Eurocurrency Markets and International Banking.2019

INTERNATIONAL BANKING
AND EUROCURRENCY
MARKET
Dr. Tinaikar
International Banking
 Reasons for International Banking

 Types of International Banking Offices
 Regulating International Banking
 International Regulatory Standards
 Basel Accord I
 Basel Accord II
 Basel Accord III
 International banks do everything domestic
banks do and in addition:
 Arrange trade financing
 Arrange foreign exchange
 Offer hedging/derivatives services for receivables
and payables and forex debt
 Offer investment banking services (where allowed):
 Borrow or lend in eurocurrency market
 Underwrite eurobond and foreign bonds
 Reasons for International Banking:
 Offer banking services in foreign countries to
subsidiaries of home country companies driven by
home country parent relationships
 Offer superior banking technology
 Offer superior banking products
 Exploit regulatory advantage
 Growth
 Risk reduction through diversification
World’s Largest 10 Banks By Assets
as of 31st March 2015 (US$ Billion)
1. ICBC China 3452
2. China Construction Bank China 2819
3. Agriculture Bank of China China 2716
4. Bank of China China 2584
5. HSBC Holdings United Kingdom 2572
6. JP Morgan Chase United States 2450
7. BNP Paribas France 2400
8. Mitsubishi UFJ Financial Group Japan 2323
9. Bank of America United States 2149
10. Credit Agricole Group France 1911
 Types of International Banking Offices:

 Correspondent Bank
 Representative Offices
 Foreign branches
 Subsidiary and affiliate banks
 Offshore banking centers
 International Banking Facilities
 Correspondent Bank
 A correspondent banking relationship exists when
two banks maintain a correspondent bank account
with one another
 Large banks in the world have correspondent
banking relationships with other banks in financial
centers in which they don’t have banking
operations
 Enables a local bank’s MNC client to conduct
business worldwide either through his local bank
or its correspondent
 Representative Office
 A representative office is a small service facility
which does not provide any credit services and is
staffed by parent bank personnel
 It assists MNC clients of the parent bank in
dealing with the bank’s correspondents
 It serves as a liaison between the parent bank and
its clients
 It assists with information about local business
customs and credit evaluation of MNC’s local
customers
 Foreign Branch
 A foreign branch operates like a local bank, but is
legally part of the parent
 Subject to both the banking regulations of home
country and foreign country
 Can provide fuller range of services than rep office
 Competes with host country banks at local level
 Most popular means of internationalizing bank
operations
 Subsidiary and Affiliate banks
 A subsidiary bank is a locally incorporated bank
that is either wholly owned or owned in majority
owned by a foreign parent
 An affiliate bank is one that is only partly
owned but not controlled by the foreign parent
 Both subsidiary and affiliate banks operate
under the banking laws of the country in which
they are incorporated
 Edge Act Banks
 Federally chartered subsidiaries of U.S. banks
that are physically located in the U.S. and are
allowed to engage in a full range of international
banking activities
 The Edge Act was 1919 amendment Section 25
of the 1914 Federal Reserve Act
 RBI Guidelines on setting up Liaison / Branch /
Project Offices in India by Foreign Entities:
 Liaison Office / Branch Office
 Track Record
 Liaison Office – Profit making track record during
preceding three financial years in home country
 Branch Office –Profit making track record during
preceding five financial years in home country
 Net Worth
 Liaison Office – Not less than USD 50,000 or its
equivalent
 Branch Office – Not less than USD 100,000 or its
equivalent

