INTERNATIONAL BANKING AND FINANCE

VISHAKA VAMANJUR TYBBI , ROLL.NO- 55

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INDEX
INTERNATIONAL BANKING ORIGIN FEATURES FUNCTIONS
EXISTING STRUCTURE AND IMPORTANCE WITH REFERNCE TO INDIA.

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ALM ASSET LIABILITY MANAGEMENT EURO BONDS INTEREST RATE PARITY THEORY BIBLIOGRAPHY.

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INTERNATIONAL BANKING : ORIGIN: The origin of international banking dates back to the 2nd century BC when Babylonian temples safeguarded the idle funds and extended loans to merchants to finance the movements of goods. The loans extended by the Florentine banking houses were the first instance of international lending. During the nineteenth century many innovations were witnessed in the international lending, leading to trade financing and investment banking. Trade financing started as short term lending. Of the two investments banking accounted further great bulk of the international lending and financial companies acted as agents or underwriters for the placement of funds. By 1920, American banking institutions dominated international lending, and the European nations were the major borrowers. There was perfect international banking system existing till the time of First World War. The Bretton system had installed a secured financial framework and revolutionized the economic life by creating a global shopping center. International banking speeded up after the first oil crisis in 1973. Progress in the telecommunications sector across the world supplemented the growth of international banking. FEATURES OF INTERNATIONAL BANKING 1. 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. 2. Complexity of credit risk: Credit risk has additional dimensions of sovereign-political risk and also 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 recession move from one continent to another. Multinational banks face these waves and also occasional crisis such as crash of an economy. (e.g. south Asian crisis) 5. Competition for banks 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. 6. 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. 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. 3

FUNCTIONS OF INTERNATIONAL BANKING : Banks transact with forex customers, with other banks with regulatory authorities, within internal entities(department/branches)and with transaction facilitators. Accordingly International banking functions are sub-grouped as: 1. Customer Related functions: Trade Finance Export Avenue a) Pre-shipment Export Credit (packing credit) b) Pre-shipment Export Credit in Foreign currency(PCFC) c) Post shipment Export credit d) Export bill rediscounting e) Letter of Credit f) Value added (gold card) Import Avenue a) Foreign Currency Import Credit b) Suppliers Credit c) Bank guarantees International Merchant Banking (Forex ) 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. Finance of Project export Non fund based facilities a) Letter of Credit facility b) Guarantees I. Bid Bond Guarantee II. Advance Payment Guarantee III. Performance Guarantee IV. Retention money Guarantee V. Maintenance Guarantee VI. Overseas borrowing Guarantees Fund Based a) Pre-shipment Credit b) Rupee/foreign currency suppliers credit c) Buyers credit Derivatives Offering Remittances

2. Compliance related (regulatory) functions: Bank has to continuously monitor all the transactions to ensure adherence to regulatory provisions (e.g. FEMA in India) act and also relevant central bank circulars 3. Inter-bank functions : 4

Banks maintain corresponding banking relations with many banks in many countries. The accounts such as Nostro, Vostro and Loro and also mirror accounts and to be financed and monitored . 4. Internal functions: These include branch management and communication, accounting, risk management and forex markets, settlement with in various offices, money market investment of bank, etc.

STRUCTURE OF FOREIGN EXCHANGE MARKET IN INDIA : The foreign exchange market in India maybe broadly said to have three segments or layers. First layer consists of the central bank i.e. RBI and the Authorized dealers (ADs). ADs or mostly commercial banks and financial institutions such as IDBI, ICICI, and the travel agent Thomas Cook. Second layer is the inter-bank segment in which Ads deal with each other. Third layer is in which Ads deal with their corporate customers. In retail market in addition to ADs there are moneychangers who are allowed to deal in foreign currency. Full-fledged moneychangers are allowed to buy and sell foreign currency and restricted moneychangers are allowed only to buy. Indian market also has accredited brokers who match buyers and sellers. FEDAI i.e. Foreign Exchange Dealers Association of India has made it mandatory to root deals between two ADs through brokers. IMPORTANCE: India poised to be the 3rd largest in Public Private Partnership PPP by the year 2025. PPP solicits participation of private sector enterprises in infrastructure development. Infrastructure was so far the monopoly and responsibility of the government. Private sect participation requires greater role of banks in this process. In PPP India is only behind US, China and Japan. India is 6th largest in foreign exchange reserve. India is haven for techno-MNCs- third biggest market for computer goods, cellular industry CAGR-35%,which is highest in asia pacific and japan. Internationally acknowledged base for ITES( IT enabled services) segment. Identified hub for auto component industry. Foreign corporate in out right acquisition, MNAs and JVs. Indian conglomerates on foreign acquisition spree. Tatas and others have acquired international firms. Vast industrial and service infrastructure.

