International Banking
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ib_crossrisk1.pdf
International Banking
Managing cross-border risk
2
Learning outcomes
Review the strategic rationale for international banking
Understand how international banks reach their clients
Comprehend risk transmission through international bank
subsidiaries using examples
Define what is country risk
Identify methods for measuring country risk
Qualification of different types of risk
Case study: Swiss Bank Corporation’s assessment of political
risk in China
Strategic explanations
Gain new customers (M&A, subsidiaries, branches)
Obtain a foothold (test the market first)
Follow the leader – herd instinct; follow the customer
Profit / efficiency gains – careful … market power
Managerial motives – careful … expense preference
Government motives – liberalise to promote competition 3
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Reaching international clients
How do banks structure their international operations?
Correspondent banking
Least amount of foreign exposure
Domestic bank provides services to the foreign bank
e.g. forex & trade-related services for multinational customers
foreign bank does not incur costs of a physical presence
correspondents refer foreign partners (re syndication)
Representative office
Physical presence but limited functions
act as marketing tools for foreign parent banks
useful when domestic regulations forbid foreign bank entry
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Reaching international clients
Branch office
Higher level of commitment - a legal part of the parent bank
fairly independent with respect to decision making; can take deposits & make loans (unlike rep office); mainly wholesale lending; but, not separately capitalised from parent - problem?
Agency
falls between branch & rep office in terms of functions
used primarily for wholesale int’l commercial lending
Subsidiary
separate legal entity from parent bank
organised under laws of host country
can engage in full array of services of host country
can be used to circumvent restrictive regulations
separately capitalised - costly & could compete with parent
Consortium banks
strategic alliance of partners. Not so popular anymore
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Risk transmission:
micro prudential issues
Compare offshore & onshore banks …
offshore can more freely manage their balance sheets since they are subject to less regulations
offshore banks tend to be more profitable and liquid
offshore banks tend to be less solvent and less risk-averse
onshore banks can exploit the risk-return trade-off offshore to boost ROE (through increased risk)
But, offshore risks are ultimately borne onshore
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Risk transmission:
macro prudential issues
1. Downloading offshore funds … risk transmission off- to onshore possible (if capital a/c restrictions absent)
downloading funds off-to onshore maturity mismatch & risks … liquidity; credit; solvency; and foreign exchange risks
large, ST foreign-currency funds rapidly parents’ balance sheets … parent capital bases can be built up but ST vulnerability rises
2. Uploading onshore funds … problem assets uploaded to circumvent onshore regulations …
uploading can occur offshore establishment is larger than onshore
by exploiting prudential arbitrage and using uploaded funds to finance offshore business onshore risks are concentrated offshore
a large, leveraged, illiquid (at worst insolvent) offshore bank can sink its onshore parent bank
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Offshore banking & financial crises
The Asian experience of the 1990s …
large capital inflows credit expansion exposures to risks
prudential & fiscal arbitrage led onshore banks (& firms) into int’l capital
markets via offshore subsidiaries
1. Thailand …
By mid-90s, ST capital inflows = 60% of capital a/c; 66% of ST inflows
intermediated via Bangkok IBFs …
BIBFs domestic foreign currency loans/total sector credit to 17% in 1996.
Lending was generally unhedged to foreign exchange risk; $32 billion in 1996
BIBFs sourced funds mainly from their foreign branches; ST but rolled over since
branches borrowed LT to finance lending to parent BIBFs
2. Malaysia & Korea …
analysis of asset quality/condition of Malaysian banks in Labuan …
improve disclosure; intensify monitoring of OBS; consolidated accounting
Korea liberalised capital a/c 1993-96 …
but, restrictive ceilings on banks’ borrowing of foreign MT-LT funds forced them
offshore to bank subsidiaries of chaebol
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Offshore banking and financial crises
The experience in Latin America in the 1990s …
OFCs not intermediaries for regional capital inflows …
alternatives to domestic regulations & capital controls
regional political instability promoted OFCs as safe havens …
fuelled uploading of bank assets and liabilities from on-to offshore
a lack of effective consolidated supervision prudential arbitrage
1. Argentina - Tequila crisis, 1995 …
before crisis banks operated 2 types of offshore establishment …
subsidiaries of large provincial banks; & shell branches of wholesale banks
were offshore banks immune to country risks?
