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 UNIT 1: FOREIGN EXCHANGE CONTROL
SECTION 0: Introduction and Objectives

A. Introduction

This unit provides a comprehensive assessment of how the state and government
monetary agency that is the Central Bank interference with the free play of market
forces that determine the foreign exchange rate.

Understanding of the mechanism use in controlling foreign exchange rate in a country

is crucial to international banking operations.

B. Objectives

At the end of this unit, you should be able to:

Describe the foreign exchange control and its basic features Identify various mechanism
for foreign exchange control list the disadvantage of foreign exchange control

SECTION 1: Foreign Exchange Control Defined

Exchange control means the interference by the state, central bank or any other
agency with the free play of market forces that determine foreign exchange rate.
Exchange rates, under exchange control system, are fixed arbitrarily by the government
and are not determined freely by the forces of demand and supply. In other words,
exchange control system represents government domination of the foreign exchange
market. Each international transaction requiring payment in foreign currencies is
sanctioned by the government and all foreign exchange receipts from international
transactions are surrendered to the government. The main object of exchange control
is to secure stability of fixed exchange rate and to ensure balance of payments
equilibrium.

Exchange control may be complete or partial. Exchange control is complete when

the government has full control over the exchange market. In fact, under complete

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exchange control, there exists no exchange market and disequilibrium in the balance
of payment is impossibility. The exchange control applies to all types of international
transactions and the government restricts the sale and purchase of all currencies.
Exchange control is partial when the government partially controls the exchange
market. The exchange control applies only to certain types of international
transactions and the government restricts the sale and purchase of some selected
currencies.

Exchange control is a method of influencing international trade and investment as

well as the payments mechanism. As such, it has the advantages and disadvantages of
other means of protection. It is adopted by and is specially suited to those nations
which seek to achieve economic goals by manipulating the market behaviour. It is
not an appropriate measure for the free-market economies. For this reason, the system
of exchange control is commonly used in the less developed countries and the
communist countries.

Exchange control is the most drastic means of balance of payments adjustment. It

may be compared with other trade restrictions in respect of its impact and
administration: Exchange control is more certain than tariffs in its impact on a
country’s balance of payments; Exchange control has the advantage of controlling
visible trade and invisible transactions and capital movements; Whereas the trade
controls are generally operated by the ministry of commerce through customs
department, the exchange controls are usually operated by the central bank through
commercial banks; There may be some degree of discretion given to the individual
banks in case of exchange control. But, no such discretion exists in case of trade
controls.

SECTION 2: Features of Foreign Exchange Control

The system of exchange control possesses the following broad features:

The government monopolizes the foreign exchange business and exercise full
control over the foreign exchange market.

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 The rate of exchange is fixed officially by the government and the market forces
of demand and supply have no effect on its determination.
The government centralizes all foreign exchange operations in the hands of the
central bank which administers various foreign exchange regulations.
The exporters have to deposit all their foreign exchange earnings with the central
banks.
Imports of the country are regulated and the importers are allocated foreign
exchange at the official rates to enable them to make payments for the goods
imported.
The government or the central bank determines the priorities in the allocation of
scarce foreign currencies.
As a result of exchange control, the volume of imports gets automatically
reduced and there is a favourable impact on country’s balance of payments.

SECTION 3: Objectives of Foreign Exchange Control

The system of exchange control may be adopted to achieve different objectives.

Important among them are given below:

- To Correct Adverse Balance of Payments

A country may follow the system of exchange control when it faces a deficit in its
balance of payments and does not want to leave the process of adjustment either on
the mercy of automatic mechanism of fluctuating foreign exchange rates or on
deflation. By adopting exchange control, imports are restricted to the level
permitted by the availability of foreign exchange reserves and, thereby, the
balance of payments equilibrium is established.

- To check flight of Capital

Exchange control may be adopted to prevent the flight of capital from the country.
Flight of capital refers to the action of the citizen of a country to convert their cash

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holdings (i.e., short-term securities and bank deposits) into foreign currencies. Flight
of capital may be the result of speculative activities, economic fluctuations and
political uncertainty.

Flight of capital exhausts the country’s limited reserves of foreign exchange and
destabilise the economy. Through exchange control, the government imposes
restrictions on the sale of foreign currencies and there-by checks the flight of capital.

- To Stabilise Exchange rate

The government may adopt exchange control to check fluctuations in the rate of
exchange. Fluctuations in the rate of exchange are the normal feature in a free
exchange market and cause disequilibrium in the economic life of a country. These
fluctuations can be checked by officially fixing the exchange rate at a predetermined
level.

- To Conserve Foreign Exchange

Exchange control may be used to conserve country foreign exchange reserves

through exports. These reserves are restricted for; paying off external debt;
importing essential goods for economic development and purchasing defence
materials.

- To Check Economic Fluctuations

Cyclical fluctuations depression and inflation, spread from one country to another
through international trade. Exchange controls are used to check the spread of the
de-stabilising tendencies by controlling imports and exports.

- To Protect Home Industry

Exchange control may be resorted to protect the home industry from foreign
competition. For this purpose, the government restricts the imports through foreign

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exchange controls and thus provides opportunity to the domestic industries to
develop without any fear of international competition.

