International Banking - Modern Banking

International banking has been singled out for special attention because although its origins date back to the 13th century, there was a rapid increase in the scale of international banking from about mid-1975 onward. The main banks from key western countries established an extensive network of global operations.

There are varying opinions as to what constitutes an international bank. For example, a bank is said to be international if it has foreign branches or subsidiaries. Another alternative definition is by the currency denomination of the loan or deposit – a sterling deposit or loan by a UK bank would be ‘‘domestic’’, regardless of whether it was made in Tokyo, Toronto or Tashkent. A third definition is by nationality of customer and bank. If they differ, the bank is said to be international. All of the above definitions are problematic. To gain a full understanding of the determinants of international banking, it is important to address two questions.

  1. Why do banks engage in the trade of international banking services; for example, the sale of foreign currencies? Below, it is argued that the trade in global banking services is consistent with the theory of comparative advantage.
  2. What are the economic determinants of the multinational bank, that is, a bank with cross-border branches or subsidiaries? Multinational banking is consistent with the theory of the multinational enterprise.

International Trade in Banking Services

Comparative advantage is the basic principle behind the international trade of goods and services. If a good/service is produced in one country relatively more efficiently than elsewhere in the world, then free trade would imply that, in the absence of trade barriers, the home country exports the good/service and the COUNTRY gains from trade.

Firms engage in international trade because of competitive advantage. They exploit arbitrage opportunities. If a firm is the most efficient world producer of a good or service, and there are no barriers to trade, transport costs, etc., this firm will export the good from one country and sell it in another, to profit from arbitrage. The FIRM is said to have a competitive advantage in the production of that good or service.

If certain banks trade in international banking services, it is best explained by appealing to the principle of competitive advantage. Banks are exploiting opportunities for competitive advantage if they offer their customers a global portfolio diversification service and/or global credit risk assessment. The same can be said for the provision of international money transmission facilities, such as global currency/debit/credit facilities. Global systems/markets that facilitate trade in international banking services are discussed below.

The International Payments System

A payments system is the system of instruments and rules which permits agents to meet payment obligations and to receive payments owed to them. It becomes a global concern if the payments system extends across national boundaries. Earlier, the payments systems (or lack thereof) for the UK, USA and EU were discussed. The payments systems of New York and London take on global importance because they are key international financial centres.

The Euromarkets

However, their contribution to the flow of global capital is worth stressing. Prior to their development, foreign direct investment was the predominant source of global capital transfers between countries. The euro markets enhanced the direct flow of international funds.

The Interbank Market

Used by over 1000 banks in over 50 different countries, the growth of interbank claims has been very rapid. In 1983, total interbank claims stood at $1.5 trillion, rising to $6.5 trillion by 1998 and, early in the new century, $11.1 trillion, with interbank loans making up over half of this total. Among the developed economies, cross-border lending in the first quarter of 2001 reached an all time high of $387.6 billion, a 70% increase over the previous quarter.28 On the other hand, banks continued to reduce their claims in emerging economies, especially Turkey and Argentina.

Interbank trading in the euro markets accounts for two-thirds of all the business transacted in these markets. The interbank market performs six basic functions.

  1. Liquidity smoothing: banks manage assets and liabilities to meet the daily changes in liquidity needs. Liquidity from institutions with a surplus of funds is channelled to those in need of funds.
  2. Global liquidity distribution: excess liquidity regions can pass on liquidity to regions with a liquidity deficit.
  3. Global capital distribution: deposits placed at banks are on-lent to other banks.
  4. Hedging of risks: banks use the interbank market to hedge exposure in foreign currencies and foreign interest rates. With the emergence of the derivatives markets, the role expanded, giving banks tools to manage market risk.
  5. Regulatory avoidance: reduce bank costs by escaping domestic regulation and taxation.
  6. Central banks use the interbank markets to impose their interest rate policies.

While the emergence of the euro markets and interbank markets has been instrumental in changing the way capital flows around the world, there is concern that the interbank market exacerbates the potential instability arising from contagion effects. However, Furfine (1999), using simulations, found the risk to be very small. On the other hand, Bernard and Bisignano (2000) identify a fundamental dilemma with the interbank market. Implicit central bank guarantees are necessary to ensure the liquidity of the interbank market, but one consequence is moral hazard because lending banks have less incentive to scrutinise borrowers.

Portfolio Diversification

Another reason why firms engage in international banking is to further diversify their portfolios. Canadian banks are a case in point. The major Canadian banks increased the foreign currency assets from the end of World War II on, so that by the early 1990s, international assets accounted for Canadian banks over the period 1978–85, Xu (1996) uses a mean variance framework to test why banks diversify their assets internationally. He finds that Canadian banks diversify to reduce risk (variance), thereby increasing the stability of their asset returns. Making international loans meant the banks could reduce the systematic risk arising from operating in a purely domestic market.

