ib assignment - combine

8/12/2019 IB Assignment - Combine

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Table of Contents

TRENDS IN FOREIGN BANKING ENTRY IN EMEs...................................................... 3

1. INTRODUCTION .............................................................................................................. 3

2. TRENDS IN FOREIGN BANKING ENTRY IN EMEs .................................................. 3

2.1. The external drivers of Foreign Bank entry ................................................................ 3

2.2. Aggregate trends: Foreign banks tend to invest in EMEs ........................................... 5

2.3. Drivers for investment in EMEs market ..................................................................... 5

2.4. Which banks expand in EMEs? .................................................................................. 7

2.5. Subsidiary by M&A .................................................................................................... 8

3. CONCLUSION .................................................................................................................. 8

RECENT DEVELOPMENT IN BANKING REGULATIONS.......................................... 9

1. INTRODUCTION .............................................................................................................. 9

2. RECENT DEVELOPMENT IN BANKING REGULATIONS ........................................ 9

2.1. The need of banking regulation ................................................................................... 9

2.2. Basel Framework....................................................................................................... 11

2.3. Money Laundering .................................................................................................... 14

2.4. Other developments in banking regulation ............................................................... 16

3. CONCLUSION ................................................................................................................ 17

REFERENCES ....................................................................................................................... 19

APPENDIX - TABLE ............................................................................................................ 24


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List of tables

Table 1 Number of banks by host country, Aggregates by income Level and Region (Stijn &

Neeltje, 2012) ........................................................................................................................... 24

Table 2 Foreign banks most common corporate structures .................................................... 24

Table 3 Summary statistic for bank M&A transaction ............................................................ 25

Table 4 Key international standards for sound financial system (Financial stability forum,

2011) ........................................................................................................................................ 26

Table 5 Changes in Basel III .................................................................................................... 27

List of figures

Figure 1 Number and share of Foreign Banks, 1995-2009 (Stijn & Neeltje, 2012) ................ 30

Figure 2 Number of entries and exits of Foreign banks (Stijn & Neeltje, 2012) ..................... 30

Figure 3 Relative Foreign bank presence across Host countries (Stijn & Neeltje, 2012) ....... 30

Figure 4 Economies share of world GDP ............................................................................... 31

Figure 5 GDP growth and the banking sector (PCW, 2013) ................................................... 31

Figure 6 FDI inflows to EMEs 1990-2008 (Arbatli, 2009) ..................................................... 32

Figure 7 Colume of world trade (Federal Reserve bank of Dallas, 2012) ............................... 32

Figure 8 Banking return on asset ratio (PCW, 2013)............................................................... 33

Figure 9 E7 v. G7 total domestic credit (PCW, 2013) ............................................................. 33

Figure 10 Four-phase location ................................................................................................. 34

Figure 11 Size of the financial market by country, region (Allen et al., 2004) ....................... 35

Figure 12 Number of Bank failures 1980-1994 (FDIC, 2001) ................................................ 35

Figure 13 Measures of Bank Performance 1980-2008 (FDC, 2009) ....................................... 35


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TRENDS IN FOREIGN BANKING ENTRY IN EMEs

1. INTRODUCTIONOver the last two decades, emerging markets economies (EMEs)1has seen an unprecedented

development of globalization, especially in foreign bank entry2. They effect strongly on

domestic economies and then reform EMEs financial system. Understanding the important

of foreign bank entry, this paper aims to discuss on the trends of foreign bank entry in EMEs

with updated information to answer prominent questions on why they are going abroad,

where they intend to enter, which banks are likely to invest in emerging market, which

business model they will use in host countries as well as what is their future development

strategies.

2. TRENDS IN FOREIGN BANKING ENTRY IN EMEsIn general, number of foreign banks in the world increases rapidly in the last two decades

from 774 in 1995 to 1334 in 2009 as mention in IMF report (Stijn & Neeltje, 2012) (See

Table 1). As a result, the share of foreign bank also increased from 18% to 36% (SeeFigure

1). This is the result of two balanced trends. Firstly is the decreasing of domestic banks. In

2009, the number of domestic bank is 17% lower than in 1995 due to the consolidation driven

by technological changes and deregulation in many countries. In addition, the financial crisisalso forces many banks to go bankrupt or changing their ownership to foreign banks (Stijn &

Neeltje, 2012). Secondly, the numbers of foreign bank increased sharply before the financial

crisis, and it is continue in present. InFigure 2 andFigure 3,the number of bank entry was

always higher than exit even during financial crisis, especially in 2006 and 2007.

