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Federal Reserve Bank of Philadelphia
MARCH-APRIL 1981

Managing the Money Stock:
A Time of Transition

Regulating
the Eurocurrency Market:
What Are the Prospects ?

MARCH/APRIL 1981

MANAGING THE MONEY STOCK:
A TIME OF TRANSITION
Richard W. Lang

. . . The Monetary Control Act requires
adjustments by depository institutions, regu
lators, and the public.
REGULATING
THE EUROCURRENCY MARKET:
WHAT ARE THE PROSPECTS?

Nicholas Carlozzi
Federal Reserve Bank of Philadelphia
100 North S ixth Street
(on Independence Mall)
Philadelphia, Pennsylvania 19106

The BUSIN ESS REVIEW is published by
the Department of Research every other
month. It is edited by John J. Mulhern, and
artwork is directed by Ronald B. Williams.
The REVIEW is available without charge.
Please send subscription orders, changes
of address, and requests for additional copies
to the Department of Public Services at the
above address or telephone (215) 574-6115.
Editorial communications should be sent to
the Department of Research at the same
address, or telephone (215) 574-6426.
*

The Federal Reserve Bank of Philadelphia
is part of the Federal Reserve System—a

. . . Increasing supervision appears to have a
better chance than imposing reserve require
ments.

System which includes twelve regional banks
located around the nation as well as the
Board of Governors in Washington. The
Federal Reserve System was established by
Congress in 1913 primarily to manage the
nation’s monetary affairs. Supporting func
tions include clearing checks, providing coin
and currency to the banking system, acting
as banker for the Federal government, super
vising commercial banks, and enforcing
consumer credit protection laws. In keeping
with the Federal Reserve Act, the System is
an agency of the Congress, independent
administratively of the Executive Branch,
and insulated from partisan political pres
sures. The Federal Reserve is self supporting
and regularly makes payments to the United
States Treasury from its operating surpluses.

FEDERAL RESERVE BANK OF PHILADELPHIA

Managing the Money Stock:

A Time of Transition
B y R ichard W. Lang*

In March of 1980, Congress passed a law
that already is changing the shape of the
American financial industry. The Depository
Institutions Deregulation and Monetary
Control Act of 1980—Monetary Control Act
or MCA for short—affects consumers and
businesses by letting banks and other finan
cial institutions compete more directly for
deposits and loan customers. It also affects
the nation’s monetary policymakers by giving
the Federal Reserve System more institutions
and more reserve balances to keep track of.
In the past, the Federal Reserve dealt
mainly with its own member banks. These
banks received services from the Fed, such
as check clearing and wire transfers of funds,
without paying explicit unit prices for them.
But these services were not cost-free to the

banks, since the banks had to keep reserve
balances on account with the Fed—balances
that earned no interest—based on their de
posits. Thus member banks implicitly paid
for Fed services by forgoing interest income
on their reserves.
The Monetary Control Act requires the
Fed to make its services available to all
deposit-taking institutions, not just member
commercial banks, on an explicit price
schedule. It also requires all of these institu
tions to hold reserve balances based on their
deposits. In the short term, these changes are
likely to complicate the Fed’s task of manag
ing the money supply. The year 1981 will be
a time of transition for the Federal Reserve
and the U .S. financial system as they both
become accustomed to the new financial
environment brought about by the MCA. But
in the longer run, the extension of reserve
requirements to all depository institutions is
intended to improve the Fed’s control of the
money supply.

‘ Richard W. Lang, Research Officer and Economist
in charge of policy analysis at the Philadelphia Fed,
received his Ph.D. from The Ohio State University.

BUSINESS REVIEW

MARCH/APRIL 1981

MANAGING MONEY
Prior to October 1979, the Federal Reserve
attempted to manage money growth by moni
toring and modifying movements in short
term interest rates, particularly the Federal
funds rate (the rate banks charge on overnight
loans to one another). Today, the Fed places
less emphasis on interest rates and instead
focuses primarily on controlling the growth
of bank reserves, pretty much in agreement
with the textbook formula that the money
stock is a product of bank reserves times a
factor called the money multiplier.1 Simply
put, the Fed now tries to achieve a desired
rate of growth for the money stock by
manipulating the growth of reserves.
Most depository institutions are required
by regulation to hold reserves in amounts
based on their deposits.2 And some institu
tions may choose to hold more than the
legally required reserves, even though these
excess reserves earn no interest.
When an institution finds its excess re
serves rising above desired levels, however,

it will move quickly to loan out more funds.
Putting more loans on its books typically
increases its deposits, since banks usually
make loans by crediting funds to the accounts
of their borrowers.
Increases in bank reserves thus lead banks
to create more deposits. And since banks are
required to hold reserves against only a small
fraction of deposits, the financial system can
support a large increase in deposits with a
small addition to reserves. This expansion of
deposits is what the money multiplier is
supposed to gauge: it measures how much
the money supply increases for each addi
tional dollar of bank reserves.3
How big is the money multiplier and how
does it change from one week to the next?
That may not be so easy to figure, and the
MCA initially may make it harder. The
money multiplier depends on which defini
tion of money is being used (the Fed uses
four common ones) and on how people
decide to hold their money. If money is
defined most narrowly as currency plus
checking accounts in the hands of the nonbank
public (MIA), for example, a certain money
multiplier will apply.4 If it is defined to
include all other kinds of transaction ac-

