An International Banking And Finance Project.

(Prof. Lalita Khurana)

Compiled By: Neha Soningra TYBBI 50.

Q1. Explain the origin, features and functions of international banking. Evaluate its existing structure and importance with reference to India.
All the Banking and monetary non monetary financial banking transactions crossing national boundaries is termed as international banking.

Origin: The first noted international bankers were the Knights Templars (1200 AD). They created safe depositories where lords could leave their treasure in safekeeping while on pilgrimage. This early form of banks which were created across Europe and Middle East from France to Jerusalem were the first international banks.

Features of International Banking

a) Currency risk: International Banks operate in different currencies. Currencies may weaken or strengthen with respect to each other. Accordingly wealth value of the bank may vary. This is a significantly sensitive aspect in International arena.

b) Complexity of credit risk: Credit risk has additional dimensions of sovereign-political risk and also socio-cultural factor about honoring credit.

c) Competition for market share among banks: Competition is stiff because of presence of many giant bankers. This is in effect reduces margins and demands highly efficient performance.

d) Cyclical nature, with periodic crises:

World economies are not moving in unison. Cycles of growth and recession move from one continent to another. Multinational Banks face these waves and also occasional crises such as crash of an economy.

e) Competition for bank loans from the international bond market: Threat of disintermediation is more because international banking has many big value transactions which may eventually bypass banks. Bond market is matured in developed countries, even for foreign currency denominated bonds.

f) Importance of international interbank market (IIBM) as source of liquidity and funding for banks: Interbank transactions in multiple currencies are common in International Banking. In effect bankers enjoy better liquidity solutions.

g) Role of risk management activities: Being in forex market, banks deal with additional

hedging instruments such as currency futures, options, etc.

Functions of International Banking:

1. Customer related functions: (a) Trade finance: This includes export avenues like preshipment export credit, post shipment export credit, export bill rediscounting, letter of credit and value added services like gold card.It also includes import avenues like foreign currency import credit, suppliers credit and bank guarantees. (b) International merchant banking: It includes international loan syndication, arranging external commercial borrowings in the form of commercial loans, loans backed by export credit agencies, lines of credit from foreign banks and financial institutions and import finance for Indian corporate.

(c) Finance of project export: This includes non-fund based activities such as letter of credit facility and guarantees like bid bond guarantee, advance payment guarantee, performance guarantee, retention money guarantee, maintenance guarantee and overseas borrowing guarantee. It also includes fund based activities like pre-shipment credit, foreign currency suppliers credit and buyers credit (d) Derivatives offering (e) Remittances 2. Compliance related functions: Banks has to continuously monitor all the transactions to ensure adherence to regulatory provisions e.g. FEMA in India and also relevant central bank circulars (RBI). 3. Inter-bank functions: Banks maintain correspondent banking relation with many banks in many countries. The accounts such as Nostro, Vostro and Loro and also mirror accounts are to be financed and monitored.

4. Internal functions: This includes branch management, communication, accounting, risk management, forex markets, and settlement within various offices, money market investments of bank and treasury functions. Structure: International banking structure includes central bank and commercial banks. They provide liquidity in the exchange markets. While central banks act as implementers of government policy, commercial banks provide one of the main conduits for the flow of foreign exchange transactions. Central banks have a greater role in foreign exchange market for countries whose exchange rates are not allowed to float freely. In a country where market forces decide exchange rates, central banks usually perform two vital roles: monitoring the foreign exchange market and intervening when policy dictates.
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The following factors highlight the importance of international banking in India: 1. Contribution of service sector to Indias GDP is growing. Service sector would need greater support from banks. 2. Agriculture provides largest pool of jobs. Banks need to address the need of agro-industry. 3. Banks can contribute in all the sectors for generating savings, capital formation and help increase income levels. 4. International banks are vital for the growth of import and export.

Q2) Explain ASSET LIABILTY MANAGEMENT in Banks.

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Asset liability management (ALM) in limited context, is a system of matching cash inflows and outflows, and thus of liquidity management. Hence, if a bank meets its cash reserve ratio and statutory liquidity ratio stipulations regularly without undue and frequent resort to purchased funds, it can be said to have a satisfactory system of managing liquidity risks, and , hence, of ALM.

