International banking lesson 04

34 International Banking LESSON 4 EUROCURRENCY MARKET CONTENTS 4.0 Aims and Objectives 4.1 Introduction 4.2 The Creation of Euromoney 4.3 Growth of the Euromarkets 4.4 Operation of

34

International Banking LESSON

4

EUROCURRENCY MARKET

CONTENTS

4.0 Aims and Objectives 4.1 Introduction

4.2 The Creation of Euromoney 4.3 Growth of the Euromarkets 4.4 Operation of the Euromarkets 4.5 Typical Euro Bank Balance Sheet 4.5.1 Liabilities

4.5.2 Assets 4.6 Functions of the Euromarkets 4.6.1 Foreign Exchange Hedging 4.6.2 Domestic Intermediation 4.6.3 International Intermediation 4.7 Interbank Transactions

4.8 Default Risk of Eurocurrency Banks 4.9 Let us Sum up

4.10 Lesson End Activity 4.11 Keywords

4.12 Questions for Discussion 4.13 Suggested Readings

4.0 AIMS AND OBJECTIVES

After studying this lesson, you should be able to understand:

z The growth of eurocurrency market

z The practices of the Eurocurrency system

4.1 INTRODUCTION

The Euro currency markets constitute the short to medium term debt part of the international capital flow structure The market is made by banks and other financial institutions that accept time deposits and make loans in a currency or currencies other than that of the country in which they are located The latter characteristic defines the Eurocurrency market - it is a non-domestic financial intermediary In the light of the rapid growth of similar institutions in Hong Kong and Singapore (and to a lesser extent in the Middle East) the market is new worldwide and is more appropriately called the offshore or external money market Growth of this new work of intermediaries has been spectacular The Eurocurrency market is extremely large and

35 Eurocurrency Market

has grown rapidly in a short interval It has received a bad press from central banks,

which continue to call it a major cause of inflation and an obstacle to their control of

domestic monetary systems A number of basic questions and issues crop up soon as

one looks at the offshore capital markets First, what separates them from domestic

markets? Second, why were they needed and how could they grow so fast when

sophisticated domestic capital markets already existed? Third, is there a process of

offshore money creation analogous to money creation in a domestic banking system

and what effect does this have on world inflation?

4.2 THE CREATION OF EUROMONEY

There are no offshore currencies, only national currencies of different countries A

national currency deposit becomes part of the offshore currency market when it is

transferred to a bank outside the controlled national, monetary system This usually

means transferred to a bank outside the nation in question Offshore deposits can be

created in two ways:

1 One can take the physical currency of a country and deposit it in a bank in another

country Banks do hold currency for other countries but mainly for the

convenience of travelers And large quantities of currency have been smuggled

out from time to time in recent years However this is usually done with the

expectations of a depreciation of the currency being smuggled, and the receiving

banks quickly convert these balances into some hard currency So this method is

in general of trivial importance as a creator of deposits

2 One can transfer deposits from within the country whose currency is in question

to an offshore bank This may well be an overseas subsidiary of the very same

bank with which the original deposit was held

If we confine our attention to domestic money supplies, the offshore currency markets

could only cause inflationary pressure if they could lower statutory reserves against

deposits by allowing transformation of deposits from one category to another (and if

there were different reserve requirements against the different categories of deposits)

This actually happened briefly in the United States in the late 1960s While there were

reserve requirements against ordinary deposits, there were none against banks'

borrowings from foreign branches When domestic rates came to exceed the

Certificate of Deposits (CDs) ceilings, then in effect, funds from domestic U.S CDs

were transferred to London branches of American banks (which faced no interest rate

ceilings) and were then loaned to the parent banks Since there were no reserve

requirements, the same volume of CDs supported more loans than before

Of course, once offshore banking systems exist in tandem with domestic banking

systems it is no longer particularly meaningful to measure money supplies according

to the domestic banking system exclusively What are you interested in when you

measure the money supply? What purpose do these measurements serve? If our

interest is inflation, we are concerned with the demand for and the supply of money

