Chapter Twenty Three

Geographic Diversification: International

Chapter Outline

Introduction

Global and International Expansions

Advantages and Disadvantages of International Expansion

Summary

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 Solutions for End-of-Chapter Questions and Problems: Chapter Twenty Three

1. What are three ways in which FI can establish a global or international presence?

The three most common methods are (1) selling financial services from domestic offices to
foreign customers, (2) selling financial services through a branch or representative office
established in the foreign customer’s country, and (3) selling financial services to a foreign
customer through subsidiary companies in a foreign customer’s country.

2. How did the Overseas Direct Investment Control Act of 1964 assist in the growth of global
banking activities? How much growth in foreign assets occurred from 1980 to 2003?
Which types of foreign assets saw the largest amount of growth?

The Overseas Direct Investment Control Act of 1964 restricted the ability of U.S. banks to lend
to U.S. corporations that wanted to make investments overseas. Although later repealed, the law
created incentives for U.S. banks to establish offices offshore to serve the financial needs of their
U.S. corporate clients. From 1980 to 2003, foreign assets of U.S. banks grew from $354 billion
to $804 billion, growth in foreign assets of 127% in 23 years. The largest dollar increase and the
largest percentage increase occurred in individual loans. These numbers are affected by the slow
economic activity of the first 3 years of this decade. Table 23-2 clearly shows that C&I loans
had shown the largest dollar increase through the end of 2000.

3. What is a Eurodollar transaction? What are Eurodollars?

Eurodollars are dollar-denominated claims at foreign or U.S. banks outside the United States.
The Eurodollar transaction may be a liability or an asset transaction that is booked external to the
boundaries of the United States.

4. Identify and explain the impact of at least four factors that have encouraged global U.S.
bank expansion.

First, the growth of international trade with the dollar as the primary medium of exchange has
encouraged the use of U.S. foreign bank subsidiaries to assist in these trade-related transactions.
Second, the U.S. banks in strategic locations, such as the Cayman Islands and the Bahamas,
became preferred depositories for funds that were flowing out of politically sensitive and risky
countries. Third, the Federal Reserve Bank often allowed U.S. banks to participate in activities
that were permitted in foreign countries, even though those same activities may not have been
permitted in the U.S. Finally, the technological improvements in communications, and the
development of an international payment system (CHIPS) provided banks with the control of
overseas operations at a decreasing rate.

5. What is the expected impact of the implementation of the revised BIS risk-based capital
requirements on the international activities of some major U.S. banks?

Several large banks may find it necessary to increase capital because only loans to OECD
countries rated above AA- will require zero risk weight or zero capital set aside.

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6. What effect have the problems of emerging-market economies in the late 1990s had on the
global expansion of traditional banking activities by U.S. banks?

Many U.S. banks have become more cautious in expanding outside the traditional overseas
markets even though the regulatory environment seems more favorable.

7. What factors gave the Japanese banks significant advantages in competing for international
business for an extended period of time through the mid-1990s? What are the advantages
of size in a competitive market? Does size necessarily imply high profitability?

Japanese banks had access to a large domestic savings base at relatively low cost, enjoyed a slow
pace of deregulation in their domestic markets, and were very large in asset size. The size
advantage gave these banks the ability to diversify across borders and attract business by
aggressively cutting fees and spreads. The size advantage of the Japanese banks deteriorated as
thin margins, an economic domestic recession, and increasing nonperforming assets weakened
the Japanese financial structure.

8. What is the European Community (EC) Second Banking Directive? What impact has the
Second Banking Directive had on the competitive banking environment of Europe?

The EC Second Banking Directive created a single banking market in Europe wherein banks
could branch and acquire banks throughout the entire European Community. As a result, a
significant cross-border merger wave among European banks has occurred, as well as the
development of strategic alliances that allow customers to utilize any of the branches of the
members of the alliances to open accounts, access account information, and make payments to
third parties. These actions obviously make a more competitive environment for U.S. banks.

9. Identify and discuss the various ways that foreign banks can enter the U.S. market. What
are international banking facilities?

First, a foreign bank subsidiary can be chartered with its own capital and access to both retail and
wholesale markets. Second, branch bank can be established with capital support from the parent,
but with access to both the retail and wholesale markets. Third, an agency organization is
restricted in its access of funds to those available in the wholesale and money markets. Fourth,
Edge Act Corporations specialize in international trade-related banking transactions. Fifth, a
representative office serves as a loan production office that generates loans that are booked in the
home country. International Banking Facilities are allowed to take deposits from and to make
loans to foreign customers only, effectively operating as offshore banking units onshore, but
without the effects of U.S. bank regulation and taxes.

