Functions of International Banking. .

Functions of international banking

1. UNIT 1C: Functions of International Banking

2. What is Correspondent Banking Correspondent banking refers to a banking relationship between two banks, where one bank (the “correspondent bank”) provides banking services to another bank (the “respondent bank”), allowing the respondent banks to access services in foreign markets These services can encompass banking activities such as processing international payments, managing foreign currency transactions, facilitating international trade and investment by providing a means for cross-border transactions etc. Correspondent banking transactions generally involve following steps A respondent bank receives a request from a customer to execute a transaction in a foreign currency or foreign market. The respondent bank does not have a presence or relationship in that market, so it contacts a correspondent bank that does. The correspondent bank agrees to facilitate the transaction on behalf of the respondent bank and provides the necessary services, such as processing the payment or executing the trade. The correspondent bank charges a fee for its services, usually paid by the respondent bank or passed on to the customer. Once the transaction is completed, the correspondent bank informs the respondent bank of the outcome, and the funds are settled between the two banks.

3. When do you need to use a Correspondent Bank International payments : If you need to make a payment in a foreign currency, and your bank does not offer that currency or does not have a presence in the beneficiary’s country, a correspondent bank will be needed to facilitate the payment. Trade finance : If you are involved in international trade, a correspondent bank may need to provide trade finance services, such as issuing letters of credit or providing guarantees. Foreign currency transactions : If you need to convert funds to another currency and your bank does not offer that currency, a correspondent bank may be needed to provide the foreign currency. Clearing services : The process of settling financial transactions between two or more banks, typically involving the verification of the transaction and the transfer of funds. Access to foreign markets : A correspondent bank may be necessary if you want to expand your business in a foreign market. Risk mitigation : If you want to mitigate risks associated with international transactions, such as compliance with local regulations or managing settlement risks, a correspondent bank with a presence in that market may be required.

4. Instruments Used for Making International Payment Cash in Advance – It is one of the most commonly used international payment methods. It refers to when the buyer pays the seller in full before the goods are shipped. The common ways to pay cash in advance include: Wire Transfers - This involves the buyer making a direct electronic fund transfer to the seller’s bank account, typically via SWIFT (Society for Worldwide Interbank Financial Telecommunication). Credit Cards - Credit card payments are widely accepted, especially for smaller transactions. Payment Platforms - The buyer can also make payments through online payment service providers like PayPal and Stripe. International Payment Gateways -These platforms facilitate international transactions and often support multiple currencies Pros Cons Buyer Establish a commitment to purchasing the goods The seller may fail to ship the goods Payments may be hard to recover in cases of scams or undelivered shipment Immediate effect on cash flow management Seller Eliminates the risk of non-payment Immediate access to funds that can be used for other business needs Buyers may not trust new or unfamiliar suppliers Buyers who prefer more flexible payment terms may not be interested

5. Letter of Credit - A letter of credit (LC), also known as a documentary credit, is a binding promise by a creditworthy bank on behalf of the buyer to pay the seller once the specified terms and conditions of the sales contract are met. It is one of the most secure methods of payment in international trade, as the seller can rely on the bank's trustworthiness, and the buyer does not have to pay for the goods in advance. A letter of credit is particularly useful for larger transactions or when dealing with new or unfamiliar trading partners . General steps in a letter of credit transaction: The buyer and seller agree on the terms of the sale, including price, quantity, shipping details, and payment method. The buyer applies for a letter of credit with their bank, providing transaction details. After assessing the buyer’s creditworthiness, the bank issues the LC to the seller’s bank, which will then inform the seller. The seller ships the goods according to the contract terms and prepares the necessary documents, such as a commercial invoice. The seller presents the documents confirming the shipment to their bank, which will forward them to the buyer’s bank. If the documents comply, the buyer’s bank will release the payment to the seller’s bank and forward the documents to the buyer. The buyer collects the purchased goods. Instruments Used for Making International Payment

