INTL 401 International Finance & Banking

The International Banking and Finance Project

Part 1

Submitted to:

Professor Green

Prepared by:

Natalia Doronina #300695375

Oleksandr Zaviriukha # 300686394

Maxim Gromyko #300693987

Short summary of the country:

The United Kingdom is one of the strongest economies in Europe and also part of the

European Union (EU). The national currency is British pound sterling, which is considered as

one of the strongest currencies in the world. The UK as well as Sweden and Denmark have not

joined the EMU (European Monetary Union), they saved their currency because these countries

did not want to experience the impact of other unstable economic countries on their currency.

“UK importers and exporters have learnt to trade in the euro as a matter of routine, and the City

of London retains its domination of financial markets despite fears that the centre of gravity

would move to Frankfurt”.1

From the export perspective, the most important partner for the UK is EU because this

partnership takes around two-third of the UK trades on the foreign markets. The situation has

significantly changed since 1972 – the date when Great Britain became a member of EU, where

before the export had been oriented on the former colonies beyond the Eurozone.

The inflation level in the UK is quite low – around 3,5%; “CPI inflation stood at 3.5% in

March 2012, down from a peak of 5.2% in September 2011. That fall reflected the effects of

earlier increases in energy prices and VAT dropping out of the twelve-month inflation rate. The

prospects for inflation are uncertain. The near-term outlook is judged to be somewhat higher

than expected three months ago, with inflation now likely to remain above the 2% target for the

next year or so”2.

The present system of reserve ratio for commercial banks is based on the voluntary base, in

other words the bank can make a decision about its reserves independently. ”The reserves

scheme is voluntary and members undertake to hold a particular target balance not every day but

on average over a monthly "maintenance period".”3 Also there are some flexible mechanisms

that allow banks to borrow or deposit money with rates that are usually 1% lower or higher the

official course of the bank.

1 Investors Guide to the UK, Consultant Editor Jonathan Reuvid; Kogan Page, London, 2005, p.62 The bank of England, overview of inflation report, May 2012; http://www.bankofengland.co.uk/Pages/home.aspx3 The bank of England, http://www.bankofengland.co.uk/Pages/home.

Bank of England

The Bank of England is the central bank of the Great Britain. It’s called among common

people as 'Old Lady' of Threadneedle Street. The Bank was founded in 1694; on 1 March 1946 it

was privatized by British Government, and became independent again in 1997. The Bank is the

centre of the UK's financial system; the Bank’s main functions are developing and maintaining

monetary and financial stability as its contribution to the British economy.

The Bank does this work through the personal risk of assessment and risk of the reduction

of work, market intelligence functions, payments systems, banking and market operations as

well.

The Bank's roles and functions have been changing through whole bank’s history. Since its

foundation, it has been the Government's banker, than it has been banker to the banking system

for the whole century, it means in more general sense - the bankers' bank. Nowadays, The Bank

of England is providing banking services to its customers and manages the UK's foreign

exchange and gold reserves.

As we mentioned before The Bank has two main functions - monetary stability and

financial stability. The Bank of England is visible to the common public through its banknotes

and its interest rate decisions. The Bank of England has had a monopoly on the issue of

banknotes in England and Wales since the early 20th century, as a part of its functional

maintenance. However, the responsibility for national interest rate The Bank got just in 1997.

“Interest rate decisions are taken by the Bank's Monetary Policy Committee. The MPC has

to judge what interest rate is necessary to meet a target for overall inflation in the economy. The

inflation target is set each year by the Chancellor of the Exchequer. The Bank implements its

interest rate decisions through its financial market operations - it sets the interest rate at which

the Bank lends to banks and other financial institutions.” 4

The Bank has tight connections with financial markets and institutions. These contacts

inform and help to protect its financial stability role the publication of monetary and banking

statistics.

“The Bank of England is committed to increasing awareness and understanding of its

activities and responsibilities, across both general and specialist audiences alike. It produces a

large number of regular and ad hoc publications on key aspects of its work and offers a range of

4 The bank of England; http://www.bankofengland.co.uk/about/Pages/default.aspx

educational materials. The Bank offers technical assistance and advice to other central banks

through its Centre for Central Banking Studies, and has a museum at its premises in

Threadneedle Street in the City of London, open to members of the public free of charge.”5

In 2010 the Government highlighted a plan for reform of the UK regulatory framework,

including the creation of an independent Financial Policy Committee at the Bank of England.

Reasons and measures of dealing with financial crisis.

The House of Commons Treasury Committee in the ninth report for session 2008-2009 has

suggested several reasons for UK bank system failures during the financial crisis.