■'with the implementation of the MCA, it is more
appropriate to refer to reserves of the entire financial
system than to reserves of banks only. An alternative
framework that often is used in textbooks is to make the
money stock equal to the product of a different money
multiplier and the monetary base (reserves plus currency
in circulation). Since the Federal Reserve’s operating
procedure focuses on reserves, not the monetary base,
however, it is more convenient to talk in terms of
reserves than of the base. A more extensive discussion
of the money supply process can be found in most eco
nomics textbooks. See, for example, L.S. Ritter and
W.L. Silber, Principles of Money, Banking, and Finan
cial Markets, third edition (New York: Basic Books,
1980).

3A more extensive discussion of these points can be
found in most textbooks. See, for example, Ritter and
Silber.
4M1A is defined as currency and commercial bank
demand deposits (checking accounts) held by the non
bank public. M1B consists of M IA plus all other
transactions accounts (such as ATS accounts and NOW
accounts) at all depository institutions (such as credit
unions, mutual savings banks, and savings and loan
associations). M2 consists of M lB plus savings and
small time deposits at all depository institutions, money
market mutual fund shares, overnight Eurodollar
deposits held by U.S. residents other than banks at
Caribbean branches of U.S. banks, and overnight RPs
(repurchase agreements) issued by commerical banks.
M3 consists of M2 plus large time deposits at all
depository institutions and term RPs at both commerical
banks and savings and loan associations. For more
information on the construction of the monetary aggre
gates, see “The Redefined Monetary Aggregates,”
Federal Reserve Bulletin (February 1980), pp. 97-114.

2Before the MCA, the Fed required member banks to
hold reserves in the form of vault cash or deposits at
Federal Reserve banks, and state banking authorities
required banks under their supervision to hold certain
reserve assets, usually defined more broadly than assets
eligible to satisfy Federal Reserve requirements. Under
the MCA, all kinds of depository institutions will be
required to hold reserves according to Fed regulations,
but financial institutions with assets less than $2 million
have been exempted initially.

FEDERAL RESERVE BANK OF PHILADELPHIA

in fact, the MCA involved such a change.5
And finally, depository institutions can
choose to keep their reserves right at the
required level or somewhat above it, and that
choice will be reflected in the multipliers. In
sum, the behavior of the Fed, the public, and
banks and thrift institutions all can affect the
multiplier.
It used to be that only member commercial
banks had their reserves measured directly
as part of the process of managing money
growth. But the MCA brings nonmember
banks and thrift institutions directly into the
process, by extending reserve requirements
to all depository institutions—such as mutual
savings banks, savings and loan associations,
and credit unions (see APPENDIX).
How does the Fed change the overall level
of reserves in the system? In most instances,
by buying or selling government securities in
the open market. When the Fed buys govern
ment securities from a bank, for example, it
pays for them by crediting the bank’s reserve
account, thus increasing its reserves and its
ability to make loans. Fed sales of securities
decrease reserves, since the Fed debits the
reserve account of the seller. These open
market operations are the source of the Fed’s
provision of nonborrowed reserves. Reserves
can also be increased when banks borrow
directly from the Fed.
To make its money management work
under the MCA, the Fed has to decide which
definition of reserves will yield the best
monetary control as well as gauge the effects
of the MCA on the money multipliers.

counts as well (M1B), a different money
multiplier will be appropriate (Figure 1). If
people decide to switch some of their funds
from commercial bank checking accounts to
savings accounts, the multipliers will change
accordingly.
The Fed itself can affect the multiplier by
changing the level of reserve requirements;
FIGURE 1

THE
MONEY MULTIPLIERS
FOR RESERVES
RECENTLY
HAVE RANGED
FROM 8% TO IOV2 *

WHAT COUNTS AS A RESERVE?
Before the MCA, when only member banks

*M1A and M1B multipliers for reserves are,
respectively, M IA -5-reserves and M lB reserves.
Data are seasonally adjusted. Reserve data are not
adjusted for changes in legal reserve ratios.

^Some data series on reserves are adjusted for changes
in legal reserve ratios in order to avoid breaks in the
historical data series. Multipliers calculated from such
adjusted reserve measures do not show a break when
the MCA took effect in November 1980. The reserve
and multiplier series discussed in the text are not
adjusted for changes in legal reserve ratios.

SOURCES: Board of Governors of the Federal
Reserve System H.6 Statistical Release, “Money
Stock Measures and Liquid Assets,” and H.9
Statistical Release, “Aggregate Reserves and
Member Bank Deposits.”