2.1. The external drivers of Foreign Bank entryWith regard to the reason for foreign bank entry, many researches has found that the needs of

serving international customers, higher profit opportunities, lower entry barriers and

technology development are the main reasons. This is the basic understanding for further

discussion on the trends of foreign bank entry.

Internationalize of banks customers

1Countries on the transition from developing to developed (Citibank, 2012)

2Foreign bank entry refers to a process by which foreign banks set up operations in a host countrymainly by either opening up a branch or a subsidiary (Citibank, 2012)


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The first reason is that foreign banks, at first, open their business in other countries to serve

their international customers. Many of the earlier study have found a strong relationship

between the entry of German banks in other countries and the level of German non-financial

FDI in those countries (Brunch, 2000; Wezel, 2004). In addition, the research of Yamori

(1998) stated that Japenese bank were more interested to invest in countries which has high

financial demand from Japan companies.

H igh opportun iti es of host countr ies

The second reason is that foreign bank wants to pursue economic opportunities in the host

countries. They are the countries which have high GNP and GDP leading to high

development chance. This argument was supported by the research of Goldberg & Johnson

(1990), Goldberg & Saunders (1980), Goldberg & Saunders (1981), Buch & Lipponer (2004)

and Yamori (1998) which stated that foreign bank participation level have positive

correlation with GNP, GDP of host countries as well as the size and growth of banking

sector. Especially for EMEs, Leung et al., (2008) and Lee (2003) also proved that foreign

bank entry level is related to the development of local banking industry.

Lower entry barr ier

The third reason is the lower of entry barrier. Many researches indicated that foreign bank

invest more in countries with easier regulation on foreign bank activities as well as lower

taxes. (Goldberg & Grosse, 1994; Focarelli & Pozzolo, 2000; Buch & DeLong, 2004; Buch

& Lipponer, 2004; Galindo et al., 2003 and Claessens et al., 2000)

Development of technology

The next reason is that technology development helps foreign bank to lower information cost

between countries as well as to build better management and control system at international

level.

There are many other reasons such as common languages and common other framework.

However, there are not famous studies to prove these arguments in recent

I ncome diversi fi cation and excess managerial capacity

An important factors motive banks to invest overseas is the needs of diversify profits. It helps

them to continuously increase their income, take the advantage of economic of scale and,


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more important, they can also reduce risk of single-country investment. In addition, bank

needs to recruit and train many expertises even if they are not necessary at the moment.

Entering a new geographical market can helps them to efficiently use these resources (Casu et

al., 2006).

Location and the product li fe cycle

The product life cycle and the location relationship can be another reason for overseas

movement. Banks can be more flexible in finding new market with high income, low cost and

allocate their resources more effectively. They can develop in four phrases (Figure 10). In

phase one, they only work in their home country and export services to customer abroad. In

the next phase, they can set up new business oversea to serve more customers. For the next

development process, they concentrate on the host country production is they have

advantages over home country. In the last phase they can totally change their business to host

country if the cost of host country is much lower.

2.2. Aggregate trends: Foreign banks tend to invest in EMEsWith all of these reasons, many banks open their business abroad and EMEs becomes the

main market for foreign bank entry. In 1995, 31% of foreign bank distribution is in OECD

countries, 4% in high-income countries, 23% in develop countries and 43% in emerging

market (Wezel, 2004). Table 1 show that EMEs always maintain the leading position in

foreign bank distribution by 43% in 2009 when OECD decreases to 25%. The number of

foreign bank in emerging market is counted for 330 in compared with 569 in 2009 (Stijn &

Neeltje, 2012), so it grew by 72%. All of these evidences prove that foreign bank tends to

invest their business in EMCs rather than in OECD and high-income country.

2.3. Dr ivers for investment in EMEs marketFollowing the fact that EMEs banking investment is increasing rapidly, the important

question is why they choose this market. There are four basic reasons which are economic

growth, internationalization of customers, baking return on assets, regulation reform and

strategic shift.

Economic growth

EMEs as in it definition is the countries which is transforming from developing to developedcountries. However, the difference is that they have more opportunities for banking


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investment when the entry barriers and domestic competition is not as hard as in developed

countries. Page (2013) predicted that in the next 40 years, E7 emerging market will got

higher GDP than G7 with the growing rate of 4.7% in compare with 2.1% of G7 countries or

in the forecast of World Bank (2010), Economies share of world GDP will be higher in

emerging market and lower in Developed countries in 2020 (Figure 4). In addition, PCW

(2013) found out a significant positive relationship between GDP per capita growth and the

average annual rise in the domestic credit to GDP ratio (Figure 5). Therefore, with very fast

economy develops, the banking system of EMEs will growth faster and become and attractive

markets for foreign banks.

