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The report about banking practices followed around the world. It also explains banking structures followed around the world.
International Banking: Introduction & Practices around the World
What is international banking? This question can be answered in different ways: ? A bank that has subsidiaries in a foreign country to conduct business is an international bank.
For e.g.: The sale of USD deposits in Toronto by American banks with Canadian subsidiaries. However the sale of the same deposits by Canadian banks would construe domestic banking. ? Another definition could be related to the currency denomination of the loan or the deposit, independent of the physical location of the bank
For e.g.: Any GBP transaction undertaken by a bank headquartered in the UK, would be considered part of British domestic banking irrespective of whether the transaction is carried out by a British branch or subsidiary located outside the UK. However transactions in currencies other than GBP would be considered part of international banking irrespective of the actual location of the British bank. ? The third way of defining international banking could be based upon the nationality of the customer and the bank.
For e.g.: If the headquarters of a bank and a customer have the same identity, then any operation for this customer is a domestic activity independent of the location of the branch or the currency denomination of the transaction. For e.g.: All Japanese banking carried out on behalf of Japanese customers would be considered part of domestic banking in Japan even if both the branch and the customer are located in Norway. Hence to understand the components of international banking, it’s important to address the following: ? ? Why do banks engage in international banking activities such as trade in foreign currencies? What the economic determinants of a bank are with cross border branches or subsidiaries?
Comparative advantage is the basic principle behind the international trade of goods and services. A country is said to have a comparative advantage in the production of goods and services, if it is produced more efficiently in that country as compared to anywhere else in the world. The economic welfare of a country increases if it exports the good or services in which it has a comparative advantage and imports from countries which are more efficient in production. In banking the core function is accepting deposits from some customers and lending the funds to others. The intermediary function involves portfolio diversification. A bank that is well diversified is able to offer a combination of risks/rewards combination of financial assets to individual depositors/investors at a lower transaction cost than would be possible if the Commercial Banking: Raji Ajwani October 2009
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International Banking: Introduction & Practices around the World
individual investor would attempt the same diversification. The banks also offer evaluation of risks and credit for the uninitiated investor. They also act as filters and help to sift through the available information. Another important ingredient is the access to reliable payment systems and banks participate in a variety of payment options from the traditional cheques, bills to the electronic variations such as cards and wire transfers. A multinational enterprise is normally defined as a firm with plants extending across national boundaries. Extending the same definition to a bank, a bank with cross border branches is a multinational bank. Banks may opt to set up branches or subsidiaries overseas because of barriers to free trade. For e.g.: US regulations in the 1960’s prevented US banks from using US dollars to finance foreign investment. US banks got around these restrictions by using their London subsidiaries to offer their clients services that they could not offer in the US. Another reason could be to deploy its intangible assets such as skilled manpower and knowledge of specialized trade practices in an alternate location and benefit. For e.g.: A British bank with management expertise in the area of securitization may transfer these experts to Asia as the need and the business of securitization grows. Another example is that of Japanese banks setting up subsidiaries in London and New York where the markets are subject to fewer regulations than Japan. In addition to establishing a footprint in the US continent and catering to potential business, the other reason that this has been done is to ensure that the human capital employed in these subsidiaries will bring and apply the expertise gained in the US and European subcontinent to Japan once the Japanese banking and financial systems are deregulated. Reputation and cashing on this intangible asset may be another reason to set-up a presence overseas. For e.g.: Some of the London merchant banks have set-up branches in overseas markets to exploit their reputation of having superior skills in corporate finance and investment banking. Additionally the bank may follow some of their prized customers to the overseas location in order to protect the relationship and its own assets. For e.g.: If a bank has to lend substantial funds to a customer who is a multinational firm, it will require to assess the creditworthiness of the funds and one way would be for the bank to set-up a subsidiary in that country. That way it is not only able to gather market intelligence and assess the credit worthiness about the client but it can also use the knowledge to replicate and grow the client portfolio. Banks act as conduits to facilitate payments across different corners of the world. They are the source and the medium of transfer of legal currency (debatable!).Typically a major bank will act as a facilitator not only for its own clients but also for other smaller banks that may not have a big presence. The key payment systems are: 1. SWIFT: Stands for the Society for Worldwide Interbank Financial Telecommunication. This was established in Belgium in 1973. It’s a co-operative company and is owned by Commercial Banking: Raji Ajwani October 2009
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International Banking: Introduction & Practices around the World
roughly 2000 financial institutions including banks. The objective of SWIFT is to meet the global and data processing needs of the financial community. It transmits financial messages, payment orders, and foreign exchange confirmations to over 3500 financial institutions which are located in 88 countries. The SWIFT network is available 24 hours a day through out the year. The messages pass through the system on a real time basis. The SWIFT system handles over 2 million messages per business day. 2. FEDWIRE and CHIPS: FEDWIRE stands for the Federal Reserves Fund Transfer System and it’s a real time gross settlement transfer system operated by the Federal Reserve. Deposit taking institutions that keep reserves with the Federal Reserve or who have a clearing account use Fedwire to send or receive messages which amounts to approx 11000 users. In 1992 there were 68 million FEDWIRE funds transfers with a value of over USD 200 trillion. The average size of a transaction is USD 3 million. CHIPS stand for the Clearing House Interbank Payments System. This is a New York based system, operated by the New York Clearing House Association since 1971. In CHIPS, there is a multilateral netting of payments and transactions and net obligations are settled at the end of each business day. At 1630 hours (ET) CHIPS informs each participant about their position. Those in net deficit must settle by 1745 hours so that all the net obligations are cleared by 1800 hours. Most of the payments transferred over CHIPS are international interbank transactions. 3. CHAPS: London based, the Clearing House Automated Payments System was established in 1984 and permits same day transfers. There are 14 CHAPS settlement banks including the Bank of England along with other financial institutions which as sub members can engage in direct CHAPS settlements. These banks are responsible for the activities of its members and have to settle on their behalf by the end of the day. CHAPS accounts for just over half the transfers in the UK payments systems. 4. A number of large banks run their own electronic payment systems alongside the global systems to facilitate payments. Citibank and Chase Manhattan bank offer competitively priced funds transfer service to their clients SWIFT is the most popular system since it operates for 24 hours round the clock. It’s cooperative and non profit maximizing characteristic also makes it very popular worldwide. Multinational Banking in the Western Hemisphere: In the 19th century, Multinational Banks (MNB) was associated with the colonial powers such as Britain, France and Japan. The well known MNB’s such as HSBC were founded to facilitate trading between the colonies that were being controlled by these countries. For e.g.: HSBC was founded in 1865 by business interests in Hong Kong specializing in the trade of opium, tea and silk. Silver was the medium of exchange. By the 1870’s the growing trade and the demands thereof led to the establishment of branches of the bank all through the Pacific basin. HSBC acquired one of Britain’s leading banks Midland Bank in 1992.Similarly the Standard Bank (presently known as the Standard Charted bank) was established in 1853 and specialized in South African wool trade. Headquarted in London, it expanded its footprint to Africa and Asia. Today the maximum business for Standard Commercial Banking: Raji Ajwani October 2009