Project Offices in India by Foreign (cont…)
 Permissible Activities
 Liaison Office
 Act as a channel of communication between H.O. and
parties in India
 Not allowed to undertake any business activity in India
and earn any income in India
 Role related to collecting information about market
opportunities and providing information about the bank
and its products to prospective Indian companies
Project Offices in India by Foreign (cont…)
 Permissible Activities
 Branch Office
 Export/Import of goods
 Research work in areas which the parent company is
engaged
 Promoting technical or financial collaboration between
Indian company and parent or overseas group company
 Represent parent company in India and act as buying /
selling agent in India
 Render technical support to the products supplied by
parent /group companies
 Offshore Banking Centers
 An offshore banking center is a country whose banking
system permits foreign currency accounts beyond the
scope of local banking regulations
 Deal primarily with non-residents and /or in foreign
currency on a scale much larger than the size of the
home economy
 Characterized by low (or zero) tax regime and
specializing in offering banking services to non-
residents on a confidential basis
 International Banking Facilities
 Established in 1981 in New York by the Fed under the
authorization of Federal Reserve as a result of success
of offshore banking
 Offshore Banking Centers
 An offshore banking center is a country whose
banking system permits foreign currency accounts
which are beyond the scope of local banking
regulations
 The host country usually grants complete freedom
from host-country banking regulations
 Reasons for offshore banks
 Low or no taxes and reserve requirements, no deposit
insurance, few or no foreign exchange controls, strict
banking secrecy laws
 Offshore Banking Centers (Cont..)
 The primary activities of offshore banks are to seek
deposits and lend in currencies other than the
currency of the host country
 The IMF recognizes the following as major offshore
banking centers:
 The Bahamas, Bahrain, the Cayman Islands, Hong
Kong, The Netherlands Antilles, Panama, and
Singapore
 Offshore Banking Centers have grown have for
three reasons:
 Growth of international trade and international
business
 Avoidance of domestic regulations (reserve
requirements and tax)
 Political Factors (e.g. to avoid confiscation of
deposits by a government because of political
events)
 International Banking Facility (IBF)
 Established in 1981 under authorization of the Fed
 Banks accept time deposits from non-U.S. citizens and
make loans only to foreigners
 An IBF is a separate set of accounts that are
segregated on the parent bank’s books; it is not a
separate physical or legal entity
 A U.S. bank or subsidiary of a foreign bank can
operate an IBF
 They are not subject to domestic reserve requirements
on deposits or FDIC insurance required on deposits
and are exempt from state and local taxes
 The Problem of Bank Failure
 A bank fails when it is unable to pay its depositors
 The value of assets decline because of inability to
meet its obligation to its depositors
 Governments attempt to prevent bank failures
through extensive regulation of their domestic
banking systems
 The main domestic safeguards to reduce the
risk of bank failure:
 Deposit Insurance
 Reserve Requirements
 Capital Requirements and Asset Restrictions
 Bank Examination
 Lender of Last Resort
 Difficulties in Regulating International Banking:
 Deposit insurance is essentially absent in
international banking
 The absence of reserve requirements reduces the
stability of banking system
 Bank examination to enforce capital requirements
and asset restrictions becomes more difficult in an
international setting
 There is uncertainty over which central bank is
responsible for providing LLR assistance in
international banking
 International Regulatory Standards:
 Capital Adequacy Standards
 Bank Capital Adequacy refers to the amount of
equity capital and other securities a bank holds as
reserves against risk assets to reduce the probability
of bank failure
 Basel Accord I (1988)
 Bank for International Settlement (BIS) established a
framework for measuring capital adequacy for banks
in the G-10 countries and Luxembourg
 Capital regulations under Basel I came into effect in
Dec’92 (after development and consultation since
1988)
 Basel Accord I (cont..)
 The aims were:
 To require banks to maintain enough capital to
absorb losses without causing systemic problems
 To level the playing field internationally (to avoid
competitiveness conflicts).
 Minimum Bank Capital Adequacy ratio of 8% of
risk-weighted assets of internationally active banks.
 Total capital includes Tier-I + Tier-II capital.
 Tier I Capital Ratio of 4%
 The Accord divides bank capital into two categories:
 Tier I: Core Capital = shareholder equity + retained
earnings; at least 50% of capital must be Tier I.
 Tier II: Supplemental Capital = non-equity items
such as cumulative preferred stock + subordinated
debt with maturity more than 5 years; Tier II < 50%
of the total bank capital or < 4% of risk-weighted
assets
 A risk weight is applied to each on-balance-sheet
asset according to its risk
 Asset Weights for 4 categories of risky assets: i) Cash
and Govt. obligations 0%; ii) short-term interbank
(OECD banks) assets 20%; iii) residential mortgages
50%; iv) corporate loans, bonds, etc. 100%
 For each off-balance-sheet item we first calculate a
credit equivalent amount and then apply a risk weight
 Risk weighted amount (RWA) consists of:
- sum of risk weight times asset amount for an on-
balance sheet items.
- sum of risk weight times credit equivalent amount
for off-balance sheet items
 Shortcomings of Basel Accord I
 Not as risk sensitive as Basel II and III
 No advanced measurement of risk, based upon
bank-specific portfolio
 Backward looking, focused on existing assets
rather than the future composition of a bank’s
portfolio
 Credit Risk only – no other risk types
 Basel Accord II (2003-2009)
 Three mutually enforcing pillars:
 New minimum capital requirement: credit, market,
and operational risks.
 Supervisory review process: more thorough and
uniform.
 Market discipline: more disclosures
 Sets out details for adopting a more risk sensitive
minimum capital requirements:
 Banks must estimate the probability of default and the
loss in the event of default for each asset on their
books
Three Pillars of Basel II and III
Minimum capital requirements: Requirements based on
credit, market and operational risk to:
Pillar 1 (a) reduce risk of failure by cushioning against losses, and
(b) provide continuing access to financial markets to meet
liquidity needs
(c) banks to develop their own (internal) models specific to
their portfolios under advanced approaches
Pillar 2 Supervisory Review: Qualitative supervision by regulators