I nternationali zation of bank customers

EMEs is opened its door for foreign investment in their countries. As a result, with high

economic growth of EMCs, many customers of banks expanded their business in these

countries. The forecast of IMF said that FDI inflow of EMEs will develop very fast in the

next 20 years (Arbatli, 2009). In their historical data, the percent FDI to GDP in EMEs

increased continuously (Figure 6). In addition, the import and export of EMEs is higher than

global and developed country as in the report of (Federal Reserve bank of Dallas, 2012). As a

result, foreign bank investment is higher in EMCs.

H igher banking return on assets

EMEs are expected to get high banking return on asset which is important for foreign

banking investment (Figure 8). It helps them to receive higher development opportunities.

According to PCW (2013), by 2050, total banking assets in the E7 tends to exceed those of

G7 (Figure 9). Furthermore, banking profit pools in the E7 markets are will also higher than

those of G7. EMEs have very low labour cost as well as operation cost for new business. In

addition, they have more opportunities for expert recruitment.

Strategic shi ft

Banks in developed countries have changed their strategies to invest in EMEs. They want to

make large portfolio in their investment to get back investors loyalty during the financial

crisis of US and Europe. Investments in EMEs help them to maintain profit and from that,

reduce the risk of doing business in one country.

Regulation reforms


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Emerging market policy was changed positively in the past 20 years. It helps foreign banks

easier for entry. In the report of HSBC, Mr. Emmett said that Emerging markets are

developing at a phenomenal pace and are set to reshape world trade patterns over the next 20

years (Adam, 2013). As a result the banking system of these counties will develop stronger

with more foreign bank.

2.4. Which banks expand in EMEs?It is a fact that many banks want to enter to EMEs, but it cannot be all of them. Only banks

with suitable size, doing business efficiently and being allowed by home country regulation

can invest in emerging market.

Size

There are many reasons for the argument that larger banks tends to expand their business in

EMEs. Firstly, larger banks have more international and giant customers. Therefore, they are

more likely to open their business in EMEs to offer services. Secondly, larger banks which

have larger home-market share is more motivated to make risk diversification in EMEs.

Tschoegl (1983) proved that larger banks exhinit a greater possibility of precense worldwide.

Efficiency

There are two conditions for business efficient of banks in host country if they intend to open

their business in EMEs. The first condition is that foreign bank entrant business in host

country is more efficient than domestic banks of host countries. This statement is confirmed

by the research of Barajas et al (2000). They found out that a larger number of foreign bank

have fewer non-performing loans, lower reserve requirements, and are more productive.

Lastly, Focarelli & Pozzolo (2000) found out that there is a positive relation between banks

return on assets and the possibility of global expanding. They believe that these banks look

for new profit opportunities and large share and revenue in EMEs.

Home countr y regulation

Home country regulation is a very important factor effect on foreign bank entry. These

include regulation or restriction on international investment in regard to how much benefit

the investment will give back to the home country. Focarelli & Pozzolo, (2000) stated that the

higher restriction on domestic banks activities, the lower degree of bank globalization.


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2.5. Subsidiary by M&AThere are four main mode of entry for foreign bank in EMEs which are representative offices,

agencies, branches, and subsidiaries (Table 2). However, representative office and agencies

can only provide on a limited services when branches and subsidiary can performs as a

domestic banks, so they effect stronger in domestic economy and is more important for

foreign banks. In total, foreign banks usually open their new business as subsidiaries because

of four main reasons.

Easier regulation: The restriction of foreign banks entry under branches is stricter

than opening subsidiary. This is true for both home and host country regulation. On

the other hands, foreign banks can usually open subsidiaries by M&A. This is usually

the result of a non-efficient financial system which can happen in EMEs.

Taxation: Subsidiary can helps foreign banks to receive the advantage of lower

corporate tax because they have seen as a domestic bank.

Risk matter : Subsidiary is prefer by parent banks because it can limit the risk by

making hard limited liability.

Size: Subsidiary is more suitable to open large business in host country because it

helps them to be more flexible in managing their business and to be easier to expand

them in different locations.

There is a recent trend in which foreign bank usually open subsidiary in host countries to be

benefit from lower taxation and easier regulation as well as more opportunities to expand

their business. The number of banking M&A in emerging market is increased as in Table 3.

