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National Monetary Systems
National Monetary Organizations – There are three types of organizations that operate on the
national plane to implement national monetary policies.
At the highest level is a political agency of the national government that sets national fiscal policy
and carries on the financial functions of the government. In most countries, this is a cabinet-level
agency, such as a Ministry of Finance or a Treasury Department.
At the next level is a central bank, such as the Bank of England, the Bank of Japan, or the U.S.
Federal Reserve System, owned by the national government in most countries. Its most important
functions are (1) to issue bank notes and coins, (2) to regulate the quantity of money in
circulation, (3) to maintain and invest currency reserves, and (4) to act as a lender of last resort.
At the third level are the commercial banks that accept and manage deposits, make loans, and
offer trust services. In the domestic arena one finds a variety of financial institutions (such as
savings banks, savings and loan associations, and credit unions), but internationally, the
commercial bank is the institution most likely to be involved. Commercial banks may be owned
privately or by the government.
Bank Deposits – Bank deposits are monies placed with a bank for its use. The term “deposit”
suggests the notion of a bailment, which implies that a bank has an obligation to keep the funds it
receives in a vault for safekeeping.
Except for monies delivered for a designated purpose, deposits become a bank’s funds. A bank
can commingle them and use them as it sees fit. Most commonly, banks use these funds to make
short- and medium-term loans. The depositor, in return for his/her deposit, receives a claim
against the bank as a general, unsecured creditor.
For some accounts, a depositor acquires the authority to write checks, payment orders, or drafts
for the benefit of third parties, with the value of the checks, orders, or drafts being deducted from
his/her claim.
Commonly, banks pay interest on the monies they hold on deposit. When large sums are
deposited for short-term investment, banks typically issue certificates of deposit (CDs), which
generally provide a higher rate of interest than funds left in a general deposit account. Not all
banks, however, pay interest. Interest payments are forbidden in countries following Islamic law.
Eurocurrency Deposits – Accounts in domestic banks that are maintained and paid in a foreign
currency are generally known as Eurocurrency deposits. Such deposits are commonly free of the
monetary control restrictions imposed by their issuing country. American dollars (or Eurodollars)
are the most common Eurocurrency; however, British pounds, Canadian dollars, EU euros,
Japanese yen, and Swiss francs are also used.
The Interbank Deposit Market – Trades are made throughout the day and night, every day of
every year, by telephone and over the Internet in a global marketplace that is virtually
unregulated.
A variety of short-term liquid instruments are traded in this interbank market, but the most
common is the certificate of deposit (CD), issued in multiples of U.S. $1 million for maturity
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Money and Banking
periods of one, three, and six months. It is a negotiable instrument. However, because interbank
CDs have relatively short maturities, they are seldom transferred from one holder to another.
The Foreign Exchange Market – It is defined as an informal network of banks, foreign
exchange brokers, foreign exchange dealers, and other persons who facilitate the exchange of
currencies. It is generally unregulated. Developing countries may impose licensing requirements
on banks and traders and require that all exchanges be made through their central banks.
The principal participants involved in the transaction are commercial and central banks. In
addition, arbitrageurs, importers, exporters, multinational firms, tourists, governments, and
intergovernmental organizations may become involved.
Commercial banks participate in the foreign exchange market both as intermediaries for
importers, exporters, multinational corporations, and the like, and as correspondent banks in the
interbank marketplace. In combination, they play three important roles: (1) they operate the
payment mechanism, (2) they extend credit, and (3) they help to reduce the risk of international
transactions.
Central banks participate as lenders of last resort and as regulators of currency exchange rates. In
addition to providing funds for local transactions when no other funds are readily available,
central banks may independently intervene in the foreign currency market to maintain orderly
trading conditions.
In making currency exchanges, traders typically use a widely traded intermediary currency. For
example, a buyer in State A purchases a widely traded intermediary currency, commonly the U.S.
dollar. Exchange rates for converting the dollar into the world’s other hard currencies are
published on a daily basis around the world. The buyer may turn to his/her central bank for
assistance when he is having difficulty obtaining the intermediary currency. The seller accepts
delivery of the intermediary currency (e.g., the U.S. dollars) and converts it into the currency of
his home country, State B.
Foreign Exchange Contracts – Foreign exchange contracts may be made as spot, future,
forward, or option contracts. A spot contract is simply a transaction involving the immediate sale
and delivery of a commodity, such as a currency.
