International Banks Activities and Their Risk Management - Coursework Example

Part A

International Banks Activities and Their Risk Management

Introduction

Globalization has increased the pursuit of business prospects in foreign countries. The chase for economic growth on international borders has increased the need for corporate financing to facilitate business in the foreign countries (Mehta and Fung, 2008). The movement of resources, services, and money has cemented the role of international banks, which have devised financial instruments to align with the regulations in the foreign markets. Additionally, financial activities or services involve risk particularly for international due to the dynamic nature of the international markets. The necessity for the mitigating or managing the risks becomes inevitable. The following discussion highlights asset diversification, securitization, trade finance, loan syndication, debt underwriting, and risk management.

Activities of the International Banks

Asset diversification

Globalization has created new markets for international banks, which has cemented the traditional need for asset diversification. Diversification is an integral practice for internal banks because it remains a traditional means for establishing an efficient portfolio, which reduces minimizes the risks on expected rate of return (Kim and McKenzie, 2010). While the overall diversification in new markets is declining due to the 2008-09 financial crisis, international banks have undertaken foreign investments to sustain mean-variance portfolio but the assortments vary from country to country.

Securitization

The recent turbulence in financial markets across the globe accentuates the significance of securitization, which is the principal way of funding credit growth among international banks. Securitization practice remains important in U.S, China, Europe, due to the ability of international banks to shed off credit risk and arbitraging capital requirements (Howells and Bain, 2008). However, the securities created from a portfolio of loans, bonds or mortgages across the globe depend on the current regulations in the international banking sector. Mehta and Fung (2008) insist that the impending intention to tighten the securitization risks may limit banks portfolios.

Trade Finance

International banks provide lending and guarantee facilities for exporters, which sustains international trade. The economic growth across borders will increase the income that international banks generate from the trade finance contracts, for example, bills of exchange and letters of credit (Kim and McKenzie, 2010). International trade theory acknowledges the role of trade finance in international trade where the traders have sufficient guarantee to receive payment when they surrender control of goods. The critical role of trading finance products from international banks is to eliminate the risk of exporting particularly in the concentrated markets or during global recessions.

Loan Syndication

The motive of international banks to participate in syndicated loans markets is to spread the risk of borrowers’ default across multiple lenders. Foreign banks provide syndicated loan markets to leverage buyout communities to finance corporate takeovers (Kim and McKenzie, 2010). The banks understand the risk of default by governments or large corporations, which becomes the basis for splitting the loans into dual tranches. The advantage of syndicated loans for international banks is providing efficient geographical and institutional means of sharing risks (Mehta and Fung, 2008). The allocation of syndicated loans may vary from global area to area.

Debt or Equity Underwriting

The dedication of international banks in the debt or equity underwriting is due to the increasing growth of the capital markets. Debts and equities are prompt sources of finance for companies. However, international banks must consider using their skills or experience to price the debt or equities to design an attractive underwriting scheme (Howells and Bain, 2008). Additionally, underwriting can be disappointing when foreign banks fail to generate projected share from equity underwriting.

Risk Management

Risk management is an essential activity for international banks (Kim and McKenzie, 2010). The exposure to various risks during business operations requires international banks to have robust risk management frameworks. Aebi, Sabato, and Schmid (2012) argues that the complexity of risk management function calls for specialized skills and expertise to mitigate risks such as credit, market, operational risks, liquidity, legal and foreign exchange risks. The interdependence between risks compels banks to consider sophisticated models for mitigating risks. Guided by the significance of risk management, international banks have distinct ways of managing the risks inherent in their business activities.

How International Banks Manage Inherent Risks

International banks create problems in the process of carrying out the activities, which generate the inherent risks. Lack of transparency during the global operations dents the integrity and reputation of an international lending institution particularly from the context financial disclosures as well as a tax payment (Howells and Bain, 2008). While political risks or involve remains the key source international banking flows, herd instinct remains a persistent occurrence among depositors and investors for banks that have demonstrated failures in the past. In addition, banks, which entrust credit rating agencies too much while using past information increase the probability of risks (Kim and McKenzie, 2010). Similarly, new markets create new factors, but banks fail to incorporate them into their risk profiles. International banks must pay attention to signs such as high forex rate, account deficient, stunted economic growth, capital flight, declining exports, and concentration of risks. Apparently, management of the identified risks is critical.

