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«International Bank Management Dileep Mehta and Hung-Gay Fung International Bank Management International Bank Management Dileep Mehta and Hung-Gay ...»

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International Bank Management

Dileep Mehta and Hung-Gay Fung

International Bank Management

International Bank Management

Dileep Mehta and Hung-Gay Fung

© 2004 by Dileep Mehta and Hung-Gay Fung

350 Main Street, Malden, MA 02148-5020, USA

9600Cowley Road, Oxford OX4 1JF, UK UK

108 Garsington Road, Oxford OX4 2DQ,

550 Swanston Street, Carlton,Victoria 3053, Australia

The right of Dileep Mehta and Hung-Gay Fung to be identified as the Authors of this Work has

been asserted in accordance with the UK Copyright, Designs, and Patents Act 1988.

All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, except as permitted by the UK Copyright, Designs, and Patents Act 1988, without the prior permission of the publisher.

First published 2004 by Blackwell Publishing Ltd Library of Congress Cataloging-in-Publication Data Mehta, Dileep R., 1939International bank management/Dileep Mehta and Hung-Gay Fung.

p. cm.

Includes bibliographical references and index.

978-1-4051-1128-7 (hardcover: alk. paper) ISBN 1-4051-1128-3 (hardcover: alk. paper)

1. Banks and banking, International–Management. 2. Bank management.

I. Fung, Hung-Gay. II.Title.

HG3881.M422 2004 332.1’5’068–dc21 A catalogue record for this title is available from the British Library.

Set in 10/121/ Bembo by Newgen Imaging Systems (P) Ltd, Chennai, India Printed and bound in Singapore Kingdom the United by TJ International, Padstow, Cornwall C.O.S. Printers Pte Ltd For further information on

Blackwell Publishing, visit our website:

http://www.blackwellpublishing.com Contents List of Figures ix List of Tables x Preface xiii Part I Overview 1 1 Basic Premises 3

1.1 Introduction 3

1.2 Risk-Return Tradeoffs 4

1.3 Why Financial Institutions Are Necessary 7

1.4 Competitive Markets and Impediments 8

1.5 Market Hierarchies 10

1.6 Uniqueness of a Bank 10

1.7 Risk Dimensions of the Banking Business 12

1.8 Conclusion 14 Part II Foundation 17 2 Globalization of Commercial Banking 19

2.1 Historical Background 1

–  –  –

In the past two decades, few enterprises have undergone as radical a change as the banking organization. Globalization of financial markets has been one of several major forces responsible for changing the character of the banking industry. As interrelated agents of change, advances in information technology and a shift in regulatory stance have affected not only the mode of conducting business in the banking arena but also its scope. If the goal of business education is to prepare students for a flourishing career in a business, which happens to be banking here, a focus on primarily domestic aspects of banking will hardly suffice.

Educating students for the challenges facing the banking industry in the coming decade is made more difficult by the ever-increasing pace of change, making yesterday’s management practices obsolete today.

Existing textbooks in the market place have adopted a variety of approaches to discuss the international dimensions of banking: a focus on domestic bank management with ancillary material pertaining to international banking; an exclusive focus on international banking through case method that highlights the complexity of international bank management with suitable abstraction of reality for expository convenience; and a macroeconomic perspective that focuses on issues related to international monetary economics and foreign exchange.

Our textbook rests on the foundation that integrates the following triad:

risk-return tradeoff;

G unique or special barriers encountered in conducting cross-border business; and G unique features of banking business.

G Based on the premises of this triad, our endeavor aims at providing “under one roof ” an up-to-date and integrated coverage of many important topics in international bank management ranging from foreign exchange markets, derivatives, country risk analysis, and asset-liability management to banking strategies. Analytical frameworks for many of these topics have been devised to accommodate vital ingredients of the decision-making process, and their applicability is illustrated with appropriate examples.

xiv PREFACE A course utilizing this textbook as its core will require a student to have a basic grounding in financial management and acquaintance with bank management in the “domestic” environment through either the classroom or workplace. Familiarity with elementary statistics will be helpful in understanding the material related to, say, derivatives; however, the textbook does not require a background in advanced mathematics or statistics.

Such a course will be appropriate for Master of Science (MS) or undergraduate students majoring in finance as well as practicing bankers keen on obtaining generalized insights in their profession. In addition, this textbook can also be used as a supplementary text in an MBA or undergraduate course in bank management when offering a stand-alone course is not feasible. Finally, selected material can also be fruitfully assigned to students taking international business courses.

During the process of developing this text, we have benefited from helpful comments and insights of bankers as well as our colleagues and students at several institutions. We would like to thank them, and especially Charles Guez (University of Houston), and Chip Ruscher (University of Arizona), who reviewed the manuscript for Blackwell Publishing. Obviously they are not responsible for remaining errors and omissions. We would also like to thank Seth Ditchik and Elizabeth Wald of Blackwell Publishing for expediting this project.

Last, but not least, we would like to dedicate our book to Marty and Linda for their unstinting support, understanding, and patience during all the years we have been working on this project.


–  –  –

1.1 Introduction The global environment in which financial institutions function has undergone rapid changes over the last two decades. Some of these changes could have been anticipated: consolidation in the banking industry or broadening of the scope of activities undertaken by banks is not surprising to observers of the industry.At the same time, other changes, such as the pace at which the banking business has embraced technology, have been vastly underrated both within the industry and outside. Further, these changes are still unfolding at such a rapid pace that a manager/observer cannot confidently predict what the banking business would look like in the foreseeable future. It is then virtually impossible for the manager to devise an ideal strategy. The best that the manager can hope is to develop the ability to discern and respond to changes in a timely and appropriate fashion.An understanding of fundamental forces that have molded the finance discipline in general and the financial institutions in particular is vital in this endeavor.

