International Banking

Central Banks and Supranational Financial Policymaking Institutions

INTERNATIONAL MONETARY AND

FINANCIAL ECONOMICS

Third Edition

Joseph P. DanielsDavid D. VanHoose

Copyright © South-Western, a division of Thomson Learning. All rights reserved.

2

International Dimensions of Financial Intermediation

• The financing of capital investment projects may be direct or indirect.

• Direct Finance: When savers allocate some of their wealth to the purchase of a bond issued by a company, they effectively make a direct loan to the company.

• Indirect Finance: When a banking firm pools together the funds of deposit holders and purchases a bond issued by a company, savers are indirectly lending funds to the company.

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Indirect Finance Through Financial Intermediation

Financial intermediaries facilitate indirect financing by issuing their own financial instruments and using the funds they obtain from savers to finance capital investments of businesses.

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The Role of Financial Intermediaries

• Savers may desire to direct funds through a financial firm because of asymmetric information.

• Asymmetric Information: Possession of information by one party in a financial transaction that is not available to the other party.

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Asymmetric Information Problems

• Asymmetric information can lead to several types of problems in financial markets such as:

• Adverse Selection: The potential for those who desire funds for unworthy projects to be among the most likely to want to borrow or to issue debt instruments.

• Moral Hazard: The possibility that a borrower might engage in more risky behavior after receiving funds from a lender.

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Economies of Scale

• Financial intermediaries specialize in collecting information and analyzing the risk of potential capital investment projects. Hence, they may help reduce asymmetric information problems.

• Economies of Scale: Another potential benefit and reason for financial intermediaries to exists is that, by pooling the funds of savers, and increasing the scale of the total amount of savings managed by a single entity, they may reduce the average costs of managing savings.

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Financial Intermediation across National Boundaries

• International Financial Diversification: Holding financial instruments in various countries to spread portfolio risks.

• World Index Fund: A portfolio of globally issued financial instruments with yields that historically have moved in offsetting directions.

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Banking Around the Globe

• One dimension along which banking systems differ concerns the extent to which banks are the predominant means by which firms finance their working capital needs.

• U.K. firms, for example, firms raise nearly 70 percent of their funds through bank loans, while U.S. firms raise fewer than 30 percent of their funds through bank loans.

• Bank market structure, or the organization of loan and deposit markets in which banks compete, is another dimension along which banking systems differ.

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Universal Banking

• Universal banking is a feature that traditionally distinguished national banking systems.

• Universal banking is an environment in which banks face few if any restrictions on their authority to offer full ranges of financial services and to own equity share sin corporations.

• There is now a convergence toward universal banking among the advanced economies.

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Global Payment Systems

• Payment System: A term that broadly refers to the set of mechanisms by which consumers, businesses, governments, and financial institutions make payments.

• Large-value wire transfer systems are payments systems that permit electronic transmissions of large volumes of funds.

• Fedwire is a large-value wire transfer systems operated by the U.S. Federal Reserve.

• Clearing House Interbank Payments System is a privately owned system that is primarily used for foreign exchange and Eurocurrency transactions.

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Payment-System Risks

• Liquidity Risk is the risk of loss that may occur if a payment is not received when due.

• Credit Risk is the risk of loss that could take place if one party to an exchange does not honor the complete terms of the exchange.

• Systemic Risk is the risk that some payment institutions may not be able to meet the terms of payment arrangements because of the failure of other institutions to settle unrelated transactions.

• Herstatt Risk is liquidity, credit, and systemic risks across international borders.

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Financial Instability and International Financial Crises

• Financial instability is a situation in which a nation’s financial sector is no longer able to allocate funds to the most productive projects.

• Financial crisis is when an nation’s financial system is unable to function and typically involves a banking crisis, a currency crisis, and a foreign debt crisis.

• Speculative attack is a concerted effort by financial-market speculators to induce abandonment of an exchange-rate target that will yield them profits in derivative markets.

