the immense pressures they have experienced in the 1970s, starting with the oil embargo
and the recycling of the petro-dollars. We must explain this remarkable record of
solvency. The key to any such explanation is the principle that in an unregulated banking
system the riskiness of a bank’s loan portfolio will be policed by depositors. They have
no choice. In a regulated system, depositors have little or no incentive to care how or to
whom their bank lends. The bank inspectors are a necessary corollary of regulation and
deposit insurance.
The two principle sources of risk for banks are:1) bad loans, and
2) Default due to dependence on maturity transformation and the occurrence of an
unfavorable term structure.The bad loan problem is the same for domestic as for foreign banks for the most
part. The striking thing about the Euro banking system is its restraint in the matter of
maturity transformation. Perhaps 90% or more of Euro credit its are on a floating rate
basis. Regardless of maturity, the usual adjustment being at six-month intervals. Thus
the borrower is obliged to compensate the lender for the cost of six-month money and the
only effective maturity transformation is from liabilities of less than six months maturity
to these six-month assets.
There are a number of differences between dealing in Euromarkets and dealing in
domestic money markets. Two important features characterize the Eurocurrency market:
the absence of reserve requirement and the international character of the competitive
advantage in dealing with reservable transactions that is, those involving lending to
corporations or other non-banks – in comparison to its domestic counterparts. It was, of
course, from this competitive advantage that the rapid growth of the Euromarkets
originally sprang. A corollary of the absence of reserve requirements is the absence of
direct control by central banks. This means that there is – at least in theory – no direct
lender of last resort for the Euromarkets. Central bankers are gradually feeling their way
toward some partial solutions of this problem, but the situation is certainly not as clear-
cut as in each country’s domestic markets.
The international character of the Eurocurrency market means that, like the
foreign exchange market, the Euromarkets does not exist in any particular location. It
consists of participants all around the world linked together by telephones, telexes, and
increasingly by computerized information systems, such as those provided by Reuters
and Telerate. It is therefore a continuous market, starting in the Far East and running
throughout the Middle East and Europe until it comes around to San Francisco, which
over laps again with the Far East. The international nature of the market raises a number
of problems, not the least of which is language and telecommunications problems. More
important, though, there are a number of gray legal areas, such as jurisdiction, the
acceptability of a freeze on deposits in one country by another country whose currency is
being traded in the first country, the question of whether booking a loan in one centre
rather than another is merely legitimate tax planning, or tax evasion, and many other