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Towards the development of an optimal comprehensive retirement preparation model Crockett, Herbert Ralph 1975

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A THEORY OF INTERNATIONAL BANKING EXPANSION by JAMES H. CLEAVE B.Comm., University of British Columbia, 1974 A THESIS SUBMITTED IN PARTIAL FULFILMENT OF THE REQUIREMENTS FOR THE DEGREE OF MASTER OF SCIENCE IN BUSINESS ADMINISTRATION in the Faculty of Commerce and Business Administration We accept this thesis as conforming to the required standard THE UNIVERSITY OF BRITISH COLUMBIA May, 1975 In presenting this thesis in partial fulfilment of the requirements for an advanced degree at the University of British Columbia, I agree that the Library shall make i t freely available for reference and study. I further agree that permission for extensive copying of this thesis for scholarly purposes may be granted by the Head of my Department or by his representatives. It is understood that copying or publication of this thesis for financial gain shall not be allowed without my written permission. J. H. Cleave Department of Commerce and Business Administration The University of British Columbia Vancouver, Canada V6T 1W5 Date May Ju_, 1975 ABSTRACT This study represents an attempt to develop a theory to e x p l a i n the r a p i d growth of i n t e r n a t i o n a l banking witnessed during the past decade. The focus i s on two major banking n a t i o n s : Canada and the United S t a t e s . The d e f i n i t i o n of i n t e r n a t i o n a l banking adopted f o r the purposes of t h i s study i s very broad i n nature and in c l u d e s s e v e r a l types of f i n a n c i a l a c t i v i t i e s . In a d d i t i o n to usual commercial banking a c t i v i t i e s we i n c l u d e the s o - c a l l e d congeneric s e r v i c e s a s s o c i a t e d w i t h merchant banking. The research process i n v o l v e d a comprehensive review of banking j o u r n a l s , sundry p e r i o d i c a l s , and the annual r e p o r t s of major Canadian and American banks. This m a t e r i a l provided d e s c r i p t i v e i n f o r m a t i o n on the i n t e r n a t i o n a l a c t i v i t i e s of the banks. A f t e r i n t e r n a t i o n a l banking i s defined a chapter i s devoted to a d i s c u s s i o n of the importance of banking to v a r i o u s world economies. In t h i s area, much r e l i a n c e i s placed on the w r i t i n g s of R. W. Goldsmith who developed a measure of the l e v e l of f i n a n c i a l s o p h i s t i c a t i o n f o r a country. Two chapters are then devoted to a d e s c r i p t i o n of the recent r a p i d growth of the i n t e r n a t i o n a l a c t i v i t i e s of Canadian and American banks. One co n c l u s i o n i s that i n t e r n a t i o n a l growth has proceeded at a considerably f a s t e r pace than domestic growth. Several observers of the i n t e r n a t i o n a l banking scene have o f f e r e d i i i i i e xplanations f o r the r a p i d growth. The most popular e x p l a n a t i o n i s that the growth of world trade has caused or at l e a s t h e a v i l y i n f l u e n c e d the growth of i n t e r n a t i o n a l banking. I t i s at t h i s p o i n t that we i d e n t i f y some flaws i n the ' f o l l o w i n g trade' argument. D i s s a t i s f a c t i o n w i t h t h i s popular explanation provides the 'jumping o f f p o i n t ' f o r development of our theory of i n t e r n a t i o n a l banking expansion. In order to l a y the foundation f o r development of a theory of i n t e r n a t i o n a l banking expansion, the l i t e r a t u r e on the theory of the f i r m and on the theory of f o r e i g n d i r e c t investment i s surveyed. Based on the above m a t e r i a l , a model has been developed which b u i l d s upon the school of d i r e c t investment theory that focuses on o l i -g o p o l i s t i c i n d u s t r y s t r u c t u r e and maximization of growth. The banks are seen to have an almost innate need f o r growth which i s the c r i t i c a l v a r i a b l e i n f l u e n c i n g i n t e r n a t i o n a l expansion. Several environmental v a r i a b l e s are i d e n t i f i e d that tend to r e t a r d growth i n the domestic s e c t o r . I t i s argued that the l o g i c a l consequence of t h i s i s that the banks turned to i n t e r n a t i o n a l markets i n order to achieve t h e i r growth o b j e c t i v e s . Foreign growth does not proceed without l i m i t however. A p r o f i t c o n s t r a i n t (drawing from the w r i t i n g s of W. J . Baumol) i s i d e n t i f i e d and incorporated i n t o the t h e o r e t i c a l model. Some of the other t h e o r i e s of d i r e c t investment ( i n c l u d i n g the popular Hymer/Kindleberger 'superior knowledge' theory) have only l i m i t e d explanatory power i n i n t e r n a t i o n a l banking. A f t e r a p r e l i m i n a r y t h e o r e t i c a l model was developed, i n t e r v i e w s iv were arranged with senior executives in the international divisions of the five major chartered banks. Their reactions to the model are dis-cussed (where appropriate) in chapters seven and eight. The study closes with a discussion of recent events that have tended to shake up international banking. Inadequate capitalization and various types of governmental interference are currently having a retarding effect on international growth. Finally, a chapter is devoted to a prediction of the future of international banking. It is concluded that, while many problems w i l l be present, the need for growth w i l l continue to be the major factor in explaining the development of inter-national banking. TABLE OF CONTENTS Page LIST OF TABLES ? . v i i i LIST OF FIGURES i x Chapter 1. INTRODUCTION 1 Objectives of Study 1 Research Methodology . . . . 2 Organization of Study 5 2. INTERNATIONAL BANKING 8 D e f i n i t i o n 8 Correspondent Banks 9 Resident Representatives 12 Agencies 14 Foreign Branches 16 S u b s i d i a r i e s and A f f i l i a t e s 18 J o i n t Ventures or C o n s o r t i a 19 Summary 21 3. IMPORTANCE OF INTERNATIONAL BANKING 25 Summary 31 4. GROWTH OF INTERNATIONAL BANKING 34 Growth of U.S. I n t e r n a t i o n a l Banking 44 v v i Chapter Page Canadian Growth 55 Summary 66 5. EXISTING EXPLANATIONS FOR THE GROWTH OF INTERNATIONAL BANKING . 70 6. THEORIES OF THE CAUSES OF DIRECT FOREIGN INVESTMENT 79 A l i b e r ' s Theory . 84 Imperfect C a p i t a l Markets 88 Mo n o p o l i s t i c Advantage 90 Oli g o p o l y and Need f o r Growth 94 Summary 97 7. TOWARD A THEORY OF INTERNATIONAL BANKING EXPANSION . . . 102 Banking: An O l i g o p o l i s t i c Industry . 102 Need f o r Growth 105 P r o f i t C o n s t r a i n t 112 Maintenance of Market Share H 3 Government I n t e r f e r e n c e 115 Superior Knowledge Theory 123 Preference f o r D i r e c t Investment 129 Cross Hauling 131 A l i b e r ' s Theory 133 Summary 134 8. A THEORY OF INTERNATIONAL BANKING EXPANSION 138 v i i Chapter Page Res u l t s of Interviews . . . . 154 Summary 155 9. CURRENT EVENTS AND THE THEORETICAL MODEL 157 10. THE FUTURE 169 BIBLIOGRAPHY 181 APPENDIXES 186 I . Interview Guide f o r F i e l d Study 187 11. The Foreign Investment D e c i s i o n 193 LIST OF TABLES Table Page 1-1. R e l a t i v e S i z e of Canadian and American Banks 4 4-1. The World's Major Banks - 1973 35 4-2. Comparative Growth Rates of Major Banks 40 4-3. Money Expressed as a Percentage of Gross N a t i o n a l Expenditure ( R e l a t i v e to the U.K. i n brackets) Estimated L e v e l at June 1973 42 4-4. Adjusted Ranking of Top Ten Banks 43 4-5. Foreign Branches of N a t i o n a l Banks By Region and By Country, March 31, 1965 45 4-6. Assets and L i a b i l i t i e s of Foreign Branches of N a t i o n a l Banks, December 31, 1964 46 4-7. Assets of Foreign Branches of U.S. Banks 1971-1974 47 4-8. Foreign Branches of U.S. Banks 1973 48 4-9. Worldwide I n t e r n a t i o n a l Network—Chase Manhattan Bank 53 4-10. Expansion of Branch Banking Overseas Compared w i t h Foreign Trade and U.S. D i r e c t I n v e s t -ment Abroad 1967-1972 54 4-11. Growth i n Assets of Chartered Banks 56 4-12. Bank Branches, Agencies, S u b s i d i a r i e s and A f f i l i a t e s - December 1973 57 4-13. Chartered Banks: T o t a l Foreign Currency Assets and L i a b i l i t i e s , 1963-1974 60 4-14. Assets of Banks i n the United Kingdom 63 7-1. P r o f i t R a t i o s By S i z e of U.S. Banks 109 7-2. P r o f i t R a t i os of Selected Banks 11° v i i i LIST OF FIGURES Figure Page 2-1. O r g a n i z a t i o n a l S t r u c t u r e of the Foreign A c t i v i t i e s of a Large U.S. Bank 23 8-1. Model of Foreign Expansion 139 8-2. Model of P r o f i t C o n s t r a i n t 142 8- 3. Numerical Example of the S t a t i c Determination of Bank S i z e 144 9- 1. C a p i t a l / A s s e t Ratios of U.S. Banking Industry 159 AI-1. Schematic of Bank Expansion Abroad 192 i x ACKNOWLEDGMENT A s p e c i a l vote of thanks i s extended to my f r i e n d , mentor, and t h e s i s a d v i s o r , P r o f e s s o r Whatarangi Winiata, who encouraged me to pursue the study. His h e l p f u l guidance and gentle 'prodding' has no doubt improved the q u a l i t y of the work you are about to read. The w r i t e r remains s o l e l y r e s p o n s i b l e f o r any e r r o r s or omissions. x DEDICATION This t h e s i s i s dedicated to my w i f e S h i r l e y who (almost always) c h e e r f u l l y t o l e r a t e d the long hours of p l a y i n g 'second f i d d l e ' to a stack of books. x i A THEORY OF INTERNATIONAL BANKING EXPANSION x i i Chapter One INTRODUCTION OBJECTIVES OF STUDY The primary objective of this study is to develop a theory to explain the rapid growth of international banking witnessed during the past decade. The United States is the world leader in international banking and Canada ranks as the third largest international banking nation. Accordingly, the main focus of our research w i l l be on the Canadian and American banks. There has been much written on the theory of foreign direct i n -vestment and considerable study of multinational enterprise. However, every serious study which this writer has been able to locate deals with manufacturing and/or resource based industries virtually exclusively and pays scant attention to the service industries. It may be because the service industries are not amenable to analysis that they are neglec-ted. Raymond Vernon, for example, dismissed the service industries as follows: The banks, insurance companies, airlines, shipping companies, and tourist agencies that s e l l their services across international boun-daries generally find themselves obliged to develop highly special-ized business s k i l l s and to adapt to specially tailored national laws and national institutions. Accordingly, the problems of the international service industries w i l l not be explored i n depth in the pages ahead.1 Vernon has a good point for very early on in the research stages this writer became somewhat frustrated by the 'messiness' of the 1 2 expansion process e x h i b i t e d by the banking i n d u s t r y . In t h i s connection an observer of the i n t e r n a t i o n a l banking scene has w r i t t e n : The expansion now t a k i n g place does not amount to any movement pro-ceeding on some grand, d e l i b e r a t e design. The process i s an u n t i d y one, motivated by c o n s i d e r a t i o n s v a r y i n g from bank to bank and coun-t r y to country, and t a k i n g place piecemeal by a v a r i e t y of methods. Yet however amorphous, i t feeds on i t s e l f , a c q u i r i n g a d r i v e of i t s own. 2 A B r i t i s h banker warned r e c e n t l y that those who seek to f i n d order and make some sense out of the development of i n t e r n a t i o n a l banking w i l l meet w i t h despair. However t h i s w r i t e r f i n d s no a. p r i o r i reason to assume that there are not some common und e r l y i n g f a c t o r s that i n f l u e n c e the development of m u l t i n a t i o n a l e n t e r p r i s e — b e i t banking or the manu-f a c t u r e of farm equipment. With t h i s i n mind we w i l l explore the more popular t h e o r i e s of f o r e i g n d i r e c t i n v e s t m e n t — t h e o r i e s developed to e x p l a i n the expansion of i n d u s t r i a l e n t e r p r i s e s — a n d attempt to i d e n t i f y some aspects of that phenomenon that might be a p p l i c a b l e to the explana-t i o n of i n t e r n a t i o n a l banking expansion. Once these common aspects are l o c a t e d , an attempt w i l l be made to p u l l the strands together i n t o a theory of i n t e r n a t i o n a l banking expan-s i o n that i s able to withstand the dual t e s t s of being l o g i c a l l y c o n s i s -tent and i n conformity w i t h the major f a c t s . RESEARCH METHODOLOGY The research process i n v o l v e d a comprehensive survey of s t a t i s -t i c s , annual r e p o r t s , and v a r i o u s p u b l i c a t i o n s (newspapers, magazines, banking j o u r n a l s ) that c o n t a i n a r t i c l e s on the subject of i n t e r n a t i o n a l 3 banking. Information from these sources coupled with the writer's per-sonal banking experience (eleven years in Canada and one year in the United States) led to the development of a theory of international bank-ing expansion. After a preliminary theoretical model had been developed, we then conducted interviews with senior executives in the international divisions of the five major chartered banks. The objective of the inter-views was to obtain insights into the major concepts upon which our model rests. We were also interested in obtaining reaction to the model de-veloped. The guide questionnaire and model utilized in the f i e l d study are included as Appendix I. It i s f a i r to say that the reaction to our preliminary model was mixed. Some areas of general agreement were identified. So too, were some areas of general disagreement. In areas where general disagreement was identified we reconsidered our position and in some cases altered our approach. Problems were encountered however in cases where the responses to specific questions or reaction to certain variables in the model were mixed. In these cases the writer has searched for outside information that tends to point in one direction or the other. The following table i s presented to give the reader a feel for 3 the size and economic power of the major Canadian and American banks. The big five Canadian banks control about 92 per cent of the Canadian banking industry, while the big five American banks control about 25 per cent of the U.S. industry. These ten banks dominate their domestic compe-titors in the international banking scene. 4 Table 1-1 RELATIVE SIZE OF CANADIAN AND AMERICAN BANKS 1973 Assets ( m i l l i o n s ) 1973 World Rank 1964 World Rank UNITED STATES BankAmerica Corporation $49,404 1st 1st C i t i c o r p 44,019 2nd 3rd The Chase Manhattan Corp. 36,790 3rd 2nd J . P. Morgan & Co. Inc. 20,375 17th 9th Manufacturers Hanover Corp. 19,850 18th 4th CANADA The Royal Bank of Canada $18,381 28th 8th Canadian Imp. B. of Commerce 16,117 35 t h 10th Bank of Montreal 14,409 41st 16th The Bank of Nova S c o t i a 10,328 55th 38th The Toronto-Dominion Bank 9,422 71st 47th I t i s q u i t e apparent from the above t a b l e that Canadian banks have s l i p p e d c o n s i d e r a b l y over the past ten years i n s i z e r e l a t i v e to other major i n t e r n a t i o n a l banks. The three l a r g e s t U.S. banks on the other hand have maintained t h e i r world dominance. I t would seem that t h i s f a c t might i n d i c a t e that Canadian banks have taken a l e s s aggressive approach to the p u r s u i t of growth than the other major world banks. We w i l l explore t h i s p o s s i b i l i t y f u r t h e r below. I t can be pointed out at t h i s time however th a t over the past few years there have been a number of banking mergers i n both Europe and Japan. These mergers have 5 catapulted some moderate-sized institutions into world prominence in banking. An example is the merger of the National Provincial Bank Ltd. and Westminster Bank Ltd., both of London, to form the National West-minster Bank Ltd..which i s now the seventh largest in the world. An important motivating factor behind at least some of the mer-gers is thought to be the widely held European view that firms must be encouraged to merge in order to reap economies of scale and meet the challenge of large American firms. The chief proponent of this view is the French journalist, Jean-Jacques Servan-Schreiber. His book, The American Challenge, outlines his view of the problems facing European 4 business and the measures necessary to overcome them. Recently, the validity of Servan-Schreiber's views have been questioned by R. Rowthorn (International Big Business 1957-67: A Study of Comparative Growth)~* and Stephen Hymer (Multinational Corporations and International Oligopoly: 6 The Non American Challenge). A more detailed examination of the issues involved w i l l be included below when we discuss the size and the apparent need or desire for growth of the banking industry. ORGANIZATION OF THE STUDY Chapter two is devoted to the development of a definition of international banking. It is important for the reader to be clear about what we mean when we use the term 'international banking' since the defi-nition has a bearing on our theoretical model. Chapter three represents an attempt to give the reader some under-standing of the contribution that international banking can make to var i -ous world economies. 6 Chapters four and f i v e t r a c e the recent growth of i n t e r n a t i o n a l banking and di s c u s s the attempts that have been made to e x p l a i n the phenomenon observed. Chapters s i x , seven and eight form the heart of the t h e s i s . Chapter s i x surveys the v a r i o u s t h e o r i e s of d i r e c t investment and Chap-t e r s seven and eigh t represent our attempt to develop a theory of i n t e r -n a t i o n a l banking expansion. In Chapter nine we di s c u s s some recent events a f f e c t i n g the i n t e r -n a t i o n a l banking environment which might c a l l f o r some minor a l t e r a t i o n s to our model. F i n a l l y , i t would seem that no paper d e a l i n g w i t h an i n s t i t u -t i o n a l problem i s complete without some treatment of the f u t u r e . Accor-d i n g l y , we w i l l c l o s e out the study by attempting to u t i l i z e the concepts developed to make some p r e d i c t i o n s about what might l i e i n s t o r e f o r i n t e r n a t i o n a l banking over the next decade. 7 Notes f o r Chapter One ^ Raymond Vernon, The Economic Environment of I n t e r n a t i o n a l B u s i - ness (Englewood C l i f f s , N.J.: P r e n t i c e - H a l l , 1972), p. 7. 2 Quoted i n The Economist (November 21, 1964), p. 845. 3 The Banker (June 1974) and Banks of the World (1964). 4 J . J . Servan-Schreiber, The American Challenge (New York: Atheneum, 1968). S. Hymer and R. Rowthorn. I n t e r n a t i o n a l B i g Business 1957-67: A Study of Comparative Growth (Cambridge: Cambridge U n i v e r s i t y P r e s s , 1971). ^ Hymer and Rowthorn, " M u l t i n a t i o n a l Corporations and I n t e r n a -t i o n a l O l i g o p o l y : The Non American Challenge," i n The I n t e r n a t i o n a l Cor- po r a t i o n s : A Symposium, C. Kindleberger (ed.) (Cambridge, Mass.: M.I.T. Press, 1970). Chapter Two INTERNATIONAL BANKING Definition International banking is a term that is commonly used to de-scribe a wide range of banking a c t i v i t i e s — f r o m f a c i l i t a t i n g a simple foreign remittance to mobilizing Euro dollars throughout the world. There is however no widely accepted 'tidy' definition of the term 'inter-national banking.' This i s not really surprising. Experts have long ago given up the attempt to set out a reasonable definition of domestic banking. The Canadian Bank Act contains no definition of banking. Sec-tion 2 of the Act contains a classic definition that a bank "means a bank to which this Act applies.""'' Section 75 of the Act contains a l i s t of the general powers of a bank and sets out types of business that may be undertaken. The 'out' used by the Act to avoid a definition i s the re-striction that prohibits the use of the words 'bank' or 'bankers' in the corporate t i t l e of any company unless i t is chartered under the Act. For the purposes of this paper we w i l l assert that a bank be-comes international when i t makes a foreign direct investment in a com-pany engaged in financial services. These financial services w i l l i n -clude issuing demand and notice l i a b i l i t i e s and granting loans (usual commercial banking) but also w i l l include the wide range of financial services offered by merchant banking. The nature of merchant banking w i l l be discussed later in the chapter. 8 9 The key to the definition is that a_ direct investment must be made. We w i l l now enter into a discussion of the various operating forms employed by the banks in their international operations. Those operating forms that f i t within our definition of international banking w i l l then be identified at the conclusion of the chapter. A. Correspondent Banks Correspondent banking is a system whereby banks maintain a de-posit relationship with each other. U.S. banks have used the system domestically for years to help in overcoming legislation that prohibits branching. Small unit banks in towns and villages maintain deposits with large city banks who in turn maintain accounts with large money centre banks. In this way surplus funds from rural areas could be put to productive use in the larger industrialized areas. Correspondent relationships with foreign banks serve a somewhat different purpose: the settlement of international clearings. In foreign centres where a Canadian or U.S. bank is not directly represented, an account with a foreign correspondent can serve as a vehicle through which payments or collections can be made on behalf of importers and exporters. The foreign exchange market, which is the link between the domes-ti c financial system and the financial system of other countries, can be operated entirely through a system of correspondent banks. While i t is true that some foreign transactions can become f a i r l y complex, in the f i n a l analysis there is virtu a l l y no financial transaction involving 10 f o r e i g n trade or c a p i t a l flows that cannot be handled through correspon-dents. To c l a r i f y the concept of correspondent banking an example of a rathe r t y p i c a l t r a n s a c t i o n f o l l o w s : a) assume The Royal Bank of Canada maintains a Canadian d o l l a r account w i t h the Tokai Bank of Japan; b) assume a Canadian exporter enters i n t o a con t r a c t to s e l l $1,000,000 i r o n ore to a Japanese importer on terms of t h i r t y days a f t e r acceptance; c) The Royal would forward the b i l l of exchange and supporting docu-ments to the Tokai Bank; d) Tokai would n o t i f y the Japanese importer; e) when shipment a r r i v e s i n port the importer would 'accept' the b i l l from the Tokai Bank who would hold i t f o r t h i r t y days; f ) on the due date the Tokai Bank would c o l l e c t the b i l l and c r e d i t the Canadian d o l l a r account maintained by the Royal Bank; g) The Royal would then simply d e b i t the Canadian d o l l a r account and c r e d i t the account of the exporter. Balances w i t h f o r e i g n banks c o n s t i t u t e a s i g n i f i c a n t p r o p o r t i o n of t o t a l f o r e i g n assets and l i a b i l i t i e s of the chartered banks. As at June 30, 1974, the chartered banks had $15,898 m i l l i o n on deposit w i t h f o r e i g n banks. In t u r n , f o r e i g n banks had $14,410 m i l l i o n on deposit w i t h Canadian banks. These f i g u r e s represented r e s p e c t i v e l y 61.8 per cent and 50.2 per cent of t o t a l f o r e i g n assets and l i a b i l i t i e s . I t appears that the magnitude of correspondent balances i s w e l l 11 i n excess of the t r a n s a c t i o n s balances r e q u i r e d to f a c i l i t a t e the flows of trade and c a p i t a l and t h a t , i n p a r t , they r e f l e c t inter-bank l e n d i n g . Some a n a l y s t s , i n n o t i n g the r a p i d b u i l d up of i n t e r n a t i o n a l bank d e p o s i t s — e s p e c i a l l y Euro d o l l a r s — h a v e warned that l o s s e s w i l l l i k e l y occur. D. R. Mandich, Senior V i c e - P r e s i d e n t , D e t r o i t Bank and Trust Company, warned i n 1972: o v e r l y l a r g e Euro d o l l a r deposits have been and are being granted to f o r e i g n banks i n r e l a t i o n to t h e i r i n d i v i d u a l c a p i t a l s and f i n a n c i a l p r o p o r t i o n s , w i t h very l i t t l e r e a l knowledge of the people of t h e i r f i n a n c i a l engagements. The theory r e p o r t e d l y i s that the deposits are short term ones and t h e r e f o r e s a f e , but there i s c l e a r l y a pro-cess of c r e d i t being extended without normal c r e d i t s t u d i e s and safeguards. Obviously, t h i s i s a p r a c t i s e which i n v i t e s misfortune at some f u t u r e time.2 The s e v e r a l bank f a i l u r e s of 1974 have c e r t a i n l y supported the foregoing statement. I t i s known that most major banks are l o o k i n g very c l o s e l y at t h e i r correspondent r e l a t i o n s h i p s . B r i t a i n ' s N a t i o n a l Westminster Bank r e p o r t e d l y e l i m i n a t e d $100 m i l l i o n worth of c r e d i t l i n e s w i t h Ameri-can banks as a r e s u l t of being burned by the f a i l u r e of the U.S. 3 N a t i o n a l Bank of San Diego. Furthermore, N a t i o n a l Westminster Bank has adopted the p o l i c y of r e f u s i n g to handle l e t t e r s of c r e d i t from U.S. banks unless they have assets i n B r i t a i n . Thus because of carelessness i n i n t e r bank d e a l i n g an impediment to f o r e i g n trade has been erected. I t was o r i g i n a l l y intended that the primary f u n c t i o n of i n t e r bank deposits would be to f a c i l i t a t e the reverse flows of funds that accompany a l l t r a n s a c t i o n i n r e a l goods and s e r v i c e s . I t now seems that i n t e r bank deposits c o n s t i t u t e an important investment o u t l e t as w e l l . An i n t e r e s t i n g and important i s s u e which a r i s e s i s whether or not 12 these activities can be adequately supervised from a domestic base. Traditional functions of correspondents also include the exchange of information on economic conditions, p o l i t i c a l events and credit reports on commercial enterprises. In addition the correspondent bank can be thought of as the Canadian or U.S. window to a foreign market. It i s reported that Canadian banks have at least 5,000 corres-pondent banks throughout the world and, while no figures could be located, i t is very li k e l y that U.S. banks have substantially more correspondents. B. Resident Representatives The representative office i s used by both Canadian and U.S. banks, primarily in areas where f u l l service banking is prohibited. This operating form has been described as the weak link in the banking structure of any country because the function is ill-defined and is not readily susceptible to control by the monetary authorities. The function of a resident representative of a Canadian or U.S. bank is to "hunt down business and make money for us."^ This function however is subject to the constraint that normal banking act i v i t i e s (acceptance of deposits, granting loans) are prohibited. In several countries the representative is also prohibited from entering into a contract. Any business obtained in the foreign country is supposed to be contracted for and booked at head office. The representative i s essentially a roving marketing officer for the head office. He v i s i t s correspondent banks, maintains liaison with local officers of multinational clients of head office, and attempts to 13 contact p o t e n t i a l customers. The banks o f t e n regard the r e p r e s e n t a t i v e o f f i c e as the f i r s t step toward a f u l l branch. In some markets i t i s thought a d v i s a b l e to t e s t the waters i n a r e l a t i v e l y inexpensive way by s e t t i n g up a r e p r e -s e n t a t i v e o f f i c e . In the m a j o r i t y of cases however the r e p r e s e n t a t i v e i s used i n areas that p r o h i b i t f u l l s e r v i c e banking by f o r e i g n e r s . Canada i s a good example. The 1967 Bank Act s t a t e s that no f o r e i g n c o r p o r a t i o n c a r r y i n g on business i n Canada may use the word bank, banker, or banking to d e s c r i b e i t s a c t i v i t i e s . Despite t h i s at l e a s t t h i r t y f o r e i g n banks have, w i t h immunity, e s t a b l i s h e d o f f i c e s i n Canada using the name of the bank above the door. C a n a d i a n • o f f i c i a l s have turned a b l i n d eye toward the representative, o f f i c e . The importance of a r e s i d e n t r e p r e s e n t a t i v e to the i n t e r n a t i o n a l a c t i v i t i e s of a bank i s d i f f i c u l t to assess because a separate p r o f i t centre cannot be created. I t appears u n l i k e l y however that the c o n t r i -b u t i o n of the r e p r e s e n t a t i v e i s s i g n i f i c a n t i n r e l a t i o n to other oper-a t i n g forms. The r e p r e s e n t a t i v e o f f i c e appears to be used more exten-s i v e l y by those banks t h a t are l e s s committed to i n t e r n a t i o n a l a c t i v i t i e s . For example, Bankers Trust New York Corporation, s i x t h l a r g e s t bank i n the U.S. w i t h assets of $21 b i l l i o n , had (at December 31, 1973) nineteen r e p r e s e n t a t i v e o f f i c e s around the world and only seven f u l l s e r v i c e branches."' On the other hand BankAmerica Corporation maintained only twelve r e p r e s e n t a t i v e o f f i c e s w h i l e i t s f o r e i g n branches t o t a l l e d 103 i n 1973. 6 14 C• Agencies The P o r t e r Commission described an agency as an o f f i c e f r e e to conduct a l l phases of banking business other than the acceptance of d e p o s i t s . ^ The best known, and o l d e s t , Canadian agencies are l o c a t e d i n New York. P r i o r to the development of Canadian f i n a n c i a l markets the chartered banks c a r r i e d the b u l k of t h e i r secondary reserves i n the form of c a l l loans to New York brokers. The New York agencies f a c i l i t a t e d these t r a n s a c t i o n s . C a l l loans have r e c e n t l y d e c l i n e d both i n absolute and r e l a t i v e terms. As at June 30th, 1974, c a l l loans i n a f o r e i g n currency t o t a l l e d $225 m i l l i o n compared to $1,017 m i l l i o n i n g 1964. In r e l a t i v e terms f o r e i g n c a l l loans have d e c l i n e d from 24 per cent of t o t a l f o r e i g n currency assets i n 1964 to l e s s than 1 per cent i n 1974. In a d d i t i o n to g r a n t i n g loans, the agencies a l s o provide a wide range of ' f r i n g e ' banking s e r v i c e s i n c l u d i n g buying and s e l l i n g s e c u r i -t i e s and handling f o r e i g n exchange t r a n s a c t i o n s . There i s a s i g n i f i c a n t advantage i n opting f o r agency r a t h e r than branch s t a t u s s i n c e an agency i s not u s u a l l y subject to reserve requirements. I t can borrow funds from the l o c a l p u b l i c , book them at head o f f i c e , and then borrow a l i k e amount from head o f f i c e f o r placement i n the l o c a l markets. The advantage of the agencies over l o c a l banks who are subject to reserve requirements can be s u b s t a n t i a l as the f o l l o w -i n g h y p o t h e t i c a l example i l l u s t r a t e s : 15 assume: loan rate 10% deposit rate 8% reserve requirement 10% - customer deposits $1,000,000 New York Agency of Canadian Bank unproductive assets (reserves) 0 deposit $1,000,000 productive loan $1,000,000 $1,000,000 $1,000,000 revenue (10%) $100,000 interest expense (8%) 80,000 net revenue $ 20,000 The Chase Manhattan Bank unproductive assets (reserves) $ 100,000 deposits $1,000,000 productive loan 900,000 $1,000,000 $1,000,000 revenue (10%) $ 90,000 interest expense 80,000 net revenue $ 10,000 In a highly competitive market i t is easy to see that the agency could, i f i t desired, cut the loan rate or bid up the deposit rate to make i t unattractive for the U.S. bank to enter the market. Another advantage of agency status in the United States is that an agency can avoid Regulation "Q," which restricts U.S. banks in the rate of interest they can pay on time deposits. 16 The above advantages have not gone unnoticed i n the United States and we appear to be heading i n t o "a new era of s u p e r v i s i o n and c o n s t r a i n t s 9 f o r the operations of Canadian banks i n the U.S." There i s c u r r e n t l y before Congress a piece of l e g i s l a t i o n aimed at e s t a b l i s h i n g a n a t i o n a l p o l i c y covering the operations of f o r e i g n banks i n the U.S. Some areas of the l e g i s l a t i o n would d i r e c t l y a f f e c t agency operations. Membership i n the Federal Reserve System would be compulsory and would mean that agencies would have to c a r r y reserves and be subject to v a r i o u s F e d e r a l r e g u l a t i o n s , i n c l u d i n g the i n t e r e s t r a t e c e i l i n g . I f passed, t h i s l e g i s l a t i o n could w e l l s i g n a l the end of the agencies. I t appears l i k e l y that the chartered banks would opt i n s t e a d f o r f u l l s e r v i c e branches. D. Foreign Branches The most popular method of e s t a b l i s h i n g i n the i n t e r n a t i o n a l arena i s v i a the f o r e i g n branch. F u l l s e r v i c e banking o f f e r s s e v e r a l advantages over the three operating forms mentioned above. A branch oper-a t i o n allows the bank to compete d i r e c t l y f o r indigenous business i f i t so d e s i r e s . The establishment of a deposit base i n the l o c a l currency can enable an i n t e r n a t i o n a l bank to serve l o c a l f i n a n c i n g needs as w e l l as the needs of m u l t i n a t i o n a l c l i e n t s . The extensive branch network of Canadian banks i n the Caribbean i s a good example. Another advantage of branching i s that head o f f i c e can completely c o n t r o l p o l i c y — s u b j e c t of course to the laws of the host country. B i g -ness i s ass o c i a t e d w i t h s a f e t y i n banking and t h i s r e s u l t s i n an advan-tage f o r branching. The p u b l i c i s l i k e l y to have more confidence i n 17 d e a l i n g w i t h a f o r e i g n branch of the BankAmerica than i f say BankAmerica Corporation opened a f o r e i g n s u b s i d i a r y under a d i f f e r e n t name. A w e l l known name above the door i s an undeniable advantage to branching. The f a c t remains however that, of the many forms of i n t e r n a t i o n a l banking, the c r e a t i o n of f o r e i g n branches i s the most c o n t r o v e r s i a l : However sc r u p u l o u s l y a f o r e i g n branch r e f r a i n s from poaching on the preserve of i t s h o s t s , i t s mere exi s t e n c e takes business from them, because whenever a f o r e i g n branch i s e s t a b l i s h e d , the parent bank t r a n s f e r s to i t the business and deposits that p r e v i o u s l y went to i t s l o c a l correspondent banks.10 There i s disagreement among bankers about the p r e f e r r e d method of f o r e i g n expansion i n the face of a mounting t i d e of n a t i o n a l i s m around the world. John Coleman, formerly Deputy Chairman of The Royal Bank of Canada, sta t e d i n 1971 t h a t : "The world wide branch system i s not the system of the f u t u r e . U n t i l r e c e n t l y i t appeared as i f the Canadian I m p e r i a l Bank of Commerce and C i t i b a n k had ( i n s p i t e of Coleman's remarks) opted f o r the branch route. One major advantage to branching i s that head o f f i c e runs i t s own show and both the Canadian I m p e r i a l Bank of Commerce and C i t i -bank have, u n t i l r e c e n t l y , e x h i b i t e d a c l e a r cut d e s i r e to c o n t r o l what-ever business they engage i n . During N. J . McKinnon's chairmanship of the Canadian Im p e r i a l Bank of Commerce t h i s was c e r t a i n l y true but the p i c t u r e has now changed somewhat. Fewer f o r e i g n branches are being opened and emphasis seems to be on p a r t i c i p a t i o n i n c o n s o r t i a . For example the Canadian I m p e r i a l Bank of Commerce r e c e n t l y took an e q u i t y p o s i t i o n (20 per cent) i n the Energy Bank of England along w i t h three 18 other banking partners i n t e r e s t e d i n f i n a n c i n g the development of o i l 12 i n the North Sea. While the expansion of f o r e i g n branches as an op e r a t i n g v e h i c l e may slow down somewhat, i t i s safe to say that the e x i s t i n g branches w i l l continue to make a s i g n i f i c a n t c o n t r i b u t i o n to f o r e i g n operations of Canadian and U.S. banks. E. S u b s i d i a r i e s and A f f i l i a t e s Both American and Canadian banks o c c a s i o n a l l y i n c o r p o r a t e a sub-s i d i a r y company to own and operate branches i n a f o r e i g n country. The Commerce f o r example owns 100 per cent of the shares of the C a l i f o r n i a Canadian Bank which operates twenty branches i n C a l i f o r n i a . Both The Royal Bank of Canada and The Bank of Nova S c o t i a have found i t necessary to i n c o r p o r a t e s u b s i d i a r i e s i n the Caribbean to take over t h e i r branches there. This a c t i o n was i n d i r e c t response to host government pressures to a l l o w e q u i t y p a r t i c i p a t i o n i n these operations. Equity p a r t i c i p a t i o n by the parents i s i n the 75 per cent range so there i s no question about c o n t r o l . The top f i v e U.S. banks have many s u b s i d i a r i e s operating through-out the world and engaged i n a wide range of f i n a n c i a l s e r v i c e s . The chartered banks a l s o use s u b s i d i a r i e s as a v e h i c l e f o r the operation of near banks i n other c o u n t r i e s . The b i g f i v e banks have each incorporated t r u s t companies i n New York, U.K., and the Caribbean. The a f f i l i a t e route i s a l s o used by the banks of both c o u n t r i e s . This form of entry i n t o the f o r e i g n market i s used when there are r e s t r i c -t i o n s against branching or when l o c a l market c o n d i t i o n s i n d i c a t e t h i s 19 method i s p r e f e r a b l e . An example would be the approach used by some chartered banks i n Hong Kong. In t h i s market there are l i m i t e d advan-tages to branching. Says one Canadian banker: In t h i s p a r t of the world, s t r a i g h t r e p r e s e n t a t i v e s of f i n a n c i a l i n s t i t u t i o n s from the West are considered o u t s i d e r s to A s i a n b u s i -nessmen. You've got to get i n t o the b a l l game on the same l e v e l as the Asians to even hope to s u r v i v e . You've got to buy i n t o A s i a n business i n order to even hear about the deals being planned. I t s very much a close d s o c i e t y out here and, i f you don't go to the r i g h t c o c k t a i l p a r t i e s or s i t on the r i g h t boards, you aren't p r i v y to the k i n d of i n f o r m a t i o n that makes money f o r Canadian firms.13 In response to t h i s type of market the Toronto-Dominion i n 1970 purchased a 40 per cent i n t e r e s t i n I n t e r n a t i o n a l Consolidated I n v e s t -ments L t d . , a h o l d i n g company that c o n t r o l s two banks i n Hong Kong (the Overseas Trust Bank and the Hong Kong I n d u s t r i a l and Commercial Bank)."