The Multinational Monitor



Regulate the Euromarket

A U.S. Congressman calls on Western governments to cooperate in supervising the $1 trillion Eurocurrency market.

by Jim Leach

The eurocurrency market--the world's first truly international capital market-means many different things to many different interests. To the economist, it is both fascinating and frightening. To the international banker, it is a source of extraordinary profits and freedom from home country regulation. To citizens in the United States, Western Europe and Japan, it is a source of inflation and may prompt taxpayer bailouts of overextended financial institutions.

The Eurocurrency market has expanded so rapidly in the last 'two decades that in gross size it now dwarfs every other national banking system and is about the same size as our own. Its growth is largely a function of the overseas expansion of U.S. banks. In 1960, for example, only eight U.S. banks operated international branches, with overseas assets totalling $3.5 billion. By early 1979, over 130 U.S. banks had established operations outside the country, with foreign assets of $306 billion.

In the seventies, the Euromarket functioned as an efficient intermediary for international financial transactions and may well have been part of the solution to the decade's recycling problems. In the eighties, however, considering the profound political and economic changes throughout the world as well as the quantum jump in the Euromarket's size, this unregulated form of international lending may well begin to promote, rather than prevent global economic dislocation.

In light of skyrocketing inflation in developed and developing economies, prospects of recession in the industrialized world, and heightening political instability in the Third World, greater governmental control over the Eurocurrency market is an urgent necessity.

What is now considered the Euromarket encompasses banking activities not only in Western Europe but also in other industrialized countries and offshore centers such as the Bahamas, the Cayman Islands, Hong Kong and Singapore. There, the world's leading private banks hold deposits in and lend the world's major currencies outside their countries of origin. It is largely a -Eurodollar market: about three-fourths of the market's stateless currencies are U.S. dollars, while half of the remainder are German marks.

Although observers differ over the most accurate and useful measure of Eurocurrency activity, even the lowest estimates are alarming. when compared to the domestic monetary base managed by the U.S. Federal Reserve and other central banks. The accepted current estimate of the market's gross size exceeds $1 trillion. Over half of this sum represents inter-bank loans and Eurocurrency deposits claimed by banks outside the market, however, and many argue that a "net" figure of $300 billion is a more relevant gauge of Euromarket activity. Even after factoring out these sums, the $300 billion figure is distressing. The capital and retained earnings of the ten largest U.S. banks active in the Eurocurrency market barely reach $20 billion--less than one fifteenth the "net" market size or one fiftieth its "gross" size.

It may be that for evaluating the credit-creating potential and inflationary impact of the Euromarket the "net" figure is more valuable. However, the "gross" $1 trillion figure points to one of the market's unique and unsettling characteristics. Since half a trillion dollars on deposit in Eurobanks represent loans from other banks, the collapse of one bank could send not only a psychological but also a real financial tremor through the international banking system-a tremor which may not subside as it is transmitted across national borders. The unprecedented intertwining of U.S. banks with foreign banks may not mean that a failure similar to the collapse of Franklin National in this country or Herstatt in West Germany during the early seventies will lead to a worldwide banking collapse, but a big bank failure or several small failures could create a domino effect from which no bank anywhere in the Western world would be completely insulated.

The highly concentrated nature of Eurolending magnifies the dangers of failure. Whereas the capital base of all U.S. banks may be sufficient to carry the liabilities involved in the process of recycling petrodollars-- one of the major forces behind the growth of the Euromarket--recycling is largely the province of a select group of international banks. Of the 14,000 banks chartered in the U.S., for instance, only 130 participate in Eurocurrency dealings. And the ten most active, such as Citibank, Chase Manhattan and the Bank of America, account for fully 70 percent of all foreign lending by U.S.' banks. With composite capital-to-asset ratios of only 3.6 percent, there is real question whether the capital bases of these ten giant international banks have been stretched too thin. Given the intertwined nature of Eurobanking, there is even greater question whether the few foreign institutions involved are not even more precariously balanced.

Recently the Federal Reserve has expressed reservations about further unregulated growth of the Eurocurrency market. But recognition of a problem does not answer some very troubling questions. Is it too late? Are we already too interlinked and jeopardiz.ed by foreign financial institutions over which the U.S. government has no control? Is the OPEC bludgeon too heavy for the international economy to sustain?

