
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2. Explain how the Brady plan was intended to deal with the international debt
crisis.
…………………………………………………………………………………………
…………………………………………………………………………………………
…………………………………………………………………………………………
3. Identify the four major aspects of a country that are commonly analyzed by
country risk assessment systems. How can evaluations of these aspects be used to
determine an overall rating for the country?
…………………………………………………………………………………………
…………………………………………………………………………………………
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4. Explain how the new global capital requirements can discourage banks from
taking excessive risk.
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…………………………………………………………………………………………

6.20 SUMMARY

 Recently, key regulations have reduced competitive advantages of Banks in

particular countries. First, the International Banking Act of 1978 imposed
similar regulations across domestic and foreign banks doing business in the
United States. Second, the Single European Act allowed for uniform bank
regulations across European countries. Third, uniform capital standards were
imposed on banks throughout industrialized countries.
 Banks conducting international business are Exposed to default risk on their
loans. They are also exposed to exchange rate risk when they convert

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 liabilities denominated in one currency to assets denominated in another
currency. They are also exposed to movements in interest rates of any
currencies in which they do business (unless the rate sensitivity of the bank’s
assets and liabilities denominated in each currency are equal).
 Since the international debt crisis, banks with exposure to loans to less
developed countries (LDCs) have taken actions to reduce their exposure, these
actions include sates of LDC loans, exchanging LDC debit for equity
investments in the foreign country. And boosting loan loss reserves.
 When banks consider providing foreign loans, they assess country risk. They
measure country risk by assigning ratings to the various indicators of a
country’s financial and political condition. An overall country risk rating is
determined by consolidating these and other indicators.

6.21 ANSWERS TO CHECK YOUR PROGRESS QUESTIONS

1. Uniform Regulations for Banks Operating in the United States.

States. A key act
related to international banking was the International Banking Act (IBA) of 1978,
designed to impose similar regulations across domestic and foreign banks doing
business in the United States. Prior to the Act, foreign banks had more flexibility
to cross state lines in the United States than U.S.-based banks. The IBA required
foreign banks to identify one state as their home state so that they would be
regulated like other U.S.-based banks residing in that state. The stock prices of
money center banks increased in response to the announcement Regional banks
did not experience a significant stock price reaction. This may have resuited from
provisions in the IBA that would allow foreign bank to become more competitive
in the united States at the retail level. Such provisions are of more concern to
regional banks than wholesale-oriented money center banks and could offset any
favorable consequences of other IBA provisions on regional banks.
2. Use of the Brady plan to Reduce LDC Debt Exposure over
over the period from 1985
to 1988 a plan was endorsed as a means of mitigating the LDC debt crisis. The
plan was based on voluntary actions by lenders to reduce their exposure. In
December 1988, the World Bank proposed a gradual implementation of the plan,

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along with its commitment to provide loans to LDCs in place of bank loans and
impose economic reforms on the LDCs. During 1989 the plan gained momentum
as the International Monetary Fund signaled its willingness to replace LDC debt
maintained by banks. In what then became known as the Brady Plan, negotiations
between banks and individual LDCs were encouraged in order to provide banks
with the option of having their debt replace by the World Bank and IMF by
trading it in at a discount. In July 1989 banks reached an agreement with Mexico
in which they were given the following options: (1) agree to a 356 percent cut in
the principal or interest on loans, or (2) grant new loans equal to 25 percent of the
Mexican loans. Essentially, the trade-off involved either recognizing losses on
previous loans while reducing exposure or increasing investment in LDCs without
incurring immiediate losses. The agreement could improve Mexico’s position
because it reduces the amount Mexico owes on existing debt and allows for
additional loans from banks. In this way Mexico may be more able to improve its
debt servicing, which would enhance investors’ perceptions of Mexican debt
maintained by banks. The agreement between banks and Mexico is encouraging
because it could pave the way for agreements with other countries.
A dilemma involved in resolving the crisis is that if all banks prefer to discontinue
loans to LDCs by writing off all or a portion of existing loans, the LDCs may be
unable to secure adequate financing to improve economic conditions. The LDCs’
only chance to repay existing loans is by economic reform, which requires more
loans. Yet many banks may feel that providing additional loans is like “throwing
good money after bad.” For this reason, the use of World Bank and IMF funds to
assume commercial bank debt at some discounted price could help resolve the
ongoing crisis.
Although the impact of the international debt crisis is not over, commercial banks
are more prepared to deal with it than they were in the 1980s. The crisis has
demonstrated that diversifying loans among foreign countries does not guarantee
low risk and that loans for foreign governments are not risk-free. These lessons
have changed the long-term planning of commercial banks.

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3. COUNTRY RISK ASSESSMENT
Banks have historically used country risk analysis for measuring the risk of loans
to foreign governments. County risk assessment systems have recently received
more attention as a result of the international debt crisis. Those banks that were
highly exposed to the loans of the problem LDCs either had a poor country risk
assessment system or did not take their assessment seriously. Although each bank
has its own unique assessment system, most systems involve identifying factors
that influence country risk and then weighting these factors. Some of the factors
can be measured in an objective fashion, while others must be measured
subjectively. An effective country before they occur, allowing banks to avoid
lending to those countries or at least to reduce their existing loan exposure to
those contras some of the more important factors that affect country risk are:
o Economic indicators
o Debt management
o Political factors
o Structural factors
Short-term and medium-term models of these four aspects can be developed to
determine an overall short-term ratting for a country and an overall medium-term
rating
Economic indicators
o The economic indicator model evaluates the country’s economic
environment. Some of the more relevant factors for this model are
o Changes in their consumer price index
o Real growth in gross domestic product
o Current account balance divided by exports

A statistical the technique called discriminate analysis can be applied to these and
other economic indicators to determine how they influence debt –repayment
problems. This analysis creates a function that can be used to assign an overall
rating to the country’s economic indicators.