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International Banking: Introduction & Practices around the World
Chartered Bank is from outside the UK. The Mitsui Bank established its branches in Korea which was once a Japanese colony. A number of famous multinational investment banks were established in the 19 th century. Barings was established in 1762 and Rothschild in 1804. Their specialty was in raising funds for specific projects. The main capital importing countries were Egypt, Italy, Spain, Russia, Turkey, Latin America and Russia. The head office in London used to source the funds in the interbank and capital markets to source these projects. Most MNB’s are very big in wholesale banking. The main reasons for this are that the barriers to entering the retail business are high. The requirement of an extensive branch network makes it virtually impossible for a new bank to overcome the costs associated with acquiring space, human capital, and infrastructure to keep the branches efficient. The other reason is that the corporate business or wholesale banking is reputation driven and there are no major barriers to entry. The sophistication and knowledge required to meet the various banking needs of the corporate customer and the returns associated with this make it easier and lucrative to focus on this segment. The main benefits of international banking are: ? ? ? ? Increase in the number of banking options available to the customer and erosion of traditional set-ups due to increased competition. Availability of free and cheap funds to the central governments in the forms of statutory reserves Welfare associated with the employment that these banks generate Availability of the specialized know how and exposure associated with certain sections of banking. For e.g.: Treasury products
Banking Structures around the World: The variations in the banking structures around the world lie in the differences in the degree of separation between banking and commerce. Banks in UK, Italy and Switzerland have virtually no integration with the commerce in the country. Canada has specific legislation to discourage commercial links. In Germany, banks do have an ownership control over commercial concerns through equity share holding subject to certain restrictions. In Japan a group of companies called the “keiretsu” usually including a bank is loosely affiliated through shared management relationships and relatively minor equity ownership...In the USA, bank holding companies (BHC’s) may have upto 5% interest in commercial concerns but most BHC’s do not exercise this option. The term universal banking originated in Germany where banks offered bank and non-bank financial services and were formally linked to commercial firms through equity holdings A “blended” system exists in the USA, UK, Canada, Belgium, Canada, Japan and Sweden. In all the countries except the USA the integration takes place through the bank ownership of non bank subsidiaries. . In the USA, the concept of holding companies is used. These holding companies control both banking and non banking Commercial Banking: Raji Ajwani October 2009 Page 4
International Banking: Introduction & Practices around the World
entities. However the Glass Steagall Act in the USA and Article 65 in Japan have curbed such “marriages”. Banking Systems in the Developed Countries: 1. UK: Until the 1980’s, the UK financial system was clearly demarcated with demarcations in the following areas: ? Securities trading ? Insurance ? Investment banking ? Fund management ? Housing finance ? Commercial banking However in the 1980’s itself the British banks increased their focus on the retail sector. Firstly because domestic profits as a proportion of assets were greater than the profits in the international sector. Secondly the corporate dependence on bank funds reduced due to their improved financial position and tapping of alternate sources of relatively cheaper money. Thirdly the competitive pressure were far greater in dealing with corporate than with retail customers. Corporate customers had more banks to choose from and could also access capital markets and use alternate sources of finance such as securitization, thereby squeezing the margins for the banks. Illustration: Lending Pattern of UK Banks Lending to: Personal Sector Other FI’s Corporate Sector Unincorporated Firms 1980 18% 15% 53% 14% 1987 32% 24% 33% 11%
The other major happening in the UK financial industry was the happening of the “Big Bang” in 1986. Up until this time the trade rules and practices ensured that there was a demarcation between the firms operating on the stock exchange and other financial firms such as banks. In 1986 the rules were changed to allow 100% outside ownership of stock broking firms. Fixed commissions for securities trading were abolished in October 1986 and this led to a massive capital injection into the UK securities industry. The change in rules also meant that the new stock broking firms required far more capital than was necessary in the earlier scenario and hence very quickly all the securities firms became part of integrated financial institutions. 2. USA: The US banking system is very concentrated. It has over 30,000 deposit taking institutions compared to approximately 500 in the UK. Prior to 1974,Amercan banks owned 41% of the total assets of the 10 global banks followed by France (25%) and Commercial Banking: Raji Ajwani October 2009 Page 5
International Banking: Introduction & Practices around the World
UK(17%),West Germany(9%) and Japan at 8%.By 1988, Japan held 92.25% of the top ten global banks followed by France with 7.75%.. In 1981 there were 10 bank failures and by over 1000 by the end of the decade. There are four important differences between the US and the UK banking systems. ? In the US, the regulators are far more inclined to seek statutory measures leading to a lot of legislation ? Protection of the interests of small depositors has a greater importance and has received a lot of formal attention in the US ? There is far greater anxiety in the US about the stability of the banking system as is about the potential collusion among banks. ? The UK has a history of opting for potential consensus to prudential regulation. This does not generally happen in the USA. The Fed Reserve The Federal Reserve Act1913 created a central bank for the US banking system. This act allowed the Fed to provide liquidity in the event of a crisis. However there was a lot of concern that the existence of a central regulatory bank would be very much against the American philosophy of free competition in all industries including banking. As a result the FRS (Federal Reserve System) had a number of checks and balances built into it to discourage the development of cartel like tendencies. The emphasis is on decentralization and it’s made up of 12 regional Federal Reserve Banks and a Board of Governors. The main function of the Federal Reserve Bank is to pool the reserves of each of these banks. However the Federal Reserve is just one of the several regulators that operate. To function as a bank, a firm must obtain a national or state charter granted by the Comptroller of the Currency or by a state official who is usually called the Superintendant of Banks. The regulations that a bank is subject to, depend upon the charter. If it is a national charter, then the bank must join the Fed Reserve. For a state charter, membership to the Fed Reserve is optional. The regulations are relatively less stringent for state chartered banks. In the mid 1980’s, 40% of the banks in the USA were national and held more than 75% of the total deposits. Membership to the Fed Reserve System means that such banks are audited at least three times every two years by officers from the Comptroller of Currency. Auditors use the CAMELS ratings and score the banks on a scale of 1(best) to 5(worst).The banks are scored using five criteria such as capital adequacy, asset quality, management quality, earnings, performance and liquidity. A composite score is produced. Bank auditors can declare a bank as a “problem bank “if it is deemed to have many weaknesses. Since the 1991 Federal Deposit Insurance Corporation Act, regulators act swiftly if a bank is rating adversely.