This is the result of M&A of foreign banks in EMEs. There are two main reasons for this

attitude. The first is that the deregulation of EMEs as proves in the report of Hawkins &

Mihaljek (2001). The second reason comes from the financial benefit of M&A. In thisbusiness, acquirer shareholders do not lose value as a result of M&A announcement. On the

other hand, they also create more value for shareholders of acquired bank (Goddard et al.,

2010).

3. CONCLUSIONThe number of foreign banks in the world is increasing rapidly, especially in EMEs. These

markets have very fast economic growth in the recent years and also in future, this will higher

baking return on assets for foreign banks. In addition, they have to follow their customers


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who invest in EMCs to maintain their business. However, only the banks with large size have

efficient business tends to expand in EMEs. They tend to invest a large amount of money in

these markets. Furthermore, there is a trend of subsidiary mode in foreign bank entry through

M&A in EMEs. With these discussion, the assignment answered the entire prominent

questions on why they are going abroad, where they intend to enter, which banks tend to

invest in emerging market, which banking model they will use in host countries as well as

what is their future development strategies.

RECENT DEVELOPMENT IN BANKING REGULATIONS

1. INTRODUCTIONIn the last several years, the world has seen many abnormal changed in the banking industry.

In the 50s and 60s decades, the banking system is very stable, but in contrast, the frequency

of bank failures and financial crisis has increased dramatically since the Great Depression.

Because of their significant role in the economy, banking failure leads to the recession for

many economies. Therefore, banking regulators always try their best to prevent those

situations by continually improve the banking regulation system. This paper will discuss on

the recent development of banking regulation all over the world. The discussion will focus on

Basel by assessing the development in the entire three versions of this framework. In

addition, a deep review on money laundering will be also conducted.

2. RECENT DEVELOPMENT IN BANKING REGULATIONS2.1. The need of banking regulation

Bank' s role in the economy

Bank plays a very important role in the economy and the development of every country. It is

because banks ensure and facilitate the efficient allocation of resources. They play the role of

delegated mentors and ensure borrowers (households and firms) to use funds effectively

(Diamond, 1984). They connect different lenders to borrowers, funds to firms and therefore

they are both lenders and borrowers in the financial market. As a result, they help

government to develop economy and increase GDP (Gorton & Winton, 2003). More

specifically, according to Allen & Carletti (2011), banks have four basic functions. At first,

they ameliorate the information problem (moral hazard and asymmetric information) between

investors and borrowers. In addition, they also provide insurances to savers againstunpredicted consumption shock. Lastly, as mentioned, they contribute to the growth of the


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economy and help corporate governance. In the real economy, as in the Figure 11,bank loan

is always the most and or the second biggest market at abouthe United States, except for

United States, and this position is almost unchanged historically.

The r isk of bank runs and of moral hazard banki ng and their eff ects on the economy

Because of the importance of the banking system, any failure in this industry may lead to the

damage of the whole economy. However, the bank industry faces with very high risk. The

first risk is bank runs3. Because all banks operate in the base of liquidity reserve, with a low

level of liquidity, a bank can be bankrupt by bank runs. There are many famous cases in the

literature when many depositors withdraw money at the same time because of the concern

about bank solvency. Lehmans Brother can be a significant evidence of this situation. In

parallel, another problem is the risk of excessive risk taking (moral hazard4) in banking. This

problem happened because the risk of investment failure is mostly carried by savers or

depositors when the profit is, in fact, come to the bank. They tend to invest in high risk

projects to earn more profit. Therefore the first important purpose of banking regulation is to

ensure the safety and stability of financial and the whole economic system (Bonn, 2005).

Another reason for banking regulation is to limit the negative effect of bank failure of the

economy. Specifically, they avoid the systemic dangers and the dangers of the paymentsystem. According to Feldstein (1991), the systemic dangers can be distinguished in two

situations. The first is a consequent failure when a bank failure results in decreasing in the

value of the assets sufficient to induce the failure of another bank. The second is contagion

failure when the bank failure of one bank lead to the failure of other fully solvent bank and

then damages the whole banking system due to the interrelation in the system. In terms of

dangers to the soundness of the payment system, bankruptcy of banks can stop the payment

system of the economy.

An overview of banking regulation

Any bank in the world is controlled by many national and international regulations. As

mentioned, all of them have the aims of ensuring sound and efficient payment system,

controlling liquidity of the banking system, regulating the allocation of financial resources as

3The situation when all depositors demanded their deposits back at the same time

4

The risk that a party to a transaction has not entered into the contract in good faith, has providedmisleading information about its assets, liabilities or credit capacity, or has an incentive to takeunusual risks in a desperate attempt to earn a profit before the contract settles (Investopedia, 2013).


