World Financial Markets and International Banking | Management Optional Notes for UPSC PDF Download

Introduction

• In the current business environment, there has been a significant acceleration in international trade activities, highlighting the heightened importance of the global finance market. This market primarily revolves around the lending and borrowing of foreign currencies to facilitate cross-border trade transactions. 
• Operating beyond the confines of any specific country's regulations, directives, and legislative framework, the global finance market comprises various elements, including the euro currency market, export credit facilities, the International bond market, and institutional finance. Bond issues and investors play a predominant role in shaping the dynamics of the global finance market. 
• The selection of currency holds a crucial position in this domain, with the most commonly preferred currencies being the US dollar, pound sterling, and Japanese yen. Contributors to the global finance market encompass multinational corporations, corporate enterprises, and government entities.

Factors Driving the Global Finance Market:

1. Deregulation: Rules and restrictions have been loosened, allowing more freedom in financial activities.
2. Science and Technology: Advancements in technology help monitor and analyze the world market, execute orders, and identify financial opportunities.
3. Institutionalization: More large-scale investors are involved in the financial market, shifting away from individual investors.
4. Competition: Global competition pushes governments to relax regulations in international financial markets.
5. Information Flow: Improved telecommunication allows for the easy and free flow of market information worldwide.

Benefits of the Global Finance Market:

• Flexibility: The market offers flexibility in operations and is widely dispersed.
• Innovative Instruments: Various innovative financial instruments, like swaps (including interest and currency swaps) and debt equity swaps, are prevalent in the global finance market. These instruments help manage risks and optimize financial strategies (Gurusamy, 2009).

Major Global Finance Markets

1. US Financial Market:

   • Overview: The United States boasts the largest and most versatile financial market globally. It offers a wide range of funding options and is characterized by sophisticated and innovative financial institutions.
   • Currency Significance: The US Dollar holds a dominant position in the international financial arena, making the US financial market even more significant.
   • Components: The US financial system comprises a network of commercial banks, domestic and foreign international banks, non-bank financial institutions, insurance companies, pension funds, mutual funds, savings, and loan associations.
   • Regulation: Three main authorities regulate commercial banks in the US: the Comptroller of Currency, the Federal Reserve Board, and the Federal Deposit Insurance Corporation.

2. Euro Market:

   • Composition: The Euro market includes Euro dollar bonds, Floating Rate Notes (FRNs), and Negotiable Instruments of Finance (NIFs).
   • Euro Dollar Bond: Euro dollar bonds represent a substantial portion of Euro bond issues.
   • Attractiveness: The Eurocurrency market is appealing due to the absence of government regulation, allowing for higher interest rates on deposits and lower interest rates on loans compared to domestic currencies.
   • Risks: However, involvement in the Eurocurrency market exposes participants to risks such as potential bank failures and foreign exchange risks.

3. Japanese Market:

   • Integration: Japan's financial system became integrated with the international market starting in the 1970s.
   • Components: Similar to other major industrialized nations, Japan's financial system includes commercial banks, government-owned financial institutions, securities companies, capital markets, and money markets.
   • Regulation: The Ministry of Finance closely monitors Japan's financial system.
   • Securities Firms: Japan's securities firms, especially the "Big Four," play a significant role in international financial transactions.

4. German Market:

   • Currency: The German market is denominated in Deutsche Mark.
   • Role: It holds an important position within the broader Euro market.
   • Development: Since 1985, Germany's financial system has been aligned with liberalization and deregulation.
   • Banking Model: Universal banking is a prevalent model in Germany.

5. Swiss Financial Market:

   • Development: Switzerland boasts a well-developed banking system, attracting global players in the financial market.
   • Offshore Funds: A significant portion of worldwide offshore funds is held in Swiss banks.
   • Regulation: The Swiss Financial Market Supervisory Authority (FINMA) regulates banking activities in Switzerland.

6. Australian Market:

   • Currency Influence: The Australian dollar gained popularity in the offshore market, particularly in bond issuance.
   • Growth Phases: The Australian financial market experienced rapid expansion in the 1980s, followed by continued growth in the 1990s.
   • Participants: Banks, especially in foreign exchange and derivatives, dominate the Australian financial market.
   • Regulation Impact: Deregulation in the mid-1980s contributed significantly to the growth of the Australian financial market.