*"^ Together these banks have t h i r t y - f i v e branches i n the Hong Kong area engaged p r i m a r i l y i n r e t a i l banking. The U.S. banks are engaged i n investments through a f f i l i a t e s on a much broader s c a l e than the chartered banks. C i t i c o r p , f o r example, has consumer finance a f f i l i a t e s i n B r i t a i n , B r a z i l , Belgium, Colombia, Hong Kong, the P h i l i p p i n e s , and i n S w i t z e r l a n d ; f a c t o r i n g companies i n A u s t r a l i a , B r i t a i n , Canada, Colombia, Panama, and Spain; and c r e d i t card a f f i l i a t e s i n Costa R i c a , Panama, and Venezuela. F. J o i n t Ventures or C o n s o r t i a This v e h i c l e has evolved s i n c e the 1960's as a method of e n t e r i n g merchant banking on a t r u l y i n t e r n a t i o n a l s c a l e . B a s i c a l l y , a j o i n t ven-tu r e i s a p a r t n e r s h i p of ( u s u a l l y ) three to s i x l a r g e banks who pool p a r t 20 of t h e i r resources to enter a s p e c i f i c market. Domestic operations of the partner banks are always kept separate. Merchant banking i s d i f f i c u l t to d e f i n e but i t can be s a i d that i t i n c l u d e s almost every type of f i n a n c i n g imaginable. Merchant bankers underwrite s e c u r i t y i s s u e s ; extend loans over s h o r t , medium, and long terms; take equity p o s i t i o n s i n companies; a s s i s t corporate mergers; s e l l advice, d e a l i n f o r e i g n exchange; manage mutual funds; and under-w r i t e insurance . . . and the l i s t goes on. These banking p r a c t i c e s have long been common i n C o n t i n e n t a l Europe i n c o n t r a s t to the Anglo-Saxon t r a d i t i o n i n which banks act c h i e f l y as d e p o s i t o r i e s and extenders of short term c r e d i t . During the past decade however the b a s i c d i s t i n c -t i o n between deposit and merchant banks has faded somewhat. Both the U.S. and Canadian banks have incorporated f o r e i g n a f f i l i a t e s t hat hold e q u i t i e s , a s s i s t i n s e c u r i t y u n d e r w r i t i n g s , and provide long term ven-tu r e f i n a n c i n g . An example of a l a r g e i n t e r n a t i o n a l j o i n t venture engaged i n merchant banking i s the Orion Banking Group. The partners are The Royal Bank of Canada, The Chase Manhattan Corporation, N a t i o n a l Westminster Bank, and Westdeutsche Landesbank G i r o z e n t r a l e . Members of the Orion group i n c l u d e : — Orion Bank L t d . which provides f i n a n c i a l c o u n s e l l i n g , manages i n t e r n a t i o n a l u n derwritings, organizes consortium l o a n s , and a s s i s t s i n mergers and a c q u i s i t i o n s ; Orion Termbank L t d . which s p e c i a l i z e s i n l a r g e s c a l e Euro-currency loans; and 21 — Orion Multinational Services Ltd. which conducts research and acts as the central planning agency for the partners. The evolution of consortia serves to underscore the need for bigness in banking. As the credit demands of major multinational clients and governments increase i t is li k e l y that major banks w i l l continue to meet the challenge at least partly via the consortia route. SUMMARY Based on the above discussion, the only type of international operation excluded from our definition of international banking is the correspondent relationship. The foreign representative office, while lik e l y only representing a nominal investment, does qualify. Agencies, branches, and subsidiaries also qualify. A f f i l i a t e s f i t the definition provided the investing bank exercises effective control over the com-pany. Participation in consortia presents a b i t of a problem. Often no single bank has effective control. For example the Bank of Montreal, Australia and New Zealand Banking Group Ltd., Irving Trust Co. of New York, and Crocker Citizens Bank of California each put up $13.75 million to launch the Melbourne-based Australian International Finance Corpora-tion. Is this a direct investment by the three foreign partners? While the investment admittedly is in some 'grey' area between portfolio and direct investment, this writer would argue that because each of the companies have representation in management and take an active part in direction of operations, the investment should be classified as direct. Support for this viewpoint is provided by the U.S. government: 22 Although definitions vary greatly from country to country, direct investment generally covers only investment in which business is controlled from abroad. The U.S. government defines this as an ^ ownership interest in foreign enterprise of at least ten per cent. In summary, then, our definition of international banking is very broad in scope and includes virtu a l l y any international financial activity undertaken by the major banks. The key variable i s only that a direct investment be involved. It should be noted that the definition of international banking that has evolved in this chapter is consistent with the self-image of the major international banks. The Chase Manhattan Bank, for example, thinks of i t s e l f as: "An agressive, high quality international financial services corporation.""^ The definition i s also consistent with the concept of international banks of the future: It is now apparent that the world bank of the future w i l l range from property investment to handling companies' cash flow problems on a multinational basis, or from managing portfolios which are invested on a number of the world's stock exchanges to running r e t a i l branch networks in as many countries as possible round the globe.18 Figure 2-1 i s presented to give the reader some idea of the organ-izational structure of the international operations of a large U.S. bank. U.S. BANK HOLDING COMPANY EDGE CORPORATIONS EQUITY IN FOREIGN BANK Figure 2-1 ORGANIZATIONAL STRUCTURE OF THE FOREIGN ACTIVITIES OF A LARGE U.S. BANK 24 Notes f o r Chapter Two ^ An Act Respecting Banks and Banking (Ottawa: Queen's P r i n t e r , 1967). 2 D. R. Mandich, " I n t e r n a t i o n a l Loans: P r o f i t Centre or Loss Leader?" J o u r n a l of Commercial Bank Lending (Sept. 1972), p. 39. 3 Canadian Business, 'From Ottawa' (January 1974), p. 6. 4 Quoted i n The Canadian Banker and ICB Review, 1-74, p. 21. ^ Bankers Trust New York Corporation, 1973 Annual Report. BankAmerica Corporation, 1973 Annual Report. ^ Report of the Royal Commission on Banking and Finance, 1964, p. 373. g Bank of Canada Review (August 1974). 9 The F i n a n c i a l Post (December 28, 1974), p. 9. "Banking Across F r o n t i e r s , " The Economist (Nov. 21, 1964), p. 846. Quoted i n "The Bankers Take the Plunge," The Executive (June 1971), p. 32. 12 John Davidson, "Canadian Banks Think G l o b a l l y , " Canadian  Banker and ICB Review, 1-74. 13 Quoted i n The F i n a n c i a l Post (October 13, 1973), p. 1. 14 . , Ibid. 1 5 "The Bankers Take the Plunge." S. H. Robock and K. Simmonds. I n t e r n a t i o n a l Business and  M u l t i n a t i o n a l E n t e r p r i s e (Georgetown, Ont.: R. D. I r w i n , Inc., 1973), p. 40. ^ Chase Manhattan Corporation, Annual Report, 1973. I Q The Banker, 122 (1972), 777. Chapter Three IMPORTANCE OF INTERNATIONAL BANKING The trend toward economic interdependence among nations of the world i s evidenced by a dramatic expansion of world trade over the past decade. T o t a l exports of a l l c o u n t r i e s i n 1973 grew 37 per cent to. $566 b i l l i o n . ' ' " In constant d o l l a r s t h i s i n c r e a s e amounted to 13 per c e n t — roughly double the r e a l growth r a t e i n world G.N.P. Over the past decade, trade has been growing at an annual average of about 10 per cent compared w i t h a g l o b a l GNP growth r a t e of a p p r o x i -2 mately 5 per cent. The r e d u c t i o n i n trade b a r r i e r s i n c l u d i n g the General Agreement on T a r i f f s and Trade (GATT) has been an important con-t r i b u t i n g f a c t o r to the growth of trade. One can l e g i t i m a t e l y ask of course what the above has to do w i t h banking. The answer i s that f o r almost a l l f o r e i g n trade t r a n s a c t i o n s there are two monetary u n i t s i n v o l v e d — t h e currency of the e x p o r t i n g country and the currency of the importing country. Foreign t r a d e r s be-come i n v o l v e d i n what Binhammer c a l l s a 'double s a l e ' or 'double 3 purchase.' That i s , an importer d e s i r i n g to purchase Japanese automo-b i l e s must f i r s t buy Japanese yen and then buy the automobile. The banks have long been the most important s u p p l i e r of f o r e i g n exchange to f a c i l i -t a t e trade between n a t i o n s . Canadian chartered banks maintain a world-wide network of c o r r e s -pondent banks to f a c i l i t a t e the f i n a n c i a l flows that must accompany f o r -eign trade. B a s i c a l l y the r e l a t i o n s h i p between a Canadian bank and i t s 25 26 correspondent c o n s i s t s of r e c i p r o c a l deposit accounts. The account main-ta i n e d by a chartered bank w i t h a f o r e i g n correspondent i s u s u a l l y denom-ina t e d i n the currency u n i t of the l a t t e r . The correspondent on the other hand o f t e n maintains a Canadian d o l l a r account at the chartered bank. I t has a l s o become q u i t e common f o r the chartered banks to main-t a i n U.S. d o l l a r denominated dep o s i t s w i t h t h e i r f o r e i g n correspondents — p a r t l y to f a c i l i t a t e the l a r g e volume of trade i n U.S. currency and p a r t l y f o r investment purposes. These dep o s i t s are r e f e r r e d to as 'Euro-d o l l a r s ' which are simple U.S. d o l l a r s l o c a t e d outside the country. There i s no question that f i n a n c i n g f o r e i g n trade i s an impor-tant f u n c t i o n of the banking i n d u s t r y . However i t i s a s e r v i c e that can be o f f e r e d from a domestic base without d i r e c t f o r e i g n investment. The maintenance of t r a n s a c t i o n s balances w i t h f o r e i g n correspondents i s r e a l l y a l l that i s r e q u i r e d . In the circumstances, and i n keeping w i t h our d e f i n i t i o n of f o r e i g n banking developed i n Chapter Two, f i n a n c i n g trade flows does not q u a l i f y as an important c o n t r i b u t i o n of i n t e r n a -t i o n a l banking. This does not mean that f i n a n c i n g f o r e i g n trade i s not important per se. As important t r a d i n g n a t i o n s , i t i s v i t a l that the United States and Canada each have a h i g h l y developed banking system which provides export-import f i n a n c i n g and operates the f o r e i g n exchange markets. To r e i t e r a t e , i t i s t h i s w r i t e r ' s b e l i e f that the above func-t i o n s can be f u l f i l l e d from a domestic base and without the n e c e s s i t y of d i r e c t f o r e i g n investment by the banks. The banks of course a l s o f a c i l i t a t e c a p i t a l flows among the nations of the world. Here again t h i s w r i t e r would argue that no great 27 impediment to c a p i t a l flows would be encountered i f a simple system of correspondent banks were used. One need only look at the experience of a n a t i o n such as Canada that has imposed severe r e s t r i c t i o n s on the entry of f o r e i g n banks f o r evidence that c a p i t a l flows can indeed take place on a huge s c a l e . I t i s not necessary f o r C i t i c o r p of New York to have a branch i n Toronto to a l l o w one of i t s customers to make a d i r e c t or p o r t f o l i o investment i n t h i s country. I t should not be i n f e r r e d from the above that the w r i t e r i s opposed to f o r e i g n branching. On the c o n t r a r y : the d i s c u s s i o n i s merely intended to cast doubt upon the u s u a l l y accepted explanation that the importance of f o r e i g n banking i s i n f i n a n c i n g trade and c a p i t a l flows. From the p o i n t of view of the host country, the r e a l importance of i n t e r n a t i o n a l banking i s that i t makes a very s i g n i f i c a n t c o n t r i b u t i o n to the c r e a t i o n of f i n a n c i a l assets and the development of e f f i c i e n t f i n a n c i a l markets. There i s no doubt that the t r a n s m i s s i o n of f i n a n c i a l technology, as w e l l as the more f a r - r e a c h i n g establishment of new types of f i n a n c i a l i n s t i t u t i o n s by f o r e i g n e r s has played a l a r g e part i n the f i n a n c i a l development of most c o u n t r i e s . ^ The development of f i n a n c i a l markets i s e s s e n t i a l to economic g r o w t h — a t l e a s t i n 'western' economies. Goldsmith has pointed out that every modern economy has a super-s t r u c t u r e of f i n a n c i a l assets that e x i s t s i d e by s i d e w i t h the i n f r a -s t r u c t u r e of n a t i o n a l wealth composed of p h y s i c a l a s s e t s . ~* F i n a n c i a l assets of course are l a r g e l y a product of the banking system. A f i n a n -c i a l asset can be defined as a c l a i m against some other economic u n i t . 28 Unlike a physical asset, the financial asset of one party i s the debt of another. It follows that in a closed economy the net value of financial assets would be zero. It has been found that in an advanced economy such as the U.S., financial institutions (primarily the banks) are connected as holders or issuers with a majority portion of a l l financial instruments outstanding.1 Furthermore this relationship has increased over time. The following example is meant to ill u s t r a t e the creation of financial assets: a) assume a firm purchases ten acres of industrial land for $10,000 and wants to erect a warehouse costing $90,000; b) bank A i s willing to finance 100 per cent of the project secured by a mortgage bond of $100,000; c) bank A in turn borrows $10,000 via term deposits from each of ten customers; d) a l l ten bank A customers lever their investment by borrowing $5,000 each from bank B; and e) bank B in turn borrows $50,000 via term deposit from another de-positor. The end result i s : Real Assets: Financial Assets: Land & Building $100,000 Mortgage Bond $100,000 Bank A term dep. 100,000 Bank B loans 50,000 Bank B deposits 50,000  $300.000 29 Goldsmith has argued that a measure of the l e v e l of economic development of a country can be obtained by i t s " f i n a n c i a l i n t e r r e l a t i o n s r a t i o . T h e r a t i o i s obtained by d i v i d i n g the gross value of f i n a n c i a l assets by the value of r e a l assets or n a t i o n a l wealth plus net f o r e i g n balance. In the h y p o t h e t i c a l example above the r a t i o : would be 300,000 = _ 100,000 which i n r e a l l i f e would i n d i c a t e a very high l e v e l of development. As a country develops, i t s f i n a n c i a l s u p e r s t r u c t u r e grows more r a p i d l y than i t s stock of r e a l a s s e t s . The reason i s that i t has been necessary f o r the c r e a t i o n of f i n a n c i a l i n t e r m e d i a r i e s to f a c i l i t a t e flows of savings from surplus to d e f i c i t u n i t s . A diagrammatic i l l u s -t r a t i o n of the f a m i l i a r process i s as f o l l o w s : DEFICIT SPENDING UNIT s e l l primary s e c u r i t i e s j s e l l i n d i r e c t s e c u r i t i e s [ SURPLUS SPENDING UNITS Adding a f i n a n c i a l intermediary has the e f f e c t of i n c r e a s i n g the f i n a n -c i a l i n t e r r e l a t i o n r a t i o ( i n the simple case by a f a c t o r of 2). The c o n t r i b u t i o n of f o r e i g n banking to the f i n a n c i a l super-s t r u c t u r e can be i n s e v e r a l areas. I t may simply i n v o l v e the c r e a t i o n INTERMEDIARY 30 of a whole r e t a i l banking system f o r a country. An outstanding example of t h i s i s the Canadian banking system i n the Caribbean. These banks have unquestionably aided i n the development of a f i n a n c i a l s u p e r s t r u c -t u r e and thus i n an attendent increase i n n a t i o n a l wealth. I t has been found t h a t , u n t i l World War I , f o r e i g n banks h e l d a dominating or at l e a s t a very strong p o s i t i o n i n v i r t u a l l y every country i n which they operated. Up to t h i s time then the main c o n t r i b u t i o n would have been to create a r e t a i l banking system f o r a country. Foreign banks may a l s o focus on the development of a market seg-ment neglected by indigenous f i n a n c i a l i n t e r m e d i a r i e s . A good example of t h i s i s the entry i n t o medium term commercial f i n a n c i n g by U.S. and Canadian banks operating i n Europe. On a broader s c a l e , f o r e i g n banks can f a c i l i t a t e f i n a n c i n g across n a t i o n a l borders. This a b i l i t y to supplement domestic funds w i t h an outside source or m o b i l i z e surplus domestic funds f o r use abroad has enabled the banks to play a s i g n i f i c a n t r o l e i n the economic development of many c o u n t r i e s . In a d d i t i o n , Goldsmith r e p o r t s that Probably as important f o r the f i n a n c i a l development of most c o u n t r i e s as the flow of funds across i n t e r n a t i o n a l boundaries was the example provided by the more advanced c o u n t r i e s . Transfer of technology and entepreneurship have been e a s i e r to accomplish, and on the whole more s u c c e s s f u l , w i t h respect to f i n a n c i a l instruments and f i n a n c i a l i n s t i -t u t i o n s than i n many other f i e l d s . 8 The l a t t e r sentence i n c l u d e s the assumption that firms i n more advanced c o u n t r i e s have some s o r t of market advantage to e x p l o i t i n the host coun-t r y . This i s an important p o i n t which w i l l be discussed i n Chapters s i x and seven below. 31 One i m p l i c a t i o n of the i n t r o d u c t i o n of f o r e i g n banks i s that i t opens up a wider range of choice to holders and i s s u e r s of f i n a n c i a l a s s e t s . T h i s . o f f e r s an advantage i n th a t a c l o s e r f i t should be p o s s i b l e 9 i n matching asset holdings w i t h asset preference. Canadian bankers seem to recognize t h i s c o n t r i b u t i o n . Says A l l e n Lambert, Chairman of the Toronto-Dominion: I n t e r n a t i o n a l business has been developing r a p i d l y i n the A s i a n -P a c i f i c r e g i o n , and Toronto-Dominion Bank was one of the e a r l i e s t to p a r t i c i p a t e i n t h i s . The development of new banking s e r v i c e s has transformed the f i n a n c i a l s u p e r s t r u c t u r e of the A s i a n / P a c i f i c r e g i o n and there now e x i s t s a much greater v a r i e t y of f i n a n c i a l instruments and a r a p i d growth of f i n a n c i a l institutionsTTO In a d d i t i o n i t has been found that the i n t r o d u c t i o n of a f o r e i g n bank o f t e n 'shakes up' the l o c a l market and r e s u l t s i n lower i n t e r e s t costs and g e n e r a l l y more e f f i c i e n t s e r v i c e s to customers. SUMMARY The o v e r r i d i n g importance of i n t e r n a t i o n a l banking then i s that i t a s s i s t s i n c r e a t i n g a f i n a n c i a l s u p e r s t r u c t u r e i n the host country. Goldsmith has found a p a r a l l e l i s m between economic and f i n a n c i a l develop-ment, however he cautions t h a t : there i s no p o s s i b i l i t y of e s t a b l i s h i n g w i t h confidence the d i r e c t i o n of the caus a l mechanism; i . e . , of d e c i d i n g whether f i n a n c i a l f a c t o r s were r e s p o n s i b l e f o r the a c c e l l e r a t i o n of economic development or whether f i n a n c i a l development r e f l e c t s economic growth whose main-springs must be sought elsewhere.11 Predominant t h i n k i n g however supports the view that the caus a l chain runs from f i n a n c i a l development to economic development. The 32 reason for this view is that i t has been observed that financial i n s t i -tutions tend to f a c i l i t a t e the flow of funds to the best user in the system: i.e., to that economic unit that w i l l generate-the highest return on the funds employed. Another important (but controversial) contribution of interna-tional banking is that i t tends to weaken the boundaries set up to separate nation states. The big banks, lik e other multinationals have been described as: a modern concept designed to meet the requirements of a modern age; the nation state is a very old fashioned idea and badly adapted to serve the needs of our present complex world.12 Nationalism i s an outmoded concept and any contribution the banks, by their active expansion across national boundaries, can make to promote the growth of economic interdependence among nations can be considered worthwhile. In summary, international banking makes a key contribution to the development of world financial markets. Furthermore there are indi -cations that the trend toward international banking is here to stay. Accordingly i t is probably time to develop some insights into the forces that have caused the banks to expand—but f i r s t a discussion of the rela-tive size and growth of the foreign operations of the U.S. and Canadian banks. 33 Notes for Chapter Three 1 Ibid. Business Week (July 6, 1974) 2 3 H. H. Binhammer, Money, Banking and the Canadian F i n a n c i a l  System (Toronto: Methuen, 1968). 4 R. W. Goldsmith, F i n a n c i a l Structure and Development (New Haven, Conn.: Yale Un i v e r s i t y Press, 1969). 5 Ibid. 6 I b i d . 7 I b i d . g Ibid., p. 47. • D. E. Bond and R. A. Shearer, The Economics of the Canadian  F i n a n c i a l System (Toronto: P r e n t i c e - H a l l , 1972). The Toronto Dominion Bank, Annual Report, 1973. Goldsmith, p. 48. 12 George B a l l quoted i n Fortune, 75, No. 6 (June 1, 1967), 80. Chapter Four GROWTH OF INTERNATIONAL BANKING It i s the primary purpose of this chapter to trace the growth over the past ten years of the international banking activities of U.S. and Canadian banks. The following chapter w i l l then explore the more popular explanations offered for the rapid growth experienced. To place the growth experience of U.S. and Canadian banks in per-spective i t may be worthwhile to discuss the overall growth of interna-tional banks in recent years. Since 1970, 'The Banker' has published an annual l i s t of the top 300 commercial banks in the world (see Table 4-1 for a partial l i s t i n g ) . Since banks perform somewhat different functions in various countries i t is d i f f i c u l t to establish c r i t e r i a upon which to base the annual rankings but i t is clear that profits have never been considered. Deposit taking and short term lending constitute typical banking activities and any companies performing this service are included in the l i s t . However banks a l l over the world are diversifying wherever permitted by legislation and therefore the l i s t includes several mixed banks who combine deposit taking and short term lending with other finan-c i a l services. This policy is consistent with the broad definition of international banking developed in Chapter two. U.S. bank holding com-panies represent a good example of 'mixed banks' included in the annual l i s t prepared by The Banker. In 1964 the top ten banks of the world had deposits totalling 34 35 Table 4-1 THE WORLD'S MAJOR BANKS, 1973 Rank Bank Head o f f i c e Date of accounts Assets l e s s contra a/c T o t a l de-p o s i t s C a p i t ' l & r e -serves 1 BankAmerica San Fra n c i s c o 31.12.73 31.12.72 48,772 40,465 41,453 35,085 1,550 1,454 2 C i t i c o r p New York 31.12.73 31.12.72 44,018 34,385 34,942 27,704 1,770 1,515 3 Chase Manhattan Corp New York 31.12.73 31.12.72 36,790 30,704 29,913 25,032 1,348 1,262 4 Banque Na t i o n a l e de P a r i s P a r i s 31.12.73 31.12.72 30,142 21,034 29,780 20,732 251 205 5 D a i - I c h i Kangyo Bank Tokyo 30.9.73 30.9.72 28,467 20,969 21,298 16,815 845 594 6 Barclays Bank London 31.12.73 31.12.72 28,304 21,591 24,748 18,790 1,586 1,394 7 N a t i o n a l Westmin-s t e r Bank London 31.12.73 31.12.72 27,555 20,568 24,802 18,887 2,095 1,265 8 F u j i Bank Tokyo 30.9.73 30.9.72 24,418 17,636 18,735 14,551 1,083 784 9 Deutsche Bank Fr a n k f u r t 31.12.73 31.12.72 24,389 18,212 22,847 17,050 836 617 10 Sumitomo Bank Osaka 30.9.73 30.9.72 23,905 17,127 18,233 14,201 879 624 17 J.P. Morgan & Co. New York 31.12.73 31.12.72 19,905 16,128 15,367 12,839 957 881 18 Manufacturers Hanover Corp New York 31.12.73 31.12.72 19,540 16,163 17,210 14,150 895 846 28 Royal Bank of Canada Montreal 31.10.73 31.10.72 17,737 14,567 16,816 13,769 491 449 35 Canadian I m p e r i a l Bank of Commerce Toronto 31.10.73 31.10.72 15,669 13,133 14,815 12,414 495 466 41 Bank of Montreal Montreal 31.10.73 31.10.72 13,988 11,138 13,304 10,535 390 370 55 Bank of Nova S c o t i a H a l i f a x 31.10.73 31.10.72 10,462 8,647 9,769 8,072 340 308 71 Toronto-Dominion Bank Toronto 31.10.73 31.10.72 9,030 7,354 8,513 6,953 407 306 Source: The Banker, June 1974. 36 $73,407 m i l l i o n ( i n c l u d i n g the two l a r g e s t Canadian banks)."*" By the end of 1973 the ten l a r g e s t banks i n the world had t o t a l d e p o s i t s of 2 $266,751 m i l l i o n . This represents a compound annual growth r a t e of a l -most 14 per cent. During the ten year p e r i o d from 1964 to 1973 there were substan-t i a l changes i n the top ten rankings: 1964 (1973 rank) 1. (1) Bank of America 2. (3) Chase Manhattan 3. (2) F i r s t N a t i o n a l C i t y 4. (18) Manufacturers Hanover Trust 5. (6) Barclays Bank 6. (21) Midland Bank 7. (23) Chemical Bank 8. (28) The Royal Bank of Canada 9. (17) Morgan Guaranty Trust 10. (35) Can. Im p e r i a l Bank of Com. 1973 (1964 rank) (1) BankAmerica Corporation (3) C i t i c o r p (1st N a t i o n a l C i t y ) (2) The Chase Manhattan Corp. (31) Banque N a t i o n a l e de P a r i s (41) D a i - I c h i Kangyo Bank (5) Barclays Bank (17) N a t i o n a l Westminster (20) F u j i Bank (26) Deutsche Bank (23) Sumitomo Bank As was noted in Chapter One, several of the major banks now in the top ten have arrived there via mergers and acquisitions. In fact a common theme has emerged since the late 1960's in the international bank-ing scene. It is that the large banks are striving for increasingly sophisticated ways to overcome the constraints on growth imposed by their environment. Traditionally the share of the market was sustained or increased by direct competition between like institutions. But in recent years 37 r a t i o n a l i z a t i o n and d i v e r s i f i c a t i o n i n t o near banking areas of a c t i v i t y have become de ri g u e u r f o r the b i g or medium s i z e d banks seeking f o r something more than the n a t u r a l growth a r i s i n g out of increases i n money supply and demand f o r c r e d i t . 3 Of course the quickest way to move i n t o the b i g leagues of bank-ing i s through a corporate merger. In 1970 D a i - I c h i and Nippon Kangyo Banks of Japan merged t h e i r operations to become the f i f t h l a r g e s t bank i n the world. P r i o r to the merger each bank ranked around f o r t i e t h i n the Banker's l i s t . This merger touched o f f a wave of aggressive i n t e r n a t i o n a l expan-s i o n by Japan's major banks. In 1971 the Japanese banks began s e t t i n g up i n t e r n a t i o n a l branch networks and they a g g r e s s i v e l y entered the Euro-currency markets on a s u b s t a n t i a l s c a l e . This r a p i d expansion has r e c e n t l y been h a l t e d and there i s some evidence that the Japanese may have been somewhat overeager i n t h e i r e x p a n s i o n i s t i c z e a l . The F i n a n c i a l Post describes the banking ' i n v a s i o n ' t h i s way: Anyone who has ever been standing i n a l i n e invaded by a squad of Japanese t o u r i s t s w i l l understand the b r u i s e d f e e l i n g s of the i n t e r -n a t i o n a l banking community. The Japanese banks a r r i v e d w i t h a t y p i -c a l l y l a r g e and co-ordinated bang. I t h u r t . And then they dramati-c a l l y reversed d i r e c t i o n l a s t w i n t e r (1973). But t h i s time they were the ones who were bruised.4 I t appears that at the beginning of the 1970's the Japanese banks began to make s u b s t a n t i a l low r a t e , medium term Euro currency loans. " I t was as i f they [the Japanese] had a d i f f e r e n t message from the r e s t of us,""' one banker commented i n obvious reference to the general consensus of o p i n i o n that i n t e r e s t r a t e s would soon r i s e . The Japanese banks were accused of using 'dumping' t a c t i c s i n redeploying the country's f o r e i g n 38 exchange reserves to t h e i r primary loan o u t l e t — r e s o u r c e r i c h developing c o u n t r i e s . The 1973 Middle East war and the r e s u l t a n t h i k e i n o i l p r i c e s forced a change i n the Japanese posture almost overnight. Faced w i t h a balance of payments d e f i c i t caused by higher o i l p r i c e s , the Japanese had to borrow i n the Euro market. By the second quarter of 1974, Euro d o l l a r borrowings by the Japanese banks were s i x times the l e v e l of one year e a r l i e r , and at s i g n i f i c a n t l y higher r a t e s of i n t e r e s t . The banks soon f e l l i n t o the trap of having to borrow short at hi g h r a t e s of i n t e r e s t to fund long term loans at lower r a t e s . By June of 1974 Japan-ese a u t h o r i t i e s had ordered t h e i r banks to cease making loans i n the Euro currency market. This a c t i o n e f f e c t i v e l y stopped the Japanese ex-pansion and a reasonable guess would be that the Japanese banks have s l i p p e d c o n s i d e r a b l y i n 1974. (Ratings w i l l be prepared ( i n June 1975) by The Banker.) The year 1972 saw a f u r t h e r r e s h u f f l i n g of p o s i t i o n s i n the top 300 l i s t due p r i m a r i l y to d i f f e r i n g r a t e s of economic growth i n home markets discussed below. There are of course some f a c t o r s o u t side the c o n t r o l of the banks that c o n t r i b u t e to t h e i r r e l a t i v e growth r a t e s . Re-alignment of c u r r e n c i e s can have a s u b s t a n t i a l impact. For example, i n 1972 the r e v a l u a t i o n of the D-mark and the f r a n c allowed major German and French banks to improve t h e i r world ra n k i n g . I t should be noted however that the impact of a r e v a l u a t i o n or d e v a l u a t i o n of the l o c a l c ur-rency i s l a r g e l y dependent upon the degree to which a bank has gone i n t e r n a t i o n a l . The true i n t e r n a t i o n a l banks have assets and l i a b i l i t i e s 39 i n s e v e r a l c u r r e n c i e s and the e f f e c t of a currency realignment may be d i f f u s e d . The r a p i d expansion of major i n t e r n a t i o n a l banks continued i n 1973 w i t h the Japanese banks again showing the f a s t e s t growth r a t e s . Table 4-2 shows the comparative growth r a t e s s i n c e 1971 of the top U.S., Japanese, and E.E.C. banks. 7 Rapid growth i n 1973 r e s u l t e d i n the F u j i Bank and Sumitomo Bank pushing i n t o the top ten f o r the f i r s t time and the D a i - I c h i Kangyo Bank overtaking Barclays i n f i f t h spot. Again, exchange r a t e s played a r o l e i n the r e l a t i v e growth r a t e s w i t h Japan showing up w e l l due p a r t l y to r e v a l u a t i o n of the Yen. In c l o s i n g t h i s s e c t i o n i t i s probably a d v i s a b l e to p o i n t out some of the weaknesses i n the use of balance sheet data to compare the r e l a t i v e s i z e and growth r a t e s of the world's l e a d i n g banks. The prob-lem of exchange r a t e realignment has already been mentioned. However there are o'ther p o t e n t i a l problem areas. George F o r r e s t of Barclays Bank has attempted to r e l a t e the s i z e of major world banks to the r a t i o g of the money supply to GNP i n t h e i r home country. The approach i s s i m i l a r to that of Goldsmith (see Chapter Two),who found that a h i g h r a t i o of money and near money to GNP i s somewhat i n d i c a t i v e of a l a c k of f i n a n c i a l s o p h i s t i c a t i o n . This p a r t i c u l a r r a t i o should not be con-fused w i t h Goldsmith's ' f i n a n c i a l i n t e r r e l a t i o n s r a t i o ' which i s the r a t i o of the gross value of a l l f i n a n c i a l assets to n a t i o n a l wealth. A h i g h value f o r the l a t t e r i s i n d i c a t i v e of a f i n a n c i a l l y advanced country. On the other hand a high r a t i o of money to GNP o f t e n i n d i c a t e s that more 40 Table 4-2 COMPARATIVE GROWTH RATES OF MAJOR BANKS 1973 /o Change 1972 /o Change 1971 TOP 10 U.S. BANKS ($ m i l l i o n s ) 1 BankAmerica Corp 48,772 20.5 40,465 21.1 33,406 2 F i r s t N a t i o n a l C i t y Corp 44,018 28.0 34,385 16.8 28,713 3 The Chase Manhattan Corp 36,790 19.8 30,704 25.3 24,507 4 J.P. Morgan & Co. Inc. 19,905 23.4 16,128 18.7 13,871 5 Manufacturers Hanover Corp 19,540 20.9 16,163 13.8 14,347 6 Chemical New York Corp 18,364 19.8 15,324 21.5 12,702 7 Bankers Trust New York Corp 18,272 33.0 13,737 23.2 10,738 8 Western Bancorporation 17,751 17.6 15,088 14.8 13,138 9 C o n t i n e n t a l I l l i n o i s Corp 16,784 32.0 12,713 23.7 10,081 10 F i r s t Chicago Corp 15,292 36.8 11,181 27.1 9,152 255,488 24.1 205,888 20.6 170,655 TOP 10 JAPANESE BANKS ($ m i l l i o n s ) 1 D a i - I c h i Kangyo 28,467 35.8 20,969 32.9 15,774 2 F u j i Bank 24,418 38.4 17,637 37.5 12,823 3 Sumitomo Bank 23,905 39.6 17,127 38.2 12,393 4 M i t s u b i s h i Bank 23,433 39.0 16,860 37.8 12,236 5 Sanwa Bank 22,373 42.1 15,747 35.1 11,658 6 I n d u s t r i a l Bank of Japan 18,550 40.4 13,212 10.8 11,927 7 The Tokai Bank 18,215 47.3 12,362 42.0 8,706 8 M i t s u i Bank 16,845 41.8 11,877 45.6 8,158 9 Taiyo Kobe Bank 16,460 45.3 11,331 46.3 7,742 10 Bank of Tokyo 16,298 51.3 10,771 55.3 6,936 208,964 41.3 147,893 36.4 108,353 TOP 10 EEC BANKS ($ m i l l i o n s ) 1 Banque Na t i o n a l e de P a r i s 30,142 43.3 21,034 34.0 15,698 2 Barclays Bank 28,304 31.1 21,591 15.6 18,680 3 N a t i o n a l Westminster Bank 27,555 34.0 20,568 21.0 16,982 4 Deutsche Bank 24,389 34.0 18,212 20.0 15,168 5 C r e d i t Lyonnais 23,450 17.3 19,994 35.0 13,529 6 Societe Generale 22,821 31.8 17,321 35.9 11,078 7 Banca Nazionale d e l Lavore 22,651 20.4 18,819 27.6 14,754 8 Dresdner Bank 20,667 38.4 14,926 18.8 12,560 9 Banco d i Roma 19,395 23.8 15,663 54.1 10,161 10 Westdeutsche Landesbank G i r o z e n t r a l e 19,366 37.2 14,118 11.7 12,639 238,740 31.0 182,246 29.0 141,249 Source: The Banker, June 1974. 41 sophisticated financial assets and markets have not yet been developed. In these countries, banks are by far the most important financial i n s t i -tution and their size i s often out of proportion (in relative terms) to the domestic economy. Thus i t is not unusual to see a bank from a developing country included in the top 300 l i s t . In comparing the relative size of banks from developed countries one should be mindful of the appropriate government's view of the role of monetary policy. The governments of some countries, notably Germany, focus on the supply of money. Thus the growth of domestic deposits i s restricted. Governments of other countries, Italy for example, use monetary policy primarily to stabilize interest rates. In recent months this has resulted in a very rapid rate of growth in the Italian money supply, primarily consisting of deposits at commercial banks. Italian banks are thus somewhat larger than one would expect they should be. Another factor to consider in comparisons of the relative size of banks in various countries i s whether the commercial banks are con-sidered the major savings medium. Forrest argues that, in the United Kingdom, they are not. The building societies dominate in the short term savings markets and the insurance companies the long term market. Thus the majority of savings do not come into the money supply and do not show on the books of the banks—resulting in 'smaller' banks than otherwise. In Germany, Switzerland, Japan, or Hong Kong, for example, the banks are the major savings mediums; 'near money' figures are dramatically boosted and the banks are greatly increased in size.^ In an effort to correct for the above problem, Forrest has pre-pared tables (Tables 4-3 and 4-4), which adjust the asset holdings of world banks by a coefficient based on the ratio of money supply to GNP.'' 42 Table 4-3 MONEY EXPRESSED AS A PERCENTAGE OF GROSS NATIONAL EXPENDITURE (RELATIVE TO THE UK IN BRACKETS) ESTIMATED LEVEL AT JUNE 1973 Money Near- Money supply money (Money + near-money) United Kingdom 21.2 24.5 45.7 (1.00) Argentina 50.0 27.9 77.9 (1.71) A u s t r a l i a 20.3 41.1 61.3 (1.34) A u s t r i a 21.3 45.1 66.4 (1.45) Belgium 37.9 18.2 56.0 (1.23) B r a z i l 22.9 3.7 26.7 ( .58) Canada 21.7 23.2 44.9 ( .98) Denmark 28.7 24.9 53.5 (1.17) E i r e 24.3 32.5 56.8 (1.24) Egypt 34.6 12.2 46.9 (1.03) F i n l a n d 9.8 40.7 50.5 (1.11) France 30.7 20.6 51.3 (1.12) Germany 15.3 42.8 58.2 (1.27) Greece 21.3 42.7 64.0 (1.40) Hong Kong 48.8 64.2 113.0 (2.47) I n d i a 24.7 13.6 38.3 ( .84) Ira n 21.9 20.8 42.7 ( .93) I s r a e l 21.8 40.7 62.4 (1.37) I t a l y 69.3 33.9 103.1 (2.26) Japan 39.9 59.5 99.4 (2.17) Korea 12.3 21.9 34.2 ( .76) Kuwait 13.2 26.3 39.5 ( .86) Mexico 13.2 4.8 18.1 ( .40) New Zealand 20.3 11.1 31.4 ( -69) Netherlands 26.0 27.7 53.6 (1.17) Norway 23.9 41.6 65.5 (1.43) P a k i s t a n 39.3 16.9 56.3 (1.23) Peru 20.8 6.4 27.2 ( .60) Po r t u g a l 56.8 54.3 111.1 (2.43) South A f r i c a 20.2 25.8 46.0 (1.01) Spain 38.2 69.1 107.3 (2.35) Sweden 10.1 26.4 36.5 ( .80) Switz e r l a n d 48.0 ' 66.2 114.2 (2.50) Taiwan 23.7 37.6 61.3 (1.34) Thailand 17.0 26.1 43.2 ( .94) Turkey 12.9 19.6 32.4 ( -71) USA 22.0 29.0 51.0 (1.12) Yugoslavia 33.4 55.3 88.7 (1.94) Source: The Banker, June 1974. 