Risk of International Money Market Securities When MNCs and govern- ment agencies issue debt securities with a short-term maturity (one year or less) in the international money market, these instruments are referred to as international money market securities. Normally these securities are perceived to be very safe, especially when they are rated high by rating agencies. And because the typical maturity of these securities is one year or less, investors are less concerned about the issuer’s financial condition dete- riorating by the time of maturity than if the securities had a longer-term maturity. How- ever, some international money market securities have defaulted, so investors in this market need to consider the possible credit (default) risk of the securities that are issued.
International money market securities are also exposed to exchange rate risk when the currency denominating the securities differs from the investor’s home currency. Specifi- cally, the return on investment in the international money market security will be reduced when currency denominating the money market security weakens against the home currency. This means that, even for securities without credit risk, investors can lose money because of exchange rate risk.
Borrowers usually prefer that loans be denominated in the currency of their primary in which they receive most of their cash flows, which eliminates the borrower’s exchange rate risk. However, the loan’s interest rate depends on the currency in which the loan is denominated. A loan denominated in the currency of a country with very low inflation (such as Japan or the United States) normally has a relatively low interest rate; loans denominated in the currency of a country with high inflation rates (such as some Latin American and Asian countries) tend to have correspondingly higher interest rates. Hence borrowers subject to high interest rate loans in their domestic currency might consider borrowing in a low–interest rate currency, although doing so exposes the borrower to exchange rate risk (see Chapter 18 for additional details).
Because banks accept short-term deposits and sometimes provide longer-term loans, their asset and liability maturities do not match. This misalignment can adversely affect a bank’s performance during periods of rising interest rates, since the bank may have locked in a rate on its longer-term loans while the rate it pays on short-term deposits continues to rise. In order to avoid this risk, banks commonly use floating rate loans. The loan rate floats in accordance with the movement of a market interest rate, such as LIBOR. For example, a loan that is denominated in a par- ticular currency and is provided by a bank to an MNC might be structured with an interest rate that resets every six months to the prevailing LIBOR for that currency plus 3 percent. International credit market activity has increased over time, yet the growth is mostly concentrated in regions where economic conditions are relatively strong. Those regions tend to have more funds deposited by MNCs as well as a strong demand for loans by MNCs that are expanding their business. Conversely, lending tends to decline in regions where economic conditions are weak because MNCs are less willing to expand and thus do not borrow additional funds. Banks then are also less willing to grant loans because credit risk is higher in regions where economic conditions are weak.
3-3a Syndicated Loans in the Credit Market
Sometimes a single bank is unwilling or unable to lend the amount needed by a particular corporation or government agency. In this case, asyndicate of banks may be organized.
Each bank within the syndicate participates in the lending. A lead bank is responsible for negotiating terms with the borrower, after which this bank organizes a group of banks to underwrite the loans.
Borrowers that receive a syndicated loan incur various fees besides the interest on the loan. Front-end management fees are paid to cover the costs of organizing the syndicate and underwriting the loan. In addition, a commitment fee of about .25 or .50 percent is charged annually on the unused portion of the available credit extended by the syndicate.
Syndicated loans can be denominated in a variety of currencies. The interest rate depends on the currency denominating the loan, the loan’s maturity, and the borrower’s creditworthiness of the borrower. Interest rates on syndicated loans are usually adjusted to reflect movements in an interbank lending rate, and the adjustment may occur every six months or every year.
For each bank involved, syndicated loans reduce the default risk of a large loan to the extent of that individual bank’s participation. In addition, borrowers have an extra incen- tive to repay loans of this type. If a borrower defaults on a loan to a syndicate then word will quickly spread among banks, in which case the borrower will find it difficult to obtain loans in the future. Borrowers are therefore strongly encouraged to repay syndicated loans promptly. From the banks’ perspective, syndicating a loan increases the likelihood of its timely repayment.
3-3b Regulations in the Credit Market
Regulations contributed to the development of the credit market because they imposed restrictions on some local markets, thereby encouraging local investors and borrowers to circumvent these restrictions. Differences in regulations among countries allowed banks in some countries to have comparative advantages over banks in other countries.
Yet international banking regulations have become more standardized over time, a trend that has enabled more competitive global banking. Three of the more significant regula- tory events allowing this more competitive global playing field are the Single European Act, the Basel Accord, and the Basel II Accord.