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International Banking: Introduction & Practices around the World
The Comptroller of Currency examines national member banks. The Fed examines the state charter banks and the FDIC examines the non member (of the Fed Reserve) banks. The main benefit of a Fed membership is the ability to borrow and an image of quality and reputation. Recently the right to borrow has been extended to non members as well. Banks which are members of the Fed reserve system must meet a tier one capital to banks assets ratio of at least 5%. = banks tier one capital (equity capital+ long term funds)/ banks assets
Deposit Insurance: FDIC All member banks of the Fed Reserve are required to join the FDIC (Federal Deposit Insurance Corporation).Membership is important to attract deposits.97% of the US banks representing 99.8% of the deposits are insured by the FDIC. FDIC members pay a premium with which the FDIC purchases securities which provide it with a stream of revenue. FDIC insures deposits upto USD 250,000 (earlier it was USD 100000).The FDIC is allowed to borrow from the US Treasury. The main reason for deposit insurance is to protect the interests of small investors. However the argument against deposit insurance is that it encourages greater risks than otherwise would be possible. Hence in 1991 the FDICIA (Federal Deposit Insurance Corporation Improvement Act) was passed. This act requires the FDIC to use a “least cost” approach for resolving bank failures. Under this act, the riskier banks are required to pay higher insurance Banks are assigned ratings to determine the premia. Ratings are kept confidential and are based on inspections by statutory auditors rather than rating agencies. Banks wishing to remain in the top portion have to adhere to more stringent requirements than those laid down in Basle norms (8% capital adequacy). Glass-Steagall Act (1933): Separated commercial banking, from investment banking. The objective was to reduce collusion in the banking sector. Under this act, Investment banks can engage in securities business and underwriting but cannot accept deposits. The argument in favor of this was that this would help to reduce the collusion in the banking sector. It was argued that if a bank could hold the equity of a company and underwrite its securities, there could be a greater potential for collusion between the bank and the customer. The large number of bank failures between the periods 1929-1933 was also one reason that this measure was undertaken. There is however a lot of lobbying going one in the USA to repeal the Glass-Steagall Act. The argument being made is that technology and other competitive pressures have meant that the boundaries between commercial banks and investment banking are gradually being Commercial Banking: Raji Ajwani October 2009
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International Banking: Introduction & Practices around the World
eroded. Investment banks have been able to enter retail banking through money market funds, cash management, private placement, corporate finance and commercial paper markets either through holding companies or through subsidiaries. The Supreme Court ruling has meant that the Fed Reserve has allowed bank subsidiaries to underwrite commercial paper, municipal bonds, and sell bonds and stocks provided the affiliate earns no more than 10% of its gross revenue from these activities. Banks have also expanded into the insurance business. Regulation of Bank Holding Companies BHC’s: The Bank Holding Company Act 1956 defined a BHC as any firm holding at least 25% of the voting stock of a bank subsidiary. It required BHC’s to be registered with the Fed Reserve. The purpose of the Act was to restrict BHC activity that had not been subject to the usual regulations. However it did the opposite, it actually enhanced their growth because it gave them legal status. In the 1960’s the BHC’s controlled 15% of the bank’s deposits but by 1990’s 92% of the US banks were owned by BHC’s. Wholly owned bank subsidiaries were subject to a lot of bank regulations which BHC’s were not subject to. BHC’s are attractive because of tax advantages. The interest paid on BHC debt is tax deductible. Dividends from subsidiaries are a tax exempt source of revenue for BHC’s. The BHC framework also helps that banks can diversify into non bank financial activities such as credit card operations, mortgage lending, data processing etc. If a BHC has more than 300 shareholders it is required to register with the Securities and Exchange Commission. However they have not been permitted to enter into certain businesses excluded by the Glass-Steagall Act or in businesses not related to banking. Post 2008 crisis, many former investment banks such as Goldman Sachs converted to BHC’s to get greater access to funding. This allowed them to access the Fed Reserve and borrow funds for the short term (called the discount window) and also get access to the TARP (Troubled Assets Relief Program) which came about post the 2008 sub prime crisis. Branch Banking Regulations: To discourage concentration, USA has always imposed restrictions on branch banking. The McFadden Act (1927) permitted branching for national banks but required them to obey state regulations. The Douglas Amendment of the Bank Holding Company Act (1956) which set out guidelines for mergers between federally insured banks, individual states were given the final say in the expansion of out-ofstate banks. Between 1980’s and 1990’s most states decided to allow out-of-state bank entry through the merger of healthy BHC’s with unsound local banks .The guidelines for the mergers were laid down in the Bank Merger Act (1960) an example of a piece of legislation where the concern for the soundness of the banking system received priority over anxiety about the concentration of economic power. In the states of Arizona, Nevada, Washington 80-90% of the banking assets are controlled by non local BHC’s. Commercial Banking: Raji Ajwani October 2009 Page 8
International Banking: Introduction & Practices around the World
Thereafter legislation such as the Riegle-Neal Interstate Banking and Branching Efficiency Act 1994changed the BHC scenario. It allowed adequately capitalized BHC’s to acquire banks in other states. From 1995 onwards BHC’s can acquire or establish a bank anywhere in the country regardless of the state law. June 1997 onwards the federal agencies can approve applications from BHC’s to consolidate their multi-state operations and branch interstate. Technology and innovations such as ATM machines have also meant that branching regulations can be bypassed. Plus acts such as “The Edge Act” (1919) and its usage also allowed banks to set-up out of state subsidiaries provided that the deposits accepted and loans disbursed were related to international finance. Regulation of Foreign Banks: The International banking Act (1978) was expected to level the playing field between domestic banks and foreign banks operating in the US. Prior to this act, foreign banks had relatively lax requirements. They did not have to meet Fed Reserve requirements on liabilities. Since they were not covered by the McFadden Act (1927) they could establish branches across state boundaries. They were also exempt from the Glass-Steagall Act and could engage in a business close to banking. However their entry into the retail business was prohibited because they were not eligible for FIDC insurance. However post 1978, each foreign bank is required to designate one state as its home state and foreign banks are restricted from acquiring any offices outside their home state. The 1994 Riegle-Neal Act allows foreign banks to engage in interstate activity but by acquisition only. Under the 1978 Act, FDIC insurance was made compulsory. Reciprocity by the home country towards US banks wanting to operate in that country is also a criterion. Reserve requirements were imposed on all foreign banks where the parent had more than USD 1 billion in international assets covering all banks in the USA. However the International banking act was passed in 1978 when there were only 122 foreign banks and hence its scope and application to a certain extent became redundant. Hence in 1991, the Foreign Bank Enforcement Supervision Act was passed to establish uniform rules and level the playing field for foreign banks operating in the USA. Essentially the Act ensures that foreign bank operations are regulated, supervised the same way as is for the US banks. For e.g.: foreign banks wanting to setup state licensed branches need Fed Reserve approval and are subject to audits and examinations. Regulation of BHC’s (Bank Holding Companies): Until the 1960’s, BHC’s were a minor part of the US banking scene controlling about 15% of the bank’s deposits. By 1990’s, 92% of the banks in the US were owned by BHC’s. They became popular because banks realized that they could use BHC’s as a way to circumvent banking regulations. Wholly owned subsidiaries on the other hand were required to conform to a whole lot of regulations. The Bank Holding Company Act 1956 defined a BHC as any firm holding at least 25% of the voting stock of a bank subsidiary. Per this act, a BHC was required to be registered with the Fed Reserve Board. The purpose of this act was to actually restrict the BHC activity since they were not subject to the usual Commercial Banking: Raji Ajwani October 2009 Page 9