43 Table 4-4 ADJUSTED RANKING OF TOP TEN BANKS ($000 m i l l i o n ) Adjusted Assets Unadjusted Assets Rank 1. Bank of America 43.7 48.8 1 2. F i r s t N a t i o n a l C i t y Bank 39.7 44.0 2 3. Chase Manhattan Bank 33.1 36.8 3 4. Barclays Bank 28.3 28.3 5 5. N a t i o n a l Westminster Bank 27.6 27.6 6 6. Banque N a t i o n a l de P a r i s 26.8 30.1 4 7. C r e d i t Lyonnais 20.8 23.6 11 8. Societe Generale 20.4 22.6 12 9. Deutsche Bank 19.3 24.4 9 10. Midland Bank 19.1 19.1 20 Source: The Banker, June 1974. Applying the F o r r e s t c o e f f i c i e n t to Canadian banks r e s u l t s i n a s i g n i f i - r cant upward adjustment i n t h e i r ranking. The Royal Bank f o r example, would advance from twenty-eighth place to eleventh. While F o r r e s t ' s a n a l y s i s i s r a t h e r i n t e r e s t i n g , there i s a poten-t i a l l y important flaw. The i m p l i c i t assumption i s that the major p o r t i o n of a p a r t i c u l a r bank's assets are based i n the home country and thus s t r o n g l y i n f l u e n c e d by the i n s t i t u t i o n a l and monetary arrangements i n that country. As pointed out above, the t r u l y i n t e r n a t i o n a l banks have assets l o c a t e d i n s e v e r a l c o u n t r i e s . For example, C i t i c o r p of New York has 52 per cent of i t s t o t a l d eposits i n f o r e i g n c o u n t r i e s . In t h i s 44 case i t i s d i f f i c u l t to argue that the bank's assets should (for compara-tive purposes) be reduced by a coefficient based upon domestic (U.S.) economic data. With the above qualifications in mind i t can be said that, in the era of international banking, size and growth have taken on renewed importance. In the past, size represented to a large degree status. In recent years, p r o f i t a b i l i t y has become much more important in banking, but increasingly volatile markets and greater involvement in economic development through monetary policy have made size more important again. The 1930's depression proved that big banks weather storms better than smaller banks.IN-GROWTH OF U.S. INTERNATIONAL BANKING In the previous section we discussed the recent growth of the world's major international banks. No distinction was made between the domestic/foreign composition of their balance sheets. The intention rather was to give the reader some feeling for the 'growth cult' that has characterized the banking industry over the past decade. We now switch our approach somewhat and focus on the ten year growth of the international operations of the U.S. banks. We have not limited our discussion to the growth experience of the five major U.S. banks but':have chosen to discuss the international growth of the U.S. banking industry in general. Specific reference w i l l be made occasion-al l y to the experience of the major banks. In an effort to il l u s t r a t e the determination exhibited by the U.S. banks in penetrating foreign markets, we have singled out Canada as a case study. 45 We c l o s e t h i s s e c t i o n w i t h a b r i e f d i s c u s s i o n of the outlook f o r f u r t h e r growth of the i n t e r n a t i o n a l operations of U.S. banks. As i l l u s t r a t e d by Table 4-5, i n March 1965, U.S. n a t i o n a l banks 12 had 144 f o r e i g n branches spread around the world. Table 4-5 FOREIGN BRANCHES OF NATIONAL BANKS, BY REGION AND COUNTRY, March 31, 1965 Region & Country Number Region & Country Number L a t i n America 68 A f r i c a 1 Argentina 17 N i g e r i a 1 Bahamas 1 B r a z i l 15 Near East 4 C h i l e 2 Lebanon 2 Colombia 5 Saudi A r a b i a 1 Dominican Republic 1 Dubai 1 Ecuador 2 E l Salvador 1 Far East 36 Guatemala 2 Hong Kong 5 Jamaica 1 I n d i a 5 Mexico 5 Japan 10 Nicaragua 1 Malaysia 5 Panama 5 Okinawa 1 Paraguay 2 P a k i s t a n 2 Peru 2 P h i l i p p i n e s 5 Uruguay 2 Taiwan 2 Venezuela 4 Thailand 1 C o n t i n e n t a l Europe 12 U.S. overseas area 14 Belgium 1 Canal Zone 1 France 2 Guam 1 Germany 3 Puerto Rico 11 Greece 1 Truk I s l a n d s 1 I t a l y 1 Netherlands 3 England 9 Switzerland 1 TOTAL 144 Consolidated assets and l i a b i l i t i e s of f o r e i g n branches of U.S. banks at 13 December 31st, 1964 were broken down as i n d i c a t e d i n Table 4-6. 46 Table 4-6 ASSETS AND LIABILITIES OF FOREIGN BRANCHES OF NATIONAL BANKS, DECEMBER 31, 1964: CONSOLIDATED STATEMENT (Dollar amounts in thousands) Number.of branches 138 ASSETS Loans and discounts $1,924,827 Securities 178,958 Currency and coin 31,331 Balances with other banks and cash items in process of collection 480,730 Due from head office and branches 320,858 Fixed assets 28,352 Customers' l i a b i l i t y on acceptances 304,362 Other assets 50,461 Total assets $3,319,879 LIABILITIES Demand deposits of individuals, partnerships, and corporations $ 730,761 Time and savings deposits of individuals, partner-ships, and corporations 1,178,987 Deposits of U.S. Government 190,932 State and municipal deposits 12,988 Deposits of banks 753,791 Other deposits (certified and officers' checks, etc.) 21,468 Total deposits $2,888,927 Due to head office and branches 8,591 Rediscounts and other l i a b i l i t i e s for borrowed money 61,015 Acceptances executed by or for account of reporting branches and outstanding 305,481 Other l i a b i l i t i e s 55,865 Total l i a b i l i t i e s $3,319,879 In commenting on the 1964 results the U.S. Comptroller of the Cur-rency noted that foreign branch assets had increased by 27 per cent over 1963, a rate well in excess of the growth rate of domestic banking opera-14 tions. In addition to the foreign branches; in 1964 thirteen national banks had direct investment in eighteen subsidiaries engaged in 47 i n t e r n a t i o n a l banking and finance. The combined assets of these corpor-a t i o n s exceeded $750 m i l l i o n and t h e i r c a p i t a l funds exceeded $100 m i l l i o n . While the 1964 annual growth r a t e of 27 per cent i s c e r t a i n l y impressive, i t does not come c l o s e to matching the phenomenal expansion over the f o l l o w i n g nine years. By December 31, 1973, assets of f o r e i g n branches of U.S. banks had reached $121,866 m i l l i o n (see Table 4-7). This represents a nine-year average compound growth r a t e of almost 50 per cent. Table 4-7 ASSETS OF FOREIGN BRANCHES OF U.S. BANKS (In m i l l i o n s of d o l l a r s ) L o c a t i o n and Currency Form Year T o t a l Claims on U.S. Claims on Forgners Other A l l C o u n t r i e s , 1971 $ 61,253 $4,791 $ 54,678 $1,784 A l l Currencies 1972 80,034 4,735 73,031 2,268 1973 121,866 4,881 112,240 4,745 Mar. 1974 136,983 7,986 123,823 5,174 United Kingdom 1971 34,552 2,694 30,996 862 1) A l l Currencies 1972 43,684 2,234 30,430 1,020 1973 61,732 1,789 57,761 2,183 Mar. 1974 68,076 3,070 63,020 1,986 2) U.S. D o l l a r s 1971 24,428 2,585 21,493 350 1972 30,381 2,146 27,787 447 1973 40,323 1,642 37,816 865 Mar. 1974 46,062 2,967 42,212 882 Source: Federal Reserve B u l l e t i n , June 1974. The growth i n branches and other f i n a n c i a l o u t l e t s has not kept pace w i t h asset growth, which has r e s u l t e d i n l a r g e r average branch s i z e . By the end of 1973 (see Table 4-8) 125 Federal Reserve member banks had i n a c t i v e operation 699 branches i n seven t y - s i x f o r e i g n c o u n t r i e s . 48 Table 4-8 FOREIGN BRANCHES OF U.S. BANKS Lo c a t i o n No. L o c a t i o n No. Abu Dhabi 1 L i b e r i a 2 Argentina 38 Luxembourg 6 A u s t r i a 1 M a l a y s i a 5 Bahamas 91 Mariana Islands 1 Bahrain 2 M a r s h a l l Islands 1 Barbados 4 Mexico 5 Brunei 2 Monaco 1 Belgium 9 Netherlands 6 B o l i v i a 3 Netherlands A n t i l l e s 3 B r a z i l 21 Nicaragua 3 Canal Zone 2 Okinawa 2 Cayman Islands 32 P a k i s t a n 4 Colombia 32 Panama 33 Dominican Republic 16 Paraguay 6 Dubai 3 Peru 6 Ecuador 15 P h i l i p p i n e s 4 E l Salvador 1 Puerto Rico 22 F i j i I s lands 4 Qatar 1 France 15 Saudi A r a b i a 2 Germany 30 Singapore 14 Greece 16 S w i t z e r l a n d 9 Guam 7 Taiwan 5 Guatemala 3 Thailand 2 Guyana 1 T r i n i d a d and Tobago 6 H a i t i 2 T r u c i a l State of Sharjah 1 Honduras 3 Truk Islands 1 Hong Kong 23 United Kingdom 52 I n d i a 11 Uruguay 5 Indonesia 6 Venezuela 4 I r e l a n d 4 Vietnam 3 I s r a e l 2 V i r g i n Islands (U.S.) 21 I t a l y 8 V i r g i n I s l a n d s ( B r i t i s h ) 3 Jamaica 9 Japan 23 Other (West Indies) 14 Korea 3 Lebanon 3 T o t a l 699 Source: 1973 Annual Report, Board of Governors of the Federal Reserve System. 49 Average branch s i z e has r i s e n from $23 m i l l i o n i n 1964 to $174 m i l l i o n at the end of 1973. An important c o n t r i b u t i n g f a c t o r to the growth i n average branch s i z e has been the r a p i d growth i n s i z e of branches i n the United Kingdom as a r e s u l t of t h e i r p a r t i c i p a t i o n i n the Euro d o l l a r market. At December 1973, U.S. banks operated f i f t y - t w o branches i n the United Kingdom w i t h t o t a l assets of $61,7.22 m i l l i o n f o r an average branch s i z e of $1,187 m i l l i o n , w e l l i n excess of the o v e r a l l average. In f a c t i f U.S. branches and assets i n the United Kingdom are removed, the remaining 647 f o r e i g n branches show assets t o t a l l i n g only $53,790 m i l l i o n f o r an average s i z e of $83 m i l l i o n . I t should be noted that the average s i z e of f o r e i g n branches by any measure i s s t i l l l a r g e i n r e l a t i o n to the average s i z e of U.S. domestic branches. At December 31, 1973, the 40,408 banking o f f i c e s i n the U.S. had assets t o t a l l i n g $835,224 m i l l i o n which on average works out to $21 m i l l i o n per banking ... 15 -o f f i c e . U nfortunately i t i s not p o s s i b l e to compare the growth s i n c e 1964 i n average s i z e of the London branches. The Federal Reserve system only began c o l l e c t i n g monthly data on the assets and l i a b i l i t i e s of U.S. 16 branches operating i n f o r e i g n c o u n t r i e s i n September 1969. I t does appear very l i k e l y however t h a t , because of p a r t i c i p a t i o n i n the Euro d o l l a r market, the London branches have expanded t h e i r average s i z e at a co n s i d e r a b l y f a s t e r r a t e than other f o r e i g n branches. In f a c t , assets of U.S. banks operating i n London now c o n s t i t u t e an important p r o p o r t i o n of the e n t i r e United Kingdom banking i n d u s t r y . 50 Bank of England s t a t i s t i c s i n d i c a t e that r e p o r t i n g banks i n the U.K. ( i n c l u d i n g the major London c l e a r i n g banks) held assets t o t a l l i n g f104,391 m i l l i o n at A p r i l 17, 1974."*"^  The London c l e a r i n g banks, which i n c l u d e B a r c l a y s , Midland, L l o y d s , and N a t i o n a l Westminster, h e l d f23,477 m i l l i o n or 22.4 per.cent of the t o t a l . At the same time, U.S. banks operating i n London he l d assets t o t a l l i n g f28,131 m i l l i o n or 27 per cent of the t o t a l . ^ The expansion of U.S. banks i n t o f o r e i g n markets has, l i k e the Canadian banks, been by a v a r i e t y of means. By 1972 (the l a t e s t date f o r which s t a t i s t i c s could be located) the top ten U.S. banks had, i n a d d i t i o n to an extensive f o r e i g n branch network, e s t a b l i s h e d s i x t y - f i v e s u b s i d i a r i e s , 208 a f f i l i a t e s , and eighty-seven r e p r e s e n t a t i v e o f f i c e s i n vari o u s f o r e i g n markets."*"^ Canada i s a case i n p o i n t . Because of banking l e g i s l a t i o n which p r o h i b i t s f o r e i g n banks from branching i n t o Canada, the U.S. banks have created s u b s i d i a r i e s that o f f e r many normal banking s e r v i c e s but do not use the word 'bank' i n t h e i r corporate t i t l e . During the past few years more than 100 f o r e i g n banks ( p r i m a r i l y U.S.) have entered Canadian f i n a n c i a l markets through a v a r i e t y of i n d i r e c t ways. The i n s t i t u t i o n s created might be termed 'near banks' i n that they o f f e r a range of f i n a n -c i a l s e r v i c e s that f a l l s somewhat short of f u l l s e r v i c e banking. Here i s how J . A. Boyle, P r e s i d e n t of the Canadian Bankers A s s o c i a t i o n described these operations: Their Canadian operations are c a r r i e d out mainly through s u b s i d i a r i e s and a f f i l i a t e s , covering almost a l l phases of what i s g e n e r a l l y understood to be 'banking.' By law i n Canada such i n s t i t u t i o n s may not describe themselves as 'banks' nor may they describe t h e i r 51 function formally as 'banking,' but this i s really just a matter of semantics. They are very much here and are becoming increasingly important components of the Canadian financial scene.20 The purpose of Boyle's comment was to make public the concern of Canadian bankers that the foreign operations are virtu a l l y unregulated and thus not subject to reserve requirements or diversification r e s t r i c -tions. The Bank of Canada reported that, as at October 31, 1974, assets 21 of foreign owned financial institutions totalled $1.1 b i l l i o n . It should be noted that the reporting program is voluntary and this undoubtedly results in understatement of the figures. Another factor contributing to understatement of the figures would be the fact that assets of a f f i l i a t e s (less than 50 per cent foreign owned) are not included. For example, BankAmerica owns in excess of 20 per cent of Montreal Trust, a large Quebec based trust company with assets in the 22 $600 million range. These assets are not included in the Bank of Canada st a t i s t i c s . Another method used by foreign banks to enter Canada has been by way of a resident representative. More than thirty foreign banks oper-ate representative offices in Canada with the implicit blessing of government o f f i c i a l s . The representative offices do place the name of the foreign bank above the office door so to speak which is technically in contravention of the Bank Act. There are indications however that the foreign representatives receive a friendly welcome from the chartered banks and "are given a warm reception from government o f f i c i a l s and even an off-the-record apology that their office cannot have the status of a 23 f u l l operating branch." The clear message that comes out of the 52 Canadian experience is that banks, especially the American ones, w i l l not let restrictive legislation stand in the way of their growth require-ments. The growth rate of the overseas expansion of U.S. banks via a f f i l i a t e s , subsidiaries or consortia i s not possible to measure because no statistics are available. However the suspicion i s that growth has been rapid. A review of recent annual reports of the major U.S. banks indicates that considerable attention i s paid to expansion by vehicles other than branching. It appears to be the case however that some major banks prefer to go i t alone via the branch route. Citibank has, until recently followed this method. It now appears that Citibank may be changing their policy somewhat. In a recent address to a national con-vention of the Bank Administration Institute, S. C. Eyre, Comptroller of Citicorp stated: The case of Citibank i s perhaps i l l u s t r a t i v e of the altered economics of foreign expansion. Whereas in the late 1960's, we were frequently adding new overseas branches at the rate of about one new branch every two weeks, in 1972 we opened only eleven new branches, and we actually closed more branches, by a count of 16 to 11, than we opened.24 At the same time Citibank is actively investigating further expansion via participation with foreign banks. One reason advanced for this somewhat altered policy i s the spiralling costs of branch operation. BankAmerica on the other hand has pursued a more balanced pattern of international growth. From 1964 to 1973 the bank expanded i t s inter-national branches from twenty-seven to 103, an increase of 3.8 times. Over the same period the Bank's international subsidiaries grew from 53 three to twenty-one (seven times) and equity investments in other ven-tures grew from eighteen to eighty-one (4.5 times). The following exerpt from the 1973 annual report of BankAmerica seems indicative of i t s policy toward international expansion: The bank continued to diversify i t s international investments in com-mercial banks, leasing firms, finance companies, and multi-speciality merchant banks. With the growing emphasis on the overseas potential of merchant banks, the bank participated in the operating of three such institutions in Southeast Asia and has plans for three more in 1974. 2 5 Chase Manhattan bank has expressed a similar policy toward over-seas expansion: In expanding our international business base, i t has been our policy to employ a mix of branches, wholly owned subsidiaries, controlled but not wholly owned subsidiaries, and a f f i l i a t e s . The decision on which type of investment to in i t i a t e depends on our estimate of oppor-tunities in each country.26 27 The following table illustrates Chase's worldwide international network. Table 4-9 WORLDWIDE INTERNATIONAL NETWORK—CHASE MANHATTAN BANK Overseas Branches: 1969 1973 Canada, Caribbean, & Latin America 32 58 Europe and Africa 11 19 Asia and the Middle East 12 22 Total 55 99 Subsidiaries: Canada, Caribbean, & Latin America 10 21 Europe and Africa 5 11 Asia and the Middle East 0 2 Total 15 34 A f f i l i a t e s : Canada, Caribbean, & Latin America 2 4 Europe and Africa 4 11 Asia and the Middle East 4 14 Total 10 29 54 In summary, the growth of f o r e i g n operations of U.S. banks has been s p e c t a c u l a r . Over the f i v e year p e r i o d ending i n 1972 the growth of f o r e i g n assets of U.S. banks c l e a r l y o u t s t r i p p e d the growth of U.S. 28 trade and d i r e c t investment as seen i n the f o l l o w i n g t a b l e : Table 4-10 EXPANSION OF BRANCH BANKING OVERSEAS COMPARED WITH FOREIGN TRADE AND US DIRECT INVESTMENT ABROAD, 1967-1972 ( i n bn $) Global 1967 1968 1969 1970 1971 1972 Assets of Overseas Branches of Member Banks Federal Reserve System 15.7 23.0 41.1 52.6 67.1 77.4 US Exports 31.5 34.6 38.0 43.2 44.1 49.8 US Imports 26.8 33.2 36.0 40.0 45.6 55.6 Bookvalue, US D i r e c t Investments Abroad 59.5 65.0 71.0 78.1 86.0 94.0 Western Europe Assets of Overseas Branches of Member Banks Federal Reserve System 10.9 17.3 31.2 39.2 48.1 53.9 US Exports 10.3 11.3 12.4 14.5 14.2 15.3 US Imports 8.2 10.3 10.1 11.2 12.6 15.4 Bookvalue, US D i r e c t Investments Abroad 17.9 19.4 21.7 24.5 27.6 30.7 As may be seen from the above t a b l e , f o r e i g n branch assets increased by 4.9 times w h i l e U.S. exports increased by 1.6, and d i r e c t investment by 1.6 times. There appears to be a good p o s s i b i l i t y that U.S. i n t e r n a t i o n a l 55 expansion i s at a crossroad. It has been argued that the physical expan-sion of U.S. banking offices abroad is waning and that asset growth may also slow down. There are a variety of reasons behind the above thinking. F i r s t l y , spreads in the London market are very thin and i t i s unlikely that banks contemplating an office there could hope to earn an acceptable level of profits. Secondly, i t can be argued that the major U.S. banks are now represented (where permitted by legislation) in every worthwhile nation and further physical expansion appears improbable. There are other problems currently muddying the water. "The devaluation of the dollar, a tighter competitive situation as evidenced by rate pressures in London, the uncertain effects of the emergencies, the administration's announced intention' to phase out exchange controls by the end of 1974 [now done], a l l tend to make expansion through new offices a far less 29 intriguing proposition." A liquidity problem in the domestic U.S. banking industry may also have a repressive effect on foreign expansion (see Chapter Nine). Professor Paul Nadler of Rutgers University has stated that the liquidity 30 problem i s causing: "the worst c r i s i s in confidence I've ever seen." For reasons that w i l l become clearer in later chapters, one cannot help thinking that, while some retrenching might take place, the pause in growth w i l l be only temporary. CANADIAN GROWTH In this section we w i l l follow a format somewhat similar to that presented for the U.S. case. After a brief discussion of the overall 56 growth of the major chartered banks (which can be compared to Table 4-2), we enter into a discussion of the growth of international operations. Both size of assets and number of banking installations are presented. In common with the U.S. case, i t is considered preferable to use assets as the measure of international growth. Perhaps the entry into international wholesale banking receives more emphasis in this section. This i s primarily because the Canadian banks seem to be focusing more attention on this area than their American counterparts. While differences in preference for operating forms do exist within the U.S. banking industry, on the whole i t appears that the U.S. banks have followed a more balanced expansionary process. The following table shows the growth rate, since 1971, of the five largest chartered banks. Table 4-11 GROWTH IN ASSETS OF CHARTERED BANKS $ Millions 1973 Change 1972 Change 1971 Royal Bank 17,737 17.8 14,567 17.1 12,430 C.I.B.C. 15,669 19.3 13,133 19.3 11,008 Bank of Montreal 13,988 25.5 11,138 12.7 9,897 Bank of Nova Scotia 10,462 20.9 8,647 26.7 6,823 Toronto-Dominion 9,030 22.7 7,354 17.7 6,246 66,886 21.2 54,839 18.7 46,386 When compared to Table 4-2 i t is apparent that the Canadian banking indus-try has been growing at a substantially slower pace than the banking i n d u s t r i e s of Japan and the E.E.C., but at a comparable pace w i t h the U.S. i n d u s t r y . However the above s t a t i s t i c s do not t e l l the whole s t o r y . I t i s the case that domestic expansion of the chartered banks has been ra t h e r slow but f o r e i g n operations are growing at a consi d e r a b l y f a s t e r pace. Table 4-12 sets out the i n t e r n a t i o n a l network of the chartered banks as at December 31, 1973. Table 4-12 BANK BRANCHES, AGENCIES, SUBSIDIARIES AND AFFILIATES December 31, 1973 Country Number Country Number Argentina 5 Indonesia 3 A u s t r a l i a 2 I t a l y 2 Bahamas 47 Jamaica 90 Belgium 2 Japan 5 B e l i z e 9 Lebanon 3 B r a z i l 3 Malaysia 1 Colombia 9 Mexico 3 Dominican Republic 19 Netherlands 4 E i r e 2 Puerto Rico 10 France 6 Singapore 4 Germany (West) 9 Switzerland 1 Great B r i t a i n 27 United States 62 Greece 2 Venezuela 13 Guyana 12 B r i t i s h V i r g i n I s . 2 H a i t i 2 U.S. V i r g i n I s . 6 Hong Kong 7 West Indies 104 I n d i a 1 TOTAL 477 Source: Factbook '74, The Canadian Bankers' A s s o c i a t i o n . 58 I t appears reasonable to assume that few people r e a l i z e the ex-tent to which the chartered banks have gone i n t e r n a t i o n a l i n the past ten years. I t i s thought to be common knowledge that the banks operate the foreign exchange market and f a c i l i t a t e the financing of exports and imports. It i s also f a i r l y w e l l known that a r e t a i l banking operation has been conducted i n the Caribbean for the past 100 years. While these aspects of the foreign operations of Canadian banks continue to be impor-tant, the r e a l growth area during the past few years has been i n merchant and wholesale banking. It may be well to i d e n t i f y three d i s t i n c t , but i n t e r r e l a t e d areas 31 of foreign currency business. The f i r s t area may be described as the operation of the foreign exchange market and export-import financing. The second area involves the operation of a r e t a i l banking business i n a foreign market. The branch networks of the chartered banks i n the Caribbean and i n C a l i f o r n i a are good examples. The t h i r d area may be described as i n t e r n a t i o n a l wholesale banking. There are at l e a s t four ways of entering the wholesale market on the i n t e r n a t i o n a l l e v e l : a) branching; b) purchase of e x i s t i n g ventures ( a f f i l i a t e route); c) establishment of a foreign subsidiary; and d) p a r t i c i p a t i o n i n i n t e r n a t i o n a l consortia. While the above d i s t i n c t i o n concerning types of foreign currency business may be useful i n some respects, i t should be remembered that the 59 boundaries are often fuzzy. For example a Canadian bank may have a branch in London that provides a foreign exchange service, a r e t a i l oper-ation, and engages in wholesale banking. Unfortunately the financial data available on foreign operations is not sufficiently disaggregated to allow precise comparisons of the growth rates of the three areas of foreign operations. Gross data only is provided by the Bank of Canada covering total foreign currency assets and l i a b i l i t i e s (see Table 4-13), and this source w i l l be u t i l i z e d below when discussing the ten year growth rate of foreign currency business. A comparison of the numbers of operating vehicles employed in foreign countries over the past ten years was considered as an indicator of the growth rates of the three areas of foreign currency business. The potential weakness of using this measure rather than some financial yardstick such as contribution to profits or asset growth is so great that the measure was rejected. For example the single Bankers Trust Office in London is very large and showing good growth. "Our London office, which was established in 1923 and by any measure would rank among the largest banks in the United States, continues to grow both in 32 size and in profit contribution." Thus i t would be possible for—say the Royal—to open several Caribbean 'mini branches' but just one major wholesale outlet operating in a financial centre might contribute far more to growth and profits. A perusal of recent annual reports of the major chartered banks indicates that they a l l emphasize the importance of their wholesale oper-ations and their participation in consortia. In the f i n a l analysis Table 4-13 CHARTERED BANKS: TOTAL FOREIGN CURRENCY ASSETS AND LIABILITIES End A S S E T S L I A B I L I T I E S Net of Period Call loans Other loans Sec-u r i -ties Deposits with banks Other assets Total Deposits of banks Other deposits Total foreign assets 1963 1,013 1,566 538 1,110 9 4,236 816 3,398 4,214 22 1964 1,017 2,011 587 1,597 -33 5,179 931 4,281 5,211 -33 1965 732 2,287 642 1,384 -8 5,037 1,260 3,822 5,083 -46 1966 892 2,622 621 1,516 -9 5,643 1,271 4,297 5,568 75 1967 744 2,658 788 2,326 -46 6,470 1,529 4,780 6,309 162 1968 712 2,943 814 3,263 75 7,806 2,134 5,243 7,378 429 1969 676 3,853 860 6,381 -138 11,632 3,240 8,390 11,630 2 1970 623 4,671 733 7,526 138 13,691 4,915 8,618 13,533 158 1971 715 5,315 516 7,669 254 14,469 6,419 7,743 14,162 307 1972 973 5,510 613 9,524 -48 16,572 8,411 8,607 17,018 -446 1973 537 7,082 546 14,759 375 23,298 13,323 11,255 24,577 -1,279 1974 526 11,692 726 14,885 796 28,626 15,284 14,117 29,400 -774 Millions of Canadian dollars. Source: Bank of Canada Review. August 1974. 61 however we are forced to discuss the growth of the i n t e r n a t i o n a l currency business of the chartered banks i n gross terms. As at June 30th, 1974, f o r e i g n currency assets of Canadian char-tered banks t o t a l l e d $25,743,000,000 or about 30 per cent of t o t a l bank assets of $87,194,000,000.compared to 1964 f i g u r e s of $5,179,000 and 33 $23,872,000 r e s p e c t i v e l y . Growth of f o r e i g n assets over the ten year p e r i o d was at a compound annual r a t e of about 17 per cent compared to a U.S. growth r a t e of almost 50 per cent per annum over the same time p e r i o d . Canadian d o l l a r assets grew at about 11.75 per cent over the p e r i o d . The growth i n i n t e r n a t i o n a l business i s c l e a r l y o u t s t r i p p i n g domestic expansion and, i f the present trend continues, f o r e i g n operations w i l l dominate (51 per cent) Canadian banking before 1990. While the above s t a t i s t i c s present a reasonably accurate p i c t u r e , the f u l l extent of the Canadian banks' i n t e r n a t i o n a l operations i s some-what understated. Under the Bank Act only wholly owned s u b s i d i a r i e s engaged i n banking may be c o n s o l i d a t e d i n the annual f i n a n c i a l statements 34 of a chartered bank. The r e s u l t i s that a bank only records i t s investment i n a s u b s i d i a r y or a f f i l i a t e and not the l a t t e r ' s t o t a l assets on a c o n s o l i d a t e d b a s i s . For example, the Royal Bank of Canada owns 35 ,75 per cent of the c a p i t a l stock of The Royal Bank Jamaica L t d . The l a t t e r company had t o t a l assets as at September 30th, 1973, of J$75,215,144 (1 Jamaican = $1.10 Canadian) which e f f e c t i v e l y c o n s t i t u t e s f o r e i g n currency assets of the Canadian bank. However t h i s investment was c a r r i e d on the books of the Royal at $2,532,005 and i t i s t h i s f i g u r e that appears i n the f o r e i g n currency data reported i n the monthly Bank 62 of Canada Review. A l l of the 'big five' chartered banks have similar investments, which appear to be carried on the books following the cost rather than the equity method recommended by accountants. Other foreign currency assets not included in the available statistics include foreign investments in bank premises and equipment. It is not possible to accurately determine the magnitude of the understatement of foreign currency assets owned by the Canadian banks but, based on sketchy information available, this writer would estimate that i t is less than 5 per cent of the total. As mentioned above i t is not possible to obtain hard data to prove that international wholesale banking is growing faster than the other two areas of foreign banking. There is substantial soft evidence to support this contention however. The authors of the Porter Commission asserted that international wholesale banking was growing much more 36 rapidly than the other areas. The majority of comments concerning international operations by Canadian bankers focus on the wholesale area. The following are some samples from Canadian bankers: John H. Coleman, formerly Deputy Chairman, The Royal Bank of Canada: The world wide branch system i s not the system of the future. We just pulled out of Peru for example. Some countries want us to incor-porate our branches and offer some of the equity to the nationals. So now the thrust i s to lessen our exposure to these forces (nationalism) by going into wholesale banking.37 Bob Peel, General Manager, Corporate Accounts Development, Bank of Nova Scotia: We've always been a hard core international operation. However we only really started to move into Europe in the late 1950's and, in 63 terms of wholesale banking, have been doing business internation-a l l y since that time.38 F. H. McNeil, formerly President, Bank of Montreal: The bank's international expansion in the past year (1973) has been primarily in the inter-bank (wholesale) market. Furthermore, the bank has taken steps to improve i t s a b i l i t y to develop more corpor-ate business abroad. London has been established as a regional office with responsibility for operations in Europe, Africa and the Middle East.39 R. F. Harrison, President, Canadian Imperial Bank of Commerce: A relatively large proportion of the bank's international business is in the wholesale money market field.^® A significant part of the chartered banks recent growth has been the result of participation in the financial markets of Britain. As at April 17th, 1974, deposits of banks located in the U.K. totalled f104,391 m i l l i o n 4 1 (see Table 4-14). Table 4-14 ASSETS OF BANKS IN THE UNITED KINGDOM BANKS IN THE UNITED KINGDOM: SUMMARY (f millions) A l l holders m i o Other Total Sterling currencies Apr. 18 73,369 34,096 39,273 May 16 73,158 33,930 39,227 June 20 74,603 35,095 39,507 July 18 78,730 36,363 42,367 Aug. 15 82,386 36,755 45,631 Sept. 19 84,932 38,383 46,549 Oct. 17 88,002 38,942 49,060 Nov. 21 92,724 40,536 52,188 Dec. 12 95,490 41,125 54,364 Jan. 16 99,260 41,735 57,525 Feb. 20 100,777 42,454 58,323 Mar. 20 101,049 41,576 59,474 Apr. 17 104,391 42,472 61,919 (Source - a l l sections: Bank of England Quarterly Bulletin, June 1974. 64 DEPOSIT BANKS: LONDON CLEARING BANKS (£ m i l l i o n s ) A l l h olders T o t a l S t e r l i n g Other c u r r e n c i e s 1973 Apr. 18 17,932 16,474 1,458 May 16 17,936 16,469 1,467 June 20 18,605 17,036 1,569 J u l y 18 19,669 17,950 1,719 Aug. 15 19,661 17,859 1,802 Sept. 19 20,267 18,413 1,854 Oct. 17 20,749 18,823 1,925 Nov. 21 21,482 19,498 1,984 Dec. 12 21,632 19,613 2,019 1974 Jan. 16 22,299 20,097 2,202 Feb. 20 22,520 20,297 2,223 Mar. 20 22,733 20,414 2,319 Apr. 17 23,477 21,066 2,411 OVERSEAS BANKS: BRITISH I OVERSEAS & COMMONWEALTH (f m i l l i o n s ) A l l holders T o t a l S t e r l i n g Other c u r r e n c i e s 1973 Apr. 18 10,147 3,039 7,108 May 16 9,908 2,785 7,123 June 20 10,191 2,884 7,307 J u l y 18 10,870 2,926 7,944 Aug. 15 11,393 2,978 8,415 Sept. 19 11,599 3,077 8,522 Oct. 17 11,781 3,101 8,680 Nov. 21 12,301 3,154 9,147 Dec. 12 12,766 3,215 9,551 1974 Jan. 16 13,195 3,213 9,981 Feb. 20 13,321 3,376 9,946 Mar. 20 13,114 3,195 9,919 Apr. 17 13,315 3,207 10,107 OVERSEAS BANKS: AMERICAN (f m i l l i o n s ) A l l holders T o t a l S t e r l i n g Other c u r r e n c i e s 1973 Apr. 18 20,060 2,900 17,160 May 16 19,796 2,872 16,923 June 20 19,364 2,841 16,523 J u l y 18 20,274 3,008 17,266 Aug. 15 21,687 3,150 18,538 Sept. 19 21,728 3,500 18,228 Oct. 17 22,769 3,431 19,338 Nov. 21 24,855 3,785 21,070 Dec. 12 25,621 3,945 21,676 1974 Jan. 16 26,670 4,115 22,555 Feb. 20 27,418 4,342 23,076 Mar. 20 27,389 4,045 23,343 Apr. 17 28,121 4,087 24,034 65 A partial breakdown of the share in these deposits i s as follows: (Millions) Amount %_ London Clearing banks f23,477 22.6 Commonwealth banks 13,315 12.8 U.S. banks 28,121 27 The major set of banks (in terms of assets) making up the Commonwealth group are Canadian. The above figures include a l l currencies on deposit in the U.K. If sterling deposits are eliminated, then the share in hold-4 ing foreign currency deposits (primarily $ U.S.) breaks down as follows: (Millions) Amount % London Clearing banks f 2,411 3.9 Commonwealth banks 10,107 16.4 U.S. banks 24,034 38.9 A l l other 25,367 40.8 Total for U.K. f61,919 100.0 In summary then a case can be made that a substantial portion of the very rapid growth in the international activities of the chartered banks has been in the wholesale banking area. This feature w i l l have important implications when we explore the existing explanations for international banking growth. 66 SUMMARY To give the reader some idea of the size of foreign operations of Canadian banks compared to large U.S. banks; foreign deposits of the five largest U.S. banks totalled approximately $70,000 million at June 30th, 1974, compared to $28,732 million for the whole Canadian banking 44 industry. In fact the combined foreign deposits of BankAmerica and Citicorp at some $40,000 million exceeded the Canadian figure. Both U.S. and Canadian banks have high propensities toward foreign assets although some interbank differences are evident. St r i c t l y com-parable data is d i f f i c u l t to locate because the chartered banks do not invariably disclose the domestic/foreign composition of their balance sheets. The Bank of Canada, of course, publishes only aggregate data. Occasionally the president or chairman of a bank w i l l make some comment in the annual report to shareholders which indicates the size of the particular bank's foreign operations. For example the following are comments by R. W. Frazee, Executive Vice-President, Royal Bank, in his 1973 report to shareholders: This is reflected in the significant increase in the bank's foreign currency deposits which grew by 44 per cent during 1973 to $6,400 million at year end. At that date these deposits represented 38 per cent of our total deposit l i a b i l i t i e s , which gives some indica-tion of the importance to the bank of our foreign operation.^5 More recently the three smaller chartered banks have reported the foreign/domestic asset s p l i t in their annual reports. Available figures for the big five Canadian and U.S. banks are: 67 Per cent Foreign Deposits to T o t a l Deposits BankAmerica 42% Royal 38% C i t i c o r p 52% CIBC about 24% Chase Manhattan 42% B/M 32% Manufactures Hanover 28% BNS 44% J.P. Morgan 43% T.D. 36% Based on the above data and the p r e v i o u s l y mentioned f a c t that f o r e i g n business i s growing at a f a s t e r pace than domestic, i t i s becom-ing very apparent that the home o f f i c e l o c a t i o n i s only i n c i d e n t a l to the b i g banks. They have become m u l t i n a t i o n a l corporations i n every sense of the word. In c l o s i n g t h i s s e c t i o n i t should be r e i t e r a t e d that growth of f o r e i g n operations has been at a very r a p i d pace over the past ten years. A l l three areas of the U.S. and Canadian banks' f o r e i g n currency b u s i -ness has grown but the most r a p i d growth has occurred i n the wholesale banking s e c t o r . I t i s the general f a i l u r e to recognize t h i s important p o i n t that has l e d the w r i t e r to question the v a l i d i t y of the most popu-l a r e x i s t i n g explanations f o r g r o w t h — t h e subject of the next chapter. 68 1974) Report• Notes for Chapter Four 1 Banks of the World (1964). 2 The Banker (June 1974). 3 Ibid., 121 (1971), 659. 4 Quoted i n the F i n a n c i a l Post (Sept. 21, 1974), p. J12. 5 I b i d . 6 I b i d . 7 Adapted from The Banker (June 1973) and (June 1974). g G. Forrest, "How Comparisons Can Mislead," The Banker (June 9 Ib i d . , p. 613. Ibid. 1 1 The Banker (June 1974). 12 Comptroller of the Currency, 1964 Annual Report. 1 3 I b i d . I b i d . ^ Board of Governors of the Federal Reserve System, 1973 Annual 16 Federal Reserve B u l l e t i n (February 1972). 1 7 Bank of England: Quarterly B u l l e t i n (June 1974). Ibid. 19 H. V. Prochnow and H. V. Prochnow, J r . The Changing World of  Banking (New York: Harper and Row, 1974). C.B.A. B u l l e t i n , 17, No. 2 (June 1974). 21 Bank of Canada Review (October 1974). 22 Burrough's Clearing House (January 1974). 23 J . A. McMyn, "What Rules f o r Foreign Banking?" Canadian  Banker and ICB Review, 1-74. 24 S. C. Eyre, " E x p l o r i n g Some Trends i n I n t e r n a t i o n a l Banking," Burrough's C l e a r i n g House (February 1974). 25 BankAmerica Corporation, 1973 Annual Report, p. 7. 26 The Chase Manhattan Corporation, 1973 Annual Report, p. 4. I b i d . 28 E. P. Imhof, "Rapid Expansion of Overseas Banking," I n t e r - economics , No. 8/74. 29 Eyre, p. 54. 30 Quoted i n Business Week (September 21, 1974), p. 52. 31 P o r t e r Commission, p. 137. 32 Bankers Trust New York Corporation, 1972 Annual Report. 33 Bank of Canada Review (August 1974). 34 The Bank of Nova S c o t i a , 1973 Annual Report. 35 The Royal Bank of Canada, 1973 Annual Report. 36 P o r t e r Commission, p. 137. 37 Quoted i n The Executive (June 1971), p. 32. p. 9. 38 Quoted i n The Canadian Banker and ICB Review (January 1974), 39 Bank of Montreal, 1973 Annual Report, p. 13. 40 Canadian I m p e r i a l Bank of Commerce, 1971 Annual Report. ^ Bank of England: Q u a r t e r l y B u l l e t i n (June 1974). 4 2 I b i d . I b i d . 