By this step, a Eurodollar deposit has been created. The London bank has now
obtained the power to deal in dollars outside the United however, that total deposit levels
in the United States have not changed; the $1,000 liability of the London bank is matched
deposit in the New York bank. The only change at the New York bank was in the name
of the depositor from the International Trading Company to the London bank.
Step 2. Because the London bank has to pay interest on its 90-day deposit
liability to the International Trading Company, it decides to extend a Eurodollar loan of
$1,000 to a Paris firm. This loan transaction will be reflected in the books of the London
bank and the Paris firm as follows:
Because the New York bank still has $1,000 deposit liability to the London bank,
its balance sheet has not changed. But the London bank has increased its deposits and
loans by $1,000. This expands the total Eurodollar deposit liabilities of non-U.S. banks
to $2,000. The International Trading Company now holds $1,000 of Eurodollars with the
London bank and the Paris firm has an additional $1,000 of Eurodollars in the London
bank.
The London bank exhausted its dollar lending capacity. Thus, if the Paris firm
had held its dollar deposit with the London bank, the multiple creations of Eurodollars
would have stopped. However, if the Paris firm withdraws its dollar deposits from the
London bank and deposits it with a Paris bank, the Eurodollar creation process could
continue.
Step 3: Assume that the Paris firm withdraws its deposit from the London bank
and deposits it in a Paris bank. The following set of T-accounts record the event.
After Step 3 the amount of Eurodollars is still $2,000, but the Paris bank has
obtained Eurodollar deposits that it can lend out. The potential expansion of Eurodollars
is infinite in the case where banks do not maintain any reserves a against their Eurodollar
deposits.
DEFAULT RISK OF EUROCURRENCY BANKS
The offshore monetary system is an unregulated banking system with no lender of
last resort. Except in a very informal way there are no bank inspections by any central
bank to evaluate the soundness of the loan portfolio. Parent banks obviously have a very
large stake in the credit-worth mesa of their subsidiaries but ultimately do not give
unconditional guarantees. This contrasts sharply with domestic banking systems, whose
very comprehensive regulation has been in large part justified by the need to protect
depositors. Yet there have been very few defaults of unregulated offshore banks, despite