7. Indian Financial Market:

   • Prominence: India's financial market is recognized as one of the prominent financial markets globally.
   • Establishment: The market began to organize in the 19th century with the establishment of the Security Exchange Board of India (SEBI).
   • Growth Factors: Liberalization measures since 1991 spurred growth, with the introduction of the National Stock Exchange (NSE) and the Over the Counter Exchange of India (OTCIE) enhancing transparency.
   • Characteristics: The Indian financial market encompasses various sectors such as foreign investment, insurance, loans, mutual funds, foreign exchange, and both national and international market relations.

8. Sterling Market:

   • Significance: The Sterling market holds a significant position within the global financial market, particularly due to the importance of the British pound sterling currency.

International Banking

International banks are financial institutions that offer services like payment accounts and loans to customers from other countries. These customers can be individuals or businesses, and each international bank has its own rules for who they work with. International banks stand out from local banks by the services they provide.

Major Functions of International Banking:

1. Facilitating Trade: International banks help clients with import and export transactions by providing trade financing services.

2. Foreign Exchange Services: They assist in arranging foreign exchange for cross-border transactions and foreign investments.

3. Risk Hedging: International banks help clients hedge against exchange rate risks, protecting them from fluctuations in currency values.

4. Trading Activities: They engage in trading foreign exchange products for their own accounts, leveraging opportunities in global markets.

5. Eurocurrency Market: International banks borrow and lend in the Eurocurrency market, which involves transactions in currencies held outside their countries of origin.

6. Loan Syndication: They participate in international loan syndicates, providing funding to multinational corporations (MNCs) for projects and supporting sovereign governments' economic development initiatives.

7. Underwriting: International banks underwrite Eurobonds and foreign bond issues, facilitating capital raising for various entities.

8. Consultancy Services: They offer consultancy and advice on hedging strategies, interest rate and currency swap financing, and international cash management services to help clients optimize their financial operations.

Types of International Banking Offices

1. Correspondent Bank:

   • Banks from different countries establish accounts in each other, allowing multinational clients to conduct global business.
   • Provides income for large banks and offers opportunities for smaller foreign banks to engage in business.

2. Representative Office:

   • A small service facility staffed by the parent bank to assist multinational clients with dealings through correspondents.
   • Identifies foreign market opportunities, serves as a liaison, and provides information on local business customs and credit evaluations.

3. Foreign Branch Bank:

   • Operates like a local bank but is legally part of the parent bank, not a separate entity.
   • Not subject to host country reserve requirements or deposit insurance, enabling competition at the local level.

4. Subsidiary and Affiliate Bank:

   • A subsidiary bank is locally incorporated and wholly or majorly owned by a foreign parent.
   • An affiliate bank is partially owned but not controlled by its foreign parent.
   • Operate under the banking laws of the country where incorporated, allowed to underwrite securities.

5. Offshore Banking Centre:

   • A country organized for external accounts beyond normal local economic activity.
   • Operates with freedom from host-country banking regulations, offering services as branches or subsidiaries of the parent bank.
   • Provides primary credit services in a currency other than the host country currency.
   • Reasons for offshore banks include low taxes, services for non-resident clients, and a legal regime upholding bank secrecy.

Advantages of Opening an International Bank Account:

• Safe and secure global access to money 24/7.
• Quick and easy transfers in multiple currencies for flexibility.
• Simple and convenient operations with one central location for all banking needs.
• Unlimited access to foreign exchange with protection against exchange rate fluctuations.
• Growth and protection of funds in a stable offshore jurisdiction.
• Confidential service available worldwide.

Features of International Banking:

• Involves currency risk, complexity of credit risk, and typical banking risks.
• Competition for market share among banks with narrow spreads and cyclical nature.
• Competition for bank loans from the international bond market as substitutes for loans.

Role of International Banks in the Global Economy:

1. Financial Globalization and Integration:

   • International banking has been a major component of financial globalization, expanding alongside international trade.
   • Local operations of foreign banks contribute to the development of financial systems in emerging markets.

2. International Financial Markets:

   • Complementary functions of international banks and financial markets are crucial for the smooth functioning of the financial system.
   • Deep international capital markets ease funding strains for large corporations during credit contractions, while banks are essential for financing households and small to medium-sized businesses.

Reasons for International Banking

1. Migration of Clients:

   • People move globally for jobs and other purposes.
   • Migration of domestic customers, especially Multinational Enterprises (MNEs) expanding foreign activities, is a major reason for opening accounts in international banks.