44 Business Week (September 21, 1974) and Bank of Canada Review (August 1974) 45 The Royal Bank of Canada, 1973 Annual Report. Chapter Five EXISTING EXPLANATIONS FOR THE GROWTH OF INTERNATIONAL BANKING The r o l e of a service industry i n i n t e r n a t i o n a l business expan-sion has generally been thought of as a passive one. That i s , some external or environmental v a r i a b l e i s usually held out as the force ' p u l l i n g ' a service f i r m to a foreign market. Most service businesses l i m i t e d the scope of t h e i r operations to a few foreign countries p r i o r to the mid 1950's, but the tremendous volume of foreign a c t i v i t y by t h e i r t r a d i t i o n a l l y domestic c l i e n t s , beginning i n the 1960's, induced—or perhaps ' f o r c e d ' — t h e banks, accountants, a d v e r t i s i n g agencies, and so on, to go i n t e r n a t i o n a l themselves.1 When commercial banks engage i n i n t e r n a t i o n a l business they are t y p i c a l l y thought of as operating the foreign.exchange market and as a channel and/or source of financing f o r trade and c a p i t a l flows. Here are two quotes, the f i r s t r e l a t i n g to the Canadian banks, the second to U.S. banks, that i l l u s t r a t e s the popular explanation for i n t e r n a t i o n a l growth: A major reason for Canadian bank expansion l i e s i n the fac t that Canada r e l i e s to a very large extent on export of raw materials, a g r i c u l t u r a l products, manufactured goods and engineering know-how. The banks provide a comprehensive network of f a c i l i t i e s and services r e l a t i n g to foreign trade and f i n a n c i a l t r a n s a c t i o n s . 2 There has been a close c o r r e l a t i o n between the high l e v e l s of i n t e r -national trade and investment on the onehand, and i n t e r n a t i o n a l a c t i v i t i e s of U.S. banks on the o t h e r . 3 70 71 The clear implication that follows from these quotes is that the banks are followers in the international business arena. The above comments are consistent with the earlier expressed motivation of the French, English, and German banks, who claimed their objective was to track the expansion of their respective countries' external trade and overseas investments. The particular intent was to serve domestic customers in their colon-i a l and foreign ventures, to provide them with the services they re-quired, to finance their imports and exports, and to help finance their investments. 4 It is not clear why banks would find i t necessary to establish a foreign operation to serve domestic customers in their foreign trade and investment a c t i v i t i e s . Let us assume that a major Canadian corpora-tion requires a chartered bank to look after i t s export and import trans-actions. In the f i r s t place a l l documents and collections (letters of credit, documentary b i l l s , etc.) can be handled by a domestic bank branch whose only contact with the foreign market is through correspondent banks. Up to this point there is no need for a Canadian bank to establish over-seas. An office set up in a foreign market just to handle the other end of trade transactions could hardly hope to survive. The above discussion covers the handling of foreign exchange transactions. But what about financing foreign trade? In this area, why bank expansion abroad i s a function of the growth of foreign trade i s also unclear. The credit needs of the Canadian company are almost always provided in Canadian dollars. That i s , no distinction i s generally made in financing an account receivable, whether i t be due from a company in 72 Tokyo or Toronto. J. A. Galbraith, formerly Chief Economist, Royal Bank of Canada, has noted: Canadian banks, of course, have always played an important role in financing Canadian exports and imports. Much of their lending activity in Canadian dollars helps to accommodate the international trading transactions of their customers. Only a small proportion of bank financing of Canada's international trade is provided in U.S. dollars although much of Canada's trade is invoiced in U.S. dollars.^ In his 1969 M.B.A. thesis, Barry Bruce attempted to explain why the banks go abroad. Bruce conducted a f i e l d study in which bankers from the international divisions of the five major Canadian and five major U.S. banks were interviewed. A l l of the bankers interviewed stressed that the nature of the flow of trade was an important force directing the banks abroad. It i s interesting to note that the bankers interviewed by the writer continue to stress trade as an important motivating factor in international expansion of the chartered banks. In summary, the 'foreign trade' argument to explain bank expan-sion abroad i s open to criticism. Perhaps the argument has continued to prevail somewhat because i t is not in the best interests of the banking community to dispell i t . Facilitating foreign trade is a type of activity that receives f a i r l y wide public acceptance—unlike some of the other banking services such as moving 'hot' money among various world markets. In a speech presented to the Canadian Conference on Banking in September 1974, Page Wadsworth, Chairman of the Canadian Imperial Bank 73 of Commerce gave the impression that in the growth of international banking there are factors other than trade expansion. The following com-ment: "Trade expansion has therefore been a significant factor in the burgeoning of our international banking activities in the 1960's and 1970's1'^ was followed, somewhat later in the speech, by: the great increase in activity in international financial markets in recent years, and in the acti v i t i e s of international banks in these markets, can be characterized as wholesale banking—the fast e f f i c -ient movement of high volumes of short, medium, and long term funds g from lenders to borrowers by way of the international banking system. This writer would argue that the rapid growth of wholesale banking is good evidence that the banks are no longer simply tracking Canadian trade and investment around the world. Bruce did uncover evidence that government regulation was a moti-vating force behind overseas expansion. We are in complete agreement with this finding and w i l l develop the government variable further when we present our model of foreign bank expansion in Chapter Eight. Bruce also uncovered some evidence that the 'bandwagon effect' influenced the decisions of at least some of the banks. This type of behavior which has been termed 'oligopolistic reaction' w i l l be explored in Appendix II. Several other reasons for the growth of the international a c t i v i -ties of U.S. and Canadian banks have been suggested. S. C. Eyre, Comp-tro l l e r of Citicorp, summarizes the reasons as follows: The reasons for this rapid rate of growth are well known. Many banks were catching up with their corporate clients, who had expanded 74 abroad. Various exchange controls, imposed throughout the mid 1960's, encourage banks to develop deposit bases overseas. And, of course, after the credit crunches of 1966 and 1969-70 banks set up foreign branches to be able to tap the Eurodollar market for domestic use.9 Two distinct reasons seem to emerge from the above comment: the 'pull' of multinational clients and the 'push' of government interference in the market system. It i s somewhat d i f f i c u l t to argue that the pull of the multi-national firm influences the Canadian banks. Canada's multinationals are few in number and the writer has been unable to uncover any evidence that the spread of these firms has been a significant influence in over-seas operations of the banks. About 60 per cent of this country's foreign direct investment is in the U.S.—largely concentrated in breweries and d i s t i l l e r i e s due to the U.S. prohibition era which severely set back the domestic industry. Canadian banks only have branches in a few states—New York, California, Washington, and Oregon—and there i s l i t t l e correlation between the location of Canadian industry in the U.S. and the location of the Canadian banks. One factor that may have some influence however is the experience the Canadian banks have gained in financing U.S. multinationals in Canada. Successful banking is very dependent on personal contact and favourable experience built up in Canada is thought by some to open up opportunities for the Canadian banks to serve major U.S. firms p a r t i c i -pating in overseas markets. While there may be some element of truth in this line of reasoning, i t appears to this writer to be almost self-evident that the U.S. multinational would prefer to deal with i t s major U.S. bankers in the foreign market. This i s based on the reasonable 75 assumption that the U.S. bank has l o c a t e d i n the r e l e v a n t f o r e i g n market. There i s more reason to b e l i e v e that the expansionary f o r e i g n development of U.S. banks has been caused to some degree by the spread of U.S. based m u l t i n a t i o n a l s , The overseas expansion of U.S. banking i s , of course, a l o g i c a l con-sequence of the p r i o r expansion of American c o r p o r a t i o n s , and of the predominant r o l e of the d o l l a r i n f i n a n c i n g the world's trade.10 An example of the advantages of being represented i n s e v e r a l f o r e i g n mar-ke t s , i s evidenced by the experience of C i t i b a n k w i t h a l a r g e U.S. based m u l t i n a t i o n a l . Perkin-Elmer; a Connecticut based manufacturer of o p t i c a l and s c i e n -t i f i c instruments, was l o o k i n g f o r a blanket c r e d i t covering the short-term and medium term needs, i n l o c a l c u r r e n c i e s , of i t s Euro-pean s u b s i d i a r i e s i n seven c o u n t r i e s . The company found that only C i t i b a n k , w i t h branches i n a l l seven c o u n t r i e s , could handle the loan.11 The s t r e n g t h of the ' p u l l ' f o r c e s o v e r — s a y the l a s t f i v e y e a r s — i s open to some doubt however. A s u b s t a n t i a l part of f o r e i g n growth during the past f i v e years has been i n London. In 1953 there were ten U.S. banks i n London. At t h i s time the primary m o t i v a t i o n was thought to be to acquire a s t e r l i n g base and to serve U.S. i n d u s t r i a l s u b s i d -i a r i e s . Since the m i d - l a t e 1960's however the prime a t t r a c t i o n to London has been the E u r o - d o l l a r market. As at March 31, 1974, assets of U.S. branches l o c a t e d i n the United Kingdom t o t a l l e d $68,076 m i l l i o n . This f i g u r e represented 4 9 . 6 per cent of t o t a l assets ( $ 1 3 6 , 9 8 3 m i l l i o n ) of U.S. banks l o c a t e d i n a l l f o r e i g n c o u n t r i e s . The magnitude of assets concentrated i n one centre provides 76 reasonable evidence that the pull force of multinational clients might have been somewhat overplayed as a determinant of foreign expansion of the U.S. banks. Furthermore, we w i l l argue later that the Euro-dollar market, rather than 'pulling' U.S. banks abroad, largely was spawned by domestic market interference from the U.S. government. Government inter-ference w i l l be a key variable in developing a theory of foreign bank expansion. The Euro-dollar market therefore w i l l be seen to be the result (or victim i f you will) of an aggressive outward 'push' by the U.S. banks—a push caused in part by government interference. In summary, this writer has become somewhat dissatisfied with the rather stock explanations that have the banks playing a passive role in responding to the needs of their domestic customers—be i t to f a c i l i -tate a trade transaction or to finance the customer in a foreign market. There are good reasons to believe that the banks are considerably more aggressive than generally believed. The banks of course do very l i t t l e to promote the idea that they have aggressively expanded—and for good reason. Maintaining a low profile and fostering the belief that a pas-sive role is played is much more li k e l y to result in less unfavourable comment from the wide variety of observers of the banking industry. Bankers are well aware that they are in an industry that is often the target of nationalistic opposition. Says C. Langston, Assistant General Manager, Canadian Imperial Bank of Commerce: "It's an extremely sensitive p o l i t i c a l situation when you move into a country. It is definitely not 13 in your interest to step right in and make waves." Occasionally however some comment is made that indicates that 77 the chartered banks are more aggressively viewing the world as their market. For example, here is a quote from the 1974 annual report of the Bank of Nova Scotia: Some of this growth in foreign currency loans reflected our efforts to meet the financing requirements of our domestic customers. But a larger proportion represented the expansion of our international lending activities.14 This writer does not claim to be the f i r s t to recognize the trend away from the passive role of the banks in foreign expansion. L. C. Nehrt, writing in 1967 reported: A very recent, and most interesting development in the overseas expan-sion of U.S. commercial banks, however, is a tendency toward aggres-sive investments. Some banks are no longer passively (and often reluctantly) responding to the needs of their domestic customers; rather they are looking upon investments in an overseas branch in the same manner as the opening of another branch in their home state or city.15 Nehrt, however did not explore the underlying reason for the trend toward aggressive expansion. This would involve developing a theory of growth and to the writer's knowledge none has been developed for the banking industry to this date. The growth and expansion of the foreign activities of Canadian and U.S. banks certainly qualifies them as multinationals. It therefore appears appropriate to examine the theoretical analysis that has been applied to other multinational firms in an effort to develop a theory that might be applied to the banking industry. 78 Notes f o r Chapter F i v e I D. B. Zenoff and J . Zwick, I n t e r n a t i o n a l F i n a n c i a l Management (Englewood C l i f f s , N.J.: P r e n t i c e - H a l l , 1969), p. 10. 2 James Montagnes, " I n t e r n a t i o n a l Banking Canadian S t y l e , " Burrough's C l e a r i n g House (September 1974), p. 73. 3 J . P. K o s z u l , "American Banks i n Europe," i n The I n t e r n a t i o n a l  Corporation, C. P. Kindleberger (ed.), p. 276. 4 I b i d . ^ J . A. G a l b r a i t h , Canadian Banking (Toronto: Ryerson P r e s s , 1970), p. 307. B. D. Bruce, " I n t e r n a t i o n a l Banking A c t i v i t i e s of Canadian and American Banks," M.B.A. t h e s i s , U n i v e r s i t y of B r i t i s h Columbia, 1969. 7 J . P. R. Wadsworth, "Why Do Canadian Banks Want to E s t a b l i s h Abroad?" from speech presented to the Canadian Conference on Banking, Toronto, September 16, 1974. 8 I b i d . 9 S. C. Eyre, " E x p l o r i n g Some Trends i n I n t e r n a t i o n a l Banking," Burrough's C l e a r i n g House (February 1974), p. 54. J . Main, "The F i r s t Real I n t e r n a t i o n a l Bankers," Fortune (December 1967), p. 143. I I I b i d . , p. 198. 12 Bank of England: Qu a r t e r l y B u l l e t i n (June 1974). p. 12. Quoted i n The Canadian Banker and ICB Review (January 1974), 1 4 The Bank of Nova S c o t i a , 1974 Annual Report, p. 19. 1 5 L. C. Nehrt, I n t e r n a t i o n a l Finance f o r M u l t i n a t i o n a l Business (Scranton, Penn.: I n t e r n a t i o n a l Textbook Company, 1967), p. 351. Chapter Six THEORIES OF THE CAUSES OF DIRECT FOREIGN INVESTMENT This chapter of the paper forms the foundation of what is hoped w i l l be a sound micro-theory of international banking expansion. There is a considerable volume of literature, albeit of an inconclusive nature, dealing with the theory of direct foreign investment. The studies that this writer has been able to locate deal exclusively with U.S. indus-t r i a l firms; however, as mentioned in the introduction, there is no obvious reason that a service industry such as banking should not be sub-ject to some common objectives, opportunities, uncertainties, and risks when making a direct foreign investment. What follows w i l l be a rather rapid run through the f i e l d of investment theory. The chapter is organized as follows: a) definition of direct foreign investment (p. 80); b) distinction between direct and portfolio investment (p. 80); c) brief discussion of interest rate arbitrage (p. 81); d) introduction to direct investment theory (p. 83); e) Aliber's theory (p. 84); f) imperfections in capital markets (p. 88); g) monopolistic advantage (p. 90); h) oligopoly and need for growth (p. 94); and i) summary (p. 97). 79 80 The next two chapters w i l l be devoted to applying the concepts discussed i n t h i s chapter to a t h e o r e t i c a l model that might be a p p l i e d to the banking i n d u s t r y . (a) A d i r e c t f o r e i g n investment i s defined as: "the amount invested by r e s i d e n t s of a country i n a f o r e i g n e n t e r p r i s e over which they have e f f e c t i v e control.""'" (b) The d i s t i n c t i o n between d i r e c t and p o r t f o l i o investment i s that the former i n v o l v e s a net t r a n s f e r of r e a l c a p i t a l to the host country together w i t h entry i n t o a host country i n d u s t r y by a f i r m e s t a b l i s h e d i n some other country, whereas p o r t f o l i o investment only i n v o l v e s the t r a n s f e r of f i n a n c i a l c a p i t a l . Another d i s t i n g u i s h i n g f e a t u r e of the two types of f o r e i g n investment i s that d i r e c t investment i s v i r t u a l l y the e x c l u s i v e domain of the c o r p o r a t i o n w h i l e p o r t f o l i o investment i n c l u d e s s u b s t a n t i a l p a r t i c i p a t i o n by i n d i v i d u a l s . The pioneering work i n p o r t f o l i o investment theory was c a r r i e d 2 out by Markowitz. Using a c r i t e r i o n c a l l e d ' p o r t f o l i o e f f i c i e n c y , ' Markowitz confined h i s a t t e n t i o n to s e l e c t i n g from a l i s t of s e c u r i t i e s a sub-set that s a t i s f i e d the dual investment c r i t e r i a of (1) highest ex-pected r e t u r n f o r a given l e v e l of r i s k , and (2) lowest l e v e l of r i s k f o r a given l e v e l of expected r e t u r n . The dual c r i t e r i a can be i l l u s -t r a t e d as f o l l o w s : r i s k I I e f f i c i e n t f r o n t i e r (of p o r t f o l i o s ) expected r e t u r n 81 Unfortunately d i r e c t investment cannot be d e a l t w i t h i n a two parameter model. Many other f a c t o r s beside expected r e t u r n and perceived r i s k p l a y a r o l e i n the investment d e c i s i o n process. These 'other f a c t o r s ' should become c l e a r as we proceed through the next three chapters. (c) E a r l y theory simply grouped p o r t f o l i o and d i r e c t investment t o -gether and assumed that both responded to d i f f e r e n t i a l r a t e s of r e t u r n . For example, i f domestic i n t e r e s t r a t e s are l e s s than f o r e i g n i n t e r e s t r a t e s f o r s e c u r i t i e s i n a s i m i l a r r i s k c l a s s , and the cost of hedging i n the forward exchange market i s l e s s than the i n t e r e s t r a t e d i f f e r e n t i a l , then a flow of f o r e i g n investment should occur. By way of i l l u s t r a t i o n l e t us assume the f o l l o w i n g s i t u a t i o n : Canadian 180 day T.B. r a t e 4% B r i t i s h 180 day T.B. r a t e 8% Canadian p r i c e of one pound $2.50 spot $2.48 forward A Canadian r e s i d e n t purchasing a f1,000 bond w i l l go through the f o l l o w i n g process: 1) exchange $2,500 Canadian f o r f1,000; 2) purchase B r i t i s h T.B. f o r f l , 0 0 0 ; 3) engage i n a forward c o n t r a c t to s e l l f1,040 at a r a t e of $2.48; 4) r e c e i v e cheque f o r f1,040 i n 180 days; and 5) exchange f l , 0 4 0 at $2.48 f o r $2,579.20 Canadian. 82 Alternatively the same Canadian may purchase a $2,500 Canadian T.B. and at the end of 180 days w i l l receive $2,550 ($2,500 principal and $50 interest). The assumption is that rational investors w i l l take advantage of the interest rate differential and invest their funds in the United Kingdom. This example assumes that the f u l l force of interest arbitrage has not yet taken effect. If the above process were to con-tinue for many transactions the forward discount of f should wipe out the interest rate differential as follows: rf = rs rf = 2.50 rf = 250 (.980) rf = 2.45 At a forward rate of 2.45, the return in Canadian dollars from either i n -vestment would be the same. Since at least the 1960's however there has been a growing aware-ness that not a l l capital flows are sensitive to interest rate d i f f e r -entials. That i s , large capital flows have been observed even when the forward market has adjusted to remove any interest rate differential. A diagrammatic representation of Canada's case might be as follows; The diagram implies that Canada, with a domestic interest rate just equal to the world rate, w i l l s t i l l have an inflow of capital (direct investment). The determinants of direct investment must therefore be found in something other than market yields. (1 + id) (1 + i f ) (1.02) (1.04) 83 >1 Can i World 1 1 slope = interest sensitivity of portfolio flows <1 Net capital outflow 0 Net capital inflow (d) As mentioned above, no conclusive theory of direct investment has been developed and accepted by economists. Ragazzi claims that the main theoretical focus is on the advantages of 'superior knowledge' which allows a foreign firm to earn a higher rate of return than indigenous 3 firms. Aliber seems to agree: the traditional theory of foreign investment—the Hymer-Kindleberger view—suggested that firms with a monopolistic advantage expanded into foreign markets to exploit their advantage abroad. 4 Other authors, including Knickerbocker focus on the oligopolistic be-havior of multinationals as providing the main motivation for direct investment.^ Kindleberger (who seems mainly in the 'superior knowledge' camp) argues that: direct investment belongs more to the theory of industrial organiza-tion than to the theory of international capital movements. This statement certainly seems to indicate recognition that industrial 84 s t r u c t u r e plays a r o l e i n d i r e c t investment. Perhaps there i s more com-mon ground than disagreement i n the va r i o u s camps. That i s , s u p e r i o r know-ledge and o l i g o p o l i s t i c s t r u c t u r e may be c l o s e l y r e l a t e d and both serve to e x p l a i n d i r e c t investment. In f a c t Stephen Hymer would probably object to the separation of the two t h e o r e t i c a l approaches. While he i s c r e d i t e d w i t h being the f i r s t to develop the 'knowledge' theory,^ he l a t e r concentrated on o l i g o p o l i s t i c behavior as a motivator of d i r e c t i n -g vestment. The main purpose of t h i s chapter i s to review the e x i s t i n g t h e o r i e s of d i r e c t investment w i t h a view to using c e r t a i n concepts already developed to formulate a micro-theory of i n t e r n a t i o n a l banking. In the circumstances we do not f e e l o b l i g e d to f a l l i n t o any p a r t i c u l a r 'camp.' There may be some u s e f u l i n s i g h t s provided by a l l of the approaches. (e) ALIBER'S THEORY One theory that does not appear to have achieved wide acceptance but which i s included here because of i t s p o s s i b l e relevance to banking i s the one advanced by A l i b e r . He argues t h a t : The key f a c t o r s i n e x p l a i n i n g d i r e c t f o r e i g n investment i n v o l v e c a p i t a l market r e l a t i o n s h i p s , exchange r i s k , and the market's p r e f e r -ence f o r h o l d i n g assets denominated i n s e l e c t e d c u r r e n c i e s . ^ The l a t t e r part of t h i s q u otation i s l a t e r developed by A l i b e r i n h i s book, The I n t e r n a t i o n a l Money Game."^ P o r t r a y i n g the U.S. d o l l a r as 'the p r e f e r r e d currency brand name' or 'currency a t the top of the h i t parade,' A l i b e r p o i n t s out s e v e r a l advantages that accrue to companies 85 doing t h e i r main volume of business i n U.S. d o l l a r s . A l i b e r ' s main research was conducted during a time when the U.S. d o l l a r was c l e a r l y overvalued i n terms of the currencies of most other developed countries. The implication that follows i s that production costs should be higher i n the U.S. than i n countries with undervalued currencies and conse-quently there i s an incentive for i n d u s t r i a l firms to locate production f a c i l i t i e s outside the United States. A l i b e r also argues that the r i s k of exchange rate f l u c t u a t i o n s work to the advantage of firms i n the strong currency areas. His thesis i s that the: "pattern of d i r e c t foreign investment r e f l e c t s that source country firms c a p i t a l i z e the same stream of expected earnings at a higher rate than host country firms.""''''" That i s , A l i b e r would argue that a U.S. firm and a host country f i r m may w e l l perceive an opportunity to ex p l o i t a market i n the host country and both may come up with the same projected cash flow. A l i b e r argues however that, because of a d e f i n i t e bias i n the s e c u r i t i e s markets, the U.S. f i r m w i l l be able to obtain cheaper financing and thus be w i l l i n g . t o pay more for the income stream (attach a higher c a p i t a l i z a t i o n rate) than the host country firm: "In Wall Street argot, everything else being equal, the P/E r a t i o i s higher for U.S. 12 firms than f o r non U.S. firms." The bias i n the s e c u r i t i e s market i s caused by the tendency of investors i n the source country to neglect to penalize projected earnings by some r e a l i s t i c c o e f f i c i e n t representing exchange rate r i s k . A l i b e r ' s theory has been challenged on empirical grounds by Ragazzi, who points out that U.S. d i r e c t investment continued to flow 86 into Europe in recent years when several European currencies were con-13 sidered stronger than the U.S. dollar. Ragazzi also puts forth the normative argument that there is no reason for the market not to place a penalty on foreign income streams to allow for exchange risk. Based on this he then proceeds to show that Aliber's theory should be reversed: In fact, i t i s possible to argue, contrary to Aliber, that firms in weak currency areas have an advantage investing in strong currency areas i f the interest rate differential underestimates the exchange r i s k . I 4 On the other hand some support for Aliber's theory is provided by Dunning: As far as i t goes, I am fu l l y persuaded that the factors he [Aliber] mentions—noticeably that the world market of investors may attach a different exchange risk premium to equities denominated in di f -ferent currencies and hence evaluate investment opportunities d i f -ferently—should be incorporated in any generalized theory of investment behavior.15 However Dunning goes on to make i t clear that he does not view Aliber's theory as a substitute for the Hymer/Kindleberger 'superior knowledge' approach. Rather, he sees Aliber's work as providing an important addi-16 tional contribution to the more popular approach. Aliber continues to hold his position however, although he admits that the various competing theories of foreign direct investments are inconclusive."'"7 Rigorous testing is required and apparently has not yet been carried out. It should be pointed out that Aliber's theory implies that, should the U.S. become a weak currency area (a possibility not too far fetched today) then there should be an increasing amount of 'cross 87 hauling'; that i s direct investment in the U.S. by firms located in strong currency areas. Other theories of direct investment f a l l roughly into three cate-gories: (1) focus on imperfections in the capital market, (2) focus on monopolistic advantage, and (3) focus on oligopoly and need for growth. Ragazzi has conviently placed the three approaches in perspective by pointing out that a l l of them focus on some deviation from perfectly com-18 petitive conditions in the international market. Ragazzi summarizes 19 the main requirements for perfectly competitive conditions as follows: 1) the rate of return and risk of foreign equities effectively re-flect the rate of profit and risk of foreign enterprises; 2) enterprises of one country have no special advantage that allow them to operate subsidiaries in another country more profitably than local enterprises; 3) the objective of both individuals and enterprises i s the maxi-mization of profit in competitive markets; and 4) individuals and enterprises attach the same premium to exchange risks and are equally able to cover themselves against such risks. It can be argued that, under perfectly competitive conditions, there w i l l be portfolio investment only. No direct investment w i l l take place because i t can reasonably be assumed that a foreign subsidiary w i l l incur higher costs than indigenous firms in the same industry. The reasons include transportation and communication costs with the 88 parent, and l a c k of knowledge about l o c a l c u l t u r e and i n s t i t u t i o n s . Under c o n d i t i o n s of p e r f e c t competition then, funds would flow between co u n t r i e s i n response to temporary y i e l d d i f f e r e n t i a l s i n given r i s k c l a s s e s and the need f o r i n v e s t o r s to d i v e r s i f y p o r t f o l i o s . However the world markets are not p e r f e c t l y competitive as the f o l l o w i n g d i s c u s s i o n i l l u s t r a t e s . ( f ) IMPERFECT CAPITAL MARKETS Ragazzi argues that imperfections i n the market f o r s e c u r i t i e s 20 may be an important determinant of f o r e i g n d i r e c t investment. By r e -l a x i n g the assumption that the r a t e of p r o f i t s from a f o r e i g n e n t e r p r i s e i n a given r i s k c l a s s i s a c c u r a t e l y r e f l e c t e d by the r a t e of r e t u r n on i t s outstanding shares one may a r r i v e at a m o t i v a t i n g f a c t o r f o r d i r e c t investment. I f s e c u r i t i e s markets are p o o r l y developed ( l a c k i n g depth and breadth) the r e t u r n on a p o r t f o l i o investment i n a p a r t i c u l a r company may be s u b s t a n t i a l l y lower than the r e t u r n a v a i l a b l e i f c o n t r o l i s obtained. This i s p a r t i c u l a r l y true i n Europe where l a c k of i n f o r m a t i o n or downright misleading i n f o r m a t i o n seems to have developed i n t o a market norm. In the circumstances, e q u i t i e s trade at r e l a t i v e l y low P/E m u l t i -p l e s . The s i t u a t i o n i s so bad i n Europe that some major banks have e s t a b l i s h e d ' i n t e l l i g e n c e ' u n i t s to s i f t through the b i t s and pieces of i n f o r m a t i o n a v a i l a b l e about companies. One example i s 'Eurofinance, ' a company operated by s i x t e e n major banks i n c l u d i n g the Bank of Nova S c o t i a . Operating out of P a r i s , " I t was born i n 1961 when an investment a n a l y s t w i t h the merchant banking f i r m of Lazard Freres got fed up w i t h corporate 89 secrecy and down-right f i n a n c i a l l y i n g p r actised by many of Europe's 21 l a r g e s t companies." The company provides information to i t s sharehol-ders p r i m a r i l y , but also s e l l s research to investors. Ragazzi has shown that while the rate of return on U.S. s e c u r i -t i e s corresponds roughly with that of other i n d u s t r i a l i z e d countries, the standard deviation of past annual rates of return has i n general, 22 been lower i n the U.S. than i n most economically advanced countries. According to Markowitz's p o r t f o l i o theory, the investor, given a choice between s e c u r i t i e s of equal return but d i f f e r e n t r i s k classes w i l l always select the lower r i s k assets. Risk Expected return This should provide investors a l l over the world with a strong incentive to seek out the developed s e c u r i t i e s markets of New York and London. However while market imperfections may cause p o r t f o l i o flows, t h i s w r i t e r i s of the opinion that Ragazzi takes a rather large step i n assuming that these imperfections cause a reverse flow of d i r e c t i nvest-ment. There seems to be l i t t l e reason to assume that because the rate of return on equ i t i e s i s lower than corporate p r o f i t returns that investors 90 w i l l seek another market. If t h i s phenomenon were to occur i n the U.S. then one would expect a large number of investors to seek control of the U.S. company rather than looking to some foreign markets for a better p o r t f o l i o return. Ragazzi's example of course—European p o r t f o l i o i n v e s t -ment i n the U.S. and U.S. d i r e c t investment i n Europe—cannot be disputed. The facts are c l e a r but there may be some underlying psychological d i f -ferences ( l i q u i d i t y preference, r i s k avoidance, entrepreneurship) that provide more important motivation for d i r e c t investment. (g) MONOPOLISTIC ADVANTAGE 23 Within t h i s broad category of monopolistic advantage we include: 1) departures from perfect competition i n goods markets including product d i f f e r e n t i a t i o n and s p e c i a l marketing s k i l l s ; 2) departure from perfect competition i n factor markets including technology, access to c a p i t a l and proprietary managerial s k i l l s ; 3) i n t e r n a l and external economies of scale. The theory i s based on the assumption that indigenous firms have d e f i n i t e advantages i n operating i n the home markets (knowledge of l o c a l market, cultu r e , and shortened communication l i n e s ) and therefore foreign firms must have some other advantage that allows them to earn higher p r o f i t s than l o c a l firms. At l e a s t one author has questioned t h i s assump-t i o n : "I would not accept that host country firms have an i n e v i t a b l e advantage over foreign firms. This implies that c e t e r i s paribus the two 24 groups of firms are equally e f f i c i e n t and t h i s need not be the case." J. H. Dunning. 91 Kindleberger puts the argument i n simple terms as f o l l o w s : 25 C = value of asset I = income stream i = discount r a t e He argues that f o r e i g n firms operating abroad have some s p e c i a l advantage that allows them to generate a l a r g e r ' I ' than indigenous entrepreneurs and t h e r e f o r e the f o r e i g n f i r m w i l l be w i l l i n g to pay more f o r the income stream than the indigenous entrepreneur. A key feat u r e of t h i s formula-t i o n i s the assumption that the f o r e i g n f i r m and the l o c a l f i r m use the same r a t e of i n t e r e s t ( i ) . I f d i f f e r e n t r a t e s were used of course i t would be p o s s i b l e to produce the same asset value w i t h d i f f e r e n t income streams. I t i s j u s t at t h i s p o i n t that A l i b e r departs from the main body of work by arguing (as discussed above) that source country f i r m s do use a lower ' i ' and thus have a higher c a p i t a l i z a t i o n r a t e than indigenous f i r m s . Kindleberger considers t h i s p o s s i b i l i t y : I t w i l l happen, to be sure, that i n t e r n a t i o n a l c a p i t a l markets are l e s s than p e r f e c t , and that d i f f e r e n c e s i n i c o n t r i b u t e to the flow of c a p i t a l . But the behavior of d i r e c t i n v e s t m e n t , — t h e readiness of i n v e s t o r s to borrow i n the host country a t the same i as r e s i d e n t s face . . . — i n d i c a t e that i t i s c a p i t a l I not small i which domi-A unique f e a t u r e of s u p e r i o r knowledge i s that i t takes on the character of a p u b l i c good. The company that has developed the knowledge may have i n c u r r e d c o n s i d e r a b l e c o s t s which are now 'sunk' and t h e r e f o r e the marginal costs of e x p l o i t i n g the knowledge i n an overseas market i s n e g l i g i b l e i n comparison to the development cost that probably faces an nates. 26 92 indigenous firm. Up to this point the theory i s incomplete. As pointed out by Aliber: The industrial organization approach to direct investment did not ex-plain why the firm chose to exploit the foreign market through invest-ment rather than through exporting or licensing.27 On the surface i t might seem reasonable to expect that exporting or licensing should occur i f we stick with the assumption that host country producers have advantages in their home market. A further potential problem however i s the implied assumption that the objective of the firm i s to maximize profits rather than growth. As w i l l be seen when we discuss the theory focusing on oligopoly this assumption may not be valid. In other words the firm may prefer direct investment even when the return on—-say l i c e n s i n g — i s higher than on direct investments. The reason i s that direct investment shows up in consolidated sales and asset figures. Believers in this approach have offered an alternative response 28 however: the market for 'advantage' i s imperfect. If we set aside for now the above goal of profit maximization, the decision to license or invest directly should simply involve comparing the net present value of the two separate projected cash flows discounted at the company's cost of capital. The alternative with the greater NPV would then be selected. The implication of the notion that the market for 'advantages' is imper-fect i s that an adequate price cannot be obtained via licensing therefore direct investment i s often the preferred alternative even though a large capital outlay and the acceptance of increased risk i s often required. 93 The authors reviewed seem to miss another important point how-ever and that is that the recipient of the license may come back to haunt the licensor in i t s home market. The dangers of trading a football quarterback to another team in the same league are well known. The same can be said in selling 'advantages,' in fact i t has often been said that U.S. firms made a major mistake in exporting technology to Japan which soon enabled that country to compete in the domestic U.S. market. Ragazzi has pointed out—and this may be particularly relevant for banking—that many types of advantage cannot be sold because they 29 cannot be embodied in a license. Managerial expertise, knowledge of markets, and industrial organization are cited as examples. Another possible example is a form of 'corporate s p i r i t ' or a business philosophy that could probably not be sold to another company. An example that comes to mind is the American 'gung ho' marketing outlook versus the European 'status quo' or 'clubby' approach. Economies of scale were cited above as one of the factors leading to monopolistic advantage. Scale economies may be either internal or external. The latter typically involves vertical integration and, be-cause of i t s obvious inapplicability to banking, we w i l l not discuss i t here. Internal scale economics on the other hand usually involve hori-zontal investments and this i s relevant to banking. Increased output of relatively standard products may spread certain fixed costs (financing, marketing, head office administration) over a wider area and thus reduce unit costs. Kindleberger warns however that, beyond some point there are counterbalancing diseconomies of scale in administration which set 30 limits on the optimum scale of operations. 