(2) Global Financial Markets and Interest Rates

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Global Financial Markets and International Banking : 

Global Financial Markets and International Banking Madhav M.Mehta

Global Financial Markets : 

Madhav M.mehta 2 Global Financial Markets Two decades have seen massive cross border capital flows. Deregulation and liberalization. Exchange and capital controls removed A series of crises- the Mexican crisis of 1995, East Asia collapse of 1997, Russian meltdown 1998 By 1999 some of the damage repaired

Eurocurrency Market : 

Madhav M.mehta 3 Eurocurrency Market Born in mid-fifties, grew in scope and size in sixties and seventies. Borrower/investor from country ‘A” could raise/place funds in currency of country ‘B’ from/with financial institutions located in country ‘C’

Evolution of Eurocurrencies Market : 

Madhav M.mehta 4 Evolution of Eurocurrencies Market During the 1950s Russian authorities seeking dollar-denominated deposits with banks of Britain and France. During 60s and 70s restrictions imposed by the US authorities on domestic banks and capital markets. Ceiling on the rate of interest to depositors. Not applicable to Us banks outside US. Reserve requirements. Did not apply to dollar deposits out side US. Also restrictions on loans. Importance of dollar as a vehicle currency in international trade. Demand side:- Loans by non-Us entities and US MNCs to finance their foreign operations

Eurocurrency Market : 

Madhav M.mehta 5 Eurocurrency Market Prior to 1980 Eurocurrencies market was the only truly international financial market. It is mainly inter bank market trading in time deposits and various debt instruments. “Eurocurrency Deposit” is a deposit in relevant currency with a bank out side home currency of that currency. LOCATION. Over years these markets have evolved a variety of instruments other than time deposits and short term loans. CDs, Euro currency Paper (ECP), Medium to long term floating rate Notes (FRNs), Euro Medium Term Notes (EMTNs)

Eurocurrency Market : 

Madhav M.mehta 6 Eurocurrency Market These supply side factors reinforced by demand for Eurodollar loans by non-US entities and by US MNCs Emergence of Euromarkets in currencies other than the dollar. Development of offshore banking Benchmark provided by the interbank borrowing and lending rates abbreviated LIBOR( rate that the first class bank will charge) and LIBID ( rate bank willing to pay for deposits accepted)

Impact of Euro and other offshore markets : 

Madhav M.mehta 7 Impact of Euro and other offshore markets Market facilitates short-term speculative capital flows or hot money National monetary authorities lose effective control over monetary policies A crisis can turn into disaster due to very large volumes, no lender of last resort, borrowing short and lending long Too much of liquidity. Can trigger inflation. Central banks of deficit countries can borrow for BOP purposes enabling them to put off needed measures

Banking introduction 1/2 : 

Madhav M.mehta 8 Banking introduction 1/2 Banks are financial intermediaries between depositors (lenders) and borrowers. One classification of banks can be offshore (deposits/loans/bond in say $ but issued outside that country) and onshore i.e. domestic banking.

Introduction 2/2 : 

Madhav M.mehta 9 Introduction 2/2 Major International banking:- Commercial Banking:- deposits, advances. Investment Banking:- serves as agent, as an underwriter, purchase and then sale of securities, syndication of finance.

Reasons for international Banking : 

Madhav M.mehta 10 Reasons for international Banking Low marginal costs; managerial and Market knowledge can be used at low cost Home country knowledge advantage Prestige; Multinational banks- well perceived Regulation advantage; Not subject to same regulation as domestic banks Wholesale and retail defensive strategy Transaction cost and risk reduced Growth; Domestic market may be saturated Risk reduction; International diversification

Role of Banks in Foreign Trade : 

Madhav M.mehta 11 Role of Banks in Foreign Trade Vital role in the foreign trade of a country. Provide finance and act as conduit pipe for exchange of documents and money between exporter/importer. Act as extended arm of the RBI in administering FEMA

Functions of Banks in Foreign Trade 1/3 : 

Madhav M.mehta 12 Functions of Banks in Foreign Trade 1/3

Functions of Banks in Foreign Trade 2/3 : 

Madhav M.mehta 13 Functions of Banks in Foreign Trade 2/3 Financing and facilitating exports (packing credit, pre and post shipment credit) Financing Imports (Letters of credit, guarantees) Remittance facilities and foreign investment. Both inward and out ward. Dealings in foreign exchange i.e. buying and selling foreign currency for public. Cash management services

Functions of Banks in Foreign Trade 3/3 : 

Madhav M.mehta 14 Functions of Banks in Foreign Trade 3/3 Furnishing Credit information, consulting services, interest rate and currency swaps Facilitate international equity and Money Market operations Assist clients in hedging, exchange risk through forward, futures contracts. Correspondent Relationship between banks. One bank works as agent for another. Collection of bills, issue of demand drafts, reimburse letter of credits, etc.

