Eurodollars

Many foreign banks as well as foreign branches of U.S. banks accept deposits of U.S. dollars and grant the depositor an account denominated in dollars.  Those dollars are called Eurodollars.  As we will see, they exist under quite different constraints from domestic dollars.  While Eurodollar banking got its start in Europe, such banking is now active in major financial centers around the world. 

Importance of Eurodollars 

Today the Eurodollar market is the international capital market of the world.  It includes U.S. corporations funding foreign operations, foreign corporations funding foreign or domestic operations, and foreign governments funding investment projects or general balance-of-payment deficits. 

Overseas branches of a U.S. bank are treated as an integral part of the parent bank.  In its published statements the parent bank consolidates the assets and liabilities of all branches, domestic and overseas, and it has just one account at the Fed, held by the head office.  However each overseas branch keeps its own books for day-to-day operations.

An Example 

Suppose the AAA Corporation draws a check for five million dollars on Citibank, its New York bank, and deposits it at a London Eurodollar bank.  The result is that the ownership of five million U.S. dollars has passed from AAA to the London bank in exchange for a Eurodollar time deposit.  The London bank now holds a deposit at Citibank balanced by a liability, the time deposit credited to AAA. 

Since that money earns no interest at Citibank, the London bank will use the funds to make a loan, say to the BBB Corporation which banks at Wells Fargo.  Citibank will then show a decrease of five million dollars on deposit at the Fed and a decrease in liability of that amount to the London bank.  Wells Fargo will gain that deposit at the Fed and an equal liability as a deposit for BBB.  The London bank will record a loan of five million dollars to BBB balanced by a time deposit owed to AAA. 

Eurodollars Never Leave the U.S. 

Regardless of where they are deposited, London, Bahrain, or Singapore, and regardless of who owns them, Americans or foreigners, Eurodollars never leave the U.S.  Note that throughout both transactions there was no change in banking system reserves at the Fed, and the $5 million remained on deposit at a U.S. bank.  A somewhat more involved analysis would show this to be true even if the Eurodollars had been lent to a foreign corporation.

In this example, the London eurobank is acting as a financial intermediary in U.S. dollars.  It is doing much the same as any U.S. non-bank intermediary, like a finance company or a pension fund.  Unlike domestic U.S. banks, Eurobanks cannot create money in U.S. dollars through the act of lending.  Their lending only transfers ownership of deposits at U.S. banks. 

Eurobanking Practices 

Banking ground rules in the Euromarket differ sharply from those in the U.S. domestic arena.  One important distinction is in the character of their liabilities.  In the Euromarket, all deposits with the exception of call money have a fixed maturity that may range from one day to five years.  Also, interest is paid on all deposits, the rate being determined by market conditions.

For U.S. banks, another important distinction between their domestic and Euro operations is that no reserve requirements and no FDIC premiums are imposed against their Eurodollar deposits.  Thus they can invest every Eurodeposit they receive.  The Euromarket operates outside the control of any central bank. 

Eurobank Investments 

Banks accepting Eurodollar deposits use the dollars to make two sorts of investments, loans and interbank placements.  All such placements, like other Eurodeposits, have fixed maturities and bear interest.  The rate at which banks in London offer Eurodollars in the placement market is referred to as the London interbank offered rate, LIBOR for short. 

The usual practice is to price loans at LIBOR plus a spread.  Some term loans are priced for the life of the loan, but far more often they are priced on a rollover basis.  This means that every three or six months, the loan is re-priced at the prevailing LIBOR for 3- or 6-month money plus the agreed-upon spread. 

Source of Eurodollar Funds 

The funds that form the basis for the Eurodollar market are provided by a wide range of depositors:  large corporations (domestic, foreign, multinational), central banks and other government bodies, supranational institutions such as the Bank for International Settlements, and wealthy individuals.  Most of the funds come in the form of time deposits with fixed maturities.

The Eurobanks also receive a certain amount of call money.  A call account can be a same-day value account, a 2-day notice, or a 7-day notice account.  The going rate for call money closely tracks the overnight Eurodollar rate, which in turn is tied by active arbitrage to the U.S. Fed funds rate.  The main attraction of a call deposit is liquidity.  Time deposits pay more, but a penalty is incurred if such a deposit is withdrawn before maturity. 

Lender of Last Resort 

Two questions arise regarding the liquidity of the Euromarket:  Who lends if the supply of Eurodollars dries up?  Who lends if the solvency of a major bank in the Euromarket is threatened?  The dollars don't disappear, but it’s possible that holders of Eurodollar deposits could move them back to banks in New York.  Thus Eurobanks could face a liquidity crisis.  To protect against any such risk, many have negotiated standby lines with U.S. banks.

In addtion, central banks have concluded that each looks after its own.  Thus the Fed is the appropriate lender to a U.S. banker whether its troubles arise from its New York or London operations.  Other central banks are expected to stand behind their own domestic banks both at home and abroad.