The Structure of the International Capital Market
- The main actors in the international capital market are:
• Commercial banks
• Corporations
• Nonbank financial institutions
• Central banks and other government agencies
• Forex brokers
International Banking and the International Capital Market
- Growth of the International Capital Market
• The removal of barriers to private capital flows across countries’ borders has contributed to rapid growth in the international capital market.
• A policy “trilemma” refers to three available options:
– Fixed exchange rate
– Monetary policy oriented toward domestic goals
– Freedom of international capital movements
The Role of Banks
- Wholesale market for foreign exchange
- Retail market for foreign exchange
- Clients
• Commercial customers
• Speculators
• Arbitrageurs
Reasons for International Banking
- Low Marginal Costs
- Knowledge Advantage
- Home Nation Information Services
- Prestige
- Regulatory Advantage
- Wholesale Defensive Strategy
- Retail Defensive Strategy
- Transactions Costs
- Growth
- Risk Reduction
International Banking Services
- International Banks do everything domestic banks do and:
• Arrange trade financing.
• Arrange foreign exchange.
• Offer hedging services for foreign currency receivables and payables through forward and option contracts.
• Offer investment banking services (where allowed).
Types of International Banking Offices
- Correspondent Bank
- Representative Offices
- Foreign Branches
- Subsidiary and Affiliate Banks
- Offshore Banking Centers
- International Banking Facilities
Foreign Exchange Instruments
- Deposits, credits and balances payable in foreign currency
- Drafts, travellers’ cheques, letter of credit or bill of exchange expressed or drawn in local currency but payable in foreign currency
- Drafts, travellers’ cheques, L/Cs, etc. drawn by banks, institutions or persons in foreign country but payable in local currency
Factors affecting exchange rate quotations
- Major banks that act as market-makers always give two-way quotes; gives depth and volume to the market
- Fundamental reasons
- Technical reasons
- Speculation
Fundamental Reasons
- Balance of payments->surplus->appreciation
- Growth rate of the economy-> higher growth->depreciation of currency
- Fiscal policy-> financing of fiscal deficit influences exchange rate
- Monetary policy->loose monetary policy-> depreciation of exchange rate
Technical reasons
- Freedom or restrictions on capital movements can affect exchange rates to a large extent
- Among other factors there are:
• Huge trade surpluses of oil exporting countries
• Capital moving from low-yielding currencies to high yielding currencies (interest differential)
Speculation
- Self-fulfilling prophecies
• Anticipation of depreciation of a currency can cause dealers to sell that currency
- Speculation serves to provide depth and liquidity to the forex market
- Acts as a cushion as well- contrarian traders exist in the market
Exchange Rate Transactions
- Ready/cash- Settlement of funds on the same day (date of the deal).
- Tom- Settlement of funds takes place on the next working day of the date of the deal
- Spot- Settlement of funds takes place on the second working day following the date of the deal
- Forward- Delivery takes place on any day after the date of the deal at specified price
Modes of Remittances
- Telegraphic Transfers (TT) of funds are done from one centre to another by way of instructions through telex, telegram or SWIFT (Society for Worldwide Interbank Financial Transfer). Of late SWIFT is becoming popular
- Mail Transfer (MT) of funds is done by way of instructions sent by mail. An MT is an order in writing on the correspondent bank/branch abroad to pay the beneficiary the sum mentioned
- Demand draft (DD): A DD is an order in writing on the correspondent bank/branch abroad to pay the beneficiary the sum mentioned therein.
International Banking
| US$ | |
| On Shore | U.S. bank deposit U.S. Treasury bills and bonds U.S. corporate bonds |
| Off Shore | Euro-$ deposit Euro-$ bond |
International Banking and the International Capital Market
- Offshore Banking and Offshore Currency Trading
• Offshore banking
– The business that banks’ foreign offices conduct outside of their home countries
– Banks operate offshore though any of three types of institution:
– Agency office
– Subsidiary bank
– Foreign branch
• Offshore currency trading
– Trade in bank deposits denominated in currencies of countries other than the one in which the bank is located
– It is referred to as Eurocurrency trading.
International Banking and the International Capital Market
• Eurodollars
– Dollar deposits located outside the U.S.
• Eurobanks
– Banks that accept deposits denominated in Eurocurrencies
• Eurocurrency trading has grown for three reasons:
– Growth in world trade
– Evasion of financial regulations like reserve requirements
– Political concerns
Offshore Financial Centers
- Focus on offering banking and other financial services to non-resident customers
- Locations
• Bahamas, Bahrain, the Cayman Islands, Bermuda, the Netherlands Antilles, Singapore, Luxembourg, Switzerland
International Banking and the International Capital Market
- The Growth of Eurocurrency Trading
• London is the leading center of Eurocurrency trading.
• The early growth in the Eurodollar market was due to:
– Growing volume of international trade
– Cold War
– New U.S. restrictions on capital outflows and U.S. banking regulations
– Federal Reserve regulations on U.S. banks (e.g., the Fed’s Regulation Q)
– Move to floating exchange rates in 1973
– Reluctance of Arab OPEC members to place surplus funds in American banks after the first oil shock
• International banking facilities (IBFs)
– Banks that accept time deposits and make loans to foreign customers.
– They are not subject to reserve requirements or interest rate ceilings.
– They are exempt from state and local taxes.
Regulating International Banking
- The Problem of Bank Failure
• A bank fails when it is unable to meet its obligations to its depositors.
• Governments attempt to prevent bank failures through extensive regulation of their domestic banking systems.
• The main U.S. safeguards to reduce the risk of bank failure:
§ Deposit insurance
§ Reserve requirements
§ Capital requirements and asset restrictions
§ Bank examination
§ Lender of last resort (LLR) facilities
§ The Fed lends to banks facing massive deposit outflows to satisfy their depositors’ claims.
- Difficulties in Regulating International Banking
• Deposit insurance is essentially absent in international banking.
• The absence of reserve requirements reduces the stability of the banking system.
• Bank examination to enforce capital requirements and asset restrictions becomes more difficult in an international setting.
• There is uncertainty over which central bank is responsible for providing LLR assistance in international banking.
• A major change in international financial relations in the 1990s has been the rapidly growing importance of new emerging markets as sources and destinations for private capital flows.
• The trend toward securitization has increased the need for international cooperation in monitoring and regulating nonbank financial institutions.
How Well Has the International Capital Market Performed?
- Onshore-Offshore Interest Differentials
• If the world capital market is functioning well, international interest rates should move closely together and not differ too greatly.
– Large interest rate differences would be strong evidence of unrealized gains from trade.
– Data shows that rates of return on similar deposits issued in the major financial centers are quite close.