BUSINESS REVIEW

MARCH/APRIL 1981

had reserve requirements, actual reserves
were fairly easy to define and to count. But
with the spread of reserve requirements, the
Fed has had to ask anew just what to count as
a reserve for monetary policy purposes.
Updating the Definition. Member banks
hold reserves in two forms—as credits in
their accounts with the Fed and as cash in
their own vaults. In the past, member banks’
deposits at the Fed and their vault cash were
counted in total reserves—the relevant figure
for policy purposes. But member bank hold
ings of vault cash typically are small rela
tive to the deposits against which they have
to hold reserves, especially in comparison to
vault cash holdings at thrifts.
Many nonmember commercial banks and
thrift institutions have more vault cash than
they need to meet reserve requirements,
particularly now, since their reserve require
ments are being phased in over an eight-year
period and still are quite low. Since including
this surplus vault cash at nonmember insti
tutions in the reserve figure would introduce
a conceptual discontinuity with the Fed’s
past definition of excess reserves, the Fed
has been focusing on a measure of reserves
that excludes surplus vault cash (Figure 2).
“Reserve balances plus vault cash used to
satisfy reserve requirements” does not in
clude “surplus vault cash at other nonmember
institutions” but is thought to be “most con
sistent with the total reserve concept pub
lished historically.”6
More than one measure of reserves is
being watched by policymakers. Among
them is a measure that includes surplus vault
cash. But for the present, at least, the Fed is
focusing on reserve balances at the Fed and
required vault cash at financial institutions
for purposes of monetary control.7

Keeping Track of Reserves. Once reserves
are defined, they still have to be measured
each week in order for the Fed to control
money growth under its reserve targeting
procedure. Under a system called lagged
reserve accounting, the Fed knows in ad
vance the amount of reserves banks are
required to hold in the current week because
their current requirements are based on their
deposits of two weeks earlier. Because de
pository financial institutions must file
weekly reports of their deposits at the end of
each week, the Fed can calculate the reserves
they must hold in the next week to meet their
reserve requirements.
Since total reserves consist of required
and excess reserves, and since excess re
serves are small relative to required reserves,
the Fed knows in advance a large portion of
the reserves banks desire to have each week.
The Fed then has to determine what level of
reserves it will supply and in what form—
either through open market operations or
through the discount window.
When reserve requirements for non
members became effective in early Novem
ber of last year, however, there was some
uncertainty about how much in the way of
transactions accounts at banks and thrifts
would be subject to reserve requirements,
even with the lagged reserve accounting
system. The weekly reports of deposits
should have provided the Fed with informa
tion on the amount of reservable deposits in
advance of the week in which MCA reserve
requirements had to be held—the week of
November 13, 1980. Initially, however, the
Fed found it difficult to obtain accurate
reports on a timely basis from both member
tion is permitted to satisfy reserve requirements by a
pass-through account with another institution which
does hold reserves on deposit with a Reserve Bank. The
first institution holds funds at the second institution,
which holds reserves for both of them at the Fed.
Ultimately, the reserve requirements of both institutions
are met by a combination of vault cash and a deposit
with the Fed.

®See the special explanatory note accompanying the
Federal Reserve’s H .4.1 Statistical Release dated
November 21, 1980.
7Under the MCA, a nonmember depository institu-

FEDERAL RESERVE BANK OF PHILADELPHIA

FIGURE 2

FEDERAL RESERVE_________
Factors Affecting Reserves of Depository Institutions and
Condition Statement of F.R. Banks
8 * 4 .1

For ianmdlace re le a s e
January 1 6 , 1981

R eserves of d ep o sito ry I n s titu tio n s
Reserve Bank c r e d i t ,
and related Items
Reserve Bank c r e d i t :
U.S. Government s e c u r i t l e s - Bought o u tr ig h t— System account
Held under repurch ase agreements
Federal Agency o b lig a tio n s -*
Bought o u trig h t
Held under repurch ase agreements
A ccep tan ces-Bought o u trig h t

Averages o f d a lly
Week ended Change
January 14, January
1981
1981*
(In ad .lllo n s
12 0 ,5 4 3
"

8 ,7 3 9
—

Other F .R . l i a b i l i t i e s and c a p ita l

fig u re s
trow week ended Wednesday
7 , Jan u ary 16, January 14
1981*
1
1980
of d o lla rs )

+ 1 ,4 0 4
- 2 ,3 1 0

1 ,8 3 0

+
-

523

8 ,7 3 9
—

4 .8 9 1
1 4 2 ,8 2 7

311

+
62
- 1 ,5 7 4

35
+ 1 1 ,2 0 0

2 6 ,7 8 4
2 0 ,3 9 0

- 934
+ 2 ,5 4 9

6 ,0 1 3
N/A

2 9 ,8 0 7
2 0 ,3 9 0

1 4 ,2 6 8

+ 1 ,7 7 0

+ 1 ,5 2 2

1 4 ,2 6 8

N/A

700

N/A
N/A

5 ,4 2 2
5 0 ,3 1 0

4 ,5 4 9
- 4 ,7 9 1
♦
242

4 4 ,8 8 8
4 1 ,2 4 0
3 ,6 4 8

700

- -

5 ,4 2 2
4 7 ,2 8 7

+ 779
+ 1 ,6 0 6

4 1 ,8 6 5
4 1 ,2 4 0
625

+
+
-

827
866
39

On January 1 4 , 1 9 8 1 , m arketable U.S. Governsent s e c u r i t i e s h eld in
custody by the F ed eral Reserve Banks fo r foreign o f f i c i a l and in te rn a
tio n a l accou n ts were $ 9 2 ,9 8 3 m illio n , an in c re a se of $112 m illio n fo r
the week.
5/

Adjusted to Include $113
m illio n w aivers of p e n a ltie s f o r re se rv e
d e f ic ie n c ie s in accordan ce with Board p o licy e f f e c t i v e November 1 9 ,
1975.

