Paul de Grauwe
The Euro-currency market is an international banking market specializing in the borrowing and lending of currencies outside their countries of issue. Participants in the market are commercial banks, monetary authorities, and nonbanks, the latter comprising mainly business firms (particularly large multinational corporations), government agencies, and semi-governmental entities, including central banks and international organizations. Comprehensive official statistics are lacking and estimates on the size of the market vary widely, placing the gross volume of Euro-currency assets of banks in major international banking centers in the range of $200-400 billion. Available statistics suggest that interbank transactions constitute the largest and generally fastest growing portion of the Eurocurrency market, while nonbank sources and uses of funds channeled through the market account for less than one third of total Euro-currency transactions. Since the largest part of the market is located in Europe and since the bulk of the transactions is in dollars, the market is commonly called the “Euro-dollar market.” With increasing use of currencies other than the dollar, for example, the deutsche mark and the Swiss franc, a more appropriate general term is “Euro-currency market”; but even the prefix “Euro” is misleading as a significant part of the transactions is carried out in centers outside Europe, such as the Bahamas, Panama, and Singapore. Therefore, terms such as “xeno-currency” and “offshore market” might be preferable.
Origin and growth
While international banking centers had for a long time known some operations in offshore currency assets and liabilities, two developments Jo ward the end of the 1950s appear to have been most important in prompting banks to engage on a substantial scale in Euro-dollar operations. First, in 1957 in response to the sterling crisis, the United Kingdom authorities instituted tight controls on nonresident sterling borrowing and lending by U. K. banks. In order to retain their position in the financing of world trade, the U. K. banks turned to dollars as a substitute for sterling. Second, at the end of 1958 the currencies of the major Western European countries were made convertible for nonresidents. This allowed banks in those countries to buy and sell dollars freely and to use them in the financing of international trade.
In the early 1960s, two major international dollar markets existed, one centered on New York, the other on London. At that time the volume of international transactions was larger in the New York market, but it was already apparent that the London banks had a competitive advantage. To some extent, this reflected “natural” locational advantages, for example, time differences and closer proximity to some important customers. But a major factor was the absence of regulations of banking operations in currencies other than the pound sterling in the London market. Unlike banks operating in the United States, banks operating in the United Kingdom were not, and are still not, subject to legal reserve requirements or official interest rate ceilings in respect of their dollar transactions. This enabled them to pay higher deposit rates and to operate with narrower margins than U.S. banks subject to such regulations.
Such differential treatment of national and offshore banking operations was typical not only for the United Kingdom but also for most other countries where important offshore banking centers developed. This explains much of the spectacular growth of the Euro-currency market. However, it is not the sole explanation. The New York financial market might have maintained its relative position in international financial transactions had it not been for specific actions taken by the U. S. authorities to restrict the outflow of funds from the United States. First, in 1963 an “interest equalization” tax was introduced which effectively closed the New York capital market to many foreign borrowers. Second, in order to cope with increasing balance of payments deficits, the U. S. administration instituted in 1965 a voluntary program of direct controls over nonresident lending by banks and other financial institutions—the Voluntary Foreign Credit Restraint (VFCR) Guidelines. This program was gradually strengthened and in 1968 made effectively mandatory. Third, controls over U. S. direct investment abroad were introduced which limited inter alia the use of U. S. bank credit to finance new or additional direct investments abroad.
This set of controls had two important effects on the growth and structure of the Euro-currency market. First, U. S. companies wishing to finance new or additional foreign investment outlays had to rely more on funds raised outside the United States. Second, U. S. banks constrained in lending to foreign residents, including foreign branches of U.S. companies, had to raise funds outside the United States if they wanted to avoid losing out in the growing international loan business. They succeeded in doing this by establishing branches in London and elsewhere, thus shifting a large part of their international business from New York to offshore banking centers.
The growth of the Euro-dollar market since the late 1960s followed essentially similar lines. In 1969 the U. S. authorities embarked on a course of restrictive monetary policy. As U. S. banks were unable under Regulation Q to increase the interest rate on time deposits, including certificates of deposit, they experienced a substantial drain of funds which were attracted to more profitable investment outlets. They turned to their London branches and borrowed heavily from them. In the process, interest rates in the Euro-dollar market rose sharply, increasing the drain of deposits from the U. S. market to the Euro-dollar market. In 1970 the Federal Reserve eased its monetary stance and partially relaxed Regulation Q ceilings on time deposits. U. S. commercial banks could again compete for time deposits in the U. S. market, and repay most of their outstanding debts vis-à-vis their London branches. As a result, Euro-banks were left with liquid funds, but since at the same time major European countries followed policies of monetary tightness, there was ample demand for funds by European borrowers.
The growth of the Euro-currency market continued to be very rapid until mid-1974, with an estimated growth rate of more than 40 per cent in 1973 and early 1974 in that part of the market on which official statistics are reported to the Bank for International Settlements (BIS). Thus, its growth continued undiminished, even after termination in January 1974 of U. S. measures restricting capital outflows. However, by mid-1974 concern about the viability of some banks and uncertainty about the future of the market caused its growth to be checked sharply, and the recently resumed growth of the market has been at a significantly reduced rate.