10. What factors affected the relative growth of the proportion of U.S. banking assets that are
controlled by foreign banks during the 1990s into 2003?

Several factors have led to this decline including the highly competitive wholesale market for
banking in the United States, a decline in the quality of U.S. loans, capital constraints and poor
lending performance on Japanese banks at home, and the introduction of FBSEA in 1991.

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11. What was the fundamental philosophical focus of the International Banking Act (IBA) of
1978?

The IBA of 1978 and the Foreign Bank Supervision Enhancement Act of 1991 brought the
regulation of foreign banks under the control of federal regulators with the intent of treating them
under the same guidelines as domestic national banks.

a. What advantages and disadvantages did foreign banks have relative to domestic banks
prior to the passage of this legislation?

As state-licensed organizations, they were not subject to reserve requirements, audits, or

b. What requirements were placed on the foreign banks by the IBA?

The foreign branches were required to meet reserve requirements if their worldwide assets
exceeded $1 billion, made subject to Federal Reserve examinations, and made subject to
both McFadden Act interstate branching restrictions and the Glass-Steagall Act securities
underwriting restrictions.

c. What was the likely effect of the IBA on the growth of foreign bank activities in the
United States? Why?

Although restrictive in nature, the IBA also provided access to the discount window, the
Fedwire, and FDIC insurance. Thus foreign bank activities expanded in the United States.

12. What events led to the passage of the Foreign Bank Supervision Enhancement Act
(FBSEA) of 1991? What was the main objective of this legislation?

The primary objective of FBSEA was to extend federal regulatory authority over foreign banking
organizations in the United States. The three events that served as the catalyst for this legislation
were the failure of the Bank of Credit and Commerce International (BCCI), the issuance of more
than $1 billion of unauthorized letters of credit to Iraq by the Atlanta branch of Banca Nazionale
del Lavoro, and the unauthorized use of deposit funds by the U.S. representative office of the
Greek National Mortgage Bank of New York.

13. What were the main features of FBSEA? How did FBSEA encourage cooperation with the
home country regulator? What was the effect of the FBSEA on the Federal Reserve and on
the foreign banks?

The five main features of FBSEA are identified and discussed below:

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Entry. The Fed must approve the establishment of a subsidiary, branch, agency, or
representative office in the United States. The two mandatory standards are (a) the
comprehensive supervision of the foreign bank on a consolidated basis by a home country
regulator, and (b) the provision by the home country regulator of all of the necessary
information needed by the Fed to evaluate the application.

Closure. The Fed has the power to close the foreign bank if (a) the home country supervision is
inadequate, (b) the bank has violated U.S. laws, and (c) the bank is engaged in unsound and
unsafe banking practices.

Examination. The Fed has the power to examine each office of a foreign bank, and must
examine at least annually each branch or agency.

Deposit taking. Only foreign subsidiaries with access to FDIC insurance are allowed to take
deposits under $100,000.

Activity powers. Effective December 19, 1992, state-licensed branches and agencies of foreign
banks could not engage in any activity not permitted to a federal branch.

Clearly the authority of the Federal Reserve over the foreign banks was increased. Further,
Further, the regulatory burden and the costs of entry by foreign banks into the United States also
increased.

14. What are the major advantages of international expansion to FIs? Explain how each
advantage can affect the operating performance of FIs?

First, an FI can benefit from significant risk diversification, especially if the economies of the
world are not perfectly integrated, or if different countries allow different banking activities.
Second, an FI may benefit from economies of scale. Third, the returns from new product
innovations may be larger if the market is international rather than just domestic. Fourth, the risk
and cost of sources of funds both should be reduced. Fifth, FIs should be able to maintain
contact with, and thus provide better service to, their international customers. Sixth, an FI may
be able to reduce its regulatory burden by selectively finding those countries that have lower
regulatory restrictions.

15. What are the difficulties of expanding globally? How can each of these difficulties create
negative effects on the operating performance of FIs?

First, the difficulties of international expansion include the higher cost of information collection
and monitoring in many countries. Because the level of customer specific information may not
be as readily available as in the U.S., the absolute level of lending risk may be higher. Also,
coordinating different regulatory rules and guidelines will increase the cost of regulation.
Second, the political risk of nationalization or expropriation may increase the costs to an FI from
the loss of fixed assets to the legal recovery of deposits in U.S. courts from such action. Third,
the establishment of foreign offices may have large fixed costs.

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