Reserve balan ces w ith F ed eral Reserve Banks pirns v a u lt cash a t
in s titu t io n s with required reserv e balances pins v au lt cash equal to
required re se rv e s a t o th e r i n s titu tio n s .

Reserve b alan ces w ith Fed eral Reserve Banks plus v a u lt cash used to
s a t i s f y rese rv e requirem ents le s s required r e s e r v e s . (T his measure of
e xcess re se rv e s i s comparable to the old e x ce s s re se rv e concept
published h i s t o r i c a l l y .)
Vault cash and req u ired re se rv e s a re p a r t i a l l y e s t t a a t a d .
Estim ated (San F ra n cisco D i s t r i c t ) .

Estim ated (T r e a s u r y 's F ig u r e s ).

1 1 2 1 ,5 7 1
--

4 ,9 7 1
143,896

Reserve balan ces with F .R . Banks 3 /
T o tal v a u lt cash (e stim a te d )
a) Vault cash a t in s titu tio n s
with required re s e rv e balances
b) Vault cash equal to required
re se rv e s a t o th e r in s titu tio n s
c ) Surplus v a u lt cash a t o th er
in s titu tio n s 4 /
Reserve balan ces + t o t a l v au lt cash 5 /
Reserve balan ces + t o t a l M u lt cash
used to s a t i s f y re s e r v e requirements 5 / 6 /
Required re se rv e s (e stim a te d )
Excess re se rv e balan ces a t F .R . Banks 5 / 7 /

MARCH/APRIL 1981

BUSINESS REVIEW

levels of the multipliers could change, and so
could their tendency to vary from week to
week and month to month.
Phasing in Reserve Requirements. The
link between reserves and money is affected
by changes in reserve requirements, so that
the changes in legal reserve ratios for member
and nonmember financial institutions at each
step of the phase-in will result in changes in
the money multiplier. For example, the in
crease in required reserves for nonmembers
was smaller (up about $1.4 billion) than the
decrease in required reserves for members
(down about $4.1 billion) at the first step of
the phase-in, so the money multiplier tended
to increase.9
As long as changes in total required re
serves at each step of the phase-in to the new
reserve requirements are known with reason
able precision, changes in the multiplier can
be offset by changing reserves in the opposite
direction via open market operations. Since
the Fed will have fairly accurate information
about reserve positions at both member and
nonmember institutions, the phase-in of re
serve requirements is not likely to result in
significant uncertainties for monetary con
trol.
Excess Reserves and Vault Cash. Hold
ings of excess reserves or vault cash also
could be affected by the extension of reserve
requirements to nonmembers. An increase
in holdings of excess reserves or vault cash
over what financial institutions held prior to
enactment of the MCA would tend to lower
the money multipliers. The reason is that
institutions would be using less of their
reserves or cash to make loans which generate
additional deposits, so that the same level of

and nonmember institutions. Nonmembers
weren’t familiar with the Fed’s reporting
system, and member banks were faced with
more complicated reporting requirements
than they had had before. Furthermore, the
near tripling in the number of reporting
institutions resulted in processing delays at
the district Federal Reserve Banks and the
Board of Governors.
These kinds of difficulties are only transi
tional, however, and have been largely alle
viated. As weekly reserve accounting be
comes more familiar to nonmembers, and as
member banks become accustomed to the
new reporting forms, there will be less diffi
culty in calculating the changes in required
reserves at each of the subsequent steps of
the phase-in of the new reserve requirements.
But even when the definitions of reserves
and the procedures for reporting them have
become well established, the Fed still will
have to forecast how much money a given
level of reserves will generate. That is, it will
have to calculate—either explicitly or im
plicitly—values of the money multiplier.
HOW MUCH MONEY FROM RESERVES?
The Fed’s Open Market Committee meets
regularly to set target rates for money growth
over, say, a three-month period. There are
several target rates, one for each of the
several definitions of money. The Board of
Governors’ staff then estimates a growth
path for total reserves in the financial system.
They also determine a path for nonborrowed
reserves by subtracting out the FOMC’s esti
mate of the reserves institutions will borrow
from the discount window. In the course of
this exercise, the Board staff implicitly esti
mates money multipliers (one for each defi
nition of money).8 Under the MCA, the

“Monetary Policy Report to Congress Pursuant to the
Full Employment and Balanced Growth Act of 1978,”
February 19, 1980.

8This is done by separately estimating public holdings
of various types of deposits and bank holdings of
required and excess reserves. For more details, see “The
New Federal Reserve Technical Procedures for Con
trolling Money,” Appendix B of the Board of Governors’

9Some data series on reserves are adjusted for changes
in legal reserve ratios in order to avoid breaks in the
historical data series. At present we are referring to
reserve data which are not so adjusted.