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well as controlling cross-border flow. Table 4 shows the major international standards in the

banking system. However, in recent, Basel is one of the most discussed topics on banking

regulation. It is an international framework for all of the regulators in the world. In parallel,

money laundering is also an important issue since the scandal of HSBC. This is the focus of

this paper.

2.2. Basel F rameworkI n the need of global regulatory f ramework

After the financial crisis, the question for all government in the world is how to better

regulate the financial system, especially the banking system. A famous evidences are the

unexpected recession of 1929 which caused by many bank-run in the U.S. and effect badly onthe economies as mentioned before. To stop bank-run, the first suitable action is to impose a

suspension on convertibility and so temporary limit deposit withdraw. In their research,

Diamond & Dybvig (1983) discuss on a better way as they believed which is deposit

insurance. The problem is that this insurance is very expensive. In addition, bank tends to

take more risky investment if this risk is limit of central bank insurance. As a result, different

country had built its own regulation based on different argument and make chaos. Therefore,

in 1988, the Basel Committee on Banking Supervision introduced Basel accord to controlbanking system under the auspices of the G10 (Basel Committee on banking supervision,

2009). This helps the world to standardized and common the global banking assessment.

Later, in 2004, they created Basel II to deal with new problems in the market. And in recent,

they are working on Basel III with more development in banking regulation.

Basel I5

The beginning of Basel Accord is, in fact, come from the 1980 crisis. At that time, a large

number of developing markets defaulted their loans in international banks. The crisis leads to

failure of 1,617 banks in the world (FDIC, 2001) (see Figure 12). However, the economic

development and the banks' business itself had developed strongly before that (Figure 13).

Many research, after that, found out that the most important reason is that failure bank has

very low capital in their balance sheet. Therefore, Basel Accord firstly pays attention to

capital adequacy requirement. This capital requirement is used to ensure that they will have

enough money to pay during bank run. In addition, this will help to improve customer loyalty

5The more specific discussion on Basel I can be found in the appendix.


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on bank solvency and do not withdraw money from the bank. Basel I requires banks to

control the capital based on the risk asset ratio.

However, later, they found out that market risk is also an important cause of bank failure. As

a result, they introduced market risk6as a new variance in Capital adequacy requirement in

the Amendment of Basel I. The new calculation, therefore:

Basel I recommend that bank must ensure the capital of equal or higher to 8% of total assets.In addition, there must be 4% of Tier 1 capital.

Basel I have a lot of limitations which fixed in the next versions. At first, Basel I only base on

Capital requirement. Secondly, risk classification in Basel I is not really reasonable because

banks with the same capital adequacy ratio many deals with different customers and different

investment which cause different levels of risk. Thirdly, the framework did not mention about

the diversification of investment portfolio which can reduce risk. In addition, Basel I did not

pay attention to other risk such as operational risk. And lastly, Basel I cannot apply for banks

having a complex structure with many subsidiaries, branches in international levels (Barth et

al., 2012).

Basel I I

In 1999, by understanding the limitation of Basel I, Basel Committee on Banking Supervision

introduced Basel II. This new version is defined by three pillars. The first pillar is the

minimum capital requirement as in Basel I. However, in this version, the regulatory capital

will be calculated in three major components of credit risk, market risk and also the new

operation risk to avoid bankrupcy. In order to ensure that, the supervisory review process is a

tool for supervisor to check if that banks will follow the minimum capital adequacy

requirement. And the third pillar is the market discipline which help the free market to join in

the supervisory process.

6 Market risk include: Equity price risk, Interest rate risk associated with fixed income instruments,Currency risk, Commodities price risk, Transaction activities which lead to market risk.


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Basel II has many advantages over the old version. It concentrates more on the internal

control of the banks itself and also the role of external supervision of other organizations.Furthermore, it allows regulators and bank management to be more flexible in applying the

new accord in order to fix the one size fit all problem. It also accepts the existence of risk

reducing technique such as positioning netting and portfolio diversification.

Basel I I I -recent and futur e development of banking regulation(Table 5)

Although Basel II is not fully applied in the world, in 2008, the financial crisis proved that

Basel II needs to be improved. This crisis occur even the entire capital adequacy of the

banking system was strong (Figure 13). A famous case is Lehman Brothers when it has very

strong capital ratios as in their report right before the bankruptcy. Later research stated that

they made their balance sheet become more attractive than it must be. In addition, their asset

has very low liquidity. Therefore, Basel III tends to fix this problem and also improve their

previous policy through informing new requirement on: minimum capital requirement,

leverage ratio and liquidity ratio.

