International Banking and the International Capital Market

OutlineIntroduction to the international capital market

The players of the ICM

Growth of the ICM

Offshore banking and offshore currency trading

Growth of Eurocurrency trading

Importance of regulatory asymmetries

Introduction to the ICM

Introduction to the ICMDefinition: the market in which residents of

different countries trade assetsIt is not a single marketThere is no physical locationMost activity is in a network of world

financial centersThe ICM exists because of international tradeThe ICM also adds to the gains of trade by

lowering transaction costs

The Players of the ICM

The Players of the ICMCommercial banks

Bulk of the ICMRun the international payments mechanismBroad range of financial activitiesFree to pursue goals overseas that they can’t do

domesticallyMultinational Corporations

Finance investments through foreign sources of funds

Use equity securities as well as debt securitiesDenominate their bonds in the foreign currency

The Players of the ICMNonbank Financial Institutions

Insurance companies, pension funds, mutual funds, hedge funds

Investment Banks Not banks; specialize in underwriting sales of stocks and bonds by

corporations and governments Glass-Steagall Act of 1932: commercial and investment banks

were required to remain separate within the U.S. until 1999 However, banks do not have such restrictions overseas

Central Banks and Other Government AgenciesCentral banks are routinely involved in the ICMGovernment agencies routinely borrow from abroadDeveloping countries and state-owned enterprises

borrow from foreign commercial banks

Growth of the ICM

Growth of the ICMThe ICM has grown faster than world GDP since

1970Fewer barriers to private capital flows across

borders, especially in OECD countriesAdvances in communication technologiesThe demise of fixed exchange rates

Growth of the ICMThe Impossible Trinity

Free capital flows

Option 2

(Greece)

Option 1(U.S.)

Independent

monetary policy

Fixed exchange rate

Option 3(P.R. of China)

• A country can pick one side but must give up far corner• Under the Bretton-Woods system, every country had to choose between options 2 or 3• Without the Bretton-Woods system, countries could now pick option 1• This allowed for more free movement of capital and led to the growth of the ICM

Offshore Banking and Offshore Currency Trading

Offshore Banking and Offshore Currency TradingOffshore banking – business that banks’ foreign offices

conduct outside of their home countriesBanks conduct foreign business through 3 institutions

Agency offices abroad arranges loans, transfers funds does not accept deposits

Subsidiary banks abroad A foreign bank is the controlling owner Subject to regulations in foreign country, but not subject to

regulations in the parent bank’s country Foreign branches

An office of the home bank in another country Carry out same business as local banks Subject to home and foreign banking regulations Branches often can take advantage of cross-border regulatory

differences

Offshore Banking and Offshore Currency TradingOffshore currency deposit – a bank deposit in a

currency other than that bank’s home country currencyFor example, dollar deposits in a bank in

FrankfurtOffshore currency deposits are often referred

to as “Eurocurrencies”The term “Eurocurrency” does not mean the

“euro” currencyEurocurrency trading happens all over the world

– not just in EuropeBanks that accept Eurocurrency deposits are

called Eurobanks – even if they’re not in Europe

Offshore Banking and Offshore Currency TradingRapid growth of offshore banking and currency

trading has been caused, in part, by an increase in international trade and the multinational nature of corporate activity

Firms involved in international trade require overseas financial services

Another reason for rapid growth is banks’ desire “to escape” domestic regulations and taxes

Banks shift some operations abroad and into foreign currencies

Depositors hold currency outside the issuing country also for political reasons

Growth of Eurocurrency Trading

Growth of Eurocurrency TradingRemember . . . “Eurocurrency” DOES NOT MEAN the

“euro” currency!Eurodollars were born in the late 1950s to respond to

the needs caused by growing international tradeLondon started and is the leader in Eurocurrency

tradingEuropean firms involved in trade needed to hold dollar

deposits or borrow dollarsThose firms found it cheaper and more convenient to

deal with local banks familiar with their circumstances rather than do business with banks in the U.S.

Growth of Eurocurrency TradingEarly Eurodollar trading grew due to

regulations and political concernsFederal Reserve Regulation Q – imposed a

ceiling on interest rates U.S. banks could pay on time deposits

Cold War spurred growth of Eurodollar marketThe move to floating exchange rates slowed

growth of Eurocurrency markets

Importance of Regulatory Asymmetries

Importance of Regulatory AsymmetriesMajor factor behind the continuing

profitability of Eurocurrency tradingDomestic currency deposits are heavily

regulated to control money supplyBanks are given far more freedom in dealing

with foreign currenciesExample: reserve requirementsFinancial centers with the fewest government

restrictions on foreign currencies are the main Eurocurrency trading centers