INTERNATIONAL FINANCE

ASSIGNMENT 2
(10MBI0039)
Why regulate operations of foreign bank in a country by the central bank of that
country?
There is no realistic prospect for having a global banking regulator and consequently, the
responsibility and authority for financial stability will continue to rest with the national or
regional authorities. The issue of the appropriate roles of home and host countries has to be
addressed, that was the key motivation for the creation of Basel Committee in the 1975
following the failures of the Herstatt and Franklin National banks. Basel Committees early
activities were focused on the supervision of the internationally active banks; it was evident
from the fact that Basel Concordats on supervision followed by Basel Accords and
Frameworks on capital and other subjects where developed. This regulatory framework of
Basel was ongoing as there were gaps in supervisory coverage and as the scale and scope of
internationally active banks grew. The principle of consolidated supervision emerged in the
early 1980s to ensure that some specific banking authority--generally the home-country
regulator--had a complete view of the assets and liabilities of the bank. This principle was
reinforced and elaborated following the Bank of Credit and Commerce International episode
in the early 1990s.
It is important to note that each Basel Committee declaration on the importance of homecountry consolidated oversight has also included a statement of the obligations and
prerogatives of host states in which significant foreign bank operations are located. This
feature of the Basel Committee's approach makes sense as a reflection both of the host
authority's responsibility for stability of its financial system and of the practical point that a
host authority will be more familiar with the characteristics and risks in its market. In
accordance with this history, the current version of the "Core Principles for Effective Banking
Supervision" sets out as one of its "essential criteria" for home-host relationships that "the
host supervisor's national laws or regulations require that the cross-border operations of
foreign banks are subject to prudential, inspection and regulatory reporting requirements
similar to those for domestic banks."
Now we know the ideology why host country should regulate its foreign banks operations lets
look into other macro economical aspects of the operations of foreign banks in the host
country.
Fear of foreign domination:
A stated fear in the minds of central bankers and governments is that unrestricted entry of
foreign banks may result in their assuming dominant positions in the domestic market, by
driving out less efficient or less resourceful domestic banks. They fear that local depositors
may have more faith in a big international bank than in smaller domestic banks. This is

especially true in economies plagued by large domestic bank failures or panics, but even
otherwise, large international banks have an exceptional aura of safety around them. As has
been discussed before, the protection of these domestic firms is justified by an infant industry
argument. Anti-protection arguments claim that domestic banks could be cutting prices to
compete more efficiently. This reasoning suffers from at least two drawbacks: first, demand
for banking services may be quite price in elastic, and secondly, the resultant dog eat dog
situation may not be socially desirable, given the public good nature of bank services.
Lack of local commitment:
The argument here is in two parts; first, under times of local distress, it is believed that
foreign banks will be the first ones to leave the ship. The reason is that for a large
international bank with solid financial strength, it is relatively painless to suffer shut-down
losses (resulting from unrecoupable fixed costs, while it is not the case for smaller domestic
banks. Secondly, in times of distress (ex: bad recession) in the foreign banks home country,
foreign banks may wind-up foreign operations in order to stabilize earnings at home.
The above argument suffers from at least two drawbacks. First, large international banks with
solid financial strength may better withstand the jolts of a few bad business years (especially,
during a local recession) than domestic banks. (Thus if foreign banks leave a country, it may
be properly viewed as a signal of low future bank profitability in the home country rather
than as a sign of poor commitment. Secondly, foreign banks will selectively wind-up
foreign operations when the parent is in financial distress, only if foreign operations are not
expected to be sufficiently profitable.
Cream-skimming behaviour:
Another concern of policy makers and domestic bankers has been that foreign banks carve
out a niche for themselves in the upper/richer end of the market, and rarely extend their
services outside (ex: To the retail segments of the market).Consequently, they cream-skim the
market, taking a disproportionate share of the best of local business away from domestic
banks. About 70% of total loans from foreign banks are advanced in the above 16% and up
to 18% category, which in India, constitutes the upper/richer segment of the market. Overall,
this probably suggests that foreign banks in India concentrate their loan business mainly on
growing private corporate sector.
The
evidence
from
the
Australia
is
mixed.
Most loans by US banks are focused on top corporate with efforts being made to move into
the middle market category. US banks are the most active in both the largest ($50 mil plus)
and the smallest category (less the $1 million). In Spain, foreign banks were invited as
friends to help tide over the banking system crisis in the early 80s. At first they
concentrated on the corporate treasurers and finance directors of the subsidiaries of major US
and European companies in Spain such as Ford and General Motors. But with their fresh
ideas and new products, foreign bankers were soon won business from Spanish corporate
treasurers. And from such major state utilities as Renfe, the national railway company and