In terms of minimum capital requirement, Basel II requires an additional of 2.5% Capital

Conservation Buffer and also allows governments to increase a counter-cyclical buffer. The

evaluation of risk weight will depend on market risk, credit risk, operational risk and also

liquidity risk.

Basel II was not good at credit valuation when a bank can use leverage ratios of non-risky

assets put on their balance sheet when it is riskier than that they write. Therefore, instead of

only calculate leverage ratio of risk based, Basel III minimum this ratio of 3% and that is not

based on the risk weights (Auer & Pfoest, 2012).

The third important change in the new accord is Liquidity standards which have not been

considered in a very long time. This new ratio includes short-term ratio called liquidity

coverage ratio (LCR) and the long-term ratio of net stable funding ratio respectively (NSFR)

(Michail & Tim, 2012). The LCR ensures that bank has high liquid assets. To prove this, the

bank must calculate the cash flow in over 30 days with stress testing. The high liquid asset

must equal or greater than the measured cash flow. About NSFR, this force banks to ensuring

that long-term assets will be funded by stable liabilities. With this aim, banks have to increase


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long-term funding for low quality liquid assets as well as for assets which is important in the

economic crisis.

With the new development of Basel III in response to the 2008 crisis, each country can

consider applying in their national regulation. It is expected to reduce risk in the banking

industry and then strengthen the financial system.

2.3. Money Launderi ngRecent issues of Money launder ing

In the recent time, money laundering becomes a significant problem for the whole economic

system. Money laundering is becoming more complex with cross - border transactions

between many different international banks. However, rapid development of the international

banking system is one of the extremely supportive tools for this violation. HSBC can be a

good example in this case. According to BBC (2012), HSBC was punished $1.9bn for money

laundering scandal. Between 2007-8, HSBC Mexico, HBMX and HSBC US transferred $7bn

around. HBMX had a highprofile customers which involved in drug transferring, they also

have millions suspicious dollar of travelers checks. In the past, they also had a scandal on

laundering $19.7bn of Iran. Or in the most recent news in March 2013, they are believed to

relate to a money laundering scandal of $77m in Argentina (BBC, 2013). Although paying

too much attention to the anti-money laundering system by investing $290m on the system of

preventing money laundering, and also be supervised strictly by the government, the relation

between money laundering and HSBC cannot be broken. This is a big problem for also other

banks and it can damage the economy.

Money Launderi ng

Money laundering is defined as the act of transforming profits earned from a criminal

activity into legal profit (Heffernan, 2007). This action can be confused as flight capital

which is a legal work of transfer money from one place to another to make more profit or to

prevent risk. However, flight capital is usually after-tax money which has been proved the

original source when money laundering has not. Money laundering can be performed by a

Smurf organization who helps to transfer money through three steps: placement, layering and

integration (Heffernan, 2007) . In the placement phase, money will be put into a financial

institution. Then, they will be moved to another institution one or many times to hide the


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original sources. Lastly, at the integration phase, they will use washed money to invest in

legal business.

Banki ng regulation on money launderi ng

The bank is the most useful channel for money laundering, therefore, many regulations has

been supervising banks strictly to avoid this violate. Willful negligence is one of them which

has a very high penalty. Many countries require that banks must report suspicious

transactions7 to the government. In addition, they must establish an internal control system

for all of their business operations to prevent money laundering from any organization or

individual. One of the famous programs is Know your customers. This program expects the

banks to evaluate their customers identity, the sources of money in all aspects of bank

business before transaction. They are also forced to have an adequate recordkeeping system

to control the currency purchases over a limit value.

In the US, the most important regulation in money laundering is Bank Secrecy Act (1970)

which stated that banks must record transaction of $10,000 or more and the government can

lower this value requirement. The history of US anti-money laundering laws also include the

money laundering control act (1986), Anti-drug abuse act 1988, Annunzio-Wylie anti-money

laundering act (1992), Money laundering suppression act (1994), Money laundering andfinancial crimes strategy act (1998), USA PATRIOT act (2001) (US states department of

treasury, 2013). The most recent development in US anti-money laundering program is the

Intelligence reform & Terrorism prevention Act introduced in 2004. This forces Secretary of

the Treasury to create regulations in which require banks to report cross-border transaction or

funding even on the electronic channel. The reason is that they found out money laundering is

operated at an international level these days.

