MODULE 13 – Global Debt and Country Risk

Introduction

In this Module, we will discuss the impact of globalization, international trade and the capital market in relation to the operation of the IB system. The consequences of the global debt crisis, especially among developing nations and emerging markets, will be discussed. We will elaborate upon the country risk issue and recommended guidelines by the Basel Committee on Banking Supervision. Furthermore, the assessment of economic and industrial policies of the nations by the IB system will be elaborated upon. Finally, we will cover the operational risk guidelines recommended by the Basel II Accord.

Objectives

Upon successful completion of this module, the student should be able to:

•Elaborate on the issue of globalization and its impact on the IB system.

•Examine the consequences of the global debt crisis.

•List guidelines provided by the Basel II Accord concerning bank supervision.

•Discuss operational risk and the Basel II Accord’s recommended guidelines.

The globalization process increased international trade and lending activities in the capital market worldwide. It would seem as thoughindustrial nations and large economieshave been the only beneficiaries of the increased activity in the capital market. However, there may be some fallacy concerning this matter, since the international capital market is also utilized by the banking system to provide the necessary funds to emerging market nations, upon qualification. Borrowing by emerging market nations resulted from a series of global debt crises whose ripple effects impacted many regions beyond their original boundaries.

This is a serious issue for developing nations, especially when loans become due and the nations default on their loan, due to a lack of capital formation. For developing nations and emerging market societies, it appears that the cycle of not being able to form capital is repeating itself, and if there has been any progress, it is not significant. Continuation of this process is posing a great obstacle for participation of all nations in the global financial market to the fullest extent. Obviously, this issue impacts the operation of IB significantly when it comes to cross-border borrowing and lending activity. Since there have been many financial crises caused by loan defaultson the part of various nations, international bankers are very prudent and take cross-border lending risk very seriously. The international financial market is dynamic, so ceteris paribus does not apply. Therefore, it is important that international bankers manage their risks, since they cannot eliminate them. There are many different risks involved with cross-border lending and borrowing, and it is imperative that a comprehensive country risk analysis be conducted by lending institutions before they embark further into the process. For example, to name a few:

  1. Liquidity risk, where one party fails to fulfill its financial obligation for signing a security. For further information, please see Footnote #1.
  2. Legal Risk, which is when a contract cannot be enforced. For further information, please see Footnote #1.
  3. Operational risk, where economies of scale fails in all aspects of the operation. For further information, please see Footnote #1.

An increase in global financial activity, due to industrialization, and economic interdependencies will eventually help the emerging markets to improve their economic status in the world community. International bankers must take under consideration the fact that the present economic status of a nation is not necessarily indicative of the future economic health of the said nation. Therefore,while a nation may not be able to qualify for borrowing at the present time, its future economic outlook may be significantly positive enough to allow it to qualify. Though they must maintain their prudence, international bankers can carefully calculate, using forecasting models, to determine the growth trend of an emerging market country. This process diminishes the risk that international bankers have to take when underwriting cross-border lending.

Technological advancementshave facilitated the overall operations of the banking system worldwide, especially e-banking services that tend to facilitate cross-border banking transactions. At the same time, they pose new challenges and risks for the banks and their customers. As cumulative advances in economic, financial and technological segmentshave increased, they have necessitated guidelines for controllinginevitable risks to which all financial entities are exposed. The Internet has helped the banking system to offer new financial services that can be accessed online worldwide, without any national hindrances. As we speak, e-banking is a major source of competition among international bankers. This matter has been recognized and addressed by the Basel Committee on Banking Supervision. For further information, please see Footnote #2.

Political instability in particular regions of the world can pose a serious threat and risk to the operations of international banks. The upheaval could result from ideological differences, ethnic tension, wars, or revolutions, etc. One or a combination of all can pose a political risk for the banking system. Historically, political risk manifests itself due to conflicts between nations that in some instances have resulted in major wars. Many investment and banking segments of European society forfeited their assets due to the First and Second World Wars. In the contemporaries, the IB system was also subject to such forfeiture due to regional conflicts, such as in the Middle East, some parts of Africa, and South America. And of course in modern times, the IB system’s operations have shown sensitivity to acts of terrorism, civil wars, revolutions and so forth, examples of which are the Balkans and the Middle East. For further information, please see Footnote #3.

It is imperative for international bankers to assess the political, financial and economic environment of the host country in order to minimize potential political risk. Also, it is essential for international bankers to ensure that enforcement of the original covenant is safeguarded by the political regime in emerging market societies. Risk(s) may arise from changes in governmental laws and regulations that may adversely impact banking operations. Furthermore, international bankers must look at the economic and industrial policies of a nation and conduct a comprehensive assessment of the past, present and future of the said policies, or the direction in which the nation is heading. It is very easy to be trapped into believing that the political and economic status quo will perpetuate and linger around. However, we just recently experienced changes in the legal regimes in Venezuela, Bolivia, and Chile whichhave brought complete changes in how nations will operate economically and politically, due to ideological changes. The questions can be asked whether the new regime will follow the same economic policy, whether they will ensure the stability of the financial market and the banking system, and how powerful will a central banker’s role be in the whole scheme of things; and finally, whether the new regime will honor their financial positions, as far as foreign debt, foreign currency and international trade are concerned.

Aside from political risk, when international banks are heavily involved in cross-border lending activity as a part of their operational orientation, they need to be cognizant of the risks that may retard their operational activity. This is known as operational risk, which encompasses issues such embezzlement of assets by external and/or internal sources, insider trading, workplace discrimination, financial fraud, quality control problems, accounting manipulation, computer hacking, negligence, and overall failure of the organizational operation. For further information, please see Footnotes#4 and #5.

When confronted with such diseconomies of scale,the IB system facessignificant operational uncertainties when dealing with legal regimes in emerging market societies. Therefore, in order to circumvent the said uncertainties, international banks should adhere to the methods of operational risk management that are mentioned in the Basel II Accord. For further information, please see Footnote #6.

International bankers are also in the business of facilitating international trade, thus they are exposed to foreign currency risk as a result of instability in the political regime. Thiscould lead toadecline in one’s rate of return when one currency devaluates against another, or the acceptance of a loss in either a long or short term contract when unexpected fluctuations in the exchange rate occur. This may also occur when repayment of a loan which was facilitated for trade by a banking entity is corrupted by the changes in a legal regime due to political or ideological differencesin the country where the business entity is located. In banking terminology, this is also known as “currency risk” or “exchange-rate risk.”

Let’s say that if a Chinese investor maintains an ownership of a French company in the form of stocks, he or she expects a certain level of return from this investment. Suppose the value of the French company’s stock appreciates by 12%, but the French Franc depreciates by 12% against the Chinese Yuan; then the Chinese investor does not benefit from this investment and only breaks even, since his or her return will be paid with depreciated French Francs. For further information, please see Footnote #7.

Conclusion

In this module, you have learned about all aspects of globalization that impact the IB system. You have gained knowledge of the global debt crises, causes, consequences and remedies. You were introduced to a series of guidelines for banking supervision. And finally, you have learned about the operational risk issue, when it comes to the IB system, and recommended guidelines for its prevention.

FOOTNOTES

(1) Overview: Other Risks. (2000). Retrieved from

(2) BIS - Risk Management Principles for Electronic Banking. (2001). Retrieved from

(3) Political Risk. (2012). Retrieved from

(4) Operational Risk Management. (1998). Retrieved from

(5) Basel II Accord. (2008). Retrieved from

(6) Basel II’s 3 Methods of Operational Risk Management. (2012). Retrieved from

(7) Currency Risk. (2007-2012). Retrieved from

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