of internal bank risk control and capital assessment process,
including ability to require banks to hold more capital than
required under Pillar I
Pillar 3
Market Discipline: Public disclosure and transparency
requirements
 Basel Accord III (2010)
 Phased Implementation between 2013-2019.
 Designed to substantially strengthen the regulatory
capital frame work and increase the quality of bank
capital.
 Key Features:
 Enhanced Capital Requirement
 Introduction of Capital Conservation Buffer
 Introduction of Countercyclical Buffer
 Leverage Ratio (Ratio of Tier I Capital to Total Assets)
 Liquidity Risk Management
 Key Features:
 Enhanced Capital Requirement
o Minimum common Equity Capital Ratio raised from 2%
to 4.5%.
o Minimum Tier-I Capital Ratio increased from 4% to 6%.
o Minimum Total Capital Ratio = 8%
 Introduction of Capital Conservation Buffer:
o Capital Conservation Buffer of 2.5% that can be drawn down
in periods of financial stress.
o New Minimum Common Equity Capital Ratio = 7%
o New Minimum Tier-I Capital = 8.5%
o New Minimum Total Capital = 10.5%
 Key Features (cont..):
 Introduction of Countercyclical Buffer:
o Varying between 0%-2.5% it can preserve national economies
from excess credit growth.
 Leverage Ratio (Ratio of Tier I Capital to Total Assets):
o Tier I Capital has to be at least 3% of Total Assets even when
there is no risk weighting.
o Non-risk based measures are a supplement to capital
requirement and serve as a backstop to risk-based measures.
 Key Features (cont..):
 Liquidity Risk Measurement:
o New instrument – Liquidity Coverage Ratio (LCR) introduced
for liquidity risk measurement.
o Banks should maintain an adequate level of unencumbered high
quality assets that can be converted into cash to meet their
liquidity needs for a 30-day time horizon under an acute
liquidity stress scenario specified by supervisors.
o LCR should not be lower than 100%.
o Net Funding Stability Ratio (NFSR) introduced – the ratio of a
banks “available amount of stable funding” divided by its
“required amount of stable funding”.
o NFSR should not be lower than 100%.
Implementation of Basel III
As of
2011 2012 2013 2014 2015 2016 2017 2018
1 Jan 2019
Parallel run 1 January 2013 – 1 January 2017
Migration
Leverage ratio Supervisory monitoring
to Pillar 1
Disclosure starts 1 January 2015
Minimum Common Equity Capital
3.5% 4.0% 4.5% 4.5% 4.5% 4.5% 4.5%
Ratio
Capital Conservation Buffer 0.625% 1.25% 1.875% 2.5%
Minimum common equity plus

3.5% 4.0% 4.5% 5.125% 5.75% 6.375% 7.0%
capital conservation buffer
Phase-in deductions from CET1

(including amounts exceeding the
20% 40% 60% 80% 100% 100%
limit for DTAs, MSRs and
financials)
Minimum Tier 1 Capital 4.5% 5.5% 6.0% 6.0% 6.0% 6.0% 6.0%
Minimum Total Capital 8.0% 8.0% 8.0% 8.0% 8.0% 8.0% 8.0%
Minimum Total Capital plus

8.0% 8.0% 8.0% 8.625% 9.25% 9.875% 10.5%
conservation buffer
Capital instruments that no

longer qualify as non-core Tier 1 Phased out over 10 year horizon beginning 2013
or Tier 2 capital
Observation period
Liquidity coverage ratio 60% 70% 80% 90% 100%
begins
Introduce
Observation period
Net stable funding ratio minimum
begins
standard
Eurocurrency Market
 Eurocurrency
 Eurocurrency Loan
 Eurocurrency Market
 Eurobank (or offshore bank)
 Major Centres
 Characteristics
 Instruments
 Origin and Growth
 Market Segments
Eurocurrency Market
 LIBOR and other Reference Rates
 LIBOR Screen Quotations
 LIBOR Scam
 Eurocredits
 Risks faced by Eurobanks
 Implied Forward Rate
 Forward Rate Agreement (FRA)
 Setting up of Offshore Banking Units in SEZs
 Setting up of International Financial Services Centre
(IFSC) Banking Units i.e. IBUs
Eurocurrency Market
 Eurocurrency
 Currency deposited in a bank outside the home country
where the currency is issued as a legal tender.
Examples:
 Eurodollars are U.S. dollar-denominated time deposits in
banks located outside the U.S.
 Euroyen are yen-denominated time deposits in banks
located outside of Japan.
 The foreign bank doesn’t have to be located in Europe.
 The term “Euro” has nothing to do with the currency €
 Instruments:
 Time Deposit
 Certificate of Deposit
Eurocurrency Market
 Eurocurrency Loan
 Foreign currency loan made by a bank outside the
country of the currency where it is issued as legal
tender e.g.
 E.g. US dollar loan made by a bank in the London
market is a Eurodollar loan
 Eurocurrency Market
 Money market for both deposits and loans in a
currency outside the home country where the currency
is issued as a legal tender.
 Eurocurrency market for a currency has a regulatory
regime different from that of the home country where
the currency is issued as a legal tender.
Eurocurrency Market
 Eurocurrency Market (Cont..)
 Develop where local laws/govt. allow them to or at
least do not discourage them
 It owes its existence to differences in national
financial regulations combined with declining
barriers to international capital movement.
 It is a parallel market in competition with national
domestic market.
 The British govt. favorably inclined to attract euro
currency market in London to maintain the
prominence of the city in international finance.
Eurocurrency Market
Currency Dimension
US$ £
U.S. bank deposit U.K. bank deposit
U.S. Treasury bills U.K. government
Onshore and bonds bonds
U.S. corporate U.K. corporate
Regulatory bonds bonds
Dimension Euro-$ deposit Euro-£ deposit
Euro-$ bond Euro-£ bond
Offshore (corporate and (corporate and
sovereign sovereign
issuers) issuers)
Eurocurrency Market
 Eurobank (or offshore bank)
 Bank which simultaneously accepts time deposits and
make loans in a currency outside the home country of
that currency.
 Minimum size of Euro-deposit is USD 1 mio.
 Major Centres
 London (1/3), Paris, Zurich, Channel Islands, Cayman
Islands, Bahamas, Panama, Luxembourg, Bahrain,
Hong Kong, Singapore, Tokyo and New York (1981)
under IBF.
 Singapore market for U.S. dollars is often called the
“Asian Dollar” Market
Eurocurrency Market
 Characteristics
 Develop where local laws permit them to develop
 Freedom from control of host or foreign
governments.
 Freedom from exchange and capital controls.
 No limit of deposit interest rates.
 No reserve requirements, taxes or deposit
insurance.
 No credit allocations.
Eurocurrency Market
 Attraction for Borrowers and Depositors
 Because of absence of reserve requirements, deposit
insurance requirements and other costly regulations
Euro banks can offer:
 Higher yields on USD deposits than U.S. banks.
 Lower interest rates on loans because of absence of
severe regulations.
 Therefore spreads are narrow typically 10 bps or
lower compared to the U.S. inter-bank market.
Domestic Loan Rate (D2) > Euro-currency Loan Rate (E2) > Euro-
currency Deposit Rate (E1) > Domestic Deposit Rate (D1)
Comparative Spreads Between Lending and
Deposit Rates in the Eurodollar Market
Interest Rate
Domestic D2
Loan Rate
E2 Eurodollar Loan Rate
Domestic Spread
Eurodollar Spread
E1 Eurodollar Deposit Rate
Domestic
D1
Deposit Rate
0
Comparative Spreads Between Lending
and Deposit Rates in the Eurodollar Market
(As on 6th September 2016)
Prime Domestic Lending Rate > Offshore Lending Rate (LIBOR )

