Internalisation of Banks: Causes, Strategies, Foreign Trade

Internalisation of Banks

The last five or six decades have seen a rise in globalisation, increased trade and spread of multinationals. When companies started to relocate or expand to various parts of the world, banks also started to go global and set up their units in different regions. Companies usually maintain cordial relations with the banks they deal with regularly.

Whenever a bank’s client company diversifies its operations into a foreign country, the bank too likes to accompany the company so that it can establish its network on a wider scale and also provide services to its client company. In the process, the bank establishes several branches across the globe, which helps it to widen its customer base.

In other words, the migration of the local multinational customers of the bank paves the way for the bank to go global. Banks that go global are called multinational banks or MNBs. Through internationalisation, banks can expand their operations across the globe. They provide innovative, cost-effective products and services to gain customer loyalty.

The other benefit of internationalisation is improvement in the flow of capital. Apart from this, internationalisation helps banks create linkages with new investors and borrowers. Such linkages help banks in expanding their businesses in both home and foreign countries.

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Causes of Internationalisation of Banks

Apart from the major motives of an MNB to provide banking services to its home client company in the foreign country and expand the market for its banking products and services, there are other reasons that motivate banks to increasingly go global and diversify their business.

Advantages from difference in the cost of capital

The cost of capital and interest rates are different in different countries. As a result of this difference, developed countries have a lot of capital, but the interest on the capital lent in the home country would be quite less.

Therefore, banks from developed countries establish their network in less developed countries because of the high rate of interest. This idea was explained by Robert Z. Aliber, the noted professor of international economics and finance, in 1984.

Diversification and risk reduction motive

As banks go international, they reap the benefits of diversification and ultimately reduce their risk exposure. In other words, if a bank faces any risk or uncertainty in the home country, the risk may be mitigated by taking advantage of the favourable environment in which the international operations of the bank take place.

For example, suppose the customers of a bank in the home country start withdrawing their money due to a crisis. In such a case, the risk exposure of the bank would be limited as the bank has deposits in its branches in other countries. Diversification therefore helps in reducing the systematic risk of a bank.

Achieving economies of scale

As the level of activities (that is, lending and borrowing activities) of a bank increases due to its expansion in developing countries, the bank starts to realise economies of scale.

Advantages from the narrow spreads

When banks go international, they have to take deposits at high rates and lend at lower rates. This strategy reduces the spread of the bank on which it operates. However, the bank gets a large customer base; therefore, it can benefit by working with a narrow spread but on a wider scale.

Advantages from the ownership, location and internationalisation

These are basically the advantages of ownership derived from international customers because of access to the international financial markets and control over the trans-border communication systems and networks.

Internationalisation benefits include quality control, arbitrage and capital flow management, while location advantages include decreased government controls and low cost of capital and foreign operations.

Advantages derived from custodial functions

A bank may get the opportunity to become a custodian bank or simply the custodian of a company. The major functions of a custodian bank are to safeguard the assets and securities of its client company, such as stocks, bonds and cash; facilitate the process of selling, purchase and delivery of securities; and manage cash.

Advantages from less strict or lenient regulations

Banks derive advantages from lenient or less stringent rules and regulations of the countries in which they set up their branches. Banks usually set up their branches in their client company’s country. If it is a developing country, the laws and regulations may not be strict, which may make it easy for banks to operate in these countries.

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International Financial and Capital Markets in Developed Countries

The world economy is tremendously growing. The important factor of this growth is the financial system of the developed as well as developing countries, which is leading to speedily growing economies and flourishing trade flow.

A well-developed financial market plays a significant role in contributing to the health of an economy. Financial markets of developed countries are characterised by healthy corporate financial statements, macroeconomic policies, and favourable market conditions.

Large and strong financial and capital markets provide more liquidity than weak and small markets. The trading opportunities are more in case of developed countries. The US financial system is strongly developed where daily transactions are very huge.

The characteristics of well-developed international financial and capital market are as follows:

• It is a vast and varied financial system consisting of different types of financial institutions and diverse financial products such as stocks, commodities and derivatives.
  
  
• Promotes economic growth by creating money.
  
  
• Involves high interconnectivity with the world.
  
  
• Promotes global trade through financing mechanisms.
  