In the UK, there are also many laws on money laundering which can be listed such as The

1986 drug trafficking offenses act, the 1987 prevention of terrorism act, the criminal justice

act of 1990 and the criminal justice act of 1993. And the most recent law in the UK is the

money laundering regulations 2007 (UK Law, 2007). This new regulation, in general requires

banks to assess the risk of being used by criminals to launder money, check customers and

beneficial owners identity, monitor customers business activities, provides internal control

system, keep all documents related to any transaction as well as make sure that banks

7Suspicious transactions include which is just below $10,000 (in US), high cash flow from industrywhich is in depression or someone who show the teller a suitcase of cash.


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(EMR). It is a proof that the future business of banks will only base on technology system

(EU Payment Services Directive, 2011).

Recent development in Stress testing

At EU level, CEBS issues a guideline on stress testing which helps banks to build and

implement the stress testing program with a robust governance structure. In the updated

version in 2011, they show that they are tighter in tier 1 capital control by introducing new

consistent capital benchmark of this capital type (Committee of European Banking

Supervisors, 2011). In the UK, government and the FSA also require banks to build a robust

stress testing program for controlling purpose of capital and liquidity in different business

situation (Financial Services Authority, 2011).

Recent development in Shadow Banks8

Shadow bank is believed to become a big problem in the banking system. They have a high

risk of facing with bank-runs when regulators, at recent, cannot control their business. In

addition, they do not have access and deposit insurance from the central banks which lead to

the low confident level for investors and customers. However, shadow banks failure can lead

to unwelcome effect on the financial system and also the whole economy by their relationship

with the regular banking system. The Financial Stabilities Board has proved that they will use

all of regulation effort to minimize risk of bank-runs and the contagion effect of shadow

banks (Financial stability board, 2012). The European Commission also wants to control

these banks through five they area: banking regulation, asset management regulation issues,

securities lending and repurchase agreement, securitizations and general work on shadow

banking entities starting in 2013 (European commission, 2012).

3. CONCLUSIONThe banking regulation system has changed too much in the last 5 years because of their

important role in the economic system. In general, regulators want to internationalize banking

laws. Basel is the most famous one. In recent, they want to improve the bank supervisory by

publishing Basel II and recommend Basel II concept. They introduced new regulations on

capital, liquidity and leverage ratio requirement. Furthermore with the fast

internationalizations of the banking system, regulators are paying more attention to money

8 The FSB has recently defined shadow banking as credit intermediation involving entities andactivities outside the regular banking system (FSA, 2012).


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laundering. They control this problem through many different regulations with high

punishment. In conclusion, to face with the high level of internationalization and the more

complex situation of banking business, regulators have changed and issues new laws which

require better management system of banks. They force management and also shareholder to

participate in internal and international control of their business system with better payment

system, and better risk calculation methodology such as stress testing. In the following year,

shadow banks will be also regulated as expected. However, regulators do not want to meet

one size fit all problem. They tend to give more regulations covering more aspect of the

banking system but with more flexibility and options for different business situation.

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bank, interbank market funds, or other money market transactions such as short-term

certificates of deposit or repurchase agreements. Agencies are attractive forms oforganization

for banks interested in wholesale banking. They can make loans, pay checks,and maintain

credit balances.

Similar to a branch and agency and unlike a subsidiary, a representative office is part of the

parent bank and not a separately capitalized, distinct legal entity. By regulation, it cannot

perform any of the core banking functions such as taking deposits, maintaining credit

balances, granting loans, or providing payments services. Representative offices are often

established either to provide services to customers based in the home country of the parent

bank or to explore market entries.

Finally foreign banks can participate in consortium banks with other banks. This type of

foreign bank entry is often used to explore foreign markets. The parent bank is not

responsible for the liabilities of this bank and is only involved as a shareholder. Particular

host country regulations may deviate from this summary. The summary here is based on

modern banking principles in advanced economies.

As discussed in the text, most regulators from Latin America impose the same capital and

liquidity requirements for branches and subsidiaries.

