International Banks and the Rise of financial Derivatives

Table of Contents

1. Introduction

2. Structure of banks
2.1 Domestic banks
2.2 International banks

3. The Rise of Financial Derivatives
3.1 International Monetary Arrangements as an Incubator for Financial Derivatives
3.2 Impacts on the Financial Architecture

4. The Changes in the Structure of International Banks
4.1 Risk
4.2 Regulation
4.3 Speculation

5. Conclusion

II. Table of Literature
II.a Reference List
II.b Table of Wesites

1. Introduction

Derivatives trading is now the world's biggest business, with an estimated daily turnover of over US$2.5 trillion and an annual growth rate of around 14 per cent (Swan, 1999). Derivatives markets have ancient origins, and a long and complex history of trading and regulation. This work examines the history of derivatives and their impacts on the structure of international banks in order to show the implications of modern international banking in comparison to domestic banking.

2. Structure of banks

Mishkin (2003) describes banks as financial institutions that accept deposits and grant loans. In this definition banks are the financial intermediaries that the average person contacts most frequently for its financial dispositions, savings, investments and payments. The structure of a bank therefore seems to be adjusted to the purpose of its business activity.

2.1 Domestic banks

Mishkins traditional definition of a bank includes to those financial institutions we refer to as mutual savings banks, savings and loan associations, commercial banks and credit unions. Their traditional core business is to provide the settlement of national payments and to transform funds from savers over time as well as to process market information (Canals, 1997). They focus on domestic or regional, eventually even local markets and realize their profits from interest margins and balance sheet activities. Therefore they employ an asset- and liability management in order to avoid liquidity and credit risks.

2.2 International banks

Heffernan (1996) finds three definitions how international banks traditionally occur. According, international banks can be identified as

- Being physically international by running branches abroad
- Trading in foreign currencies
- Having foreign customers

The problem with these definitions is, that they try to explain two different issues of international banking:

- The international activities of a home-based bank
- The establishment of cross-border branches and subsidiaries.

Nowadays we cannot directly make the distinction of domestic and international banks by regarding the currency or the market they trade in, since the globalisation and the deregulation of national and international financial markets have grown highly sophisticated.

The “international” in the traditional distinction was in former times identified as the trade in foreign currencies, the financing of investments abroad and the settlement of international money flows (Achleitner, 1999). In the modern economic world, financial institutions like international central banks, the IMF or the World Bank and global systems for information and funds processing have been established in order to enable a virtually global financial market without real barriers for international trade, investment and fund raising (Itoh & Lapavitsas, 1999).

Due to the recent changes in the international financial architecture (which we will see more detailed in the following) the ways of raising funds and financing projects in an international issue have changed as well. Therefore regarding the instruments and products they use may identify international banks and the way they obtain their profits.

International banks realise a bulk of their profits from off-balance sheet activities (Buckle & Thompson 1998). They issue securities in foreign markets and currencies, finance international investment and are mostly represented by big investment, merchant or wholesale banks.

3. The Rise of Financial Derivatives

In his theory of liquidity preference, Keynes (1936) explains how uncertainty affects the investors’ decision between liquid assets or long- term investments. According to his theory, the level of uncertainty can even override the markets´ interest rate mechanism. From a neo-classical point of view, financial derivatives may be regarded as suitable instruments to banish this black hole in inter-temporal general equilibrium. Toporowski (2000) describes the function of derivatives as replacing uncertain values with “certainty-equivalent values” that reflect future risks.

Since the use of derivatives increased rapidly during the last decades, their effects on uncertainty might appear as being paradox. Depending on the investors’ purpose, financial derivatives might reduce as well as increase uncertainty. With intend to fix a financial parameter (ceteris paribus), i.e. to reduce a risk, derivatives can reduce uncertainty. With intend to realise a profit, due to its nature and short -term maturity a derived instrument may enormously increase the level of risk and uncertainty.

Hence, having different purposes in the use of financial derivatives and means having different impacts on the structure of the international financial architecture. In order to analyse the changes in the structure of international banks during the evolution of financial futures it appears to be useful to take a look at the history of financial derivatives and the purpose for their rise.

3.1 International Monetary Arrangements as an Incubator for Financial Derivatives

Swan explains that derivatives are not inventions of recent decades. Derivatives have been used ever since in the history of trade in the Ancient Middle East, in Ancient Greece and Rome, in the Post-Roman Era (476-1204), in the Middle Ages (13th - 15th Centuries), during the growth of Trade in Northern Europe and England (16th - 17th Centuries), the industrial revolution, and World War I+II and they play an essential role in modern global economy. In particular during the second half of the 20th century derivatives became increasingly important in the context of international trade and finance.

Prior to the Second World War, there was no international central bank. International payments, in particular in settlement of inter-country debts were processed by central banks of the individual countries through transfers of gold, pound sterling or US dollars. This system, called the gold standard or gold/sterling standard (Buckley 2000) operated at the end of the 19 century and most of the first half of the 20 century. It provided a platform for international payments by use of a substitute currency (gold) into which the currencies of all participating countries were convertible at a fixed rate.

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