- To Practise Discrimination in Trade

Exchange control helps a country to follow a policy of discrimination in international

trade. The government fixes favourable rates of exchange for the countries with
which it wants to strengthen its trade relation.

- To Check Undesirable Imports

Exchange control is also needed to check the import of certain non-essential,

harmful and socially undesirable goods in the country.

- Source of Income

Exchange control can also be used as a source of income to the government. Under
the multiple exchange rate system, the government fixes the selling rates higher than
the buying rates and earns income equal to the difference between the two rates.

- Important for Planning

Exchange control forms an integral part of economic policy in a planned economy.

Planned economy development requires expansion, conservation and
proper use of foreign exchange reserves of the country according to the national
priorities. Exchange control system is directed to achieve these objectives.

- To Check Enemy Nations

Exchange control is also used by some countries to prevent the enemy countries from
using their foreign assets. Regulations are adopted to freeze the assets held by the
residents of the enemy country and they are not allowed to use or transfer these assets.

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- Overvaluation

Overvaluation refers to the fixing of the value of a currency at a rate higher than the
free market rate. It is also called pegging up.

Overvaluation, by making the home currency dearer for the foreigners, reduces the
prices of imports and raises the prices of exports. The policy of overvaluation is
adopted to facilitate the country to make its purchases at cheaper prices and to pay
off the foreign debts.

- Undervaluation

Undervaluation refers to the fixing of the value of a currency at a rate lower than the
free market rate. It is also known as pegging down.

Undervaluation, by making the currency cheaper for the foreigners, reduces the
prices of exports and raises the prices of imports. The policy of undervaluation is
adopted to promote exports, reduce imports and to give support to general rise in
prices.

SECTION 4: Methods of Foreign Exchange Control

A country desirous of adopting exchange control system can employ various

methods. Broadly these methods can be classified into two categories: direct
methods and indirect methods. Important methods of exchange control are
discussed below:

Direct Methods

1. Intervention or Exchange Pegging

A commonly adopted method of exchange control is the interference in the foreign

exchange market by the government or the monetary authority with the purpose
of either holding up or down the foreign exchange rate of its currency. This

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interference takes the form of purchasing and selling of home currency in the
exchange market and, thereby influencing the exchange rate. Intervention may be
active or passive. In the passive intervention, the monetary authority is prepared to
buy or sell the foreign currency at fixed rate without curtailing the right of the
public to deal in foreign exchange. In the active intervention the monetary authority
itself takes the initiative and bids for the foreign currency or offers it for sale with a
view to influence the exchange rate.

The government intervenes in the foreign exchange market through exchange

pegging. Exchange pegging refers to the act of fixing the exchange value of the
currency to some chosen rate. The government buys and sells the home currency
in exchange for foreign currency in order to establish a desired rate of exchange.
The pegging operation involves pegging up or pegging down the exchange rate.
When the exchange rate is fixed higher than the market rate, it is called pegging up;
when the exchange rate is fixed lower than the market rate, it is called pegging
down. In other words, pegging up means overvaluation of home currency and
pegging down means undervaluation of home currency and pegging down means
undervaluation of home currency.

In the pegging up operation, public demand for foreign currency increases and the
government must be ready to sell adequate foreign currency in exchange for home
currency. In the pegging down operation, public demand for home currency
increases and the government must be in a position to purchase foreign currency
in exchange for home currency. The exchange pegging should be used as a temporary
measure to remove fluctuations in the foreign exchange rate.

2. Rationing of Foreign Exchange

Under this method of exchange control, the government keeps the exchange value
of its currency fixed by rationing the ability of its residents to acquire foreign
exchange for spending abroad. The government imposes restrictions on the use, sale
and purchase of foreign exchange. All foreign exchange business is centralized

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either with the government or with its agents. All foreign exchange earnings are to be
surrendered by exporters to the central bank at the fixed exchange rate. The importers
are allotted foreign exchange at the fixed rate and in fixed amount. The government
also determines the priorities in the allocation of scarce foreign currencies.

3. Blocked Accounts

Block accounts refer to a method by which the foreigners are restricted to transfer
funds to their home countries. The method of blocking the accounts of creditor
countries is adopted by the debtor countries particularly during the periods of war
or financial crisis. Under this method, the foreigners are not allowed to convert
their deposits, securities and other assets into their currency. Their banking accounts
are blocked and they are not permitted to withdraw their funds and remit them to their
own countries.

4. Multiple Exchange Rates

When a country, instead of one single exchange rate, fixes different exchange rate
for the import and export of different goods, it is known as the system of multiple
exchange rates. Even for different countries or import of different exchange rates
are fixed. The system of multiple exchange rates amounts to a type of rationing by
price rather than by quantity and therefore does not directly restrict fee trade. The
system of different exchange rates for different goods and for different countries is
adopted with the objective of earning maximum possible foreign exchange by
increasing exports and reducing imports. The under developed countries can employ
this system to improve their balance of payments.

5. Standstill Agreements

Standstill agreement aims at maintaining status quota in the relationship between two
countries in terms of capital movement. This method was first adopted by Germany
after Great Depression of 1929. The main features of standstill agreements include
the fact that; the movement of capital is checked and the payments to the foreign

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exporters are made in easy installments instead of in lump sum; Short-term loans are
converted into long-term loans with a view to allow more time to the debtor country
to repay this debt.