International Banking: Introduction & Practices around the World
regulations but what it did was that it actually enhanced the growth of BHC’s. Using the BHC framework, banks started diversifying into non bank activities such as credit card operations and mortgage lending, brokerage etc. However they were not allowed to engage in any business close to banking because of the application of the Glass-Steagall Act Tax avoidance was another reason why BHC’s became unattractive. Interest paid on BHC debt is tax deductible and non banking BHC’s could avoid local taxes. In 1989, the Fed Reserve began to require that state banks which are a part of the BHC are to obtain approval to operate any business which is a subsidiary of a bank. This was done because under the BHC structure, there were two alternatives: One was a BHC with state bank subsidiaries which in turn had separately incorporated subsidiaries or a BHC with business subsidiaries. If a business was a subsidiary of a state bank as opposed to a BHC, then such a business was implicitly protected by the Deposit Protection Scheme and the federal safety net (where a failing bank was sold off to the highest bidder with the help of the FDIC support rather than liquidating a bank). 3. The Banking Structure in Japan: The Japanese banking system exhibits a number of distinctive characteristics Notable among these is the high degree of supervision by the Ministry of Finance and the Bank of Japan. The six bureaus within the MOF are responsible for very close supervision of banks. The control is over areas as diverse as opening of accounts, opening hours, credit volume, and interest rates and accounting rules. Japanese banks in turn make active and large investments in international projects and markets. The Japanese banking and financial system has a reputation for a high degree of segmentation along functional lines. This structure is illustrated as follows. This illustration is as per the date available for the period mid 1900 to early 2000: ? Trust Banks: These banks can engage in management of trusts such as pension trusts or investment trusts. E.g.: Mitsubishi, Yasuda, Sumitomo and Mitsui. These banks are allowed to raise funds through term deposits. ? Long Term Credit Banks: Such banks are not allowed to use retail deposits as a source of funds although they can take government and corporate deposits. These banks can issue long term debt with a maturity of five years. ? Commercial Banks: These banks rely on deposits from the corporate and personal sectors although their deposits are restricted to a maturity of less three years. These domestically owned banks are prohibited from engaging in trust related business and cannot issue long term debt. There were 13 city banks and 130 regional banks per data available for the year 2001. Some examples are Sumitomo, Fuji and Mitsubishi. Of the 13 banks, Bank of Tokyo is a specialized foreign exchange bank although others also engage in foreign exchange. ? Mutual savings and loan banks: The number of such banks has fallen because many of these banks converted to regional bank status. These banks are also referred to as “sogo”banks and they concentrate their activities in the smaller cities or rural areas. Additionally there are about 450 Commercial Banking: Raji Ajwani October 2009 Page 10
International Banking: Introduction & Practices around the World
plus “shinkin” banks. These are credit associations that cater to the needs of local small businesses. ? As per 1987 figures available eighty-one foreign banks operate in Japan and they are permitted to offer almost the same range of services as the domestic banks. They also engage in securities business, through partly owned affiliates and in trust activities through trust bank affiliates. However they play a minor role in the Japanese financial system. ? Specialized financial firms including the Japan Development Bank and the Export-Import Bank. Their primary function is to allocate funds received from the Ministry of Finance Fiscal and Loan programmed. They do not accept deposits. The funds for the MOF loan program come from the postal savings and social insurance system. The postal system is a very popular deposit mobilizer for the government which uses the deposits garnered as a cheap source of funds. Until 1986, the government regulated the interest rates and this made the postal deposits. The deregulation of all interest rates was completed in October 1994 and it was felt that the postal system would loose its sheen. But that did not happen, because the postal system is under no pressure to be profitable hence they continue to offer attractive deposit rates and some of their retail products are very popular and so is their mass appeal. The reach of the post office system by way of branches is also very profuse the post office system has over 25000 branches while Sakura Bank (which is supposed to have the most extensive network) has about 600+ branches. Banks are also required to seek the MOF approval to open new branches. 4. Islamic Banking: This is based on the principles of the Koran which forbids charging of “riba” which is defined as any interest. The philosophy is that money is not to be used as a commodity and must be used for productive pursuits. Hence the main distinguishing characteristic of Islamic banking is the absence of a fixed interest rate on deposits and loans. The returns from lending are earned through profit sharing or by mark-up pricing. Islamic banking is practiced in countries such as Iran, Malaysia, Pakistan, and Saudi Arabia. The liabilities side of an Islamic banks balance sheet consists of equity and investment deposit accounts. Investors share in the profits/losses of a bank but do not have any management control. Different weight ages are applied depending upon the type of product. Savings accounts are held and some banks offer nothing while some others offer a profit/loss sharing agreement. Prizes and attractive rewards are used to attract customers. Current deposits are for transactions with no profit shared by investors although the bank can invest the funds. The assets side of the balance sheet is different. The only form of loan permitted is called the “qarz-e-hasna” where the lender provides a short term loan to a “needy” borrower at no charge and repayable when the borrower is able. Personal, health and education loans fall under this category. In mortgage financing, the bank buys the house and resells it at a far higher price to the borrower. Normally the borrower is given 25 years to repay this debt. Hence the bank assumes some risk that may surface if the housing market is volatile. The other way this transaction Commercial Banking: Raji Ajwani October 2009 Page 11
International Banking: Introduction & Practices around the World
is done is when the bank and the borrower buy the house jointly and then the borrower buys the banks share at cost price. The bank then leases its share of the house to the borrower for a annual fixed rate. For other consumer durables, mark-up pricing is used to collect and maintain the accounts and other admin costs. Firms selling the durables are financed on a profit sharing basis. Banks can enter into two types of partnership with firms to provide medium and long term financing. These two categories are: ? Musharka: Here the bank and the firm make joint contribution to a project. Profits/losses are shared in proportion to the contribution. ? Mudarba: Involves the bank providing the capital and a pre arranged share of profits are returned to the bank. The bank incurs the financial loss (if any) because the firm’s time and labor are recognized as part of the contribution. In this model, the bank has to engage in the arduous task of monitoring the activities of the firm. ? Hijara: Substitute for a leasing arrangement. Under this system, the bank sells the goods to the buyer over a long period of time and demands a fee for the effort. Usually it’s possible for the lessee to gain title of the goods or assets at the end of the lease. Trade Finance is conducted through a mudarba or a hijra. The mark-up is set based upon the size of the transaction, reputation of the buyer, type of goods etc. Mudarba finance comprises the most popular form of financing. Hence in the pure Islamic banking set-up the banks prefer to deal with well reputed and tested clients and track their funds carefully. Some Islamic banks have tried to expand into the global markets since the 1980’s to capture the overseas Islamic market. However the problems are that they cannot hold government securities (interest earning government securities are not permitted under the Islamic banking setup).Islamic states raise public funds by extending profit sharing loans to state enterprises. The other issues coming in the way of expansion of pure Islamic banks is the methods of lending and the banking practices deployed by them and their being very different compared to the more regimented principles and banking norms used in other countries.
