CHAPTER 11 INTERNATIONAL BANKING AND MONEY MARKET
ANSWERS & SOLUTIONS TO END-OF-CHAPTER QUESTIONS AND PROBLEMS
QUESTIONS
1. Briefly discuss some of the services that international banks provide their customers and the
market place.
Answer: International banks can be characterized by the types of services they provide that
distinguish them from domestic banks. Foremost, international banks facilitate the imports and
exports of their clients by arranging trade financing. Additionally, they serve their clients by
arranging for foreign exchange necessary to conduct cross-border transactions and make
Two major features that distinguish international banks from domestic banks are the types of
deposits they accept and the loans and investments they make. Large international banks both
International banks frequently provide consulting services and advice to their clients in the
areas of foreign exchange hedging strategies, interest rate and currency swap financing, and
2. Briefly discuss the various types of international banking offices.
Answer: The services and operations which an international bank undertakes is a function of
A correspondent bank relationship is established when two banks maintain a correspondent
A representative office is a small service facility staffed by parent bank personnel that is
designed to assist MNC clients of the parent bank in its dealings with the bank’s
A foreign branch bank operates like a local bank, but legally it is a part of the parent bank.
As such, a branch bank is subject to the banking regulations of its home country and the country
A subsidiary bank is a locally incorporated bank that is either wholly owned or owned in
major part by a foreign subsidiary. An affiliate bank is one that is only partially owned, but not
controlled by its foreign parent. Both subsidiary and affiliate banks operate under the banking
Edge Act banks are federally chartered subsidiaries of U.S. banks which are physically
located in the United States that are allowed to engage in a full range of international banking
activities. A 1919 amendment to Section 25 of the Federal Reserve Act created Edge Act
banks. The purpose of the amendment was to allow U.S. banks to be competitive with the
services foreign banks could supply their customers. Federal Reserve Regulation K allows
An offshore banking center is a country whose banking system is organized to permit
external accounts beyond the normal economic activity of the country. Offshore banks operate
In 1981, the Federal Reserve authorized the establishment of International Banking
Facilities (IBF). An IBF is a separate set of asset and liability accounts that are segregated on
the parent bank’s books; it is not a unique physical or legal entity. IBFs operate as foreign
3. How does the deposit-loan rate spread in the Eurodollar market compare with the deposit-
loan rate spread in the domestic U.S. banking system? Why?
Answer: Competition has driven the deposit-loan spread in the domestic U.S. banking system
to about the same level as in the Eurodollar market. That is, in the Eurodollar market the
deposit rate is about the same as the deposit rate for dollars in the U.S. banking system.
4. What is the difference between the Euronote market and the Eurocommercial paper market?
Answer: Euronotes are short-term notes underwritten by a group of international investment or
commercial banks called a “facility.” A client-borrower makes an agreement with a facility to
issue Euronotes in its own name for a period of time, generally three to 10 years. Euronotes are
sold at a discount from face value, and pay back the full face value at maturity. Euronotes
5. Briefly discuss the cause and the solution(s) to the international bank crisis involving less-
developed countries.
Answer: The international debt crisis began on August 20, 1982 when Mexico asked more than
100 U.S. and foreign banks to forgive its $68 billion in loans. Soon Brazil, Argentina and more
The international debt crisis had oil as its source. In the early 1970s, the Organization of
Petroleum Exporting Countries (OPEC) became the dominant supplier of oil worldwide.
Throughout this time period, OPEC raised oil prices dramatically and amassed a tremendous
OPEC deposited billions in Eurodollar deposits; by 1976 the deposits amounted to nearly
$100 billion. Eurobanks were faced with a huge problem of lending these funds in order to
generate interest income to pay the interest on the deposits. Third World countries were only
Today, most debtor nations and creditor banks would agree that the international debt crisis
is effectively over. U.S. Treasury Secretary Nicholas F. Brady of the first Bush Administration is
largely credited with designing a strategy in the spring of 1989 to resolve the problem. Three
important factors were necessary to move from the debt management stage, employed over the
years 1982-1988 to keep the crisis in check, to debt resolution. First, banks had to realize that
Treasury Secretary Brady’s solution was to offer creditor banks one of three alternatives:
(1) convert their loans to marketable bonds with a face value equal to 65 percent of the original
loan amount; (2) convert the loans into collateralized bonds with a reduced interest rate of 6.5
6. What were the weaknesses Basel II that became apparent during the global financial crisis
that began in mid-2007?