Market Risks

The focus of international banks rests on three considerable market risks, which include interest rate, equity, and foreign exchange risks. Banks consider the market risks as the potential threat to operations considering they occur due to prices or the volatility of the financial assets and liabilities. The complexity of financial markets after 2008 financial demands foreign banks to factor in the prevailing complexity of the financial markets. Analysis of 615 banks for the period 2000-2004 showed that banks acknowledge the practice of using observable price to value trading book assets and liabilities (Pasiouras, Tanna, and Zopounidis, 2009). The evidence from the 75 countries affirmed the extent international banks costs and proficiency, particularly in restricted capital markets. On the other hand, Value at Risk (VaR) is an effective toolkit for international banks, which facilitates management of market risks at the portfolio level. According to Pérignon and Smith (2010), VaR helps banks to navigate the forex and equity risks by enabling the institutions to use observable parameters for mitigating market risks.

Liquidity risks

Meeting emerging cash or fund obligations requires international banks to eliminate liquidity risks. The risks may offer the ability to finance investment projects while increasing reliance on central banks in extremis (Bushman and Williams, 2012). A global consolidated technique of diversification reduces liquidity risks by diverting attention to maturities, currency, and region markets. However, the diversification methods may require the foreign banks to monitoring a balance of core deposits to achieve stability in the short term. Additionally, securitization is an alternative means of managing liquidity risk, but it has gained significance among global banks due to the fiscal burden of 2008-09 financial. A case study of 54 banks in Switzerland by Uhde and Michalak (2010) showed the importance of securitization in increasing banks intent to the incentive. Bushman and Williams (2012) insists that the need for securitization is as imperative as setting minimum threshold as the main contingency plan for reducing liquidity risks.

Operational Risks

Operational risks are inherent in the way international banks run their operations because they emanate from unique external events or failed internal processes. The constitution of Basel II framework has dictated the formality in the mitigation of operational risks involving incompetence, system, or back-office failures (Sun and Chang, 2011). Researchers agree that operational risks are unavoidable, but they require rigorous internal processes and controls. Deployment of external auditors may come in handy, but international banks extend their risk management reach to the insurance contracts. Panjer (2006) insists that the increasing complexity of global banking demands transference of risks to reputable insurance companies but under the guidelines of Basel II.

Credit Risks

The potential of loss when global borrowers fail to meet financial obligations is huge for international banks. According to Laeven and Levine (2009, p.261), the management of credit risks is the most important aspect of risk management for global banks where many institutions opt to allocate a significant portion of economic capital to manage risks emerging from securities or derivatives from corporate or sovereign borrowers. While diversification is the first line of defence for international banks across U.S and Europe, netting agreements as well as collateral reduces the credit risk concentration in trading books. The current practice is to reduce monitor the creditworthiness of both SMEs and large corporations across the globe. However, collateral only reduces the risk of counterparties when compared to the expansive reach of credit risk transfer (CRT) (Nijskens and Wagner, 2011, p.1392). The current practice of international banks incorporates CRT for reinforcing capacity for securitizations, loan syndication, and credit derivatives.

Conclusion

A discussion of the activities of the international banks identified risk management as the most important process. While global banks undertake asset diversification, debt, or equity underwriting, securitization, trade finance and loan syndication, the economic aspect remains an imperative part of the business operations. Conversely, the international banks deal with operational, liquidity, credit, and market risks to align their operations with the regulations as well as expectations of the core shareholders. Financial crisis is a formidable force in the current practice of international banking because banks are grappling with low assets and high liabilities hence the sources of risks. The essence of managing risks is to retain or attain a significant portion of the growing international demand for borrowing and lending.