A future contract (or future) is simply a promise to buy or sell a commodity (e.g., a currency) for
a specified price, with both delivery and payment to be made at a specified future date. Trading in
futures, however, seldom results in the physical delivery of the commodity. More often, the
obligations of the parties are extinguished by offsetting transactions that produce a net profit or
loss. Futures are used primarily as a way to transfer price risks from suppliers, processors, and
distributors to those who are more willing to take the risk.
Case 6-4: Hunt et al. v. Alliance North American Government Income Trust, Inc. et al.
Facts: Plaintiffs are shareholders in Alliance North American Government Income Trust, Inc., an
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Money and Banking
Issue: Did the prospectuses mislead investors into believing that hedging techniques were
available to the fund when in fact they were not?
Holding: Yes.
Law: Cautionary language in a prospectus will not foreclose liability if it warns investors of
Explanation: Plaintiffs claim that the prospectuses promised the fund would attempt to use
Order: District court’s order is reversed.
A forward contract (or, in the case of currency, a cash forward contract) is simply a transaction in
which a commodity is presently sold and the price presently paid but the delivery is, by
agreement, delayed to a later date.
An option contract (or option) creates the right—but not the obligation—to buy or sell a specific
amount of a commodity (e.g., currency) at a fixed price within an agreed-upon period of time.
Arbitrage – Arbitrage is the nearly simultaneous purchase of a commodity (such as a currency)
in one market and its sale in another to profit from the price differential. Arbitrageurs buy
currency in one market with the expectation of being able to sell it in a second market for a profit.
Today, arbitrageurs and other currency traders carry on their transactions at lightning speed using
telephones and the Internet. The minimum contract is normally U.S. $25,000, but contracts of $1
million are more common. Offers have to be accepted immediately, and then performed
regardless of a later dispute. If there is a dispute, traders commonly split the difference.
The Transfer of Money – A bank transfers money internationally by setting up a correspondent
bank relationship with a foreign bank and depositing funds to its own account in that bank.
When a customer goes to his/her own bank and asks to transfer money overseas, the bank accepts
the customer’s money at its domestic office, then arranges for the correspondent bank to disburse
funds in the foreign country to whomever the customer has designated. This may be done by
instruction, in which case the domestic bank directs its correspondent to pay funds directly to a
particular payee, or by the use of a bill of exchange that is drawn on the domestic bank’s account
at the foreign correspondent bank. In the latter case, the bill of exchange is given to the customer,
who in turn sends it to the payee. The payee then cashes it at the correspondent bank.
The actual physical delivery of currency internationally is seldom done. When required, it is
arranged for by central banks and is commonly managed by the BIS.
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Money and Banking
Branch Banking – International banks, unlike most other multinational companies, prefer to
operate in host countries through branches rather than subsidiaries. In most major host countries,
branch operations are not only allowed, they are encouraged.
Host countries impose few regulations limiting the operations of foreign banks. On the one hand,
host countries impose few regulations limiting the operations of foreign banks. On the other hand,
they assume few supervisory responsibilities. Foreign banks, however, cannot turn to the host
country’s central bank as a lender of last resort. From the perspective of the host country, a
foreign bank is required to stand behind the local obligations of its branches with its entire
worldwide assets.
Although host states generally impose minimal regulations on foreign branches, the presence of a
foreign branch has sometimes been used as a means to obtain information from a foreign parent
bank. In particular, the U.S. government, in an effort to curtail the use of foreign banks as
conduits for laundering illegal profits from narcotics smuggling, income tax evasion, securities
fraud, and other business crimes, has attempted to extend its regulatory jurisdiction over foreign
banks by asking courts to issue subpoenas exercisable against their U.S. branches.
Case 6-5: In Re Sealed Case
Facts: A foreign bank and its U.S. branch manager refused to provide evidence to a U.S. grand
Issues: (1) Can the bank be compelled to provide evidence? (2) Can the branch manager?
Holdings: (1) No. (2) Yes.
Law: With respect to prosecution in a foreign jurisdiction, a person wishing to claim the right not
Explanation: (1) It would be impossible for the bank to give evidence and not be in violation of
its home country laws. Moreover, ordering the bank to produce evidence from its home office
Order: The branch manager must provide evidence to the grand jury.
From the perspective of the parent bank, the foreign branch is often treated as a separate business
unit, with its own profit-and-loss statement, its own foreign tax liabilities, and its own separate
account with the parent bank.