Offshore Deposit Rate (LIBID) > Onshore Deposit Rate
Eurocurrency Market
 Market Segments
 Interbank loan market (75%).
 Non-bank euro loan or euro credit market.
Euro-bank B/S
Assets Liabilities
- Loans to banks - Time Deposits
- Loans to Co’s & Govt. - Certificate of Deposits
- Floating Rate Notes
 Most Eurocurrency transactions in interbank

market are in amounts US$ 1 mio+
Eurocurrency Market
 London Interbank Offered Rate (LIBOR)
 Rate at which one prime bank in London lends
time deposits to another prime bank in the
interbank market.
 London Interbank Bid Rate (LIBID)
 Rate at which one prime bank in London accept
time deposits from another prime bank in the
interbank market.
 London Interbank Mean Rate (LIMEAN)
 Mean of LIBID and LIBOR.
Eurocurrency Market
 Other Reference Rates
 PIBOR = Paris Interbank Offered Rate.
 SIBOR = Singapore Interbank Offered Rate.
 HIBOR = Hong Kong Interbank Offered Rate.
 FIBOR = Frankfurt Interbank Offered Rate.
 BIBOR = Bahrain Interbank Offered Rate.
 EURIBOR = Euro Interbank Offered Rate.
 TIBOR = Tokyo Interbank Offered Rate.
 MIBOR = Mumbai Interbank Offered Rate.
Eurocurrency Market
 BBA LIBOR (British Banker Association
Libor) (Formerly)
 Indicative average interest rate at which a
selection of banks (the 16 panel banks) lend to
one another unsecured funds on the London
money market.
 Announced at 11.00 am (London time) by
Thomson Reuters on behalf of BBA.
 There are 150 different LIBOR interest rates
calculated for 15 different maturities for 10
different currencies.
Eurocurrency Market
 BBA LIBOR (Formerly) Contd..
 Maturities: o/n, 1 week, 2 weeks, 1 month, 2
months,…….,12 months.
 Currencies: AUD, CAD, CHF, DKK, GBP, JPY,
NZD, SEK, EUR, USD.
 ICE LIBOR (Intercontinental Exchange

Libor) (Effective September 25, 2012)
 Maturities: o/n, 1 week, 2 weeks, 1 month, 2
months, 3 month, 6 month, and 12 months.
 Currencies: USD, EUR, GBP, JPY, and CHF
Eurocurrency Market
LIBID /LIBOR
(As on 6th October 2016)
Eurocurrency Market
(As on 6th October 2016)
LIBID / LIBOR SIBID / SIBOR CDIB / CDOR
Note: SIBOR rates are quotes for Singapore and CDOR

rates for Canadian Dollar Rates in Canada
BBA LIBOR Quotations - Reuter
Screen (before Libor scam)
ICE LIBOR Quotations - Reuter Screen
ICE LIBOR , LIBID and LIMEAN
USD 6-Mth LIBOR (Q1 2006 to Q3 2016)
USD 6-Mth LIBOR (Q1 2012 to Q3 2016)
Eurocurrency Market
 Size
Gross Eurocurrency Eurodollar