FEDERAL RESERVE BANK OF PHILADELPHIA

Since most of the increase in excess re
serves relative to pre-MCA experience has
been at members, excess reserves are likely
to fall over time to pre-MCA levels. Whether
they will be less predictable week to week
remains to be seen.
Discount Window Borrowing. Another
effect on the link between reserve and money
growth could result from the extension of
reserve requirements and Fed services to
nonmember institutions. Since the MCA has
opened the discount window to nonmember
depository institutions, the FOMC will have
to determine whether this new borrowing
privilege will materially affect its assump
tion or estimate about the level of borrowing
that is consistent with its short-run mone
tary growth path. The initial nonborrowed
reserve path is based on the FOMC’s assump
tion about or estimate of borrowings. Nonmember borrowing at the discount window
will have to be taken into account in setting a
nonborrowed reserve path that is consistent
with desired money growth.
In the past, deviations from the total
reserve path have occurred even though the
Fed was on its nonborrowed reserve path
because borrowings were larger or smaller
than expected. Sometimes such deviations
help the Fed attain its objectives for money
growth, but sometimes they tend to hinder it.
Furthermore, an increased variability of
borrowings by nonmembers from the Fed
would impart increased variability to the
link between the nonborrowed reserve path
and the money stock.
So far in 1981, nonmember borrowing at
the discount window has been limited. So
long as it remains low, nonmember borrowing
will not have a significant impact on the link
between reserves and money.
Nationwide NOW Accounts. The public’s
holdings of various types of deposits will be
altered in 1981 because of the MCA’s intro
duction of nationwide NOW accounts (nego
tiable orders of withdrawal). Although NOW
accounts previously have been available in

reserves would be supporting a smaller level
of deposits and money.
If the Federal Reserve were not using a
new definition of excess reserves which
excludes surplus vault cash at nonmember
depository institutions (Figure 2, note 7),
excess reserves would have increased after
the introduction of the MCA reserve require
ments to over $6 billion from pre-MCA
levels, which were typically less than $500
million. The new, more narrowly defined
measure of excess reserves has averaged less
than $1 billion (Figure 3). Although the Fed
does receive weekly data from nonmembers,
the majority of excess reserves could be
estimated using only member banks’ excess
reserves, as has been the case in the past.

FIGURE 3

EXCESS RESERVES
HAVE BEEN
UP SLIGHTLY
SINCE ENACTMENT
OF THE MCA
Millions of Dollars

1980

1981

SOURCE: Board of Governors of the Federal
Reserve System H.4.1 Statistical Release, “Factors
Affecting Reserves of Depository Institutions and
Condition Statement of F.R. Banks.”

BUSINESS REVIEW

MARCH/APRIL 1981

eight states—the New England states, New
York, and New Jersey—they were first of
fered in the rest of the nation beginning in
January 1981. In the forty-two states in
which they are being offered for the first
time, individuals can be expected to shift
funds into NOW accounts from both checking
and savings accounts. As the mix of deposits
held by individuals changes, the relation of
reserves to money growth may change. The
nature of the effect on money growth (with
an unchanged growth of reserves] will depend
on the particular monetary aggregate being
considered.
For example, consider the aggregate M IA,
which basically consists of currency plus
demand deposits at commercial banks. The
introduction of nationwide NOW accounts is
expected to induce people to shift funds out of
demand deposits and into NOW accounts.
Even with reserves unchanged, people will
want to hold fewer demand deposits relative
to other deposits. Hence, M IA would be re
duced. Put another way, the money multi
plier for M IA would decline.
Now consider M lB , which consists of
currency and demand deposits plus NOW
accounts and other transactions-type de
posits. A shift of funds out of demand
deposits and into NOW accounts has no
initial effect on M lB since both types of
deposits are included in it. But if NOW
accounts have lower reserve requirements
than demand deposits, then banks would
have more funds to lend out, and bank credit
and deposits would expand. All types of
deposits would increase in this case, includ
ing those in M lB . Consequently, under these
assumptions, M lB would increase somewhat
even if reserves were unchanged. Put another
way, the M lB money multiplier would rise.
Of course, if the funds that are shifted into
NOW accounts come from savings accounts,
which are not included in M lB , then M lB
would increase even if reserve requirements
on the two types of accounts were the same.
Even with total reserves unchanged, the

M lB measure of money would increase; the
M lB money multiplier would rise.
The changes in the M IA and M lB money
multipliers as nationwide NOWs are intro
duced will depend on a number of factors,
including how successfully thrifts compete
transactions accounts away from banks and
whether these accounts are drawn mainly
from member or nonmember banks. The
introduction of NOW accounts is likely to
result in effects on the monetary aggregates
similar to those that occurred when ATS
(automatic transfer service] accounts were
introduced in November 1978—a fall in the
M IA multiplier and a slight rise in the M lB
multiplier.10 The magnitudes of the changes,
however, are more uncertain than they were
when ATS accounts were introduced. The
reason is that the structure of reserve require
ments under the MCA’s phase-in is more
complicated than the structure that existed
when ATS accounts were introduced in
1978, which makes it more difficult to esti
mate the effects on the money multipliers.
The uncertainty in estimating the link
between reserves and money growth which
results from the introduction of NOW ac
counts, however, is only transitional. Once
individuals have completed changing the
composition of their deposit holdings among
demand, NOW, and time or savings deposits,
the relation of reserves to money (M IA or
M lB] should be no less predictable than it
was before the MCA was enacted.
SUMMARY
The Monetary Control Act of 1980 was