Table 3 Summary statistic for bank M&A transaction


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Table 4 Key international standards for sound financial system (Financial stability forum,

2011)


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Table 5 Changes in Basel III


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AppendixFigure

Figure 1 Number and share of Foreign Banks, 1995-2009 (Stijn & Neeltje, 2012)

Figure 2 Number of entries and exits of Foreign banks (Stijn & Neeltje, 2012)

Figure 3 Relative Foreign bank presence across Host countries (Stijn & Neeltje, 2012)


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Figure 4 Economies share of world GDP

Figure 5 GDP growth and the banking sector (PCW, 2013)


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Figure 6 FDI inflows to EMEs 1990-2008 (Arbatli, 2009)

Figure 7 Column of world trade (Federal Reserve bank of Dallas, 2012)


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Figure 8 Banking return on asset ratio (PCW, 2013)

Figure 9 E7 v. G7 total domestic credit (PCW, 2013)


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Figure 10 Four-phase location


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Figure 11 Size of the financial market by country, region (Allen et al., 2004)

Figure 12 Number of Bank failures 1980-1994 (FDIC, 2001)

Figure 13 Measures of Bank Performance 1980-2008 (FDC, 2009)


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Basel I

Basel I original

Tier 1 or core capital: common equity shares, disclosed reserves, non-cumulative preferred

stock, other hybrid equity instruments, retained earnings, minority interests in consolidated

subsidiaries, less goodwill and other deductions.

Tier 2or supplementary capital: consisting of all other capital but divided into (1) upper tier

2 capital such as cumulative perpetual preferred stock, loan loss allowances, undisclosed

reserves, revaluation reserves (discounted by 55%) such as equity or property where the value

changes, general loan loss reserves, hybrid debt instruments (e.g. convertible bonds,

cumulative preference shares) and (2) lower tier 2 subordinated debt (e.g. convertible

bonds, cumulative preference shares).

Risk weightsare assigned to assets by credit type. The more creditworthy the loan, the lower

the risk weight.

0%: cash, gold, bonds issued by OECD governments. 20%: bonds issued by agencies of OECD governments (e.g. the UKs Export and

Credit Guarantee Agency), local (municipal) governments and insured mortgages.

50%: uninsured mortgages.

100%: all corporate loans and claims by non-OECD banks or government debt, equity

and property.

Market risk calculation

There are two approaches to calculate market risk: The internal model approach and the

standardised approach

The internal model approach

Bank models must compute VaR on a daily basis.


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Specific information on market risk

Equity risk:

Determining the market risk arising from equities is a two-stage process, based on a charge

for specific risk (X) and one for market risk (Y). To obtain the specific risk the net (an offset

of the long and short of the spot and forward position) for each stock is computed. The net

exposure of each share position is multiplied by a risk sensitivity factor, which is 8% for

specific and market risk, but if the national regulator judges theportfolio to be liquid and well

diversified, the systematic risk factor is reduced to 4%. In the example below, it is assumed to

be 4%.

Foreign exchange and gold risk

Recall that all derivatives have been converted into the equivalent spot positions. A ban ks

net open position in each individual currency is obtainedall assets less liabilities, including

accrued interest. The net positions are converted into US$ at the spot exchange rate. The

capital charge of 8% applies to the larger of the sum (in absolute value terms) of the long or

short position, plus the net gold position. Alternatively, subject to approval by national

regulators, banks can employ a simulation method. The exchange rate movements over a past

period are used to revalue the banks present foreign exchange positions. The revaluations

are, in turn, used to calculate simulated profits/losses if the positions had been fixed for a

given period, and based on this, a capital charge imposed.

I nterest rate r isk

The capital charge applies to all debt securities, interest rate derivatives (e.g. futures,

forwards, forward rate agreements, swaps) and hybrid instruments. The maturity approach

involves three steps:

Obtain a net overall weighted position for each of 16 time bands. Before they are summed,

the net position in each time band is multiplied by a risk factor, which varies from 0 at the

short end to 12.5 at the long end.

10% of each net position in each time band is disallowed to take account of the imperfect

duration mismatches within each time bandknown as vertical disallowance.


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There is another problem: the interest rates in the different time buckets may move together,

which is resolved through several horizontal disallowances, which vary from between 30%

and 100% (i.e. no disallowance) in recognition that the degrees of correlation will vary. The

matched long and short positions between the time buckets can be offset, but:

a 40% disallowance applies in the first set (01 year);

a 30% disallowance applies to the other two sets of time bands, i.e. 14 years and

over 4 years;

there is a 40% disallowance for adjacent time buckets, and a 100% disallowance between

zones 1 and 3.

Commodities risk

This risk is associated with movements in prices of key commodities such as oil, natural gas,

agricultural products (e.g. wheat, soya) and metals (e.g. silver, copper, bronze) and related

risks such as basis risk, or changes in interest rates which affect the financing of a

commodity. The capital charges are obtained with a methodology similar to that used for the

other three categories, but it will not be discussed here.

ib assignment - combine

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