One thing is clear. Whatever indicators one chooses, the Euromarket has been expanding over the past decade at an average rate of 25 percent per year. If this growth rate is maintained through the 1980's--and because of major new OPEC price hikes, it is possible that in the short-term it could even accelerate -the Eurocurrency market will multiply again the eightfold it has since 1970.

While issues of size, interlocks and growth all involve potential threats to banks directly, involved in the Euromarket, the rise of Eurobanking has also generated hardships for domestic banks, as well as for the citizens of countries beleaguered by runaway inflation.

Indeed, one of the most frequently voiced justifications for regulating the . Eurocurrency market is to preservesome would say restore-governmental ability to manage domestic monetary policy. The Eurocurrency market, because it is interlinked with domestic capital markets while free from regulation, significantly complicates the implementation of monetary policy in individual countries. Specifically, the Euromarket weakens the ability of money managers like the Federal Reserve to precisely quantify domestic spending and the money supply -it is trying to control. Dollars held by banks abroad, for example, could be spent here or elsewhere.- The holders of other Eurocurrencies could also add to spending in this country. Governor Henry Wallich of the Federal Reserve recently expressed concern that the Eurocurrency market may reduce the effectiveness of domestic monetary policies-a key anti-inflation weapon. In Senate testimony last December, he Warned "there is a risk that, over time, as the Eurocurrency market expands relative to domestic markets, control over the aggregate volume of money may increasingly slip from the hands of the central banks."

The Eurocurrency market's expansionary impact on the U.S. money supply does more than complicate domestic efforts to implement monetary policy.. It is an issue of equity, particularly in this period of spiraling inflation and governmental efforts to battle rising prices. To combat the largest increases in the Consumer Price Index since the end of World War 11, the Federal Reserve has moved to dampen the growth of the money supply, by sharply restricting credit and raising reserve requirements for deposits held in the U.S. The Eurocurrency market forces domestic banks to bear the burden of restrictive policies and shifts the responsibility of- combating inflation to non-international banks and their customers.

Today, U.S. banking is anything but equitable. Large international banks have access to Federal Reserve funds as do smaller domestic banks, but because their Eurocurrency operations escape domestic regulations they face a lower overall reserve requirement. If reserves are considered a form of insurance, banks withhold a certain percentage of their deposits in return for the benefits of belonging to the Fed--international banks can be seen as paying a lower insurance premium for equal protection. And while they pay a lower insurance premium, international banks participate In substantially higher risk loans than do domestic.

While frustrating the fight against inflation, the Eurocurrency market has also contributed to the instability of the dollar. No one would realistically argue that the Eurocurrency market has directly caused the dollar problems of recent years or the frequent periods of exchange rate instability which have come to characterize international financial markets. The -Eurocurrency market has, however, facilitated currency speculation by the major banks and in doing so has perhaps contributed to the problem. For, the large international banks to deny any culpability for increased currency speculation in analogous to a candy manufacturer claiming a lack of responsibility for children consuming too much junk food.

The role of private banks in currency speculation also raises a series of questions about conflict of interest. The same institutions which constitute foreign exchange markets and profit handsomely from currency transactions benefit directly from exchange market disorder. Like commodity brokers, the international banks earn their greatest profits on the widest swings in a commodity-in this case foreign currencies. Recent charges by bank insiders of profiteering at the expense of the dollar and tax evasion provide a glimpse of the at least potential for conflict of interest-both between banks and their customers and between the allure of quick profits and the goal of a stable dollar.

Given these problems, the Federal Reserve, acting on its own or on the basis of a legislative mandate from Congress, should move ahead in the direction of greater regulation of the Eurocurrency market. Specifically, there should be stepped-up information gathering and the institution of capital-to-assets ratios, or preferably, reserve requirements on Eurocurrency liabilities. In order not to handicap U.S. banks in competition with their foreign counterparts, international cooperation must be obtained to insure that comparable restrictions are established in the principal banking jurisdictions around the world.

The current precarious condition of the Eurocurrency market demands public attention. If the Federal Reserve accepts the responsibility of lender of last resort, it will be our citizens as taxpayers who will ultimately pay the price for any failure of an American bank or any general collapse abroad that endangers the U.S. banking system. The rise of the Eurocurrency market is the most potentially disruptive economic development since World War IL Whether and how the international community responds to this unprecedented phenomenon has far-reaching implications for the ability of sovereign governments to determine their own economic destinies.

Jim Leach is a member of the U.S. House of Representatives from Iowa's First District. He is ranking minority member of the House Banking subcommittee on Trade, Investment and Monetary Policy.

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