94 In c l o s i n g t h i s section on monopolistic advantage i t should be pointed out that an important t h e o r e t i c a l contribution developed by Raymond Vernon and known as the 'Product Cycle Theory' has been omitted 31 from the above discussion. The theory deals e x c l u s i v e l y with manu-fac t u r i n g companies. On the grounds that i t i s not r e a l i s t i c to think of money (a bank's product) progressing through some form of l i f e c ycle, the main thrust of Vernon's work has not been included. However Vernon does contribute some ideas that w i l l have a bearing on our upcoming development of a micro-theory of i n t e r n a t i o n a l banking. The key c o n t r i -bution i s : "The decision-making sequence that i s used i n connection with i n t e r n a t i o n a l investments, according to various empirical studies, i s 32 not a model of the r a t i o n a l process." In t h i s connection Vernon sees investments occurring more i n response to a threat to an established p o s i t i o n rather than i n response to an opportunity for p r o f i t s . This view puts him at l e a s t p a r t l y i n the camp of those who take the oligopoly approach which i s the subject of the next section. (h) OLIGOPOLY AND NEED FOR GROWTH Terms such as 'bandwagon e f f e c t ' and 'follow the leader syndrome' have been used to describe the often observed fa c t that when one industry member located a subsidiary i n a foreign country, industry r i v a l s f e l t compelled to follow. The implication of t h i s observation i s that growth and retention of market share are the determinants of d i r e c t investment rather than the p r o f i t motive. This observation has recently been sub-jected to quantitative analysis by F. T. Knickerbocker i n h i s award 95 winning doctoral dissertation entitled "Oligopolistic Reaction and Multi-33 national Enterprise." Oligopolistic reaction is defined as an inter-active kind of corporate behavior by which r i v a l firms in an industry composed of a few large firms counter one another's moves by making similar moves themselves. Util i z i n g facts and figures from the data bank of the Harvard Multinational Enterprise Study, Knickerbocker has pro-duced s t a t i s t i c a l evidence that U.S. manufacturing industries have con-sistently illustrated that foreign direct investment decisions are made with an eye on what industry rivals are doing. Oligopoly theory's notion of interdependency would of course predict this behavior. Knickerbocker's methodology centered around development of an 'entry concentration index' which i s a measure of the extent to which, in the 1948 to 1967 period, 187 major U.S. corporations bunched the establishment of their manufacturing subsidiaries together in twenty-34 three countries. His key preliminary finding i s that of approximately 2,000 foreign subsidiaries, almost 50 per cent were established within three year peak clusters. "Industry by industry, country by country, 35 U.S. enterprise invested abroad in lock-step-like fashion." Two possible conclusions that might be drawn from the above should be dispelled: 1) that the observed sheeplike strain i s economically irrational; and 2) that oligopoly can only lead to 'bad' results for the consumer. First there i s no ,a p r i o r i reason to conclude that the observed 'follow 96 the leader syndrome' i s irrational in an economic sense. H. A. Simon in his well known book, Administrative Behavior, argues that: the limits of rationality have been seen to derive from the ina b i l i t y of the human mind to bring to bear upon a single decision a l l the aspects of value, knowledge, and behavior that would be relevant.36 Decisions often become based more nearly on a stimulus-response pattern than a choice among alternatives. The stimulus in the issue at hand of course i s the penetration of a foreign market by a competitor in the industry: the response i s to follow. Most firms in the Western world are very reluctant to lose markets to competitors and consequently i t makes some sense for others in the industry to checkmate moves abroad. The second conclusion (that oligopoly i s 'bad') can be disputed. Knickerbocker suggests that non-collusive behavior has in fact been docu-mented among most international firms. In fact, in many cases, the arrival of foreign firms sparks a renewal of competitive vigor among firms in a particular industry located within the host country. Caves provides some support for this view: Whatever the market structure that results from the influence of direct investment, i t can be argued that entry by a foreign subsid-iary is lik e l y to produce more active rivalrous behavior and improve-ment in market performance than would a domestic entry at the same i n i t i a l scale.37 Balassa and Caves have taken a different approach than Knicker-bocker in that they focus on the need for growth rather than profit as a motivation of direct investment. Galbraith has put forth a persuasive 97 argument that growth i s indeed a major objective of the large corpora-t i o n : Once the safety of the technostructure i s ensured by a minimum l e v e l of earnings, there i s then a measure of choice as to goals. Nothing i s so compelling as the need to survive. However, there i s l i t t l e doubt as to how, overwhelmingly, t h i s choice i s exercised; i t i s to achieve the greatest possible rate of corporate growth as measured i n sales.38 Balassa's hypothesis i s that a firm belonging to an o l i g o p o l i s t i c industry may f i n d i t easier to invest abroad since any action to increase i t s share of the domestic market can be expected to meet with r e t a l i a t i o n 39 from other p a r t i c i p a n t s i n the industry. Thus, although the cost of entry into the foreign market may be high, i t could well be cheaper than s t i r r i n g up a trade war at home. Caves on the other hand hypothesizes that firms i n o l i g o p o l i s t i c i n d u s t r i e s i n each country encounter l i m i t s to increasing the sales of 40 t h e i r t r a d i t i o n a l product i n the domestic market. In order to con-tinue t h e i r growth rate, they must choose between expanding across a product boundary i n the domestic markets or expanding across a n a t i o n a l border with t h e i r t r a d i t i o n a l product. (i ) SUMMARY It has been the purpose of t h i s chapter to review various theories offered to explain foreign d i r e c t investment as i t applies to i n d u s t r i a l firms. No s i n g l e theory seems to be e n t i r e l y v a l i d although each o f f e r s points that have a r i n g of truth about them. Indeed t h i s w r i t e r sees no great c o n f l i c t between any of the theories. 98 I t may be that A l i b e r ' s theory h i g h l i g h t s p r i m a r i l y a s p e c i a l type of monopolistic advantage—favourable access to c a p i t a l markets. The oligopoly theories may also r e l a t e c l o s e l y to the Hymer/Kindleberger a p p r o a c h — i f one takes the view that the pursuit of growth i s r e a l l y j u s t the pursuit of long term p r o f i t s i n disguise. Some p r a c t i t i o n e r s i n the f i e l d b elieve that growth may be the best long term strategy for maximizing p r o f i t s . In any event, the theories reviewed do provide a r i c h source of information from which to b u i l d a theory applicable to the expansion of foreign banking. 99 Notes f o r Chapter S i x I G. Ragazzi, "Theories of the Determinants of D i r e c t Foreign Investment," IMF S t a f f Papers ( J u l y 1973), p. 471. 2 H. M. Markowitz, P o r t f o l i o S e l e c t i o n : E f f i c i e n t D i v e r s i f i c a - t i o n of Investments (New York: John Wiley and Sons Inc., 1959). 3 Ragazzi, p. 472. 4 R. Z. A l i b e r , "The M u l t i n a t i o n a l E n t e r p r i s e i n a M u l t i p l e Cur-rency World," i n The M u l t i n a t i o n a l E n t e r p r i s e , J . H. Dunning (ed.). ^ F. T. Knickerbocker, O l i g o p o l i s t i c Reaction and M u l t i n a t i o n a l  E n t e r p r i s e (Boston: Harvard U n i v e r s i t y P r e s s , 1973). C. P. Kin d l e b e r g e r , American Business Abroad: S i x Lectures on  D i r e c t Investment (New Haven: Yale U n i v e r s i t y P r e s s , 1969), p. 11. 7 S. H. Hymer, "The I n t e r n a t i o n a l Operations of N a t i o n a l Firms: A Study of D i r e c t Foreign Investment," c i t e d i n American Business Abroad, by C. P. Kindleberger. g S. H. Hymer and R. Rowthorn, I n t e r n a t i o n a l B i g Business 1957- 67: A Study of Comparative Growth (Cambridge: Cambridge U n i v e r s i t y Press, 1971). 9 R. Z. A l i b e r , "A Theory of D i r e c t Foreign Investment, i n The  I n t e r n a t i o n a l C orporation, C. P. Kindleberger (ed.). 1 0 R. Z. A l i b e r , The I n t e r n a t i o n a l Money Game (New York: B a s i c Books Inc., 1973). I I A l i b e r , "A Theory," p. 28. 12 A l i b e r , Money Game, p. 187. Ragazzi. 1 4 I b i d . , p. 493. J . H. Dunning, The M u l t i n a t i o n a l E n t e r p r i s e , p. 57. I b i d . 1 7 A l i b e r , Money Game. Ragazzi. 100 19 Ragazzi, p. 478. Ibid. 21 "The Bankers Take the Plunge," Executive (June 1971), p. 33. 2 2 T> Ragazzi. 23 Kindleberger, American Business, p. 14. 2 4 n Dunning. 25 C. P. Kindleberger, International Economics (Homewood, 111.: R. D. Irwin Inc., 1968), p. 393. 2 6 TU-A Ibid. 27 A l i b e r , M u l t i n a t i o n a l Enterprise, p. 50. 28 S. H. Hymer, "The Mul t i n a t i o n a l Corporation: An Analysis of Some of the Motives f o r International Business Integration," c i t e d i n The Mu l t i n a t i o n a l Enterprise, J . H. Dunning (ed.). 29 Ragazzi, p. 485. 30 Kindleberger, American Business. 31 R. Vernon, "International Investment and International Trade i n the Product Cycle," Quarterly Journal of Economics, 80 (1966), 190-207. 32 Ibid. 33 Knickerbocker. Ibi d . 3 5 TT, • A I b i d . H. A. Simon, Administrative Behavior (New York: MacMillan and Co., 1951), p. 108. 37 R. E. Caves, "International Corporations: The I n d u s t r i a l Economics of Foreign Investment," Economica, 38 (1971), p. 15. oo J. K. Galbraith, The New I n d u s t r i a l State (New York: Signet Books, 1967). 101 3 9 B. Balassa, "American Direct Investments in the Common Market," Banca Nazionale Del Lavora (June 1966). ^ Caves. Chapter Seven TOWARD A THEORY OF INTERNATIONAL BANKING EXPANSION BANKING: AN OLIGOPOLISTIC INDUSTRY Throughout the above d i s c u s s i o n of the var i o u s t h e o r i e s of f o r -eign d i r e c t investment, one common fe a t u r e emerged: a l l t h e o r i e s assume some d e v i a t i o n from p e r f e c t l y competitive market c o n d i t i o n s . In f a c t Kindleberger argues t h a t : f o r d i r e c t investment to t h r i v e there must be some imperfections i n markets f o r goods, or f a c t o r s , i n c l u d i n g among the l a t t e r technology; or some i n t e r f e r e n c e i n competition by government or by f i r m s , which separates markets.1 The argument i s based on the presumption that i f p e r f e c t markets d i d i n f a c t e x i s t then there would be no d i r e c t investments. The only type of c a p i t a l flow p o s s i b l e would be p o r t f o l i o investment. This w r i t e r can f i n d no f a u l t w i t h the above l i n e of reasoning and i t f o l l o w s t h e r e f o r e that the s t a r t i n g p o i n t i n development of a theory to e x p l a i n f o r e i g n banking expansion should be a search f o r market imperfections i n the banking i n d u s t r y . I t i s w e l l known that the Canadian banking i n d u s t r y f i t s the textbook d e s c r i p t i o n of an o l i g o p o l y — a h o r r i b l e sounding word de r i v e d 2 from the Greek word " o l i g o s " meaning few. An o l i g o p o l i s t i c i n d u s t r y i s ch a r a c t e r i z e d by a few s e l l e r s who produce an almost i d e n t i c a l product. Economic theory s t a t e s that f i r m s i n t h i s type of i n d u s t r y recognize t h e i r mutual interdependence and thus end up a d m i n i s t e r i n g p r i c e s . I t 102 103 i s argued that there i s a c e r t a i n amount of waste to society involved i n t h i s type of industry because prices are c e r t a i n to exceed marginal costs. In addition to loss of the f a m i l i a r consumer surplus there i s also a "dead weight l o s s " that r e s u l t s from too l i t t l e of the product being produced. Samuelson gr a p h i c a l l y i l l u s t r a t e s the foregoing as f o l -lows : 3 PRICE Actual P r i c e l o s s of consumer surplus \ \ dead weight loss V \ v AC = MC \ >^Demand y MR\ • v • — QUANTITY There i s an i m p l i c i t assumption throughout t h i s type of analysis that a number of small firms i n an industry could supply t h e i r product at a lower 1 i d e a l p r i c e . ' In the banking industry a case can be made that there are economies of scale which could well mean that the marginal cost/marginal revenue i n t e r s e c t i o n for small banks i s well above the i d e a l p r i c e . I t may even be very close to the actual p r i c e charged for loans and se r v i c e s . While t h i s b r i e f discussion i s somewhat of a dive r -sion from the issue at hand, the writer considers i t important to make i t c l e a r that there i s nothing n e c e s s a r i l y e v i l or s i n i s t e r about 104 o l i g o p o l y and, f u r t h e r , that the case f o r high administered p r i c e s i s not proven. There are c u r r e n t l y ten chartered banks i n Canada. As at October 31st, 1973, the f i v e l a r g e s t c o n t r o l l e d 91.5 per cent of i n d u s t r y assets t o t a l l i n g $75,021 m i l l i o n . Concentration i s d e f i n i t e l y a f a c t i n Canadian banking. The s i t u a t i o n i n the U.S. i s somewhat d i f f e r e n t . At June 30th, 1974, there were 14,338 banks i n the U.S. w i t h t o t a l assets 4 of $853 b i l l i o n . On the surface i t would appear that the i n d u s t r y i s i n no way c h a r a c t e r i z e d by o l i g o p o l y . However there i s i n f a c t a con-s i d e r a b l e amount of c o n c e n t r a t i o n i n U.S. banking and the degree of con-c e n t r a t i o n i s growing. One quarter of a l l deposits and 22 per cent of t o t a l loans belong to the f i v e l a r g e s t banks. The top ten banks hold 35 per cent of i n d u s t r y a s s e t s . Furthermore the nature of U.S. banking law serves to promote co n c e n t r a t i o n . Laws preventing banks from branch-ing across s t a t e l i n e s r e s u l t i n the domination of the many r e g i o n a l markets by a few l a r g e banks. For example the C a l i f o r n i a market i s dominated by BankAmerica ($57,351 m i l l i o n ) , Western Bankcorp ($14,740 m i l l i o n ) , S e c u r i t y P a c i f i c ($12,571 m i l l i o n ) , Wells Fargo ($8,880 m i l l i o n ) , and Crocker N a t i o n a l ($8,326 m i l l i o n ) . Perhaps more important f o r the purposes of t h i s study the top banks centered i n New York (and BankAmerica i n C a l i f o r n i a ) are the p r i -mary p a r t i c i p a n t s i n f o r e i g n markets. The top ten banks hold an average of 36.3 per cent of t h e i r deposits w i t h f o r e i g n e r s w h i l e the vast major-i t y of deposits w i t h the f i f t i e t h through two hundredth l a r g e s t U.S. banks are domestic. In f a c t 150 of the nations 200 l a r g e s t banks have 105 n e g l i g i b l e holdings of f o r e i g n deposits ( l e s s than 10 per c e n t ) . The f i r s t and most obvious d e v i a t i o n from p e r f e c t l y competitive markets then i s i n d u s t r y c o n c e n t r a t i o n — o r o l i g o p o l y . One of the i m p l i -c a t i o n s that f a l l s out of an o l i g o p o l i s t i c i n d u s t r y s t r u c t u r e i s that i t i s very d i f f i c u l t to s i g n i f i c a n t l y a l t e r one's share of the domestic market. The banking i n d u s t r y has one r a t h e r unique a d d i t i o n a l f e a t u r e about i t that i s not common to other i n d u s t r i e s — t o t a l domestic market s i z e i s c o n t r o l l e d by c e n t r a l monetary a u t h o r i t i e s . That i s , by con-t r o l l i n g the supply of r e s e r v e s , the c e n t r a l bank set's an upper l i m i t on the amount by which banks can expand t h e i r domestic a s s e t s . I f the t o t a l market i s growing by 10 per cent per year, the only way a p a r t i c u -l a r bank can grow more r a p i d l y i s at the expense of some other bank. This can be very expensive and i n f a c t may not be p o s s i b l e s i n c e other banks w i l l l i k e l y r e t a l i a t e . A good example i s the i n t r o d u c t i o n of the 'Western Account' by the Bank of B r i t i s h Columbia, a small r e g i o n a l bank w i t h about one per cent of t o t a l market share. The 'Western Account' i s a package of usual r e t a i l banking s e r v i c e s s o l d to customers at a f l a t monthly r a t e . The idea caught on q u i c k l y and, as soon as the major banks perceived even a minute s h i f t i n market share, they a l l came out w i t h e s s e n t i a l l y the same pl a n . NEED FOR GROWTH P r o t e c t i o n of market share i s a f a c t of l i f e i n banking (as i t i s i n other o l i g o p o l i s t i c i n d u s t r i e s ) but t h i s does not i n i t s e l f pro-v i d e a m o t i v a t i o n f o r f o r e i g n d i r e c t investment. The m o t i v a t i o n i s more 106 l i k e l y to be an almost innate need for growth. There are a variety of good reasons for a bank to set growth as an objective. The most obvious is that there are economies of scale in banking. Three areas can be singled out where a large bank can operate more efficiently than a smaller bank: a) acquisition of deposits; b) asset management; and c) clearing mechanism. The use of computers can lower the costs of a l l three of the above functions. The growth of branch banking is also a good indication that economies can be achieved in the internal transfer of funds. The most obvious example is f a c i l i t a t i n g the flow of funds from surplus units (households in rural areas) to def i c i t units (business firms in indus-tri a l i z e d areas). At least one author has questioned the assumption that larger banks are more efficient. G. J. Benston has conducted a study of U.S. banks which he claims casts some doubt on the accepted truism that econo-mies of scale exist in banking."' His findings were that a doubling in size of a bank was associated with something in the order of a 7 per cent decrease in unit costs which the author claims is relatively insig-nificant. Benston also argues that i f growth is achieved by branching then economies are not achieved. There were some serious problems associated with the study however—the most important being the extreme d i f f i c u l t y in measuring the output of a bank. Benston himself admits 107 that his methodology did not measure the a b i l i t y of a bank to make large loans to valuable deposit clients nor the economies that might be expec-ted from more efficient funds management.^ A more rigorous study of the economies of scale question has g been carried out by L. Kalish and R. Gilbert. Using a sample consis-ting of 898 U.S. commercial banks the authors attempted to obtain a measure of the relationship between size and average unit cost as follows: Average Unit Cost Bank Output The objective was to locate point A on the above average cost curve. As was the case in the Benston study, there was d i f f i c u l t y in measuring bank output, however the authors did agree that the average cost curve took on a positive slope at a relatively low level of output. Specifi-cally, the Kalish and Gilbert study found a bank with assets in the $5 9 to $15 million range to have the lowest per unit average cost. These results were compared to two other studies (Alhadeff and Gramley) as follows:"^ 108 Comparison of Long Run Average Cost Curves (thousands) Bank Si z e Alhadeff Gramley (cost per u n i t of output) K a l i s h / G i l b e r t under . . . . $2,000 2,000 - 5,000 5,000 - 15,000 15,000 - 50,000 50,000 - 150,000 150,000 - 1,000,000 1,000,000 $.0438 $.0278 .0289 .0256 .0239 .0282 .0255 .0200 .0199 .0196 N/A N/A $.0401 .0349 .0304 .0307 .0318 .0323 .0457 There are a couple of p o i n t s to note about the above data. The f i r s t i s that the s t u d i e s are not i n agreement. Both the Alhadeff and Gramley st u d i e s i n d i c a t e no p o s i t i v e slope i n the average cost curve. The second po i n t i s the absence of data on major b a n k s — s a y w i t h assets above $10 b i l l i o n . There were no major banks included i n the Alhadeff and Gramley s t u d i e s and the l a r g e s t bank i n the K a l i s h / G i l b e r t study had assets of only $1 b i l l i o n . This leaves open the d i s t i n c t p o s s i b i l i t y that the authors have concentrated on much too narrow an asset range i n t h e i r samples. I t could w e l l be the case that the average cost curve of major banks i s indeed lower than those of the smaller banks. predominant opinion seems to be i n favour of the hypothesis. The recent trend toward state-wide, m u l t i p l e - b r a n c h banking i n the United States may be evidence that bankers b e l i e v e that t h i s form of expansion achieves s c a l e economies. Roger E. Anderson, Chairman of the Board of C o n t i n e n t a l I l l i n o i s N a t i o n a l Bank has r e c e n t l y s t a t e d : "An i n t e r n a l advantage f o r the branch bank i t s e l f i s f e l t to be increased operating e f f i c i e n c y and lower c o s t s , s i n c e a bank could o f f e r the same s e r v i c e s at many estab-lishments. While the case f o r economies of s c a l e i n banking remains unproven, 109 For our purposes i t i s not important to prove the e x i s t e n c e (or otherwise) of economies of s c a l e . What might be important i s that bank management b e l i e v e that there are s c a l e economies or that they want " s c a l e " f o r some reason other than f o r economies. Baumol suggests t h a t : Though businessmen are i n t e r e s t e d i n the s c a l e of t h e i r operations p a r t l y because they see some connection between s c a l e and p r o f i t s , I t h i n k management's concern w i t h the l e v e l of s a l e s goes even further.12 The -clear i m p l i c a t i o n here i s that growth would continue to be important even though f u r t h e r s c a l e economies were not achieved. We have uncovered some sketchy evidence that i n d i c a t e s Baumol may be c o r r e c t . The U.S. Federal Reserve Board annually publishes income, expense, and di v i d e n d data broken down by s i z e of member bank. I t i s i n t e r e s t i n g to note that the major i n t e r n a t i o n a l banks do not generate p r o f i t r a t i o s that compare favourably to smaller r e g i o n a l U.S. banks. 13 Tables 7-1 and 7-2 summarize the data. Table 7-1 PROFIT RATIOS BY SIZE OF U.S. BANK Net Incme S i z e Group by Deposits 000's omitted as % of $1- 2000- 5000- 10000- 25000- 50000- 100000- 500000 Gross 2000 5000 10000 25000 50000 100000 500000 & up Revenue 1973 13.9 15.1 15.1 15.4 14.3 13.3 12.0 11.3 1972 13.9 12.8 14.3 14.8 14.7 14.3 14.0 13.8 110 Table 7-2 PROFIT RATIOS OF SELECTED BANKS Net Incme as % of Gross Revenue BankA-merica Chase Man/Han Chemical Morgan Bankers Trust 1973 10.0 6.9 8.0 5.8 11.4 5.2 1972 11.6 10.2 10.8 9.3 16.0 9.9 Another advantage that i s o f f e r e d by growth i s that bigness i s a s s o c i a t e d by the banking p u b l i c w i t h s a f e t y , e f f i c i e n c y , and s e r v i c e . Evidence of t h i s i s provided by recent events i n the U.S. banking i n d u s t r y . U.S. banks are c u r r e n t l y undergoing a l i q u i d i t y c r i s i s . Compounding the problem i s the f a c t that the l a r g e New York banks continue to experience r a p i d growth w h i l e the small r e g i o n a l banks are i n t r o u b l e . To quote Profes s o r Paul Nadler: When bad news about one bank gets out, people panic, f i g u r i n g that i f i t can happen to one bank i t can happen to another. So they withdraw t h e i r money from r e g i o n a l banks and ship i t a l l o f f to the ' b i g g i e s ' because people equate bigness w i t h soundness.14 The banks are w e l l aware of the importance of s i z e so growth becomes a very r e a l o b j e c t i v e . Growth i s a l s o important f o r another r e a s o n — g e n e r a t i o n of employee enthusiasm. Banking i s unquestionably a 'people' business and i t i s v i t a l to r e t a i n aggressive young employees. One way to do t h i s i s to grow. Growth of any o r g a n i z a t i o n increases o p p o r t u n i t i e s f o r the upward i m o b i l i t y of i t s employees. This process appears q u i t e l o g i c a l to t h i s I l l writer and indeed seems essential to ensure the continued health of an organization. Galbraith however has a different interpretation of the process. While acknowledging that growth is in the self-interest of the techno-structure (defined as those who participate in corporate decision making), Galbraith views the growth process as being inherently in conflict with the preferred goal of profit maximization: The paradox of modern economic motivation is that profit maximization as a goal requires that the individual member of the technostructure subordinate his personal pecuniary interest to that of the remote and unknown stockholder. By contrast, growth, as a goal is wholly consistent with the personal and pecuniary interest of those who par-ticipate in decisions and direct the enterprise.15 The case for growth is widely accepted within the banking industry. The focus is on expanding markets but the assumption is that, eventually, profits w i l l j ustify the growth. Theorists find this a tough p i l l to swallow. In fact, Kindleberger, in response to this type of statement, stated: But the explanations which businessmen give of their thought processes must not be taken with l i t e r a l seriousness. Like Monsieur Jourdain in Moliere's Le Bourgeois Gentilhomme who spoke prose a l l his l i f e without having been aware of i t , they doubtless maximize profits rather than merely follow markets.16 This i s a rather brave statement to make especially since the author pro-vided no supportive evidence. The comment indicates Kindleberger's staunch resistance to relaxing one of the c r i t i c a l economic assumptions underlying the theory of the firm: profit maximization. At least some other economists seem more prepared to alter their position. After 112 observing the behavior of oligopolistic firms for several years (always with the profit maximization assumption firmly entrenched in his thought processes), W. J. Baumol f i n a l l y concluded that: This (d i f f i c u l t y forming a theory of the firm) is largely the result of my stubborn reluctance to part company with the universal applica-b i l i t y of the profit maximization hypothesis. Only after a number of unsuccessful attempts to force i t s implications down the throats of otherwise highly cooperative firms for which I was consulting did i t occur to me that something might be wrong with the central tenets of my position.17 Here is a comment from a British observer of international bank-ing that lends some support to Baumol's observation: Economists might wonder what has happened to the theory which ex-plained everything a firm did in terms of profit maximization. The order of the day on the international banking scene now seems to be business maximization irrespective of profits, though i t i s hoped, of course that one w i l l follow from the other.18 PROFIT CONSTRAINT Bigness and the need for growth is not a l l that counts in banking however. There i s a profit constraint imposed by the shareholders and by the need to finance further growth. There are good reasons to believe however that the constraint imposed by shareholders is something less than profit maximization. Profit norms for the banking industry have evolved over time and as long as a bank generates sufficient revenue to make normal dividend payments, i t is extremely unlikely that the position of management w i l l be threatened. On the other hand i f growth is not up to the industry norm and the bank starts to s l i p in relative size i t i s likely that shareholders, through the board of directors, w i l l begin to 113 ask questions about the efficiency and competence of management. The above phenomena are not unique to Canadian and U.S. banking. A British magazine, "The Banker," publishes an annual survey of the top 300 commercial banks. This publication recognizes and defends the need for growth of banks. There are many reasons why bankers, especially chairmen and senior managers, are concerned about the size of their bank, quite apart from any guide that listings give them. Now that traditional distinc-tions of status based on class at birth or inherited wealth have largely disappeared in advanced societies and there i s a fast growing, multinational, multilingual financial community comprising men of most diverse origins, the relative rise of the institution they work for goes some way to determine their status generally.-^ "The Banker" goes on to point out that the goal of size i t s e l f can help management define at least one readily understandable corporate goal for the organization. In an industry that essentially deals with a homogen-eous product a growth goal subject to a profit constraint has become accepted worldwide. MAINTENANCE OF MARKET SHARE A very important offshoot of the inherent need for growth is the need within the banking industry to (as a minimum) maintain one's size relative to competitors. Bankers may well reflect adherence to the Red Queen's dictum: "Now, here, i t takes a l l the running you can do to keep in the same place. If you want to get somewhere else, you must run at 20 least twice as fast as that." From the point of view of the Chase Manhattan Bank i t was a disas-ter to s l i p from the world's second largest bank to third largest within 114 the past few years. For C i t i c o r p on the other hand i t was a major v i c -t o r y to move i n t o second p l a c e . I t i s i n t e r e s t i n g to note that there i s no evidence that Chase was being c r i t i c i z e d by i t s shareholders f o r not mai n t a i n i n g p r o f i t s at the same l e v e l as i t ' s main competitors. For the ten year p e r i o d ended December 31st, 1973, the Chase had experienced an average growth i n earn-ings per share of 1\ per cent, w e l l under the growth r a t e s of BankAmerica (8.9 per c e n t ) , C i t i c o r p (10.5 per c e n t ) , and J . P. Morgan (10.9 per 21 c e n t ) . However i t was not u n t i l the Chase s l i p p e d i n t o t h i r d place that managerial competence was questioned. In response to c r i t i c s , David R o c k e f e l l e r , Chairman, i s reported to have embarked on a personal crusade to r i d Chase Manhattan "of i t s image as the slumbering g i a n t of 22 i n t e r n a t i o n a l banking." This i n v o l v e d s e v e r a l top management changes i n c l u d i n g the r e s i g n a t i o n of the president i n 1972. I t i s apparent that 23 R o c k e f e l l e r ' s crusade i s s t i l l going on. The same pressure i s i n evidence i n Canadian banking. W. E. McLaughlin, Chairman and Pres i d e n t of the Royal Bank of Canada has obser-ved that h i s bank i s Canada's l a r g e s t and f u l l y intends to remain number one. The comparison has been on the b a s i s of assets not p r o f i t s . The need to maintain one's p o s i t i o n i n the i n d u s t r y manifests i t s e l f by the p r a c t i c e of the banks matching each others moves i n t o f o r -eign markets. This p r a c t i c e has been observed i n other i n d u s t r i e s and i s more a f u n c t i o n of i n d u s t r y s t r u c t u r e than type. Kindleberger says: Indeed, i n concentrated i n d u s t r i e s there i s pressure f o r each f i r m to develop a p o s i t i o n i n each important or p o t e n t i a l l y important 115 m a r k e t — r e g a r d l e s s of the r a t e of p r o f i t o b t a inable i n absolute t e r m s — t o prevent any of i t s few competitors from o b t a i n i n g a sub-s t a n t i a l advantage which i t could put to use over a wider a r e a . 2 4 25 This observation has been supported by Vernon and i n v e s t i g a t e d i n depth 26 by Knickerbocker, who provides e m p i r i c a l support f o r the argument. GOVERNMENT INTERFERENCE The acceptance of growth as a goal i n banking does not i n i t s e l f e x p l a i n why the banks would expand abroad. There may w e l l be a t t r a c t i v e o p p o r t u n i t i e s i n domestic f i n a n c i a l markets. We have already argued that expansion of a share of the domestic banking market i s very d i f f i -c u l t f o r a s i n g l e bank. However we are now t a l k i n g about expansion i n t o near banking operations.or 'congeneric s e r v i c e s ' (meaning banking r e l a t e d s e r v i c e s ) . There i s a l u c r a t i v e market to be e x p l o i t e d i n Canada, how-ever, the chartered banks have taken only very t e n t a t i v e steps i n t h i s area. The reason i s another 'market i m p e r f e c t i o n , ' t h i s time i n the form of government i n t e r f e r e n c e . The Bank Act of 1967 i s very ' i f f y ' on the subject of d i v e r s i f i c a t i o n by the banks i n t o other f i n a n c i a l s e r v i c e areas. P r i o r to 1967 the chartered banks had been p r o h i b i t e d from owning the shares of another chartered bank and i t has a l s o been r u l e d that owning more than 50 per cent of the shares of any other c o r p o r a t i o n , whether f i n a n c i a l or not, would be beyond the powers of a bank. The 1964 Royal Commission on Banking and Finance looked c l o s e l y at t h i s i s s u e and recommended that e x i s t i n g p r o v i s i o n s be tightened. Most of the r e s t r i c t i v e P o r t e r recommendations were not heeded but the f o l l o w -27 i n g ownership p r o v i s i o n s were included i n the new Bank a c t : 116 a) a limit of 10 per cent was placed on the ownership of a trust or mortgage loan company or other deposit taking institution; and b) a limit of 50 per cent applies to a l l other companies unless the cost of shares is over $5 million in which case the limit is 10 per cent. The above regulations certainly inhibit the a b i l i t y of the banks to ex-pand in Canada. An interesting side issue is the fact that American banks are not barred from the Canadian congeneric market. Several major U.S. banks have entered Canadian financial markets and Canadian bankers are publicly expressing disapproval of the present permissible posture in Ottawa. An example is the Bank of America which is closely related to Power Corporation in Canadian financial markets. BankAmerica now con-trols 20 per cent of Montreat Trust, 5 per cent of Investors Group, and about 49 per cent of North Continent Capital (a Vancouver based indus-t r i a l leasing firm). Diversification into Canadian financial markets is going to be a hotly debated subject during the 1977 decennial revision of the Bank Act. The point of relevance to this study is that chartered banks, given that they want to expand and grow, have chosen to seek growth abroad. Until recently there has been similar interference in U.S. bank-ing. Up until the passage of the new Bank Holding Company Act in 1970, expansion of U.S. banks into near banking areas was d i f f i c u l t . Since 1970 however, acquisition of non-bank a f f i l i a t e s by bank holding compan-ies has been on firmer legal ground. This has predictably led to a rapid expansion by the U.S. banks into a wide range of financial a c t i v i t i e s , from finance companies to general insurance underwriting. The l i s t of permissible non-bank activities for U.S. bank holding companies has grown rapidly in the three years since the 1970 Amendments were passed. 28 The current l i s t of approved activities as at June, 1974, includes: a) finance companies; b) mortgage companies; c) factoring companies; d) dealers in banker's acceptances; e) credit card companies; f) operating an industrial bank; g) trust companies; h) servicing loans; i) providing portfolio investment advice; j) furnishing general economic information and advice; k) investment adviser to Real Estate Investment Trusts and to i n -vestment companies under the Investment Company Act of 1940; 1) f u l l pay-out leasing of personal and real property; m) investments in community welfare projects; n) providing bookkeeping or data processing services; o) acting as insurance agent or broker—primarily in connection with credit extensions; p) underwriting credit l i f e , accident, and health insurance; q) dealing in gold and silver bullion and coins; and r) courier services for investments of a banking or financial char-acter. 118 The McFadden Act passed in the 1920's which prohibits branching across state lines represents a major form of government interference. It is this type of legislation, based upon populist fears of a conspiracy of giant banking groups against small business interests and the rural community (especially the farmer), that led to the unit banking struc-ture in the U.S. The above legislative framework would suggest that U.S. banking growth would have to occur in the foreign sector. The following comment by Kindleberger (surprisingly) provides support: Indeed so restrictive of spatial expansion by American banks is pop-ul i s t sentiment inside the United States that i t may force expansion abroad by blocking i t at home, just as antitrust laws are believed to do in industry.29 This comment contains an underlying assumption that banks need to grow which i s consistent with the views of this study. U.S. banking laws are slowly being liberalized and i t w i l l be i n -teresting to see whether a removal of the barrier to domestic expansion and diversification w i l l divert attention away from the international sector. This possibility w i l l be explored in Chapter Nine below. At the present time however there remains significant barriers to the expansion of U.S. banking at home. Under the Bank Holding Company Act the Federal Reserve Bank has the power to turn down acquisitions. Business Week reports that the BankAmerica, Citicorp, Bankers Trust, and First Chicago ( a l l among the top ten U.S. banks) have had planned acqui-- - , . 