UNIT 8.

INTERNATIONAL CAPITAL MARKETS

Bankruptcy. Legal status of an insolvent person or an organization.

Moral hazard. Tendency to take risks because we don’t assume costs.

Lender of Last Resort. Institution that protects depositors and prevents widespread panic

withdrawal.

Tax havens. Countries where taxes are low.

1. OFFSHORE BANKING

Offshore banking refers to banking (international bank operations) outside of the boundaries of a

country.

Companies open bank accounts or conduct financial transactions in a country other than the one

where they are resident. The term “offshore” refers to the fact that these countries are typically

located far away from the country of residence.

Offshore banking is often associated with tax optimization, asset protection, and financial privacy.

Some countries that offer offshore banking services are known as tax havens, as they have

favorable tax regimes and strict bank secrecy laws.

1.1. REASONS FOR INTERNATIONAL BANKING

i. Low marginal costs. Managerial and marketing knowledge developed at home can be

used abroad with low marginal costs.

ii. Knowledge advantage. The foreign bank subsidiary can draw on the parent bank’s

knowledge of personal contacts and credit investigations for use in that foreign market.

iii. Home nation information services. Local firms in a foreign market may be able to obtain

more complete information on trade and financial markets in the multinational bank’s

home nation than is obtainable from foreign domestic banks.

iv. Prestige. Very large multinational banks have high perceived prestige, which can be

attractive to new clients.

 v. Regulatory advantage. Multinational banks are often not subject to the same regulations

as domestic banks.

vi. Wholesale defensive strategy. Banks follow their multinational customers abroad to avoid

losing their business at home and abroad.

vii. Retail defensive strategy. Multinational banks also compete for retail services such as

travelers checks, tourist and foreign business market.

viii. Transactions costs. Multinational banks may be able to circumvent government currency

controls.

ix. Growth. Foreign markets may offer opportunities to growth not found domestically.

x. Risk reduction. Greater stability of earnings due to diversification.

1.2. TYPES OF OFFSHORE BANKING

There are at least four types of offshore banking institutions, which are regulated differently:

 Agency office. An agency office in a foreign country makes loans and transfers, but

does not accept deposits, and is therefore not subject to depository regulations in either

the domestic or foreign country.

 Subsidiary bank. A subsidiary bank is a locally incorporated bank wholly or partly owned

by a foreign parent. Non-controlling subsidiary is referred to as an affiliate bank. A

subsidiary bank in a foreign country follows the regulations of the foreign country, not the

domestic regulations of the domestic parent.

 Foreign branch. A foreign branch bank operates like a local bank but is legally part of

the parent. Subject to both the banking regulations of home country and foreign country.

 International banking facilities. An international banking facility is a separate set of

accounts that are segregated on the parents books. An international banking facility is

not a unique physical or legal identity. Banks that accept time deposits and make loans to

foreign customers. They are not subject to reserve requirements or interest rate ceilings.

They are exempt from state and local taxes. They have captured a lot of the Eurodollar

business that was previously handled offshore.

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2. OFFSHORE CURRENCY TRADING

An offshore currency deposit is a bank deposit denominated in a currency other than the

currency that circulates where the bank resides.

An offshore currency deposit may be deposited in a subsidiary bank, a foreign branch, a foreign

bank or another depository institution located in a foreign country. Offshore currency deposits are

sometimes (unfortunately) referred to as eurocurrencies, because these deposits were

historically made in European banks.

2.1. EVOLUTION

Offshore currency trading has grown for three reasons:

i. Growth in international trade and international business: firms need financial

services.

ii. Avoidance of domestic regulations and taxes.

iii. Political factors: cold war, move to floating exchange rates in 1973, reluctance of

Arab OPEC members to place surplus funds in American banks after the first oil

shock.

2.2. RESERVE REQUIREMENTS

Reserve requirements are the primary example of a domestic regulation that banks have tried

to avoid through offshore currency trading.

Depository institutions in the US and other countries are required to hold a faction of domestic

currency deposits on reserve at the central bank. These reserves can’t be lent to customers and

do not interest in many countries; therefore, the reserve requirement acts a tax for banks.