The Multinational Bank

A multinational enterprise (MNE) is defined as any firm with plants extending across national boundaries. A multinational bank (MNB) is a bank with cross-border representative offices, cross-border branches (legally dependent) and subsidiaries (legally independent).

Multinational banks are not unique to the post-war period. From the 13th to the 16th centuries, the merchant banks of the Medici and Fugger families had branches located throughout Europe, to finance foreign trade. In the 19th century, MNBs were associated with the colonial powers, including Britain and, later on, Belgium, Germany and Japan. The well-known colonial MNBs include the Hong Kong and Shanghai Banking Corporation (HSBC), founded in 1865 by business interests in Hong Kong specialising in the ‘‘China trade’’ of tea, opium and silk. By the 1870s, branches of the bank had been established throughout the Pacific basin. In 1992, the colonial tables were turned when HSBC acquired one of Britain’s major clearing banks, the Midland Bank, and HSBC moved its headquarters from Hong Kong to London, in anticipation of Hong Kong’s transfer from colonial status, and its return to China in 1997.

The National Bank of India was founded in 1863, to finance India’s export and import trade. Branches could be found in a number of countries trading with India. The Standard Bank was established in 1853 specialising in the South African wool trade. Headquartered in London, it soon expanded its activities to new developments in South Africa and Africa in general. Presently it is known as the Standard Chartered Bank, and though it has a London head office, its UK domestic business is relatively small. By 1914, Deutsche Bank had outlets around the world, and German banks had 53 branches in Latin America.

The Soci´et´e G´en´erale de Belgique had branches in the Belgian African colonies, and the Mitsui Bank established branches in Japanese colonies such as Korea. Known as ‘‘colonial’’ commercial banks, their primary function was to finance trade between the colonies and the mother country. Branches were normally subject to tight control by head office. Their establishment is consistent with the economic determinants of the MNE, discussed earlier.

Branches meant banks could be better informed about their borrowers engaged in colonial trade. Since most colonies lacked a banking system, the banks’ foreign branches met the demand for banking services among their colonial customers.

A number of multinational merchant banks were established in the 19th century, such as Barings (1762) and Rothschilds (1804). They specialised in raising funds for specific project finance. Rather than making loans, project finance was arranged through stock sales to individual investors. The head office or branch in London used the sterling interbank and capital markets to fund projects. Capital importing countries included Turkey, Egypt, Poland, South Africa, Russia and the Latin American countries. Development offices associated with the bank were located in the foreign country. Multinational merchant banks are also consistent with the economic determinants of the MNE. Their expertise lay in the finance of investment projects in capital-poor countries; this expertise was acquired through knowledge of the potential of the capital importing country (hence the location of the development offices) and by being close to the source of supply, the London financial markets.

There was a rapid expansion of American banks overseas after the First World War. In 1916 banks headquartered in the USA had 26 foreign branches and offices, rising to 121 by 1920, 81 of which belonged to five US banking corporations. These banks were established for the same purpose as the 19th century commercial banks, to finance the US international trade and foreign direct investment of US corporations, especially in Latin America. In the 1920s, these banks expanded to Europe, in particular Germany and Austria. By 1931, 40% of all US short-term claims on foreigners were German.

A few American and British banks established branches early in the 20th century, but the rapid growth of MNBs took place from the mid-1960s onwards. As expected, the key OECD countries, including the USA, UK, Japan, France and Germany, have a major presence in international banking. Swiss banks occupy an important position in international banking because the country has three international financial centres (Zurich, Basel and Geneva), the Swiss franc is a leading currency, and they have a significant volume of international trust fund management and placement of bonds. The Canadian economy is relatively insignificant by most measures but some Canadian banks do have extensive branch networks overseas, including foreign retail banking; they are also active participants in the euro markets.

Locational efficiency conditions30 in a given country are a necessary but not sufficient condition to explain the existence of MNEs. Locational efficiency is said to exist when a plant is located in a certain place because it is the lowest cost producer (in global terms) of a good or service.

Given locational efficiency is present, there are two important reasons why a MNE rather than a domestic firm produces and exports a good or service.

First, barriers to free trade, due to government policy. The most obvious example is when a government imposes a tariff or quota on the imports of a good or service. A form of tax, the tariff/quota raises the relative price of the good, discouraging consumption of the import and acting as a barrier to trade. Firms can often avoid the tariff through foreign direct investment in the country or countries erecting the trade barrier.