In terms of home state law, however, the treatment of foreign branches is not so easily described.
Inconsistency is the common rule, both between and within states. Sometimes foreign branches
are treated as peculiar separate entities. Similarly, some courts have refused to issue subpoenas
directed against foreign branches, and others have treated letter-of-credit transactions between a
parent and a branch bank as if the two were unrelated entities.
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Money and Banking
Sometimes, however, home country statutes and courts treat foreign branches as mere extensions
of their parents. Courts have held that a parent bank can be ordered to freeze the account of a
foreign corporation held in the bank’s foreign branches. And courts commonly hold that a parent
bank is liable for the debts incurred by its foreign branches because the branch is subject to the
supervision and control of the parent.
Case 6-6: Vishipco Line et al. v. Chase Manhattan Bank, N.A.
Facts: Immediately prior to the fall of Saigon, Chase Manhattan Bank closed the doors of its
Issues: (1) Had the new government confiscated the monies in Chase’s Saigon branch? (2) If it is
impossible for a branch bank to perform its obligation to repay a depositor, does this excuse the
parent bank from its obligation to perform elsewhere?
Holdings: (1) No. (2) No.
Law: (1) If a foreign state confiscates property, the act of state doctrine bars any challenge to the
Explanation: (1) The bank closed before Saigon fell, so the debt at that point in time was located
Order: Chase is liable to the depositor.
Conflicts Between Host and Home State Regulations – With regard to deposits, there is no
internationally recognized rule for deciding whether a branch must comply with the home or host
state regulations. The suggested rule is that a branch bank should only be subject to the rules and
regulations of the host country, regardless of the directives given by the home country to the
parent bank.
Case 6-7: Libyan Arab Foreign Bank v. Bankers Trust Company
Facts: The Libyan Arab Foreign Bank (Libyan Bank) had money on deposit with the Bankers
Trust Bank of New York (Bankers) at its New York home office and at its London branch. The
U.S. government then froze all Libyan assets “in the United States.” According to New York law
(but not English law), the U.S. government embargo prevented the London branch from releasing
money to the Libyan Bank. When Bankers’ London branch refused to release any money to the
Libyan Bank, the latter brought suit in an English court to compel the branch to do so.
Issues: (1) Does local law govern a bank contract? (2) Is a branch bank to be treated as an entity
separate from its home office?
Holdings: (1) Yes. (2) Yes (at least in this circumstance).
Law: (1) The general rule is that a bank contract is governed by the law of the place where the
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Money and Banking
Explanation: (1) Both banks and their customers normally intend that local law govern their
Order: Bankers’ London branch must release to the Libyan Bank the money the latter has on
deposit with the former.
II. Chapter Questions
Dealing with Currency Fluctuation
1. Students’ answers may vary. Some may argue that Y will be successful. By choosing a money
2. Students’ answers may vary. Possible arguments include:
Exchange Contracts and Exchange Control Regulations
3. Students’ answers may vary. Some may argue that Mr. Zed will not succeed. Article VIII,
Branch Banking
4. Students’ answers may vary. Some may argue that the court may issue the subpoena. The
presence of a foreign branch has sometimes been used as a means to obtain information from a
5. Students’ answer may vary. Some students may argue that X will be successful. With regard to
©2013 Pearson Education, Inc. Publishing as Prentice Hall
Money and Banking
Arbitrage
6. Students’ answers may vary. Some may argue that a future contract may be included. It is
III. Key Terms
Anglo-American definition of exchange contract—A contract having as its immediate object
the international exchange of mediums of payment.
Arbitrage—(From French arbitrer: “to arbitrate” or “to regulate.”) The nearly simultaneous
purchase of currencies (or other commodities) in one market and their resale in another in
order to profit from the price differential.
Bank for International Settlements (BIS)—Intergovernmental organization, headquartered in
Basel, that functions as a bank for the world’s central banks.
Bank deposit—Money held by a bank. The bank may freely use this money as it best sees fit.
A depositor only has a claim against the bank as a general creditor and not as a bailor of
specific property deposited with the bank.
Bill of exchange—(also known as a draft) A three-party instrument on which the drawer
makes an unconditional order to a drawee to pay a named payee.
BIS facilities—The financial assistance programs available to central banks from the BIS.