6. Clearing Agreements

Clearing agreement refers to a system under which agreement is made between two
countries for settling their international trade account through their respective central
banks. Under this system, the importers instead of making payment for the imported
goods in foreign currency pay in home currency to their central bank. Similarly, the
exporters, instead of receiving payment for goods exported in foreign currency
receive it through the central bank in the home currency. Thus, the individual
importers and exporters need not clear their account in foreign currencies, but
in home currencies through their respective central bank and the transfer of
currencies from one country to another is avoided. If the exports and imports of the
two countries balance with each other, not further difficulty arises. But, if the exports
and imports of the two countries are not equal to each other, the net balance in the
clearing account is paid off in terms of gold. In this way, stability of exchange rate
is maintained through clearing agreement.

7. Payment Agreements

The system of payment agreement solves two major problems experienced

under the system of clearing agreement, that is the centralization of payments, and
the problem of waiting for the exporters.

Under the payment agreement between the two countries A and B, the exporter in
country A is paid as soon as information is received by the central bank of country A
from country central bank that the importers in country B has discharged his payment
obligation and vice versa.

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8. Compensation Agreements

This is a kind of barter agreement between the two countries under which the
exporter in a country is paid by the importing country in terms of certain goods on an
agreed basis. Since no payment is made in foreign exchange, the problem of foreign
exchange does not arise. Since the imports and exports of the two countries exactly
balance with each other, the rate of exchange between them remains stable and the
balance of payments equilibrium is maintained in the two countries.

9. Transfer Moratoria

Under the method of transfer moratoria, the payments for the imported goods or the
interest on the foreign capital are not made immediately but are suspended for a
pre-determined period, known as period of moratorium. A country adopts this
method of exchange control to temporarily solve its payments problems. The
importers and debtors make payments in the home currency and this payment is
deposited with some authorized banks, generally the central bank. During the period
of moratorium, the government used these funds and solves the foreign exchange
problems of the country. After the expiry of the moratorium period, these deposits are
transferred to exporters and creditors.

10. Exchange Stabilization Fund

The exchange stabilization fund was established by England in 1932, by America in

1934, and by France, Holland and Belgium in 1936 with the objective of neutralizing
the effects of wide fluctuations in the exchange rates as a result of any abnormal
movements of capital. The purpose of such a fund is to control seasonal or temporary
fluctuations in the exchange rate and not to interfere with the general trend in the
exchange rate and the forces influencing it. If there is large inflow of foreign
currency in the country, the exchange rate of the home currency rises. In such a
situation, the fund starts purchasing the foreign currency as a result of which the
upward movement in the exchange rate is checked. On the other hand if there is
large outflow of foreign currency, the exchange rate of the home currency falls. In

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 this case, the fund will sell the foreign currency which, in turn, will control the
downward movement of the exchange rate.

Indirect Methods

1. Change in Interest Rate

The government can influence the rate of exchange indirectly through changes in
the rate of interest. The exchange rate can be reduced by lowering the interest rate
and can be increased by raising the interest rate.

When the rate of interest is raised in the country, it attracts liquid capital and banking
funds of the foreigners. It will also prevent the capital flight because the nationals of
the country will tend to keep their funds in their own country. All this will tend to
increase the demand for home currency and, as a result, the exchange rate will move
in its favour (i.e. will rise). Similarly, lowering the rate of interest in the country will
have the opposite (i.e., depressing) effect on the rate of exchange.

2. Import Restrictions

Another indirect method of exchange control is to restrict the imports of the country
through measures like tariffs, import quotas and other such quantitative restrictions.
Import duties reduce imports by masking them costly. This raises the value of home
currency relative to the foreign currency. Similarly, import quotas fixed by the
government also reduce the volume of imports in the country, as a result of which the
demand for foreign currency falls, thus raising the value of the home currency in
relation to foreign currency. In this way, imposition of import duty and import quotas
raise the rate of exchange making it favourable to the country using import
restrictions.

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3. Export subsidies

Export subsidies refer to the financial assistance to industries producing exportable

goods. Export subsidies increase exports. As a consequence, the demand for home
currency in the foreign exchange market increase, thus raising the rate of home
currency in terms of foreign currencies.

SECTION 5: Defects of Exchange Control

In spite of the fact that a large number of nations, especially the less developed
countries, have resorted to the exchange control system, International Monetary
Fund (IMF) strongly opposes the adoption of exchange control by the member
countries because of its serious defects. Important defects are as follows:

i. The system of exchange control is not based on the sound comparative cost
principle of international trade according to which every country tends to
specialize in the production and export of that commodity of which it enjoys
comparative natural advantage. Thus, the advantages of international
specialization are sacrificed under the system of exchange control. Economic
resources are not optimally utilized.
ii. Exchange control leads to the reduction in the volume of international trade
and contraction of world welfare.
iii. iii. Exchange control encourages bilateral trade and deprives the country from the
gains of multilateral trade.
iv. iv. Exchange control is an arbitrary system. It encourages retaliation and restrictive
tendencies.
v. Exchange control interferes in the competitive working of the economy and
distorts its economic structure by diverting the resources in less economical
and less efficient areas of production which do not represent maximum natural
advantage.