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doc_206032824.pdf
The report about banking practices followed around the world. It also explains banking structures followed around the world.
International Banking: Introduction & Practices around the World
What is international banking? This question can be answered in different ways: ? A bank that has subsidiaries in a foreign country to conduct business is an international bank.
For e.g.: The sale of USD deposits in Toronto by American banks with Canadian subsidiaries. However the sale of the same deposits by Canadian banks would construe domestic banking. ? Another definition could be related to the currency denomination of the loan or the deposit, independent of the physical location of the bank
For e.g.: Any GBP transaction undertaken by a bank headquartered in the UK, would be considered part of British domestic banking irrespective of whether the transaction is carried out by a British branch or subsidiary located outside the UK. However transactions in currencies other than GBP would be considered part of international banking irrespective of the actual location of the British bank. ? The third way of defining international banking could be based upon the nationality of the customer and the bank.
For e.g.: If the headquarters of a bank and a customer have the same identity, then any operation for this customer is a domestic activity independent of the location of the branch or the currency denomination of the transaction. For e.g.: All Japanese banking carried out on behalf of Japanese customers would be considered part of domestic banking in Japan even if both the branch and the customer are located in Norway. Hence to understand the components of international banking, it’s important to address the following: ? ? Why do banks engage in international banking activities such as trade in foreign currencies? What the economic determinants of a bank are with cross border branches or subsidiaries?
Comparative advantage is the basic principle behind the international trade of goods and services. A country is said to have a comparative advantage in the production of goods and services, if it is produced more efficiently in that country as compared to anywhere else in the world. The economic welfare of a country increases if it exports the good or services in which it has a comparative advantage and imports from countries which are more efficient in production. In banking the core function is accepting deposits from some customers and lending the funds to others. The intermediary function involves portfolio diversification. A bank that is well diversified is able to offer a combination of risks/rewards combination of financial assets to individual depositors/investors at a lower transaction cost than would be possible if the Commercial Banking: Raji Ajwani October 2009
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International Banking: Introduction & Practices around the World
individual investor would attempt the same diversification. The banks also offer evaluation of risks and credit for the uninitiated investor. They also act as filters and help to sift through the available information. Another important ingredient is the access to reliable payment systems and banks participate in a variety of payment options from the traditional cheques, bills to the electronic variations such as cards and wire transfers. A multinational enterprise is normally defined as a firm with plants extending across national boundaries. Extending the same definition to a bank, a bank with cross border branches is a multinational bank. Banks may opt to set up branches or subsidiaries overseas because of barriers to free trade. For e.g.: US regulations in the 1960’s prevented US banks from using US dollars to finance foreign investment. US banks got around these restrictions by using their London subsidiaries to offer their clients services that they could not offer in the US. Another reason could be to deploy its intangible assets such as skilled manpower and knowledge of specialized trade practices in an alternate location and benefit. For e.g.: A British bank with management expertise in the area of securitization may transfer these experts to Asia as the need and the business of securitization grows. Another example is that of Japanese banks setting up subsidiaries in London and New York where the markets are subject to fewer regulations than Japan. In addition to establishing a footprint in the US continent and catering to potential business, the other reason that this has been done is to ensure that the human capital employed in these subsidiaries will bring and apply the expertise gained in the US and European subcontinent to Japan once the Japanese banking and financial systems are deregulated. Reputation and cashing on this intangible asset may be another reason to set-up a presence overseas. For e.g.: Some of the London merchant banks have set-up branches in overseas markets to exploit their reputation of having superior skills in corporate finance and investment banking. Additionally the bank may follow some of their prized customers to the overseas location in order to protect the relationship and its own assets. For e.g.: If a bank has to lend substantial funds to a customer who is a multinational firm, it will require to assess the creditworthiness of the funds and one way would be for the bank to set-up a subsidiary in that country. That way it is not only able to gather market intelligence and assess the credit worthiness about the client but it can also use the knowledge to replicate and grow the client portfolio. Banks act as conduits to facilitate payments across different corners of the world. They are the source and the medium of transfer of legal currency (debatable!).Typically a major bank will act as a facilitator not only for its own clients but also for other smaller banks that may not have a big presence. The key payment systems are: 1. SWIFT: Stands for the Society for Worldwide Interbank Financial Telecommunication. This was established in Belgium in 1973. It’s a co-operative company and is owned by Commercial Banking: Raji Ajwani October 2009
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International Banking: Introduction & Practices around the World
roughly 2000 financial institutions including banks. The objective of SWIFT is to meet the global and data processing needs of the financial community. It transmits financial messages, payment orders, and foreign exchange confirmations to over 3500 financial institutions which are located in 88 countries. The SWIFT network is available 24 hours a day through out the year. The messages pass through the system on a real time basis. The SWIFT system handles over 2 million messages per business day. 2. FEDWIRE and CHIPS: FEDWIRE stands for the Federal Reserves Fund Transfer System and it’s a real time gross settlement transfer system operated by the Federal Reserve. Deposit taking institutions that keep reserves with the Federal Reserve or who have a clearing account use Fedwire to send or receive messages which amounts to approx 11000 users. In 1992 there were 68 million FEDWIRE funds transfers with a value of over USD 200 trillion. The average size of a transaction is USD 3 million. CHIPS stand for the Clearing House Interbank Payments System. This is a New York based system, operated by the New York Clearing House Association since 1971. In CHIPS, there is a multilateral netting of payments and transactions and net obligations are settled at the end of each business day. At 1630 hours (ET) CHIPS informs each participant about their position. Those in net deficit must settle by 1745 hours so that all the net obligations are cleared by 1800 hours. Most of the payments transferred over CHIPS are international interbank transactions. 3. CHAPS: London based, the Clearing House Automated Payments System was established in 1984 and permits same day transfers. There are 14 CHAPS settlement banks including the Bank of England along with other financial institutions which as sub members can engage in direct CHAPS settlements. These banks are responsible for the activities of its members and have to settle on their behalf by the end of the day. CHAPS accounts for just over half the transfers in the UK payments systems. 4. A number of large banks run their own electronic payment systems alongside the global systems to facilitate payments. Citibank and Chase Manhattan bank offer competitively priced funds transfer service to their clients SWIFT is the most popular system since it operates for 24 hours round the clock. It’s cooperative and non profit maximizing characteristic also makes it very popular worldwide. Multinational Banking in the Western Hemisphere: In the 19th century, Multinational Banks (MNB) was associated with the colonial powers such as Britain, France and Japan. The well known MNB’s such as HSBC were founded to facilitate trading between the colonies that were being controlled by these countries. For e.g.: HSBC was founded in 1865 by business interests in Hong Kong specializing in the trade of opium, tea and silk. Silver was the medium of exchange. By the 1870’s the growing trade and the demands thereof led to the establishment of branches of the bank all through the Pacific basin. HSBC acquired one of Britain’s leading banks Midland Bank in 1992.Similarly the Standard Bank (presently known as the Standard Charted bank) was established in 1853 and specialized in South African wool trade. Headquarted in London, it expanded its footprint to Africa and Asia. Today the maximum business for Standard Commercial Banking: Raji Ajwani October 2009
