INTERNATIONAL BANKING AND FINANCE Question 1)Explain the origin,features and functions of international banking.

Evaluate the existing structure and importance with reference to India. Answer: Banks are intermediaries which accept deposits and lend to the industrial and personal borrower.Yhis intermediation process achieves moderation of risks of both,depositors as well as borrowers.Banks earn spread which is the difference between deposit interest rates and lending rates.Spreads is the recovery of banks cost and profits.Hence business entities have high dependancy on banks.Banks provide term loans,working capital,bill discounting,bank guarantees and deposit facilities for parking surplus funds. Banking transactions crossing national boundaries is termed as international banking.Corporate explore foreign markets for trade.Itis to sell products in wider markets,procure eaw material,or even to shift manufacturing base to optimize labor and other costs.As these enterprises travel,they need banking services in foreign markets.This is the basic motive for banks to go international.But this is in basic and historical prospective.In the era of globalization,many investment and cmmercial banks have developed themselves as multinational financial institutions. Factors that led to the growth of internationalization of banking: (Factors responsible for growth of international banking) 1)Migration of enterprises:As enterprises become multinational,banks also expand with them.This is mutually beneficial because entrepreneurs have comfort,proven track record and established creditworthiness with their bankers.So,if the same bank offers services in other countries too,then it is an ease for cost,time and account handling. 2)Optimization of cost of capital:In some countries,especially developed,abundant capital is available at a lower rate.In developing and Less Developed Countries(LDC),capital is costly.For instance,Japan had lowest cost of capital for many years.This is a great oppurtunity for banks as they can source deposits at lower rate and lend at higher rate in a different country.This is arbitrage oppurtunity.This enhances profit margins of the banks. 3)Diversification benefits:Diversification reduces systematic and sovereign risks.It also offers typical business diversification.If banking slows down in one economy,it may be better in another,thereby bringing stability in profits. 4)Regulatory Avoidance:Banks may set-up multi-country offices to avoid/manipulate reserve requirements,cumbersome reporting requirements,tax adjustments,etc.They may be able to escape many things of domestic regulations by routing transactions through another country office. 5)Expansion of Bank's custodial functions:Custodial services are granted to clients who make investments in overseas securities.The banks have to collect the securities,collect dividends and offer other related services.Banks have moved abroad in response to demand fir theseservices by their customers. FEATURES OF INTERNATIONAL BANKING: Following key aspects distinctly highlight features of international banking which are absent in domestic banking: 1)Currency risk:Inetrnational 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 the international arena. 2)Complexity of credit risk:Credit risk has several dimensions of sovereign-political risk and also By:Ravi.M Kungwani,TYBBI,33 1

INTERNATIONAL BANKING AND FINANCE socio-cultural factor about honoring credit. 3)Competition for market share among banks:Competition is stiff because of presence of many giant bankers.This in effect reduces margins and demands highly efficient performance. 4)Cyclical nature,with periodic crises:World economies are not moving in unison.Cycles of growth and recessionmovefrom one continent to another.Multinational bansk face these waves and also occasional crisis such as crash of an economy.(e.g.Sout Asian Crisis) 5)Competition for bank loans from the international bond market:Threat of disintediation 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. 6)Importance of international interbak(IIBM) as source of liquidity and finding for banks:Interbank transactions in multiple currencies are common in international Banking.In effect bankers enjoy better liquidity solutions. 7)Role of risk management activities(swaps,options,futures:)Being in forex market,banks deal with additional hedging instruments such as currency futures/options,etc. FUNCTIONS OF INTERNATIONAL BANKING:International Banking has functions subgrouped as follows: Customer related functions Compliance related (regulatory) functions Inter-bank functions Internal Functions

1. Customer Related functions: a)Trade Finance i)Export Avenue Pre-Shipment Export Credit(Packing Credit) Pre-Shipment Export Credit in Foreign Currency(PCFC) Post-Shipment Export Credit Export Bill Rediscounting Letter of Credit Value Added(Gold Card,etc) Foreign Currency Import Credit Supplier's credit Bank Guarantees

ii)Import Avenue

b)International Merchant Banking(Forex)