2. Benefits of Financial Centres:

   • Major financial centres offer advantages such as business contacts, customer location, skilled labor, diverse trades and professions, market liquidity and efficiency (thick market externalities), and interrelation of markets (e.g., derivatives and underlying).
   • Potential for increasing returns to scale and self-sustaining growth of financial centres.

International Banking Activities:

1. Communication Facilities:

   • International banking relies on sophisticated communication facilities like CHIPS (Clearing House Interbank Payment System) and SWIFT (Society for Worldwide Interbank Financial Telecommunication).

2. CHIPS (Clearing House Interbank Payment System):

   • Established in the US by the New York Clearing House Association in 1970.
   • Fully automated system meeting the needs of New York money centre banks.
   • Responsible for moving about 90% of the US dollar exchange in international commerce globally.

3. SWIFT (Society for Worldwide Interbank Financial Telecommunication):

   • Founded in Belgium in 1973, owned by European, North American, and Japanese banks in 15 nations.
   • Largest global financial telecommunication network, a non-profit cooperative society.
   • Facilitates standardization of international interbank communication and cash management services.
   • Utilized by financial systems like EURO clear bond clearing and MasterCard International.

Growth in Global Capital Markets:

1. Access to Capital:

   • Over the last few decades, firms and countries have gained increased access to global capital markets.
   • Access to capital, including bank credit, equity, and fixed income bond issuance, has become more abundant and competitive.

2. International Banking Operations:

   • International banking operations may be conducted in a separate division or department within a bank.
   • Big banks typically operate an international division with a network of foreign branches, subsidiaries, and affiliates.
   • Smaller banks or those with limited international activity often use a separate department along with foreign correspondent banks.

International Activities

Lending:

1. Geographic Concentration: Most international lending originates from institutions in New York City, with some conducted in secondary money-market centers like Chicago, Miami, and San Francisco.
2. Profit Source: Banks generate significant profits from interest received on loans and securities instruments, both internationally and domestically.
3. Scope and Complexity: International loans have grown in size, complexity, and geographical reach. They are extended to various entities, including foreign governments, banks, companies, multinational corporations, and U.S. importers/exporters.

Investments:

1. Capital Allocation: Banks may allocate capital internationally for investments in foreign debt securities or debentures.
2. Issuer Variety: Debentures may be issued by foreign banks, corporations, or sovereign governments to meet their capital needs.
3. Local Compliance: Banks with foreign offices may hold securities of foreign governmental entities to comply with local laws, reserve requirements, reduce tax liability, or show goodwill.
4. Unsecured Obligation: In the case of debentures, they represent an unsecured obligation of the issuer.

Foreign Exchange:

1. Definition: Foreign exchange involves exchanging the currency of one country for another, arising from international trade or capital movement between countries.
2. Bank Role: Banks historically act as ideal intermediaries in foreign exchange transactions due to their position as financial intermediaries.
3. Transaction Parties: Foreign exchange transactions occur between banks (interbank trading) and between banks and their customers (corporate trading).
4. Volume and Activity: The level of involvement varies among banks, driven by customer demand and interbank trading for a bank's own account.
5. Multinational Banks: Global banks are most active, trading across various currencies. Other banks may engage in limited activity, focusing on specific currencies.
6. Transaction Types: Banks of any size can engage in foreign exchange transactions on behalf of customers, but typically, only the largest banks and specialized international banks conduct transactions for their own account.

Key Risks in International Banks

1. Country Risk:

   • Associated with investing or lending in a country.
   • Arises from potential changes in the business environment that could negatively impact operating profits or asset value.
   • Examples include currency controls, devaluation, regulatory changes, civil unrest, and other stability factors.

2. Credit Risk:

   • Risk of default on a debt due to a borrower failing to make required payments.
   • Arises from the borrower's poor financial condition, posing a risk to the lender.

3. Currency Risk:

   • Arises from changes in the relative valuation of currencies.
   • Can lead to unpredictable gains or losses when converting profits or dividends from foreign currency to the domestic currency.
   • Investors can mitigate currency risk using hedging techniques.

4. Foreign Exchange Risk:

   • Occurs when a financial transaction is denominated in a currency different from the company's base currency.
   • Poses financial risk due to fluctuations in exchange rates.

In summary, international banking involves navigating various risks such as country, credit, currency, and foreign exchange risks. Despite challenges, international banking plays a crucial role in facilitating global financial transactions and fostering economic integration across borders.