30 sition turned down in recent months. The various attempts in the mid-1960's by the U.S. government 119 to deal w i t h a c o n t i n u i n g balance of payments d e f i c i t represents another form of ' i n t e r f e r e n c e ' that i n f l u e n c e d the growth of f o r e i g n banking. In 1963, the I n t e r e s t E q u i l i z a t i o n Tax was introduced. Designed to r e -duce p r i v a t e c a p i t a l outflows, i t placed a p r o h i b i t i v e tax on the pur-chase of f o r e i g n stocks and bonds by U.S. c i t i z e n s . The e f f e c t of the tax was to s u b s t a n t i a l l y reduce the a b i l i t y of f o r e i g n i n s t i t u t i o n s and corporations to s e l l s e c u r i t i e s i n U.S. f i n a n c i a l markets. Faced w i t h a c l o s u r e of t h i s market, the f o r e i g n borrowers turned to the U.S. banks. " I t has been estimated that p o s s i b l y as much as two-thirds of a l l new commercial and i n d u s t r i a l loans i n New York during the 1963-64 31 pe r i o d were made to f o r e i g n e r s . " Thus i n :c l o s i n g one source of c a p i t a l , government i n t e r f e r e n c e had s w i f t l y opened another. In 1965 the govern-ment introduced a new balance of payments program designed to curb the granting of bank loans to f o r e i g n borrowers. Banks i n e f f e c t v o lun-t a r i l y pledged to l i m i t the volume of c r e d i t that they extended abroad to 109 per cent of the 1964 t o t a l . E f f e c t i v e l y cut o f f from s e r v i n g a world market from a domestic base, the banks soon r e a l i z e d t h a t , i f they wished to continue t h i s a c t i v i t y they would have to tap the E u r o d o l l a r market. "Since, by d e f i n i t i o n , E u r o d o l l a r s are h e l d outside the United St a t e s , there was a major i n c e n t i v e to open o f f i c e s overseas i n order to 32 p a r t i c i p a t e d i r e c t l y i n t h i s a c t i v e market." One American banker has expressed what could w e l l be the predomi-nant banking view of government i n t e r f e r e n c e . I t i s not out of place here to r e c a l l that one of the determining f a c t o r s f o r the existence of the Euro d o l l a r market i s the r e g u l a t i o n 120 that prevents banks in the United States from paying for money the price that market conditions warrant.33 This comment reflects the view that yet another act of interference, Regulation Q, was partly responsible for the development of the Euro-dollar market. Under Regulation Q the U.S. banks are subject to an i n -terest ceiling on time deposits and are prohibited from paying interest on chequeing accounts. Evidence that U.S. Government interference i n f l u -ences foreign operations is often provided by senior bankers. The f o l -lowing comment, from the 1971 annual report of J. P. Morgan and Company is i l l u s t r a t i v e : As has been the case for several years, restrictions imposed by U.S. authorities for balance of payments reasons strongly influence the pattern of our activities in this (international) f i e l d . 3 4 Foreign expansion was also spurred on by the Federal Reserve imposed 'credit crunch' of 1969-70. At a time when U.S. banks were experiencing liquidity problems in their domestic operations i t was important to be able to tap the Eurodollar market. Thus foreign branches of U.S. banks were able to borrow in the Euro dollar market and re-lend to the U.S. head office to ease liquidity pressure. At least one author has claimed that the Euro dollar market provided, "the motivation behind the setting up of most branches opened by American banks in London in the last 10-12 years." 3 5 U.S. legislation has also interfered with the a b i l i t y of banks to select the geographical location of banking outlets. Under the pro-visions of the Federal Reserve Act (Sec. 25), permission from the Board 121 of Governors must be obtained before a bank branch may be established in 36 a foreign country. This authority also extends to the investment by member banks in the stock of corporations engaged principally in inter-national or foreign banking. Through the use of this power the Federal Reserve Board has been able to influence the direction of banking expan-sion. In 1968 the Board was clearly discouraging expansion in developed countries, preferring instead that the banks establish in developing economies. Equity investment in developed countries of continental Western Europe w i l l not, while the new provisions remain in effect, be ap-proved by the Board, unless circumstances clearly demonstrate that the transaction w i l l not be detrimental to the U.S. balance of pay-ments. But, applications to make equity investments elsewhere w i l l be considered on their merits.37 It i s an interesting fact that the various U.S. government re s t r i c -tions on capital flows have had an indirect influence on the foreign activ-i t i e s of the Canadian banks. In March 1968 the Canadian government was able to obtain almost complete exemption from the U.S. capital restraint program. However as part of the price for obtaining exemption, the government agreed to impose restrictions designed to prevent the 'flow through' of U.S. funds to 38 third countries. The guidelines read as follows: 1. The total of a bank's foreign currency claims on residents of countries other than Canada and the United States should not rise above the level of the end of February 1968 unless the i n -crease i s accompanied by an equal increase in i t s total foreign 122 currency l i a b i l i t i e s to residents of countries other than Canada and the United States. 2. If there should be a decline in the total of a bank's foreign currency l i a b i l i t i e s to residents of countries other than Canada and the United States from the level at the end of February 1968 the bank should achieve an equal reduction in i t s total foreign currency claims on residents of countries other than Canada and the United States as quickly as the liquidity of such assets w i l l permit. 3. Each bank should allow an increase in i t s U.S. dollar l i a b i l i t i e s to residents of the United States from the level at the end of February 1968 only to the extent that the increase is f u l l y matched by the sum of (1) the increase from that date in the bank's U.S. dollar claims on residents of Canada, (2) the de-crease from that date in the bank's U.S. dollar l i a b i l i t i e s to residents of Canada, and (3) the decrease from that date in the bank's own spot position in U.S. dollars. Freedman has argued that the above guidelines strongly influenced 39 the conduct of the chartered banks. The f i r s t two guidelines prevented the chartered banks from s o l i c i t i n g deposits from U.S. residents and i n -vesting the funds outside North America. Thus the banks could no longer expand their Euro dollar activities from a domestic base. If continued growth was to be achieved i t was necessary to establish foreign branches in order to s o l i c i t an adequate deposit base. Thus i t can be argued that U.S. government 'interference' had an indirect effect on the a b i l i t y 123 of the chartered banks to continue t h e i r growth. The e f f e c t of t h i s interference was to encourage the chartered banks to expand t h e i r opera-tions i n Europe i n order to tap the Euro d o l l a r market. SUPERIOR KNOWLEDGE THEORY We have thus f a r established that there are grounds f o r b e l i e v -ing that there are l i n k s between the expansion of foreign banking and di r e c t investment theories that focus on o l i g o p o l i s t i c behavior and the maximization of growth. However, the main l i n e of d i r e c t investment theory focuses on superior 'knowledge' and accordingly, we w i l l now look for some s i m i l a r i -t i e s i n the 'knowledge' area that apply to banking. I t should be remem-bered of course that superior knowledge also represents a deviation from p e r f e c t l y competitive market conditions. The fundamental argument advanced by the 'knowledge' t h e o r i s t s i s that some form of advantage must e x i s t that allows a foreign f i r m to operate more p r o f i t a b l y than a domestic competitor. The banking evidence i n t h i s area i s mixed to say the l e a s t . Canadian chartered banks are not required, nor do they deem i t necessary, to report earnings from foreign operations. The references to p r o f i t s are always v e i l e d i n g e n e r a l i t i e s . Witness the following quote from the Canadian Bankers Association: The banks' i n t e r n a t i o n a l operations have become in c r e a s i n g l y impor-tant to t h e i r balance of revenue. In 1955, only about 11% of t o t a l assets consisted of foreign currency assets; whereas by 1960 t h i s had increased to 16%; and by 1970 to 30%.40 124 The statement c e r t a i n l y leads one to b e l i e v e that f o r e i g n operations are p r o f i t a b l e ; but the evidence i s not c o n c l u s i v e . As part of our f i e l d study, we explored the p r o f i t a b i l i t y ques-t i o n w i t h s e n i o r executives i n the i n t e r n a t i o n a l d i v i s i o n s of the f i v e major chartered banks. No one was w i l l i n g to r e v e a l a c t u a l f i g u r e s but there were i n d i c a t i o n s that f o r e i g n operations were about as p r o f i t a b l e as domestic. In t h i s connection i t was mentioned that there are major d i f f i c u l t i e s i n a l l o c a t i n g costs and measuring the a c t u a l p r o f i t s p l i t between domestic and f o r e i g n operations. There appears to be good reason to assume that Canadian and U.S. banks do i n f a c t have some competitive advantages i n operating i n c e r t a i n f o r e i g n markets. We asked i n t e r n a t i o n a l operations' executives i n Canada's f i v e l a r g e chartered banks i f they thought that the chartered banks had any 'advantage' that allowed them to operate more p r o f i t a b l y i n f o r e i g n markets than indigenous banks. The answer was: "yes, i n some cases." In c e r t a i n f o r e i g n markets the s i z e and r e p u t a t i o n f o r conserva-t i v e management was thought to represent an advantage. However i t was unanimously agreed that t h i s advantage d i d not c a r r y over i n t o major world markets. New York and London were i d e n t i f i e d as two examples of markets where the chartered banks had no advantage. Whether or not the s i z e advantage i s t r a n s l a t e d i n t o s u p e r i o r p r o f i t s remains open to question. The evidence i s again c o n f l i c t i n g . Here i s a comment concerning the p r o f i t s i s s u e by J . P. K o s z u l , V i c e -P r e s i d e n t , C i t i c o r p : "The r e s u l t of a l l t h i s ( l a c k of a l o c a l deposit base) i s that t h e i r (U.S. bank's) p r o f i t margins tend to be more l i m i t e d 125 41 than those of their indigenous competitors." This comment appears to be somewhat at variance with a recent report that Citibank earns a higher 42 than proportional share of i t s profits from overseas operations. Much of the foreign business of the U.S. and Canadian banks is centred in the Euro-dollar market and there is good evidence that spreads are very thin in this highly competitive market. On the whole i t is d i f -f i c u l t to see how the Kindleberger/Hymer thesis has much explanatory power with respect to behavior in the banking industry. The crux of the theory depends on a superior 'I' in the formulation: There is no convincing evidence available that i t applies to banking. On the other hand this writer concedes that, because of the absolute unavail-a b i l i t y of data i t is probably not possible to build a convincing empiri-cal case against the theory. While i t i s not possible to obtain conclusive profit figures from the foreign operations of U.S. banks, there are scattered bits of evi-dence. Walter Wriston, Chairman of Citicorp reports that foreign earn-ings as a percentage of total earnings in 1972 and 1973 totalled 50 per 43 cent and 60 per cent respectively. Given that less than 50 per cent of Citicorp's assets are invested abroad i t appears that foreign opera-tions were more profitable than domestic operations, at least in 1972 and 1973. Some of the major U.S. banks now voluntarily offer more informa-tion about their foreign operations. The Chase Manhattan Bank, in 126 particular, appears to have adopted a policy of more adequate disclosure. In September, recognizing the desire by investors and others for more information about Chase, we gave a presentation to the invest-ment community with unprecedented detail about our operations and policies. This year's annual report underscores our continued deter-mination to provide broader information to shareholders and the public—including many new facts in the financial review and else-where. 4 4 Based on information provided by Chase i t now appears that the rate of return on foreign assets approximates the rate of return on 4 5 domestic assets: 1973 1972 1971 1970 % % % % foreign profits as a % of total profits foreign assets as a % of total assets A l 39 34 34 21 17 28.9 27.5 Furthermore, a geographical breakdown of assets and net income reveals the following: Asia/Middle Caribbean/Latn U.S. Europe/Africa East America/Canada 1972 1973 1972 1973 1972 1973 1972 1973 assets as a % of total 66 61 17 18 11 12 net income as a % of total 66 59 12 17 11 13 13 The following are the contributions of foreign operations to 46 other major U.S. banks: 127 Manufacturers Bankers BankAmerica Hanover J.P. Morgan Trust 1972 1973 1972 1973 1972 1973 1972 1973 % foreign profits 28 32 33 33 35 46 35 45 % foreign assets 31 36 29 34 N/A N/A N/A N/A In summary, i t appears f a i r to say that foreign operations of the U.S. banks have not generated 'excess' profits nor have they harmed the overall profit performance of the U.S. banks. From the point of view of U.S. bankers this is the relevant variable. However, the truly relevant figures in this issue are definitely not available; that would be a comparison not of foreign/domestic profit ratios of the Canadian or U.S. banks but a comparison of the profit ratio of an indigenous bank in—say France—with the profits generated by a Canadian or U.S. bank operating in France. In order for the Kindleberger/ Hymer analysis to hold, i t i s necessary to i l l u s t r a t e that a foreign bank can make sufficient profits in the host country to exceed the regular profits of an indigenous bank after allowing for the cost of the inherent disadvantage of operating in an unfamiliar market. Some authors (including Aliber) argue that the U.S. banks have a 47 competitive edge in international markets. The reasons given are size, leaner cost structure and use of more advanced technology. In addition the U.S. banks are accustomed to a competitive atmosphere at home unlike the 'clubby' arrangements of some European bankers. Some of these advan-tages also apply to the Canadian banks. The size qualification i s cer-tainly met. There is also not much difference between the interest rate spread (markup) in Canada and the U.S. A comparison between the prime 128 lending rate and interest rates paid on deposits has often been used by analysts in determining the 'leanness' of a bank's cost structure Canadian and U.S. banks show up well in these comparisons. While admit-tedly well behind the U.S. in the use of computer technology, Canada probably has an advantage in this f i e l d over banks in other countries. The requirement of the Kindleberger/Hymer theory that profits from direct investment be higher than a l l alternative methods of pene-trating the foreign market would not seem to apply in general to the banking industry. Vernon has pointed out that direct investment is the only route for service industries. "When s k i l l in purveying services is involved, i t is especially d i f f i c u l t to use the export route in order to test the marketability of what one has to offer. Here again one has to test one's marketing advantage by setting up a subsidiary abroad. This i s what lay behind the bold expansion of . . . U.S. banking organ-48 izations after W.W.I." This comment however does not deal with the more d i f f i c u l t question of why the banks do not s e l l their superior knowledge via a licensing arrangement. Perhaps an example of the Canadian and U.S. pene-tration of the medium term loan market w i l l shed some light on the di f -f i c u l t y involved in licensing. Walter Wriston (Chairman of Citicorp), once observed that European bankers thought medium term loans were 49 'naughty.' This observation led to an advantage by U.S. and Canadian banks who were familiar with medium term financing. Prior to the 1960's European industry seemed to have no need for medium term bank credit. However for a variety of reasons in the mid 129 1960's t r a d i t i o n a l sources of f i n a n c i n g were inadequate to support expanding European business. European bankers were u n w i l l i n g to f i l l the gap so U.S. and Canadian bankers stepped i n . W i t h i n a very short p e r i o d of time the market was booming. One question that f a l l s out of t h i s experience i s : Why d i d the U.S. and/or Canadian banks not approach European bankers w i t h a package designed to a l l o w the l a t t e r to estab-l i s h a market f o r medium term bank loans? Could not a s a t i s f a c t o r y l i c e n s i n g arrangement be e s t a b l i s h e d that would generate p r o f i t s f o r both p a r t i e s ? From the poi n t of view of the l i c e n s o r s the n e c e s s i t y of making a d i r e c t investment i n an u n f a m i l i a r f o r e i g n market could be avoided. On the other hand, the l i c e n s e e s had a w e l l e s t a b l i s h e d l o c a l branch network that generated a good source of funds. So why was l i c e n s i n g not the s o l u t i o n ? PREFERENCE FOR DIRECT INVESTMENT This w r i t e r would suggest that there are at l e a s t three impor-tant f a c t o r s that c o n t r i b u t e to the preference f o r d i r e c t investment: (a) The f i r s t i s the d i f f i c u l t y i n p l a c i n g a p r i c e on some i l l - d e f i n e d technology possessed by the l i c e n s o r . The concept of technology encom-passes t e c h n i c a l and managerial know-how which i s embodied i n p h y s i c a l and human c a p i t a l and i n published documents. (b) In banking, tech-nology i s r e l a t i v e l y l e s s important than i n — s a y the manufacturing indus-t r y . In the medium term loan f i e l d f o r example, there are no s p e c i a l ' s e c r e t s ' that could be s o l d to European bankers. The problem was one of d i f f e r i n g management p h i l o s o p h i e s . 130 European bankers have usually been asset lenders; they would go around a company's plant, kick the walls, look at the deed and the mortgage, and, then, on the basis of physical assets, make their decision on how much to lend and on what conditions. American bankers look at cash flow and lend on prospects.51 The difference in lending philosophies i s obvious. Based on this observation i t is d i f f i c u l t to conceive of a situation where U.S. or Canadian bankers could have sold European bankers on the idea of medium term credit. Furthermore, that European bankers should pay for the idea (which is really a l l i t i s : i t i s not technology) is unthinkable. The problem is based on differences among management men in Europe and the United States. It is a management gap and this management is not a commodity that can be sold via a licensing arrangement. Perhaps one of Servan Schreiber's observations about the U.S. manager is relevant to that country's bankers: Americans are not more intelligent than other people. Yet human factors—the a b i l i t y to adapt easily, f l e x i b i l i t y of organizations, the creative power of teamwork—are the key to their success.52 It i s the 'human factor' or managerial philosophy that allows U.S. and Canadian bankers to profitably exploit the medium term loan market in Europe. Here is one U.S. banker's perception of his advantage: American banks are deeply convinced that they bring something with them (to the foreign market): new methods and sometimes a new s p i r i t , which is an asset in i t s e l f , and this belief is supported by success achieved in a l l parts of the world.53 This 'new s p i r i t ' cannot be sold; i t must be transferred via direct i n -vestment . 131 The bankers interviewed unanimously agreed that no consideration had been given to entering foreign markets by any route other than direct investment. A l l banks wanted some element of control over their invest-ment. In cases where the equity investment was less than 100 per cent, the banks seemed to emphasize the importance of 'having a team of their own men on the scene.' (c) The other important reason for preferring direct investment over licensing i s that the primary objective of the banks is not profit maximization; i t is growth of assets. It i s the writers hypothesis that, given the opportunity to penetrate a foreign market that would yield identical profits through either direct investment or licensing, the bank would choose direct investment every time. The reason of course i s that gross revenues and assets would show more growth i f the direct investment were undertaken. While the licensing arrangement would (under the assump-tion) result in the same net profit figure, there would be no appreciable effect on the balance sheet. Given what is said about growth (above) i t is clear that direct investment i s preferable to licensing. This finding is not unique to the banking industry. Other multinational firms pursue multiple objectives which include growth of sales and assets subject to some 'acceptable' profit constraints. CROSS HAULING A major requirement of a theory of foreign banking i s that i t explain the preponderence of 'cross hauling' in the industry. There is absolutely no doubt that foreign banks would establish in Canada i f the 132 banking l e g i s l a t i o n were l i b e r a l i z e d . The same would be true i n the U.S. and i n f a c t i s being observed i n some s t a t e s that have opened the doors to f o r e i g n banks. Both C a l i f o r n i a and New York have s e v e r a l f o r e i g n banks competing against domestic banks i n the r e t a i l and wholesale mar-ke t s . According to the Hymer/Kindleberger theory these f o r e i g n banks must have some 'knowledge' advantage that they can e x p l o i t . I t i s some-what d i f f i c u l t to b e l i e v e that these f o r e i g n banks have some advantage that would a l l o w them to generate l a r g e r p r o f i t s than the w e l l e s t a b l i s h e d domestic competitors, e s p e c i a l l y i n the U.S. However the wide range of the market might provide a p a r t i a l answer. For example Japanese banks could concentrate on p r o v i d i n g s e r v i c e to Japanese f i r m s operating i n Canada w h i l e European banks might focus on f u n n e l i n g European funds i n t o r e a l e s t a t e and e q u i t y investments i n Canada. The type of 'knowledge' advantage i n t h i s case would be b e t t e r 'connections,' a v a r i a b l e that has always been important i n banking. I t appears to t h i s w r i t e r however that a more general explana-t i o n of cross h a u l i n g i s provided by i n d u s t r y s t r u c t u r e . I f banks i n most c o u n t r i e s are l o c a t e d i n o l i g o p o l i s t i c markets the tendency f o r them would be to expand outside n a t i o n a l borders. Thus we would expect t h a t , given the need f o r growth, Lloyds Bank may be a t t r a c t e d to the U.S., w h i l e BankAmerica would be a t t r a c t e d to B r i t a i n . Entry i n t o the f o r e i g n market f r e e s a bank somewhat from the n e c e s s i t y of ' j o i n i n g the l o c a l c l u b . ' Market share can be fought f o r without as much f e a r of r e t a l i a t i o n . Support f o r t h i s l i n e of reasoning i s provided by Stephen Hymer who argues that a l l dominant o l i g o p o l i s t s 133 54 have a s i m i l a r world wide market. Cross hauling i s a natural extension of oligopoly and the need f o r growth. A somewhat paradoxical i m p l i c a t i o n of cross hauling i s that i t introduces a competitive element to banking that would not e x i s t i f domestic markets were served only by indigenous banks. ALIBER'S THEORY A l i b e r ' s theory may contain some features that apply to banking. As mentioned above, h i s theory focuses on c a p i t a l market r e l a t i o n s h i p s , exchange r i s k , and the market's preference for holding assets dominated i n U.S. d o l l a r s . The f i r s t feature, involving a bias i n the s e c u r i t i e s market that enables U.S. firms to obtain cheaper financing, i s d e f i n i t e l y not relevant. The U.S. and Canadian banks obtain t h e i r funds e s s e n t i a l l y from depositors at going market rates, and thus obtain no advantage i n t h i s area. In f a c t i n Europe, the Canadian and U.S. banks often must obtain t h e i r funds i n the interbank market at rates higher than the indigenous banks pay f o r deposits. The relevant part of A l i b e r ' s theory i s the market preference f o r c e r t a i n currencies. The U.S. d o l l a r has long been the 'preferred cur-rency brand name' and i t appears l o g i c a l to associate the U.S. banks with the U.S. d o l l a r . This could represent a s i g n i f i c a n t advantage. This advantage i s also thought to have 'rubbed o f f on the chartered banks: World t r a d e — f a c i l i t a t e d by payments i n overseas U.S. d o l l a r s even between countries with strong currencies of t h e i r own—and the need of multinational companies to obtain arm's length financing have given Canadian banks the opportunity to p a r t i c i p a t e i n overseas 134 markets on a large scale. Moreover since these same banks have had long experience dealing with U.S. multinationals and overseas U.S. dollars, they have built up a series of contacts that rank high in world banking circles.55 This advantage could well lead to the U.S. and Canadian banks capturing a large share of the world market for dollar deposits. Some support for this line of reasoning was obtained from the bankers inter-viewed. This type of advantage is to be distinguished from the Kindle-berger/Hymer type which translates directly into an increased profit mar-gin. The advantage that Aliber has in mind does not imply that the cap-ture of a large market share of deposits leads to superior profit margins. It may however lead to an increase in absolute profit levels and certainly leads to growth in assets. SUMMARY We opened this chapter by pointing out that a common feature of a l l theories of direct investment i s that they incorporate some depar-ture from perfectly competitive market conditions. In this sense the various theories are not in great conflict with each other. It i s this writer's opinion that a l l of the theories add something to an understanding of foreign banking. The predominant forces however are oligopoly, need for growth, and government interference. Ad-vantages reaped from superior knowledge apply in certain specific cases and association with the preferred currency brand is a favourable factor for U.S. and Canadian banks. The next chapter w i l l attempt to draw these observations together into a theory of international banking expansion. 135 Notes f o r Chapter Seven C. P. Kindleberger, American Business Abroad: S i x Lectures on  D i r e c t Investment (New Haven: Ya l e U n i v e r s i t y P ress, 1969), p. 13. 1 2 P. A. Samuelson, Economics (Toronto: McGraw-Hill, 1968). 3 I b i d . , p. 567. 1974) 4 "Are The Banks Over Extended?" Business Week (September 21, 5 G. J . Benston, "Are Larger Banks More E f f i c i e n t ? " The Banker (June 1974). 6 I b i d . 7 I b i d . Q L. K a l i s h and R. G i l b e r t , "An A n a l y s i s of E f f i c i e n c y of Scale and O r g a n i z a t i o n a l Form i n Commercial Banking," J o u r n a l of I n d u s t r i a l  Economics ( J u l y 1973). 9 I b i d . I b i d . 1 1 Speech presented to the 1974 Canadian Conference on Banking, Toronto, September 61, 1974. 12 W. J . Baumol, Business Behavior Value and Growth (New York: MacMillan Company, 1959), p. 45. 1 3 Federal Reserve B u l l e t i n (June 1973) and (June 1974), and Annual Reports from s e l e c t e d banks. 1 4 Quoted i n Business Week (September 21, 1974), p. 55. 1 5 J . K. G a l b r a i t h , The New I n d u s t r i a l State (New York: Signet Books, 1967), pp. 181-82. 16 Kindleberger, American Business, p. 8. ^ Baumol, p. v i i i . 18 Quoted i n The Banker, v o l . 121, p. 661. 19 I b i d . , v o l . 123, p. 611. 136 20 Lewis C a r r o l l , A l i c e In Wonderland. 21 Business Week (September 21, 1974). 2 2 I b i d . (February 17, 1975), p. 74. 23 I b i d . 24 Ki n d l e b e r g e r , American Business, p. 15. 25 R. Vernon, "Future of M u l t i n a t i o n a l E n t e r p r i s e , " i n The I n t e r - n a t i o n a l Corporation, C. P. Kindleberger (ed.). 26 F. T. Knickerbocker, O l i g o p o l i s t i c Reaction and M u l t i n a t i o n a l  E n t e r p r i s e (Boston: Harvard U n i v e r s i t y P ress, 1973). 27 J . H. Pe r r y , "1967 Bank Act R e v i s i o n s , " Canadian Banker (Sum-mer 1967). 28 P. S. Rose, "The New I n t e r n a t i o n a l Thrust of U.S. Banking," Canadian Banker and ICB Review (July-August 1974). 29 Kindleberger, American Business, p. 123. 10 Business Week (September 21, 1974), p. 52. 31 F. Helding, " M u l t i n a t i o n a l Banking S t r i v e s f o r I d e n t i t y , " Columbia J o u r n a l of World Business (Nov.-Dec. 1968), p. 50. 32 I b i d . , p. 51. 33 J . P. K o s z u l , "American Banks i n Europe," i n The I n t e r n a t i o n a l  Corporation,'C. P. Kindleberger (ed.), p. 280. J . P. Morgan and Co. Incorporated, 1971 Annual Report, p. 9. 35 K o s z u l , p. 280. 36 Board of Governors of the Federal Reserve System, Annual  Report 1973. 37" Burrough's C l e a r i n g House (March 1968), p. 42. 38 C. Freedman, "The Foreign Currency Business of the Canadian Banks: An Econometric Study," Bank of Canada S t a f f Research Studies, p. 24. 39 I b i d . 40 C.B.A. B u l l e t i n (May 1971), p. 2. 137 4 1 K o s z u l , p. 286. 4 2 S. Rose, "Why They C a l l i t "FAT CITY," Fortune (March 1975). 4 3 The Banker ( J u l y 1974). 44 Chase Manhattan Corporation, 1973 Annual Report, p. 3. 4 5 TV. • J I b i d . 46 Selected Annual Reports of the banks. 47 R. Z. A l i b e r , The I n t e r n a t i o n a l Money Game (New York: B a s i c Books Inc., 1973). 4 8 Vernon, "Future," p. 376. 49 "The F i r s t Real I n t e r n a t i o n a l Bankers," Fortune (December 1967), p. 196. S. H. Robock and K. Simmonds, I n t e r n a t i o n a l Business and  M u l t i n a t i o n a l E n t e r p r i s e (Georgetown, Ont.: R. D. I r w i n , Inc., 1973), p. 188. Fortune (December 1967), p. 146. 52 Quoted i n Columbia J o u r n a l of World Business (Nov.-Dec. 1968), 52. 53 K o s z u l , p. 289. ~*4 S. Hymer and R. Rowthorn, " M u l t i n a t i o n a l Corporations and I n t e r n a t i o n a l O l i g o p o l y : The Non American Challenge," i n The I n t e r n a t i o n a l  Corporation, C. P. Kindleberger (ed.). J . Davidson, "Canadian Banks Think G l o b a l l y , " Canadian Banker  and ICB Review, 1-74, p. 9. Chapter Eight A THEORY OF INTERNATIONAL BANKING EXPANSION It is our hypothesis that the financing of foreign trade and capital flows no longer represents the primary explanation for the growth of international banking. These factors, to be sure, s t i l l have an i n f l u -ence but expansion of foreign banking i s proceeding somewhat independently of foreign trade. The banking industry i s no longer a 'camp follower' of i t s domestic customers. "If you want to sum up international banking in one sentence," says Geoff Styles, Deputy General Manager, of The Royal Bank of Canada, "you could say that Canadian banks have changed from banks with international departments to international banks which happen to have their head offices in Canada.""'" In other words the banks have be-come multinational corporations. It appears that U.S. regulatory bodies have become aware of the changing trend in the international operations of U.S. banks. An officer of the Federal Reserve Bank has observed: "In more recent years, however, U.S. banking organizations have diversified the scope of services avail-able to their overseas customers and with these services have tried to attract new customers from the countries in which they are doing business." It is the purpose of this chapter to develop a theory that w i l l explain the above process. The primary determinants of the expansion of foreign banking for at least the past five to ten years have been the market imperfections discussed in the preceding chapter. A model (Figure 8-1) encompassing 138 139 OLIGOPOLISTIC BANKING INDUSTRY NEED FOR GROWTH GOVERNMENT INTERFERENCE SUPERIOR KNOWLEDGE ASSOCIATION WITH U.S. DOLLAR Figure 8-1 MODEL OF FOREIGN EXPANSION 140 the v a r i a b l e s discussed i n Chapter Seven has been developed to g r a p h i c a l l y i l l u s t r a t e the major fo r c e s l e a d i n g to investment overseas. The diagram i s meant to i l l u s t r a t e that the primary f o r c e behind overseas expansion i s the o l i g o p o l i s t i c i n d u s t r y s t r u c t u r e and a need f o r growth. I n c l u s i o n of growth as a key v a r i a b l e i s the r e s u l t of a wealth of i m p r e s s i o n i s t i c evidence a v a i l a b l e . f r o m v a r i o u s published sources. Some of t h i s evidence was presented i n the previous chapter. Prominent observers of the banking scene have a l s o been impressed by the importance bankers place on growth. Paul Nadler, f o r example, has s t a t e d t h a t : Bankers are always kidded about t h e i r obsession w i t h growth r a t h e r than p r o f i t s . For i t appears that many bankers would r a t h e r jump 20 or 30 places on the American Banker's l i s t of the top 10,000 banks i n order of s i z e than increase earnings per share by a s i z e a b l e amount. 3 I n c l u s i o n of the o l i g o p o l i s t i c i n d u s t r y s t r u c t u r e as a major v a r -i a b l e has been i n f l u e n c e d by Caves who: hypothesized that firms i n o l i g o p o l i s t i c i n d u s t r i e s i n each country encounter l i m i t s to i n c r e a s i n g the s a l e s of t h e i r t r a d i t i o n a l product i n the domestic market; to continue t h e i r growth r a t e , they must choose between expanding across a product boundary i n the domestic market or expanding across a n a t i o n a l border w i t h t h e i r t r a d i t i o n a l p r o d u c t . 4 As w i l l be demonstrated below, the choice f o r the banks h a s . l a r g e l y been i n f l u e n c e d by another major v a r i a b l e : government i n t e r f e r e n c e . Two other v a r i a b l e s that r e c e i v e l e s s weight than the 'need f o r growth' but nevertheless are q u i t e important, are government i n t e r f e r e n c e and a p r o f i t c o n s t r a i n t . Note that the term ' i n t e r f e r e n c e ' i s used to i n d i c a t e an observed governmental tendency to meddle i n the a f f a i r s of 141 the banking industry. In general, this 'interference,' or 'meddling' i f you w i l l , represents a departure from perfectly competitive market con-ditions in the banking industry. The reader should note that no judgment is being passed on the desirability or otherwise of this government tendency. Clearly, some forms of government interference may, on net be desirable, while other forms may not. It i s important to note also that profit i s included in the model as a constraint rather than as a goal. This i s consistent with theories that stress growth as the main objective of a firm. From the evidence we have been able to locate on the banking industry, i t appears reasonable to argue that the profit constraint on foreign operations is that the ratio of foreign profits to foreign assets employed be similar to the domestic ratio.. That i s , i f foreign assets represent 50 per cent of total assets then foreign profits should also represent roughly 50 per cent of total profits. Before discussing the model further we should perhaps c l a r i f y some of the concepts underlying the adoption of the oligopoly-growth model. The discussion that follows has been influenced in no small way by the writings of W. J. Baumol who hypothesized that oligopolists typi-cally seek to maximize their sales subject to a minimum profit con-st r a i n t . 5 By simply substituting asset growth rather than sales growth as the objective in the banking industry we should be able to adapt Baumol's work for our purposes. Figure 8-2 i s a static model of the variables interacting in the growth-profit constraint part of our primary model (Figure 8-1). DEBT ASSETS E»5 D3 4- D.2 Dl ASSETS 142 Po P i ? 2 P 3 Figure 8-2 MODEL OF PROFIT CONSTRAINT PROFITS 1. 2. 3. 4. 5. A^ P^ D^ 100 per cent e q u i t y f i n a n c i n g . ^2 ^4 ^ 2 V T°£i-t maximization p o i n t . A^ P^ Dg h i g h l y l e v e r e d p o s i t i o n : r e g u l a t o r y bodies r e s t r i c t growth. A^ P2 D^ i n t e r n a l l y imposed p r o f i t c o n s t r a i n t s . A,. PQ D,. beyond t h i s p o i n t the bank i s t e c h n i c a l l y i n s o l v e n t . 143 According to the diagram, p r o f i t s are maximized at a l e v e l of P4 w i t h assets of A2 and a debt/asset r a t i o of D2. Asset maximization i s unde-f i n e d i n an absolute sense but c l e a r l y cannot exceed A5 where the debt/ asset r a t i o of 1.00, otherwise the f i r m would be i n s o l v e n t . For opera-t i o n a l purposes, asset maximization occurs at e i t h e r A3 or A4. The reason f o r i n d e c i s i o n on t h i s statement i s that there are two forms of c o n s t r a i n t s that impinge on the determination of asset maximization: a) P2 which i s an i n t e r n a l l y imposed p r o f i t c o n s t r a i n t (to be d i s -cussed below), and b) D3 which i s a maximum debt/asset c o n s t r a i n t imposed by r e g u l a t o r y bodies and/or the investment community. There i s no compelling reason to b e l i e v e that one or the other c o n s t r a i n t should always be dominant. We have shown the p r o f i t c o n s t r a i n t to be domi-nant i n Figure 8-2 because i t represents what i s going on today. However the g o v e r n m e n t s — p a r t i c u l a r l y the United S t a t e s — a r e s t a r t i n g to worry about high debt/asset r a t i o s and i t may w e l l be that t h i s c o n s t r a i n t w i l l soon dominate the determination of maximum asset s i z e . This f e a t u r e w i l l be discussed more f u l l y i n Chapter Nine. Figure 8-3 represents a numerical example of the s t a t i c determina-t i o n of bank s i z e . I t i s our contention that Bank D would be s e l e c t e d by bank management as the o p t i m a l s i z e although the r a t i o n a l economic man would p i c k Bank C. Perhaps some j u s t i f i c a t i o n of the assumptions made i n Figure 8-3 i s i n order. We have assumed that the banks i n our example are p r i c e takers i n the debt market. That i s , there i s no p r i c e competition f o r Bank A B C D E F Assets 000 2, 000 4, 000 5, 000 6, 000 8,000 Debt 970 1,940 3,880 4, 850 5,820 7,760 SE 30 60 120 150 180 240 Ir .10A 100. 00 .0975A 195 .00 .095A 380. 00 .0940A 470. 00 .0935A 561. 00 .0925A 740. 00 Ip .08D 77. 60 .08D 155 .20 .08D 310. 40 .08D 388. 00 .08A 465. 60 .08D 620. 80 E .025A 25. 00 .0175A 35 .00 • 015A 60. 00 .015A 75. 00 .015A 90. 00 .015A 120. 00 P (2. 60) 4 .80 9. 60 7. 00 5. 40 (. so; Pmin (.04SE) 1. 20 2 .40 4. 80 6. 00 7. 20 9. 