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International Banks & Capital Markets
Lecture 5: Measuring & managing risk
Monday 08 March
1. Introduction
In considering this topic we will seek to look at a number of risks to financial markets, systems and economies and how these impact on international banking and finance. This list is not exhaustive, nor exclusive, but takes the opportunity to look at some of the major issues. These include:
- Macro-economic impacts – e.g. inflation, fiscal instability and balance of payment/current account dysfunctionalities
- External issues – e.g. foreign debt, foreign debt servicing and FX reserves
- Monetary impacts – e.g. exposure to FX risk
- Payments performance – critical issues about cash flow & sustainability
I will try to associate each of these topics with a real life case study scenario, but essentially we have to take a firm grip on the concept that the past is absolutely no guide to the future. If it were, then we would have no need for analysts and their like, nor indeed would we need to employ fund managers; it would simply suffice to have large computers which replicated past indexed portfolios. We could manage by employing statisticians and economic historians, who together would provide all the data we needed. Regrettably this is not the case, yesterday’s boom or bust is not tomorrow’s. The lesson of 2007-2008 is that we don’t know what is round the corner, although we can often have a pretty good guess that our rosy perceptions of ever expanding growth and ever inflating property prices are really bizarre to say the least.
2. Returning to the analysis – what is a bank or a
market?
At this point we need to return to our previous analysis – before we started to look at specific instruments – when we posed the questions about the role and functionality of a bank or a market.
Economic historians will tell us that the origins of banks and of capital markets can be found in the huge expansion of trade in cities states such as Firenza, Venezia and the components of the Hanseatic League (centred on Hamburg) in the late medieval era.
The financing of trade with the east – spices, silk – and the west – wool, fish – sparked the creation of two types of entity.
TABLE 2.1:
ELEMENTS OF GDP
TABLE 2.2:
ELEMENTS OF THE BALANCE OF TRADE
3. Macro-economic impacts
Our first action is therefore to look at the effect of macro-economic impacts on the symbiotic relationship between business-trade- government and the financial markets in general.
The events of recent years have demonstrated very clearly that we cannot ignore the effect of such factors on banking/markets as interest rates, inflation and the rapid decline of real economic growth.
TABLE 3.1:
GROSS DOMESTIC PRODUCT
2009 QUARTERLY % CHANGE
Country Q1 Q2 Q3 Q Australia 0.8 0.7 0.3 0. Canada -1.8 -0.9 0.2 1. EU-27 -2.5 -0.2 0.3 0. Indonesia 1.1 1.3 1.5 1. Japan -3.2 1.3 0.0 1. USA -1.6 -0.2 0.6 1.
TABLE 3.2:
CONTRIBUTIONS TO GDP: PRIVATE
CONSUMPTION
2009 QUARTERLY % CHANGE
Country Q1 Q2 Q3 Q Australia 0.5 0.9 0.7 0. Canada -0.3 0.4 0.9 0. EU-27 -0.8 -0.2 -0.2 0. Indonesia 1.9 0.4 1.1 0. Japan -1.3 1.1 0.6 0. USA 0.2 -0.2 0.7 0.
TABLE 3.3:
CONTRIBUTIONS TO GDP: GOVERNMENT
CONSUMPTION
2009 QUARTERLY % CHANGE
Country Q1 Q2 Q3 Q
EU-27 -6.3%
Indonesia -2.6% Japan -9.5% USA -14.0%
4. The external economics environment
It is also important to assess the impact of the wider trade flows and related issues. Trade imbalances submit bankers and their customers to a range of pressures – they affect currency values, impact on credit ratings and drive interest rates.
TABLE 4.1:
NET TRADE BALANCE
2009 QUARTERLY AS % OF GDP
Country Q1 Q2 Q3 Q Australia 0.5 ± -0.4 -0. Canada 0.1 -0.2 -0.4 ± EU-27 -0.4 -0.1 ± ± Indonesia 1.1 1.4 0.9 1. Japan -0.2 0.3 0.3 0. USA -1.2 -1.1 -1.2 -1.
