Credit and liquidity creation in the international banking sector

Introduction

One of the most remarkable features of post-war economic history has been the progressive internationalisation of banking. The big banks, which had previously concentrated primarily on their domestic markets, have set up a network of affiliates around the globe bringing them closer to potential depositors and borrowers all over the world. One central feature of this development bas been the emergence of an international banking sector, the so-called Euro-currency market, largely specialising in "across-the-border" business and enjoying far-reaching freedom from regulatory constraints and centralised mircroeconomic controls. The banks active in this international banking sector are essentially the same as those in the domestic markets but their Euro-currency business is usually kept apart from their domestic business by limiting the privileged regulatory status to transactions denominated in foreign currency. Banks domiciled in countries that do not grant such regulatory privileges, or banks in the United States, for which the US dollar, the principal currency denomination used in the Euromarket, is also the domestic currency, participate in the Euro-currency market largely through affiliates set up in places where regulatory and fiscal privileges are readily granted, although these affiliates are sometimes little more than an accounting fiction.

The banks use the international banking sector mainly for wholesale business, liquidity management and funding operations. Besides transacting a substantial amount of business among themselves, their offices in the Euro-currency market take deposits from banks in the domestic markets, central banks, other public-sector entities and private entities. They use the proceeds for financing the affiliates in the national markets and for lending to other banks, to public-sector entities and to private firms, particularly those of international stature. As the Euro-currency market counts among its creditors and debtors residents of virtually every country in the world, it is a worldwide market in the truest sense of the term. Moreover, the transparency and integrating power of the market is supported by the predominant use of a single currency denomination, the US dollar.

The economic advantages of the internationalisation of banking, and of the Euro-currency market in particular, are obvious. Competition between banks on an international scale has exerted pressure on them to lower their costs and to pioneer new financing techniques. Moreover, the Euro-currency market has reduced the segmentation into national markets of the global supply of savings and of the overall demand for credit and has thereby tended to improve the allocation of scarce capital on a worldwide basis. By increasing the international mobility of capital, the market has enhanced - at times when there has been a reasonable degree of confidence in the existing exchange rate structure - the effectiveness of monetary policy as an instrument for marshalling international capital rows. It has boosted the amount of finance available for covering temporary balance-of-payments disequilibria or for long-run economic development needs. And, as a result of these various influences, it has added to international flows of trade and investment, thereby contributing to a higher level of world economic activity and growth.

There are also, however, a number of problems and dangers. The increased international integration of money and capital markets has reduced national autonomy in the use of monetary policy for domestic purposes; this may he particularly hard to accept when the influences transmitted by the international banking sector are the result of policy failures in other countries. Moreover, it is feared that at times when macro-economic management in individual countries is not too firm, the very free availability of international financing may encourage policy stances that are not in the interests of the long-run stability of the world economy as a whole. Also, at times of currency unrest and unstable exchange rate expectations, when monetary policy loses its grip on international capital movements, the increased international mobility of capital may add to the magnitude of destabilising capital flows. Finally, the privileged regulatory status of the Euro-currency market may pose problems of equity and cause distortions of competitive conditions to the disadvantage of smaller banks and other firms with less ready access to the Euro-currency market. And, what may be worse, large banks can use their affiliates in the Euro-currency market to evade the macro-economic or prudential constraints to which their business is subject at home.

It is therefore not very surprising that the Euro-currency market and its macro-economic consequences are highly controversial. What has added to the dispute is the very complex and in some respects abstract nature of the market, which makes it difficult to fit it into a simple analytical framework and to evaluate its macro-economic effects and consequences. The centre of the controversy - which is also the main subject of the present paper - has been the question of whether the market simply transmits national policy influences or whether, being largely independent of what happens in the national markets, it can exert expansionary, inflationary or other destabilising influences of its own. In other words, while the Euro-currency market may undeniably interfere with the policies of individual countries, can it also give rise to unwanted expansionary monetary impulses on a worldwide scale and thwart internationally co-ordinated macro-economic policy efforts?

This paper will start out with a model of an inter-regional banking sector in a world without national borders and with just one currency. Chapters II and III, which look at the Euro-market in its actual multicurrency setting, discuss the macro-economic consequences of the "across-the-border" nature of the market and of the reserve currency role of the US dollar. Chapter IV examines the impact of official deposits on the functioning and monetary repercussions of the Euromarket. Chapter V re-examines the question of an autonomous multiplier potential in the international context. Chapter VI discusses the factors determining the growth of the market and Chapter VII looks into the question of whether destabilising influences may emanate from the volume of credit at present outstanding in the Euro-market.

Finally, it may be appropriate to add a few words about what this paper does not include within its scope. Firstly, it does not deal with the prudential type of question related primarily to banking supervision, such as the dangers for the banks' liquidity and solvency which might conceivably result from their international risk exposure. Secondly, the paper does not seek to review the existing literature on credit and liquidity creation in the Euro-market, but simply presents the author's own very personal views on this highly controversial topic.