1. Remuneration in the banking sector. The heads of largest banks in UK shared

with information about salaries and bonuses for CEO in the banks. Bonuses were primary

distributed in the investment sector activity. “Bonus-driven remuneration structures encouraged

reckless and executive risk-taking and that the design of bonus schemes was not aligned with the

interests of shareholders and the long-term sustainability of the banks.”6 In order to solve this

problem The House of Commons Treasury Committee proposed several reforms that include: a)

“disclosure requirements on firms about their remuneration structures and about remuneration

below board-level”; b) make the remuneration policies more transparent; c) “ a Code of Ethics

for remuneration consultants”.7

2. Corporate governance. The core of the problem in this aspect is in that senior

management instead of monitoring bank activities non-executives overwhelmed CEO with their

obligations. The way suggested to solve this problem is to establish stronger connection and

better cooperation between directors and shareholders.

3. Credit rating agencies. The core of this problem lays in the “conflict of interests

faced by credit rating agencies8”.

5Bank of England http://www.bankofengland.co.uk/about/Pages/default.aspx6 Banking Crisis: reforming corporate governance and pay in the City - Treasury Contents, p.37 Banking Crisis: reforming corporate governance and pay in the City - Treasury Contents, p. 48 Banking Crisis: reforming corporate governance and pay in the City - Treasury Contents, p. 8

4. Auditors. The problem with auditing was about inability to find features of future

failures, this fact questions all competence of auditing agencies. The solution can be found in

providing banks easier access to bank activities information.

5. Fair value accounting. Fair value accounting often pushes banks and other

institutions to publish more information that affects decision of market participants. “The

uncomfortable truth for banks is that market participants had overinflated asset prices which

have subsequently corrected dramatically”9. The solution could be changes in EU accounting

standards.

6. The role of the media. The market participants’ and savers’ decisions are very

sensitive to any market oscillations. In critical moments it is important for banks to save their

depositors. In this report the benefits of bank transparency were questioned because in short term

situations it leads to loss of investors and bank can be in worse situation without their money in

crisis atmosphere.

HSBC regional distribution and performance.

Europe

“After growing by 2.1% in 2010, UK gross domestic product (‘GDP’) growth eased to

0.9% in 2011. The unemployment rate rose to 8.4% in December 2011. Despite the weakness in

the domestic economy, an increase in the rate of value added tax and rising oil prices early in the

year pushed the annual rate of consumer price index (‘CPI’) inflation to 5.2% in September 2011

before moderating to 3.6% in December 2011. The Bank of England maintained the Bank Rate

at 0.5% throughout the year and expanded the size of its Asset Purchase Programme by Ј75bn

(US$120bn) to Ј275bn (US$440bn) in October 2011.” 10

The Eurozone economy grew only by 1.5% in 2011, after the first steps of a recovery in

global trade in the first half of 2011 and domestic fixed investment growth. Within the region,

9 Banking Crisis: reforming corporate governance and pay in the City - Treasury Contents, p. 510 “Connecting customers to opportunities”, Annual reports and accounts 2011, HSBC Holding Group

Germany and France saw the strongest recovery with GDP growing by 3% and 1,8%

respectively. The German unemployment rate, as measured by the International Labour

Organization, fell during the year, pointing the rate of 5.5% in December but, for the Eurozone in

general, unemployment rose further to 10.4% in December; first of all because of Spain, Greece

and Portugal.

As we can observe from the table HSBC bank loses its profits throughout the Europe

except domestic market of UK.

HSBC European operations reported a pre-tax profit of US$4.7 bln., 9% higher than in

2010. “These results included favorable fair value movements of US$2.9bn in 2011 due to the

change in credit spreads on the Group’s own debt held at fair value, compared with adverse fair

value movements of US$198m in 201011”.

11 “Connecting customers to opportunities”, Annual reports and accounts 2011, HSBC Holding Group

Hong-Kong

Hong Kong showed very strong economic growth entering 2011. This was maintained

during the course of the year due to supply chain disruptions occurred with the earthquake in

Japan and some slowing in demand and GDP growth from mainland China following a

tightening of policy to stop an inflation. Eventually, Hong Kong GDP grew by 5% in 2011.

HSBC operations in Hong Kong reported pre-tax profits of US$5.8 bln. compared with

US$5.7 bln. in 2010, an increase of 2%. The profit level in Hong-Kong is one of the highest for

HSBS. It grew on 800 million in 2 years and now almost twice as big as the profit from operating

in U.K.