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vi. Exchange control has undesirable effects on the internal economy of the country.
Restrictions on imports may lead to inflationary rise in prices due to scarcity of
restricted goods.
vii.vii. Exchange control provides only a temporary remedy to the problem of
disequilibrium in the balance of payments. Instead of basically solving the
problem, it prevents the situation from becoming worse.
viii. Exchange controls involve; large administrative costs to enforce the exchange
controls; resource waste in the process of trying to evade the controls or of
applying for foreign exchange licenses; and psychological costs of the inevitable
perceived injustices created by the controls or their evasion.
ix. Exchange control system is also morally undesirable because it breeds
corruption in the country. Need traders use all types of illegal methods to obtain
the desired amount of foreign exchange which has been rationed by the
government?
x. Exchange control system involves great social costs and does not lead to the
maximization of community’s welfare.

UNIT 2: EURO DOLLAR MARKET

SECTION 0: Introduction and Objectives

A. Introduction

In both domestic and international arena, among the most profitable of many services
offered by a bank is its loan department. The existence of the Eurodollar market
facilitates ³hot money´ flows between nations through providing a safe base
currency for speculative transactions. This unit investigates the operation of Euro
Dollar Market in international business environment.

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 B. Objectives

At the end of this study unit, student should be able to:

Trace the origin of Euro Dollar Market Discuss operational modes of Euro Dollar
Market

Explain Risk associated with Euro Dollar Market

SECTION 1: Nature of Eurodollar Market

Eurodollars may be defined as United States dollars on deposit in banks located

outside the country of issue. The Eurodollar market serves as an international money
market used by commercial banks and institutions around the world. The Euro-
currency market is comprised of those banks located outside the country in whose
currency the deposits are denominated. This would include foreign branches of
domestic banks as well as foreign banks. The total Eurocurrency market is composed
of all foreign currency denominated accounts which, besides the Eurodollar, is mainly
composed of Euroyen, Euroguilders, Eurodeutschemarks, and Euroswiissfrancs.
The market for such Eurocurrencies is centered in London. Nevertheless, substantial
markets also exist in Hong Kong, Luxembourg, Singapore, the Caymen Islands,
and the Bahamas. These centers can compete effectively with banks located in the
issuing countries (that is, country of the currency). For example, Eurodollar
deposits are as substitute for U.S dollar deposits at banks located in United States.
However, only a few United State banks are involved in these markets due to the level
of expertise and capital commitment required. Although there is presently a shift in
the number of loans in major markets, most syndicated loan for Eurocurrencies are
arranged in London due to the high level of expertise found there, even if ultimately
the loans are booked elsewhere for tax or other reasons. In addition, the large majority
of Eurocurrency loans are demonstrated in Eurodollars.

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SECTION 2: Historical Background of Eurodollar Market

Events occurring in the late 1950s and early 1960s prompted the development of a
Eurodollar market. The political climate during that period was such that there was
rising concern on the part of the U.S.S.R. regarding the security and free accessibility
of it U.S dollar deposits.

Rather than risk possible confiscation or blocking of their accounts, the U.S. dollar
denominated deposits were placed in banks located in London. In that way, the
accounts were beyond the jurisdictional reach of the United States by being booked
outside its territory. This method was used since the U.S.S.R did not wish to
convert its U.S dollar holdings to weaker and less reliable currencies. Thus, the
creation of U.S dollar denominated accounts outside of the United States at that
time offered a more political secure arrangement for the funds.
Further spurring the development of the Eurodollar market was the enactment of
laws and regulations designed to improve the United States balance of payments by
reducing outflow of capital for foreign investment. For example, the Interest
Equalization Tax of 1964 and the Foreign Direct Investment Regulations prevent U.S
capital markets from funding domestic or foreign capital needs for operations
outside the United States. It was during this period that the growth of the Eurodollar
market accelerated. In addition, the number of foreign branches of US banks
established during this time increased significantly, due in large part of the fact that
the transaction of these branches were not subject to regulations applicable to
domestic institutions.
Therefore, dollars were drawn away from American banks to higher- yielding
foreign accounts. The absence of regulatory controls, interest rate limitations, and
reserve requirements imposed on domestic deposits, allowed offshore banks to offer a
higher interest rate on deposits while realizing a greater rate of return than on
domestic deposits.

Nevertheless, the main motivations for placing U.S dollars in the Eurodollar market
are lower costs of regulation as well as higher returns on funds. This is reflected in the

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fact that, from 1966 to 1973, growth in the Euro market was much greater than during
the years after the 1973 oil price increase. Therefore, deposits of OPEC oil fund
surpluses in the Euro-market can be said to represent redistribution in the ownership
of wealth and Euro-deposits.

During the market’s formative years, fixed time deposit accounts lured investors to
place their funds in the Eurodollar market. Time deposits remain the dominant form
of Eurodollar investment, in maturities ranging from overnight to several years,
with the majority of deposits taken from three to six months.

