Taking Risks: Going Over the Risks in International Banking
As we advance to an age wherein information and globalization are key forces to reckon with, many of the defining features of the financial world and the players that populate it are in the midst of profound and unstoppable change. These changes are characterized by the means of financial firms making money; how and by whom they are regulated; in where they raise capital; in which markets they serve; and in what role they play in society.
As the vehicle where money is placed, banks are firms that should be concerned with all the changes that are taking place. Thus, presently big banks are now venturing to cater to international markets in order to spread their services to wider and larger clients. These are the banks that are presently labeled as “international banks”, which can be characterized by the types of services they provide that distinguish them from domestic banks. Foremost, international banks facilitate the imports and exports of their clients by arranging trade financing. Additionally, they serve their clients by arranging for foreign exchange necessary to conduct cross-border transactions and make foreign investments. In conducting foreign exchange transactions, banks often assist their clients in hedging exchange rate risk in foreign currency receivables and payables through forward and options contracts. Since international banks have the facilities to trade foreign exchange, they generally also trade foreign exchange products for their own account (Eun and Nesnick 2004, p. 217).
In order to view a bank’s current financial standing, it is the bank’s balance sheet—assets, liabilities, and capital—that should be taken into serious consideration. These banks are managed based on decisions involved on what kinds of loans are to be made, what the prime rate should be, what interest rate to offer on 1-year time deposits, and so forth. These decisions reflect an interaction between the bank’s liquidity, safety, and earnings objectives and the economic and financial environment within its operations. In simplifying the terms in which a bank is managed, the bank management has to face and deal with several types of risks and uncertainties, including credit or default risk, interest rate risk, liquidity risk, and exchange rate risk. Risks in asset prices belong to a bank’s systematic risks, as to where a bank’s required rate of return, also known as its cost of capital, solely depend on. These things are a lot more easier to manage if banks are just working within the domestic market, but in dealing with the international market where there are different currencies involved, things are a lot more complicated.
The objective of this paper is to survey the importance of risks related to liquidity, interest rates and asset prices in relation to international banking. This is because an international bank plays a crucial role in determining interest rates and asset prices, both as a supplier of liquidity and through its operation in the goods and asset markets as they venture globally. Since world trade is important to world economic growth, studying the risks involved in it will save more people from the errors of the past global financial crises.
According to Fabozzi and Modigliani (2002), one feature of financial markets is that it provides a mechanism for an investor to sell a financial instrument. Because of this feature, it is said that a financial market offers “liquidity,” an attractive feature when circumstances either force or motivate an investor to sell. If a bank were not “liquid”, the manager would be forced to hold a financial instrument until the issuer initially contracted to make the final payment (i.e., until the debt instrument matures) and an equity instrument until the company is either voluntarily or involuntarily liquidated. While all financial markets provide some form of liquidity, the degree of liquidity is one of the factors that characterize different markets (p. 11).
For international banks to be effective in facilitating movement in goods, services, and assets, this type of monetary system most importantly requires an efficient balance-of-payments adjustment mechanism so that deficits and surpluses are not prolonged, but are eliminated with relative ease in a reasonably short time period. With such consideration, unless the system is characterized by completely flexible exchange rates: (1) there must be an adequate supply of international liquidity that is, the system must provide adequate reserves so that payment can be made by balance-of-payments deficit countries to surplus countries, and (2) the supply of international liquidity must consist of internationally acceptable reserve assets that are expected to maintain their values (Appleyard, Field & Comb 2005, p. 345).
According to Willet (1980), the rapid growth of international financial markets and the substantial increase in the extent to which national governments both supply funds to and borrow funds from these markets initiated the vagueness of the traditional distinctions between private and official international liquidity. This has raised serious questions about the control of international liquidity growth. The rapid growth of the Eurocurrency markets has similarly caused many to question the extent to which national monetary authorities can control their domestic financial conditions, and has further fueled fears that at present our international financial system is an engine for world inflation (p. 2).
Moreover, Willet emphasized that the potential magnitude of such concerns about liquidity expansion is illustrated by two explosions of official international liquidity: the first, generated by the massive U.S. balance-of-payments deficits and accompanying breakdown of the Bretton Woods exchange-rate arrangements in the early 1970s; and the second, accompanying the huge increases in oil prices in 1973 and 1974 with the resulting enormous balance-of-payments surpluses for Organization of Petroleum Exporting Countries (OPEC) and the corresponding deficits for most oil-importing countries. Over the 1970-1972 period, international reserves created by the official intervention of surplus countries grew by roughly as much as they had in the whole preceding part of the postwar period. These patterns during this period have been marked by rising indebtedness, volatile asset prices, and periods of financial stress. The high rates of inflation throughout the world that were temporarily associated with these developments have strongly reinforced fears that our current international financial arrangements are dangerously deficient (Willett, 1980, p. 2).