Part B

Critical Evaluation of the Impact of the Eurocurrency and Eurobond Markets on International Capital Flows

Introduction

The development of Eurocurrency and Eurobond markets was a response to the demand for credit flows and bonds in the international markets. Eurocurrency serves the global market with short-term credit flows while Eurobond market avails long-term bonds in the international capital market (Howells and Bain, 2008). Both markets mimic banking system that provides deposits and means for securing loans but on an international market. The Euromarkets operate beyond the normal context of regulators and central banks to offer access to capital for corporates, banks, and sovereign states. The constraints in the domestic markets increase the demand for Eurocurrency, but the nature of the transactions varies across international borders (Kosowski and Neftci, 2014, p.27). The underwriting and sale of bonds in more than one state raises significant capital but researchers have not focused on the impact of the Eurocurrency and Eurobond markets on the international capital flows. The paper provides a critical evaluation of the impact of Eurocurrency and Eurobond markets on the international capital flows. The paper focuses on the Euromarkets’ development, the principle users, role in the capital movement, risks, and challenges as well as how banks use the Euromarkets.

Development Eurocurrency and Eurobond Markets

European countries required significant financial assistance to rebuild themselves after the end of Second World War. The development of Eurocurrency markets provided the financial remedy after the post-war period. Eurocurrency and Eurobonds became the finest financial innovation and means for reducing overreliance on iron and steel technologies after the 1950s (Madura, 2009). The desperate need for international liquidity amplified the desire for capital in Europe to keep up with the development in the United States during the Cold War period. Presently, the need for financial reconstruction continues to sustain the demand for Euromarkets across the globe.

In addition, the development of Eurocurrency and Eurobond markets was in response to the national regulation constraints, which reduced the capital for domestic investors. Borrowers and lenders needed reliable alternatives to navigate through the restrictive national regulations. According to Madura (2009, p.60), Euromarkets brought significant liberalization of capital movements, which researchers acknowledge as the ultimate solutions to the domestic capital constraints. The dilemma was to gain significant control of the capital flows to reduce the influence of the central banks (Howells and Bain, 2008). Additionally, regulations and restrictions on U.S and European corporations reduced the ability raise domestic capital to finance overseas operations.

The limitation of outflow of capital or funds the U.S and London led to the creation of petrodollars, which facilitated the expansion of oil producing countries in 1970s-1980s (Kim and McKenzie, 2010). European and American markets created a source of capital flows, where sovereign states, banks, and corporates borrow money. The development of Eurocurrency and Eurobond in Europe increased the movement towards liability administration rather than asset management in the 1960s, which stressed the interrelationship between assets and liabilities in the balance sheet (Wilson, 2012, p.346). The attractiveness of Eurocurrency and Eurobond markets has created a significant proportion of the principle users.

Principle Users of the Eurocurrency and Eurobond Markets

Eurobond and Eurocurrency markets sustain the network of principle users who include sovereign governments, banks, and large corporations. The borrowers and lenders view the markets as efficient sources of investment, government, deficit fund, which helps to rebuild foreign currency resources. Joliet and Muller (2013) views the markets as the driver of international expansion, which has changed over time due to significant diversity in the capital structure. Despite the considerable role of Eurocurrency and Eurobond markets, D'Arista (2009) found that developing countries face significant hurdles in accessing the global capital.

The development of Eurocurrency and Eurobond markets led to the creation of Euro banks. The banks facilitate financing in the investment banking activities through syndicated lending, securitization and trade finance, which are the principle activities of international banks (D'Arista, 2009). Nonetheless, the demand for Eurocurrencies and Eurobonds faces significant hurdles due to diversified portfolios of trading partners and strong currencies. Developing regions such as London in the European market have a predominant position in the Eurocurrency markets (Howells and Bain, 2008). Such developed markets boast of proficient staff, sympathetic regulation, and the advantage of crossing New York and Tokyo. Additionally, the greatest impact of Eurobond and Eurobond markets is changing capital flow management for foreign banks.

How Banks Use Eurocurrencies and Eurobonds

Eurocurrency markets increase the capacity of international banks to adjust their fund positions. The essence of adjusting fund position is to meet the liquidity needs and the demand for required reserve by the central banks (He and McCauley, 2010). Banks capital and liquidity position further increase the ability to mitigation operational as well as credit risks. The soundness and safety of the transnational banking system boast of sufficient capital flow due to the integral role of the Eurocurrency.