6. Pros Cons Buyer The payment is only made after receiving the goods Protects the buyer from paying for goods that are not delivered or do not meet the specified quality standards Issuing an LC can be costly, and the buyer is responsible for covering the fees  Requires a lot of documents and can be time-consuming Seller The payment is guaranteed by the buyer’s bank, reducing the risk of outstanding invoices. Gives a competitive advantage in international markets Requires several documents and must follow a strict timeline Delays may occur if the documents are not presented correctly Instruments Used for Making International Payment Letter of Credit

7. Documentary Collection - Documentary collection is another common international payment method among traders. It involves banks acting as middlemen, exchanging shipping documents like bills of exchange (drafts) and commercial invoices to ensure the buyer gets the goods and the seller gets paid. Unlike a letter of credit, documentary collection only involves banks as intermediaries for the transaction; it does not guarantee that the buyer will pay. Documentary collection can be done in 2 ways: Pay at sight (Document against payment) Pay on a specified date (Documents against acceptance) Instruments Used for Making International Payment

8. Documents Against Payment (D/P) - In a Documents Against Payment (D/P) arrangement, the buyer can only get the shipping documents and the goods after making a full payment. However, the seller may have to deal with unclaimed goods in a foreign country if the buyer refuses to pay, as they can’t collect the goods without the shipping documents. The steps involved in a document against payment transaction are as follows: The buyer and seller agree on the sales contract, and the buyer requests a D/P from their bank. The seller ships the goods to the buyer. The seller gives the shipping documents to their bank. The seller’s bank forwards the documents to the buyer’s bank The buyer’s bank sends the documents to the buyer and requests payment. The buyer pays the buyer’s bank. The buyer’s bank releases the shipping documents to the buyer, who can use them to collect the goods. The buyer’s bank pays the seller’s bank, which then pays the seller. Instruments Used for Making International Payment

9. Documents Against Acceptance (D/A) - If a Document Against Acceptance (D/A) is arranged, the seller’s bank will instruct the buyer’s bank to release the shipping documents to the buyer once they accept a time draft to pay at a specified date. However, the seller may have to deal with unclaimed goods in a foreign country if the buyer refuses to pay, as they can’t collect the goods without the shipping documents. The steps involved in a D/A transaction are similar to those in a D/P transaction, with a difference in the timeframe of payment: The seller and buyer agree on a trade deal. The seller ships the goods to the buyer and gives the shipping document to their bank. The seller’s bank sends the shipping documents to the buyer’s bank The buyer’s bank forwards the documents and time draft to the buyer. The buyer accepts the time draft and promises to pay at the specified date. The buyer’s bank releases the documents to the buyer for shipment collection. The buyer collects the goods using the documents and pays the buyer’s bank on the due date. The collecting bank transfers the payment to the seller’s bank, which then pays the seller Instruments Used for Making International Payment

10. Pros Cons Buyer Cheaper than a letter of credit The buyer can inspect goods before making a payment with D/A Potential for delays in receiving documents Payment with D/P has to be made before the goods are inspected Seller The seller retains ownership of goods until the payment is made No guarantee of payment The seller may have to pay for the return shipment in case of cancellation Instruments Used for Making International Payment Documentary Collection

11. Open Account - Open account (O/A) is one of the common international payment methods in trade finance. However, it is also one of the riskiest for the seller. In an open account transaction, the seller (exporter) ships goods to the buyer (importer) before receiving payment that is typically due within 30, 60, or 90 days after the invoice date or delivery. The payment-after-receipt structure of an open account arrangement makes it an attractive option for many foreign buyers, offering flexibility and control in managing cash flow and working capital. Instruments Used for Making International Payment Pros Cons Buyer Payments are not due instantly Buyers can inspect the goods before making a payment Offers less protection in case the seller fails to deliver goods compared to other methods Seller Attracts more buyers and potentially increases sales and market expansion Offers flexibility for buyers who prefer not to pay upfront Less paperwork involved than letters of credit or documentary collections No guarantee that the buyer will pay within the due date Chasing unpaid invoices can be challenging and costly Delayed payment can disrupt cash flow