Banks are always aiming at maximizing profitability at the same time trying to ensure sufficient liquidity to repose confidence in the minds of the depositors on their ability in servicing the deposits by making timely payment of interest/returning them on due dates and meeting all other liability commitments as agreed upon. To achieve these objectives, it is essential that banks have to monitor, maintain and manage their assets and liabilities portfolios in a systematic manner taking into account the various risks involved in these areas. This concept has gained importance in Indian conditions in the wake of the ongoing financial sector reforms, particularly reforms relating to interest rate deregulation. The technique of managing both assets and liabilities together has come into being as a strategic response of banks to inflationary pressure, volatility in interest rates and severe recessionary trends which marked the global economy in the seventies and eighties.

The two types of banks balance sheet risks include interest rate risk and liquidity risks. Their regular monitoring and managing is the need of the hour. Banks should use the information about these risks as key input in their strategic business planning process. While increasing the size of the balance sheet, the degree of asset liability mismatch should be kept in control. Because, the excessive mismatch would result in volatility in earnings. Banks can also use sensitivity analysis for risk management purpose. Assets and Liabilities Management (ALM) is a dynamic process of planning, organizing, coordinating and controlling the assets and liabilities their mixes, volumes, maturities, yields and costs in order to achieve a specified Net Interest Income (NII). The NII is the difference between interest income and interest expenses and the basic source of banks profitability. The easing of controls on interest rates has led to higher interest rate volatility in India. Hence, there is a need to measure and monitor the interest rate exposure of Indian banks. The actual concept of ALM is however much wider and of greater importance to banks performance. Historically, ALM has evolved from the early practice of managing liquidity on the banks asset side, to a later shift to the liability side, termed liability management, to a still later realization of using both the assets as well as liabilities sides of the balance sheet to achieve optimum resources management.

ALM functions and its growing importance:

1. In the 1980s, volatility of interest rates in USA and Europe caused the focus to broaden to include the issue of interest rate risk. ALM began to extend beyond the bank treasury to cover the loan and deposit functions. 2. The induction of credit risk into the issue of determining adequacy of bank capital further enlarged the scope of ALM in later 1980s. 3. in the current decade, earning a proper return on bank equity and hence maximization of its market value has meant that ALM covers the management of entire balance sheet of the bank 4. The bank managements are now expected to target required profit levels and ensure minimization of risks to acceptable levels to retain the interest of investors in their banks. This also implies that ALM encompasses costing and pricing policies in comprehensive sense. ALM is a system of matching cash inflows and outflows, and thus of liquidity management. Balance sheet risk can be categorized into two major types of significant risks, which are liquidity risk and interest rate risk. The ALM system rests on three pillars, i.e.,

a) ALM Information system (MIS) b) ALM organization (Structure and responsibilities) and c) ALM Process (Risk parameters, identifying, measuring, managing risks and setting risk policies and tolerance levels). Interest rate risk is the risk to earnings or capital arising from movement of interest rates. It arises from differences between the timing of rate changes and the timing of cash flows (repricing risk); from changing rate relationships among yield curves that affect bank activities (basis risk);from changing rate relationships across the spectrum of maturities (yield curve risk); and from interest-raterelated options embedded in bank products (option risk). The value of a banks assets, liabilities, and interest-rate-related, off-balance-sheet contracts is affected by a change in rates because the present value of future cash flows, and in some cases the cash flows themselves, is changed. For measuring interest rate risk, banks use a variety of method such as gap analysis, the duration gap method, the basis point value (BPV) method, and simulation methods. Interest rate risk is measured through the use of re-pricing gap analysis and duration analysis. Liquidity risk is measured through gap analysis. Since the banks balance sheet consists predominantly of rupee assets and liabilities, movements in domestic interest rates constitute the main source of interest rate risk. Exposure to fluctuations in interest rates is measured primarily by way of gap analysis, providing a static view of the maturity and re-pricing characteristics of balance sheet positions. An interest rate gap report is prepared by classifying all assets and liabilities into various time period categories according to contracted maturities or anticipated re-pricing date. The difference in the amount of assets andliabilities maturing or being re-priced in any time period

category, would then give an indication of the extent of exposure to the risk of potential changes in the margins on new or re-priced assets and liabilities. The ALM concept though in vogue since 1997, its inherent complexities in obtaining accurate timely information from the gross root level makes the banks in not getting the full advantage of it. The computerized environment has helped the banks to achieve the objective of MIS in the area of collection of accurate and timely data required for risk management.