10For a more extensive discussion of the effect of the
introduction of ATS accounts on the money multiplier,
see Scott Winningham, “Automatic Transfers and
Monetary Policy,” Federal Reserve Bank of Kansas
City Economic ReviewJNovember 1978), pp. 18-27; and
John A. Tatom and Richard W. Lang, “Automatic
Transfers and the Money Supply Process," Federal
Reserve Bank of St. Louis Review (February 1979), pp.
2- 1 0 .

FEDERAL RESERVE BANK OF PHILADELPHIA

institutions. The public’s behavior with re
spect to deposit holdings will be changing in
response to the introduction of nationwide
NOW accounts. Thrift institutions’ holdings
of excess reserves and vault cash and their
pattern of borrowing from the discount win
dow also may be changing over time. Until
more data are available on which to base
estimates of thrifts’ short-run behavior, the
Fed’s total reserve and nonborrowed reserve
paths could be subject to greater errors than
in the past, when only member banks were
subject to reserve requirements.
The provisions of the MCA have not made
the Fed’s reserve targeting procedure un
workable during this transition period. But
there is little doubt that the Fed will have to
monitor changes in reserve behavior and
changes in monetary growth quite closely in
the coming year in order to maintain conti
nuity in its monetary policy objectives.

intended to improve the ability of the Federal
Reserve to control the money stock by chang
ing the schedule of reserve requirements and
by extending reserve requirements to all
transactions accounts regardless of where
they were held. Nonmember banks, mutual
savings banks, savings and loans, and credit
unions as well as member banks now must
hold reserves.
Although the MCA ultimately will provide
the type of control that Congress intended to
give to the Federal Reserve System, there are
some transition difficulties in going from the
old system to the new. For one, there is the
relatively simple matter of changing the
definition of reserves. For another, the Fed’s
current procedure for implementing mone
tary policy—the reserve targeting pro
ced u re-w ill be subject to greater uncer
tainties during this transition period. These
uncertainties arise from adjustments in the
behavior of both the public and financial

APPENDIX . . .
11

BUSINESS REVIEW

MARCH/APRIL 1981

THE NEW RESEff
The Monetary Control Act places reserve requirements on all types of transactions accounts as
well as on nonpersonal time deposits with maturities of less than four years. Transactions accounts
are defined to include demand deposits, NOW accounts, ATS accounts, share draft accounts, and
accounts subject to telephone or pre-authorized transfer when the depositor is authorized to make
more than three transfers per statement period. Nonpersonal time deposits are defined as time
deposits or accounts that are transferable or are held by a party other than a natural person. The
MCA reserve requirements apply to all depository financial institutions—including commercial
banks, savings and loan associations, credit unions, industrial banks, U.S. agencies and branches
of foreign banks, and Edge Act and Agreement corporations. The following two tables show the
reserve requirements that will apply after the MCA is fully phased in and the old reserve
requirements which applied to member banks before November 13, 1980.

The Phase-In
The provisions of the Monetary Control Act call for the new reserve requirements to be phased in
gradually—over a four-year period for member banks and an eight-year period for nonmember
depository institutions. Only NOW accounts will be subject immediately to the full reserve
requirement on transactions accounts—with the exception of the NOW accounts previously

The Old Reserve Requirements for M ember Banks
Category of Deposit

Reserve Ratio

Net Demand Deposits
$0-2 million
$2-10 million
$10-100 million
$100-400 million
Over $400 million

7%
9.5%
11.75%
12.75%
16.25%

Savings Deposits
Time Deposits
$0-5 million, by maturity
30-179 days
180 days to 4 years
4 years or more
Over $5 million, by maturity
30-179 days
180 days to 4 years
4 years or more

3%
2.5%

1%
6%
2.5%

FEDERAL RESERVE BANK OF PHILADELPHIA

EREQUIREMENTS

authorized in New England, New York, and New Jersey.
During the ten-month period beginning in November 1980, the amount of required reserves for
nonmember institutions is one-eighth of the full requirement. The amount will increase by oneeighth in September of 1981 and each September of the following six years.
Reserve requirements for member banks on transactions accounts and time and savings deposits
were phased down by one-fourth of the difference between the amount under the old and new
reserve requirement structures on November 13, 1980. They will be reduced by an additional oneeighth in September 1981 and by a further one-eighth at six-month intervals thereafter. To reduce
the phase-in calculations for member banks, reserve requirements on time deposits under the old
structure are determined by applying the average reserve ratio on time deposits at each bank for the
two-week period ending August 6, 1980 to the total amount of time deposits. This fixed average
reserve ratio on time deposits will be used throughout the members’ phase-in period.
Nonmember depository institutions with less than $2 million in total deposits will not have to hold
required reserves until at least May 1981. In addition, all depository institutions with total deposits
of between $2 million and $15 million have to report only on a quarterly basis rather than weekly.
Newly chartered banks and banks that become members of the Federal Reserve System after
March 31, 1980 will have a two-year phase-in period.