By:Ravi.M Kungwani,TYBBI,33

INTERNATIONAL BANKING AND FINANCE International loan syndication:Arranging External Commercial Borrowings(ECB) in form of Commercial Loans,Loans backed by Export Credit Agencies,Lines of credit from Foreign Banks and Financial Institutions,Import Finance for Indian corporate. i)Non Fund based facilities Letter of Credit facility Guarantees

c)Finance of project export

a)Bid Bond Guarantee b)Advance Payment Guarantee c)Performance Guarantee d)Retention Money Guarantee e)Maintenance Guarantee f)Overseas Borrowing Guarantee ii)Fund Based Pre-shipment credit Rupee/Foreign currency supplier's credit Buyer's credit

d)Derivatives Offering e)Remittances 2. 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 monitored and financed. 3. Compliance related (regulatory) functions:Bank has to continuously monitor all the transcations to ensure adherence to regulatory provisions(e.g. FEMA inIndia)act and also relevant central bank circulars(RBI circulars) 4. Internal Functions:These include branch management and communication,accounting,risk management in forex markets,settlement within various offices,money market investments of the bak,etc.Apart from this it also includes one important function,Treasury Function. INTERNATIONAL BANKING IN INDIA: International Banks established in India since Independence.Today all major international banks have operations in India.International Banks are governed by applicable banking laws.In addition,they also fall under purview of FEMA act. With globalization,more and more foreign banks would get entry in Inda.Also,major Indian nationalized banks have overseas operations and branches. Importance of Interational Banking in India. 1. India poised to be the third largest in Public Private Partnership PPP by the year 2025.PPP solicits participation od private sector enterprises in infrastructure By:Ravi.M Kungwani,TYBBI,33 3

INTERNATIONAL BANKING AND FINANCE development.Infrastructure was so das the monopoly and responsibility of the government.Private sector participation requires greater role of banks in this process.In PPP India is only behind the US,China and Japan. 2. India has Sixth largest in Foreign Exchange Reserves. 3. India is haven for techno-MNCs-third biggest market for computer goods,cellular industry CAGR-35%,which is highest in Asia,Pacific and Japan. 4. Internationally acknoqledged base for ITES(IT enabled services)segment. 5. Identified hub for auto component industry. 6. Foreign corporate in outright acquisition spree.Tatas and others have acquired international firms. 7. Vast industrial and services infrastructure. Role of International Banking in Industrial growth in India. 1. Contribution of service sector to India's GDP in growing.Service sector would need greater support from the banks. 2. Agriculture provides largest pool of jobs.Banks need to address the need of agro-industry and agri-business. 3. Banks can contribute in all secotrs for generating savings,Augment capital formation and help increase income levels. 4. Banks have greater role in Exports and Trade finance: Trade finance in a forte of Indian banks.Exports are a national priority.Banks' initiatives in this regard are: Centrally integrated treasury Specialized overseas branches offering of derivative products to clients offering risk mitigation and hedging mechanish Question 2)Explain ALM in banks. Answer: 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 resserve ratio and statutory liquiity 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. 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 bank's 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 resource management. ALM function and its growing importance: By:Ravi.M Kungwani,TYBBI,33 4

INTERNATIONAL BANKING AND FINANCE 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 1980s. 3. In the current decade,earn a proper return of bank equity and hence maximization of its market value has meant that ALM covers the management of the entire balance sheet of a bank. 4. The bank management are now expected to target required profit levels and ensure maximization of risks to acceptable levels to retain the interests of investors in their banks.This also implies that ALM encompasses costing and pricing policies in comprehensive sense. ALM in India: Ever sincethe initiation of the process of deregulation of the Indian banking system and gradual freeing of interest rates to market forces,and consequent injection of a dose of competition among the banks,introduction of ALM in Public sector banks(PSBs) has been suggested by several experts. to begin with,as the RBI's monetary and credit policy of October 1997 recommends,an adequate system of ALM to incorporate comprehensive risks management should be introduced in the PSBs.It is suggested that PSBs should introduce ALM which would foxus on liquidity management,interest rate rsk management and liquidity management.Broadly,there are 3 requirements to implement ALM in these banks,in the stated order: developing a better understanding of ALM concepts, introducing an ALM information system,and setting up ALM decision-making process(ALM Committee/ALCO).