12. Consignment - Consignment is an international payment method in which the exporter (seller) ships goods to a foreign distributor but retains ownership and receives payment once the products are sold to the end customer. Exporting on consignment is very risky since the exporter is not guaranteed any payment. However, it helps exporters become more competitive as goods are available for sale to international customers faster. Selling on consignment also reduces the exporter’s costs of storing inventory, as the distributor is typically responsible for storing and marketing the products. Instruments Used for Making International Payment Pros Cons Buyer Allows the buyer to test the market demand before importing a larger purchase Potential for disputes over unsold goods or damaged items Seller Enables testing new markets without having upfront investment Reduces inventory holding costs High risk of non-payment if the buyer fails to sell the items Payment is not made until goods are sold to the end customer Limited control over how the goods are marketed and sold in a foreign country

13. NRI Account A Non-Resident Indian (NRI) account is a bank account opened by an NRI or a Person of Indian Origin (PIO) with a bank or financial institution authorized by the Reserve Bank of India (RBI). NRIs can use these accounts to: Keep their income or earnings safe and secure, Remit money to dependents, Fulfill financial obligations, and Make investments To open an NRI account, one must meet the following criteria: One must have been residing outside of India for at least 120 days in a year One must have spent less than 365 days in India in the previous four years There are three types of NRI Accounts that one can opt for. Non-Resident External (NRE) Account – it allows one to transfer one's foreign earnings easily to India. However, this type of account is rupee dominated and can be opened in the form of Current, Savings, Fixed or Recurring Deposits. Non- Resident Ordinary (NRO) Account – It is primarily opened for depositing rupees earned in India. Foreign Currency Non-Resident (FCNR) Accounts - it can be opened in different currencies such as US/Canadian/Australian Dollars, Sterling Pounds, Euro, Japanese Yen, etc. in the form of term deposits for various maturity period ranging between 1 year to 5 years.

14. Export Finance Export finance is funding that helps businesses sell their products or services to customers in different countries. When a seller exports goods, there are many costs involved, like manufacturing, shipping, imports, customs fees, etc. Sellers usually have to cover these costs before receiving customer payments. This is where export finance comes into play; it bridges the gap by providing the money you need to keep your business running smoothly until you get paid. Export finance allows sellers to maintain their cash flow, complete large orders, and manage possible risks like delays in payment, etc. For small and medium-sized businesses and sellers, export finance is a critical way to grow your business globally without any financial restrictions

15. Types of Export Finance Pre-shipment finance: This is offered before the products are shipped to their destination. Pre-shipment finance covers the costs of packaging, producing, manufacturing, shipping to international customers, etc. It ensures the sellers have the capital they need to complete an order even if they haven’t received payment from the buyer. Post-shipment finance: Post-shipment finance helps clear the gap when the goods have been shipped, and the sellers have to wait for the customers to make the payment. This finance helps them by funding and maintaining the cash flow while waiting for the payment. Export working capital loans: This loan helps take care of the day-to-day operations of export businesses. It provided the funds to sellers that are needed to produce and deliver goods in international marketplaces without burdening the company’s resources.

16. Types of Export Finance Letters of credit (LC): A letter of credit is a financial guarantee given by the customer’s bank to you that you will receive payment as long as the terms and conditions are completed. This letter reduces the risk of nonpayment from customers and makes international transactions safer. Export credit insurance: Nonpayment is one of the biggest concerns of international buyers. Export credit insurance protects you as a seller by covering possible losses if the buyer fails to pay because of bankruptcy, financial instability, or other issues. Forfaiting: It is helpful for more extensive and longer-term export contracts as it helps sellers receive payment upfront and pass the credit risk to the forfeiter (usually a bank or financial institution). Factoring: It allows sellers to sell their invoices to a third party at a discount. This helps sellers maintain immediate cash flow without waiting for customers to pay.

