SUGGESTED READINGS
3.2 THE EUROCURRENCY MARKET
Figure 3.1 illustrates the linkages between the domestic credit markets of the United States, the United Kingdom, and Japan. For domestic banks, the bulk of
Eurosterling
Euro-euros Eurodollars Currency markets
for $, £, €, and ¥
Currency markets for $, £, €, and ¥ Eurocurrency
markets U.S. internal credit market
Japanese internal credit market U.K. internal credit market Eurozone internal credit market
Euroyen
FIGURE 3.1 Linkages between Domestic Credit and Eurocurrency Markets.
their transactions are with local depositors and borrowers in an internal credit market. Internal credit markets are markets for deposits and loans by domestic residents; hence, they are governed by the rules and institutional conventions of local authorities. A U.S. resident depositing dollars with a U.S. bank is an example of an internal market transaction. Another example of an internal transaction is a Japanese subsidiary of a U.S. firm borrowing Japanese yen from a Japanese bank.
Local authorities regulate each of these transactions.
The need for international banking activities arose as commercial banks followed their customers into foreign markets. As cross-border investment became more common early in the 20th century, large banks developed financial services that facilitated the overseas trade of their customers. In addition to commercial credit, banks provide ancillary services such as cash collections, cash management, trade financing, and market-making in foreign exchange. More recently, commercial banks have developed markets in interest rate and currency derivatives, as well as risk management services. Because of their foreign exchange activities, international banks are well positioned to serve as financial intermediaries in multiple credit markets.
External credit markets trade deposits and loans that are denominated in a single currency but are traded outside the borders of the country issuing that currency. Because external credit markets grew up in Europe, they are referred to as Eurocurrency markets.
Eurocurrencies trade in an external credit market.
Dollar-denominated deposits held in a country other than the United States are called Eurodollars. Similarly, the Eurosterling credit market resides outside the United Kingdom, and the Euroyen market resides outside Japan. Eurocurrency markets remain relatively unencumbered by government regulation, because the government issuing the currency has no direct jurisdiction over the deposit, the depositor, or the Euromarket bank.
Eurocurrencies are usually variable rate time deposits with maturities of less than five years. There is an active secondary market for large-denomination Eurocurrency certificates of deposit (CDs) with face values of $100,000 and up. These markets are operated outside of, or parallel to, national credit markets.
The Eurocurrency market was born in London in the late 1950s. At the time, the Soviet Union held dollar deposits in U.S. banks to finance trade with the United States and feared these deposits would be frozen or seized for political reasons. Yet the Soviets needed dollar-denominated deposits to hedge against fluctuations in the value of the dollar. When the Soviets asked London banks to hold deposits denominated in dollars, the banks were only too happy to oblige. The dollar-denominated deposits allowed the banks to make dollar-denominated loans to their customers and helped solidify their dominance of the international banking industry.
Banks making a market in Eurocurrencies quote bid ratesat which they will take deposits and offer ratesor ask rates at which they will make loans to other Eurocurrency banks. The difference between a bank’s offer and bid rates is called thebid-ask spread,and is often less than 1/8percent for large transactions in major currencies between large commercial banks. About 50 percent of all Forex (FX) transactions occur through London banks. Dealer quotes are available online from services such asQuotronixandReuters.
The London Interbank Bid Rate (LIBID) and the London Interbank Offer Rate (LIBOR) are frequently quoted rates. LIBID and LIBOR are the average bid and offer rates that London banks quote for large transactions with other Euromarket banks. LIBID and LIBOR are quoted for all major currencies, including U.S. dollars, yen, euros, and pounds sterling. Another popular benchmark is the Euro Interbank Offered Rate or Euribor (www.euribor.org), which is based on euro-denominated term deposits between commercial banks within the Eurozone.
LIBOR is a benchmark offer rate for interbank deposits.
The Eurodollar market is by far the largest Eurocurrency market and is approx- imately the same size as the domestic U.S. credit market. Eurocurrency markets are active in other major currencies as well, including Eurosterling, Euroyen, and euro-denominated Eurocurrencies (sometimes called ‘‘Euro-euros’’). Eurocurrency markets are dominated by domestic issuers. For example, U.S. banks and corpora- tions are by far the largest issuers of Eurodollars. The rest of this section describes the most important features of the Eurocurrency market.
An Absence of Government Interference
Eurocurrency transactions in the external market fall outside the jurisdiction of any single nation. This results in the Eurocurrency market’s most distinctive feature: a near-total absence of outside regulatory interference. In most countries, Eurocur- rency transactions have no withholding taxes, reserve requirements, interest rate regulations or caps, credit allocation regulations, or deposit insurance requirements.
They also tend to have fewer disclosure requirements.
MARKET UPDATE The Basel Accords on the Capital Adequacy of Commercial Banks
In 1988, the Bank for International Settlements (www.bis.org) convened a meeting of central bankers in Basel, Switzerland, to create a set of regulations governing the capital adequacy of financial institutions such as commercial banks. This accord — now called Basel I — required that banks set aside equity capital as a protection against unforeseen losses according to the credit risk of the borrower (e.g., a government, bank, or corporation). Banks with less than the required equity reserve had to raise capital or shed assets.
Basel II, adopted in 2004, more broadly assessed the various risks faced by commercial banks and introduced three elements or ‘‘pillars’’ of commercial bank regulation.