Foreign Currency Accounts : 

Madhav M.mehta 15 Foreign Currency Accounts Nostro Account:- Account maintained by a bank in India with a bank abroad. All forex transactions routed through this account. Vostro Account:- I foreign bank opening a rupee account with Indian bank. Loro Account:-Peoples Bank of China having an account with Citi bank London. Janta bank in India likes to refer to this account with citi bank it will refer it as loro account

International Banking and Institutions : 

Madhav M.mehta 16 International Banking and Institutions Correspondent Bank; Maintain A/C,L/C, dfts. Advantage:_ Low cost, Disadvantages:- Level of service poor. Use SWIFT, CHIPS Representative office; small service window, for information Foreign Branches; A part of parent bank, Regulations of both countries to be followed. Full range of services provided. Subsidiary Banks; Locally incorporated. Wholly owned or majority stake. Controlled by parent. Full range of services Affiliate Banks ; Partially owned but not controlled Offshore Banking Centers e.g. in Bahamas, Cayman Iceland , freedom from host country regulations International Banking Facility; IBF operate as a foreign bank in the home country & not subject to regulations, reserve requirement Bank Agencies ; No deposits but all other services

BASEL ACCORDHistorical Background : 

Madhav M.mehta 17 BASEL ACCORDHistorical Background Bank failures. Set up by Group of 10 in 1975. First Accord in July 1988. Capital measurement and capital standards for safety and stability of commercial banks in the world. Also called Basel I Applicable to internationally active banks Central banks of countries to finally decide

Basel I : 

Madhav M.mehta 18 Basel I Set Capital adequacy standard of 8% Over time Basel Committee issued number of operational directives to enable central banks to consider and implement it. Accord worked well but had some problems like One size fits all Certain risks not taken into reckoning

Basel II : 

Madhav M.mehta 19 Basel II Accord born in May 2004 Released on internet in June 2004 To be effective from 2007 Several consultative papers Revised framework for further strengthening soundness and stability of international banking system with provisions for sufficient consistency

Basel II (Continued) : 

Madhav M.mehta 20 Basel II (Continued) No competitive inequality Three dimensional approach (a) Risks (i) Credit Risks( Default of the counter party) (ii) Market Risk (changes in liquidity, price, exchange (iii) Operational Risk( Human failure intentional or un intentional)

Basel II (Continued) : 

Madhav M.mehta 21 Basel II (Continued) (b) Three Pillars (i) Minimum Capital; Capital to risk weighted assts. Min 8 % (ii) Supervisory Review; Sound capital assessment process, assessment of risk and internal control (iii) Market discipline; Transparency and disclosure

Money market instrumentsan overview 1/2 : 

Madhav M.mehta 22 Money market instrumentsan overview 1/2 Evolution of wide array of funding instruments. Bank loans to complex instruments involving bonds, with a variety of special features, coupled with derivative products like options and swaps. Driving force behind these innovations have diverse origin.

Money market instrumentsan overview 2/2 : 

Madhav M.mehta 23 Money market instrumentsan overview 2/2 Floating rate loans and bonds:- Reflect investor preference towards short term instruments due to volatility of interest rates. Note issuance facility permit the borrower to raise cheaper funds directly from the investor with fall back facility. Swaps have their origin in the borrowers’ desire to reshuffle composition of their liabilities. Medium Term Notes were designed to fill in the gap between very short term instruments like C.P. and long term instruments like bonds. Some like swaps have origin in market participants to drive to exploit capital market inefficiencies and arbitrage possibilities.

Overview of Money Market Instruments : 

Madhav M.mehta 24 Overview of Money Market Instruments Commercial Paper; Corporate, short term, unsecured promissory note issued at discount. Maturities usually 270 days. Usually roll over to retire old loan Placed through CP dealers. For highly rated borrowers. Cheaper than bank loan. For investor attractive short term investment opportunity. Negotiable but secondary market not very active. Back up from commercial bank required. 50 to 100% of the issue. Very popular in the U.S.

Overview of Money Market Instruments : 

Madhav M.mehta 25 Overview of Money Market Instruments Certificates of Deposit; Negotiable instrument, for larger values, deposit with bank, Used for short term bank funding in denomination of U.S.D 100,000/ or more. Banker’s Acceptances; Exporter’s usance bill on importer’s bank. Shipment. L/C. Exporter ‘s bank sends to importer’s bank with stamp “accepted.”and discounted Eurocurrency Market; A time deposit of money in an international bank located in other country

Overview of Money Market Instruments : 

Madhav M.mehta 26 Overview of Money Market Instruments Bonds Treasury bills, REPO and reverse repo. Repurchase obligations. Used by securities dealers to finance their holdings of securities. Repurchase price is same as purchase price but seller( borrower) pays interest. Overnight to upto a year.

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