Eurodollar Deposits and Loans

The most important distinction between the Eurodollar banking market and domestic banking is that Eurocurrency markets are not subject to domestic banking regulations. Eurobanks may obtain same profit levels as domestic banks even though they achieve lower spreads on lending depositors’ funds than their domestic counterparts. The absence of reserve requirements and regulations enables Eurobanks to offer slightly better terms to both borrowers and lenders. Eurodollar deposit rates are higher, and effective lending rates a little lower, than they are in domestic money markets. The absence of regulations is the key to the success of the Eurocurrency markets.

Deep Euromarkets exist only in those currencies, such as the US dollar, the German mark and the pound sterling, that are relatively freely convertible into other currencies.

A Eurodollar deposit may be created and lent on in the manner set out below. A US corporation with $2 million surplus funds decides to take advantage of the more attractive Eurodollar rates on deposits relative to domestic dollars. The company’s surplus funds were held originally in a time deposit with a demand deposit in the local US bank. The company transfers ownership, by payment, of the demand deposit in the local US bank to the US bank in London, where a time deposit is made. This process creates a Eurodollar deposit, substituting for an equivalent domestic time deposit in a US bank. The London branch of the US bank deposits the cheque in its account in a US bank. The US company holds a dollar deposit in a bank in London rather than in the USA. The total deposits of the banks in the USA remains unchanged. However, investors hold smaller deposits in the USA and larger deposits in London. The London Bank now has a larger deposit in the U.S.A. The increase in the London bank’s deposits in the US bank is matched by the increase in dollar deposits for the world as a whole. The volume of dollar deposits in the USA remains unchanged, while the volume in London increases.

The London bank will not leave the newly acquired $2 million idle. If the bank does not have a commercial borrower or government to which it can lend the funds, it will place the $2 million in the Eurodollar interbank market. In the words, it will deposit the funds in some other Euro bank.

If this second Euro bank cannot immediately use the funds to make a loan, it will redeposit them again in the inter-bank market. This process of re depositing might proceed through several Euro banks before the $2 million finds its way to a final borrower. At each stage the next bank will pay a slightly higher rate than the previous bank paid. But the margins involved in the inter-bank market are very small - of the order of 1/8 per cent. As a rule, larger, better-known banks will receive initial deposits while smaller banks will have to bid for deposits in the inter-bank market.

This inter-bank re-depositing of an original Eurodollar deposit merely involves the passing on of funds from bank to bank. It does not, of course, add to the final extension of credit in the financial markets. Only when the $2 million is lent on to a corporation or a government is credit eventually and effectively extended. To evaluate the true credit- creation capacity of the Eurodollar market, inter-bank deposits have to be netted out. The ultimate stage in the credit-creating process occurs when a Euro bank lends funds to a non- bank borrower.

Loans made in the Euro market are similar to those made domestically by UK and US banks and so on. More lending is done on a corporate reputation or name basis, as it is sometimes called, to well-known entities, with less credit investigation and documentation being involved than in domestic lending. When the amount needed is greater than one Euro bank is prepared to provide, borrowers obtain funds by tapping a syndicate of banks from different countries. Borrowers often have the option of borrowing in any of several currencies. Eurocurrency loans may be for short-term working capital or trade finance, or they may have maturities up to ten years. The latter would be called medium-term Eurocredits, although they are basically no different from their short-term counterparts. When a Eurocurrency loan has a maturity of more than six months, the interest rate is usually set on a roll-over basis – that is, at the start of each three – or six – month period, it is reset at a fixed amount (e.g. 1 per cent) above the prevailing London inter-bank offered rate.

Eurocurrency deposits often carry interest rates of ½ per cent higher than domestic deposits and borrowers can obtain cheaper money in Euromarkets as opposed to domestic ones. So why do not all depositors and borrowers shift their business into the Eurocurrency market. One reason is the existence of exchange controls. Many governments make it difficult for depositors to invest abroad, and many restrict foreign borrowing by domestic companies. Another reason is the inconvenience and cost involved with maintaining balances or borrowing in a foreign country. Furthermore, the market is largely a wholesale one, and deals in sums of under $1 million are not available. Euro banks also prefer to lend to large, well-known corporations, banks or governments. But the most important difference is that Euro deposits, because they are located in a different country, are in some respects subject to the jurisdiction of the country.