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International Banking: Introduction & Practices around the World
Chartered Bank is from outside the UK. The Mitsui Bank established its branches in Korea which was once a Japanese colony. A number of famous multinational investment banks were established in the 19 th century. Barings was established in 1762 and Rothschild in 1804. Their specialty was in raising funds for specific projects. The main capital importing countries were Egypt, Italy, Spain, Russia, Turkey, Latin America and Russia. The head office in London used to source the funds in the interbank and capital markets to source these projects. Most MNB’s are very big in wholesale banking. The main reasons for this are that the barriers to entering the retail business are high. The requirement of an extensive branch network makes it virtually impossible for a new bank to overcome the costs associated with acquiring space, human capital, and infrastructure to keep the branches efficient. The other reason is that the corporate business or wholesale banking is reputation driven and there are no major barriers to entry. The sophistication and knowledge required to meet the various banking needs of the corporate customer and the returns associated with this make it easier and lucrative to focus on this segment. The main benefits of international banking are: ? ? ? ? Increase in the number of banking options available to the customer and erosion of traditional set-ups due to increased competition. Availability of free and cheap funds to the central governments in the forms of statutory reserves Welfare associated with the employment that these banks generate Availability of the specialized know how and exposure associated with certain sections of banking. For e.g.: Treasury products
Banking Structures around the World: The variations in the banking structures around the world lie in the differences in the degree of separation between banking and commerce. Banks in UK, Italy and Switzerland have virtually no integration with the commerce in the country. Canada has specific legislation to discourage commercial links. In Germany, banks do have an ownership control over commercial concerns through equity share holding subject to certain restrictions. In Japan a group of companies called the “keiretsu” usually including a bank is loosely affiliated through shared management relationships and relatively minor equity ownership...In the USA, bank holding companies (BHC’s) may have upto 5% interest in commercial concerns but most BHC’s do not exercise this option. The term universal banking originated in Germany where banks offered bank and non-bank financial services and were formally linked to commercial firms through equity holdings A “blended” system exists in the USA, UK, Canada, Belgium, Canada, Japan and Sweden. In all the countries except the USA the integration takes place through the bank ownership of non bank subsidiaries. . In the USA, the concept of holding companies is used. These holding companies control both banking and non banking Commercial Banking: Raji Ajwani October 2009 Page 4
International Banking: Introduction & Practices around the World
entities. However the Glass Steagall Act in the USA and Article 65 in Japan have curbed such “marriages”. Banking Systems in the Developed Countries: 1. UK: Until the 1980’s, the UK financial system was clearly demarcated with demarcations in the following areas: ? Securities trading ? Insurance ? Investment banking ? Fund management ? Housing finance ? Commercial banking However in the 1980’s itself the British banks increased their focus on the retail sector. Firstly because domestic profits as a proportion of assets were greater than the profits in the international sector. Secondly the corporate dependence on bank funds reduced due to their improved financial position and tapping of alternate sources of relatively cheaper money. Thirdly the competitive pressure were far greater in dealing with corporate than with retail customers. Corporate customers had more banks to choose from and could also access capital markets and use alternate sources of finance such as securitization, thereby squeezing the margins for the banks. Illustration: Lending Pattern of UK Banks Lending to: Personal Sector Other FI’s Corporate Sector Unincorporated Firms 1980 18% 15% 53% 14% 1987 32% 24% 33% 11%
The other major happening in the UK financial industry was the happening of the “Big Bang” in 1986. Up until this time the trade rules and practices ensured that there was a demarcation between the firms operating on the stock exchange and other financial firms such as banks. In 1986 the rules were changed to allow 100% outside ownership of stock broking firms. Fixed commissions for securities trading were abolished in October 1986 and this led to a massive capital injection into the UK securities industry. The change in rules also meant that the new stock broking firms required far more capital than was necessary in the earlier scenario and hence very quickly all the securities firms became part of integrated financial institutions. 2. USA: The US banking system is very concentrated. It has over 30,000 deposit taking institutions compared to approximately 500 in the UK. Prior to 1974,Amercan banks owned 41% of the total assets of the 10 global banks followed by France (25%) and Commercial Banking: Raji Ajwani October 2009 Page 5
International Banking: Introduction & Practices around the World
UK(17%),West Germany(9%) and Japan at 8%.By 1988, Japan held 92.25% of the top ten global banks followed by France with 7.75%.. In 1981 there were 10 bank failures and by over 1000 by the end of the decade. There are four important differences between the US and the UK banking systems. ? In the US, the regulators are far more inclined to seek statutory measures leading to a lot of legislation ? Protection of the interests of small depositors has a greater importance and has received a lot of formal attention in the US ? There is far greater anxiety in the US about the stability of the banking system as is about the potential collusion among banks. ? The UK has a history of opting for potential consensus to prudential regulation. This does not generally happen in the USA. The Fed Reserve The Federal Reserve Act1913 created a central bank for the US banking system. This act allowed the Fed to provide liquidity in the event of a crisis. However there was a lot of concern that the existence of a central regulatory bank would be very much against the American philosophy of free competition in all industries including banking. As a result the FRS (Federal Reserve System) had a number of checks and balances built into it to discourage the development of cartel like tendencies. The emphasis is on decentralization and it’s made up of 12 regional Federal Reserve Banks and a Board of Governors. The main function of the Federal Reserve Bank is to pool the reserves of each of these banks. However the Federal Reserve is just one of the several regulators that operate. To function as a bank, a firm must obtain a national or state charter granted by the Comptroller of the Currency or by a state official who is usually called the Superintendant of Banks. The regulations that a bank is subject to, depend upon the charter. If it is a national charter, then the bank must join the Fed Reserve. For a state charter, membership to the Fed Reserve is optional. The regulations are relatively less stringent for state chartered banks. In the mid 1980’s, 40% of the banks in the USA were national and held more than 75% of the total deposits. Membership to the Fed Reserve System means that such banks are audited at least three times every two years by officers from the Comptroller of Currency. Auditors use the CAMELS ratings and score the banks on a scale of 1(best) to 5(worst).The banks are scored using five criteria such as capital adequacy, asset quality, management quality, earnings, performance and liquidity. A composite score is produced. Bank auditors can declare a bank as a “problem bank “if it is deemed to have many weaknesses. Since the 1991 Federal Deposit Insurance Corporation Act, regulators act swiftly if a bank is rating adversely.