Asia

In mainland China the annual rate of inflation was at 6.5% in July and dropped to around

4% by the year end. Furthermore, the annual pace of GDP growth slowed from 9.7% in the first

quarter to 8.9% in the fourth quarter, bringing the full year GDP growth down to 9.2% in 2011

from 10.4% in 2010 and is going to fall at least in on 2 percent in the nearest two years.

Japan’s economy began 2011 strongly in compare with the previous rates, but the

earthquake and tsunami in March led to a sharp fall and decrease in growth. Japan continued to

suffer from recession consequences, leading the Bank of Japan to expand its quantitative easing

program.

“The Rest of Asia-Pacific region experienced a relatively strong first half, with exports and

domestic demand growing robustly, following which growth slowed in the latter months of 2011.

The highly trade-dependent economies of South Korea, Taiwan and Singapore experienced the

most significant decline in activity. In a number of economies, notably India and South Korea,

domestic demand also slowed markedly in the second half of 2011 after rising inflationary

pressures prompted central banks to tighten monetary policy.”12

12 “Connecting customers to opportunities”, Annual reports and accounts 2011, HSBC Holding Group

The Asia-Pacific region faces a constant growth in profits. Especially it concerns China,

which is as profitable for nowadays for HSBC as U.K., and Australia.

HSBC operations in the rest of Asia-Pacific region reported pre-tax profits of US$7.5 bln.

compared with US$5.9 bln. in 2010, an increase of 27% as we can observe from the table above.

The growth in profitability in the region reflected strong lending and deposit growth during 2010

and 2011, mainly in Singapore and mainland China as well as in India.

Middle East and Africa

In the Middle East and North Africa region, GDP grew by more than 5% in 2011, which is

less than average in Pacific ad South Asia, but still higher than in Europe and Americas. In the

oil producing states of the Persian Gulf, high oil prices prompted growth in oil output and

encouraged increases in capital spending and economic growth, mostly in Saudi Arabia.

The export-oriented service sectors of countries including the UAE also grew greatly, this

high rate was supported by the high Asian demand.

As we can observe, Middle East is becoming highly profitable region for HSBC. Countries

of MENA and UAE increased their activity and purchasing services from HSBC bank in 5 times

in two years.

HSBC operations in the Middle East and North Africa reported a profit before tax of

US$1.5 billion, an increase of US$600m, or 67%. In 2011, HSBC recorded a gain of US$27 mil.

as a result of the reduction of the holding in HSBC Saudi Arabia Limited following its merger

with SABB Securities Limited.

North America

In the US, GDP was measured by 3.0% in 2010 and the implementation of simulative tax

policies at the end of that year promised an even faster rate of growth in 2011. However, this

failed to become true for a number of reasons. As a result, GDP rose by only 1.7% in 2011.

“ US headline inflation increased during 2011 with the annual rate of CPI inflation rising to

3.1% compared with 1.7% in 2010, but core inflation remained subdued. The unemployment rate

fell to 8.5% in December 2011, down from 9.6% in 2010, but much of the decline can be

attributed to a fall in labour force participation. “13

The annual rate of GDP growth in Canada lowered in 2011 to 2.4% from 3.2% in 2010.

The problems with the economic growth in the US and problems with our European partners

have slowed the economic growth in Canada. As a result, we are facing lower creation of jobs

and a bit higher unemployment rate.

HSBC lost its position in USA after the crisis in 2008, as well as the most profitable

country which used to give a profit as big, as the all other countries. Now it is lower in 8 times.

HSBC operations in North America reported a profit before tax of only US$100 mil in

2011, compared with US$7,738m in 2009, a decrease of 778%. Reported profits included

favourable movements on HSBC own debt designated at fair value of US$970 mil. resulting

from changes in credit spreads. On an underlying basis, which excludes the above, HSBC

reported a pre-tax loss of US$870 mil. in 2011 compared with a profit before tax of US$285 mil.

in 2010.

Latin America

Brazil has badly surprised in 2011, it’s economic and GDP growth became very low as for

the BRIC country – just 3%. By the end of 2011 inflation had fallen to 6.5% after being at

around 7.5% in June. This allowed the government to reverse lots of the policy restrictions

implemented in early 2011.