Bretton Woods Conference—UN-sponsored monetary and financial conference held in
Bretton Woods, New Hampshire, in July 1944. It led to the creation of the International
Monetary Fund and the World Bank.
Bridging loan—Short-term loan that allows a debtor to meet its current obligations until a
permanent loan can be obtained.
Central bank—A state’s bank that is responsible for issuing the state’s currency, regulating
the quantity of its money in circulation, maintaining currency reserves, and acting as a lender
of last resort.
Certificate of deposit (CD)—A promissory note issued by a bank in which the bank promises
to repay money it has received, plus interest, at a certain time.
Commercial bank—A business firm that maintains custody of money deposited by its
customers and pays on drafts written by its customers. It earns its profits by investing the
money it has on deposit.
Continental European definition of exchange contract—Any contract that in any way affects
the currency exchange resources of a country.
Correspondent bank—A bank that acts as an agent of another bank, especially in carrying a
deposit balance for the latter.
Currency basket—A selected group of currencies whose weighted average is used to define
the amount of an obligation.
Current international transaction—Any currency transaction other than the transfer of capital.
Eurocurrency deposits—Foreign currency on deposit in a bank, on which the bank pays
interest in the same foreign currency.
Foreign exchange—The conversion of the money of one state into that of another state.
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Money and Banking
Foreign exchange market—An informal network of banks, foreign exchange brokers, and
foreign exchange dealers who facilitate the exchange of currencies.
Forward contract—A contract in which a commodity is presently sold and the price presently
paid but delivery is, by agreement, delayed to a later date.
Future contract—A promise to buy or sell a commodity (e.g., a currency) for a specified
price, with both delivery and payment to be made at a specified future date.
Global Environment Facility (GEF)—A World Bank source of grant and concessional
funding for protecting and improving the global environment.
Gold bullion standard—A monetary system that required states to buy and sell gold bullion
with paper currency at a fixed price.
Gold standard—A monetary system that provided for the free circulation between states of
gold coins of standard specification.
IMF conditionality—Principle that a member’s right to the use of credit tranches and credit
facilities will depend on its progress in regularizing its balance-of-payments obligations and
developing sustained economic growth.
IMF facilities—The financial assistance programs available to IMF members.
IMF quota—The amount of funds that a member of the IMF is required to contribute. It
determines the voting rights of a member and the sum of IMF funds that a member may draw
upon to stabilize its currency and to meet balance-of-payments obligations.
IMF par value system—The currency exchange mechanism specified by the IMF prior to
1971, which required all members to declare a value (the par value) at which their currencies
could be converted into gold.
IMF Second Amendment System—The currency exchange mechanism established by the
IMF in 1978 that allows members to define the value of their currency by any means other
than by reference to the value of gold.
Instruction—Order to a bank to disburse funds to a particular person.
International Development Association (IDA)—A subsidiary of the World Bank that provides
concessional development financing to less developed countries.
International Finance Corporation (IFC)—A subsidiary of the World Bank that provides
development financing to private enterprises.
International Fund for Agricultural Development (IFAD)—An intergovernmental
organization, headquartered in Rome, that provides financing to its developing member states
to promote food production.
International Monetary Fund (IMF)—Intergovernmental organization headquartered in
Washington, D.C. Using funds contributed by its members, it will purchase a currency on the
application of a member to help the member discharge its international indebtedness and
stabilize its currency exchange rates.
International monetary system—The world’s informal money and banking system.
Maintenance of value clause—A contractual provision that says that the price will be adjusted
according to the inflation rate.
Money—Anything customarily used as a medium of exchange and a measure of value.
Money of account—The money used to define the amount of an obligation.
Money of payment—The money used to pay off an obligation.
Nominalism—The principle that an obligation to pay a particular sum of money is fixed and
does not change even if the purchasing power or foreign exchange rate of the money does
change.
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Money and Banking
Option contract—A contract that creates the right—but not the obligation—to buy or sell a
specific amount of a commodity (e.g., currency) at a fixed price within an agreed-upon period
of time.
Spot contract—A contract for the immediate sale and delivery of a commodity, such as a
currency.
Tranche—(From French: “installment” or “block of shares.”) A percentage of an IMF
member’s quota that it may withdraw to stabilize its currency or to meet balance-of-payments
obligations.
World Bank—Informal name for the International Bank for Reconstruction and
Development. An intergovernmental organization, headquartered in Washington, D.C., that
provides development financing for its members.
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