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Debt Management
The debt management model evaluates a county’s ability to manager debt. The
more relevant variables for rating debt management include:
o Debt service and short-term debt divided by total exports
o Ratio of total debt to gross domestic product
Short –term debt divided by total debt
Other thing being equal, the debt service and short –term debt are relative to
expert or to gross domestic product, the higher the probability that a country
would experience debt-repayment problems. The ratio of short-term debt to total
debt indicates the percentage of debt principal that must be repaid in the near
future. A high percentage could cause cash flow problems in the near future. In
addition, countries with a high percentage are usually more vulnerable to interest
rate movements.

Political Factors
The political rating model is used to measure governmental characteristics and
political stability. The political factors are generally measured subjectively and
include the following
o Probability of destabilizing riots or civil unrest
o Probability of increased terrorist activities
o Probability of civil war
o Probability of foreign war
o Probability of government overthrow
Each factor can be assigned a probability ranging from 1 (extremely likely) to5
(extremely unlikely).

Structural Factors
The structural rating model measures socioeconomic conditions. Some of the
more important structural factors are.
o Natural resource base

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 o Human resource base
o Leadership
These factors are also subjectively rated
4. Uniform Capital Adequacy Guidelines Around the World. Before 1987,
capital standards imposed on banks varied across countries, which allowed some
banks to have a comparative global advantage over others. As an example,
consider a bank in the United States that is subject to a 6 percent capital ratio that
is twice that of a foreign bank. The foreign bank could achieve the same return
on equality as the U.S. bank by generating a return on assets that is only one-half
that of the U.S. bank. In essence, the foreign bank’s leverage measure (assets
divided by equity) would be double that of the U.S. bank, which would offset the
low return on assets. Given these conditions, foreign banks could accept lower
profit margins while still achieving the same return on equity. This affords them
a stronger competitive position. In addition, growth is more easily achieved, as a
relatively small amount of capital is needed to support an increase in assets.
Some analysts would counter that these advantages are somewhat offset by the
higher risk perception of banks having low capital ratios. Yet, it the governments
in those countries are more likely to back banks that experience financial
problems, banks with low capital may not necessarily be too risky. Therefore,
some non-U.S. banks had globally competitive advantages over U.S banks with
out being subject to excessive risk. In December 1987, 12 major industrialized
countries attempted to resolve the disparity by proposing uniform bank standards.
In July 1988, central bank governors of the 12 countries agreed on standardized
guidelines. Briefly, capital was classified as either Tier 1 capital (which is
primarily retained earnings or funds obtained from issuing stock) or Tier 2 capital
(which includes loan loss reserves and some forms of long-term debt). Tier 1
capital must be at least 4 percent of risk-weighted asset. The use of risk
weightings on assets implicitly caused a higher capital ratio for riskier assets,
because those assets were assigned lower weights. Off-balance sheet items were
also accounted for so that banks could not circumvent capital requirements by
focusing on services (such as letters of credit and interest rate swaps)that are not

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 explicitly shown on a balance sheet. Even with uniform capital requirements
across countries, some analysts may still contend that U.S. banks are at a
competitive disadvantage because they are subject to different accounting and tax
provisions. Nevertheless, the uniform capital requirements represent significant
progress toward a more level global field.

6.22 MODEL EXAMINATION QUESTIONS

1. Explain the operations of foreign branches of U.S. banks.

2. What are Edge Act corporations?
3. What was the purpose of the International Banking Act (IBA)?
4. In what ways has the Japanese government recently deregulated its financial
markets?
5. Explain how banks become exposed to exchange rate risk.
6. Oregon Bank has branches overseas that concentrate in short-term deposits in
dollars and floating-rate loans in British pounds. Because it maintains rate
sensitive assets and liabilities of equal amounts, it believes it has essentially
eliminated its interest rate risk. Do you agree? Explain.
7. Explain how the Brady plan was intended to deal with the international debt
crisis.
8. Why were many LDCS generating less cash flow than the anticipated prior to the
international debt crisis?
9. How did the strengthening dollar during the early 1980s affect the ability of LDCs
to repay the loans to U./S banks?
10. Explain why LDCs increased their negotiating power when they joined together
to announce their inability to repay loans.
11. Theory suggests that diversification of loans among countries can insulate a
bank’s loan portfolio from any single event. Yet the international debt crisis
devastated the market value of loan portfolios of some large
12. Identify the four major aspects of a country that are commonly analyzed by
country risk assessment systems. How can evaluations of these aspects be used to
determine an overall rating for the country?

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13. Explain how the single European Act affects international banking.
14. Explain how the new global capital requirements can discourage banks from
taking excessive risk.
15. Explain why Japanese banks have found it feasible to expand even when the
expected return on these ventures may not be sufficient for U.S. banks.
16. How may banks facilitate the trend toward privatization in Eastern Europe?

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