Aim: to avoid capital, liquidity, credit portfolio diversification & disclosure regs
But, exposed to emerging markets offshore banks failure of onshore parents
2. Venezuela – 1994 …
no effective consolidated supervision offshore vehicles exploited PA …
universal banking let financial groups (led by banks) hide losses
bank risk due to investments made by offshore establishment
Government compensation downloading of offshore liabilities to onshore
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Debt crises characteristics
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Country risk – a definition
All cross-border lending involves country risk …
1. Unsystematic risk
e.g. credit risk & foreign direct investment risk
can be diversified close to zero through portfolio changes
2. Systematic risk
e.g. transfer risk (able to pay, unable to convert)
e.g. sovereign risk (government default) &
e.g. exchange risk (variability affects ratings)
this risk limits banks’ ability to diversify unsystematic risk in managing
its portfolio in a particular country
but, it can be made unsystematic through international portfolio
diversification i.e. operating in more than one country
3. Ambient risk (transcends national political boundaries)
is systematic because it limits positive effects of IPD
switch into non-financial assets like gold, property to hedge against
financial turmoil e.g. Asian crisis; Great depression
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Measuring country exposure
Banks must know their levels of exposure to the following …
industries
countries
regions
Why? Since default affects many clients simultaneously
3-dimensions of global exposure tracking
Banks will set limits on country exposure …
they often establish sub-limits for different maturities
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Dimensions of global tracking
Source: Smith and Walter
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Valuation of country exposure
Aim: maximise value of cross-country portfolio
Key words: expected return, variance, risk
NPVj = E (Ft) - E (Ct) t = 0 (1 + it + αt)
t
CB exposure effects E(Ft) (returns), E(Ct) (costs) & αt (risk)
Each element has its own time profile and expected value
calculating net expected returns is complex
Likewise, calculating the risk associated with net expected returns is complex, e.g. determining interest rate risk
The components of net expected returns are …
repayment of principal; stream of interest payments; & fees relating to banks’ commitment
Importance of relationships re syndication
Collecting on defaulted loans is expensive
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Factors influencing NPV in country j
Country j …
May be unwilling or unable to repay - very rare today
Cannot meet external debt obligations …
forced to reschedule debt but not at market rates
can involve extended maturity, further credit and so on
ties up bank capital
Repays but credit rating so risk & value of bank assets
What factors affect country risk?
How can banks forecast future prospects?
VX - VM - DS + FDI + U - K = DR - NBR
A negative balance on the left means a country has to NBR or
DR. Implies a future in DS
Various internal & external shocks impact on debt service
obligations, & on NPVj
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Domestic economic issues
Source: Smith and Walter
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National economic management
How do the workings of an economy affect a country’s ability to service its debt?
1. Supply-side measures: labour force data; natural resources and productivity. Are past data reliable for making projections?
Government policies affecting domestic savings & investment, capital flight, FDI, business risk, economic & social conditions
2. Demand-side measures: taxation, govt. expenditure, fiscal soundness of public sector, demand for g&s from private & export sectors
Forecasting needs accurate data & is more difficult over long periods
forecasting monetary factors is difficult
disentangling the effects of government policy responses like devaluation, liberalisation is difficult
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External economic aspects
Banks need to measures those flows that impact on a country’s debt
service capabilities …
e.g. balance of trade, current account. Medium-to-long term projections
Debt service is determined by availability of foreign exchange …
for exports, banks examine ST and LT trends
alignment of exports with international competitive advantages
diversification of export risk, policies threatening future export earnings
for imports, banks examine ST & LT trends
import price volatility
concentration of loans/deposits among trading partners
All analyses should refer to the policy context
e.g. tariffs, protectionism, domestic resource allocation/productivity
foreign direct investment alters country profile/credit rating
grant aid requires analysts’ attention
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Liquidity and debt
Consider a country’s reserves and its IMF position …
overseas borrowing / refinancing existing debt depends on the projected state of financial markets & creditworthiness of a country by international banks/institutions
Measure borrower indebtedness & debt service ability …
debt service ratio = debt service payments to exports
ignores effects of import savings
cash flow index = R + A + LC + T / DS
If the CFI < 1 additional borrowing will be required to finance debt servicing for that year
interpret ratios with caution & with respect to a specific context. Show how banks perceive a country’s situation
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Political aspects
Banks place great emphasis on political aspects … international banks want to evaluate the debt service capability
of a country in which it carries out business
Do debtor governments have the power, will, competence to achieve debt service reductions? is a govt receptive to outside advice?
advice can have political cost
e.g. increased taxes, devaluation, monetary restraint
IMF action reassures international banks … but support is conditional on country undertaking reforms that
may be unpopular with domestic residents
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Country risk assessment
International banks collate / interpret vast & complex information …
Qualitative assessments - country reports
but cross-country comparisons are difficult
Structured country reviews - formatted approach using standard ratios
(for cross country comparisons) & field visits
but this approach de-emphasises political risk
Country ratings - assign weighted values to quantitative & qualitative
variables
captures historical evidence and future outlook
heavily subjective & often ignores non quantifiable information
Country evaluation filters - multiple discriminate analysis
here the focus is on past data
Outside views - second opinions, expertise?
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Country decision
Solid lines = reporting relationships;
Dashed lines = information flows;
CRA = country risk assessment;
SICOF = senior international credit
offices;
IBG = international banking group;
O/S = overseas offices
Source: Smith and Walter
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Making the decisions that count
Country exposure must be correctly measured … using appropriate array of measurement techniques
measurements should be frequently updated
Decentralisation creates closer client relationships, quicker response times … large international banks typically have country desks
General approaches fail to concentrate on the true sources of risk in country exposure … country risk analysis must be specific
A complex task … implies bankers require more training
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Country assessment profile, PRC
Source: Smith and Walter
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Political risk assessment, PRC
Source: Smith and Walter