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International Banking: Introduction & Practices around the World
The Comptroller of Currency examines national member banks. The Fed examines the state charter banks and the FDIC examines the non member (of the Fed Reserve) banks. The main benefit of a Fed membership is the ability to borrow and an image of quality and reputation. Recently the right to borrow has been extended to non members as well. Banks which are members of the Fed reserve system must meet a tier one capital to banks assets ratio of at least 5%. = banks tier one capital (equity capital+ long term funds)/ banks assets
Deposit Insurance: FDIC All member banks of the Fed Reserve are required to join the FDIC (Federal Deposit Insurance Corporation).Membership is important to attract deposits.97% of the US banks representing 99.8% of the deposits are insured by the FDIC. FDIC members pay a premium with which the FDIC purchases securities which provide it with a stream of revenue. FDIC insures deposits upto USD 250,000 (earlier it was USD 100000).The FDIC is allowed to borrow from the US Treasury. The main reason for deposit insurance is to protect the interests of small investors. However the argument against deposit insurance is that it encourages greater risks than otherwise would be possible. Hence in 1991 the FDICIA (Federal Deposit Insurance Corporation Improvement Act) was passed. This act requires the FDIC to use a “least cost” approach for resolving bank failures. Under this act, the riskier banks are required to pay higher insurance Banks are assigned ratings to determine the premia. Ratings are kept confidential and are based on inspections by statutory auditors rather than rating agencies. Banks wishing to remain in the top portion have to adhere to more stringent requirements than those laid down in Basle norms (8% capital adequacy). Glass-Steagall Act (1933): Separated commercial banking, from investment banking. The objective was to reduce collusion in the banking sector. Under this act, Investment banks can engage in securities business and underwriting but cannot accept deposits. The argument in favor of this was that this would help to reduce the collusion in the banking sector. It was argued that if a bank could hold the equity of a company and underwrite its securities, there could be a greater potential for collusion between the bank and the customer. The large number of bank failures between the periods 1929-1933 was also one reason that this measure was undertaken. There is however a lot of lobbying going one in the USA to repeal the Glass-Steagall Act. The argument being made is that technology and other competitive pressures have meant that the boundaries between commercial banks and investment banking are gradually being Commercial Banking: Raji Ajwani October 2009
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International Banking: Introduction & Practices around the World
eroded. Investment banks have been able to enter retail banking through money market funds, cash management, private placement, corporate finance and commercial paper markets either through holding companies or through subsidiaries. The Supreme Court ruling has meant that the Fed Reserve has allowed bank subsidiaries to underwrite commercial paper, municipal bonds, and sell bonds and stocks provided the affiliate earns no more than 10% of its gross revenue from these activities. Banks have also expanded into the insurance business. Regulation of Bank Holding Companies BHC’s: The Bank Holding Company Act 1956 defined a BHC as any firm holding at least 25% of the voting stock of a bank subsidiary. It required BHC’s to be registered with the Fed Reserve. The purpose of the Act was to restrict BHC activity that had not been subject to the usual regulations. However it did the opposite, it actually enhanced their growth because it gave them legal status. In the 1960’s the BHC’s controlled 15% of the bank’s deposits but by 1990’s 92% of the US banks were owned by BHC’s. Wholly owned bank subsidiaries were subject to a lot of bank regulations which BHC’s were not subject to. BHC’s are attractive because of tax advantages. The interest paid on BHC debt is tax deductible. Dividends from subsidiaries are a tax exempt source of revenue for BHC’s. The BHC framework also helps that banks can diversify into non bank financial activities such as credit card operations, mortgage lending, data processing etc. If a BHC has more than 300 shareholders it is required to register with the Securities and Exchange Commission. However they have not been permitted to enter into certain businesses excluded by the Glass-Steagall Act or in businesses not related to banking. Post 2008 crisis, many former investment banks such as Goldman Sachs converted to BHC’s to get greater access to funding. This allowed them to access the Fed Reserve and borrow funds for the short term (called the discount window) and also get access to the TARP (Troubled Assets Relief Program) which came about post the 2008 sub prime crisis. Branch Banking Regulations: To discourage concentration, USA has always imposed restrictions on branch banking. The McFadden Act (1927) permitted branching for national banks but required them to obey state regulations. The Douglas Amendment of the Bank Holding Company Act (1956) which set out guidelines for mergers between federally insured banks, individual states were given the final say in the expansion of out-ofstate banks. Between 1980’s and 1990’s most states decided to allow out-of-state bank entry through the merger of healthy BHC’s with unsound local banks .The guidelines for the mergers were laid down in the Bank Merger Act (1960) an example of a piece of legislation where the concern for the soundness of the banking system received priority over anxiety about the concentration of economic power. In the states of Arizona, Nevada, Washington 80-90% of the banking assets are controlled by non local BHC’s. Commercial Banking: Raji Ajwani October 2009 Page 8
International Banking: Introduction & Practices around the World
Thereafter legislation such as the Riegle-Neal Interstate Banking and Branching Efficiency Act 1994changed the BHC scenario. It allowed adequately capitalized BHC’s to acquire banks in other states. From 1995 onwards BHC’s can acquire or establish a bank anywhere in the country regardless of the state law. June 1997 onwards the federal agencies can approve applications from BHC’s to consolidate their multi-state operations and branch interstate. Technology and innovations such as ATM machines have also meant that branching regulations can be bypassed. Plus acts such as “The Edge Act” (1919) and its usage also allowed banks to set-up out of state subsidiaries provided that the deposits accepted and loans disbursed were related to international finance. Regulation of Foreign Banks: The International banking Act (1978) was expected to level the playing field between domestic banks and foreign banks operating in the US. Prior to this act, foreign banks had relatively lax requirements. They did not have to meet Fed Reserve requirements on liabilities. Since they were not covered by the McFadden Act (1927) they could establish branches across state boundaries. They were also exempt from the Glass-Steagall Act and could engage in a business close to banking. However their entry into the retail business was prohibited because they were not eligible for FIDC insurance. However post 1978, each foreign bank is required to designate one state as its home state and foreign banks are restricted from acquiring any offices outside their home state. The 1994 Riegle-Neal Act allows foreign banks to engage in interstate activity but by acquisition only. Under the 1978 Act, FDIC insurance was made compulsory. Reciprocity by the home country towards US banks wanting to operate in that country is also a criterion. Reserve requirements were imposed on all foreign banks where the parent had more than USD 1 billion in international assets covering all banks in the USA. However the International banking act was passed in 1978 when there were only 122 foreign banks and hence its scope and application to a certain extent became redundant. Hence in 1991, the Foreign Bank Enforcement Supervision Act was passed to establish uniform rules and level the playing field for foreign banks operating in the USA. Essentially the Act ensures that foreign bank operations are regulated, supervised the same way as is for the US banks. For e.g.: foreign banks wanting to setup state licensed branches need Fed Reserve approval and are subject to audits and examinations. Regulation of BHC’s (Bank Holding Companies): Until the 1960’s, BHC’s were a minor part of the US banking scene controlling about 15% of the bank’s deposits. By 1990’s, 92% of the banks in the US were owned by BHC’s. They became popular because banks realized that they could use BHC’s as a way to circumvent banking regulations. Wholly owned subsidiaries on the other hand were required to conform to a whole lot of regulations. The Bank Holding Company Act 1956 defined a BHC as any firm holding at least 25% of the voting stock of a bank subsidiary. Per this act, a BHC was required to be registered with the Fed Reserve Board. The purpose of this act was to actually restrict the BHC activity since they were not subject to the usual Commercial Banking: Raji Ajwani October 2009 Page 9