Year Bank Deposits (US$ Bn) (% of Total)
1970 115 81
1980 1578 76
1995 5000+ 75
2005 10,000+ 80
2015 13,000+ 70
Eurocurrency Market
 Origin
 Cold War in the 1950s between erstwhile USSR and
the US.
 Speculative attack on the pound sterling in 1957
 Growth
 Deteriorating BOP situation in the U.S. in the 1960s
resulting in imposing the following capital controls by
Fed to prevent outflow of dollars:
 Interest Equalization Tax (IET) (1963)
 Foreign Currency Restraint Program (FCRP) (1965)
 Regulation Q (1966)
 Regulation M
Eurocurrency Market
 Growth (Contd..)
 No Deposit Insurance
 Mandatory regulation on the US for all banks to insure
deposits accepted from the public. FDIC insures
deposits
 No such insurance offered in the unregualted
eurocurrency markets thus enabling eurobanks to offer
higher interest rates on dollar deposits and attracting
such deposits
 Two oil shocks i.e.1973 and 1979 by OPEC countries
 Recycling of surplus petro dollars earnings in the
London market
Eurocurrency Market
 Growth (Contd..)
 Attractiveness for both borrowers and depositors
because of favorable regulatory environment
 Desire of British banks to maintain a their leading
position in international finance
Eurocurrency Market
 Origin
 Cold War in the 1950s between erstwhile USSR
and the US.
 Concerned about potential freeze of their dollar
accounts with US banks and needing dollars for
international trade and investments, shifted their
deposits to London
 The first bank in London market accepting these
dollar deposits was the Banque Commercial pour
l’Europe du Nord – a French bank controlled by the
Soviet Union also know by its cable code,
EUROBANK
Eurocurrency Market
 Origin (Cont..)
 Speculative attack on the pound sterling in the late
1950s
 Suez Canal crisis in 1956
 High inflation rates in Great Britain than in other
European countries resulting in speculative attack on
the sterling threatening the Bretton Woods sterling
parity of $2.80
 Bank of England prohibited pound sterling for financing
foreign trade and credit to non-residents
 Tight monetary policy resulted in high interest rates and
direct ceilings were imposed on bank lending for
domestic and foreign purposes
 European banks started soliciting dollar deposits which
were not regulated by BOE
Eurocurrency Market
 Growth
 Deteriorating BOP situation in the U.S. in the
1960s resulting in imposing the following capital
controls by Fed to prevent outflow of dollars
 Interest Equalization Tax (1963)
 On July 18, 1963 President Kennedy proposed a
15% IET on purchase price of foreign bonds issued
in N.Y. and purchased by American investors.
 The IET increased the cost to foreign borrowers who
issued Yankee bonds in the U.S.
 The tax was extended to certain bank loans with
maturity of 1-3 years in early 1964 and was repealed
in the beginning of 1974
Eurocurrency Market
 Growth (cont..)
 Foreign Credit Restraint Program (1965)
 In Feb 1965 the U.S. Voluntary Credit Restraint
Program was instituted which set up certain limits on
the quantum of lending by U.S. banks to U.S. MNCs
involved in foreign direct investments and their
foreign subsidiaries
 In Jan 1968 these controls were made legally
mandatory
 These set of controls gave companies incentive to
borrow dollars from offshore markets which were not
subject to these restrictions
Eurocurrency Market
 Growth (cont..)
 Regulation Q (1966)
 The Fed imposed ceilings on interest rates that
banks could pay on deposits of various sizes and
maturities. This prevailed from 1933 until Repeal of
the Glass Steagall Act in 2010.
 No interest was allowed on demand deposits from
Jan 1957 to Nov 1964.
 Interest < 1% on time deposits < 90 days
 With higher interest rates on US dollar deposits in the
Eurodollar market funds moved to banks in Europe.
 US banks opened offices in Europe to attract dollar
funds
Eurocurrency Market
 Growth (cont..)
 Regulation M
 Regulation M of the Federal Reserve Act required
maintaining reserves against deposits accepted by
banks in the US.
 Since reserves constitute idle funds it increases the
cost of funds for banks and so they offer lower
interest rates on deposits
 In the absence of reserve requirements in the
eurocurrency markets banks operating in these
markets could offer higher interest rates to attract
dollar deposits
Eurocurrency Market
 Instruments
 Eurocurrency markets have evolved a variety of
instruments over the years other than time
deposits, certificate of deposits and short-term
interbank loans:
 Euro Commercial Paper (ECP).
 Medium to Long Term Floating Rate Loans
 Eurobonds.
 Floating Rate Notes (FRNs).
 Euro Medium Term Notes (EMTNs).
Eurocurrency Market
 LIBOR Scam (2012)
 BBA trusts that the Libor quoted by banks are
the actual ones
 Libor is used as benchmark for payments on
US$ 800 trillion worth of financial instruments
including complex interest rate derivatives
 BBA LIBOR panel banks understated the rates
at which they could borrow during the depths of
Global Financial Crisis in order to hide financial
weakness resulting from toxic assets and show
financial soundness
Eurocurrency Market
 LIBOR Scam (2012) (Cont…)
 There was massive collusion among panel
banks to manipulate daily rate fixing in their
favor in order to earn excess profit from their
financial position indexed to BBA LIBOR
 In June 2012 Barclays bank was accused of
falsely reporting lower rates during the period
2005-2009 in order to earn excess profits and
was fined US$ 450 mio. Barclays CEO Bob
Diamond resigned
Eurocurrency Market
 Euro Loans / Euro Credits
 Short to medium-term loans of Eurocurrency
to corporations, governments, non-prime
banks or international organizations
 Loans are often too large for one bank to
underwrite; a syndicate of banks share the risk
 Variable rates of interest: the base rate is 3
month or 6 month LIBOR
 Loans extended through rollover pricing
Eurocurrency Market
 Euro Loans / Euro Credits (cont..)
 Rollover pricing:
i(t) = r(t) + lending margin
where: r(t) = reference rate (e.g. LIBOR)
lending margin depends on the borrower’s
credit quality
Eurocurrency Market
Example: Roll Over of a 6 Month Euro-Credit