60 P r o f i t maximization = 9.60 Assets = 4,000 Asset maximization = 5,000 P r o f i t s = 7.00 Assets = A P r o f i t s = P Interest paid = Ip Assumptions 6^  D e f i n i t i o n s Debt = D Equity = SE Interest received = I r Other expenses = E Minimum l e v e l of p r o f i t s ( p r o f i t constraint) = Pmin P = (Ir - Ip) - E Ip = constant 8% Ir = d e c l i n i n g function of A E = declining function of A to 5,000, then constant @ 1.5% A D/SE r a t i o .= 97/3 = 32.33 Pmin = .04SE Figure 8-3 NUMERICAL EXAMPLE OF THE STATIC DETERMINATION OF BANK SIZE 4> 145 savings and the banks have a good supply a v a i l a b l e at 8 per cent. Ex-penses are set as a d e c l i n i n g function of assets to allow for scale economies. At some point these economies are assumed to cease and ex-penses become a constant proportion of assets. A constant debt/equity r a t i o i s also assumed for t h i s simple model. The consequences of relax i n g t h i s assumption w i l l be discussed below. Up to t h i s point the writer would argue that the assumptions are quite reasonable. The assumption of a reducing y i e l d on assets may prompt some c r i t i c i s m but i t does appear reasonable to argue that some p r i c e c u t t i n g i s necessary to promote asset growth. This i s e s p e c i a l l y true when we consider that growth i s occurring i n a foreign market. I t was pointed out above that even though the Canadian and United States banks are o l i g o -p o l i s t s (and behave as such) i n t h e i r domestic markets, t h i s behavior often does not carry over into the foreign market. Indeed i t has been observed that entry by a Canadian or U.S. bank into a foreign market often introduces r i v a l r o u s behavior and improved market e f f i c i e n c y . Part of the r i v a l r o u s behavior manifests i t s e l f i n the form of p r i c e com-p e t i t i o n for loans and investments so i t seems appropriate to include the assumption that as assets increase so do revenues, but at a d e c l i n -ing r a te. Inclusion of a p r o f i t constraint i n Figure 8-2 seems very l o g i -c a l for obviously the firm cannot continue to grow or even survive i f p r o f i t s decline to zero. P r o f i t s are absolutely e s s e n t i a l to allow the firm to grow. Baumol has described the determination of a minimum p r o f i t l e v e l as follows: 146 r a t i o n a l behavior would require that the firm determine i t s mini-mum p r o f i t l e v e l , i t s dividend payments and the magnitude of i t s retained earnings i n a way which achieves a balance between i t s current financing needs and the e f f e c t s of i t s dividend h i s t o r y on the a v a i l a b i l i t y of cash i n the future i n the form of demand for future issues of s e c u r i t i e s . 6 The above de s c r i p t i o n provides no operational way for determin-ing a minimum p r o f i t l e v e l . However Baumol goes on to say that: In p r a c t i c e , the determination of a minimum acceptable p r o f i t l e v e l probably comes down to no more than a rough attempt, again p a r t l y by r u l e of thumb, to provide competitively acceptable earnings to stockholders while leaving enough over for investment i n future out-put expansion at the maximum rate which management considers to be reasonably safe.7 As w i l l be pointed out i n Chapter Nine, at present, there appears to be some disagreement between bankers and t h e i r regulatory bodies over the d e f i n i t i o n of a 'safe' rate of asset growth. I t i s t h i s disagreement that has caused us to hedge i n our d e f i n i t i o n of asset maximization i n Figure 8-2. As mentioned, we assumed i n Figure 8-3 a constant debt/equity r a t i o . This was p r i m a r i l y to avoid a controversy over whether or not there e x i s t s some optimal r a t i o that w i l l minimize the bank's cost of c a p i t a l and thus maximize the value of the bank to i t s shareholders. I t i s generally accepted within the f i e l d of finance that i t i s not possible to provide conclusive support for e i t h e r the t r a d i t i o n a l approach which assumes the following r e l a t i o n s h i p : k D/E 147 and therefore an optimal debt/equity r a t i o ; or the ' M o d i g l i a n i - M i l l e r ' approach which assumes the following r e l a t i o n s h i p : k D/E and therefore independence of the cost of c a p i t a l and a firm's c a p i t a l structure. A f t e r some r e f l e c t i o n i t becomes c l e a r that neither p o s i t i o n does any harm to our approach. I f we relax the assumption of a constant debt/equity r a t i o , the MM p o s i t i o n would say that the cost of obtaining new equity financing increases as the debt/equity r a t i o increases by j u s t enough to o f f s e t the savings achieved through the use of lower cost debt. What t h i s means i n terms of Figure 8-3 i s that the minimum p r o f i t constraint would vary over d i f f e r e n t debt/equity r a t i o s . I t would not a f f e c t the choice of asset optimization over p r o f i t maximization. The t r a d i t i o n a l approach (which appears to t h i s w r i t e r to be a r e a l i s t i c depiction of the actual s i t u a t i o n ) o f f e r s good support for our model. The t r a d i t i o n a l approach hypothesizes that the cost of debt r e -mains constant over a c e r t a i n range. This r e s u l t s i n a d e c l i n i n g aver-age weighted cost of c a p i t a l . Beyond some point leverage becomes too high and debt costs increase, d r i v i n g up the o v e r a l l cost of c a p i t a l . The above phenomenon appears relevant to the banking industry and i n fact has recently been experienced by the Japanese banks. In com-mon with other Japanese businesses that country's banks are notoriously 148 over levered. A f t e r the o i l c r i s i s and r e s u l t ant balance of payments problems changed the p o s i t i o n of the Japanese banks from being net sup-p l i e r s to net borrowers of Euro-dollars, these banks found, that, because of t h e i r over-levered p o s i t i o n , they had to pay a f u l l 2 per g cent above the London i n t e r bank rate. (This i s the base rate banks charge each other for Euro currencies.) This event was a c l e a r cut case of p r i c e discrimination brought about by recognition of increased r i s k due i n large part to the extremely high debt/equity r a t i o s of the Japanese banks. In t h i s writer's opinion i t would be d i f f i c u l t for Modigliani and M i l l e r to argue that the average weighted cost of c a p i t a l of the Japanese banks had remained constant throughout the above process. I f we hold to the t r a d i t i o n a l approach that the cost of c a p i t a l increases beyond some optimal debt/equity r a t i o then t h i s serves to tighten one of the p r o f i t constraints i n Figure 8-2. More s p e c i f i c a l l y , i f the cost of c a p i t a l begins to increase t h i s w i l l have the e f f e c t of giving management a more c l e a r d e f i n i t i o n of the l e v e l of operations that the market considers appropriate given a c e r t a i n l e v e l of equity c a p i t a l . More about t h i s feature w i l l be presented i n Chapter Nine. A s t a t i c model of the form set out i n Figure 8-2 has only l i m i t e d usefulness i n a constantly changing banking environment. As Baumol has pointed out: Although the s t a t i c theory of the firm i s a h e l p f u l snapshot descrip-t i o n of a system i n motion, i t i s useful also to have an a l t e r n a t i v e construction . . . another equilibrium analysis i n which the rate of growth of output, rather than i t s l e v e l , i s the v a r i a b l e whose value i s determined by optimality considerations.9 149 Again, we consider i t useful to adopt Baumol's formulation to set out the var i a b l e s and constraints i n f l u e n c i n g the l e v e l of growth of the banks. The formulation i s as follows: maxxmxze subject to where g = f ( i , n) I = f(n, D) + E n = D + E g = growth rate of assets I = growth rate of equity c a p i t a l II = p r o f i t rate as a % of present equity D = dividend as a % of p r o f i t s E = retained earnings as a % of p r o f i t s . Under t h i s formulation, the rate of growth i s rel a t e d to invest-ment and p r o f i t rates as follows: g p r o f i t constraint That i s , growth varies d i r e c t l y with investment but has f i r s t a p o s i t i v e , then a negative r e l a t i o n s h i p to p r o f i t s . The behavioral reason f o r the eventual inverse r e l a t i o n s h i p with p r o f i t s i s that, behond some rate, growth s t r a i n s the firm's entrepreneurial resources and adds to the com-pany 's r i s k s . The equation I = f(n, D) + E i l l u s t r a t e s "that the p r o f i t rate 150 i n d i r e c t l y a s s i s t s growth by providing c a p i t a l through retained earnings, and by a t t r a c t i n g funds from outside sources at a rate, f(n, D), which depends both on the dividend rate and the company's p r o f i t rate.""'"'"' Bank management would l i k e l y f i n d the above formulation more relevant than the previous s t a t i c model. As w i l l be discussed i n Chapter Nine, i t appears that because of generally depressed market conditions, the banks now must r e l y on retained earnings to finance further growth. If we assume that the banks are at t h e i r maximum permissable debt/equity positions and that new share issues are not f e a s i b l e , then the p o t e n t i a l growth of assets j u s t equals the rate of growth of retained earnings. Assume the following s i t u a t i o n for Bank X: I = 0 ; n = 10% ; D = .411 ; E = .611 Then the maximum rate of growth of assets of Bank X i s simply 6 per cent as follows: Period 1 Period 2 A 1,000 D 970 A 1,060.00 D 1,028.20 E 30 E 31.80 1,000 1,000 1,060.00 1,060.00 Note that the above example says nothing about p r o f i t maximization. I t i s hoped that the foregoing discussion has c l a r i f i e d the con-cept of the p r o f i t constraint operating i n our model (Figure 8-1). We now turn to a discussion of the other v a r i a b l e s included i n the model. The other key v a r i a b l e i n the model, government interference i n the banking industry, manifests i t s e l f i n many ways. Bankers are used to ' f l o a t i n g on a sea of con t r o l s . ' Citibank Chairman, Walter Wriston i s reported to have shrugged o f f a question about the e f f e c t of controls with the short remark: "Our natural habitat i s the c o n t r o l l e d environ-ment." 1 1 Government interference of various types was discussed i n Chapter Seven. The dashed l i n e s i n Figure 8-1 represent s p e c i f i c types of i n f l u -ence as follows: 1. Line one represents interference encountered when a fir m i n an o l i g o p o l i s t i c industry attempts to grow by expanding i t s share of the domestic market. Inclusion of t h i s v a r i a b l e has been influenced by Balassa who argued: "when a mature o l i g o p o l i s t i c structure has been established i n the domestic market, the f i r m may be induced to invest abroad because e f f o r t s at increasing i t s share i n the domestic market would meet r e t a l i a t i o n from 12 other o l i g o p o l i s t s . " 2. Line two represents government interference i n the domestic mar-ket which i s manifested by con t r o l of the money supply and thus the ultimate c o n t r o l of the s i z e of the domestic market. In the United States, t h i s l i n e could also represent government cont r o l of the geographical markets which p r o h i b i t s expansion across s t r e e t , county, or state l i n e s . 3. Line three represents various government imposed b a r r i e r s to d i v e r s i f i c a t i o n into other domestic f i n a n c i a l markets. 152 The primary message that the model attempts to convey i s that the banks have a strong need for growth. This growth need could be met i n the domestic and/or foreign markets, but government interference which l i m i t s growth i n the domestic sector has deflected the focus of attention to the foreign market. This i s the heart of the theory. I t i s only at t h i s point that the other t h e o r e t i c a l variables have a r o l e to play. Superior knowledge and a s s o c i a t i o n with the 'preferred cur-rency brand' only have an influence on bank behavior i n s p e c i f i c areas. Superior knowledge enables the banks to enter c e r t a i n foreign market segments—for example the medium term financing f i e l d mentioned above. This i s represented by dotted l i n e number f i v e . Line number four repre-sents superior knowledge i n r e t a i l banking. For example the Canadian banks were able to e s t a b l i s h an e n t i r e r e t a i l banking industry i n the Caribbean. Superior 'knowledge' i n r e t a i l banking does not apply gen-e r a l l y however. For example, while at l e a s t two hundred foreign banks have established i n the United Kingdom, none has s e r i o u s l y attempted to storm the r e t a i l market. The same would probably be true i f foreign banks were allowed to branch into Canada. Witness the following comments by David Rockefeller: I see no threat to the v i a b i l i t y of any banking system—and c e r t a i n l y not one as healthy as Canada's—because of the presence of foreign banks. Canada's r e t a i l banking system i s established so f i r m l y across the nation that i t should not s u f f e r any adversity i n the form of foreign banking presences.13 Line s i x indicates that the U.S. and Canadian banks may have superior knowledge i n congeneric s e r v i c e s — b u t only i n s p e c i f i c areas. 153 For example, U.S. banks have developed expertise i n the lea s i n g f i e l d and have been able to p r o f i t a b l y e x p l o i t t h i s i n foreign m a r k e t s — p a r t i c -u l a r l y i n Canada. Association with the 'preferred currency brand' may give the U.S. and Canadian banks an advantage i n the commercial and wholesale markets ( l i n e s seven and e i g h t ) . This argument has been put forward by A l i b e r as follows: The t h i r d advantage of U.S. banks i n the new i n t e r n a t i o n a l market i s that t h e i r domestic currency, the d o l l a r , i s l i k e l y to remain the preferred currency brand name. Indeed, the share of banking b u s i -ness denominated i n d o l l a r s r e l a t i v e to other currencies i s l i k e l y to increase. This gives a clear advantage to U.S. banks, f or i f de-positors prefer d o l l a r denominated deposits, they w i l l also prefer that these deposits be issued by U.S. banks.I 4 For the reasons outlined i n Chapter Seven, part of t h i s advantage i s thought to have 'rubbed o f f on the Canadian banks. In summary, however, the superior knowledge and preferred currency v a r i a b l e s have influence only i n c e r t a i n s p e c i f i c market areas. The above comments represent the primary reason f o r the div e r -sion away from the main l i n e of the theory of d i r e c t investment—the focus on superior knowledge that allows a foreign firm to obtain higher rates of return than l o c a l competitors. Bankers look at overseas oppor-t u n i t i e s somewhat d i f f e r e n t l y than do i n d u s t r i a l corporations. The Canadian and U.S. banks do not generally attempt to compete head on with indigenous banks. This i s i n d i r e c t contrast to i n d u s t r i a l corporations. Fortune magazine has put the process of foreign expansion by the banks i n perspective as follows: 154 They (banks) cannot hope to storm the entrenched markets of native banks. Nor do they expect a. p a r t i c u l a r l y high rate of p r o f i t . Bank-ing i n Europe i s not inherently more p r o f i t a b l e than i n the U.S.; the spread between what a bank pays and what i t can charge a bor-rower i s about the same. The banks going abroad do not even i n s i s t on s u b s t a n t i a l earnings from every branch. The aim rather i s to b u i l d up a system whose intertwined operations w i l l improve the bank's o v e r a l l earnings.15 RESULTS OF INTERVIEWS In general i t i s f a i r to say that the reaction of senior bankers to our model was mixed. Some bankers supported our hypothesis that govern-ment interference and l i m i t e d domestic growth opportunities had influenced the decision to look outward to foreign markets. One or two pointed out that the model made no reference to p r o f i t s . This was true at the time of our interviews. In the f i n a l version of the model however we have i n -cluded p r o f i t s as a constraining v a r i a b l e . There was general agreement on the i n c l u s i o n of 'superior know-ledge' and 'association with the U.S. d o l l a r ' as important v a r i a b l e s that allow entry into foreign markets. In t h i s area however some bankers thought we should include a v a r i a b l e that recognizes the importance of trade flows. We r e s i s t e d t h i s suggestion for the reasons outlined i n Chapter Five. The area of our model that ran into heaviest opposition was the 'need for growth' v a r i a b l e . No banker was w i l l i n g to admit that t h i s v a r i a b l e played anything more than a minor r o l e i n the development of i n t e r n a t i o n a l banking. Some bankers i n s i s t e d that the pursuit of p r o f i t was the more important v a r i a b l e . And yet at various times throughout our discussion we uncovered cases where d i r e c t investments were made 155 without giving p r o f i t projections anymore than a cursory glance. In fact one banker stated that h i s bank did not prepare p r o f i t projections when considering a foreign d i r e c t investment. In some cases ego involve-ment of a top executive was i d e n t i f i e d as the key to a decision to enter a foreign market. Based on the wealth of impressionistic evidence a v a i l a b l e i n the l i t e r a t u r e , some of which was presented i n Chapter Seven, we are not w i l l i n g to concede that 'need f o r growth' i s anything less than the KEY var i a b l e that has influenced foreign growth over the past decade. In the f i n a l analysis however, we recognize that the reader must weigh the ava i l a b l e evidence and then decide for himself. SUMMARY A l o g i c a l extension of t h i s chapter would be to subject our model to empirical t e s t i n g . However the absence of s u f f i c i e n t l y d e t a i l e d 'hard' data rules out t h i s p o s s i b i l i t y . The main support that can be offered i s i n the form of anecdotal evidence, much of which was presented i n Chapter Seven. This evidence must be weighed against the rather nega-t i v e reaction obtained i n our f i e l d study. We also have a v a i l a b l e some sketchy information on the decision making process followed when a bank invests i n a foreign market. This process i s discussed i n Appendix II i n the hope that i t w i l l lend some support for our model. 156 Notes for Chapter Eight ^ Quoted i n The Canadian Banker and ICB Review, 1-74, p. 9. 2 Federal Reserve Bank of Chicago: Economic Review (October 1974), p. 3. 3 Paul Nadler, "Why A Bank Has to Grow—A U.S. View," The Banker (June 1974), p. 615. 4 Quoted by R. Z. A l i b e r , "The Mu l t i n a t i o n a l Enterprise i n a Mult i p l e Currency World," i n The M u l t i n a t i o n a l Enterprise, J . H. Dunning (ed.), p. 50. 5 W. J . Baumol, Business Behavior Value and Growth (New York: MacMillan Company, 1959). ^ I b i d . , p. 52. 7 I b i d . , p. 53. Q F i n a n c i a l Post (September 21, 1974), p. J12. 9 •• W. J . Baumol, "On the Theory of Expansion of the Firm," i n The Theory of the Firm, G. C. Archibald (ed.), p. 319. Ib i d . , p. 326. 1 1 Quoted i n The Banker, v o l . 123 (1973), p. 613. 12 Quoted i n G. Ragazzi, "Theories of the Determinants of Di r e c t Foreign Investment," IMF Staff Papers (July 1973), p. 489. 13 Excerpt from a speech to the Canadian Conference on Banking, Toronto, September 16, 1974. R. Z. A l i b e r , The International Money Game (New York: Basic Books Inc., 1973), p. 161. Fortune (December 1967), p. 143. Chapter Nine CURRENT EVENTS AND THE THEORETICAL MODEL There are two elements of our model that are being influenced by the current i n t e r n a t i o n a l banking environment. The f i r s t i s that growth i s c urrently being retarded by various environmental f a c t o r s . The second i s that government 'interference' i s being relaxed i n some areas and tightened i n others. In view of the fact that government interference and a need for growth form the foundation of our approach, i t i s approp-r i a t e to discuss the above events i n order to test the ' d u r a b i l i t y ' of the model developed i n Chapter Eight. The recent rapid growth rates of U.S. banks, i n p a r t i c u l a r , has l e f t them somewhat over levered. The amount of c a p i t a l that a bank should have i n order to ensure the safety of depositors i s open to ques-t i o n but some rules of thumb have evolved. The c a p i t a l / a s s e t r a t i o has been suggested as a measure of the amount by which a bank's assets can shrink before the depositors w i l l face a l o s s . Binhammer has pointed out however that a better measure of shock absorbing capacity may be the r a t i o , c a p i t a l to r i s k assets since i t emphasizes where exposure r e s i d e s . 1 The p r i n c i p l e that the q u a l i t y of bank assets should be considered i n judging c a p i t a l adequacy has received growing acceptance 2 among American bank supervisory and regulatory bodies. While i t i s true that other factors such as age, s i z e , managerial experience, and asset d i v e r s i f i c a t i o n , are also important, the c a p i t a l / a s s e t r a t i o i s a convenient 'early warning' index. Once the r a t i o begins to f a l l the 157 158 s i g n a l i s given to commence a more d e t a i l e d evaluation encompassing the other factors named above. The c a p i t a l / a s s e t r a t i o f o r the BankAmerica for example i s as 3 follows for selected years: 1950 1955 1960 1965 1970 1971 1972 1973 1974 5.8% 5% 5.5% 5.2% 4.1% 3.9% 3.5% 3.1% 2.8% (projected) It appears that the s t e a d i l y d e c l i n i n g r a t i o i s placing a growth constraint on BankAmerica. The bank was recently turned down by the Federal Reserve Board i n i t s b i d to acquire a foreign insurance company. The following i s an explanation of the Board's decision offered by Messrs. Wallich and Sheehan, members of the Board of Governors of the Federal Reserve: We agree that the applicant's (BankAmerica's) c a p i t a l p o s i t i o n i s somewhat lower than what the Board would consider appropriate. We also agree with out colleague's concern over the tendency of many U.S. banking organizations to pursue a p o l i c y of rapid expansion and agree that funds earmarked for expansion by U.S. banking organi-zations with c a p i t a l p o s i t i o n s not considered appropriate should be used instead to strengthen the c a p i t a l p o s i t i o n s of such organiza-t i o n s . 4 While the 'appropriate' c a p i t a l p o s i t i o n i s not defined, presumably i t i s something greater than 2 per cent to 3 per cent. The following graph (Figure 9-1) i l l u s t r a t e s that a d e c l i n i n g c a p i t a l / a s s e t r a t i o has occurred generally i n the U.S. banking i n d u s t r y . 5 While the adequacy of the c a p i t a l of Canadian banks has not r e -ceived widespread public attention, some s e c u r i t i e s analysts have Figure 9-1 CAPITAL/ASSET RATIOS OF U.S. BANKING INDUSTRY* 160 c r i t i c i z e d the banks for operating on r a t i o s that are too t h i n . A comparison of c a p i t a l / a s s e t r a t i o of the Royal Bank and the Commerce reveals that they are indeed i n a r e l a t i v e l y weaker p o s i t i o n than the BankAmerica: 1965 1970 1971 1972 1973 1974 Royal 4.9% 3.4% 3.1% 2.9% 2.6% 2.3% Commerce 4.9% 3.6% 3.7% 3.4% 3.0% 2.7% The obvious s o l u t i o n to the above constraint on the a b i l i t y of the banks to grow i s to issue more share c a p i t a l . However current depres-sed stock market conditions represent an environmental constraint on t h i s a l t e r n a t i v e . No major U.S. banks have yet shown a willingness to attempt to f l o a t an equity issue although three Canadian banks have come out with r i g h t s issues i n the past year. A l l issues were at r e l a t i v e l y depressed p r i c e s . I t c e r t a i n l y appears u n l i k e l y that any large bank w i l l attempt to f l o a t a major share issue u n t i l the stock market turns around. There i s reasonable evidence that the banks themselves were not w i l l i n g to forsake t h e i r goal of more growth—at l e a s t i n i t i a l l y . The BankAmerica was vexed at the thought of the Fed giving the world's largest bank a public spanking. In response to c r i t i c i s m that i t was u n d e r c a p i t a l i z i n g i t argued that i t s " c a p i t a l p o s i t i o n i s strong and f u l l y capable of b u i l d i n g dividend growth." The f a c t that the Federal Reserve has had to step i n and r u l e against several other expansionary moves by the banks i s also good e v i -dence that the banks were not giving up growth without a f i g h t : 161 Not only BankAmerica, but C i t i c o r p , second biggest i n the world, and Bankers Trust and F i r s t Chicago, each among the nations ten biggest banking operations, have a l l had planned a c q u i s i t i o n s turned down by the Fed i n recent months. Two weeks ago the Fed announced that i t would not allow bank holding companies to underwrite mortgage guaran-tee insurance because i t feared the holding companies were growing too f a s t . 7 I t appears that the 'go slow' message has recently been acknow-ledged by the banks. The Bank of America has recently received much pub-g l i c i t y over i t s decision to slow down the growth of i t s assets. For our purposes i t i s v i t a l that the reader understand that t h i s d ecision was 9 only taken a f t e r 'prodding by the Federal Reserve Board.' Af t e r being backed into a corner by the Fed i t appears that the Bank i s now merely attempting to make t h e i r decision p u b l i c a l l y 'acceptable.' One may rest assured that i f i t s major competitors do not f a l l into l i n e and adopt a consolidation philosophy, that BankAmerica w i l l again adopt a growth objec-t i v e . I t i s u n l i k e l y that the Bank of America w i l l allow the F i r s t National C i t y Bank of New York to replace i t as the world's larges t bank — a t l e a s t not without a strong f i g h t . Bank management w i l l not give up the growth objective for very long because, as pointed out by Galbraith, i t i s not i n t h e i r best i n t e r -ests to do so. I t i s probably necessary to temporarily abandon what John B a l l e s , President of the Federal Reserve Bank of San Francisco, c a l l s the 'performance c u l t ' of the 1960's and early 70's; but only u n t i l c e r t a i n weaknesses that crept into the r a p i d l y growing system can be shaken out. Of course the inadequate c a p i t a l base w i l l also have to be r e c t i f i e d . While there has been no p u b l i c i t y over the state of the 162 c a p i t a l i z a t i o n r a t i o s of the chartered banks, t h i s w r i t e r submits that i t i s extremely l i k e l y that the Bank of Canada has used 'moral suasion' to slow down the banks. The reason i s that some of the banks, i n t h e i r 1974 annual r e p o r t s , defended the adequacy of t h e i r c a p i t a l l e v e l s . They are being prodded by s o m e o n e — l i k e l y the Bank of Canada. In defending the adequacy of t h e i r c a p i t a l , the chartered banks put f o r t h the argument that the f o l l o w i n g items c o n s t i t u t e t h e i r c a p i t a l : shareholder's e q u i t y ; a p p r o p r i a t i o n s f o r l o s s e s ; and debentures. The argument might have some v a l i d i t y — i f the focus of a t t e n t i o n i s on the s a f e t y of d e p o s i t o r s . This w r i t e r submits however that the focus of concern should a l s o be on the shareholders. In t h i s case i t i s only r a t i o n a l to argue that a bank's c a p i t a l c o n s i s t s only of t o t a l shareholder's e q u i t y . While the innate need f o r growth remains, the major banks do seem to be c u r r e n t l y f o c u s i n g t h e i r a t t e n t i o n on l i q u i d i t y problems brought about by the move of OPEC funds through the system. We have r e -c e n t l y witnessed the unusual s i t u a t i o n of major banks d e c l i n i n g to take up a l l deposit funds o f f e r e d . The reasons are twofold: (a) the funds are very v o l a t i l e , and (b) the funds are provided by a l i m i t e d number of sources. The l a t t e r p o i n t i n v o l v e s the concept of banker's r i s k ( i t i s l e s s r i s k y to have 100 customers w i t h deposits of $10 each than ten 163 customers with deposits of $100 each). The former point r e l a t e s to the bank's l i q u i d i t y p r o b l e m s — e s p e c i a l l y i n the Euro d o l l a r market. Since the early 1960's the Euro d o l l a r market has consisted mainly of banks c o l l e c t i n g short term deposits and u t i l i z i n g these funds to extend medium and long term loans to i n d u s t r i a l c l i e n t s . The market functioned reasonably s m o o t h l y — u n t i l the o i l c r i s i s . The o i l producing nations have t y p i c a l l y placed t h e i r funds on deposit for a very short term and often p u l l large sums out of the market f or l i t t l e apparent reason. This a c t i o n of course severely l i m i t s the a b i l i t y of the banks to re-cycle those 'petrodollars' toward productive use. In the circum-stances some prudence has been self-imposed by the banks which indicates some awareness that growth cannot proceed without regard to other v a r i a b l e s . In these uncertain times growth must take a back seat to the more important overriding goal of any organization: i t s own s u r v i v a l . Governmental interference of both the p o s i t i v e and negative type i s also currently having an influence on i n t e r n a t i o n a l banking. On January 29, 1974, the Federal Reserve Board announced termination of the Voluntary Foreign Credit Restraint (VFCR) program. 1^ This action was co-ordinated with the simultaneous l i f t i n g of the c a p i t a l outflow r e s t r a i n t program administered by the Treasury and Commerce Departments of the U.S. This included termination of the Interest E q u a l i z a t i o n Tax. On January 30, 1974, the Ministers of Finance and of Industry, Trade and Commerce announced the withdrawal of Canadian guidelines that had o r i g i n a l l y been erected i n order to obtain exemption from the U.S. program. 1 1 The r e s u l t of the above action i s that both Canadian and U.S. 164 banks have been granted an increased amount of freedom to operate i n i n t e r -n a t i o n a l markets. For the Canadian banks i t means that they may be able to renew t h e i r r o l e as a conduit of U.S. funds between North America and Europe. That i s , a Canadian bank may bid for U.S. d o l l a r deposits i n Canada or the U.S. and, i f i n t e r e s t rate d i f f e r e n t i a l s e x i s t , the funds may be invested i n a foreign market. The e f f e c t of the removal of the various guidelines on the Canadian and U.S. banking systems i s uncertain at t h i s time. There are simply too many environmental v a r i a b l e s . C l e a r l y , the U.S. government would l i k e the U.S. banks to p a r t i c i p a t e i n the Euro d o l l a r market from a domestic base. In f a c t , former President Nixon's i n t e r n a t i o n a l economic report of February 1974 s p e c i f i c a l l y urged that Euro d o l l a r market opera-12 tions of U.S. banks be brought home. However, there are s i g n i f i c a n t b a r r i e r s to t h i s occurring. Reserve requirements and c e i l i n g s on deposit y i e l d s would l i k e l y make i t impossible for the domestic U.S. banks to compete for Euro d o l l a r s . (Note that a Euro d o l l a r placed on deposit at a domestic branch of a U.S. bank becomes subject to a l l the U.S. banking regulations.) I t does not appear f e a s i b l e for the Federal Reserve to grant exemptions f o r repatri a t e d Euro d o l l a r s since 'a d o l l a r i s a d o l l a r ' within the border of the nation. Some bankers have predicted however that the removal of controls w i l l have an impact: With the disappearance of controls, d i r e c t lending from the U.S. i s bound to surge, thus lessening the need to use foreign branches to fund loans to multinational customers.^ 3 165 Other bankers simply see the l i f t i n g of r e s t r i c t i o n s as giving them (and t h e i r c l i e n t ) the f l e x i b i l i t y to choose the l o c a t i o n of f i n a n -14 cing. Presumably the p r i c e mechanism, operating through i n t e r e s t rates w i l l at l a s t have a r o l e to play i n the a l l o c a t i o n of funds on a world-wide basis from surplus to d e f i c i t spending u n i t s . While the above government action might be termed ' p o s i t i v e , ' there i s a high p r o b a b i l i t y that some a d d i t i o n a l negative interference w i l l soon impinge upon the foreign operations of U.S. banks. The Board of Governors of the Federal Reserve System has created a steering com-mittee: charged with the r e s p o n s i b i l i t y of reassessing the s t r u c t u r a l aspects of U.S. i n t e r n a t i o n a l banking regulations that involve home country r e s p o n s i b i l i t i e s for U.S. banks o v e r s e a s . ^ The Board of Governors of the Federal Reserve System has for some time been charged with the r e s p o n s i b i l i t y of regulating the i n t e r -n a t i o n a l operations of U.S. banking organizations. The statutory author-16 i t y stems from the following: a) Section 25 of the Federal Reserve Act (amended 1966); b) Section 25(a) of the Federal Reserve Act (known as the Edge Act) ; and c) The Bank Holding Company Act 1956 (amended 1970). C r i t i c s however have claimed that the p o l i c y of the Fed toward foreign banking has been much too l a x . 1 7 A d i f f e r e n t philosophy now seems to be emerging however and i t 166 appears l i k e l y that a new 'interference' l i n e w i l l soon have to be added to our model (from government to the foreign market). These same regulators (the Fed) that permitted banks to grow and d i v e r s i f y at breakneck speed are now t r y i n g to bring things back un-der c o n t r o l . x 8 C l e a r l y , the Federal Reserve Board has the power to retard the growth of foreign banking a c t i v i t i e s of U.S. banks. However, i f r a t i o n -a l i t y p r e v a i l s , one might hope that the Fed w i l l concern i t s e l f only with minimizing the r i s k introduced to the domestic a c t i v i t i e s of U.S. banks by t h e i r foreign operations. It was pointed out above that Canadian l e g i s l a t i o n has only had an i n d i r e c t influence on the foreign operations of the chartered banks. Various Bank Act r e s t r i c t i o n s against d i v e r s i f y i n g i n t o domestic f i n a n c i a l markets are thought to have diverted attention to foreign operations. The Bank Act i s scheduled for r e v i s i o n i n 1977 however and some observers f e e l that the doors to some other Canadian f i n a n c i a l markets may be opened to the chartered banks. It was pointed out i n Chapter Four that U.S. banks have entered Canadian f i n a n c i a l markets by creating s u b s i d i a r i e s that provide many f i n a n c i a l services that the chartered banks are barred from. An example i s C i t i c o r p F i n a n c i a l Services Canada Ltd., a wholly owned subsidiary of F i r s t National C i t y Bank. The company provides a wide range of f i n a n c i a l services including leasing, commercial c r e d i t s , mortgage financing, con-sumer lending, and investment management. In a recruitment poster for MBA's the company advises prospective employees that: "In the past year 167 we have doubled i n s i z e and plans c a l l f o r expansion at a s i m i l a r rate 19 during the next year." This rapid growth has caused Canadian bankers to lobby for entry into a wider range of domestic f i n a n c i a l markets. Here i s an excerpt from the text of the 1974 Annual Report to Shareholders of the Bank of Nova Scotia presented by C. E. R i t c h i e , Chairman: " I t i s the utmost of absurdity to permit unregulated foreign i n s t i t u t i o n s to do 20 business such as leasing which domestic banks are forbidden to do." It i s not possible at t h i s time to predict whether the government w i l l allow the banks to expand into other domestic markets. However, i f permission to enter other markets i s granted, t h i s would q u a l i f y as the removal of l i n e '3' i n terms of our model. The p r e d i c t i o n that follows i s that the pressure for growth that has i n the past been diverted to foreign markets may be re-directed toward growth i n the domestic area. Some slackening i n the pace of foreign growth should then be expected. In summary, environmental factors can be expected to continually play a r o l e i n the development of i n t e r n a t i o n a l banking. I t i s submitted that the model developed can adequately deal with various events as they occur although i t may be that some a d d i t i o n a l v a r i a b l e s (e.g., a govern-ment interference l i n e running to foreign market) w i l l have to be added. As long as the banks continue to embrace growth as a goal however, our model should remain v a l i d . The f i n a l chapter w i l l be devoted to a ' c r y s t a l b a l l ' look at the future. One feature that w i l l be dealt with i s the p r o b a b i l i t y that growth w i l l continue as the overriding goal of the banking industry. I 168 Notes for Chapter Nine H. H. Binhammer, Money, Banking and the Canadian F i n a n c i a l  System (Toronto: Methuen, 1968), p. 13. 2 Ibid.. 3 BankAmerica, 1973 Annual Report. 4 Business Week (Sept. 21, 1974), p. 52. 5 I b i d . 6 I b i d . (Feb. 24, 1975), p. 55. 7 Ibid. (Sept. 21, 1974), p. 52. 8 Ibid. (Feb. 24, 1975). 9 I b i d . Board of Governors of the Federal Reserve System, 1973 Annual Report. ^ Bank of Canada, 1973 Annual Report. 12 E. P. Imhof, "Rapid Expansion of Overseas Banking," Inter- economics , No. 8, 1974. 13 S. C. Eyre, "Exploring Some Trends i n International Banking," Burrough's Clearing House (February 1974), p. 54. 14 J . P. Morgan and Co. Inc., 1973 Annual Report. ^ "Business Conditions," Federal Reserve Bank of Chicago (Oct. 1974), p. 3. 1 6 I b i d . 1 7 Business Week (Sept. 21, 1974). 18 Ibid., p. 52. 