Telefonica. Spains telephone company, and one of the countries highest rated international
borrowers.
Capital flight:
Foreign banks are often blamed for encouraging an increase in capital flight (from less
developed countries to more developed ones). In times of an external crisis, this can put
added pressure on the exchange rate. Closer scrutiny however reveals again that the problem
is not peculiar to foreign banks but to all domestic banks with an open capital account. The
problem is usually traceable to macroeconomics incentives that arise from say an imminent
devaluation prospect or the presence of an substantial interest rate differential. Adverse
political environments may also exacerbate this problem. In any case, as Duwendag and
others have pointed out, accurate capital flight measurements are difficult to perform, and in
any case the specific claim that presence of foreign banks induces capital flight is even harder
to substantiate.
The above are some of the reasons why a country/Central bank should regulate
entry/operations of the foreign banks in their economy to safeguard their own interest.
Changes in the regulation of foreign banks carried on by RBI (India) and Peoples Bank
of China.
Paid up-capital;
RBI states, the initial minimum paid-up capital for a WOS shall be 5 billion rupees and
existing branches of foreign banks desiring to convert into WOS shall have a minimum net
worth of 5 billion.
Whereas PBC states that the minimum amount of registered capital of a solely foreign-funded
bank or Sino-foreign equity joint bank shall be RMB 1 billion Yuan or freely convertible
currency of the equivalent value.
Where the PBC minimum capital requirement for the foreign banks to operate is almost half
of the capital requirement for foreign banks to operate in India according to RBI
(5,000,000,000.00 INR = 507,450,000.00 CNY).
PBCs changes in the regulation of foreign bank:
When a wholly foreign-funded bank or a Chinese-foreign joint venture bank establishes a
branch in China, the branch shall receive from its parent bank a non-callable allocation of no
less than 100 million Yuan ($16 million) or an equivalent amount in convertible currencies as
its operating capital. That requirement on the amount of no callable allocation of operating
capital has been removed from the revised regulations, effective as of Jan 1.
In the past, a foreign bank should have maintained a representative office in China for more
than two years before the bank applied to establish its first branch in the country. That

restriction has also been removed, said officials from the Legislative Affairs Office of the
State Council and the China Banking Regulatory Commission.

RBIs changes in the regulation of foreign bank:

Subsidiarisation of foreign banks in India.
The Wholly Owned Subsidiaries (WOSs) would be given near-national treatment, including
in the opening of branches.
It will not be mandatory for existing foreign banks (i.e., banks set up before August 2010) to
convert into WOSs, they will be incentivised to convert into WOSs by the attractiveness of
the near-national treatment afforded to WOSs. The initial minimum paid-up voting equity
capital or net worth for a WOS shall be `5 billion.
Foreign banks with more than 20 branches in India were brought on par with domestic banks
for PSL compliance purpose. However, banks with less than 20 branches were allowed to
continue with fulfilling 32% requirement largely through export finance.
The implication in the banking sector of the country and Macro economic implications
are:
The recently released WOS guidelines provide foreign banks with the option to open new
branches, thus increasing the depth of their business in India, list on Indian exchanges and
enter into M&A with private sector banks, subject to the overall investment limit of 74%.
As per the new guidelines, foreign banks that choose to adopt the WOS model will be
permitted to enter into mergers and acquisitions with Indian banks, which may present wider
prospects for inorganic growth. However, this will be subject not only to regulatory approval
for the transaction, but also to an assessment of the overall foreign bank participation and its
success in Indian banking sector.
Foreign banks present in India prior to 2010 will have the option to subsidiarise or continue
to operate as branch. Given the macroeconomic and political condition as well as
uncertainties of global economic recovery, this must be a welcome relief.
Indian banking regulation makes it mandatory for banks to transfer parts of profits to
reserves. Repatriation of such profits to the head office requires RBI approval. Both before
and after the financial crisis, regulations have been issued under FEMA and the Banking
Regulation Act to restrict cross border movement of liquidity. These measures limit the
likelihood of free capital repatriation to parent by branches. In countries with relative ease of
capital movement, this is one of the important tenets driving the agenda on local
incorporation.
Rebalancing of global capital, greater trade interconnectivity of Asia, Africa, Australia and
the Middle East, migrating populations and geopolitical realignment are likely to lead to
changes in the foreign bank landscape in India, and the window of opportunity to grow as a

