Case Scenario: JAPANESE LOANS AND FORWARDS
1. Show how Japanese banks were able to create the dollar-denominated loans synthetically using cash flow diagrams.
2. How does this behavior of Japanese banks affect the balance sheet of the Western counterparties?
3. ?What are nostro accounts Why are they needed? Why are the Western banks not willing to hold the yens in their nostro accounts?
4. What do the Western banks gain if they do that?
5. Show, using an "appropriate" formula, that the negative interest rates can be more than compensated by the extra points on the forward rates. (Use the decompositions given in the text.) NEW YORK, (Reuters) - Japanese banks are increasingly borrowing dollar funds via the foreign exchange markets rather than in the traditional international loan markets, pushing some Japanese interest rates into negative territory, according to bank officials. The rush to fund in the currency markets has helped create the recent anomaly in short-term interest rates. For the first time in years, yields on Japanese Treasury bills and some bank deposits are negative, in effect requiring the lender of yen to pay the borrower. Japanese financial institutions are having difficulty getting loans denominated in U.S. dollars, experts said. They said international banks are weary of expanding credit lines to Japanese banks, whose balance sheets remain burdened by bad loans.
"The Japanese banks are still having trouble funding in dollars," said a fixed-income strategist at Merrill Lynch & Co. So Japan's banks are turning to foreign exchange transactions to obtain dollars. The predominant mechanism for borrowing dollars is through a trade combining a spot and forward in dollar/yen. Japanese banks typically borrow in yen, which they have no problem getting. With a three-month loan, for instance, the Japanese bank would then sell the yen for dollars in the spot market to, say, a British or American bank. The Japanese bank simultaneously enters into a three-month forward selling the dollars and getting back yen to pay off the yen loan at the stipulated forward rate. In effect, the Japanese bank has obtained a three-month dollar loan. Under normal circumstances, the dealer providing the transaction to the Japanese bank should not make anything but the bid-offer spread. But so great has been the demand from Japanese banks that dealers are earning anywhere from seven to 10 basis points from the spot-forward trade.
The problem is that the transaction saddles British and American banks with yen for three months. Normally, international banks would place the yen in deposits with Japanese banks and earn the three-month interest rate. But most Western banks are already bumping against credit limits for their banks on exposure to troubled Japanese banks. Holding the yen on their own books in what are called NOSTRO accounts requires holding capital against them for regulatory purposes. So Western banks have been dumping yen holdings at any cost-to the point of driving interest rates on Japanese Treasury bills into negative terms. Also, large Western banks such as Barclays Plc and J.P. Morgan are offering negative interest rates on yen deposits-in effect saying no to new yen-denominated deposits. Western bankers said they can afford to pay up to hold Japanese Treasury bills-in effect earning negative yield- because their earnings from the spot-forward trade more than compensate them for their losses on holding Japanese paper with negative yield. Japanese six-month T-bills offer a negative yield of around 0.002 percent, dealers said. Among banks offering a negative interest rate on yen deposits was Barclays Bank Plc, which offered a negative 0.02 percent interest rate on a three-month deposit. The Bank of Japan, the central bank, has been encouraging government-lending institutions to make dollar loans to Japanese corporations to overcome the problem, said [a market professional]. (Reuters, November 9, 1998).