The MCA’s Reserve Requirements
Category of Deposit

Reserve Ratio

Transactions Accounts
First $25 million*
Amounts greater than $25 million*

3%
12%

Nonpersonal Time Deposits
Maturities less than 4 years
Maturities of 4 years or more

Personal Time Deposits
Nontransferable
Transferable

(no reserve requirement)
(see Nonpersonal]

Eurocurrency Liabilities

*The base figure of $25 million will be adjusted annually beginning in 1982 based on the changes
in transactions accounts during the previous year.

From the Philadelphia Fed...

Copies of this pamphlet are available
without charge from the Department
of Public Services, Federal Reserve
Bank of Philadelphia, 100 North
Sixth Street, Philadelphia,
Pennsylvania 19106.

FEDERAL RESERVE BANK OF PHILADELPHIA

Regulating
the Eurocurrency Market:
What Are the Prospects?
B y N ich o las C arlozzi*
attempting to extend certain forms of regula
tion to it. Their position is that the existence
of unregulated financial markets alongside
the regulated ones makes it more difficult for
national authorities to control the growth of
the money supply and their own economic
destiny. They argue also that banks ought to
be required to behave as prudently in their
international operations as in their domestic
ones in order to preserve the soundness of
the national and international financial sys
tems.
Governments have considered a variety of
measures for increasing their control over
the eurocurrency market, including the
imposition of reserve requirements and the
extension of supervisory authority. Little
progress has been made with reserve require
ments because nations disagree over the
desirability of eurocurrency reserve require
ments and the means of applying them.
Some progress has been made, however, in
the supervisory area, and more can be ex
pected even in the short term.

During the 1970s, the rising costs of com
plying with national banking regulations
spurred many U .S. and foreign financial
institutions to extend their international
banking operations beyond their home coun
tries. By channelling international borrowing
and lending through foreign offices, they
found that they could avoid national banking
regulations and increase their profitability
sharply. These offshore banking operations,
denominated in currencies other than those
of the nations in which the transactions take
place, make up the so-called eurocurrency
market. Participation in this unregulated
market grew far faster than national banking
operations, and eurobanking now plays an
important role in international finance.
Bank regulators have responded to the
rapid growth of the eurocurrency market by
‘ Nicholas Carlozzi, who received his training in
economics at the University of Wisconsin, specializes
in international finance and macroeconomics. He joined
the bank’s research staff in 1978.

BUSINESS REVIEW

MARCH/APRIL 1981

currency market (see THE EUROCUR
RENCY NETWORK).
Although domestic banking activity in the
U .S. remains far larger than eurodollar ac
tivity, the growth of the eurocurrency market
exceeded that of the domestic banking system
in the 1970s. Total eurocurrency assets (loans
to customers and deposits at other banks) of
reporting banks in the European market cen
ter grew at a compound annual growth rate
of 27 percent from the end of 1969 to the end of
1979 (see. . .RAPID GROWTH).2 Total assets
of large commercial banks in the U.S. grew at
a compound annual growth rate of only about
8 percent over the same period.3

THE EUROCURRENCY MARKET
DEVELOPS
For over twenty years, commercial banks
have been accepting dollar deposits and
making dollar-denominated loans through
offices outside the United States—the eurodollarm arket.1 Dollar deposits on the books
of any banking office located outside the
United States are counted as eurodollar de
posits, and dollar-denominated loans are
counted as eurodollar loans. In addition to
the head offices of foreign banks, branches
and subsidiaries of U .S. and foreign banks
are active participants in this market.
The dollar is the most widely used currency
in the offshore banking network, but the
Deutsche mark and Swiss franc also are
traded actively there. Transactions in the
U.S. dollar, the Deutsche mark, the Swiss
franc, and the other currencies with offshore
banking facilities together make up the euro-

2The European market center includes reporting
banks in Austria, Belgium-Luxembourg, Denmark,
France, the Federal Republic of Germany, Ireland,
Italy, the Netherlands, Sweden, Switzerland, and the
United Kingdom. The total eurocurrency assets of
banks in this region were $58.17 billion in December
1969 and $639.9 billion in December 1979. Bank for
International Settlements, 48th Annual Report, p. 98
and 50th Annual Report, p. 122.

lrThe nonbank customers of these institutions include
both residents and nonresidents of the United States.
Nonresidents make dollar deposits and take out dollar
loans because of the dollar’s importance in financing
world trade.