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Estimated Exchange Market Pressure

Pressure on currency values in foreign exchange markets during the 1990s

appear to have first increased in

Thailand before spreading to

Malaysia, Indonesia and Korea.

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Bank Regulation and Capital Requirements

• Bank regulation and supervision is a fundamental part of most nation’s strategies for reducing the potential for financial instability and crisis. Typically, regulation aims to limit bank failures, maintain bank liquidity, and promoting an efficient financial system.

• Insolvency is a situation in which the value of a bank’s assets falls below the value of its liabilities.

• A bank is illiquid if it has insufficient funds available to meet the cash needs of its depositors.

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Deposit Insurance

National governments increasingly offer deposit insurance guarantees to promote confidence in their countries’ banking systems. Hence, the number of

government systems has increased significantly since the 1960s.

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Bank Capital Requirements

• Risk-Based Capital Requirements are regulatory capital standards that account for different risk factors that distinguish bank’s assets.

• Under the Basel capital standards, developed at the Bank for International Settlements, banks must compute ratios of capital in in relation to their risk-adjusted assets. This is a weighted-average of assets in which the weights reflect regulator’s perception of distinctive asset risks.

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Equity as a Percentage of Bank Assets in the United States

U.S. bank equity ratios fell considerably between the mid-nineteenth and mid-twentieth centuries. Recently they have

risen slightly.

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Central Banks

• Considerable expansion of the number of central banks occurred in the beginning of the latter part of the nineteenth century and particularly during the latter part of the twentieth century.

• The best place to begin an examination of the functions of a central bank is with their balance sheets.

• Two principle assets are holdings of domestic government securities and foreign-currency denominated securities and deposits. Two principle liabilities are currency notes in circulation and bank reserve deposits.

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Number of Central Banking Institutions1670 - Present

The twentieth century witnessed considerable growth in the number of central banks.

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What Central Banks Do

• Central Banks as Government Banks: Central banks may serve as government depositories and as fiscal agents.

• Central Banks as Bankers’ Banks: Central banks supervise and regulate the systems through which individuals, businesses, and banks exchange payments and promote confidence in the banking system by acting as a lender of last resort.

• Central Banks as Monetary Policy Makers: Central banks can bring about variations in interest rates, thereby changing the volumes of money and credit.

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Central Banks as Monetary Policy Makers

• Central banks have access to a number of policy instruments, or financial variables that they can control in an effort to achieve policy objectives.

• Traditionally these instruments are:– Interest Rates on Central Bank Advances– Open-Market Operations– Reserve Requirements

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Supranational Financial Policymaking Institutions

• International Monetary Fund (IMF): A multinational organization that promotes international monetary cooperation, exchange arrangements, and economic growth. It provides temporary financial assistance to nations experiencing balance-of-payments difficulties.

• World Bank: A sister institution to the IMF that is more narrowly specialized in making loans to developing nations in an effort to promote their long-term development and growth.

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International Monetary Fund

• Currently has over 180 member nations.

• A quota subscription is required when joining. these are a pool of funds that IMF managers can use for loans to member nations.

• Conditionality is a set of limitations on the range of allowable actions of a government that is receiving IMF loans.

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Growth in IMF Membership

The number of member nations in the International Monetary Fund is now about six times larger than it was when the organization was founded.

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IMF Quota Subscriptions

The quota subscription of each member nation, which is denominated in SDRs, depends on the nation’s real national income. A country’s quota subscription determines its voting share within the IMF and how much it is able to borrow under standard IMF credit arrangements.

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The World Bank

• Narrowly specialized, making loans to about 100 developing nations.

• In contrast to the IMF, the World Bank has always specialized in long-term loans designed to spur long-term development and growth.

• Typically governments seek World Bank loans for specific projects as opposed to supplementing their overall budget.

• The wealthiest nations fund most of the World Bank’s activities, though the Bank also raises funds in private capital markets.