SECTION 3: Euro-dollar Market Activities

The Euro-dollar market specialized in accepting short-term deposit and in making

short-term loan. These funds are used to satisfy liquidity requirements of banks
and financial firms, as well as being used for trade financing and interest arbitrage.
If access to a longer-term market is desired, the smaller Eurobond market offers an
alternative. With the growth of the market, various ³rollover´ devices developed for
both CD deposits and loans. As with CDs, the rolling-over of a Eurodollar loan
achieves the same effect as entering a loan with a longer term; applicable
interest rates are periodically adjusted by the terms of the loan agreement, however,
to reflect fluctuations in the current market rate. Changes in short-term deposit rate,
ordinarily based upon LIBOR (or the (London Inter-bank Operating Rate),
account for such fluctuations.

In a Eurodollar loan context, the lender will acquire a deposit normally at an interest
rate fixed on the LIBOR in effect two days form the date of acquisition. The amount
of the deposit and its duration will match the amount of the loan and the period for
which it will be outstanding. A loan agreement typically reflects this practice by
setting the loan interest in relation to LIBOR rate two days from the beginning of the
loan period.

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SECTION 4: Risk of Eurodollar Market

The decision to lend is based upon the bank’s assessment of the risk that the funds
lent will not be repaid with the interest and at the time agreed upon. Assessment of
risk affects not only the decision to lend, but also the structure of the loan and the
interest rate to be charged as compensation for what is, in fact, a calculated
gamble. While some of the risks to be found in Eurodollar transactions are
amenable to negotiation and apportionment between borrower and lender, some
general types of risk must be borne in mind by both parties when initially
deciding to enter the market. Three major areas of assessment include currency risk,
country risk, and credit risk.

1. CURRENCY RISK

Currency risk encompasses two major forms of risk exposure; risk of fluctuations in
currency value and risk of interference with repayment from local exchange control
restrictions.

The transfer of funds across international borders requires conversion from one
national currency into that of another, whether the transfer be the original
transmission of loan funds, periodic advances of funds, or debt repayment. The
exchange rates at which currency conversions are made constantly fluctuate. It is
therefore possible that throughout the duration of loan, as fund transfers become
necessary, the desired currency will either be unavailable or prohibitive in cost.
Obviously, this subjects the parties to a potential serious risk of exposure to un-
predictably greater funding costs than originally bargained for. The borrower, who
will be making payments perhaps years from the signing of the loan agreement, is not
the only party to face this problem. The lender also faces this risk when making
periodic advances of funds, called draw-downs, as well as when receiving
repayment of funds whose value may differ greatly from the time of lending.

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 2. COUNTRY RISK

Political, economic, and jurisprudential conditions in the borrowers country will

have obvious and far-ranging impacts on the decision to lend. This aspect of the
loan decision may illustrate the limits of pure legal or economic analysis as
experience and judgment are heavily called upon in assessing and limiting this risk.
Certain risk factors may be anticipated in the loan agreement and guarded against.
Nevertheless, adequate and realistic evaluation of political and economic events can
mean the difference between a profitable loan transaction and a default situation.

In regard to defaults, one should realize that, in the event of a breach of the
agreement, legal remedies will vary from state to state. Moreover, these legal
remedies may be either inconsistent or in conflict with each other and thus should
be provided for Eurodollar transactions. Otherwise, disputes may arise as to the
proper legal principles to be applied in the event of disagreement between the
parties. Perhaps of more importance, the sophistication and integrity of local tribunals
and judicial systems, upon which the parties will rely to enforce their agreement,
must be also be considered.

Eurodollar transactions are particularly vulnerable to jurisdictional disputes. Since,

in effect, Eurodollars are foreign currency every country, no one country can be
relied upon for support in the event of a deposit holding bank’s failure. Unlike
banking systems such as that of the United States, the Eurodollar market does not
have an official ³lending of last resort,´ such as the Federal Reserve Bank to which
it may turn in the event of an emergency.

3. CREDIT DECISIONS

Greater costs are incurred in acquiring information with which to assess risks in
dealing with foreign banks, particularly those new to international markets. Credit
officers must deal with a greater lack of credit information when making an
international investment decision as compared to similar investment in a domestic
context. For example, the lending officer must evaluate:

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- character and business reputation of the borrower;
- business history and financial polices of the institution;
Despite the knowledge of which factors to asses, however, significant difference
between domestic and foreign business and accounting practices frequently pose
difficulties when a straightforward credit analysis based on domestic principles is
attempted.

a. Concept of Syndication

Syndication involves a number of lending banks, which when acting in concert are
effectively able to extend the size limit of loans that could be made individually on
the Eurodollar market. The banks are also able to spread their risks amongst
themselves. Each lenders obligation is generally separate.
Syndication of the lending commitment among several participating banks adds
flexibility to the making of Eurocurrency loans, a development that benefits both the
borrowers and lenders. Many of the technical functions of credit evaluation and
servicing are provided by a lead bank which typically is an experienced
international bank. As a result of this procedure, access to the international
lending market has been provided to relatively unsophisticated banks whose
limited resources would otherwise prevent their being direct lenders. The resulting
larger ³SRRO´ of loan funds permits borrowers to arrange loans of a size that would
be beyond the capabilities of individual institutions, due to limitations such as those
found in U.S. banking regulations.