17. Commercial Banks: They are the most common source of export finance, with a wide range of services like pre-shipment and post-shipment finance, and letters of credit. Export Credit Agencies (ECAs): ECAs are institutions backed by the government to support exporters by dissolving the risks involved in international trade. They provide export credit insurance, guarantees, and direct loans while reducing the potential risks of nonpayment due to market instabilities. Development Banks (DB): DBs, such as ADB/World Bank, focus on funding long-term projects with low-cost finance in emerging markets Trade Finance Companies (TFC): These companies focus on the unique needs of exporters and offer services like factoring, forfeiting, and exporting working capital. TFCs are quick and adaptable in financing exporters who need alternative to bank funding. Government Grants and Subsidies: Many governments provide grants/ subsidies/incentives and funding for market research, travel to international markets, promotional activities etc. to boost exports. Who Provides Export Finance

18. Once an order from an international buyer/customer, exporter will need money to fulfil it, like producing products, buying raw materials, packaging, etc. Exporter approaches a bank/financial institution/export credit agency to apply for export finance based on order details and financial details. After reviewing application, the lender approves it and grant export finance. Thereafter it provide exporter access to the money as per the contract. Exporter starts production of goods with the money, ship them to international buyer/customer, and provide international shipping documents to the lender. The international buyer/customer receives the shipment and pays the exporter as per the terms they agreed on. When exporter receives the payment, he uses that money to repay the export finance to the lender. How Does Export Finance Function

19. Import finance is a type of trade finance that provides funding for the purchase of goods from another country. It helps importers pay for the costs associated with importing goods, such as tariffs, duties, and freight rates Without import finance, the ability of companies to trade and engage in business would be severely restricted. Import finance offers a number of critical benefits: Optimises cash flow and access to working capital when needed. Mitigates risk in importing Flexible timelines for repayment. Prompt payment of invoices from suppliers Helps in establishing strong, trusting business relationships. Helps in creating efficient supply chain operations Import Finance

20. Types of Import Finance Letter of Credit (LC) : LC can be defined as a commitment by a bank to pay the exporter of goods/services when he presents the documents evidencing the shipment of goods or the performance of service to the importer. LC is an essential instrument for conducting international trade today. Usance letter of credit allows the importer to delay payment, giving them more time to inspect and sell the goods. Standby letter of credit is a guarantee of payment to the exporter, which helps avoid the risk of default Bank Guarantee (BG) : A bank issues a guarantee that the importer will pay the exporter. Invoice Finance/Factoring (IF) : IF allows businesses to sell their accounts receivable (i.e., invoices that have yet to be paid) and receive a specified percentage of the amount of the invoices in advance. Import Loans : A loan that helps the importer purchase goods Asset-based lending: A type of loan that uses importer’s assets as collateral

21. International Merchant Banking (IMB) In India IMB refers to financial institutions that provide specialized services like capital raising, mergers and acquisitions advisory, and underwriting to large corporations, often with a focus on facilitating cross-border transactions, while operating within the Indian market Essentially, they act as a bridge between Indian companies and international investors, assisting them in accessing global capital markets The merchant banks and investment banks are quite similar but there is a subtle difference as well. While both facilitate capital raising, merchant banks usually focus on smaller, more niche clientele with tailored advisory services and have a more localized presence, whereas investment banks often deal with large-scale transactions for major corporations and government and have a global reach with operations in multiple markets Some prominent International Merchant Banks operating in India are Kotak Mahindra Capital, Axis Capital, JM Financial, ICICI Securities, SBI Capital Markets, Morgan Stanley India, Goldman Sachs India etc. Merchant banks have to obtain a certificate of registration from Securities and Exchange Board of India (SEBI). to operate in India.