“Mexico’s economy was shows higher rate of growth in 2011; however export growth

depends of lower external demand and still lower than it was expected. Though, domestic

demand continued to grow, reflecting the greater availability of credit and a constant reduction of

unemployment rate. GDP grew to rate of 3.9% in 2011. The annual rate of CPI inflation rose at

the end of 2011 to 3.8%.”13

In Argentina in 2011 real GDP increased by 9.4% compared with the same period in 2010,

mostly from increases in consumption of 11.3% and in gross fixed investment of 19.9%. The

annual rate of CPI inflation stayed high and the GDP deflator rate of inflation accelerated to

16.4%

In Latin America, HSBC operations reported a profit before tax of US$2.3 bln. in 2011, an

increase of 29% compared with 2010. This was contributed by strong growth in lending balances

in our CMB and RBWM businesses in Brazil, which reflected the positive economic

13 “Connecting customers to opportunities”, Annual reports and accounts 2011, HSBC Holding Group.

environment. Improved revenue in GB&M arose from higher income from foreign exchange,

while growth in insurance revenue followed an increase in HSBC sales force.

This diagram shows the whole amount of 80 representatives in the world and the allocation

between the different regions. The biggest amount is in the Asian countries.

Europe – 21; Middle East and Africa – 12; Asia – 26; North America, Latin America – 21

Performance.14

14 Financial Service UK Banks Performance Benchmarking Report HY Results 2011

Reference: Financial Service UK Banks Performance Benchmarking Report HY Results 2011

HCBS’s profit performance is relies on reductions in impairment charges (a total £4

billion reduction compared to June 2010) due to more stable economic conditions in the UK and

US. Moreover, HSBC* bank continue to benefit from geographic variation, with the Asian

markets being a key contributor to profits.

As for net interest margins so it remained under pressure with a reversal of the increases

experienced from the first half to the second half of 2010. This was due to competitive deposit

markets making rates up, higher funding costs, shifting of lending books and replacement of

government debt with more expensive wholesale funding. Unfortunately, HSBC* bank

experienced a decline in net interest margin in the second half of 2010.

“Net interest margin is a performance metric that examines how successful a firm's

investment decisions are compared to its debt situations. A negative value denotes that the firm

did not make an optimal decision, because interest expenses were greater than the amount of

returns generated by investments.

”

Reference: http://www.answers.com/topic/net-interest-margin-1

Total assets

“An asset is anything the company owns that is expected to provide future benefits.

Assets may be tangible and intangible. Current assets include cash, as well as other items that are

expected to be turned into cash in less than one year. Regular expenses that have been prepaid

with cash are also current assets. Long term assets are last longer than 1 year.”

Reference: Financial Management For Decision Makers, Second Canadian Edition,

Peter Atrill and Paul Hurley.

This graph shows an increase in total assets for HSBC bank in billion GBP which

targeted growth in lending compared with decrease at RBS and Lloyds banks due to the

continued overflow of loan portfolios during the period from 2009 till 2011.

Impairment cover

HSBC continue to have the highest impairment coverage ratio of the bank.

This graph shows an increase in HSBC’s impairment coverage by 66 basis points from

72.1 percent as at 31 December 2010 to 72.7 percent.

Funding and liquidity

“Liquidity ratios are concerned with the ability of the business to meet its short-term

financial obligations.”

Reference: Financial Management For Decision Makers, Second Canadian Edition,

Peter Atrill and Paul Hurley.

HSBC* continue to be with the lowest loans to deposits ratios, which has been relatively

stable at just under 80 percent, with growth in lending broadly being matched by new customer

deposits. Furthermore, HSBC* has also been ambitious in refinancing wholesale funding in

advance of due dates as well as increasing the maturity profile. Therefore, term funding was

issued HSBC ($18 billion).

Overall, HSBC* can be expected to hold areas of critical focus for the predictable future

as funding and liquidity have continued to improve, whereas all banks build liquidity buffers and

the required infrastructure to ensure compliance with the FSA Liquidity Regime.

Reference: UK Banks: Performance Benchmarking Report | Half Year Results 2011

Financial summary of the balance statements of the 2009, 2008, 2010

Total assets 874,804 864,254 780,723

Profitability.

As we can observe HSBC lost it’s profit growth because of 2008 crisis. After the crisis the profit

after tax became lower on 500 millions of pounds. The profitability of the bank in the 2010 has

lowered on seventh part of the amount of 2008.

_________________________

“Connecting customers to opportunities”, Annual reports and accounts 2010, HSBC Holding Group

Liquidity.

The liquidity of the bank increases, because of higher measures of cash and interest

earnings which means that there are more assets that can be easily converted into cash.

Growth by the assets.

The assets rate has grown on 95 millions of pounds from in 2010 after 2008. In the same

time biggest part of this amount was rich in 2009, which means that a bank has a problem in

growing by assets in last years.

Capitalization.