Minimum capital requirementsto refine the framework set out in Basel I Supervisory reviewof capital adequacy and internal assessment processes
by regulatory bodies
Market disciplinethrough accounting disclosure requirements to encour- age sound banking practices
Basel II assessed credit risk based on external ratings (e.g., Standard and Poors (S&P) or Moody’s) or on a bank’s internal ratings. Unfortunately, Basel II may have contributed to the 2008 financial crisis by increasing capital requirements and thereby reducing bank lending just at the time that credit was most needed. The resulting credit crunch exacerbated the difficulties that companies faced because of their own deteriorating financial conditions.
The financial crisis of 2008 prompted a further review of bank capital adequacy, leverage, and liquidity. The Basel Committee on Banking Supervision (www.bis.org/bcbs) is proposing several changes in a newly proposed standard called Basel III to be implemented over the next several years.
■ Strengthen bank capital reserve requirements
■ Expand credit risk coverage to include derivatives and other financial securities
■ Introduce a financial leverage ratio to supplement Basel II’s risk-based framework
■ Introduce measures to encourage the accumulation of capital buffers during good times
■ Introduce a liquidity standard encompassing both short-term and long- term liquidity
A major thrust of Basel III is to create regulatory policies that are countercyclical to economic and financial fluctuations. Collectively, the three regulatory standards are referred to as theBasel Accords.
Eurocurrencies are not entirely free from government interference. For example, the U.S. SEC Rule 144A on private placements imposes a reserve requirement on dollars deposited from a foreign bank to a U.S. bank. But for deposits and loans that remain offshore, this market remains essentially unregulated by domestic authorities.
With market values in the trillions of dollars and few regulatory constraints, this is the world’s most competitive and efficient credit market.
Floating Rate Pricing
In most credit markets, lenders prefer short-term loans because of their liquidity and their lower exposures to interest rate risk and default risk. Consequently, borrowers that prefer long-term loans must pay a premium to attract funds. This supply and demand for loanable funds results in a term premium, and in a term structure of interest rates or ‘‘yield curve’’ (the relation of fixed rate bond yields to bond maturities) that is typically upward sloping.
Eurocurrency deposits are no different, in that Eurocurrency lenders prefer to make short-term, low-risk loans. Because of this preference, Eurocurrencies typically have maturities shorter than five years and interest rates tied to a variable rate base.
The short maturity keeps default risk to a minimum. The variable interest rate lowers interest rate risk relative to a fixed rate contract of comparable maturity. LIBOR is the most common variable rate base. Although fixed rate Eurocurrency deposits and loans and Eurocurrencies with maturities longer than five years are available, the interbank market conducts most of its transactions in floating rate Eurocurrency contracts with maturities shorter than five years.
Eurocurrencies have short maturities and floating rates.
Interest Rates in Domestic Credit and Eurocurrency Markets
Figure 3.2 displays the relation between interest rates in domestic credit markets and Eurocurrency bid and offer rates. The interbank Eurocurrency market is very competitive. The domestic lending rate is greater than LIBOR and the domestic
Domestic loan rate for commercial accounts
Domestic deposit rate commercial accounts
1 percent
Eurocurrency loan rate for commercial accounts
Eurocurrency deposit rate for commercial accounts
½ percent
Eurocurrency loan rate in the inter-
bank market
Eurocurrency deposit rate in the inter-
bank market
½ percent8
LIBOR
LIBID
½ percent8
FIGURE 3.2 Credit Spreads in Domestic and Eurocurrency Markets.
deposit rate is less than LIBID, so the Eurocurrency market pays more interest on deposits and accepts less interest on loans than on comparable transactions in domestic credit markets.
To make a profit, banks purchase funds at low rates and lend them out at higher rates. For example, a bank might pay 1.5 percent per year on the savings account of a depositor and lend these funds out to a small business at 2.5 percent per year.
The 1 percent spread is the source of the bank’s profit. For large loans to corporate customers in the external Eurocurrency market, the bank might charge 2.25 percent.
For large deposits (greater than $1 million) in the external Eurocurrency market, the bank might be willing to pay 1.75 percent. In this case, the bank’s spread falls to 0.5 percent (2.25−1.75). Corporate customers with large enough borrowing needs and good enough credit to be able to borrow in this market often find they can improve on the rates they would face in their domestic credit market.
Interest rates extended to corporate borrowers depend on the borrower’s cred- itworthiness and the size of the loan. Interest rates on large loans to AAA-rated corporate borrowers typically are made at a minimum of 15 to 25 basis points (0.15 percent to 0.25 percent) over LIBOR. Larger spreads are charged on smaller loans and on loans to customers with lower credit quality.
Interest rate spreads often are quoted in basis points,where one basis point is 1/100thof 1 percent (or, sometimes, 1/100thof one cent).
1 percent is equal to 100 basis points.
A bank might quote borrowing and lending rates of 1.9375 percent and 2.0625 percent on a large transaction with another bank in the Eurocurrency market. At these rates, the bank’s bid-ask spread is 0.125 percent, or 12.5 basis points. The bank can afford to quote such a small bid-ask spread for large transactions with a reputable counterparty. Larger spreads would be quoted for smaller amounts, for longer maturities, with banks of lower credit quality, and in volatile market conditions.
Clearing and Settlement for International Transactions
Transfers between international financial institutions are cleared and settled through the Society for Worldwide Interbank Financial Telecommunications (SWIFT) (www.swift.com). SWIFT is an industry-owned cooperative with thousands of members from the commercial banking, asset management, securities, and insurance industries. SWIFT ensures low-cost, secure transmission of electronic messages between member institutions.