22. Functions of International Merchant Banking (IMB) Corporate Advisory Services : Merchant banks provide strategic advice on mergers, acquisitions, and corporate restructuring. They assist companies in identifying potential acquisition targets, negotiating deals, and navigating the complex regulatory landscape ensuring successful transactions. Issue Management : They help companies raise capital by managing the process of issuing shares or debentures. This includes preparing prospectus, liaising with regulatory authorities, and ensuring compliance with legal requirements. Merchant banks also play a critical role in marketing the issue to potential investors, ensuring its success. Underwriting of Shares : Underwriting services involve guaranteeing the subscription of a company's shares in case of undersubscription. This means they buy any unsold shares. Loan Syndication : Arranging large loans by collaborating with multiple financial institutions to meet the funding requirements of corporate clients. Portfolio Management : Offering investment management services to clients, merchant banks help optimize their investment portfolios. By leveraging their market insights and analytical skills, merchant banks maximize client’s return on investment. Leasing Services : They provide leasing services to companies in the form of capital goods, vehicles and office equipment. This helps to reduce the overall financial burden of the companies.

23. Merchant Banking Vs Investment banking Feature Merchant bank Investment Bank Focus International finance, business loans for companies, and underwriting Underwriting and issuance of securities on behalf of large corporations Clients Small and medium-sized businesses, high-net-worth individuals, and family offices Large corporations and government entities Services Underwriting, debt and equity securities issuance, mergers and acquisitions (M&A), project finance, trade finance, leasing, and advisory services Large and cross border mergers and acquisitions (M&A), sell parts of company’s business, underwriting, private placement, initial public offering (IPO) management, debt and equity securities issuance, and financial restructuring Risk appetite Higher risk appetite since they deal with smaller businesses Lower risk appetite, generally not open to doing business with riskier, high-growth businesses Income model Fee-based Commission-based

24. Financing Project Exports A project financing for export refers to a financial structure used to fund large-scale overseas projects, where the project's future cash flows are the primary source of repayment, rather than relying on the creditworthiness of the exporting company. It is a method of financing that uses a nonrecourse or limited-recourse financial structure. In project finance, the loan structure relies primarily on the project's cash flow for repayment, with the project's assets, rights, and interests serving as secondary collateral. This method is particularly beneficial for projects with long construction periods and complex contractual arrangements, providing access to substantial funding for exporters seeking to secure major international contracts. A separate legal entity is created specifically for the project, isolating the project's assets and cash flows from the exporting company, allowing lenders to assess the project's viability based on its own merits. Financing Sources: Export Credit Agencies (ECAs): Government-backed institutions that provide loans, guarantees, and insurance to support export projects, often offering competitive interest rates and longer tenors. Commercial Banks: Provide financing for project development and construction phases, particularly when complemented by ECA support. Private Equity: Invest in project equity, especially for high-risk, high-potential projects.

25. Financing Project Exports Types of project export finance: Pre-shipment finance: Provides funds to purchase raw materials, process them into final products, and package them Post-shipment finance: Provides funds after the goods have been shipped Export credit insurance: Protects the exporter against non-payment by overseas buyers Commodity financing: Funds the production, transportation, and sale of commodities Benefits of Project Financing for Export Access to Large Capital: Enables companies to secure funding for large, complex projects that might be beyond their traditional credit lines. Reduced Risk for Lenders: By relying on project cash flows, lenders can mitigate risks associated with the exporting company's overall financial health. Market Expansion: Opens up new export opportunities in markets where traditional trade finance might be limited. Economic Development: Can contribute to infrastructure development and economic growth in the host country.

26. Derivative Offering Derivative is a financial contract between two or more parties whose value is based on an underlying asset, such as stocks, bonds, commodities, currencies, interest rates or a group of assets, or a benchmark. Derivative trading has emerged as a powerful tool, offering investors a strategic way to buy and sell assets for future dates. Value of derivatives depends on changes in the prices of the underlying asset Derivatives can be traded on an exchange or over the counter. Derivatives are used to hedge, speculate on the directional movement of an underlying asset, or leverage a position. There are 4 types of derivative: Forward contracts Futures contracts Options contracts Swap contracts