  
• Finances large projects with the help of public-private partnership.

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Investment Banking Services

Investment banking can be defined as a branch of banking in which there is a creation of capital for institutions such as government, companies, etc. It means matching the expectations of the people who have capital with those of the people who need the capital.

An investment bank provides services for investment banking by helping individuals and corporations in raising the financial capital. This bank acts as the client’s agent. Banking services are provided in the form of advising on options such as mergers, acquisitions, joint ventures for optimising valuation.

Investment banking services include the following:

• Private Equity Fund Raising
• Mergers and Acquisitions
• Equity Capital Markets
• Restructuring & Privatisation
• Brokerage Service

The enhancement in the pace of globalisation has integrated each individual economy into the global economy. The movement of money across an economy decides not only the economic health of that particular economy but also the different economies associated with that economy on the basis of trade and business practices.

It is important to note that the banking sector of an economy is one of the major sectors of the financial framework of that economy, which ensures the movement of money across that economy. Therefore it becomes important to study global trends of international banking to understand the global economy. Almost all countries of the world keep facing one or the other type of shock or problem.

A shock refers to an event that occurs due to natural calamities or the significant movement of trade activities in domestic and international markets. The shocks that occur due to movements in financial markets are called economic shocks. These are unpredictable shocks that may be positive or negative for an economy and involve mass job layoffs, winding up of many businesses, frequent trade shocks, etc.

Economic shocks can be in the form of supply shocks or demand shocks or due to unanticipated devaluation of currency. Supply shocks involve decrease in supply and increase in prices. Demand shocks involve a huge change in the demand of a product.

It a country faces shocks for a continuous period of time and the monetary policy adopted by its central bank fails to achieve price stability and economic growth, the central bank will have to take certain critical measures to bring back economy in a good condition.These measures may include expansionary monetary policy and quantitative easing.

An expansionary policy is adopted when the ordinary monetary policy made by the central bank fails. Under this policy, the central bank buys government and other securities (long-term as well as short-term) from the open market in order to lower interest rates and increase money supply. Due to lower interest rates, financial activities in the market get a boost.

A specific type of expansionary policy is quantitative easing. Under this policy, the central bank buys long-term government and other securities from the open market in order to lower interest rates and increase money supply in the financial system. Let us consider the example of the sub-prime crisis in 2008 that is also known as the subprime mortgage crisis or the mortgage mess.

The US economy had suffered the dotcom bubble in 2000 and was at the risk of a deep recession. The US was also shocked by the 9/11 terrorist attack in 2001 on the World Trade Center. As US dollar is the main trading currency, anything that affects the US dollar also affects all countries and currencies of the world.

The whole world including all central banks of countries wanted to stimulate economic activities for which they lowered interest rates. Since the rate of interest was lowered, investors wanted to make better returns by making riskier investments and lenders (banks and FIs) also took risks by approving sub-prime mortgage loans to borrowers without checking their credit position.

No prior credit history checks resulted in huge demand for credit by individuals for purchasing houses which led to housing bubble of 2005 that ended in 2006. The craze for subprime lending resulted in lending to those individuals who could not repay their loan amounts. As a result, various large lenders (banks and FIs including Lehman Brothers) and hedge funds had to declare themselves bankrupt.

After the crisis, the existing borrowers were paying their loans from their savings and banks were not lending, which led to the dilution of economic growth all over the world. The subprime crisis of the US affected all countries. For instance, the Bank of England had to roll out a QE programme.

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Concept of International Banking

Let us understand few concepts that play important role in international banking:

BoP

The International Monetary Fund (IMF) defines BoP(Balance of Payments) as a statistical statement that systematically summarises, for a specific time period, the economic transactions of an economy with the rest of the world.

Transactions, for the most part between residents and non-residents, consist of those involving goods, services and income; those involving financial claims on, and liabilities to, the rest of the world; and those (such as gifts) classified as transfers, which involve offsetting entries to balance—in an accounting sense—one-sided transactions.

From the above definition, the following viewpoints can be drawn regarding BoP:

• It is a statistical statement of systematic summarisation: BoP is a statistical statement published by each country using a set of accepted standards and conventions. A detailed explanation of these conventions is discussed later in the chapter.
  