Second, market imperfections, such as monopoly power in a key global market. If one firm has control over the supply of a commodity (iron-ore, oil) which is a critical factor input in the production process of key goods, it can affect many industries around the world. For example, in the 1970s, OPEC31 members formed a cartel, controlling much of the world’s oil supply. They agreed to restrict production, which raised the price of oil, with serious negative consequences for the production processes of oil-dependent industries.

Market imperfections also arise because the market mechanism fails if the trade of some products, such as knowledge, is attempted. Superior knowledge about a production or swap technique is not easily traded on an open market. One way of profiting from it is to expand overseas and use the knowledge advantage there. Hirtle (1991) observed that certain US commercial banks, US securities firms and some European universal banks are key players in the global swap markets. Though the consumer base is multinational, the banks and securities firms tend to deal in swaps denominated in their home currency.

The presence of multinational banks may be explained using this paradigm. MNBs establish themselves because of trade barriers and/or market imperfections. In the 1960s, US banks met locational efficiency conditions, but this is not enough to explain their expansion overseas. US regulation at the time strongly discouraged foreigners from issuing bonds in the USA, and American banks were not allowed to lend US dollars to finance foreign direct investment by US multinationals. US banks set up overseas branches to help American companies escape these restrictions. For example, Nigh et al. (1986) confirm that US bank branching overseas is correlated with US business presence in a particular country.

Branching restrictions also meant US banks could not easily extend their activities to other states, and in a few states such as Illinois, banks were not allowed to have more than one branch. Thus, domestic regulation was a major contributory factor to the expansion of US multinational banks in the 1960s. For example, Citibank set up operations in London to take advantage of the euro dollar market, lending and borrowing on its own account and to assist US multinational firms to fund their foreign direct investment overseas.

Darby (1986) looked at the factors behind the growth of American MNBs from the 1960s onwards, when the number of foreign branches of US banks rose from 124 in 1960 to 905 in 1984. He argues that the motivation for US foreign bank subsidiaries was domestic banking regulations such as deposit interest ceilings, reserve requirements, various capital controls and restrictions on investment banking.

However, there was a decline in US MNB activity from the late 1980s onwards, which, argued Darby (1986), can be explained by a number of factors. In 1978, US banks were authorised to use international banking facilities (IBFs). An IBF allows a US bank to participate directly in the euro currency market. Prior to IBFs, they had to use foreign branches or subsidiaries. The international competitiveness of US banks also declined and interest in foreign expansion waned as earnings from global sources contracted.

Darby also identified several factors explaining foreign bank entry into the American market. First, there was a differential between US and euro dollar interest rates; banks were able to fund their dollar-denominated assets more cheaply in the presence of a large differential. Second, the price–earnings ratios for American banks were relatively low, so purchasing an existing US bank was a cheap way to enter the market.

Generally, MNBs tend to focus on wholesale rather than retail banking. One exception is Citibank, which operates as a wholesale and retail commercial bank in the UK, Spain and Germany. Likewise, it has a significant presence in some Latin American countries.

In Mexico, Citibank offers retail and wholesale banking. The two large banks, BBVA Bancomer and Banamex, hold about 30% and 20% of total deposits, respectively, while Citibank holds roughly 6%. However, its attempts to establish a British retail banking network in the 1960s and 1970s was unsuccessful. The explanation was the presence of the big four clearing banks, together with a number of smaller banks and building societies.

Citibank found it was unable to establish a branch network that could compete with the big four clearing banks, and the building societies were mutually owned. At the end of the 1990s, Citibank did establish a limited presence in UK retail banking, using remote delivery channels (telephone and internet banking, with a shared ATM network) to provide services to a select group of middle and high net worth individuals.

In the 1980s, Japanese banks entered the global banking scene to follow their corporate customers overseas. The growth of Japanese multinational enterprises is, in turn, explained by two factors. The first was to overcome barriers to trade. By locating plants in the UK or other European states, firms (e.g. Japanese car and, later, electronic good manufacturers) could escape onerous tariffs imposed on imports from outside the EU area. The second key reason is unique to Japan. As the size of the Japanese current account surplus and the strength of the yen increased from the mid-1970s onwards, the country came under extreme pressure from the USA and other western governments to do something to reduce the size of the current account, and the strength of the yen. Foreign direct investment and the international use of the yen would help to offset this surplus. From 1983 onwards, the Japanese government introduced measures designed to increase the international use of the yen. For example, restrictions on foreign entry into the country’s domestic financial markets were eased, which put pressure on domestic banking markets and encouraged banks to expand internationally. Some Japanese banks used their London and New York offices to gain experience in new markets (e.g. derivatives), to be in a good position to take advantage of any regulatory reform in Japan, which finally came with ‘‘Big Bang’’ in 1996.