Baker (2002) pointed out that the two major financial risks are constantly present in these global transactions: credit and liquidity risk. Credit risk is the risk that one party will not settle an obligation for full value, either when due or at any time afterwards. Liquidity risk is the risk that a counterparty to a transaction will not settle an obligation for full value when due, but will do so on some unspecified day afterwards. Before the performance of such an obligation, it may not be possible to know whether the failure to settle an obligation for full value when due represents liquidity risk or credit risk (p. 117).
With this, the Revised Basle Concordat on Bank Oversight (1983) emphasized the allocation of responsibilities for the supervision of the liquidity of banks’ foreign establishments between parent and host authorities depend, as with solvency, on the type of establishment concerned. As Basle Concordat explained that the host authority, where the international bank has settled, assumes responsibility for monitoring the liquidity of the foreign bank’s establishments in its country. While the parent authority, on the other hand, has responsibility for monitoring the liquidity of the banking group as a whole. For branches, the initial presumption should be that primary responsibility for supervising liquidity rests with the host authority. Host authorities will often be best equipped to supervise liquidity as it relates to local practices and regulations and the functioning of their domestic money markets (IMF Survey, p. 202).
In accordance to that, Basle Concordat on Bank Oversight added that the liquidity of all foreign branches will always be a matter of concern to the parent authorities, since a branch’s liquidity is frequently controlled directly by the parent bank and cannot be viewed in isolation from that of the whole bank of which it is a part. Parent authorities need to be aware of parent banks’ control systems and need to take account of calls that may be made on the resources of parent banks by their foreign branches. Host and parent authorities should always consult each other if there are any doubts in particular cases about where responsibilities for supervising the liquidity of foreign branches should lie (IMF Survey 1983, p. 203).
The revisions in international banking regulations were pushed because unexpected factors, like the unusually competitive conditions in world capital markets (factors clearly externally affecting individual emerging markets) play an important role, especially in the face of an international financial crisis. The Bank for International Settlements (BIS), in particular, has expressed concern about the marked expansion in global liquidity that led to the unusually low real interest rates in G-7 countries, a search for yields, compressed spreads, and soaring asset prices (BIS, Annual Report, 1998). In the case of Southeast Asian countries, high domestic interest rates reflected the struggle to fight the inflationary impact of big capital inflows, given the currency measures. As a result of these policy differences, to give just one example, yields on the Thai baht investments funded by depreciating yen loans exceeded 35 percent in early 1997 (Little & Olivei, 1999, p. 53).
This is primarily the reason why liquidity, up to the present, has been used in a fairly loose fashion, the possibility to buy or sell without affecting the price. It is measured by the difference between ask and bid prices, the so-called ‘spread’, most relevant for small trades. Liquidity in this narrow sense must be completed by three other dimensions: depth, immediacy and resilience. Depth indicates the way the spread widens when the order becomes larger. Immediacy tells how soon a price can be found at which it is possible to trade. Resiliency is the extent to which the transaction price departs and returns to equilibrium price. In short, in a perfectly liquid market, it is possible to buy and sell an infinite volume without delay at the same price. One often meets in literature the qualification that a trade will be made at ‘the best price’ (Nickson 2000, p. 42).
Another type of risk that must be managed by any financial institution is the interest rate risk, which is termed as the risk that occurs when interest rate will unexpectedly change so that the costs of any international bank’s liabilities exceed the earnings on its assets. This risk emanates from the relationship between the interest rate (return) earned on assets and the cost of, or interest rate paid on, liabilities. The profitability an international bank is directly related to the spread between these rates (Burton, Nesiba & Lombra 2003, p. 151).
When the Federal Deposit Insurance Corporation Improvement Act (FDICIA) of 1991 was introduced, mandatory procedures called prompt corrective actions (PCA) required regulators to promptly close depository institutions when their capital falls below predetermined quantitative standards, thus eliminating the possibility of regulators providing special consideration to large banks because of the possible systemic impact of large bank failure. Therefore, the notion of “too-big-to-fail” should be less relevant since FDICIA (Brewer, Jackson, Jagtiani & Nguyen, 2000, p. 2).
International regulators had been discussing adding more factors—especially interest-rate risk–to the risk-based capital guidelines for some time before the FDIC Improvement Act (FDICIA) became law. Passage of the controversial act forced the issue, however. FDICIA’s Section 305 requires the three federal banking regulators to publish by the middle of next year amendments to risk-based capital measures to “take adequate account of’ interest-rate risk, concentrations of credit risk, and the risks of nontraditional activities (Cochero, 1992).