Single European Act One of the most significant events affecting international banking was the Single European Act, which was phased in by 1992 throughout the European Union countries. Some provisions of the Single European Act of relevance to the banking industry are as follows.
■ Capital can flow freely throughout Europe.
■ Banks can offer a wide variety of lending, leasing, and securities activities in the EU.
■ Regulations regarding competition, mergers, and taxes are similar throughout the EU.
■ A bank established in any one of the EU countries has the right to expand into any or all of the other EU countries.
As a result of this act, banks have expanded across European countries. Efficiency in the European banking markets has increased because banks can more easily cross coun- tries without concern for the country-specific regulations that prevailed in the past.
Another key provision of the act is that banks entering Europe receive the same bank- ing powers as other banks there. Similar provisions apply to non-U.S. banks that enter the United States.
Basel Accord Before 1988, capital standards imposed on banks varied across coun- tries; this variance gave some banks a comparative global advantage over others when extending their loans to MNCs. Banks in countries that were subject to lower capital requirements had a competitive advantage over other banks because (1) they could grow more easily and (2) a given level of profits represented a higher return on their capital. Furthermore, a bank so advantaged was not perceived by investors to have exces- sive risk, despite its limited capital, because they presumed that its government would protect it from failure. In 1988, the central banks of 12 developed countries established theBasel Accord, according to which their respective commercial banks were required to maintain capital (common stock and retained earnings) equal to at least 4 percent of their assets. For this purpose, banks’ assets are weighted by risk, which means that a higher capital ratio is required for riskier assets. Off–balance sheet items are also accounted for, so banks cannot circumvent capital requirements by focusing on services that are not explicitly shown as assets on a balance sheet.
Basel II Accord Banking regulators who formed the so-called Basel Committee completed another accord (called Basel II) that subjected banks to more stringent collat- eral guidelines to back their loans. In addition, this accord encourages banks to improve their techniques for controlling operational risk, which could reduce failures in the bank- ing system.
Basel III Accord The financial crisis in 2008–2009 revealed that banks were still highly exposed to risk, as many banks might have failed without government funding.
The crisis also illustrated how financial problems at some banks could spread to other banks and how financial problems in the banking system could paralyze economies. A global committee of bank supervisors discussed solutions that would enhance the safety
of the global banking system with the aim of preventing another financial crisis. This led to a global agreement among bank regulators in September 2010 that is informally referred to as“Basel III.”
The accord called for estimating risk-weighted assets with new methods that would increase the level of risk-weighted assets and thus require banks to maintain higher levels of capital. It also required that capital be at least 6% of total risk-weighted assets. Basel III also recommended that by 2016 banks establish an extra layer of capital, a capital conservation buffer,amounting to at least 2.5 percent of risk-weighted assets. Banks that do not maintain this buffer could be restricted from making dividend payments, repurchasing stock, or granting bonuses to executives.
This accord also focused on ensuring that banks maintain a sufficient level of liquid assets that can be easily sold if access to cash is needed. The liquidity provisions are contro- versial because severe restrictions on liquidity could force a bank to hold assets that earn less than its cost of funds. As a consequence, banks could be exposed to higher default risk.
All of the Basel III provisions are meant to be phased in. Some provisions may not take effect until 2019, and other provisions have not yet been finalized. For example, there is still debate concerning whether the provisions should apply to all banks or only to large banks.
3-3c Impact of the Credit Crisis
In 2008, the United States experienced a credit crisis that affected the international credit market. The credit crisis was triggered by the substantial defaults on subprime (lower- quality) mortgages. This led to a halt in housing development, which reduced income, spending, and jobs. Financial institutions holding the mortgages or securities representing the mortgages experienced major losses. Financial institutions in other countries, such as the United Kingdom, had also offered subprime mortgage loans and also experienced high default rates. Because of the global integration of financial markets, the problems in the U.S. and U.K. financial markets spread to other markets. Some financial institutions based in Asia and Europe were common purchasers of subprime mortgages that were orig- inated in the United States and United Kingdom. Furthermore, the resulting weakness of the U.S. and European economies reduced their demand for imports from other countries.
Thus the U.S. credit crisis blossomed into an international credit crisis and increased con- cerns about credit risk in international markets. Creditors reduced the amount of credit that they were willing to provide, and some MNCs and government agencies were then no longer able to obtain funds in the international credit market.