The syndication process requires the involvement of several participant lenders from
the outset and entails several steps aimed at meeting the requirements of
individual lenders, as well as those of the borrower. These include:

- information of the loan package;

- marketing to other participants ;
- administration of the loan.

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The responsibility for accommodating the demands of these divergent groups falls
on the lending, or manager, bank.

At the outset, the lead banks managers, responsibility is to negotiate with the
borrower and determine the most efficient and profitable means of selling the loan.
This is accomplished through credit analysis and a full assessment of the risk
factors. Thereafter, interest in the package terms is solicited from other prospective
participating banks that may ultimately join with the manager to extend credit.
Participations may be offered on the general market, in much the same way that
securities might be offered. However, due to this similarity the manager runs a risk of
subjecting the offering to rigorous disclosure requirements under securities laws.

b. Syndication Loan Marketing

Typically, one of the three distinct means is available for the manager to market the
loan. Briefly, these include:

i. Best-efforts syndication

Best-efforts syndication contemplates a completed set of terms and conditions that

will be offered on the market by the manager and, if not accepted by lenders,
withdraw with no further commitment to the borrower.

ii. Firm-commitment syndication

Firm-commitment syndicate pre-suppose a commitment to lend by the manager,

who, if unsuccessful in marketing the loan to others, will assume the un-marketed
portions on its own books. Managers normally will not agree to underwrite a
syndicated loan. As a result, borrowers typically agree on the best-efforts method.

iii. Pre-advanced syndication

Pre-advanced syndicate provides for a firm commitment by the manager to lend at

specific terms, with the right to participate the loan out at a later date.

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The syndication of international loans has developed in response to ever increasing
credit demands of large borrowers. The Eurocurrency market is a main source of
funding for international banks and institutions. With sufficient expertise, the
extension of Eurocurrency loans offers the opportunity for increased revenues and
business. However, some of the dangers present in such transactions must be
appreciated and carefully analyzed.

UNIT 3 BANKERS’ ACCEPTANCES, COLLECTIONS

AND CHEQUES CONTENTS
SECTION 0: Introduction and Objectives

A. Introduction

Several methods are available to those who wish to effect international payments,
apart from the use of letter of credit as discussed in the previous unit. In this unit, we
examine other payment options that may be employed in making international
payments. These include; Bankers’ Acceptance, Collections and Cheques.
B. Objectives

At the end of this unit, you should be able to:

Explain banker’s acceptances, collections and Cheques
Identify different types of bankers’ acceptances and Cheques
Identify Uniform rules of collection

SECTION 1: Bankers’ Acceptances Defined

A banker’s acceptance is a draft or bill of exchange drawn on a bank (the drawee) by a
party (the drawer) and accepted by that bank to pay a third party (the payee) a certain
sum at a fixed future date. The bank’s acceptance of a draft represents a formal
acknowledgement of the bank’s unconditional promise to pay the draft at maturity. A

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distinction should be made between the bankers’ acceptance and a letter of credit
under which it is often created, since the acceptance is a credit mechanism whereas
the letter of credit is a security device.
Bankers’ acceptances represent a flexible and efficient means of obtaining credit for
short periods of time. They are utilized particularly in instances where the underlying
transaction is self-liquidating in nature. The transaction financed by this type of
acceptance will thus produce the funds necessary to pay off the acceptance. Thus, the
bankers’ acceptance covers the time normally needed to ship and sell goods. In theory,
this eliminates a great deal of risk of the accepting bank since payment will be
forthcoming from the transaction.
On the other hand, the fact that the bank assumes primary responsibilities for payment
upon creation of an acceptance eliminates substantial risk from the point of view of
the purchaser of the acceptance. The steps followed in the creation of an acceptance
involve a presentation of the draft signed by the drawer to the drawee for
acknowledgement or acceptance of its payment obligation on the face of the draft
along with the drawee’s signature. Any words of acceptance that accompany the
signature can create a valid acceptance. If the drawee is a bank, the draft is called a
bankers’ acceptance. Since these actions are taken prior to the due date of the draft, all
that remains it to await its maturity for payment of the draft. If funds are desired prior
to maturity, the holder may be able to sell it at a discount as an alternative. An
acceptance is evidenced by an authorized signature appearing on the face of the draft
and must be accompanied by delivery or appropriate notification to the holder.
Liability on an accepted instrument is primarily that of the accepting bank and is
unconditional. The drawer of the draft is now secondarily liable unless his signature
was accompanied by the words ³without recourse´.

SECTION 2: Dimensions of Acceptances

Acceptances may be created for reasons related to trade and for non-trade reasons.
A. Trade-Related Acceptances

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Trade-related acceptance may be created in the buyers’ and seller’s attempt to finance
their deal. Typically, a buyer of goods does not have cash to pay to the seller. The
buyer will seek out a bank to act as his intermediary and provide the credit he needs
until he has the cash (such as when he has sold the goods that he is now seeking to
buy). If a bank is willing to provide its assurance that payment will be made, it notifies
the seller that he may draw a draft on the bank for an indicated naira amount payable
at a future date. The bank then stamps ³ACCEPTE'´ across the face of the draft and
places an authorized bank signature on the draft.
B. Non-trade-Related Acceptances

The uses of acceptances are not limited to the needs of trade. One type of non-trade-
related acceptances is known as a finance bill. This type of bill raise working capital
for the firm drawing the draft, and it is a corollary to commercial paper. Another type
of non-trade-related acceptance is known as a dollar exchange bill. Dollar exchange
bill is another type of non-trade acceptance that is used to finance the extension of
dollar exchange credits to foreign countries. This type of financing is especially
attractive to foreign banks in countries whose exports to the U.S are highly seasonal.
Through the dollar exchange acceptance, a bank seeks to provide itself with dollars to
finance its customer’s imports during seasons when export earnings are low and
dollars are in short supply.