19 Excerpt from recruitment poster, C i t i c o r p F i n a n c i a l Services Canada Ltd. 20 "International Challenges and Canadian Responses," Bank of Nova  Scotia Monthly Review (Dec. 1974), p. 5. Chapter Ten THE FUTURE The reader should keep i n mind throughout t h i s chapter that pre-d i c t i o n s of the f u t u r e are n o t o r i o u s l y u n r e l i a b l e . Nowhere i s t h i s more true than i n the banking i n d u s t r y . Banking i s an area c o n s t a n t l y being i n t e r f e r e d w i t h by v a r i o u s governmental bodies; progression through time i s c h a r a c t e r i z e d by banking action—government r e a c t i o n — b a n k i n g r e a c t i o n . In these circumstances, i t i s easy to see the problems i n v o l v e d i n ' s t a r gazing.' Nevertheless, there are some events u n f o l d i n g that seem to poi n t the banks i n c e r t a i n d i r e c t i o n s . There i s no doubt that the v a r i o u s s t r a i n s i n the i n t e r n a t i o n a l environment ( o i l c r i s i s , balance of payment problems, i n f l a t i o n , and creeping s o c i a l i s m ) have had and w i l l continue to have more than a nomi-n a l impact on i n t e r n a t i o n a l banking. The l i q u i d i t y c r i s i s (discussed e a r l i e r ) , f o r e i g n exchange l o s s e s and s e v e r a l bank f a i l u r e s are p a r t l y the r e s u l t of these environmental events. Incompetent management has a l s o c o n t r i b u t e d ; e s p e c i a l l y i n the f a i l u r e of some smaller banks. The major Canadian and U.S. banks appear capable of weathering the storm, however p u b l i c a t t e n t i o n has now been focused on the banking i n d u s t r y . From the p o i n t of view of bankers, t h i s i s unfortunate. Bankers gener-a l l y p r e f e r to maintain a low p u b l i c p r o f i l e , which permits them more freedom to pursue t h e i r growth goals. The focus of p u b l i c a t t e n t i o n on banking has r e s u l t e d i n a ground-s w e l l of p r o t e c t i o n i s m i n s e v e r a l i n t e r n a t i o n a l banking markets. As at 169 170 June 1973, one of the world's top ten banks rated the degree of d i f f i -c u l t y with which a foreign bank can operate i n a p a r t i c u l a r country. In order to rate the degree of d i f f i c u l t y or ease of operation the countries have been ranked on a one to f i v e scale. The c r i t e r i o n by which the countries are ranked i s as follows: 1) Complete freedom on the same terms as indigenous banks, i . e . , no discrimination at a l l . 2) Areas where some discr i m i n a t i o n , e.g., there must be some l e g a l p a r t i c i p a t i o n or formal rules applied to foreign banks; informal constraints are ignored. 3) Areas of heavy discr i m i n a t i o n , e.g., no branches allowed or d i r e c t s u b s i d i a r i e s . 4) Areas where only a very f a i n t foreign banking presence i s allowed, e.g., only through representative o f f i c e s . 5) Areas where a l l foreign banks of whatever d e s c r i p t i o n are banned. Grouped by regions, the countries have been rated according to (a) before opening o f f i c e s , and (b) a f t e r o f f i c e s have been established. Where only one r a t i n g i s given, the r a t i n g i s the same for both (a) and (b). Where there are two numbers, the f i r s t i s (a) and the second (b). Taken from The Banker, v o l . 123, 1973. EUROPE Nassau 1 A l g e r i a 5 Muscat 1 U.K. 1 Jamaica 1 Tanzania 5 United Arab Emirates 1 Germany 1 H a i t i 1 Kenya 1 Lebanon 1 Greece 1 Cayman Islands 1 Ghana 3 Jordan 1 Netherlands 1 Costa Rica 2 Uganda 2 Syria 5 I t a l y 1 Honduras 2 Angola 2 Turkey 3 France 1 Venezuela 2 Mozambique 2 Iran 3 Belgium 1 Trinidad 2 Cameroon 1 Kuwait 4 Luxembourg 1 Dominican Republic 2-1 Upper Volta 1 Iraq 5 Switzerland 2 Canada 3 Mali 5 India 1 Republic of Ireland 2 Mexico 3 Rhodesia' 1 Pakistan 1 A u s t r i a 2 Bermuda 3-2 Tunisia 1 Afghanistan 3 Denmark 2 Guatemala 4 Malawi 1 Nepal 1 Portugal 3 Cuba 4 Ivory Coast 1 Bangla Desh 1 Spain 3 United States* 3 Zambia 2 S r i Lanka 1 Sweden 3 SOUTH AMERICA Guinea 3 Cyprus 1 Norway 3 Ecuador 2-3 Senegal 1 Finland 3 Paraguay 2 Niger 1 ASIA-PACIFIC U.S.S.R. 4 B o l i v i a 2 Chad 1 Hong Kong 1 Hungary 4 Colombia 3 Somalia 5 Brunei 2-1 Poland 4 B r a z i l 3 Dahomey 1 F i j i 2 Yugoslavia 4 Argentina 3 Sie r r a Leone 1 Malaysia 2-3 Rumania 4 Uruguay 3 Libya 5 Singapore 2-3 Bulgaria 5 Peru 4 Togo 1 Phil i p p i n e s 2 Albania 5 Chi l e 5 Central A f r i c a n Republic 1 Vietnam 2 Germany Democratic AFRICA L i b e r i a 1 Guam 2 Republic 5 MIDDLE EAST Mauritania 1 Japan 2-4 SOUTH ASIA . Lesotho 1 Taiwan 2-4 CANADA-CARIBBEAN Nige r i a 2 Congo (Brazzaville) 3 A u s t r a l i a 3-4 Nicaragua 1 Egypt 5 Mauritius 1 Indonesia 3-4 E l Salvador 1 Ethiopia 2 Botswana 1 Thailand 3-4 Barbados 1 South A f r i c a 1 Gabon 1 Korea 3-4 Netherlands A n t i l l e s 1 Zaire 1 Swaziland 1 People's Rep/China 4 Puerto Rico 1 Sudan 3 Gambia 1 Burma 5 V i r g i n Islands 1 Morocco 2 Saudi Arabia 1 Mongolia 5 £ h-1 writer's estimate 172 There i s no doubt that the i n t e n s i t y of discrimination against foreign bankers w i l l grow. The European Commission (the i n i t i a t o r of p o l i c y for the European Economic Community) has currently under study a proposal that would severely r e s t r i c t the operations of foreign banks within the Community. The proposal i s being strongly r e s i s t e d by the United Kingdom (a country that welcomes for e i g n banks) but other member countries may be i n favor. S u r p r i s i n g l y enough, protectionism i s very prevalent i n the United States. American p o l i t i c i a n s long ago adopted the Marxian view that banking i s one of the commanding heights of the economy. As such i t i s a height that should be barred to the foreigner. The American a t t i -tude also has i t s roots i n the populist fear of large banking organiza-tions who are thought to move savings from r u r a l areas to the national (or i n t e r n a t i o n a l ) money centres. Representative Wright Patman (a popu-l i s t ) , formerly Chairman of the Banking and Currency Committee i n the U.S. House of Representatives has long been an opponent of the entry of foreign banks i n t o the U.S. His highly r e s t r i c t i v e Foreign Bank Control Act submitted i n 1973, while not passed into law, served to focus atten-2 ti o n on the problem. There are now several studies underway that might lead to discrimination against foreign banking i n the U.S. It seems to t h i s w r i t e r that the most reasonable and l o g i c a l ap-proach to take i n t h i s area i s to adopt the philosophy of r e c i p r o c i t y and equality. That i s , foreign banks be allowed into the country provided that domestic banks are allowed to enter the relevant foreign market. This i s b a s i c a l l y the approach adopted by the American Banker's 173 3 A s s o c i a t i o n . Support f o r t h i s philosophy a l s o comes from the B i b l e : "One law s h a l l be to him that i s homeborne, and unto the stranger that -.4 sojourneth among you. The w r i t e r i s not o p t i m i s t i c however that the above philosophy w i l l p r e v a i l . S u r p r i s i n g l y enough the Canadian Banker's A s s o c i a t i o n has not come out w i t h a p o l i c y statement on the r e c i p r o c i t y and e q u a l i t y i s s u e . During the course of our i n t e r v i e w s we found out why: the Can-adian banks cannot agree on the i s s u e . Three of the major banks are s o l i d l y i n favor of r e c i p r o c i t y and e q u a l i t y and the other two are e i t h e r opposed or very non-committal about the sub j e c t . In an apparent attempt to e l i m i n a t e the s t u l t i f y i n g s e n i o r i t y system that r e s u l t e d i n b a r r i e r s to the e f f e c t i v e flow of l e g i s l a t i o n , the U.S. House of Representatives r e c e n t l y removed s e v e r a l key committee chairman, i n c l u d i n g Wright Patman, Chairman of the Banking and Currency Committee. 5 Patman's replacement i s a younger man who has the power to s t r o n g l y i n f l u e n c e the American p o l i c y toward i n t e r n a t i o n a l banking. From the poi n t of view of the banking community, the new chairman, Henry Reuss i s a disappointment. The f o l l o w i n g quotation provides e v i -dence t h a t Reuss i s l i k e l y to continue where Patman l e f t o f f : The Government should do f o r people t h a t , and only t h a t , which they cannot do f o r themselves, l i k e standing up to conglomerates and m u l t i - n a t i o n a l s , and other examples of gi a n t i s m . . . I f that be Populism, I'm a Populist.^> As Kindleberger has pointed out, populism and n a t i o n a l i s m are c l o s e l y r e l a t e d and are a t t i t u d e s of the 'True B e l i e v e r . ' 174 Those who hold extreme opinions are thoroughly persuaded that the other extreme a c t u a l l y shapes the course of events. Nationalism can e a s i l y be c a r r i e d to the point of b e l i e v i n g that foreigners p l o t against the nation. Joined with populism, i t fears foreign banking as the C h r i s t i a n S c i e n t i s t fears f l u o r i d e . ^ Canada, of course, has her share of n a t i o n a l i s t s , the most famous of whom i s probably Walter Gordon. He has recently received renewed g attention i n the media with h i s "30-firm plan f o r buying back Canada." Gordon claims that a Gallup P o l l published i n March 1974 indicated that 52 per cent of Canadians favour l e g i s l a t i o n that would s i g n i f i c a n t l y r e s t r i c t and c o n t r o l further foreign investment; and a further 17 per 9 cent p a r t l y favoured such a move. This i s bad news for i n t e r n a t i o n a l banking. If Canadian p o l i t i c i a n s r e f l e c t the above sentiments, then i t appears u n l i k e l y that the doors w i l l be opened to foreign banking. Other nations who permit foreign banks to enter often s t i p u l a t e for r e c i -p r o c i t y so the expansion by the chartered banks into these markets could be prevented. Japan i s a good example. Since the Japanese banks are only permitted to open representative o f f i c e s i n Canada, the chartered banks are only permitted to enter the Japanese market on the same basis — a l t h o u g h i t i s known that both p a r t i e s would prefer to e s t a b l i s h f u l l service branches. In summary, the f i r s t p r e d i c t i o n that evolves from the above com-ments i s that i n t e r n a t i o n a l banking i s heading into a period of increased governmental interference; spawned i n part by world economic troubles and i n part by economic nationalism that focuses quite n a t u r a l l y on bank-ing as a 'commanding height' of the economy. Of course the banks have become used to operating i n c o n t r o l l e d 175 environments and can be expected to react i n ways that allow continued growth. One p o s s i b i l i t y that has received a good deal of attention i n recent years i s the development of consortia. I t i s thought that the banding together of four or f i v e banks from d i f f e r e n t countries tends to reduce n a t i o n a l i s t i c sentiment somewhat. J . H. Coleman, formerly with the Royal Bank once stated that economic nationalism was one of the reasons behind the Royal's decision to take an equity p o s i t i o n i n the Orion banking group (discussed above). In an address to the 1974 Can-adian conference on Banking, A. F. Tuke, Chairman of Barclay's Bank Limited, stated that: "The most important aspect of the next f i v e to ten years i s the question of consortia banking.""'"^ It should be remembered that consortia banking brings p o t e n t i a l problems with i t . When economies are booming, a l l partners are l i k e l y to be happy with the arrangement. However, i f problems occur (large loan defaults, etc.) i t w i l l be i n t e r e s t i n g to see i f c o n f l i c t i n g manage-ment i n t e r e s t s w i l l a r i s e . Another possible reaction to growth constraints imposed by v a r i -ous governments i s the development of improved banking technology. A l i b e r has predicted that a technological revolution i s about to h i t com-mercial banking. The technology of money payments i s about to change, the geographic scope of the market w i l l increase, and the effectiveness of national controls i n l i m i t i n g competition among banks i s being eroded.H What A l i b e r has i n mind of course i s more sophisticated u t i l i z a t i o n of computer technology i n banking. 176 E l e c t r o n i c banking w i l l further enlarge the market area for deposits beyond nation a l boundaries. Chicago banks w i l l advertise i n Frank-f u r t for mark deposits and loans while Frankfurt banks w i l l compete for Chicago deposits and loans. Banks w i l l be able to a t t r a c t f o r -eign customers without the costs of e s t a b l i s h i n g o f f i c e s a b r o a d . ± 2 With a l l due respect to Professor A l i b e r , he does miss a very important point. As John Coleman, former Deputy Chairman of the Royal Bank once said: "The product of banking i s the same, so i t s the personal contact 13 that counts." Every banker has been aware of t h i s for years. The story i s often t o l d of the man who came to J . P. Morgan, the famous banker, during the panic of 1907 to borrow a m i l l i o n d o l l a r s . Mr. Morgan's reply was reported to be: "No, I won't lend you the money, but 14 f o r a s l i g h t fee, I ' l l walk down Wall Street with my arm around you." While computers w i l l undoubtedly play an increasing r o l e i n banking, i t i s inconceivable to t h i s writer that the importance of personal contact w i l l d e c l i n e — t h a t i s unless mechanized robots who speak computereze assume executive management of our major corporations. I t follows there-fore that the need to have phy s i c a l representation i n foreign markets w i l l not be eliminated by an improved payments mechanism. This argument received unanimous support from the bankers interviewed. In f a c t one banker strongly suggested that computers had been 'oversold to the banking community.' Up to t h i s point, the study has been p r i m a r i l y d e s c r i p t i v e i n nature. This i s p a r t i c u l a r l y true about the t h e o r e t i c a l model s t r e s s i n g need for growth as the major motivator behind foreign banking. The d e s i r a b i l i t y of growth as a goal has not been c a l l e d into question. Perhaps i t i s now time to step back somewhat and look at banking as j u s t 177 one part of spaceship earth. Growth as a goal has been c a l l e d into question by the famous club of Rome study e n t i t l e d "The Limits to Growth. While some of the assumptions and methodology used by the r e -searchers has been questioned, there appears to be reasonable evidence that i f the growth trends of i n d u s t r i a l i z a t i o n , population, and deple-t i o n of non-renewable resources i s not brought into check, the world i s heading for serious trouble. The author's s p e c i f i c conclusion i s : I f the present growth trends i n world population, i n d u s t r i a l i z a t i o n , p o l l u t i o n , food production, and resource depletion continue unchanged, the l i m i t s to growth on t h i s planet w i l l be reached sometime within the next one hundred years. The most probable r e s u l t w i l l be a rather sudden and uncontrollable decline i n both population and indus-t r i a l capacity.1^ One might ask what a l l t h i s has to do with banking. The answer quite simply i s that banking may well be viewed as the gasoline that fu e l s the engine of i n d u s t r i a l i z a t i o n . Evidence that the banking industry view themselves i n t h i s r o l e i s provided by the following statement by executives of the Chase Manhattan Bank: Our major challenge l i e s at the heart of our service to corporate customers—financing t h e i r continuing need to expand and modernize productive assets. In short f u e l i n g corporate growth.-*-7 That t h i s objective might be somewhat out of step with society's wishes i s evidenced by the pressure from many i n t e r e s t groups to include more s o c i a l goals i n the determination of loan and investment p o l i c y . Bankers are reluctant to give i n to t h i s pressure for two reasons: 178 a) i t i s the government's not the banker's duty to decide what should and should not be done to improve the q u a l i t y of l i f e ; and b) funds placed at the bank's disposal are to be invested i n f i n a n -c i a l l y safe assets that provide some p o s i t i v e y i e l d . Rare i s the s o c i a l project that promises safety and a p o s i t i v e return. Nevertheless, there i s no denying the pressure brought to bear upon the banks. Since the banks hold an ino r d i n a t e l y large proportion of society's f i n a n c i a l resources, they may be expected i n the future to play an increasing r o l e i n the a l l o c a t i o n of resources for s o c i a l pur-poses. There are some bankers who w i l l f i g h t t h i s . Walter Wriston, Chairman of C i t i c o r p responded to a question about the s o c i a l responsi-b i l i t y of banks as follows: Oh, the s o c i a l audit was the g i r l at l a s t year's dance. Nobody knew what i t was, but i t sounded as i f i t was something wonderful, and good. Then you analyze what they're t a l k i n g about and I've never yet found anybody who knew.-*-8 I t i s the pr e d i c t i o n of t h i s w r i t e r however that i f banks are going to expect to continue operating i n foreign markets, they are going to have to adopt the view that s o c i a l r e s p o n s i b i l i t y i s a normal cost of doing business. The problem facing the chief executives of banks i s the same as for leaders of other major corporations: they are judged by t h e i r c o n t r i -bution to the corporation over a very short time span. Most corporate executives are i n power for only f i v e to ten years and there i s pressure 179 on them to produce within that period. The Club of Rome study h i g h l i g h t s t h i s as an important v a r i a b l e i n mankind's pursuit of short run goals. The two missing ingredients are a r e a l i s t i c , long-term goal that can guide mankind to the equilibrium s o c i e t y and the human w i l l to achieve that goal. Without such a goal and a commitment to i t , short term concerns w i l l generate the exponential growth that drives the world system toward the l i m i t s of the earth and ultimate collapse. With that goal and that commitment, mankind would be ready now to be-gin a c o n t r o l l e d , orderly t r a n s i t i o n from growth to global e q u i l i b -rium. 19 Senior executives i n the banking industry w i l l c e r t a i n l y not be leaders i n the r e j e c t i o n of growth for growth's sake. I t remains to be seen whether society i s able to develop the w i l l to force the t r a n s i t i o n from growth to equilibrium. I believe i t i s f a i r to say that the banks w i l l adapt to society's wishes. Once the rules are l a i d down the banks w i l l play the game. 180 Notes f o r Chapter Ten I Reproduced i n The Banker, v o l . 123 (1973). 2 C. S. Ganoe, "Banking Across Borders: Reciprocity and E q u a l i t y , " Burrough's Clearing House (February 1974). 3 I b i d . 4 Quoted i n "Future of Mu l t i n a t i o n a l Enterprise," i n The Inter-na t i o n a l Corporation, C. P. Kindleberger (ed.). 5 Time (February 3, 1975). ^ I b i d . , p. 11A. 7 C. P. Kindleberger, American Business Abroad: Six Lectures on  Direct Investment (New Haven: Yale University Press, 1969), p. 124. Q F i n a n c i a l Post (Oct. 5, 1974). 9 I b i d . A. F. Tuke, "Recent Developments and Future Trends i n M u l t i -n a t i o n a l Banking," speech presented to the Canadian Conference on Bank-ing, Toronto, September 16, 1974. I I R. Z. A l i b e r , The International Money Game (New York: Basic Books Inc., 1973), p. 149. 12 Ibid., p. 156. 13 Quoted i n Macleans (March 1972), p. 77. 1 4 H. V. Prochnow and H. V. Prochnow, J r . The Changing World of  Banking (New York: Harper and Row, 1974), p. 383. 1 5 D. H. Meadows et a l . , The Limits to Growth (New York: Signet Books, 1972). 1 6 I b i d . , p. 29. 1 7 The Chase Manhattan Corporation, 1973 Annual Report, p. 8. 18 Interview i n The Banker (July 1974), p. 744. 19 Meadows, p. 188. B I B L I O G R A P H Y 181 182 BOOKS Aharoni, Y a i r . The Foreign Investment Decision Process. Boston: Harvard Univ e r s i t y Press, 1966. A l i b e r , Robert Z. The International Money Game. New York: Basic Books Inc., 1973. Archibald, G. C. The Theory of the Firm. Harmondsworth, England: Penguin Books, 1971. Baumol, W. J. Business Behavior, Value and Growth. New York: MacMillan Company, 1959. Binhammer, H. H. Money, Banking and the Canadian F i n a n c i a l System. 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The International Corporation: A Symposium. Cambridge, Mass.: M.I.T. Press, 1970. Knickerbocker, F. T. O l i g o p o l i s t i c Reaction and Mu l t i n a t i o n a l Enter- p r i s e . Boston: Harvard University Press, 1973. 183 Markowitz, H. M. P o r t f o l i o Selection: E f f i c i e n t D i v e r s i f i c a t i o n of  Investments. New York: John Wiley and Sons Inc., 1959. Meadows, D. H., D. L. Meadows, J. Randers, and W. Behrens. The Limits  To Growth. New York: Signet Books, 1972. Nehrt, L. C. International Finance for Mu l t i n a t i o n a l Business. Scran-ton, Penn.: International Textbook Company, 1967. Orsinger, Roger. Banks of the World. New York: Walker, 1967. Prochnow, H. V. and H. V. Prochnow, J r . The Changing World of Banking. New York: Harper and Row, 1974. Robock, S. H. and K. Simmonds. International Business and Mul t i n a t i o n a l  Enterprises. Georgetown, Ontario: Irwin-Dorsey Ltd., 1973. Samuelson, P. A. and A. Scott. 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"An Analysis of E f f i c i e n c y of Scale and Organizational Form i n Commercial Banking." Journal of I n d u s t r i a l  Economics (July 1973). Macleans (Toronto), March 1972. Mandich, D. R. "International Loans: P r o f i t Centre or Loss Leader?" Journal of Commercial Bank Lending (Sept. 1972). Ragazzi, G. "Theories of the Determinants of Direct Foreign Investment I.M.F. Sta f f Papers (July 1973). Time (New York), Feb. 3, 1975. Vernon, R. "International Investment and International Trade i n the Product Cycle." Quarterly Journal of Economics, 80 (1966), 190-207 185 OTHER SOURCES Bank America Corporation, Annual Reports, 1971, 1972, 1973. Bankers Trust New York Corporation, Annual Reports, 1971, 1972, 1973. Bank of Canada, 1973 Annual Report. Bank of Canada Review, Aug. 1974, October 1974. Bank of Montreal, Annual Reports, 1972, 1973, 1974. The Bank of Nova Scotia, Annual Reports, 1972, 1973, 1974. Board of Governors of the Federal Reserve System, 1973 Annual Report. Bruce, B. D. "International Banking A c t i v i t i e s of Canadian and American Banks." M.B.A. thesis , University of B r i t i s h Columbia, 1969. Canada, Revised Statutes. An Act Respecting Banks and Banking, 1967. Canadian Imperial Bank of Commerce, Annual Reports, 1970, 1971, 1972, 1973, 1974. The Chase Manhattan Corporation, Annual Reports, 1971, 1972, 1973. Chemical New York Corporation, Annual Reports, 1971, 1972, 1973. C i t i c o r p , Annual Reports, 1971, 1972, 1973. Freedman, Charles. "The Foreign Currency Business of the Canadian Banks." Bank of Canada St a f f Research Studies, 1974. J . P. Morgan and Co. Inc., Annual Reports, 1971, 1972, 1973. Manufacturers Hanover Corporation, Annual Reports, 1971, 1972, 1973. Report of the Royal Commission on Banking and Finance. Ottawa: Queen's P r i n t e r , 1964. The Royal Bank of Canada, Annual Reports, 1972, 1973, 1974. The Toronto-Dominion Bank, Annual Reports, 1972, 1973, 1974. U.S. Comptroller of the Currency, 1964 Annual Report. A P P E N D I X E S 186 APPENDIX I INTERVIEW GUIDE FOR FIELD STUDY 188. DISCUSSION QUESTIONS A. Scope of International Operations 1. Preliminary to our discussion we would l i k e to obtain an o v e r a l l view of your Bank's commitments to i n t e r n a t i o n a l business. Would you k i n d l y i n d i c a t e the approximate percentage d i s t r i b u t i o n of r e -sources employed i n the following areas: Foreign Domestic a) employees - number - compensation b) loans c) deposits d) t o t a l assets e) gross revenue f) net p r o f i t s B. The Decision to Invest Abroad In t h i s section the objective i s to determine those variables which play an important r o l e i n the decision to commit management time and other resources to the conduct of i n t e r n a t i o n a l operations. 2. We would l i k e to discuss an expansion project which i s presently under consideration: a) what resources would be required? b) what c r i t e r i a w i l l you use to determine the value of the foreign operation? c) are these c r i t e r i a d i f f e r e n t from those used—say, f i v e years ago? 3. What objectives do you have for i n t e r n a t i o n a l operations over the next f i v e years? a) are these objectives d i f f e r e n t from those set f i v e years ago? 4. Have growth opportunities i n the domestic sector been l i m i t e d i n r e -cent years? I f so, what i s the nature of the domestic l i m i t a t i o n ? For example: 189 a) few p r o f i t opportunities? b) low p r o f i t margins? c) r e s t r i c t i o n s against domestic d i v e r s i f i c a t i o n ? 5. Have l i m i t e d growth opportunities at home influenced your decision, to expand abroad? 6. Some analysts maintain that overseas investment occurs because the investing f i r m possesses some advantage (computer technology, mana-g e r i a l expertise, economies of scale) that allows them to operate i n the foreign markets more p r o f i t a b l y than indigenous firms. a) does t h i s explanation apply generally to the banking industry? b) to your bank? c) what i s the nature of the advantage? d) do you compete i n any foreign market where you do not have an advantage over indigenous banks? 7. Have you entered, or would you consider entering a foreign market by any form other than d i r e c t * investments (for example by: l i c e n s i n g or management services contract)? a) what factors would you consider i n choosing the form of entry? C. The Role of Government In t h i s section the objective i s to determine whether governments have played a r o l e ( p o s i t i v e or negative) i n the growth of i n t e r n a t i o n a l banking. 8. Is the Canadian money supply growing or able to grow f a s t enough to enable your bank to meet i t s growth objectives? 9. Have Canadian government b a r r i e r s to domestic d i v e r s i f i c a t i o n had any influence on overseas expansion? 10. In general, should governments adopt a ' r e c i p r o c i t y and equality' a t t i t u d e toward foreign banks? Why? (including investments i n representative o f f i c e s , agencies, branches, s u b s i d i a r i e s and consortia) 190 D. Reflections and Expectations of the Future 14. In retrospect, what would you say have been the major disadvantages ( i f any) i n going international? a) l o s t of p r o f i t opportunities i n home market? b) p o l i t i c a l complications? c) s t i f f competition—low p r o f i t s margins? d) economic nationalism? 15. What, do you see, i s the future for p r i v a t e i n t e r n a t i o n a l banking? a) do you foresee a continuation of growth? b) do you a n t i c i p a t e the entry of more banks into the i n t e r n a t i o n a l arena? c) what changes i n operating forms would you predict? d) what changes i n operating methods, organization and management techniques do you foresee? 16. Some observers of the banking scene say that as the technology of the payments system develops (increasing use of computers), the major banks w i l l be able to service foreign customers without i n c u r r i n g the costs and r i s k s of e s t a b l i s h i n g overseas o f f i c e s . Do you agree? a) w i l l the importance of personal contact with c l i e n t s diminish? 191 APPENDIX II THE FOREIGN INVESTMENT DECISION 194 I t i s hoped that the t h e o r e t i c a l framework developed i n Chapter Eight meets the test of l o g i c a l consistency. The writer believes that the theory i s consistent with observed f a c t s . Perhaps an exploration of the decision-making process followed when a bank makes a d i r e c t foreign investment w i l l unearth some addi-t i o n a l support for the theory. In launching t h i s discussion i t may be advisable to remind the reader that today's banker i s not an i n d i v i d u a l entrepreneur, motivated s o l e l y by the prospects of p r o f i t . Rather he i s an employee of a huge corporation composed of hundreds of other d e c i s i o n -makers, each with h i s own set of values and goals. Furthermore, today's banker operates i n a world of uncertainty where decisions are often, i n the end, r e a l l y based on i n t u i t i o n rather than hard data. This i s f a r removed from the economically perfect world often assumed i n textbooks where investment d e c i s i o n s — f o r e i g n or domestic—are simply made on the basis of s e l e c t i n g those investments which maximize the net present value of the earning stream. The problems of decision-making i n the r e a l world have been explored by Y. Aharoni i n h i s book, The Foreign Investment Decision Process. 1 Aharoni's framework w i l l be kept i n mind throughout our discussion of the decision-making process followed by the banks when making a foreign d i r e c t investment. One ce n t r a l Aharoni hypothesis has relevance from the outset: In f a c t , one important thesis of t h i s book i s that i n organizations composed of i n d i v i d u a l s and groups within a c e r t a i n culture, faced with uncertainty, operating on a basis of incomplete information, and constantly pressed by ongoing a c t i v i t i e s , one simply cannot be-have i n a r a t i o n a l way as t h i s term i s defined i n economic theory. 2 195 There i s very l i t t l e evidence that the banks generally have a master plan to use when considering a foreign investment. One exception i s C i t i c o r p , one of the more aggressive i n t e r n a t i o n a l banks. I t i s i n t e r e s t i n g to note that Walter Wriston, Chairman of C i t i c o r p was f o r -merly i n charge of i n t e r n a t i o n a l operations. The f a c t that a strong i n t e r n a t i o n a l i s t i s i n charge of o v e r a l l operations may have an i n f l u -ence on that bank's focus on offshore banking. Aharoni has found e v i -dence that the drive of a high ranking executive can be a powerful 3 motivating force f o r i n t e r n a t i o n a l growth. 4 C i t i c o r p ' s plan i s based on a pattern of d e c e n t r a l i z a t i o n . Long term goals include the s e t t i n g of target rates of return, however the focus i n the short run seems to be more upon growth than on p r o f i t s . The planning followed by C i t i c o r p seems to pay o f f eventually i n p r o f i t s how-ever. For the twelve months ended June 30th, 1974, C i t i c o r p reported net operating income of $268.2 m i l l i o n compared to $235 m i l l i o n f or the larger BankAmerica. 5 C i t i c o r p has had a ten year growth rate i n earn-ings per share of 10.5 per cent, well i n excess of i t s two major competi-tors. This might be evidence that a more sophisticated planning process should be adopted by the other banks. During interviews with senior executives of the f i v e major char-tered banks i t became c l e a r that planning has not reached a very high l e v e l of s o p h i s t i c a t i o n . The question was asked: "What objectives do you have for i n t e r n a t i o n a l operations over the next f i v e years?" In some cases a general answer such as "to become a major i n t e r n a t i o n a l f i n a n c i a l i n s t i t u t i o n " was given. This i s f i n e as a statement of an 196 o v e r a l l objective, but some operational strategies must be implemented to achieve t h i s end. In a l l cases except one i t was c l e a r that the bank did not have an operational plan. The one bank that did, stressed the point that once objectives were established, progress toward achieving them i s c l o s e l y monitored. I t i s i n t e r e s t i n g to note that t h i s bank was described by other bankers as being the industry leader i n i n t e r n a t i o n a l operations. In two cases we were t o l d that the bank ei t h e r did not set objec-t i v e s or i f objectives were set by the top executive, they were not revealed to i n t e r n a t i o n a l d i v i s i o n . I t appears that there i s much room for improvement i n the planning area. Research c a r r i e d out by B. Bruce generally supports the above, and furthermore, Bruce discovered a tendency for the banks to engage i n "reactionary planning."*' Reactionary planning i s the same as Knicker-bocker's o l i g o p o l i s t i c reaction discussed below. That i s , the banks consider i t e s s e n t i a l to be where t h e i r competitors are. This phenomenon would be predicted from our t h e o r e t i c a l model which stresses growth over p r o f i t . Some American bankers deny that they enter markets because t h e i r competitors are there; implying that a t o t a l l y independent d e c i s i o n -making process i s followed. This contention i s not consistent with the evidence. There i s considerable evidence that growth i s the r e a l objective — r a t h e r than p r o f i t s . When asked about the objectives of i n t e r n a t i o n a l investment most bankers include p r o f i t s as a goal. However, when pressed with evidence that a s i g n i f i c a n t amount of foreign banking may be 1 9 7 unprofitable, bankers respond with the point, apparently w e l l known, that maximization of a system may require sub-optimal performance' from one or more sub-systems. Banks appear to draw on t h i s idea i n explain-ing t h e i r a c t i v i t i e s i n the i n t e r n a t i o n a l arena—and i t may be v a l i d . The thinking i s that an unprofitable foreign subsidiary may produce valuable but intangible benefits to head o f f i c e . The problem with t h i s type of analysis however i s that i t i s v i r t u a l l y impossible for the banks to obtain good evidence of the d o l l a r value of the i n v i s i b l e or c o l l a t e r a l benefits to head o f f i c e . There i s a danger that a r e a l l o s i n g foreign operation may be hidden i n the system. As mentioned above, there i s evidence that the banking industry engages i n o l i g o p o l i s t i c reaction (an i n t e r a c t i v e kind of corporate behavior by which r i v a l s i n i n d u s t r i e s composed of a few large firms counter one another's moves by making s i m i l a r moves themselves). 7 J u l i e n - P i e r r e Koszul, Vice-President, C i t i c o r p , says: Competition i s very intense among American banks. I t i s c l e a r that i f one American bank opens a branch i n a part of the world where American firms are located i t w i l l stand a good chance of getting the l o c a l companies' banking business. This would be too much for the other American banking competitors to s i t back and watch. 8 Koszul goes on to point out that there i s more at stake than j u s t loss of the f o r e i g n banking business of a major domestic c l i e n t : " I t i s also to prevent the head o f f i c e s of these foreign s u b s i d i a r i e s from g l o b a l l y s h i f t i n g t h e i r huge business to another more i n t e r n a t i o n a l American 9 bank." An example of t h i s i s the a c q u i s i t i o n by C i t i c o r p of the accounts of Samsonite, a Denver based manufacturer of luggage."^ 198 Commencing i n 1964, Samsonite established s u b s i d i a r i e s i n four European countries. As i t turned out Citibank had a branch i n each of the r e l e -vant areas. As a r e s u l t Samsonite turned to C i t i c o r p f o r i t s fo r e i g n banking needs and i t was not long before the bank obtained a s i g n i f i c a n t portion of the domestic business as w e l l . Walter Page, Vice-President, Morgan Guaranty believes that h i s company was able to move from number two bank for a major U.S. chemical company to number one because of services performed for the chemical company i n various foreign areas where Morgan had branches."'""'' Evidence that the follow-the-leader syndrome i s s t i l l going on i s provided by the recent change of events i n the Middle East. A recent Banker a r t i c l e e n t i t l e d "Bankers Troop to the Middle East" describes the rush by various banks to obtain a foothold i n a previously 12 ignored area. The Canadian Imperial Bank of Commerce and BankAmerica for example, have taken equity po s i t i o n s i n Compagnie Arabe et Inter-nationale d'Investissement i n an apparent attempt to tap some of the new 'petrodollars' flowing into the Arab states. The company was formed i n A p r i l 1973 and i s engaged i n channeling funds to the Eurodollar market and i n t o d i r e c t and p o r t f o l i o investments around the world. I t i s i n t e r e s t i n g to note that several other chartered banks had something to say about the Middle East market by the time t h e i r October 1973 annual reports were made a v a i l a b l e . South East Asia i s another case i n point. The big f i v e chartered banks have a l l recently established banking connections i n the area. The Toronto-Dominion Bank and The Royal Bank were f i r s t to make a 199 13 concentrated drive into the market. The other major banks now have made d i r e c t investments i n t h i s area as w e l l . In summary, i t i s hoped that t h i s b r i e f look at the d e c i s i o n -making process has added some support for our model. S p e c i f i c a l l y i t appears that the focus of decision-making on growth i s consistent with the model. The process of o l i g o p o l i s t i c reaction i s also consistent with the model. From an economic point of view of course these processes may appear i r r a t i o n a l . However, as Aharoni has pointed out, once pre-conceived economic notions are set aside, an orderly system of behavior 14 emerges. I t has not been the purpose of t h i s study to develop norma-t i v e theory based on r e s t r i c t i v e assumptions. Rather, our purpose has been to develop theory that can be used to describe and predict the behavior of banks. While o l i g o p o l i s t i c r e a ction, for example, might appear to p u r i s t s to be i l l o g i c a l , from the point of view of bank manage-ment the process may be e s s e n t i a l to the a b i l i t y of the bank to survive i n i t s competitive environment. The fact that some p r o f i t s may be s a c r i -f i c e d i n favour of growth becomes somewhat i r r e l e v a n t given a l l the c i r -cumstances . 200 Notes for Appendix II ^ Y a i r Aharoni, The Foreign Investment Decision Process (Boston: Harvard Un i v e r s i t y Press, 1966). 2 I b i d . , p. 9. 3 I b i d . 4 G. A. Constanzo, "Planning For International Growth," The  Banker (June 1974). 5 Business Week, "Annual Survey of Bank Performance," September 21, 1974. ^ Barry Bruce, "International Banking A c t i v i t i e s of Canadian and American Banks," M.B.A. Thesis, U n i v e r s i t y of B r i t i s h Columbia, 1969. 7 F. T. Knickerbocker, O l i g o p o l i s t i c Reaction and Mu l t i n a t i o n a l  Enterprise (Boston: Harvard U n i v e r s i t y Press, 1973). ^ J . P. Koszul, "American Banks i n Europe," i n The International  Corporation, C. P. Kindleberger (ed.). 9 I b i d . , p. 279. ^ Fortune (December 1967). 1 1 I b i d . 12 The Banker, "Bankers Troop to the Middle East," March 1974. 13 F i n a n c i a l Post, "Canadian Banks Push the Asian Connection," October 13, 1973. ^ Aharoni. 

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