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Chapter 7: International Banking and Money Market In this chapter, the topics of international banking, the international money

market, the Third World debt crisis, and the recent global financial crisis are discussed. This chapter begins the textbooks five-chapter sequence on world financial markets and institutions. 1. International banks can be characterized by the types of services they provide. International banks facilitate the imports and exports of their clients by arranging trade financing. They also arrange foreign currency exchange, assist in hedging exchange rate exposure, trade foreign exchange for their own account, and make a market in currency derivative products. Some international banks seek deposits of foreign currencies and make foreign currency loans to nondomestic bank customers. Additionally, some international banks may participate in the underwriting of international bonds if banking regulations allow. 2. Various types of international banking offices include correspondent bank relationships, representative offices, foreign branches, subsidiaries and affiliates, Edge Act banks, offshore banking centers, and International Banking Facilities. The reasons for the various types of international banking offices and the services they provide vary considerably. 3. The core of the international money market is the Eurocurrency market. A Eurocurrency is a time deposit of money in an international bank located in a country different from the country that issued the currency. For example, Eurodollars, which make up the largest part of the market, are deposits of U.S. dollars in banks outside of the United States. The Eurocurrency market is headquartered in London. Eurobanks are international banks that seek Eurocurrency deposits and make Eurocurrency loans. The chapter illustrated the creation of Eurocurrency and discussed the nature of Eurocredits, or Eurocurrency loans. 4. Other main international money market instruments include forward rate agreements, Euronotes, Eurocommercial paper, and Eurodollar interest rate futures. 5. Capital adequacy refers to the amount of equity capital and other securities a bank holds as reserves against risky assets to reduce the probability of a bank failure. The 1988 Basel Capital Accord established a framework for determining capital adequacy requirements for internationally active banks. The Basel Accord primarily addressed banking in the context of deposit gathering and lending. Thus, its focus was on credit risk. The accord has been widely adopted throughout the world by national bank regulators. Bank trading in equity, interest rate, and exchange rate derivative products escalated throughout the 1990s. The original capital adequacy requirements were not sufficient to safe-guard against the market risk from trading in these instruments. Additionally, operational risk, which includes such matters as computer failure, poor documentation, and fraud, was not covered by the original accord. In 2004, a new capital adequacy framework commonly referred to as Basel II was endorsed by central bank governors and bank supervisors in the G-10 countries. It requires 8 percent minimum capital to be held against a banks credit, market, and operational risk. The global financial crisis that began in mid-2007 illustrated how quickly and severely liquidity risks can crystallize and certain sources of funding can evaporate, compounding concerns about the valuation of assets and capital adequacy. A number of banking organizations have experienced large losses, most of which were sustained in the banks trading accounts. These losses have not arisen from actual defaults, but rather from credit agency downgrades, widening credit spreads, and the loss of liquidity. In July 2009, the Basel Committee finalized a package of proposed enhancements to Basel II to strengthen the regulation and supervision of internationally active banks. These enhancements are part of a broader program, nicknamed Basel III, designed to




strengthen the regulatory capital framework. The new program aims to build up capital buffers that can be drawn down in periods of stress, strengthen the quality of bank capital, and introduce a leverage ratio requirement to contain the use of excess leverage. The international debt crisis was caused by international banks lending more to Third World sovereign governments than they should have. The crisis began during the 1970s when OPEC countries flooded banks with huge sums of Eurodollars that needed to be lent to cover the interest being paid on the deposits. Because of a subsequent collapse in oil prices, high unemployment, and high inflation, many less-developed countries could not afford to meet the debt service on their loans. The huge sums involved jeopardized some of the worlds largest banks, in particular, U.S. banks that had lent most of the money. Debt-for-equity swaps were one means by which some banks shed themselves of Third World problem debt. But the main solution was collateralized Brady bonds, which allowed the lessdeveloped countries to reduce the debt service on their loans and extend the maturities far into the future. The Asian crisis began in mid-1997. The troubles, which began in Thailand, soon affected other countries in the region and also emerging markets in other regions. Not since the LDC debt crisis had international financial markets experienced such widespread turbulence. The crisis followed a period of economic expansion in the region financed by record private capital inflows. Bankers from industrialized countries actively sought to finance the growth opportunities. The risk exposure of the lending banks in East Asia was primarily to local banks and commercial firms, and not to sovereignties, as in the LDC debt crisis. Nevertheless, the political and economic risks were not correctly assessed. The global financial crisis began in the United States in the summer of 2007 as a credit crunch, or the inability of borrowers to easily obtain credit. The origin of the credit crunch can be traced back to three key contributing factors: liberalization of banking and securities regulation, a global savings glut, and the low interest rate environment created by the Federal Reserve Bank in the earlier part of the decade. Low interest rates created the means for first-time homeowners to afford mortgage financing and for existing homeowners to trade up to more expensive homes. During this time, many banks and mortgage financers lowered their credit standards to attract new home buyers who could afford to make mortgage payments at current low interest rates. These so-called subprime mortgages were typically not held by the originating bank making the loan, but instead were resold for packaging into mortgage-backed securities (MBSs) to be sold to investors. As the economy cooled, many subprime borrowers found it difficult, if not impossible, to make mortgage payments, especially when their adjustable-rate mortgages were reset at higher rates. As matters unfolded, it was discovered that the amount of subprime debt held in exotic investment vehicles, and who exactly held it, was essentially unknown. When subprime debtors began defaulting on their mortgages, liquidity worldwide essentially dried up. Commercial and investment banks suffered huge losses, and many were forced into mergers with stronger banks or had to receive government bailout funds to stay in business. A deep, worldwide recession resulted. At this stage, virtually every economic entity has experienced a downtown. Many lessons should be learned from these experiences. One lesson is that bankers seem not to scrutinize credit risk as closely when they serve only as mortgage originators and then pass it on to MBS investors rather than hold the paper themselves. New banking regulations and financial regulations are currently being implemented to try and prevent or mitigate future financial crises.