SECTION 3: Investors in Acceptances

Acceptance investors include state and local governments, governmental agencies,

savings institutions, foreigners, foreign central banks, industrial corporations,
insurance companies, investment funds, accepting banks, and individuals. In addition,
banks may join together to syndicate eligible acceptances. Non-bank investors play a
limited role even though acceptance yields are comparable to commercial paper
yields. This is so because it is difficult to obtain large blocks of bankers’ acceptances
with the maturity desired. Initial investors usually hold acceptances to maturity.

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SECTION 4: Concept of Collections

In a typical import-export situation, the collection procedure entails the delivery of a

collection order by the principal (a seller of goods) to the remitting bank with specific
instructions to have them presented through a collecting bank to the buyer. The bank
will arrange for presentation of the draft to the importer for payment or acceptance,
depending upon the seller’s instructions, in conformity with its role as collector for the
principal. The most important bank in the collection process is the presenting bank
because it is responsible for the release of documents against payment or acceptance.
The bank is frequently designated by the exporter since it controls the funds paid by
the importer until receipt by the exporter’s bank. However, if the principal does not
choose a collecting bank, the remitting bank may choose any bank in the country of
payment or acceptance in order to carry out the instructions of the principals.
Significantly, the intermediary banks involved in the collection process act as agents
for collection. As agents for collection, banks would not normally have the authority
to sell goods in the case of non-payment by the initial buyer. This method of payment
minimizes the bank’s responsibilities concerning payment when the standard
procedures of presentation and acceptance are followed. More importantly, the bank’s
liability for payment of the draft is eliminated, since the credit of the bank is not
substituted for that of the buyer.

SECTION 5: Uniform Rules of Collections

Over the years, uniform terms, rules, and procedures have evolved and are now
routinely applied by banks when handling documents for collection payments. The
uniform Rules Brochure No. 322 (URC), prepared by the International Chamber of
Commerce, is one of the more comprehensive codifications of these principles; for
that reason, it is recognized and used by most banks in both the developed nations like
United Sates and developing countries like Nigeria.

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The articles of the Uniform Rules for Collection are divided into subsections
governing particular phases of the collection process. These include: Responsibilities
of the Bank As a general matter, the responsibilities, as well as the limitations on the
collecting bank’s liability, are contained in the Uniform Rules for Collection (URC).
Normally, an agreement for collection entered into with a bank is made subject to the
URC. In addition, however, certain provisions of the Uniform Commercial Code
(UCC) may otherwise be found applicable to a bank collection. The application of the
UCC to bank collections may be varied by agreement of the parties. Nevertheless, no
agreement can disclaim a bank’s responsibility to deal in good faith and exercise
ordinary care.
Furthermore, damages resulting from the bank’s failure to exercise such duties may
not be limited. Collection Order The procedure for presentation of documents is
contained in the collection order issued by the principal, which defines the permissible
actions of the bank and, in so doing, establishes additional rights and obligations
between the parties. The collecting banks have the responsibility to comply with the
specific instructions for collection contained in the order, in the event that these
instructions cannot be complied with, the bank must immediately advise the party who
initially submitted the order of any difficulties.
Additional items that may be included in the collection order are terms concerning
who will pay costs, conditions to be met for release of documents, methods of
transferring payment, procedures to be employed in case of non-payment, and
protection of goods against loss. Protest Frequently, the protest procedure or formal
demand for payment is a legal prerequisite to suit in foreign jurisdictions for non-
payment of an accepted draft or bill of exchange. This official protest must satisfy the
formal prerequisite to suit for payment on the accepted instrument.
The case of the buyers’ refusal to accept the draft, a suit for breach of contract is the
most likely legal remedy. Presentation Once the presenting bank is in possession of
the collection order, drafts, and /or documents, presentation will be made to the buyer
as drawee. Therefore, the bank notifies the buyer of the arrival of the draft and
documents. The bank is required to make presentation for payment without delay if
the documents (including drafts) are payable on sight.

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Presentation for acceptance must also be made without delay and before the specified
maturity date. Advice of non-payment or non-acceptance may be called for if
difficulties arise. The draft will be presented to the buyer as drawee. The drawee only
has the right to examine the collection documents held by the bank; that is, actual
delivery of the documents to the buyer may occur only after the buyer has satisfied the
seller’s conditions.

Payment
The currency of payment is an important factor to consider when international
collections are being handled. Potential problems may be caused by local foreign
exchange regulations and interfere with the immediate transfer of proceeds to the
seller. If local currency is called for by the collection order, the presenting bank must
release the documents only against payment in local currency that is immediately
available for disposal according to the terms of the order.
If the collection order requires payment to be made in foreign currency, the bank must
only release documents against payment in the foreign currency provided it may
immediately be remitted according to the terms of the collection order.