The changing structure of the market
Throughout the history of the market, the U. S. dollar has accounted for by far the largest share of transactions. However, the share of nondollar-denominated assets and liabilities continued to increase. At the end of 1973 the nondollar share of the market had increased to 28 per cent, from about 17 per cent in 1969. This trend was mainly the result of an increased demand for deutsche mark and Swiss franc financial assets as these currencies were at that time generally expected to appreciate. Since investments in the Federal Republic of Germany and Switzerland by nonresidents were increasingly restricted by capital controls, demand for deutsche mark and Swiss franc assets shifted to offshore banking centers and, as a result, Euro-banks became increasingly active in the deutsche mark and Swiss franc part of the market.
Not only the currency composition but also the regional composition of the market has changed over time. This change cannot be detailed because of the lack of comprehensive statistics. However, estimates made by the BIS give a general idea of the direction of shifts in the pattern of uses and sources of funds channeled through the market. These estimates point to an increasing relative importance of countries outside North America and Western Europe as lenders and borrowers in the Euro-currency market since 1964.
Banks active in the Euro-currency market operate from widely dispersed banking centers. London is still the main center of the offshore banking business. However, since 1970 its share in the total has declined, mainly to the advantage of the Bahamas, Singapore, Panama, and Beirut. There has also been a significant change in the distribution of Eurocurrency business among banks according to their national origin. From 1963 to 1969 the share of U. S. banks in the London Euro-currency market increased substantially (fr”im about 25 per cent to 54 per cent of the total). The remainder was taken up mainly by U. K. banks. However, since 1973 U. S. banks have accounted for somewhat less than 40 per cent of the London market, and banks with head offices outside the United States and the United Kingdom have gained a larger share. At the end of 1974 these banks accounted for more than 30 per cent of the total Euro-currency business centered in London. Since the mid-1960s, there has also been a growing number of mostly multinational consortium banks, which in 1974 accounted for about 7 per cent of the total Euro-currency business based on London.
General features of the Euro-currency market
The Euro-banks have developed some characteristic lending and borrowing practices. In general these techniques emerged as a response to the particular structure of the market and to changes in this structure.
First, the Euro-currency market is a “wholesale” market in the sense that most final borrowers are large companies or official entities and the average unit size of transactions is large. As a result, the banks’ overhead costs are relatively low.
Second, the Euro-currency market is to a large extent an interbank market. Thus, more than 75 per cent of the foreign currency liabilities and assets of the reporting European banks are against other banks. In the last few years most of the increase in the gross size of the market was due to an increase in interbank deposits.
Third, the Euro-currency market is a highly competitive market. New entry into the market is unrestricted. This has at times led to a general decline in the margin between deposit and loan rates and lower rates of return on Eurocurrency assets than those on domestic currency assets in national markets. During periods of increasing competition among banks operating in the Eurocurrency market some Euro-banks have also taken higher credit risks, both in the choice of borrowers and in the acceptance of longer maturities of loans generally extended on an unsecured basis. There is some evidence that the market has recently become more cautious both with regard to exposure to individual borrowers and to longer maturities.
While in many ways the Euro-currency market is similar to national money markets, it is basically different from them since it is a market wthout central monetary authority and free from controls.
Loans and deposits
As a means of spreading the risk inherent in generally large scale loans, Eurobanks have increasingly relied on the technique of syndicating medium-term loans extended outside the interbank market. There are different methods for syndicating a loan. The common characteristic is that it involves a large number of participating banks (as many as 95 in one case) with one bank—the lead bank—managing the loan. This system has allowed many small- or medium-sized banks to operate in the Euro-currency market. The same factors that have led to the growth of syndicated loans have in recent years also prompted many banks to join in consortia. In order to limit the default risk resulting from indirect loan relationships often involving many banks, Euro-banks typically place limits on the amount of outstanding advances that they will extend to any single borrower and to borrowers in any single country.
Another typical feature of Eurocurrency lending outside the interbank market is the use of “floating rate” medium-term credit arrangements. These represent a type of roll-over credit with interest rates determined periodically, usually every six months, on the basis of interest rates prevailing in the interbank market. In this way lending banks aim at reducing the interest rate risk that is inherent in unmatched maturities of assets and liabilities. Most loan contracts specify lending rates as a margin over the deposit rates of “reference banks,” usually taken to represent the London Interbank Offer Rate (LIBOR). However, “LIBOR” is not necessarily the rate at which interbank funds are obtainable for refinancing by all banks participating in a syndicated loan.
Many loan agreements contain a multicurrency clause. Before the recent upheavals in the exchange markets, most loans were denominated in U.S. dollars. However, as the uncertainty concerning exchange rates grew, so did the risk for lenders and borrowers faced with the choice of currency. The multicurrency clause provides an important element of flexibility in this respect by offering a choice of currencies in which the whole or parts of a loan may be drawn upon.
Euro-banks do not provide checking facilities. However, the relatively short maturities of most Euro-currency deposits make these deposits very close substitutes for liquid assets. In 1966 an important new facility was introduced. Following the lead of their offices, U.S. branches in London started issuing negotiable dollar certificates of deposit (CDs). These are negotiable receipts for a U.S. dollar deposit with a London bank. The advantage of this instrument is that it combines the yield opportunities of time deposits with a high degree of liquidity. The liquidity of CDs, of course, depends on a well-functioning secondary market. The latter exists and it is generally agreed to be very efficient.