This chapter provides a broad brush picture of the major contributions to the finance discipline over the last four decades that have shaped not only our understanding of the finance function but also the practice of managing financial affairs.This description, in turn, facilitates comprehending description and analysis of the changing role of financial institutions such as banks in today’s global economy.


1.2 Risk-Return Tradeoffs The bedrock of finance theory is the nature of the relationship between return on an investment and the risk it entails. Risk is inversely related to the degree of certainty about obtaining the return: the higher the certainty, the lower the risk. Investing in a bank savings account involves little risk especially when the deposits are insured, whereas uncertain future prospects tend to make investing in a fledgling corporation a highly risky proposition.

Although there is a consensus that investors demand a higher return for assuming higher risk, the precise nature of the tradeoff has been the focal point of the inquiry in the finance discipline. Four cornerstone theories in the second half of the twentieth century have enhanced our understanding of this tradeoff and in the process transformed the role played

by important participants, such as banks, in the financial markets.These four theories are:

–  –  –

1.2.2 Capital asset pricing model So far, we have not defined risk in any precise sense. Any unexpected change in the return weighed with the likelihood of its occurrence is the foundation for measuring risk. The statistical measure representing risk is the variance, or its square root, the standard deviation.

When an investor considers investing in more than one asset, that is, wants to create a portfolio of investments, Markowitz (1952) pointed out that the risk of the portfolio cannot be measured by the simple sum of the weighted risks of its components. A portfolio of unrelated investments, for instance, allows the investor to reduce some risk of individual investments. As long as the trends in the returns are not closely correlated, the gains of some investments will compensate for the losses of others.The net effect is that the portfolio risk is less than the sum of risk of individual investments.The reduction in risk depends on the extent to which volatility in returns of individual investments move together: the smaller the comovement, the greater the reduction in risk of the portfolio. In finance literature, this phenomenon is described as diversification. Sharpe (1964) and Lintner (1965) extended the notion of the portfolio to the “market” portfolio – consisting of all risky securities (“assets”) that are traded in the market – and devised the CAPM framework.They demonstrated that the risk for an individual security in an informationally efficient market is measured by its contribution to the risk of the market portfolio and not by the standard deviation of its returns (since the standard deviation measures the total risk).The total risk of an asset or investment is thus decomposed in two parts: systematic risk that the investor will assume, and the unsystematic risk that will be diversified away when the portfolio includes other assets.The systematic risk is typically measured in terms of an index widely known as “beta.” The investor gets compensated for assuming only the systematic risk. Hence, the expected return on a security is given by the sum of the return on a risk-free asset (such as a government obligation), and the risk premium on the security is defined by the product of its beta and the market risk premium.

Because the MM theory and the CAPM share the common basis of efficient markets, their compatibility implies that a change in the capital structure (reflected in its debt–equity ratio) of a firm will induce a commensurate change in the beta of its stock.

Notice that investors are compensated for assuming only the systematic risk component of any security trading in the market place. If investors were to invest in fewer securities than those represented in the market portfolio, they would be unable to diversify risk to the extent that the market portfolio would; hence the compensation for risk would not be commensurate with risk assumption. A financial institution, such as a mutual fund or a bank, allows an investor to circumvent this return reduction when, say, resource limitations prevent an investor from actually holding a portfolio that resembles the market.

Further, the CAPM requires that market participants allocate their funds in only two investments, risk-free security and the market portfolio, depending on how much risk they 6 OVERVIEW want to assume: if they do not want to assume any risk, they should invest exclusively in the risk-free security; otherwise they should invest at least a portion of their capital endowment in the market portfolio.1 Thus, they do not exercise a choice in excluding some securities trading in the market, nor in investing in larger or smaller proportion in a given security (the proportions are dictated by the market portfolio). Finally, the CAPM does not distinguish between “good” risk and “bad,” although any unexpectedly high return (a “good” risk) is certainly liked by the investor.

1.2.3 Option pricing theory

Black and Scholes (1973) showed through the OPT that an individual investor can manage the risk by selling (“writing”) or buying derivatives that are based on securities.Thus individuals do not necessarily have to hold all securities represented in the market portfolio.Two basic forms of derivatives are futures and options. In turn, options are divided into puts and calls. When individuals sell a put option, they assume the downside (“bad”) risk and receive appropriate compensation for that. If they buy the call option, they enjoy the “good” risk, that is, “unexpectedly high” returns without assuming the downside risk; of course, they have to pay the premium to the seller of the call option. For the firm, the OPT has the advantage of risk management, that is, altering the firm’s risk profile, without tinkering with its asset or capital structure. Organized markets dealing in derivatives have been striving to satisfy customer needs for risk management products by offering innovative products; however, these markets by their very nature lag behind in meeting customer needs. Banks have been playing an important complementary role by offering customized derivative products that help their customers in fine-tuning risk management.

1.2.4 Agency theory

–  –  –

Efficient markets also presume that owners armed with perfect knowledge control a firm’s allocation of resources. Absence of such presumption along with the agency cost problem raises an important issue: which party – owner-principal or management-agent – ultimately controls the firm’s resources? When the management-agent exploits owner ignorance in the resource allocation process that is not in the best interest of owners, banks play an important monitoring role in mitigating the agency problem by holding management accountable through holding equity or extending loans in the firm.

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