years
Today 1 2 3 4 5 6
etc. etc. etc.
Loan is re-scaled at new LIBOR every six months,

with interest payments made on those roll-over dates
Eurocurrency Market
 Types of Euroloans
 Term Loan
 Revolving Credit
 Stand-by Credit
 Multiple Option
 Multi-currency
 Multi-tranche
Eurocurrency Market
 Eurobanks face three types of risks:
 Interest Rate Risk
 Exchange Rate Risk
 Credit Risk
 Sovereign Risk
Eurocurrency Market
 Interest Rate Risk:
 Maturities of assets and liabilities are not
matched.
 Eurobanks engage in maturity transformation
i.e. borrow short-term liabilities floating rate and
lend long-term assets floating rate.
 Eurobanks make profit based on the difference
between long-term and short-term rates i.e. “riding
the yield curve”.
 Maturity mismatch risk is reduced by roll-over
pricing.
Eurocurrency Market
 Funding of a foreign currency loan:
Matched Funding
 Taking deposit in foreign currency say euro
by borrowing in the interbank market and
lend foreign currency for the same maturity.
 Taking a deposit in dollars and swap the
dollars for foreign currency say euro in forex
market for the same maturity as the dollar
deposit i.e. “buy-sell” swap in foreign
currency”.
Eurocurrency Market
Matched Funding
 Example:
 Take 6-month $ deposit and make 6-month €
loan without 6 month € deposit.
 Buy € spot by selling $ spot and
simultaneously Sell € 6-month forward by
buying $ 6-month forward i.e. “Buy-Sell” swap
in €.
 Pay the 6-month $ deposit when the 6-month €
loan matures.
Eurocurrency Market
Unmatched Funding (1)
 Take a 1 month € deposit and make a 6
month € loan.
 After 1 month take a 5 month € deposit.
 Pay the 5 month € deposit when the 6 month
€ loan matures.
Eurocurrency Market
 Funding of a foreign currency loan: Unmatched
Funding (2)
 Make a 6 month € loan without 6 month € deposit
 Take a 1 month $ deposit and sell $ spot and buy €
spot.
 Sell € and Buy $ 1 month forward (“Buy-Sell” swap)
to pay 1 month $ deposit.
 After 1 month:
 Take 5 month $ deposit.
 Sell $ spot and buy € spot.
 Sell € and Buy $ 5 month forward to pay 5 month
$ deposit.
Eurocurrency Market
 Credit Risk
 Counterparty may not perform on a
contract
 Establish counter party limits in interbank
market
 Margin over Libor depends on credit
worthiness for non-bank customers
Eurocurrency Market
 Sovereign Risk
 Regulating the eurocurrency market
 Exchange and capital controls
 Local banking regulations apply to
eurocurrency markets
 Reserve requirements
 Taxes
 Deposit insurance
 Credit allocations etc.
Eurocurrency Market
 Linkages between Interest Rates and
Exchange rates in Eurocurrency Market:
F$/£
(1 + i$) = × (1+ i£)
S$/£
The above CIP is approximated as:

F–S
≈ i$ – i £
S
Swap Rate = Interest Differential
(Forex Market) (Euro Market)
Eurocurrency Market: Implied
Forward Rate
---------------------I-----------------------
0 3 mth 6 mth
<---------R3-------->I<-------RF ----------->
<---------------------R6---------------------->
(1+R3) (1+RF) = (1+R6)

Therefore RF = (R6–R3)/(1+R3)
RF is 3 mth interest rate 3 mths from now
RF is the implied forward rate or forward-forward
interest rate or the break-even rate
Forward Rate
 Example:
R3 = 4% p.a. R6 = 8% p.a.
(1+0.04 x 3/12) (1+RF x 3/12) = (1+0.08 x 6/12)
(1+ 0.25 x RF) = (1+0.04) / (1+0.01)
Therefore: 0.25 RF = [(1.04) / (1.01)] – 1
0.25 RF = 1.0297 – 1
0.25 RF = 0.0297
RF = 0.1188
If you invested in 3 mth deposit @4% and then reinvested
the deposit with interest rate for another 3 mths at the
implied forward rate of 11.88% the final return would be
the same as if you invested for 6 mth i.e. 8%
Forward Rate
 Example (Cont…):
OR
If you borrowed for 6 mth @ 8% invested the money for 3
mths @ 4% and then reinvested again for 3 mths @ 11.88%
then you break-even
 Borrowing Short and Lending Long:
 You will break-even if you refinance the short-term
loan at the implied forward rate.
 Borrowing Long and Lending Short:
 You will break-even if the short-term loan is rolled
over at the implied forward rate.
Forward Rate
 Example (Cont…):
If market interest rates at time ‘t’ for maturity ‘T’ are different
from implied forward rate, then borrowing short and lending
long will result in profit or loss.
 Borrowing Short and Lending Long represents a bet
that actual short-term market rates will turn out to be
below the implied forward rate you will earn profit
if you roll over the loan at a rate below the implied
forward rate
 Borrowing Long and Lending Short is a bet that actual
short-term rates will turn out to be above the implied
forward rate you will earn profit if you roll over
the loan at a rate above the implied forward rate
Forward Rate
 Interest Rate risk is associated with maturity

