INTEREST RATE SPREADS AND RISK Interest rates on a particular currency might be constrained by capital

controls. Controls on international capital flows could include quotas on foreign lending and deposits or taxes on international capital flows. For instance, if Switzerland limits inflows of foreign money, then we could have a situation where the domestic Swiss deposit interest rate exceeds the external rate on Swiss franc deposits in other nations. Although foreigners would prefer to have their Swiss franc deposits in Swiss banks in order to earn the higher interest, the legal restrictions on capital flows might prohibit such a response.

It is also possible that a perceived threat to private property rights could lead to seemingly perverse interest rate relations. If the United States threatens to confiscate foreign deposits, the funds would tend to leave the United States and shift to the external dollar market. This could result in the Eurodollar deposit rate falling below the U.S. deposit rate.

In general, risk contributes to the domestic spread exceeding the external spread. In domestic markets government agencies help ensure the sound performance of domestic financial institutions, whereas the Eurocurrency markets are largely unregulated, with no central bank ready to come to the rescue. There is an additional risk in international transactions in that investment funds are subject to control by the country of currency denomination (when it is time for repayment) as well as the country of the deposit bank. For instance, suppose a U.S. firm has a U.S. dollar bank deposit in Hong Kong. When the firm wants to withdraw

106 International Money and Finance

those dollars—say, to pay a debt in Taiwan—not only is the transaction subject to control in Hong Kong (the government may not let foreign exchange leave the country freely), but the United States may control outflows of dollars from the United States, so that the Hong Kong bank may have difficulty paying back the dollars. It should be recognized that even though domestic and external deposit and loan rates differ, primarily because of risk, all interest rates tend to move together. When the domestic dollar interest rate is rising, the external rate will also tend to rise.

The growth of the Eurodollar market is the result of the narrower spreads offered by Eurobanks. We have seen the size of the Eurodollar market grow as the total demand for dollar-denominated credit has increased and as dollar banking has moved from the United States to the external market. The shift of dollar intermediation has occurred as the Eurodollar spread has narrowed relative to the domestic spread or as individual responsiveness to the spread differential has changed.

Over time, important external markets have developed for the other major international currencies (euro, pound, yen, Canadian dollar, and Swiss franc). But the value of activity in Eurodollars (which refers to offshore banking in U.S. dollars) dwarfs the rest. In the end of 2010, the Bank for International Settlements estimated the currency composition of the Eurocurrency market to be: U.S. dollar, 58%; euro, 21%; yen, 3%; British pound, 5%; with other currencies taking the remainder.

Figure 5.2 illustrates the foreign assets held by banks of different nations. The major role of the United Kingdom and the United States in international banking is obvious. Note that the figure distinguishes between bank assets, including interbank claims and credit extended to nonbanks. Interbank claims are deposits held in banks in other countries. If we want to know the actual amount of credit extended to nonbank borrowers, we must remove the interbank activity. Figure 5.2 illustrates the huge size of the interbank market in international finance. An example of interbank deposits versus credit extended to nonbanks is provided later in the chapter.

The Eurocurrency Market 107

7000 Interbank Claims

6000 Nonbank Claims

Billions of US Dollars 2000 1000

U.K.

U.S.

Japan Germany France Cayman Islands

Figure 5.2 Bank’s foreign assets, by country. (Data from June 2011 and are from Bank for International Settlements, Basel [ http://www.bis.org ].)

the Cayman Islands or the Bahamas really amounted to nothing more than a small office and a telephone. Yet by using these locations for book- ing loans and deposits, U.S. banks could avoid the reserve requirements and interest rate regulations that applied to normal U.S. banking. In Figure 5.2 the country of Cayman Islands had $1,656 billion in external position bank assets in June, 2011. However, most of those are banks owned by another country than Cayman Islands. If one looks at external assets in banks that are owned by Cayman Islands corporations, then the assets are only $2.4 billion. Thus, most of the bank assets in Cayman Island are foreign banks setting up local offices in Cayman Islands.

In December 1981, international banking facilities, or IBFs, were legalized in the U.S. IBFs did not involve any new physical presence in U.S. bank offices. Instead, they simply required a different set of books for an existing bank office to record the deposits and loans permitted under the IBF proposal. IBFs are allowed to receive deposits from, and make loans to, nonresidents of the United States or other IBFs.

108 International Money and Finance

banking office. The location of IBFs reflects the location of banking activity in general. It is not surprising that New York State, as the financial center of the country, has over 75 percent of IBF deposits. Aside from New York, California and Illinois are the only states with a significant IBF business. After IBFs were permitted, several states encour- aged their formation by granting low or no taxes on IBF business. The volume of IBF business that resulted mirrored the preexisting volume of international banking activity, with New York dominating the level of activity found in other states.

Since IBFs grew very rapidly following their creation, we may ask where the growth came from. Rather than new business that was stimu- lated by the existence of IBFs, it appears that much of the growth was a result of shifting business from Caribbean shell branches to IBFs. After the first month of IBF operation, $29.1 billion in claims on foreign residents existed. During this same period, the claims existing at Caribbean branches of U.S. banks fell $23.3 billion. Since this time, IBF growth has continued with growth of Eurodollar banking in general. As of June 2011, the IBFs surpassed the $700 billion mark, almost entirely as interbank claims.