balances for transactions purposes

To the extent that they are-negotiable, Euromarket CDs are probably used as

transactions balances Analysis of problems involving the money supply should,

therefore, embrace a money supply consisting of the domestic monetary aggregates

plus the negotiable part of offshore deposits in the currency concerned If the relevant

domestic monetary aggregate includes time deposits, then one should include also

Euro time deposits of the same maturity

The offshore banking system is outside the control of the central banks whose

currencies it uses We should consider briefly whether this is good or bad, or even, for

some purposes, true Let us consider first the question of whether the central banks

have now lost control of the money supply and therefore of inflation Since every

Eurocurrency unit, has its origin in a domestic currency deposit or cash unit, this

36

International Banking cannot be true Just as in a system of purely domestic banking, the central bank

controls the monetary base and so controls the money supply, up to the vagaries of the money multiplier The monetary based multiplied to create the money supply, because deposits are relent except for the portion held as reserves plus the portion held as cash by' the public The offshore currency markets might make the multiplier different in size, or they might make it more variable A multiplier different in size from that in a purely domestic banking system does not affect the monetary control of the central bank The latter body must simply know that it is working with a multiplier of size x rather than size y Hence problems in monetary control arise from variability of the size of the multiplier

For practical purposes we have one short-term CD-cum-time deposit market, and whatever practical problems there are in the conception and implementation of monetary policy cannot be sensibly described, as more severe in one part of this whole than in another part

If this is so, we must explain the hostility central bankers often voice towards the

offshore markets A number of factors are important here First, while the central

banks have as much control as they ever had on creation of money, they have no

control over allocation of credit in the offshore capital market Second, as the

Euromarkets are still viewed by the press and the public as mysterious and omnipotent, they make convenient scapegoat for failures of nerves in the handling of

domestic monetary policy Finally, the European central banks made fools of

themselves in the 1960s in their Euromarket dealings in a way which they would rather forget, but which is instructive for us to examine

In the 1960s the European central banks were pegging exchange rates, and absorbing growing dollar deficits In the early 1960s these dollar deficits, which became dollar reserves of the absorbing central banks, were matched by growth of U.S official obligations to foreign central banks in the U.S balance of payments accounts However, in the late 1960s the European central banks were surprised to observe a growing discrepancy between the change in U.S official obligations to foreign central banks, and their own record of dollar reserves held The central bankers kept getting more dollars more dollars than the United States seemed to be losing on the official settlements definition of the balance of payments The well-known economist Fritz Machulp said of them, "Most magicians who pull rabbits out of their hats know full well that they put them there before the beginning of the show The magicians in… (this ) story, however are more naive, they are just as surprised as the audience by the emergence of the rabbits from their hats." Consider what might have happened to the Eurodollar deposits owned by the foreign central banks Under the fixed exchange rate system there were periodic exchange crises, during which people would try to switch other currencies into DM or Swiss francs in anticipation of appreciation Frequently the off shore banks would lend the dollar deposits of the Swiss and German central banks to speculators who convened them into DM or Swiss francs Under their exchange pegging policies, these tendered dollars had to be absorbed by the central banks, what re-deposited in the offshore markets, see that they could be lent again! This is the rabbit in the hat trick of which Machlup was speaking The central banks came to own very large Eurodollar claims by this circular process, but these large claims were not on the United States but rather on the speculators

Check Your Progress 1

1 What do you understand by Eurocurrency market?

……… ………

2 How can offshore deposits be created?

……… ………

37 Eurocurrency Market

4.3 GROWTH OF THE EUROMARKETS

The Euromarkets are not a bogeyman but in unregulated financial intermediary They

bring together borrowers and, lenders, frequently from the same country They deal

only in the currencies; of individual countries and are thus a substitute for the

domestic banking system The incredibly rapid growth of the Euromarkets shows that

they were a strongly preferred substitute But why? The question has an obvious

answer An offshore credit market will not exist unless: depositors receive better terms