In cognizance with the global phenomena, the borrowing and lending behavior in small economies have integrated the domestic capital markets with global capital markets. Using extended loanable funds analysis, the framework reconciles the main financial relations that link domestic and foreign interest rate – the Fisher effect, purchasing power parity and uncovered interest parity. It also shows that the reaction of foreign lenders to factors influencing an economy’s creditworthiness is central to determining interest risk premiums and how changing exchange rate expectations affect international interest differentials through borrowing and lending behavior (Makin, 2000, p. 85).
Presently, international banks could be in danger to take a positive spread today which can turn into a negative spread when the cost of liabilities exceeds the return on assets. For example, Burton, Nesiba & Lombra (2003) mentioned that whenever intermediaries borrow short term through passbook savings deposits and make long-term loans or purchase long-term, fixed-rate financial assets such as bonds or mortgages, they are exposed to an interest rate risk. This risk has been a chronic problem for some intermediaries, particularly the banking industry during the 1970s and 1980s as the financial system was deregulated and interest rates fluctuated over a fairly wide range. Financial institutions have responded to this changing environment in a variety of ways, including utilizing adjustable rate loans and financial futures, options, and swaps. The latter three instruments, are now used extensively by banks to hedge interest rate risk.
Risks in asset prices is determined though the systematic risk, which refers to changes in the values of assets that are driven by movements in some risk factors that affect all bundles of cash flows. To divide the total risk of an exposure into unsystematic and systematic components, some set of systematic risk factors must be defined. A systematic risk factor is any economic factor (e.g., aggregate consumption growth) whose changes drive all asset prices. The impact of a change in a risk factor on any particular asset price may be different depending on the asset, but if the risk factor is truly systematic, it affects all asset prices in some way (Culp, 2001, p. 26).
One significant example wherein asset prices played a role was when large inflows of private capital resulted in a credit boom in the Asian countries in the early and mid-1990s. The credit boom was often directed to speculations in real estate and stock markets as well as to investments in marginal industrial projects. Fixed or stable exchange rates also encouraged unhedged financial transactions and excessive risk-taking by both lenders and borrowers, who were not much concerned with exchange risk. As asset prices declined (as happened in Thailand prior to the currency crisis) in part due to the government’s effort to control the overheated economy, the quality of banks’ loan portfolios also declined as the same assets were held as collateral for the loans. Clearly, banks and other financial institutions in the afflicted countries practiced poor risk management and were poorly supervised. In addition, their lending decisions were often influenced by political considerations, likely leading to suboptimal allocation of resources (Eun and Nesnick, 2004).
Prior to that event, Kindleberger (1978) stressed the importance of booms in credit, which leads banks to make insufficient provision for risk, and also to a high degree of speculative activity among investors in asset markets. Asset prices start off in close touch with reality but become progressively more excessive. Cutler et al. (1989) characterized this type of behavior as ‘positive feedback trading’–traders whose purchases respond to rising prices rather than falling or low prices. The reversal of this as the ‘bubble’ is punctured aggravates the downturn. This is when an effect of adjustment in personal-sector debt on saving and asset prices can also be discerned. As well as being relevant to macroeconomic policy, this may also have indirect implications for the unstable situation.
If a decline in borrowing–or a response of monetary policy to general inflation–causes asset prices to fall, existing borrowers, particularly those purchasing property at the peak of the boom, may face difficulties. Moreover, a fall in asset prices may entail a further decline in borrowing, a rise in the saving ratio, and a reduction in consumption. In general, higher leverage, especially with floating-rate debt, may increase the effectiveness of monetary policy, as a given rise in interest rates has a greater effect on disposable income of net debtors. Nevertheless, lags may still be long if credit availability is unchanged, while agents initially compare higher interest rates with expectations of inflation and still rapidly-increasing asset prices (Davis, 1995, p. 103).
The broadening understanding of risks from liquidity, interest rates and asset prices in international banking and through the development characterized by the use of futures and options, growth of a multitude of index-funds, and international diversification all give evidence to the impression of various changes in global finance. Although not completely converted, financial management will never be viewed the as before. As Bernstein (1992) puts it,
Big risks are scary when you cannot diversify them, especially when they are expensive to unload; even the wealthiest families hesitate before deciding which house to buy. Big risks are not scary to investors who can diversify them; big risks are interesting. No single loss will make anyone go broke . . . by making diversification easy and inexpensive, financial markets enhance the level of risk-taking in society (p. 156).
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