  To facilitate standardisation and comparison of BoP statements from different countries, IMF issues a standard manual providing internationally accepted standards and rules for publishing data pertaining to BoP. The latest manual is called “Balance of Payments and International Investments Position Manual” and was issued as the sixth edition of the manual in 2009 (BPM6).
  
  
• It is for a specific time period: The BoP statement is prepared for a specific time period as it is a flow statement like the trade and profit and loss statement. It records transactions that occurred during a particular time period. A country may issue a BoP statement with a frequency of monthly, quarterly, half-yearly and/or annually.
  
  
• It includes economic transactions of a country with the rest of the world: The statement records the value of all economic transactions between residents, businesses and government with the rest of the world for a specific period of time. The IMF manual provides more detailed information on each of these categories (for example, the concept of residence is not based on nationality or legal status but based on the centre of economic interest.
  
  Similarly, what constitutes the rest of the world or non-resident is also defined in the manual). Note that BoP is not just about exports and imports of companies. It also involves the transactions of individuals. For example, if a Non-resident Indian (NRI) makes foreign currency deposit with his bank in India, the transaction will be included in the BoP statement.
  
  
• The economic transactions include those involving goods, services and income: As mentioned earlier, it includes exports and imports of goods, exports and imports of services and related income (apart from capital account transactions). It includes financial claims on, and liabilities to, rest of the world. Each export or import is done by exchanging a financial asset.
  
  For example, when an Indian corporate exports goods to the US and invoices it in US dollars (USD), he expects the US importer to make payment in USD as per the invoice amount. The BoP statement records both the export transaction and the related financial claim.
  
  For example, if the importer credits the exporter with USD amount by depositing the amount in the USD Nostro account belonging to the Indian bank where the exporter holds his account, then it is considered as an increase in the financial claim of India on the US (i.e. rest of the world).
  
  Similarly, if a Foreign Institutional Investor (FII) belonging to the US invests in the Indian stock market, he would deposit an equivalent amount of USD into the Nostro account of an Indian bank that would provide him with the required amount of Indian currency to purchase Indian stocks.
  
  This increase in dollar deposit in the Nostro account of the Indian bank will lead to an increase in the financial claim of India on the US. Similarly, the asset (stocks, in this case) purchased by FII represents an increase in foreign claim on Indian assets. Similarly, when an Indian corporate borrows abroad in Euro currency, India’s liability to the rest of the world increases.
  
  
• It includes transfers and gifts: The BoP statement also includes transfer transactions that do not involve an exchange. Similarly, gifts made in cash or kind between residents and non-residents also form part of the BoP.

PPP

The prevailing exchange rates actually indicate the degree of purchasing power of each individual unit of currency. If we consider the INR/USD currency pair, the exchange rate of 63.60 implies that one USD can purchase more goods than one unit of rupee. Similarly, in case of GBP, one GBP can purchase more goods than both one unit of USD and one unit of INR.

Given that one unit of USD or GBP has more purchasing power than one unit of Indian currency, we want to know how much more. If we go by the current exchange rates, this would mean that one unit of GBP would purchase as much goods as INR 99.3609 rupee would purchase.

This explanation of exchange rate levels is based on purchasing power of the currencies and forms the basis of PPP theory of exchange rate. The theory of PPP states that the exchange rate between currencies of two countries should be equal to the ratio of the price levels prevailing in the two countries.

If ER denotes Exchange Rate between INR and USD, then

ER = Price Level of India / Price Level of US

The absolute form of PPP theory gives the exchange rate applicable at any particular point of time based on the price level prevailing in two countries. The relative form of PPP takes into account the changes in price levels between countries over a period of time. The relative form of PPP says if there is price increase (or inflation) in both the countries, then the exchange rate between the currencies would adjust to maintain the PPP.

Carry Trade

Carry trade is a very famous strategy in exchange rate in which money is borrowed at the lower interest rate for investing in an asset that involves higher return. This strategy relies on stability of asset prices.

Forex Reserves/External Debt of Countries

Forex reserves can be described as the reserves held by the central bank of a country. These reserves are in the form of foreign marketable securities, monetory gold, Special Drawing Rights (SDRs), etc. The main aim of these Forex reserves is to make international payments.