transformation because of the fact that short-
term market rates may be different from
implied forward rate
Forward Rate Agreement
 FRA is a forward-forward inter-bank contract on
interest rates.
 The contract involves two parties, a buyer and a
seller.
 Buyer wants to protect against future rise in interest
rates.
 Seller wants to protect against future fall in interest
rates.
 If the actual interest rate on the settlement date >
agreed (contract) rate, the seller pays the buyer the
difference.
Forward Rate Agreement: Uses
 If the actual interest rate on the settlement date <

agreed (contract) rate the buyer pays the seller the
difference.
 Hedge assets / liabilities that a bank owns against
interest rate risk.
 Speculate on future interest rates.
Forward Rate Agreement (3 x 6)
FRA Terminology
 Trade Date: Date on which the terms of the FRA
are set.
 Forward Date: Date on which the contract begins.
 Maturity Date: Date on which the contract period
ends.
 Contract Period: Period protected. Quoted as for e.g.
3x6 meaning that the contract is for a
3 mth period commencing in 3 mths
time.
 Settlement Date: Date when the payment of interest
differential is made. Usually same
as the Forward Date.
FRA Terminology
 Fixing Date: Two days prior to the Settlement or
Forward Date.
 Contract Rate : Forward rate of interest agreed
between the two parties on the Trade
Date.
 Settlement : The floating rate of index in the
Rate contract e.g. LIBOR.
 Settlement : Difference between the Contract Rate
Sum and Settlement Rate multiplied by the
Notional Principal Amount and the
period of the contract.
Settling a Forward Rate
Agreement
 At the end of the agreement period, the loser
pays the winner an amount equal to the present
value of the difference between the settlement
rate (SR) and the contract rate (CR), sized
according to the length of the agreement period
and the notational amount.
days
Notational Amount × (SR – CR) ×
360
days
1 + SR ×
360
Settling a Forward Rate
Agreement
• A €5,000,000, 4%, 3 x 9 FRA entered into January 1, 2014 has
the following terms:
1 2 4 5 6 7 8
On 1/3/14 if the 184 days

Payment
actual rate is 4%
184
there is no payment. €5,000,000 × (SR – 0.04) ×
360
If on 1/3/14 the SR = 5% 184
1 + SR ×
the seller pays the buyer €24,918.74. 360
If on 1/3/14 the SR = 3% the buyer pays the seller €25,169.62.
FRA Quotations
Start/End USD
(In Months) (%)
1x4 0.8637/9037
2x5 0.8789/9189
3x6 0.9124/9524
4x7 0.9250/9650
5x8 0.9396/9796
6x9 0.9521/9921
USD FRA Quotations
USD FRA Quotations
FRA Quotations
FRA Quotations
Setting up of Offshore Banking Units
(OBUs) in Special Economic Zones (SEZs)
 RBI announced scheme for setting up OBUs in SEZs on