Offshore currencies in many countries are not subject to this requirement, and thus the total

amount of deposits can earn interest if they become offshore currencies. Deposits in local

currency are more regulated to control money supply.

2.3. ATTRACTIONS

- It gave opportunity to those who wanted to deposit or borrow dollars (later, other

currencies, as well).

- Lack of government regulations make the Eurocurrency attractive.

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 - Banks offer higher interest rates.

2.4. DRAWBACKS

- Unregulated system could result in loss of deposits.

- Borrowing funds internationally can expose a company to foreign exchange risk.

3. REGULATION OF INTERNATIONAL BANKING

3.1. BANKS FAILURE

Banks fail because they do not have enough or the right kind of assets to pay for their liabilities.

The principal liability for commercial banks and other depository institutions is the value of

deposits, and banks fail when they cannot pay their depositors.

If many loans fail or if the value of assets decline in another manner, then liabilities could become

greater than the value of assets and bankruptcy could result. But not only depositors are

affected, but also the metronomic stability. If there is a general mistrust on the financial system.

In many countries there are several types of regulations to avoid bank failure (financial collapse).

3.2. REGULATIONS

3.2.1. CAPITAL ADEQUACY STANDARDS

Bank capital adequacy refers to the amount of equity capital and other securities a bank holds as

reserves. There are various standards and international agreements regarding how much bank

capital is enough to ensure the safety and soundness of the banking system. While traditional

bank capital standards may be enough to protect depositors from traditional credit risk, they may

not be sufficient protection from derivative risk.

3.2.2. DEPOSIT INSURANCE

Insures depositors against losses up to $100.00 in the US when banks fail. Prevents bank panics

due to a lack of information: because depositors cannot distinguish a good bank from a bad one,

it is in their interests to withdraw their funds during a panic when banks do not have deposit

insurance. Creates a moral hazard for banks to take on too much risk.

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Moral hazard is a hazard that a borrower will engage in activites that are undesirable from the

less informed lender’s point of view.

3.2.3. RESERVE AND CAPITAL REQUIREMENTS

Banks are historically required to maintain some deposits on reserve at the central bank in case

of emergencies.

Higher bank capital allows banks to protect themselves against bad loans and investments. By

preventing a bank form holding risky assets, asset restrictions reduce risky investments. By

preventing a bank from holding too much of one asset, asset restrictions also encourage

diversification.

3.2.4. BANK EXAMINATION AND LENDER OF LAST RESORT

Regular examination prevents banks from engaging in risky activities.

In the US, the Federal Reserve may lend to banks with large deposit outflows. Prevents bank

panics. Acts as insurance for depositors and banks, in addition to deposit insurance. But

increases moral hazard for banks to take on too much risk.

4. DIFFICULTIES IN REGULATING INTERNATIONAL BANKING

4.1. DIFFICULTIES

Deposit insurance in the US covers losses up to $250.000, but since the size of deposits in

international banking is often much larger, the amount of insurance is often minimal.

Reserve requirements also act as a form of insurance for depositors, but countries cannot

impose reserve requirements on foreign currency deposits in agency offers, foreign branches, or

subsidiary banks of domestic banks.

Bank examination, capital requirements and asset restrictions are more difficult internationally.

Distance and language barriers make monitoring difficult. Different assets with different

characteristics exist in different countries, making judgment difficult. Jurisdiction is not clear in the

case of subsidiary banks.

No international lender of last resort for bank exists, the IMF sometimes acts as a lender of last

resort for governments with problems in the balance of payments. The activities of non-bank

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financial institutions are growing in international banking, but they lack the regulation and

supervision that banks have. New and complicated financial instruments like derivatives and

securitized assets make it harder to assess financial stability and risk. A securitized asset is a

small part of many combined assets with different risk characteristics.

4.2. COOPERATION

4.2.1. INTERNATIONAL REGULATORY COOPERATION

Basel Committee. It is a group of central bank heads from 11 industrialized countries. The

purpose is to increase coordination on the monitoring of national authorities over the international

bank system. It enhances regulatory cooperation in the international area. Its 1975 Concordat

allocated national responsibility for monitoring banking institutions and provided for information

exchange.