Apart from this, forex reserves also help in hedging against the exchange rate risks. It is important to note that the external debt of a country is considered as one of the most important elements of the Forex reserves of the country. External debt is the total debt a country owes to foreign creditors.

Role of Rating Agencies

Rating agencies such as CRISIL play an important role in the global financial system. The following points describe the role of rating agencies:

• Provide valuations about the creditworthiness of bonds issued by corporations, governments, etc.
  
  
• Provide a long-term view of creditworthiness.
  
  
• Provide the credit quality. Remember, ratings do not reflect market sentiments.
  
  
• Follow a forward approach as these agencies assess the impact of predictable events.
  
  
• Help in developing global capital market.

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Strategies for Internationalisation of Banks

Banks follow a particular strategy for expanding their operations in foreign countries. The strategy may be about something as simple as setting up branches abroad, or it may relate to something as complex as mergers and acquisitions. Some of the strategies that are pursued by banks in the process of globalisation are:

Setting Up a Representative Office Abroad

Banks usually decide to establish a representative office in a foreign country in two cases: first, when the laws of the country prohibit foreign banks either to establish subsidiaries or their own business in the country, and second, when the bank does not want to invest a lot of money in the foreign country early and instead wants to check the market before making an actual entry.

A representative office carries out or engages in the functions of the bank on its behalf but is restricted from engaging in any kind of commercial banking business. This means that the representative office is not allowed to carry out conventional retail activities such as lending and borrowing.

The advantage of this method is that the international bank does not have to bear the cost of establishing new offices and engaging workforce in the foreign country. However, the biggest limitation of establishing a representative office is that the bank is not allowed to offer commercial banking services and products, which restrict its presence and market share.

Establishing a Network of Correspondent Banks

Another strategy adopted by banks in their effort to globalise is to use correspondent banks. As stated earlier, a bank that provides services on behalf of another bank is a correspondent bank. Correspondent banks can conduct business transactions, accept deposits and gather documents on behalf of the other bank. In other words, the correspondent bank acts as an agent of the international bank and carries out the transactions and other work on behalf of the international bank on the subsidiary.

This arrangement is advantageous for the international bank as it does not need to establish branches and employ people. However, a disadvantage of this strategy is that, in most cases, correspondent banks are not serious enough in maintaining a healthy, long-term relationship with the foreign bank and its clients. Short-term gains remain the focus of correspondent banks.

Linking With Associate or Affiliate Banks

This implies that the international bank has a minority holding in the domestic bank of the foreign country. International banks usually adopt this strategy to enter less developed countries; the banks of these nations are not very powerful and their shares are not highly priced.

Therefore, international banks enter less developed countries by acquiring less than majority stake in the shares of domestic banks. If the conditions of the foreign country seem to be positive, the international bank gradually starts acquiring more stakes and establishing its presence on a wider scale.

Establishing Branches Abroad

Multinational banks try to establish their presence in a foreign country by opening new branches. Generally, multinational banks in the host country are allowed to provide the entire range of banking services and products such as taking deposits, making advances and loans, and carrying out all other services.

These banks are also engaged in short-term and long-term lending and borrowing. Generally, these banks are interested in wholesale lending and borrowing in the host country and outside it. These banks also engage in short-term lending to companies and in financing international trade. The foreign branches of multinational banks are also involved in the money market and forex market operations.

Acquiring Foreign Banks

A bank may decide to enter foreign markets by acquiring the domestic bank of a foreign country. This strategy allows banks to establish their presence in different countries. The acquisition may be a majority acquisition or a fullfledged acquisition.

Equity Participation

A bank may buy some equity stake in the domestic banks of a foreign country. By doing this, multinational banks are able to establish their presence in the foreign country.

Establishing Subsidiaries

International banks may own a majority stake or have full ownership of foreign banks. The subsidiary may be set up as a new venture in the foreign country or the international bank may acquire a majority stake or buy out the entire bank in the foreign country. A subsidiary bank is a bank that is owned by an international bank in a foreign country but is established and run according to the laws and rules of the country in which it is set up.

The subsidiary runs as a separate entity having its own capital. However, the level of control exercised by the parent bank on the subsidiary may differ. The parent bank may let the subsidiary operate in a decentralised manner, quite independently but maintaining necessary control over it; or the parent may want to maintain strict control and let the subsidiary run under a centralised system.