Answer: The crisis illustrated how quickly and severely liquidity risks can crystallize and certain
sources of funding can evaporate, compounding concern related the valuation of assets and
capital adequacy. Prior to the onset of the financial crisis, banks built up significant exposures
to off-balance sheet market risks that were not adequately reflected in the capital requirements
7. Discuss the regulatory and macroeconomic factors that contributed to the credit crunch of
2007-2008.
Answer: The origin of the credit crunch can be traced back to three key contributing factors:
The U.S. Glass-Steagall Act of 1933 mandated a separation of commercial banking from
other financial services firms—such as securities, insurance, and real estate. The repeal of
Glass-Steagall caused a blurring of the functioning of commercial banks, investment banks,
The Commodity Futures Trading Commission (CFTC) was created in 1974 to oversee
futures trading to guard against price manipulation, prevent fraud among market participants,
and to ensure the soundness of the exchanges. Credit default swaps (CDSs), a type of OTC
In the years leading up to the crisis, the world was awash in liquidity in recent years,
much of it denominated in U.S. dollars, awaiting investment. As a result, the United States was
The Fed Funds target rate fell from 6 ½ percent set on May 16, 2000 to 1.0 percent on
June 25, 2003, and stayed below 3.0 percent until May 3, 2005. The decrease in the Fed
Funds rate was the Fed’s response to the financial turmoil created by the fall in stock market
8. How did the credit crunch become a global financial Crisis?
Answer: As the credit crunch escalated, many CDOs found themselves stuck with various
tranches of MBS debt, especially the highest risk tranches, which they had not yet placed or
were unable to place as subprime foreclosure rates around the country escalated. Commercial
and investment banks were forced to write down billions of subprime debt. As the U.S.
economy slipped into recession, banks also started to set aside billions for credit-card debt and
other consumer loans they feared would go bad. The credit rating firms—Moody’s, S&P, and
Fitch—lowered their ratings on many CDOs after recognizing that the models they had used to
evaluate the risk of the various tranches were mis-specified. Additionally, the credit rating firms
9. What is a mortgage backed security?
Answer: A mortgage-backed security is a derivative security because its value is derived from
10. What is a structured investment vehicle and what effect did they have on the credit crunch?
Answer: A structured investment vehicle (SIV) is a virtual bank, frequently operated by a
commercial bank or an investment bank, but which operates off balance sheet. Typically, an
SIV raises short term funds in the commercial paper market to finance longer-term investment in
mortgage-backed securities (MBSs). SIVs are frequently highly levered, with ratios of 10 to 15
times the amount equity raised. Structured investment vehicles have been one large investor in
To cool the growth of the economy, the Fed steadily increased the Fed Funds target rate
at meetings of the Federal Open Market Committee, from a low of 1.0 percent on June 25, 2003
to 5 ¼ percent on June 29, 2006. In turn, mortgage rates increased and home prices stopped
increasing, thus stalling new housing starts and precluding mortgage refinancing to draw out
paper capital gains. Many subprime borrowers found it difficult, if not impossible, to make
mortgage payments in this economic environment, especially when their adjustable-rate
11. What is a collateralized debt obligation and what effect did they have on the credit crunch?
Answer: A collateralized debt obligation (CDO) is a corporate entity constructed to hold a
portfolio of fixed-income assets as collateral. The portfolio of fixed-income assets is divided into
different tranches, each representing a different risk class: AAA, AA-BB, or unrated. CDOs
To cool the growth of the economy, the Fed steadily increased the Fed Funds target rate at
meetings of the Federal Open Market Committee, from a low of 1.0 percent on June 25, 2003 to
5 ¼ percent on June 29, 2006. In turn, mortgage rates increased and home prices stopped
increasing, thus stalling new housing starts and precluding mortgage refinancing to draw out
paper capital gains. Many subprime borrowers found it difficult, if not impossible, to make
mortgage payments in this economic environment, especially when their adjustable-rate
mortgages were reset at higher rates. As matters unfolded, it was discovered that the amount