than they can retrieve onshore, and borrowers can borrow more, possibly at lower

rates, than they can onshore That is, banks in the offshore market must operate with a

lower spread between the interest rates they charge to borrowers and the ones they pay

to lenders

The rapid emergence in the 1960s of a worldwide Eurocurrency market that co-exists

and competes with traditional foreign exchange banking resulted from the peculiarly

stringent and detailed official regulations governing residents operating with their own

national currencies These regulations contrast sharply with the relatively great

freedom of non-residents to make deposits or borrow foreign currencies from these

same constrained national banking systems On an international scale, offshore

unregulated financial markets compete with onshore regulated ones The differences

in national regulatory regimes and the internationalization of finance brought the birth

of the Eurodollar markets

4.4 OPERATION OF THE EUROMARKETS

There are two levels of offshore currency transactions:

1 A highly competitive wholesale market centered in London which determines the

basic deposit rates on placements by large non-bank firms and by commercial

banks These banks sell their funds to each other as need arises, at a basic interest

rate called LIBOR (London Interbank Offered Rate) All transactions are

undertaken by telephone or telegraph, telex, dealing screen via brokers, so the

bank cannot be sure which other banks they are negotiating with until after a deal

is consummated Thus only the best "name" banks can transact on this wholesale

market Certain very large and well-known non-bank borrowers have access to the

wholesale market, but most do not

2 A retail business on loans: Smaller banks, non-bank borrowers, governments of

developing countries can acquire loans only after credit investigation The first to

borrow Eurodollars were corporations whose name, size and good standing

enabled banks to make loans to them with a little more than a cursory analysis of

credit standing In recent years, the range of corporate and governmental

borrowers has spread considerably Even domestic firms with no international

activities are relying on Euroloans when local credit conditions become tight

In order to explore the lending practices of the Eurocurrency system, it is useful to

refer to the hypothetical balance sheet of a Eurobank, presented here

4.5 TYPICAL EURO BANK BALANCE SHEET

4.5.1 Liabilities

1 Interbank deposits

2 Non-bank time deposits

3 London dollar and other currencies CDs

4 Notes and bonds

38

International Banking 5 Loans from other branches

6 Loans from parent bank

7 Equity capital held by parent bank

4.5.2 Assets

1 Reserve balances

2 Liquid assets

3 Interbank loans

4 Other loans

An important financial obligation now shown on financial statements of a Eurobank is the loan commitments held with the bank by other financial or non-bank institutions These involve a commitment by the bank to lend funds at some future date, and therefore can involve a substantial financial liability at a time of\tight credit Conversely, the asset side of the balance sheet does not show the lines of credit that the Eurobank might have contracted for some future date with other Eurobank and domestic banks Interbank deposits, non-bank time deposits, and London dollar CDs represent the bulk of the liabilities of a Eurobank Interbank transactions bulk particularly large and we will shortly see why The final depositor in the Eurocurrency market can choose among two major financial instruments Most funds are raised by fixed time deposits (TDs), the other source being certificates of deposits (CDs) The maturities of time deposits range from one day to several years but most of them are

in the one week to six months range: Negotiable certificates of two different forms: the top CDs issued in single amounts by a bank, which remain an interbank financial instrument; and the tranche CDs, which are managed issues by several banks and denominated in smaller amounts, so that they can be attractive to corporations and individual investors

While borrowers often want to borrow for longer than five years, CDs are not currently issued for any longer maturities Thus there have developed forward CDs, whereby a bank will issue and other banks will agree to contract CDs at a fixed or floating interest rate at some given future date This device allows banks to make medium term loans to corporations or governments which extend beyond five years and be certain of available resources