Question 3)Discuss advantages of euro-bonds to investors and borrowers. Answer: Advantages of Euro bonds to Investors: 1. Tax free income:Eurobonds are issued in sucha 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 creditwothiness.This makes it an attractive investment at low risk. 3. Convertible to Equity:Convertible Eurobonds are optionally (at the discretion of the investor)convertible to euity shares at a fixed price and within a specific period. 4. Liquid investment:Eurobonds are actively traded in primary and secondary markets.Hence this is a good investment with good level of liquidity. Advantages of Eurobonds to Borrowers(Issuing companies): 1. Large amounts:This size and depth of the Eurobond market are such that it has capacity to absorb large and frequent issues. By:Ravi.M Kungwani,TYBBI,33 5

INTERNATIONAL BANKING AND FINANCE 2. Freedom and Flexibility:Te Eurobond market has a freedom and flexibility not found in domestic markets.The issuing techniques make it possible to bypass restrictions. 3. Lower cost issue:The cost of issue of Eurobonds is relativel low.It is around 2.5% of the face value of the issue. 4. Lower interest cost:Interest cost on dollar Eurobonds are competitive with those in New York.Ofthen US multinationals have been able to raise funds at slighty lower costs in Eurobond market than in the US domestic market. 5. Longer matuities:Eurobonds are suitable for long term funding requirement.Most of them are issued for 15 years,but some are also issued upto 30 years maturity.Five to ten years Eurobonds compete within medium term Eurodollar loans.Longer maturities ensure funds availability for longer term at known rate. Question 4)Explain interest rate parity theory. Answer: The basic premise of this theory is an open economic system,the real future worth of a monetary asset would be the same irrespectie of the currency in which its invested.In simple words,Rs 48 million invested in India for one year would fetch same interest as US$ 1 million invested in the US(considering the exchange rate today at Rs/$48). The Interest Rate Parity process ensure that the annualized forward premium or discount equals the interest rate differentials on equivalent securities in two currencies. It is a theory that the interest rate differential between two countries is equal to the differential between the forward exchange rate and the spot exchange rate. The Fisher effect:Irving Fisher in his book titled "The Theory of Interest" has explained the formation of the interest rates.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 as 'interest'.Problem is that money looses its value(or purchasing power) over the period because of inflation.Hence if inflation rate is 4% pa. and if an interest of 4% is charged,then the lender would earn nothing as 'rent' or 'interest'.Money he will get back after one year would have the same purchase power as it had at the time of lending.Hence any lender would expect an interest rate higher than the rate of inflation rate.Thus in this case if interest rate is charged at 7% the,4% of this would just restore purchasing power on account of inflation.The 'real' gain or 'real interest rate' is 3%.The value of 7% is called as 'nominal interest rate'.Hence, 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 exchange rate=Interest rate differential UNCOVERED INTEREST RATE PARITY(UCIP): As per the International Fisher effect,expected rate of change of the exchange rate should be equal to Interest rate differential.Under UCIP,future exchange rate to be used for this comparison should be future 'spot rate'(and not forward rate).Ofcourse,such comparison is possible only with retrospect By:Ravi.M Kungwani,TYBBI,33 6

INTERNATIONAL BANKING AND FINANCE 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 uniased predictor of future spot rates.Empirical studies do not confirm UCIP.Higher interest rate currencies do depreciate,but to a lesse extent than the UCIP predictsForward rates are essentially used to 'cover' risk of unpredictabililty of future 'spot' rates.UCIP doesn't use forward rates,hence the word 'uncovered',i.e. one need not enter in to any forward contract if interest parity works perfect. COVERED INTEREST PARITY(CIP): CIP uses forward rate to effect Interational Fisher effect(and not future's spot rates' like UCIP).CIP states that interest rate differences offset forward-spot exchange rate differences.This relates closely to PPP since purchasing power relates to inflation and inflation is a major component of country's interest rate.However,CIP differs from PPP in two ways: PPP considers purchasing power at teh beginning and at the end of the period.So,CIP should use 'spot rates' at the beginning and at the end of the transaction period.Instead,it uses spot and forward rates. PPP compares inflation whereas CIP considers nominal interest rates which include inflation as well as real interest rate.

By:Ravi.M Kungwani,TYBBI,33