Basel accords. Provided standard regulations and accounting for international financial

institutions. In 1998 accords tried to make bank capital measurements standard across countries.

It developed risk-based capital requirements, where more risky assets require a higher amount of

bank capital. A major change in international financial relations in the 1990s has been the rapidly

growing importance of new emerging markets as sources and destinations for private capital

flows. Their financial institutions are more weak. Core principles of effective banking supervision

was developed by the Basel Committee in 1997 for developing countries without adequate

banking regulations and accounting standards.

4.2.2. THE BASEL III

In December 2009, Basel Committee issued two consultative documents: strengthening the

resilience of the banking sector, and international framework for liquidity risk measurements,

standards and monitoring.

The objectives were two: improving banking sector’s ability to absorb shocks and reducing risk

spillover to the real economy.

4.3. CHALLENGES

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The trend toward securitization has increased the need for international cooperation in

monitoring and regulating nonbank financial institutions. Securization is the aggrupation of

different bank assets in order to be easily tradable.

5. HOW WELL HAS THE INTERNATIONAL CAPITAL MARKETS PERFORMED?

5.1. EXTENT OF INTERNATIONAL PORTFOLIO DIVERSIFICATION

In 2003, US owned assets in foreign countries represented about 35% of US capital, while

foreign assets in the US was about 48% of US capital. These percentages are about 5 times as

large as percentages from 1970, indicating that international capital markets have allowed

investors to increase diversification. Likewise, foreign assets and liabilities as a percent of GDP

has grown for the US and other countries.

The international capital market has contributed to an increase in international portfolio

diversification since 1970. Consumers benefit because they diversify risk through more assets

and allocate capital in more productive investments. The extent of diversification appears small

compared with what economic theory would predict.

5.2. EXTENT OF INTERTEMPORAL TRADE

Some observers claim that the extent of international trade, as measured by countries’ currency

account balances, has been too small. These claims are hard to evaluate.

If some countries borrow for investment projects whole others lend to these countries, then

national saving and investment levels should not be highly correlated. Some countries should

have large current account surpluses as they save a lot and lend to foreign countries. Some

countries should have large current account deficits as they borrow a lot from foreign countries.

National saving and investment levels are highly correlated.

5.3. EXTENT OF INFORMATION TRANSMISSION

If the world capital market is functioning well, international interest rates should move closely

together and not differ too greatly. We should expect that interest rates on offshore currency

deposits and those on domestic currency deposits within a country should be the same if:

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 - The two types of deposits are treated as perfect substitutes.

- International capital markets can quickly and easily transmit information about any

differences in rates.

Differences in interest rates have approached zero as financial capital mobility has grown and

information processing has become faster and cheaper through computers and

telecommunications.

5.3.1. THE EFFICIENCY OF THE FOREIGN EXCHANGE MARKET

Exchange rates provide important signals to those who engage in international trade and

investment. If assets are treated as perfect substitutes, then we expect interest party to hold on

average.

Under this condition, the interest rates difference is the market’s forecast of expected changes in

the exchange rate. If we replace expected exchange rates with actual future exchange rates, we

can test how well the market predicts exchange rate changes.

But interest rate differentials fail to predict large swings in actual exchange rates and even fail to

predict which direction actual exchange rates change.

5.3.2. THE ROLE OF RISK PREMIUMS

Given that there are few restrictions on financial capital in most major countries, does this mean

that international capital markets are unable to process and transmit information about interest

rates? Not necessarily. If bonds denominated in different currencies are imperfect substitutes for

investors, the international interest rate difference equals expected currency depreciation plus a

risk premium.

Interest rates differentials are associated with exchange rate changes and with risk premiums

that change over time. Changes in risk premiums may drive changes in exchange rates rather

than interest rate differentials.

Since both expected changes in exchange rates and risk premiums are functions of expectations

and since expectations are unobservable. It is difficult to test if international capital markets are

able to process and transmit information about interest rates.

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In fact, it is hard to predict exchange rate changes over short horizons based on money supply

growth, government spending growth, GDP growth and other fundamental economic variables.

The best prediction for tomorrow’s exchange rate appears to be today’s exchange rate,

regardless of economic variables. But over long time horizons economic variables do better at

predicting actual exchange rates.