The capitalization rate grows through the years, pretty slowly starting from 2009, though.

The slowest growth was in 2010.

Balance sheet, HSBC Holding, December 31, 2011, £m

Assets

Cash and balances at central banks 83,917Items in the course of collection from other banks 5,302Hong Kong Government certificates of indebtedness 13,156Trading assets 213,471Financial assets designed at fair value 19,933Derivatives 223,761Loans and advances to banks 116,918Loans and advances to customers 607,517Financial investments 258,428Assets held for sale 25,554Other assets 31,460Current tax assets 685Payments and accrued income 6,498Interest in associates and joint ventures 13,178Good will and intangible assets 18,756Property, plant and equipment 7,019Differed tax assets 4,991

Total assets: 1,650,904

Liabilities

Hong Kong currency notes in circulation 13,516Deposits by banks 72,883Customer accounts 810,036Items in the course of transaction to other banks 5,649Trading liabilities 171,314Financial liabilities designated by fair value 55,378Derivatives 223,115Debt securities in issue 84,634Liabilities of disposal groups held for sale 14,341Other liabilities 18,068Current tax liabilities 1,368Liabilities under insurance contracts 39,573Accruals and deferred income 8,466Provisions 2,147Deferred tax liabilities 981Retirement benefit liabilities 2,368Subordinated liabilities 19,771Total liabilities 1,543,606

Equity

Called up share capital 5,771Share premium account 5,463Other equity instruments 3,780Other reserves 15,255Retained earnings 72,267Total shareholders’ equity 102,536Non-controlling interests 4,760Total equity 107,296

Total equity and liabilities 1,650,904

Task #1, currency trading operations.

The problem: Sell to the Finnish Bank (primary currency is Euro) 60 million GBP.

1. When it comes to trading operations the first thing that we covert the amount of money in GBP into euros; 1EUR = 0.799846 GBP. Then we need to negotiate the rate of selling to the different bank; at the moment of selling operation the rate that we achieved in the negotiations – 1.5993% sterling to euro. Thereby:

£60,000,000 = €75,014,273.25€ (at May 17, 2012)

€75,014,273.25 × (1+ 0.015993) = €76,183,745.77

Therefore, profit from the operation is: €76,183,745.77 - €75,014,273.25 = €1,169,472.52 which is in pounds: €1,169,472.52 × 0.799846 = £935,397.92 or 0.9354 million

2. There is decrease in assets (the most liquid assets) in 60 million, so it should be decrease in liabilities (trading liabilities) at the same amount.

The most liquid assets are the sum of the first four balance accounts. After changes the balance sheet will look like this:

All changes we need to show in the balance sheet.

Assets:

83,917 Total:316,8455,302

13,156213,471

Most Liquid Assets 315, 845 - 60 =315,785Financial assets designed at fair value 19,933Derivatives (acquisition) 223,761 + 60 + 0.9354 = 223,821.9345Loans and advances to banks 116,918Loans and advances to customers 607,517Financial investments 258,428Assets held for sale 25,554Other assets 31,460Current tax assets 685Payments and accrued income 6,498Interest in associates and joint ventures 13,178Good will and intangible assets 18,756Property, plant and equipment 7,019Differed tax assets 4,991

Total assets: 1,650,904 + 0.9354 = 1,650,904.9354

Equity

Called up share capital 5,771Share premium account 5,463Other equity instruments 3,780Other reserves 15,255 + 0.9354 = 15,255.9354Retained earnings 72,267Total shareholders’ equity 102,536Non-controlling interests 4,760Total equity 107,296

Total equity and liabilities 1,650,904 + 0.9354 = 1,650,904.9354

Task #2 forward transactions

UK rate = 5%; Sweden rate = 3% => UK would be treated with discounts; Sweden would be

treated with premium.

We need to sell to the Sweden 70 million GBP. 1 GBP = 11.16 SEK; sell 3m £ forward 3

months. 1 SEK = 0.1424 GBP => difference between currencies is

First step: to find the discount, which is calculated by (Spot rate + forward rate)/ spot rate ×

12/N; With 5% UK rate and 3% in Sweden => (11.16 + 10.7136)/11.16 = 1,96 × 12/3 = 7,84%

or 0.078 – Discount

Second step: The GBP is inverted currency; thereby we have to subtract the discount from

the currency rate: 11.16 × (1 – 0,078) = 10.2895 GBP/SEK

Third step: calculate the result

3,000,000 £ = 30,868,500 SEK will be sold with forward rate, where Swedish Krona will

be appreciated to the British Pound.