OFFSHORE BANKING PRACTICES The Eurocurrency market handles a tremendous volume of funds.

Because of the importance of interbank transactions, the gross measure overstates the actual amount of activity regarding total intermediation of funds between nonbank savers and nonbank borrowers, as Figure 5.2 shows. To measure the amount of credit actually extended through the Eurobanks, we use the net size of the market—subtracting interbank activity from total deposits or total loans existing. To understand the dif- ference between the gross and net volume of Eurodollar activity, consider the following example.

Suppose that a U.S. firm, IBM in New York, shifts $1 million from its U.S. bank to a Eurobank, Eurobank A, to receive a higher return on its

The Eurocurrency Market 109

Table 5.1 IBM-New York Deposits $1 Million in Eurobank A

U. S. Bank

Assets

Liabilities $1 million due Eurobank A

Eurobank A

Assets

Liabilities

$1 million deposit in U. S. Bank $1 million Eurodollar deposit due IBM

Table 5.2 Eurobank A Deposits $1 Million in Eurobank B

U.S. Bank

Assets

Liabilities $1 million due Eurobank B

Eurobank A

Assets

Liabilities

$1 million Eurodollar deposit in $1 million Eurodollar deposit due IBM Eurobank B

Eurobank B

Assets

Liabilities

$1 million deposit in U.S. Bank $1 million Eurodollar deposit due

Eurobank A

accepted from IBM. Now suppose that Eurobank A does not have a borrower waiting for $1 million (U.S.), but another Eurobank, Eurobank B, does have a borrower. Eurobank A will deposit the $1 million with Eurobank B, earning a fraction of a percent more than it must pay IBM for the $1 million.

Table 5.2 shows that after Eurobank A deposits in Eurobank B, the U.S. bank now owes the U.S. dollar deposit to Eurobank B, which is shown as an asset of Eurobank B, matched by the deposit liability of $1 million from Eurobank B to Eurobank A.

Finally, in Table 5.3 , Eurobank B makes a loan to BMW in Munich.

110 International Money and Finance

Table 5.3 Eurobank B Loans $1 Million to BMW

U.S. Bank

Assets

Liabilities $1 million due BMW

Eurobank A

Assets

Liabilities

$1 million Eurodollar deposit in $1 million Eurodollar deposit due IBM Eurobank B

Eurobank B

Assets

Liabilities

$1 million loan to BMW $1 million Eurodollar deposit due

Eurobank A BMW-Munich

Assets

Liabilities

$1 million deposit in U.S. Bank $1 million loan owed to Eurobank B

in Eurobank B). The net size of the market is found by subtracting interbank deposits, and thus is a measure of the actual credit extended to nonbank users of dollars. In the example, Eurobank A deposited $1 million in Eurobank B. If we subtract this interbank deposit of $1 million from the total Eurobank deposits of $2 million, we find the net size of the market to be $1 million. This $1 million is the value of credit actually intermediated to nonbank borrowers.

Since the Eurodollar market deals with such large magnitudes, it is understandable that economists and politicians are concerned about the effects the Eurodollar market can have on domestic markets. In the United States, Eurodollar deposits are counted in the M3 definition of the money supply. Measures of the U.S. money supply are used by economists to evaluate the resources available to the public for spending. Eurodollars are not spendable money but, instead, are money substitutes like time deposits in a domestic bank. Because Eurodollars do not serve as a means of payment, Eurobanks are not able to create money as banks

The Eurocurrency Market 111

because the domestic company need not use domestic currency for its transactions anymore.

All banks are interested in maximizing the spread between their deposit and loan interest rates. In this regard, Eurobanks are no different from domestic banks. All banks are also concerned with managing risk, the risk associated with their assets and liabilities. Like all intermediaries, Eurobanks tend to borrow short term and lend long term. Thus, if the deposit liabilities were reduced greatly, we would see deposit interest rates rise very rapidly in the short run. The advantage of matching the term structures of deposits and loans is that deposits and loans are maturing at the same time, so that the bank is better able to respond to a change in demand for deposits or loans.

Deposits in the Eurocurrency market are for fixed terms, ranging from days to years, although most are for less than six months. Certificates of deposit are considered to be the closest domestic counter- part to a Eurocurrency deposit. Loans in the Eurocurrency market can range up to ten or more years. The interest rate on a Eurocurrency loan is usually stated as some spread over LIBOR and is adjusted at fixed intervals, like every three months. These adjustable interest rates serve to minimize the interest rate risk to the bank.

Large loans are generally made by syndicates of Eurobanks. Syndicates of banks are an organized group of banks. The syndicate will be headed by a lead or managing bank; other banks wishing to participate in the loan will join the syndicate and help fund the loan. By allowing banks to reduce their level of participation in any loan, syndicates can participate in more loans. Thus, each individual bank reduces their risk by having

a diversified loan portfolio.

INTEREST RATE SPREADS AND RISK Interest rates on a particular currency might be constrained by capital