Additionally, the increasing role of banks in the foreign exchange transactions requires affirms the influence of Eurocurrency markets (Howells and Bain, 2008). Banks take advantage of the opportunity created through Eurocurrencies to generate money for trading and placing surplus funds. In addition, markets further increase capital flows between banks by providing a central mechanism for channelling funds between banks. London Interbank Offered Rate (LIBOR) is the world acclaimed benchmark for determining of interbank access to short-term loans (Rose and Hudgins, 2008). While the standard avails capital to banks, He and McCauley (2010) argues that using restricting currencies to US$, Euro, Sterling Pound, Japan Yen and Chinese Franc limits the access from other countries unless they align their rates with the currencies.

Eurobond and Eurocurrency markets sustain international trade by offering an interest rate arbitrage tool. Arbitrageurs across the globe consider the changes in interest rates as means of generating yields from bonds (Howells and Bain, 2008). The efficiency of determining interests rates is due to the new global channels that the Eurocurrency markets. Arbitrage efficiency increases the integration of international capital markets and flows consequently. However, the interdependence between markets may bring great interdependence. In addition, interest rates on developed markets in the U.S, Asia, and Europe may bring undue pressure to a developing country, which may cause absorption ultimately. According to Kim (2011), banks play the ‘yield curve’ to protect their investments, sustain investors’ confidence and increased access to unsecured debt instruments.

Assisting Capital Movement

The greatest impact of Eurocurrency and Eurobond market is facilitating efficient capital movement. Interbank transactions create a platform for higher saving rate and lower borrowing rates (Clark et al., 2012). Governments are the greatest beneficiaries because they use the markets to tap the opportunities created by the bond markets to refund existing debts while raising significant capital. On the other hand, the failure of principle users to benefit from deposit guarantee scheme sustains the demand for Eurocurrency and Eurobonds market. Banks in the U.S, Germany, and Europe are among institutions that enjoy relaxed regulations for keeping capital requirements, which is a common practice in local markets through the oversight role of central banks (Bhole and Mahakud, 2009). Additionally, capital flows increase because sovereign governments, corporates, and banks do not incur forex costs for accessing currency of choice.

Corporations and banks operate with separate pools of finance created through the Eurocurrency markets. The institutions use the pool of finance to make loans, which reduces overreliance on deposit holders (Howells and Bain, 2008). Over time, global institutions gain liquidity capacity by utilizing the Eurocurrency market for short-term borrowing. Capital flows reinforce the capacity to meet cash or fund obligations. Additionally, the loan flotation and easy reset rates every 3-6months enables financial institutions to mismatch assets-liabilities easily. The biggest beneficiaries are SMEs in the domestic markets who lack the capacity to access the global Eurocurrency and Eurobond markets (Kawai and Prasad, 2011). However, principle users of Eurocurrency and Eurobond markets must consider the inevitable risks and challenges.

Risks and Challenges of the Eurocurrency and Eurobond Markets

While the regulations Eurocurrency and Eurobond markets assist in capital movement across the globe, lack of regulation increases liquidity as well insolvency risks due to counterparty and concentration risks (Howells and Bain, 2008). Transmission of efficient monetary policies in the U.S and European market is impossible, which increases the risk of bankruptcy particularly for firms that are grappling with the effects of 2009-09 financial crisis (Guttmann, 2009). The capital transfer may amplify contagion risks predominantly in the Eurozone due to the recent Greece crisis. Economists must remain keen if they seek to sustain efficient capital flows created in the Eurocurrency and Eurobond markets.

Sovereign governments consider the Eurobond as offshore banking means, but it may elicit dubious practices. A number of the sovereign crises have emerged due to the simplified access to the offshore markets. The crisis dents the capacity of the Eurobond markets in providing short-term borrowing. Whelan (2013, p.478) found that the crisis in the Eurozone in 2012 meant that countries such as Greece could not use monetization and devaluation to prevent capital generation difficulties.

Conclusion

Evidently, Eurobond and Eurocurrency markets have positive and negative impacts on international capital flows. The markets provide capital that countries use to rebuild themselves. The domestic lending constraints increase the demand for the Euromarkets, which banks acknowledge as efficient sources of investment capital and liquidity. Banks view it as a mechanism for adjusting fund positions and arbitraging opportunities. The efficient movement of capital between financial institutions and countries increase capital flows. However, the same markets can lead to limited capital flows by evoking suspicious practices for among sovereign institutions and individual corporations. Poor regulations in the Eurocurrency and Eurobond markets increase the liquidity, solvency, and contagion risks.