Japanese foreign branches engaged in two types of loan business in the global markets. Credit is granted to Japanese firms, including trading houses, auto producers, consumer electronics firms, stockbrokers and the banks’ own merchant banking subsidiaries. In addition, loans are made to non-Japanese institutions with a very low default risk. In the UK, these are building societies, governments and utility companies. Both involve large volume simple loan instruments, supplied at low cost. Japanese foreign branches and subsidiaries are not important players in foreign domestic markets. Their foreign presence is greatest in London, but Japanese banks have experienced severe problems since 1990.

Their difficulties at home throughout the decade may explain the decline in their share of total UK bank assets, from 7.6% in 1997 to 4.3% in 1999.

Ter Wengel (1995) sets out to identify the factors which explain international banking, including multinational banking. The sample consisted of 141 countries with a MNB presence in the form of representative offices, branches and subsidiaries of the home bank. A number of explanatory factors were found to be highly significant. They include:

regulations such as restrictions on capital movements, the size of the exporting country (measured by GNP), the presence of home country MNBs, and countries with designated banking centres.

As was noted earlier, the presence of market imperfections is another reason for the growth of multinational enterprises. In the case of MNBs, the knowledge factor is a critical component for successful banking, but difficult to trade on open markets. For example, the expertise of the top US commercial banks in securitisation can be used by their subsidiaries in Europe as this activity grows. Since it cannot normally be traded,35 expansion through MNBs allows the banks to profit from the knowledge factor.

A paper by Alford et al. (1998) provides an interesting illustration of the importance of knowledge transfers. The authors were looking at the reasons why joint ventures were chosen as a means of building up a merchant banking industry in Singapore. The government had signalled its plan to turn Singapore into a key regional and international financial centre. Merchant banking was viewed as an important component of any key centre, and the first merchant bank was established in 1970. By 1982, 45 merchant banks had been established.

The sample consisted of 79 banks, 56 of which were wholly owned; 23 spent at least a year as a joint venture in the period 1974–91. There were 85 partners in the 23 joint ventures – 67 were from outside Singapore. Of the 56 wholly owned merchant banks, 52 were foreign, i.e. headquartered outside Singapore.

The paper compares the performance of the joint venture and wholly owned merchant banks. Alford et al. identify the potential benefits of joint ventures, such as knowledge creation and learning, limiting entry into product markets, or bypassing government regulations. There are also costs. There is an incentive for partners to free-ride on each other because each one shares the output of the firm regardless of the resources invested to make the venture a success. Communication problems between partners can be aggravated if they are international.

Alford et al. (1998) argue their findings are consistent with two theoretical reasons for joint ventures. First, they are created to transfer knowledge among partner firms. In one case, the commercial banking partner learned about merchant banking from the international partner, and the foreign partner obtained connections with blue chip Singaporean firms.

Once these learning/networking advantages were realised, the organisational form of the bank changed and it became wholly owned.

Second, a large number of partners were international. Entering into joint partnerships limited their exposure to economic and political uncertainties. As these uncertainties are alleviated over time, it became optimal to buy out the Singapore partners. The results of this study suggest cautious foreign banks may enter a new country via a joint venture, to reduce exposure to economic and political uncertainties. Over time, some of these concerns are alleviated and knowledge is gained. The response is to buy out the host country partner (e.g. the Singapore firm), leaving an independent MNB. Thus, by 1991, only 6 (out of 23) joint ventures remained – 15 became wholly owned and 2 were dissolved.

Other factors explain the growth of MNBs. First, reputation is important: the US money centre banks can set up subsidiaries in Europe and take advantage of their good reputation – though there are limits to this, as Citibank found to its cost. Also, following corporate activities overseas means banks can monitor the credit risk of their MNE borrowers by assessing the performance of overseas operations, in addition to supplying banking services.

Finally, foreign bank entry may stimulate economic development in emerging markets. Some countries limit foreign bank entry, usually to protect the national banking sector, for reasons related to national sovereignty. However, the foreign banks can stimulate competition in this sector, and in emerging markets provide services that would not otherwise be available. He and Gray (2001) use the relaxation of controls on foreign banks in China to demonstrate the point. After China announced it would allow foreign bank entry in December 1990, the number of foreign banks doubled, rising from 12 in 1990 to 24 in 1997 in the Shenzhen Special Economic Zone (SSEZ). Using data on inward foreign direct investment and GDP in the SSEZ, the authors show that the presence of multinational banks improved the financial infrastructure, which in turn encouraged more foreign direct investment, raising SSEZ GDP.

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