27. Derivative Offering Futures contracts : A futures contract, or simply futures, is an agreement between two parties for the purchase and delivery of an asset at an agreed-upon price at a future date. Futures are standardized contracts that trade on an exchange. Traders use futures to hedge their risk or speculate on the price of an underlying asset. The parties involved are obligated to fulfill a commitment to buy or sell the underlying asset. Forward contracts : Forward contracts, or forwards, are similar to futures, but they do not trade on an exchange. These contracts only trade over the counter. When a forward contract is created, the buyer and seller may customize the terms, size, and settlement process. As OTC products, forward contracts carry a greater degree of counterparty risk. Counterparty risks are a type of credit risk where the parties involved may fail to deliver on the obligations outlined in the contract. Options contracts : An options contract is similar to a futures contract in that it is an agreement between two parties to buy or sell an asset at a predetermined future date for a specific price. The key difference between options and futures is that with an option, the buyer is not obliged to exercise their agreement to buy or sell. It is an opportunity only, not an obligation, as futures are. As with futures, options may be used to hedge or speculate on the price of the underlying asset. An American-style option allows holders to exercise the option rights anytime before and including the day of expiration. A European-style option can be executed only on the day of expiration. Swap contracts : Swaps are another common type of derivatives, often used to exchange one kind of cash flow for another. For example, a trader might use an interest rate swap to switch from a variable interest rate loan to a fixed-interest-rate loan, or vice versa.

28. How Swap Contracts Work? Let us assume that a Company Blue Horizon (BH) borrows INR 1000 at a variable interest rate currently at 6% from New Bank. BH may be concerned about rising interest rates that will increase the costs of this loan or encounter a lender that is reluctant to extend more credit while the company has this variable-rate risk. Let us assume BH creates a swap with Company Quant Financial Services (QSF) which is willing to swap the payments of BH at variable 6% for the payments on a fixed-rate of 7%. This means that BH will pay 7% to QSF on its INR1,000 principal and QSF will pay BH 6% interest on the same principal. At the beginning of the swap, BH will just pay QSF the 1-percentage-point difference between the two swap rates. If interest rates fall so that the variable rate on the original loan is now 5%, Company BH will have to pay Company QSF 2-percentage-point difference on the loan. If interest rates rise to 8%, then QSF would have to pay BH the 1-percentage-point difference between the two swap rates. Regardless of how interest rates change, the swap has ensured that BH’s original objective of turning a variable-rate loan into a fixed-rate loan has been achieved.

29. Remittances People who move to a different country to find work often send money back to their families and community. The movement of funds from the country of work back to a home country is known as remittances. They are targeted to meet specific needs of the recipients and thus tend to reduce poverty. Cross-country analyses generally find that remittances have reduced the share of poor people in the population They have been growing rapidly in the past few years and now represent the largest source of foreign income for many developing countries. In 2023, remittances back to home countries totaled about USD 656 billion. In more than 60 countries, remittances account for 3% or more of the GDP. Remittance flows tend to be more stable than capital flows, and they also tend to be countercyclical—increasing during economic downturns or after a natural disaster in the migrants’ home countries, when private capital flows tend to decrease.

30. Costs Associated with Remittances There are a number of potential costs associated with remittances Transaction costs are not usually an issue for large remittances (those made for the purpose of trade, investment, or aid), because, as a percentage of the principal amount, they tend to be small, and major international banks are eager to offer competitive services for large-value remittances. But for smaller remittances—under $200, say, which is often typical for poor migrants—remittance fees typically average 10 percent, and can be as high as 15–20 percent of the principal in smaller migration corridors. For example, in Australia–Papua New Guinea corridor. Money transfer operators charge 15.3% of the principal and banks charge 18.1%. However, for the UK-India corridor transfer operators charge 2.5% of the principal and banks charge 5.0%. Countries that receive remittances from migrants incur costs if the emigrating workers are highly skilled or if their departure creates labor shortages If remittances are large, the recipient country could face an appreciation of the real exchange rate that may make its economy less competitive internationally. Remittances can also create dependency

31. Remittances - India

32. Remittances – India and China