What are the risks that bankers assume when making loans to foreign borrowers?This question is from a International Business course
In my mind, foreign investment always holds some level of risk and challenge. A nation has to strike some level of balance between making loans to foreign borrowers and not overindulging in it. At any point when foreign capital occupies a dominant presence in an economic setting, I think that challenges can be present. Maintaining this balance is a risk that bankers assume and something that has to be kept in mind when conducting foreign transactions as well as making loans for foreign borrowers. If such loans become unchecked and not soundly made, economic challenges can result for both the domestic bank and the community it represents. I think that ensuring that loans are made that can paid back in a timely manner as well as making sure that the balance between foreign money and domestic value is followed and respected is critical for bankers, and a risk that has to be undertaken.
When bankers provide loans to foreign borrowers they face a risk of the borrower defaulting and another risk due to a change in the exchange rate currencies.
Banks decide the rate of interest that is charged based on the credit rating of foreign borrowers provided by credit rating agencies. These are calculated by the rating agencies based on the assets and liabilities of the borrowers and the anticipated cash flows. Banks have to discount the ratings of the borrower with the credit rating of the nation in which the borrower is based. For example, if there are two borrowers with similar credit ratings, one based in the UK and the other in Greece, the bankers would have to take into account the fact that Greece has a lower credit rating than the UK, and therefore charge a higher rate of interest from the borrower based in Greece. This is one of the ways in which the default risk can be reduced.
The exchange rate risk arises due to fluctuations in the exchange rate of currencies which may lead to a difference in the exchange rate when the loan is issued and when it has to be repaid. This can be dealt with using currency derivatives, which include futures and options.