Loans in a specific currency are priced according to a "LIBOR plus" principle Three

parameters usually determine the cost: a commitment fee, which is per annum fee expressed as a per cent on the undrawn, uncancelled portion of the loan; a front end fee which is a one-time payment, expressed as a percentage of the amount of the loan, usually paid shortly after the signing of the loan; and a spread which is the per cent

per annum margin added to the hank's cost of funds, which is LIBOR The sum of these pricing elements allows us to determine a total spread, which is annualized and represents the total margin of the loan expressed as an annualised percentage over LIBOR Under this pricing procedure, the most common in the Eurocurrency market, Euroloans are floating rate loans which depend on the value of LIBOR The total spread over LIBOR varies with market conditions Historically it has varied between

0.5% to 3% If one compares the pricing of Euroloans with domestic loans, the

principle difference are as follows: Euroloans do not involve compensating balances but rather involve commitment fees on the unused part of credit lines, and the front-end fee has become of substantial importance in the Euromarkets Since credit standing is measured by markup over LIBOR, there has arisen a willingness of weaker borrowers to trade larger front-end fees for lower markups On a present-value basis the outcome is equivalent, but a lower markup is supposed to have cosmetic advantages

39 Eurocurrency Market

4.6 FUNCTIONS OF THE EUROMARKETS

We can distinguish three distinct functions served by the offshore financial system:

4.6.1 Foreign Exchange Hedging

In the Eurocurrency markets, commercial banks can take positions that cover the

forward commitments they have made vis-à-vis their customers Let us suppose, for

example, that the London branch of Citibank has agreed to loan French francs to a

French corporation It has then acquired a foreign currency asset which it can turn

immediately to a dollar asset by engaging in the forward sale of French francs with the

BNP in London, with the maturity of the forward sale corresponding to the maturity of

the loan Conversely, a dollar loan can be converted immediately into any foreign

currency asset by a forward purchase of the foreign currency in which the bank wants

to have the asset Also, forward currency commitments can be hedged by offsetting

depositing or borrowing transactions It is only a short step from such activities to

covered interest arbitrage, which 'is an important interbank activity

4.6.2 Domestic Intermediation

The offshore markets can at times partially supplant normal channels of domestic

financial intermediation when the government imposed a severe credit policy on the

banking system and at the same time encouraged corporations to seek the necessary

financing they needed in the Eurocurrency system

4.6.3 International Intermediation

The offshore markets channel liquid resources from countries with a loanable surplus

to those with a desire to borrow The most striking example of this is the so-called

"recycling of petrodollars" When OPEC countries started rolling in cash in 1973,

almost everyone predicted a collapse of the world financial system because all those

dollars were going to the Arab countries, and everybody wondered how all the

importing countries would pay their bills The dollars were in fact deposited by the

OPEC countries in the Eurocurrency system and relent to the importing countries as

one might have expected The real impact of OPEC oil price rise has been a transfer of

income it has brought about, not the financial flows that have resulted

Check Your Progress 2

What are major functions of the euromarkets?

………

………

4.7 INTERBANK TRANSACTIONS

As was mentioned earlier when we presented the theoretical balance sheet of a

Eurobank, interbank transactions represent a large part of the activity of a Eurobank

The actual figure for the size of the Eurocurrency markets vary depending on the

source and method of calculation The most agreed-upon figures are those given by

the Bank for International Settlements (BIS) annual reports Other sources include

Morgan Guaranty Trust and Bankers Trust More than a third of the volume of

transactions is interbank trade rather than transactions with non-bank depositors or

non-bank borrowers The BIS figures for the size of the Eurocurrency system net out

all the interbank transactions The BIS figures, which are the most commonly reported

ones, treat the system only as a financial intermediary If the covered interest arbitrage

and foreign exchange hedging aspects of the market are considered, a good part of the