International Banking: Introduction & Practices around the World
regulations but what it did was that it actually enhanced the growth of BHC’s. Using the BHC framework, banks started diversifying into non bank activities such as credit card operations and mortgage lending, brokerage etc. However they were not allowed to engage in any business close to banking because of the application of the Glass-Steagall Act Tax avoidance was another reason why BHC’s became unattractive. Interest paid on BHC debt is tax deductible and non banking BHC’s could avoid local taxes. In 1989, the Fed Reserve began to require that state banks which are a part of the BHC are to obtain approval to operate any business which is a subsidiary of a bank. This was done because under the BHC structure, there were two alternatives: One was a BHC with state bank subsidiaries which in turn had separately incorporated subsidiaries or a BHC with business subsidiaries. If a business was a subsidiary of a state bank as opposed to a BHC, then such a business was implicitly protected by the Deposit Protection Scheme and the federal safety net (where a failing bank was sold off to the highest bidder with the help of the FDIC support rather than liquidating a bank). 3. The Banking Structure in Japan: The Japanese banking system exhibits a number of distinctive characteristics Notable among these is the high degree of supervision by the Ministry of Finance and the Bank of Japan. The six bureaus within the MOF are responsible for very close supervision of banks. The control is over areas as diverse as opening of accounts, opening hours, credit volume, and interest rates and accounting rules. Japanese banks in turn make active and large investments in international projects and markets. The Japanese banking and financial system has a reputation for a high degree of segmentation along functional lines. This structure is illustrated as follows. This illustration is as per the date available for the period mid 1900 to early 2000: ? Trust Banks: These banks can engage in management of trusts such as pension trusts or investment trusts. E.g.: Mitsubishi, Yasuda, Sumitomo and Mitsui. These banks are allowed to raise funds through term deposits. ? Long Term Credit Banks: Such banks are not allowed to use retail deposits as a source of funds although they can take government and corporate deposits. These banks can issue long term debt with a maturity of five years. ? Commercial Banks: These banks rely on deposits from the corporate and personal sectors although their deposits are restricted to a maturity of less three years. These domestically owned banks are prohibited from engaging in trust related business and cannot issue long term debt. There were 13 city banks and 130 regional banks per data available for the year 2001. Some examples are Sumitomo, Fuji and Mitsubishi. Of the 13 banks, Bank of Tokyo is a specialized foreign exchange bank although others also engage in foreign exchange. ? Mutual savings and loan banks: The number of such banks has fallen because many of these banks converted to regional bank status. These banks are also referred to as “sogo”banks and they concentrate their activities in the smaller cities or rural areas. Additionally there are about 450 Commercial Banking: Raji Ajwani October 2009 Page 10
International Banking: Introduction & Practices around the World
plus “shinkin” banks. These are credit associations that cater to the needs of local small businesses. ? As per 1987 figures available eighty-one foreign banks operate in Japan and they are permitted to offer almost the same range of services as the domestic banks. They also engage in securities business, through partly owned affiliates and in trust activities through trust bank affiliates. However they play a minor role in the Japanese financial system. ? Specialized financial firms including the Japan Development Bank and the Export-Import Bank. Their primary function is to allocate funds received from the Ministry of Finance Fiscal and Loan programmed. They do not accept deposits. The funds for the MOF loan program come from the postal savings and social insurance system. The postal system is a very popular deposit mobilizer for the government which uses the deposits garnered as a cheap source of funds. Until 1986, the government regulated the interest rates and this made the postal deposits. The deregulation of all interest rates was completed in October 1994 and it was felt that the postal system would loose its sheen. But that did not happen, because the postal system is under no pressure to be profitable hence they continue to offer attractive deposit rates and some of their retail products are very popular and so is their mass appeal. The reach of the post office system by way of branches is also very profuse the post office system has over 25000 branches while Sakura Bank (which is supposed to have the most extensive network) has about 600+ branches. Banks are also required to seek the MOF approval to open new branches. 4. Islamic Banking: This is based on the principles of the Koran which forbids charging of “riba” which is defined as any interest. The philosophy is that money is not to be used as a commodity and must be used for productive pursuits. Hence the main distinguishing characteristic of Islamic banking is the absence of a fixed interest rate on deposits and loans. The returns from lending are earned through profit sharing or by mark-up pricing. Islamic banking is practiced in countries such as Iran, Malaysia, Pakistan, and Saudi Arabia. The liabilities side of an Islamic banks balance sheet consists of equity and investment deposit accounts. Investors share in the profits/losses of a bank but do not have any management control. Different weight ages are applied depending upon the type of product. Savings accounts are held and some banks offer nothing while some others offer a profit/loss sharing agreement. Prizes and attractive rewards are used to attract customers. Current deposits are for transactions with no profit shared by investors although the bank can invest the funds. The assets side of the balance sheet is different. The only form of loan permitted is called the “qarz-e-hasna” where the lender provides a short term loan to a “needy” borrower at no charge and repayable when the borrower is able. Personal, health and education loans fall under this category. In mortgage financing, the bank buys the house and resells it at a far higher price to the borrower. Normally the borrower is given 25 years to repay this debt. Hence the bank assumes some risk that may surface if the housing market is volatile. The other way this transaction Commercial Banking: Raji Ajwani October 2009 Page 11
International Banking: Introduction & Practices around the World
is done is when the bank and the borrower buy the house jointly and then the borrower buys the banks share at cost price. The bank then leases its share of the house to the borrower for a annual fixed rate. For other consumer durables, mark-up pricing is used to collect and maintain the accounts and other admin costs. Firms selling the durables are financed on a profit sharing basis. Banks can enter into two types of partnership with firms to provide medium and long term financing. These two categories are: ? Musharka: Here the bank and the firm make joint contribution to a project. Profits/losses are shared in proportion to the contribution. ? Mudarba: Involves the bank providing the capital and a pre arranged share of profits are returned to the bank. The bank incurs the financial loss (if any) because the firm’s time and labor are recognized as part of the contribution. In this model, the bank has to engage in the arduous task of monitoring the activities of the firm. ? Hijara: Substitute for a leasing arrangement. Under this system, the bank sells the goods to the buyer over a long period of time and demands a fee for the effort. Usually it’s possible for the lessee to gain title of the goods or assets at the end of the lease. Trade Finance is conducted through a mudarba or a hijra. The mark-up is set based upon the size of the transaction, reputation of the buyer, type of goods etc. Mudarba finance comprises the most popular form of financing. Hence in the pure Islamic banking set-up the banks prefer to deal with well reputed and tested clients and track their funds carefully. Some Islamic banks have tried to expand into the global markets since the 1980’s to capture the overseas Islamic market. However the problems are that they cannot hold government securities (interest earning government securities are not permitted under the Islamic banking setup).Islamic states raise public funds by extending profit sharing loans to state enterprises. The other issues coming in the way of expansion of pure Islamic banks is the methods of lending and the banking practices deployed by them and their being very different compared to the more regimented principles and banking norms used in other countries.
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