18 Oct 2016

The Evolution of International Banking, the Impact of The Euro and the Likely Impact of Brexit

The Evolution of International Banking, the Impact of The Euro and the Likely Impact of Brexit

By Richard Bottomley

During the summer months, I was able to spend some quality time with graduate recruits, all aspiring to be the coverage bankers and transaction banking experts of the future. I believe it is worthwhile to record the issues they raised and some of the discussions we had during that time.

The Bedrock: Domestic Banking

Once upon a time, banking used to be a domestic activity. In these good old days, banks largely (sometimes exclusively) serviced their own domestic market places. The accounts of the banks themselves were safely housed within their own Central Banks. The banks’ Clients held their own bank accounts at “home”, within their own financial centre (for each currency), domestic clearing and settlement systems efficiently processed domestic payables and receivables (from cash, to cards, to wire transfers) and domestic single currency liquidity solutions offered Clients robust opportunities to optimise their overall cash positions. “Cash is King, I used to be taught.” “Richard, 98 % of companies go bust because they run out of cash, not because they are unprofitable.”

In the 1970s and 1980s, cash management became a vibrant domestic specialisation and the role of the Corporate Treasurer morphed from the Finance Department into a specialist role, so as to ensure each company was able to “meet the obligations of the company as and when they fall due”, still to this day a primary role of the Corporate Treasurer.

Domestic banking capabilities and activities form the bedrock of the banking market place and still dominate the transaction volumes of banking as a whole.

Where is the Real Money?

Whether we are talking about my personal account, or the accounts of a large company or institution, our real money is represented by a computer entry in the books of bank ABC, or bank XYZ. Bank ABC and bank XYZ both hold their domestic currency account with their own Central Bank. So when a client of bank ABC pays a client of bank XYZ, then bank ABC’s account at the Central bank is debited and bank XYZ’s account is credited, resulting (at the moment of settlement) in something called “Finality”, when the real value exchanges hands.  In reality, the money never really leaves the Central Bank. Everything else is just a series of book entries. These principles help me to lead on to explain the workings of international banking.

The Evolution of International Banking

In the 1970s/1980s, “trade” instruments were becoming expensive and international trade was growing rapidly. As both sellers and buyers expanded internationally, the cost of trade instruments was becoming prohibitive.  Both sellers and buyers wished to move to “open account” settlement, particularly with counter-parties they trusted, having traded with each party for a growing number of years. Cash based Foreign Currency Accounts (FCAs) increased in number rapidly, initially still in the “home” financial centre of the companies concerned, to facilitate foreign currency payables and receivables. However, these payables and receivables were still made on a cross-border basis, with cross-border access to the clearing and settlement systems for the currencies concerned, all based upon washing funds through the “nostro” accounts of bank ABC, XYZ.

These latter accounts were held either directly with the Central Bank in the country/currency concerned, or with “Correspondents”, a chosen partner bank in each financial centre. As cash payments grew and grew, as international trade activity grew and as more traditional Trade instruments became less and less popular, the incidence of these FCA based solutions also grew. Time zones impacted heavily on solutions of this nature and “cut-off” times within both financial centres were key drivers behind services of this nature.

Now, the cost of cross-border wire payments also became prohibitive and both banks and Cients sought to re-locate these FCAs from the “home” financial centre, to the appropriate financial centre for the currency concerned, what we used to call “away”.  This logical next step gave Clients in-border access to clearing and settlement systems, in-border payables and receivables and in-border single currency liquidity solutions for the currencies concerned.

I hear you ask “and where is the real money behind all of these transactions?”

The answer my friends is that the real money is always with the Central Bank for the currency concerned, because International Banking is 100 % based upon the Domestic Banking principles described above.

So, the saying “all US Dollars are in New York” is 100 % correct. No matter where you are told your US Dollar account is based, the actual dollars are in a bank’s account in New York City and their account is with The Federal Reserve Bank (FRB), thus proving the theory.

Technology and connectivity.

I won’t spend much time in this part of the journey, particularly as, unlike some of my colleagues in Moneta I am not really known as an expert in this field.  Suffice it to say that with one bank domestically with a fully functional domestic banking based “electronic banking system”, built upon and operating to single country domestic formats, is a much more simple solution to provide than those involving multiple currencies, in multiple locations, possibly with more than one bank involved.

Indeed, there was a time when multiple bank systems/platforms were a common sight within a Corporate Treasury Department. Through the passage of time, a few global banks have evolved these systems, improved them, given access to bank accounts based in many different locations, together with host to host systems for high volume transaction processing, all formatted in compliance with local standards.

For the top end of the Corporate and Institutional market, however, it is likely that SWIFT will become the selection of choice.


The Euro: How is it different?

Simply put, because now nineteen countries (and growing by the day) have the same currency.

So, how do I apply my golden rule of “All US Dollars are in New York” to The Euro? Where is the financial centre of The Euro? In which country does it reside?

The answer of course is that The Euro still works to exactly the same principles described above, in that Euros never really leave The European Central Bank(ECB), being in the accounts of bank ABC, bank XYZ within the ECB, just as in our previous, past experiences. The real difference with The Euro is in the ability to effect payables and receivables as in-border transactions, despite the accounts debited/credited being in different countries within the Eurozone.

This will enable banks and their Clients to rationalise their respective bank account structures and payables/receivables flows markedly over time. Furthermore, liquidity structures in Euro will be greatly enhanced under these enhanced capabilities and these simplified resultant structures.

My real concern with the Euro is over its longevity. A shared currency is a big undertaking. It works in GBP because the four countries have learned to “share” the good times and the bad times, with surpluses in one of the four countries being used to cover the deficits of others, possibly rotating in the short term, for example with Scottish oil revenues. However, over the longer term, the four support each other. In The United States, not all States generate surpluses, but again “the common good” created by a single market alleviates the burden on the “surplus” States, making their willingness to support the whole structure a viable alternative.

In 2015, Germany and The UK together represented almost 35 % of EU GDP.  In my view, given the relatively small size of certain “surplus” nations, the burden upon Germany and the German people will become intolerable. Therein lies the real problem with The Euro, namely its’ sustainability!

Brexit: A Contentious Issue!

In my view, not really. The UK banks were never “in” The Euro, and yet still offered(offer) Euro based products and services, as they do with US Dollars. The major UK banks will look to continue offering these, possibly through “partner” bank arrangements, possibly directly through a branch or subsidiary. The European reaction to the latter possibility is awaited.

Again, in my view, London will always be in The Euro. Indeed, it will be difficult for London to function without The Euro, but equally The Euro cannot fully function without London. London is not a UK city, it is a global city!


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