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Explain ALM (Asset Liability Management) in Banks. ALM is a comprehensive and dynamic framework for measuring, monitoring and managing the market risk of a bank. It is the management of structure of balance sheet (liabilities and assets) in such a way that the net earning from interest is maximized within the overall riskpreference (present and future) of the institutions. The ALM functions extend to liquidly risk management, management of market risk, trading risk management, funding and capital planning and profit planning and growth projection. Benefits of ALM - It is a tool that enables bank managements to take business decisions in a more informed framework with an eye on the risks that bank is exposed to. It is an integrated approach to financial management, requiring simultaneous decisions about the types of amounts of financial assets and liabilities - both mix and volume - with the complexities of the financial markets in which the institution operates The concept of ALM is of recent origin in India. It has been introduced in Indian Banking industry w.e.f. 1st April, 1999. ALM is concerned with risk management and provides a comprehensive and dynamic framework for measuring, monitoring and managing liquidity, interest rate, foreign exchange and equity and commodity price risks of a bank that needs to be closely integrated with the banks business strategy. Therefore, ALM is considered as an important tool for monitoring, measuring and managing the market risk of a bank. With the deregulation of interest regime in India, the Banking industry has been exposed to the market risks. To manage such risks, ALM is used so that the management is able to assess the risks and cover some of these by taking appropriate decisions. The assets and liabilities of the banks balance sheet are nothing but future cash inflows or outflows. With a view to measure the liquidity and interest rate risk, banks use of maturity ladder and then calculate cumulative surplus or deficit of funds in different time slots on the basis of statutory reserve cycle, which are termed as time buckets. As a measure of liquidity management, banks are required to monitor their cumulative mismatches across all time buckets in their Statement of Structural Liquidity by establishing internal prudential limits with the approval of the Board / Management Committee. The ALM process rests on three pillars: ALM Information Systems Management Information Systems Information availability, accuracy, adequacy and expediency ALM Organization Structure and responsibilities Level of top management involvement ALM Process Risk parameters Risk identification Risk measurement Risk management Risk policies and tolerance levels.

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 the later 1980s. 3. In the current decade, earning 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 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 the comprehensive sense.

DISCUSS THE ADVANTAGES OF EUROBONDS TO INVESTORS AND BORROWERS : A Eurobond is defined as 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 restrictions. Eurobonds are similar in many respects to the normal domestic bonds. Eurobond market is almost free of official regulation. It is, however, self-regulated by the association of international bond dealers. For each currency, the bond market can be divided into two parts: the markets within the country of the currency, namely the domestic and foreign bond markets, and the markets outside of direct jurisdiction of the country, that is the Eurobond market. Eurobonds can be denominated in any of the several different currencies. These different markets are linked to one another through the currency swap market. Swap market provides contracts for future exchange of interest and principal in two different currencies, or alternatively through the long dated forward-exchange market. ADVANTAGES OF EUROBONDS TO THE BORROWERS (ISSUNING COMPANIES): 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 the 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 costs on dollar Eurobonds are 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 upto 30 years of 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: 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 are held outside the country of the investor, enabling investors 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 Eurobonds are optionally (at the discretion of the investor) convertible to equity shares at a fixed price and within a specified period. 4. Liquid investment: Eurobonds are actively traded in primary and secondary markets. Hence this is a good investment with good level of liquidity.

EXPLAIN INTEREST RATE PARITY THEORY: The basic premise of this theory is that in an 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 invested in the US. Definition: the process that ensures 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 differentials 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 explaimed 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. 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 is offset by the loss on foreign exchange transaction. Hence, Expected rate of the exchange rate = interest rate differential Uncovered interest rate parity (UCIP): As per 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). Of course, such comparison is 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, i.e. one need not enter into any forward contract if interest parity works perfect. Covered interest rate parity (CIP): CIP uses forward rates to effect International Fisher effect (and not futures 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 a countrys interest rate. However, CIP differs from PPP in two ways: 1. PPP considers purchasing power at the 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. 2. PPP compares inflation whereas CIP considers nominal interest rates which include inflation as well as real interest rate. Implications of Interest Rate Parity Theory If IRP theory holds then arbitrage in not possible. No matter whether an investor invests in domestic country or foreign country, the rate of return will be the same as if an investor invested in the home country when measured in domestic currency. If domestic interest rates are less than foreign interest rates, foreign currency must trade at a forward discount to offset any benefit of higher interest rates in foreign country to prevent 9

arbitrage. If foreign currency does not trade at a forward discount or if the forward discount is not large enough to offset the interest rate advantage of foreign country, arbitrage opportunity exists for domestic investors. So domestic investors can benefit by investing in the foreign market. If domestic interest rates are more than foreign interest rates, foreign currency must trade at a forward premium to offset any benefit of higher interest rates in domestic country to prevent arbitrage. If foreign currency does not trade at a forward premium or if the forward premium is not large enough to offset the interest rate advantage of domestic country, arbitrage opportunity exists for foreign investors. So foreign investors can benefit by investing in the domestic market. Limitations of Interest Rate Parity Model In recent years the interest rate parity model has shown little proof of working. In many cases, countries with higher interest rates often experience it's currency appreciate due to higher demands and higher yields and has nothing to do with risk-less arbitrage.

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BIBLIOGRAPHY http://www.moneyschool.indianmoney.com/money-gyanmodules.php?page_id=3&subcat=1&cat=2&subcat=1&topic =Banking&mid=157&lid=157 http://en.wikipedia.org/wiki/Asset_liability_management http://www.forexkarma.com/interest-rateparity.html#.UgDXVL-BL-Y Also reffered to International Banking and Finance Vipul Prakashan

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