TABLE 4.2:
CURRENT ACCOUNT BALANCE
2009 FORECAST AS % OF GDP
Country 2009f Australia -3. Canada -1. EU-27 -1. Indonesia -1. Japan 3. USA -3.
TABLE 4.3:
REAL EFFECTIVE EXCHANGE RATE
OECD DATA 2009 BY QUARTER
Currency Q1 Q2 Q3 Q AUS 87.9 98.4 105.2 112. CAN 94.8 100.3 105.1 108. EUR 104.3 104.7 105.0 106. IDR 100.3 108.1 111.9 115. JPY 104.9 97.4 98.7 100. OECD definition: Real effective exchange rates take account of price level differences between trading partners. Movements in real effective exchange rates provide an indication of the evolution of a country’s aggregate external price competitiveness.
TABLE 4.4:
3-MONTH INTERBANK INTEREST RATE
2009 BY QUARTER
Country Q1 Q2 Q3 Q Australia 3.35 3.16 3.27 3. Canada 1.28 0.70 0.40 0. EU- eurozone
Indonesia 11.04 9.67 8.69 7. Japan 0.69 0.58 0.54 0. USA 1.08 0.62 0.30 0.
5. The risk environment for banks
This then leads on to an element that is crucially important to the role of banks in financing trade and also in the management of cash flows within enterprises. It is an element that also impacts strongly on the credibility of enterprises on a wider level – e.g. on the capital markets – as well as affecting the perceived value of banking institutions in terms of the potential problems that may exist in their lending to enterprises.
TABLE 5.1:
PAYMENT PERFORMANCE OF COMPANIES
As amount of outstanding invoice values paid by
importers to exporters
Country Prompt/< days
30 days + 60 days + 120 days +
Australia 60% 33% 17% 5% Canada 53% 46% 29% 18%
TABLE 5.2:
TERMS OF TRADE
Key issues affecting exporters and those financing
exports to this sample of countries
Country Time delay for bank transfers (months)
Terms of trade (instruments)*
Terms of payment (days)
Export Credit insurance
Australia 0-1 Sight Draft 30 days
Full cover Canada 0-1 Open Account
30 days
Full cover Indonesia 0-2 Letter of credit
30 days
Short Term only Japan 0-1 Sight Draft 30 – 90 days
Full cover USA 0-1 Open Account
30 days
Full cover
* TERMS OF TRADE INSTRUMENTS
Letter of Credit = a guarantee of payment to an exporter from the importer’s bank normally conditional on delivery of goods/services Sight deposit = a bank draft or bill payable on demand or presentation Open account = credit is extended without a note, bill or guarantee
6. FX risk – effects on companies, banks and
economies
TABLE 6:
FX risk – effects on companies, banks and
economies
SCENARIO 1 - DOMESTIC CURRENCY REVALUES (i.e.
strengthens)
+ Imports become cheaper
+ Import cover increases
+ Capital flow attraction – FX reserves improve
+ FDI becomes more attractive
+ Improved borrowing propensity
+ External debt servicing costs decrease
- Exports come under price competition
- Capital inflows lessen in value
weakens)
+ Exports become more competitive
+ Capital inflows increase in value
- External debt servicing costs increase
- Imports become dearer
- Capital flow detraction – FX reserves decline
- Import cover declines
7. The global financial system – what may go
wrong?
Next week, I will seek to address some further issues relating to the inherent risks in banking and in the operation of capital markets at an international level. This will include the topic of interest rate risk, which we had to abandon this week due to conditions in the lecture theatre.
I will then seek to define how in the very changed world we are now facing, the role of the regulator and of international governmental bodies may be shifting very decisively. Regulation based on principle and light touch has patently and very explosively failed; regulation based on rules – which implies a harder touch – may well be the direction in which we are heading.