Establishing Consortium Banks

Big international banks may come together and form a consortium or syndicate of banks. This consortium can be established as a legal entity in the foreign country. The participating banks have their shares in the consortium, and a board of the consortium includes members from all the participating banks. The consortium approach is mostly followed in cases where a single bank is not able to finance the requirements of a big project.

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Foreign Trade and International Banking

History has witnessed various foreign trade events that have affected businesses between different countries. Before the evolution of foreign trade, internationalisation was known for trade over long distances, which involved only a few products and services like silk, salt, amber, etc.

However, with a more current liberalised market, a lot of changes have taken place in foreign trade practices. Foreign trade refers to exchange of products and services across foreign borders, and it is considered an important element that influences the Gross Domestic Product (GDP) of various countries.

Foreign trade has changed the political, social, economic and financial significance of countries and is a result of liberalisation, privatisation and globalisation (LPG). Trading is a value-added function of the market. There is a specific risk, borne by the trader of that business.

Banks also bear the exporting risk and provide trade finance to foreign traders. In foreign trade practices, where the trading partner is located at distant locations, the risk of non-completion of the contract is always present. Therefore, the importer or exporter may refuse to enforce the agreement.

So trading firms can mitigate risks through products, covered by trade finance, as offered by a financial institution or a bank. International banks have also faced obstacles in foreign trade because of strict regulatory norms of some countries. This has led banks to offer their products and services in a way that suits the host country’s regulatory norms.

In cross-border transactions, both the importer and the exporter need to decide the best possible way to settle a transaction because of substantial risk faced by these parties with regard to non-payment of goods. In order to reduce this risk, both parties generally tend to approach a bank, which acts as a mediator or financial intermediary to solve the problem.

Figure shows some products and services typically offered by an international bank for foreign trade:

These products and services are explained as follows:

Letter of Credit

Export-import transactions lead to various kinds of risks, which may lead to the refusal of the contract by either party. Banks provide protection against such risks by issuing a letter of credit, which is a kind of guarantee taken by the issuing bank that once the goods are delivered to the importer, the said amount will be paid to the exporter.

The exporter needs to provide details of the delivery of the goods and present the appropriate shipment documents to the issuing bank. In case the issuing bank refuses to make the said payment, the exporter can take the help of a confirming bank, which makes the payment to the exporter for such default transactions. A confirming bank always takes the risk of non-payment of money for such transactions.

Documentary Collection

Apart from the letter of credit, another important service provided by banks in export-import transactions is documentary collection. Here, the bank does not take any guarantee for payment of amount, but the exporter’s bank forwards all ownership documents of the goods from the exporter to the importer, and possession of goods is given to the importer once the payment is done to the exporter.

Market Development

International banks help develop market leads for customers by maintaining close links with the target countries through their correspondent banks and bank officers who travel overseas frequently. A primary task of international banks is to spot potential sales and investment opportunities for their customers.

International banks also regularly monitor the political as well as economic conditions in the market countries. Market development activities also include advising potential exporters of the prospective markets for their products.

Exchange of Foreign Currency

International banks also provide foreign currency exchange services. Various MNCs are required to pay their clients the right amount and banks help them by offering the latest and best foreign exchange currency conversion rates.

Business Financing

Businesses need money for fixed capital and working capital requirements. Every business needs to borrow money for various activities like payment to the raw material supplier, for purchasing equipment and machinery parts, for payment to labours, etc. International banks can help such businesses in financing their business activities in exchange for some kind of guarantee.

Other Banking Services

International banks also provide other banking services like checking corporate accounts, offering international credit cards in specific currencies for eliminating cross-currency purchasing, providing lock boxes for collection of cheques from overseas clients, etc. To facilitate foreign trade, banks have started providing several key financial services to overseas clients.

These include:

• Administration of business
• Credit management
• Deposit collection
• Management of foreign exchange
• Management of fund
• Investment and custody management
• Letters of credit, documents collection and trade finances
• Guarantee services
• Wireless funds transfers

These are just some services that banks provide for foreign trade. The type of service may vary from bank to bank. For example, some banks provide retail services, which tend to be low-cost and homogeneous and some provide private, personalised banking services to the client.