Q.3) Discuss advantages of Euro Bounds to investors and borrowers.

Euro Bonds : A bond underwritten by an international syndicate of banks and marketed internationally in countries other than the country of currency in which it is denominated. The issue is thus not subject to national restriction. The Eurobond market is made up of investors, banks, borrowers, and trading agents that buy, sell, and transfer Eurobonds. Eurobonds are a special kind of bond issued by European governments and companies, but often denominated in non-European currencies such as dollars and yen. They are also issued by international bodies such as the World Bank. The creation of the unified European currency, the euro, has stimulated strong interest in eurodenominated bonds as well; however, some observers warn that new European Union tax harmonization policies may lessen the bonds' appeal.

Eurobonds are unique and complex instruments of relatively recent origin. They debuted in 1963, but didn't gain international significance until the early 1980s. Since then, they have become a large and active component of international finance. Similar to foreign bonds, but with important differences, Eurobonds became popular with issuers and investors because they could offer certain tax shelters and anonymity to their buyers. They could also offer borrowers favorable interest rates and international exchange rates.

Advantages of Eurobonds to the Borrowers

1. Large amounts: the size and depth of the Eurobond market are such that it has the capacity to

absorb large and frequent issues.

2. Freedom and flexibility: the Eurobond market has a freedom and flexibility not found in

domestic markets. The issuing techniques make it possible to bypass restrictions

3. Lower cost of issue: the cost of issue of Eurobonds is relatively low. It is around 2.5% of the

face value of the issue. 4. Lower interest cost: interest cost on dollar Eurobonds is competitive with those in New York. Often US multinationals have been able to raise funds at slightly lower costs in Eurobond market than in the US domestic market. 5. Longer maturities: Eurobonds are suitable for long term funding requirement. Most of them are issued for 15 years but some are also issued up to 30 years maturity. Five to ten years Eurobonds compete with medium term Eurodollar loans. Longer maturities ensure funds availability for longer term at known rate.

Advantages of Eurobonds to Investors.

. There are several benefits to an investor who does put its money into Eurobonds:
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1. Tax free income: Eurobonds are issued in such a form that interest can be paid free of

income tax or withholding tax of borrowing countries. Also the bonds are issued in bearer form and held outside the country of the investor, enabling investor to evade domestic income tax. 2. Low risk investment: issuers of the Eurobonds have an excellent reputation for creditworthiness. This makes it an attractive investment at low risk. 3. Convertible to equity: convertible euro bonds are optionally convertible to equity shares at a fixed price and within a specific period. 4. Liquid investment: Eurobonds are actively traded in primary and secondary market. Hence this is a good investment with good level of liquidity 5. The bonds give an investor a possibility of achieving a higher yield on investments as compare to investing in most shares, bank and building society accounts, money market placements, etc. 6. It is a safe investment in the sense that the full value of the bond will be replayed when the bond matures.

Eurobonds
1.Cost of borrowing Eurobonds are issued in both fixed and floating rate forms. Fixed rate bonds are attractive exposure management tool since known long term currency inflows can be offset with known long term outflows in the same currency. 2. Maturities Longer maturities 3. Size of issue Till 1983, eurocredit market was far bigger than Eurobonds. As corporate started realizing saving of cost in issue process of bonds, the size expanded dramatically. 4. Flexibility Funds must be drawn down in one sum on a fixed date. Funds can be repaid according to a fixed schedule. Prepayment can be with substantial penalty.

Eurocredit (Eurocurrency loans)

Interest rate on eurocredit is variable. It is better hedge for non-contractual currency exposures.

Relatively shorter maturities Now its a size competition between the two markets.

It can be staggered to suit borrowers needs. Can be prepaid in full or in part often without penalty.

5.Speed Eurobonds take more time to issue because of procedures. This difference is vanishing very fast.

Internationally known borrowers can raise funds in Eurocurrency market very quickly, often within 10 two or three weeks of the first request.

Q.4) Explain Interest Rate Parity Theory.