WOS may be an important strategic imperative in that context. This trend is evident from the
fact that of the 75 new bank branches granted to foreign banks since the financial crisis;
approximately 40% are new foreign bank entrants. After the financial crisis, 13 new foreign
banks have been granted licenses by the RBI, which include five Asian, four Australian and
two European banks.
India, concerns around operational and systemic risk from non-bank operators will continue
to make banks important partners to innovative technology companies for mutual benefit. The
regulatory preference for banks as better regulated and therefore safer vehicles for financial
services will continue to work for banks for the foreseeable future.
Foreign banks clearly are focusing on expansion activities in urban areas. This makes sense
because the initial amount of deposit required is also high and would not be feasible for
people in rural areas.
Over the last 20 years the number of rural branches in foreign banks have only increased to
about 15 branches (in 1995 there were 3 branches) in comparison to the private sector banks
which have more than doubled their rural branches in the same time period. However,
licenses issued by the RBI are few in number; hence it is difficult to open branches in rural
areas. This situation could be corrected if banks opt for wholly owned subsidiary structure, in
which case banks will be forced to open at least 25% branches in rural area. However they
will also be entitled to open as many branches as they like in bigger cities. Therefore the loss,
if any arising from operating rural branches can be absorbed by bigger branches in cities.
Fast paced economy: India being a developing economy offers a number of business
opportunities to banks which are present here and also for the ones who would like to enter
the Indian market. The other markets in the world have already saturated.
Indian banks: In India the banks need to go to other banks or markets in order to raise the
required money. Raising capital is a difficult problem and most foreign banks go back to
headquarters for getting money required.
Priority sector: Foreign banks have a smaller priority lending requirement of 32 percent as
against 40 percent for government sector banks. Also the sectors which are a part of the
lending sectors allowed are also different for foreign banks. Foreign banks can fulfil this
through exports, imports and do not have to lend to agricultural sector like the other banks.
IT systems are useful to speed up processes: The It development in India at a faster pace than
the other countries gives India an advantage and makes it more sought.
Conclusion
To conclude, India has a long history of welcoming foreign banks, while cautiously allowing
its expansion, keeping the countrys needs in perspective. India offers ample scope for growth
for the foreign banks in universal banking, more specifically in the highly sophisticated and
profitable markets of trade finance, investment banking, treasury banking and personal
banking. The permitted and desired structure of foreign banks is in effect as per the current
international ethos. The regulatory and supervisory approaches are, by and large, common
and non-discriminatory.

Looking at the impact of foreign banks over the years, the following characteristics have been
observed:
1) Rural presence: Foreign banks have a very small presence in rural and semi-rural
areas. Only 1 or 2 percent of the total branches of foreign banks are in rural / semirural areas. This is in contrast with the scheduled commercial banks which have
grown enormously in the rural sector (currently rural branches account for 58 percent
of their total number of branches).
2) Technological development: Foreign banks have helped in bettering the technology
used in the banking sector. The first ATM in India was brought up by HSBC and from
then on foreign banks have contributed to the latest banking practices helping them
become more efficient
3) Priority sector lending: The priority sector requirement itself is different for foreign
banks and also the percentage rates are lower for them. For banks with less than 20
branches the requirement is at 32 percent as against 40 percent for the other
nationalized banks. Also the requirement is mostly satisfied by banks by lending in
the export-import sector and not lending in sectors like agriculture which are the
actual constituents of the priority sector.
4) Return on Assets: This has clearly shown a positive trend bringing into forefront the
improvements brought across by the operational improvements through better
practices of foreign banks.
References:
http://www.iimb.ernet.in/research/sites/default/files/WP%20No.%20451.pdf
http://www.rbi.org.in/Scripts/bs_viewcontent.aspx?Id=2758
http://www.ft.com/intl/cms/s/0/65934496-032b-11e3-9a4600144feab7de.html#axzz3PuG9IPaZ
www.rbi.org.in