Nov 12, 2002.
 SEZs are specially delineated duty free enclaves and
deemed to be a foreign country for the purpose of trade
operations and duties/ tariffs so as to promote export-led
growth.
 Eligibility Criteria
 Public sector, private sector and foreign banks authorized to
deal in foreign exchange are eligible to set up OBUs.
 Preference to banks having overseas branches.
 Each of the eligible banks allowed to establish only one
OBU which would carry on wholesale banking operations.
 Licensing
 Prior permission of RBI u/s 23(1)(a) of the Banking
Regulation Act, 1949.
 Capital
 OBU deemed as overseas branch of the parent bank and so
no separate assigned capital for such branches required.
 Parent bank required to provide a minimum of US$ 10
million to its OBU.
 CRR: Exemption to the parent bank with reference to its
OBU branch.
 SLR: Parent banks required to maintain SLR in respect of
their overseas branches. In case of necessity, request for
exemption will be considered.
 Resources and Deployment
 External sources of raising funds i.e. from Non-Residents.
 Funds can also be raised from residents sources provided
that such residents are permitted under exchange control
regulations to invest/maintain foreign currency accounts
abroad.
 Deployment of funds would be restricted lending to units
located in SEZ and SEZ developers.
 If funds are lent to residents in the Domestic Tariff Area
(DTA), then existing exchange control regulations would
apply.
 Ring Fencing Activities of OBUs
 OBUs to operate and maintain balance sheet only in foreign
currency and not allowed to deal in Indian rupees.
 Ring Fencing Activities of OBUs (cont..)
 Maintain Special Rupee Account with an AD in India out of
convertible foreign exchange resources for meeting local
expenses only.
 OBUs to maintain separate nostro accounts with
correspondent banks.
 Priority Sector Lending
 Loans and advances of OBUs would not be considered as
net bank credit for computing PSL obligations.
 Deposits of OBUs are not covered by deposit insurance.
 Regulation and Supervision
 OBUs will be regulated and supervised by RBI through its ECD,
DBOD, and DBS.
Setting up of International Financial
Services Centre (IFSC) Banking Units
(IBUs)
 RBI has formulated a scheme for setting up International
Financial Services Centre (IFSC) Banking Units (IBUs)
by banks in IFSC vide its notification on April 1, 2015.
 GOI has announced setting up an IFSC in Gujarat viz.
Gujarat International Financial Tec-City (GIFT) in
Gandhinagar, Gujarat.
 Eligibility Criteria
 Public sector and private sector banks authorized to deal in
foreign exchange are eligible to set up IBUs.
 Each of the eligible banks permitted to establish only one
IBU in each IFSC.
(IBUs)
 Licensing
 Prior permission of RBI for opening IBU u/s 23(1)(a) of the
Banking Regulation Act, 1949 (BR Act).
 IBU will treated on par with a foreign branch of an Indian
bank.
 Capital
 Parent bank to provide minimum capital of US$ 20 million
or equivalent in any foreign currency to its IBU.
 IBU to maintain minimum prescribed regulatory capital on
on-going basis.
(IBUs)
 Liabilities of IBU exempt from SLR and CRR requirements
of RBI.
 Resources and Deployment
 Sources of raising funds, including borrowing in foreign
currency will be non-residents.
 Deployment of funds will be with both persons resident in
India and persons non-resident in India the former subject to
FEMA 1999.
 Permissible activities of IBUs
 Can undertake transactions with non-resident enities other
than individual / retail customer / HNI.
 All transactions in currencies other than INR.
(IBUs)
 Permissible activities of IBUs
 IBUs can deal with WOS/JVs of Indian companies
registered abroad.
 Can undertake transactions with non-resident entities other
than individual / retail customer / HNI.
 All transactions in a currency other than INR.
 IBUs allowed to have liabilities including borrowing in
foreign currency only with original maturity period greater
than one year.
 IBUs can raise short-term liabilities from banks subject to
limits prescribed by RBI.
 IBUs not allowed to open any current or savings accounts.
They cannot issue bearer instruments or cheques. All
payments transactions via bank transfers.
(IBUs)
 Permissible activities of IBUs (cont..)
 IBUs permitted to undertake factoring / forfaiting of export
receivables.
 IBUs permitted to undertake all types of structured product
and derivative transactions with prior approval of their
Board of Directors.
 Ring Fencing the Activities of IFSC Banking Units
 IBUs will operate and maintain balance sheets only in
foreign currency and will not be allowed to deal in Indian
rupees.
 Maintain Special Rupee Account with an AD in India out of
convertible foreign exchange resources for meeting local
administrative and statutory expenses only.
 OBUs to maintain separate nostro accounts with
correspondent banks.
(IBUs)
 Priority Sector Lending
 Loans and advances of OBUs would not be considered as
net bank credit for computing PSL obligations.
 Deposits of OBUs are not covered by deposit insurance.
 Lender of Last Resort (LORL)
 No liquidity support or LORL will be available to IBUs
from RBI.
 Regulation and Supervision
 IBUs will be regulated and supervised by RBI.
 Prudential norms applicable to overseas branches of Indian
banks would apply to IBUs.
 The bank’s board to set out appropriate credit risk
management policies.
(IBUs)
 Indian Banks Operating in IFSC

 Seven Indian banks have been granted license by RBI and
are active in the offshore market
 Indian banks include SBI, ICICI Bank, IDBI Bank, Kotak
Mahindra Bank, IndusInd Bank, Punjab National Bank and
Corporation Bank
 Recorded transaction volume of USD 700mio as of August
end 2016

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INTERNATIONAL BANKING

 Reasons for International Banking

 Types of International Banking Offices:

 RBI Guidelines on setting up Liaison / Branch /

Pillar 2 Supervisory Review: Qualitative supervision by regulators

Minimum common equity plus

Phase-in deductions from CET1

Minimum Total Capital plus

Capital instruments that no

(As on 6th September 2016)

Prime Domestic Lending Rate > Offshore Lending Rate (LIBOR )

 Most Eurocurrency transactions in interbank

 ICE LIBOR (Intercontinental Exchange

Note: SIBOR rates are quotes for Singapore and CDOR

Gross Eurocurrency Eurodollar

Example: Roll Over of a 6 Month Euro-Credit

Loan is re-scaled at new LIBOR every six months,

The above CIP is approximated as:

(1+R3) (1+RF) = (1+R6)

 Interest Rate risk is associated with maturity

 If the actual interest rate on the settlement date <

On 1/3/14 if the 184 days

 RBI announced scheme for setting up OBUs in SEZs on

 Indian Banks Operating in IFSC

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