Partial Payment
A situation may arise where the buyer wishes to make partial payment of his
obligation. The URC specified that partial payment may not be accepted as a
condition of release of documents unless authorized by the principal. Consequently, in
the case of documentary collections, the presenting bank may release documents only
against full payment. Unless authorized, partial payment need not be accepted.

SECTION 6: Cheque Defined

Cheque, drafts, and money orders are an integral part of the payment mechanism in
use both in the International business environment. A Cheque is a three-party
instrument drawn on a payer bank (the drawee) by its customer (the drawer) ordering
a specific sum to be paid to a payee. The fact that the Cheque is drawn on a bank
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distinguishes it from an ordinary draft. A draft is an instrument whereby the drawer
orders the drawee to pay a specific sum of money on the indicated date or on demand
to the order of a payee.
Therefore, Cheques are simply a demand unless post-dated. In effect, the Cheque
represents the drawer’s instructions to the bank to pay money held in the drawer’s
account to the specific third party.
Two basic types of Cheques are used commercially; personal checks, which include
checks drawn by business and other establishments, and bank Cheques.
The most important distinction between personal and bank Cheque is the identity of
the party having primary responsibility for payment of the Cheque. In the case of a
bank Cheque, the bank is primarily liable as the drawer thereof, whereas in the case of
a personal Cheque, the bank typically serves merely as drawee without assuming
primary liability for payment for the instrument. Liability for a personal Cheque may
be shifted onto the bank as regards third parties through the procedure of certification.

SECTION 7: Forms of Cheques

There are different forms of cheques. Some of these include: Certified Cheque,
Cashier’s Cheques, Teller’s Cheques, Traveller’s Cheque and Euro-Cheques.

i. Certified Cheque
Certification of Cheque indicates that: The Cheque is drawn on sufficient funds in the
hands of the drawee bank; these funds have been set aside for the satisfaction of the
Cheque; and that the funds will be paid to a holder entitled to the funds when the
Cheque is presented for payment since certification constitutes an acceptance by the
drawee bank. Because the customer’s account is charged for the amount of the Cheque
when it is certified, the bank is obliged to make proper payment even when it is
presented for payment more than six months after its date. This differs from the
general rule governing ordinary Cheques whereby the drawee bank is under no
obligation to pay a Cheque that is considered ³sWDOH´ (that is, one that is presented
for payment more than six months after its date).
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ii. Cashier’s Cheques
Cashier’s Cheques are one of the most frequently encountered forms of bank cheque.
A cashier’s cheque is a draft or bill of exchange that is drawn by the bank on itself and
that is issued by an authorized officer or employee of the institution. Thus, a cashier’s
cheque differs significantly from an ordinary cheque drawn by a customer on an
account, as well as from an ordinary bank or cashier’s cheque. The banker’s cheque is
a draft drawn by one bank upon another bank. For this reason, the banker’s cheque is
subject to the general rules governing ordinary cheques including those permitting
stop-payment orders. When the bank issues a cashier’s cheque, a direct payment
obligating is created. Furthermore, this obligation is said to be accepted by the mere
issuance of the cashier’s cheque. The bank has an independent and direct obligation to
the holder to honour the instrument.
iii. Teller’s Cheques
Instruments drawn by savings banks and savings and loan association and commercial
banks are known as teller’s cheque. In effect, the institution draws a cheque on its
account held at a commercial bank. Such a cheque is not issued by the commercial
bank as in the case of a cashier’s cheque. For this reason, the act of issuing such a
cheque does not in itself constitute acceptance of a primary payment obligation.
Although courts are in disagreement on this point, several instances have occurred
where a stop payment order was effectively placed by the drawer institution, making
such a cheque resemble a personal cheque rather than bank cheque in this regard.
iv. Traveller’s Cheque
Traveller’s cheques are instruments having the features of a cash substitute, which
offers the security of a cashier’s cheque. In fact, when issued by a bank, traveller’s
cheques are essentially equivalent to cashier’s cheques once a proper endorsement in
the form of a countersignature is placed upon the instrument. The cheque form
typically provides a space for the signature of the purchaser, which is used for
comparison with the countersignature at the time payment. Thus, the countersignature
requirement provides security against loss or theft subsequent to the purchase of the
instrument since the cheque is properly payable only if a valid countersignature is
placed on the instrument at the time of payment.

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v. Euro-Cheques
The Euro-Cheques is a blank cheque issued in a uniform format and colour by any of
the member banks of the European countries that formed the Euro-cheque system.
Despite their official appearance, the Eurocheque is like an ordinary cheque even
when cashed with what is called the Euro-cheque Guarantee Card. The Euro-cheque
guarantee of payment extends only to European countries and to some North African
countries bordering on the Mediterranean Sea. Therefore, a Euro-cheque should be
treated like an ordinary cheque since the guarantee does not extend to all parts of the
world.

SELF ASSESSMENT EXERCISES

i. Define Bankers’ Acceptances and State the various types of acceptances.
ii. Enumerate the key players in the acceptance market.

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