Interest rate parity is a no-arbitrage condition representing an equilibrium state under which investors will be indifferent to interest rates available on bank deposits in two countries. Two assumptions central to interest rate parity are capital mobility and perfect substitutability of domestic and foreign assets. The interest rate parity condition implies that the expected return on domestic assets will equal the expected return on foreign currency assets, due to an equilibrium in the foreign exchange market resulting from changes in the exchange rate between two countries. Interest rate parity takes on two distinctive forms: uncovered interest rate parity refers to the parity condition in which exposure to foreign exchange risk (unanticipated changes in exchange rates) is uninhibited, whereas covered interest rate parity refers to the condition in which a forward contract has been used to cover (eliminate exposure to) exchange rate risk. Each form of the parity condition demonstrates a
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unique relationship with implications for the forecasting of future exchange rates: the forward exchange rate and the future spot exchange rate.

Interest rate parity rests on certain assumptions, the first being that capital is mobile - investors can readily exchange domestic assets for foreign assets. The second assumption is that assets have perfect substitutability, following from their similarities in riskiness and liquidity. Given capital mobility and perfect substitutability, investors would be expected to hold those assets offering greater returns, be they domestic or foreign assets. However, both domestic and foreign assets are held by investors. Therefore, it must be true that no difference can exist between the returns on domestic assets and the returns on foreign assets. That is not to say that domestic investors and foreign investors will earn equivalent returns, but that a single investor on any given side would expect to earn equivalent returns from either investment decision.

The basic premise of this theory is that open economic system, the real future worth of a monetary asset would be the same irrespective of the currency in which it is invested. In simple words, Rs 48 million invested in India for one year would fetch same interest as US$ 1 million in US. (Assuming todays exchange rate at Rs/$ 48)

Features of Interest Rate Parity Theory

1. Uses nominal interest rates to analyze the relationship between spot rate and a corresponding forward rate 2. Relates interest rate differentials between home country and foreign country to the forward premium/discount on the foreign currency 3. The size of the forward premium or discount on a currency should be equal to the interest rate differential between the countries of concern 4. If nominal interest rates are higher in country A than country B, the forward rate for country Bs currency should be at a premium sufficient to prevent arbitrage

The Fisher Effect

According to him the interest rate has two components viz, a real return and adjustment for price level changes. As we take rent for any premises or object, we also take rent for the money given to anybody. This rent is called interest. Problem is that money loses its value over the period because of inflation. Hence if inflation rate is 4% per annum and if the interest rate charged is 4%, then the lender would practically earn nothing as rent or interest. Money he will get back after one year would have the same purchasing power as it had at the time of lending. Hence any lender would expect an interest rate higher than inflation rate. Thus in case if interest rate is charged as 7%, then 4% of this would restore the inflation rate. The real gain is only 3%. The value 7% is called nominal interest rate.
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Nominal interest rate = Real interest rate + Expected inflation rate International Fisher Effect According to this, the interest rate differential will exist only if the exchange rate is expected to change in such a way that the advantage of the higher interest rate is offset by the loss on foreign exchange transaction. Hence , Expected rate of change of the exchange rate = interest rate differential

Uncovered Interest Rate Parity

Under UCIP, future exchange rate to be used for this comparison should be future spot rate (and not forward rate). Of course, such comparisons possible only with retrospect and not as a predictive tool, and hence we cannot derive any definite arbitrage benefit using this. As per UCIP, current spot rate and interest rate differences should form an unbiased predictor of future spot rates. Empirical studies do not confirm UCIP. Higher interest rate currencies do depreciate, but to a lesser extent than UCIP predicts. Forward rates are essentially used to cover risk of unpredictability of future spot rates. UCIP doesnt use forward rates, hence the word uncovered, that is one need not enter into any forward contract if interest parity works perfect.

Covered Interest Rate Parity

CIP uses forward rates to effect international Fisher effect. CIP states that interest rate differences offset forward spot exchange rate differences. This relates closely to purchasing power parity since PPP relates to inflation and inflation is a major component of countys interest rate.

However, CIP differs from PPP in two ways:

1. PPP considers purchasing power in the beginning and at the end of a period. while CIP uses spot and forward rates. 2. PPP compares inflation whereas CIP considers nominal interest rates which include inflation as well as real interest rate.

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Bibliography

Vipul Prakarshan International Banking & Finance (Banking & Insurance series)
http://www.referenceforbusiness.com/encyclopedia/Ent-Fac/EurobondMarket.html#b

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