40

International Banking interbank transactions represent legitimate economic transactions and not just

reshuffling of funds within the network of intermediaries

4.8 DEFAULT RISK OF EUROCURRENCY BANKS

The off shore monetary system is an unregulated banking system with no lender of

last resort Except in a very informal way there are no bank inspections by any central bank to' evaluate the soundness of the loan Portfolio Parent banks obviously have a very large stake in the credit-worth mesa of their subsidiaries but ultimately do not give unconditional guarantees This contrasts sharply with domestic banking systems, whose very comprehensive regulation has been in large part justified by the need to protect depositors Yet there have been very few defaults of unregulated offshore banks, despite the immense pressures they have experienced in the 1970s, starting with the ail embargo and the recycling of the petro-dollars We must explain this remarkable record of solvency The key to any such explanation is the principle that in

an unregulated banking system the riskiness of a bank's loan portfolio will be Policed

by depositors They have no choice In a regulated system, depositors have little or no incentive to care how or to whom their bank lends The bank inspectors are a necessary corollary of regulation and deposit insurance

The two principle sources of risk for banks are:

1 Bad loans, and

2 Default due to dependence on maturity transformation and the occurrence of an unfavorable term structure

The bad loan problem is the same for domestic as for foreign banks for the most part The striking thing about the Euro banking system is its restraint in the matter of maturity transformation Perhaps 90% or more of Euro credits are on a floating rate basis Regardless of maturity, the usual adjustment being at six-month intervals Thus the borrower is obliged to compensate the lender for the cost of six-month money and the only effective maturity transformation is from liabilities of less than six months maturity to these six-month assets

There are a number of differences between dealing in Euromarket and dealing in domestic money markets Two important features characterize the Eurocurrency market: the absence of reserve requirement and the international character of the competitive advantage in dealing with reservable transactions – that is, those involving lending to corporations or other non-banks – in comparison to its domestic counterparts It was, of course, from this competitive advantage that the rapid growth

of the Euromarket originally sprang A corollary of the absence of reserve requirements is the absence of direct control by central banks This means that there is- at least in theory - no direct lender of last resort for the Euromarkets Central bankers are gradually feeling their, way toward some partial solutions to this problem, but the situation is certainly not as clear-cut as in each country's domestic markets The international character of the Eurocurrency market means that, like the foreign exchange market, the Euromarket does not exist in any particular location It consists

of participants all around the world linked together by telephones, telexes, and increasingly by computerized information systems, such as those provided by Reuters and Telerate It is therefore a continuous market, starting in the Far East and running throughout the Middle East and Europe until it comes around to San Francisco, which over laps again with the Far East The international nature of the market raises a number of problems, not the least of which is language and telecommunications problems More important, though, there are a number of gray legal areas, such as jurisdiction, the acceptability of a freeze on deposits in one country by another country whose currency is being traded in the first country, the question of whether booking a loan in one centre rather than another is merely legitimate tax planning, or

41 Eurocurrency Market

tax evasion, and many other questions that have not been fully resolved Because the

Euromarket is a fluid and evolving market, certainly the most dynamic deposit dealing

market in the world, many of these questions probably will never be finally settled; in

some respects this is probably for the best since the innovative capacity of the market

has depended greatly on its relative freedom from bureaucratic regulations

Another important feature of the market in which it differs from domestic, markets is

that it is a purely wholesale market Although some banks in the United States allow

some individual customers to place funds through them into the Euromarket with a

view to obtaining a better return, trading in the Euromarket proper is typically done in

blocks of $1 million and upward The major advantage, again, is the relative freedom

from regulation in a wholesale market compared with the retail banking market, which

is typically heavily regulated in many countries

Finally, another significant difference between the Euromarket and many domestic

deposit markets is that the Euromarket is almost exclusively concerned with matched

deposit dealing That is, each deposit (liability) of an international bank will tend to be

matched by an asset (usually a deposit in another bank) of the same currency and of

similar maturity Deliberate mismatches might be incurred with a view to making a

profit, but the book of each bank as a whole, will be matched within certain periods

Hence loans are typically made for a specified period and funded by a deposit of a

similar period This is very different from a domestic market where typically large

amounts of lending are done on the basis of a prime (or base) rate, with these loans

being funded day to day in the domestic overnight or short-date money market, or

from normal customer deposits

Check your Progress 3

Fill in the Blanks:

1 The offshore banking system is outside the control of

the _whose currencies it uses

2 Smaller banks, non-bank borrowers, governments of developing

countries can acquire loans only after

3 A corollary of the absence of _ is the absence of direct

control by central banks

4 The offshore markets channel liquid resources from countries with a

_ to those with a desire to borrow

4.9 LET US SUM UP

This lesson focuses on the Euro currency markets constitute the short to medium term

debt part of the international capital flow structure The market is made by banks and

other financial institutions that accept time deposits and make loans in a currency or

currencies other than that of the country in which they are located The latter

characteristic defines the Eurocurrency market - it is a non-domestic financial

intermediary In the light of the rapid growth of similar institutions in Hong Kong and

Singapore (and to a lesser extent in the Middle East) the market is new worldwide and

is more appropriately called the offshore or external money market

4.10 LESSON END ACTIVITY

Discuss the developments of Eurocurrency market in last one year with special

reference to its relation with Dollar

42

International Banking 4.11 KEYWORDS

Ask-Rate: The selling rate of currency

Bid-ask spread: Difference between buying and selling rates of a currency expressed

as a percentage

Exchange Rate: Rate for transaction between one currency and other currency

Eurocurrency: Currency used in European Union

4.12 QUESTIONS FOR DISCUSSION

1 Under what circumstances would a financial manager of an MNC consider using Eurocurrency markets? What advantages or special features can these markets offer compared to borrowing from domestic markets? Are there drawbacks? Explain

2 Is there a multiplier process in the placement of Eurocurrency deposits and subsequent Eurocurrency loans granted by financial institutions which receive these deposits? What are the major factors determining the size of the multiplier coefficient?

3 There are several methods of measuring the size of the Eurocurrency market Comment on this statement and list the reasons for these different measurements

4 Why are Eurocurrency deposit rates closely related to rates obtainable on instruments of corresponding maturity in home money markets? For example, why is the overnight Eurodollar rate closely aligned to the federal funds rate in the u.s money market? Why is the former deposit rate usually (but not always) higher

by some 25 to 50 basis points than the latter?

5 What is LIBOR? What determines the spread over LIBOR charged borrowers for Eurocurrency credits and loans?

6 Discuss the major advantages which the syndicated Eurocurrency loan market offers to lenders and borrowers, compared to domestic lending operations Why is the quoted rate (spread over LIBOR) not an accurate indicator of the cost of a typical syndicated Eurocurrency loan?

Check Your Progress: Model Answers

CYP 1

1 The Euro currency markets constitute the short to medium term debt part of the international capital flow structure The market is made by banks and other financial institutions that accept time deposits and make loans in a currency or currencies other than that of the country in which they are located The latter characteristic defines the Eurocurrency market - it is a non-domestic financial intermediary

2 Offshore deposits can be created in two ways:

™ One can take the physical currency of a country and deposit it in a bank

in another country Banks do hold currency for other countries but mainly for the convenience of travelers And large quantities of currency have been smuggled out from time to time in recent years However this

is usually done with the expectations of a depreciation of the currency being smuggled, and the receiving banks quickly convert these balances into some hard currency So this method is in general of trivial importance as a creator of deposits

Contd…

™ One can transfer deposits from within the country whose currency is in

question to an offshore bank This may well be an overseas subsidiary

of the very same bank with which the original deposit was held

43 Eurocurrency Market

CYP 2

Functions of the Euro Market:

(i) Foreign exchange hedging

(ii) Domestic intermediation

(iii) International intermediation

CYP 3

1 central banks

2 credit investigation

3 reserve requirements

4 loanable surplus

4.13 SUGGESTED READINGS

C Jeevanadam, Foreign Exchange Management

Levi, International Finance

Ian H Giddy, Global Financial Markets

Rupnaryan Bose, Fundamentals of International Banking, Macmillan India Ltd

Vyuptakesh Sharan, International Financial Management, Prentice Hall of India

ICFAI University Press, International Banking

B.K Chauduri, O P Agrarwal, A Textbook of Foreign Trade and Foreign Exchange,

Himalaya Publishing House