3The total assets of large, weekly reporting commer
cial banks were $316.4 billion at the end of 1969 and
$674.0 billion at the end of 1979. Federal Reserve Board,

THE EUROCURRENCY NETWORK
The eurobanking network provides the world with a truly international financial market.
Although eurocurrency banking originated in Europe (hence the prefix), today there are market
centers scattered around the globe. These centers are linked by high speed communications lines so
that there are very few hours during which eurobanking business is not being transacted. Active
market centers include London, Paris, the Caribbean, Singapore, and Bahrain.
Eurobanking offices accept deposits and make loans much like domestic banks, but there are a
few differences. Deposits are received for anywhere from 1 day to 5 years or more, but all deposits
have a fixed maturity and all deposits earn interest. Loans in the euromarket have maturities from a
few days to over 5 years, and interest rates on these loans are reset twice or four times a year to
reflect changes in credit market conditions. Public-sector and private-sector corporations,
governments, and central banks make up the bulk of the eurobanking system’s customers. Few
individuals participate because of the complexity of the market and the size—$1 million or more—
of transactions.
Banks that participate in the market use the funds they receive in the form of deposits to make
loans to nonbank customers and to make interbank placements—deposits of one bank at another
bank. Flows of funds among banks channel funds from market centers that are net sources of funds
(more depositors than borrowers) to centers that are net users (more borrowers than depositors).

FEDERAL RESERVE BANK OF PHILADELPHIA

banks in the reporting area.5
Why has the eurocurrency market grown
so rapidly? Primarily because few nations
regulate foreign-currency banking activities
that occur within their boundaries. Reserve
requirements, which specify the percentages
of deposits that must be held as readily
available reserves, are not applied to euro
currency deposits in most nations. Interest
rate ceilings which limit the rates of interest
payable on deposits at U .S. banks are not
applied to eurocurrency deposits either. And
in some nations, bank examiners who scru
tinize the assets and liabilities of domestic
banking offices do not review the portfolios
of eurobanking branches. This absence of
regulation reduces the cost of doing business
in the eurocurrency market. And in the
competitive world of international banking,
a portion of this cost advantage is used to
attract customers to the eurocurrency market
through lower interest rates on loans and
higher interest rates on deposits.
The growth of the eurocurrency market,
though clearly a benefit in many respects,
has been thought by some to make it more
difficult for the Federal Reserve to achieve
its monetary objectives and for banking
supervisors to insure the soundness of the
international banking system. Current pro
posals for regulating the eurocurrency mar
ket address these concerns.

THE EUROCURRENCY
MARKET HAS SEEN
A DECADE
OF RAPID GROWTH
Gross External Assets of Banks
in the European Reporting Area
Billions of Dollars

SOURCE: Bank for International Settlements.

By June 1980, the net size of the euro
currency market was approximately $190
billion or one-tenth the magnitude of the
monetary aggregate labeled M 3—a measure
of the financial services offered by domestic
financial institutions.4 This measure of the
eurocurrency market includes the deposit
liabilities of reporting eurobanks to non
banks but excludes the liabilities of reporting
eurobanks to other commercial and central

RESERVE REQUIREMENTS
FOR THE EUROMARKET?
The U .S. central bank—the Federal Re-

“Banking and Monetary Statistics: 1941-1970,” p. 278
and Federal Reserve Bulletin, March 1980, p. A21.

5The reporting eurobanks are located in Europe and
Canada and include the branches of U.S. banks in the
Bahamas, Cayman Islands, Panama, Hong Kong, Singa
pore, and Bahrain. All types of customers outside the
reporting area are included in the net measure of the size
of the market. Eurocurrency liabilities of banks in the
European area to nonbanks totaled $128 billion. Banks
in Canada accounted for $26 billion in eurocurrency
liabilities to nonbanks, and U.S. branches in the re
maining market centers booked approximately $36
billion in eurocurrency liabilities to nonbanks.

4M3 consists of demand deposits, negotiable orders
of withdrawal and automatic transfer service accounts
at banks and thrift institutions, credit union shares, de
posits at mutual savings banks, savings and time de
posits, overnight and term repurchase agreements,
overnight eurodollars held by United States residents,
money market mutual fund shares, and currency in the
hands of the public. Data taken from Federal Reserve
Bulletin, November 1980, p. A13.

BUSINESS REVIEW

MARCH/APRIL 1981

serve—requires commercial banks (and, with
the passage of the Monetary Control Act of
1980, other depository institutions as well) to
hold money in reserve against their commit
ments to depositors. At present, reserve
requirement management is one of the Fed’s
tools for influencing the growth of the do
mestic money supply. Thus the extension of
reserve requirements to the euromarket has
appeared to some to be a reasonable move.
But the reaction from foreign central banks
has been less than overwhelmingly receptive.
How Reserves Affect Money Growth.
The Fed controls the quantity of transactions
balances (currency and demand deposits)
available in the domestic economy by adjust
ing the supply of reserves available to banks.
Under this system, domestic banks must
hold a fraction of their deposits as readily
available, noninterest-bearing reserves (cash
in their vaults or deposits at a Federal Reserve
bank). Even if there were no reserve require
ments, banks still would choose to hold a
fraction of their deposits as reserves, but this
fraction undoubtedly would be smaller than
that required by national regulations.
The presence of banks in the eurodollar
market complicates monetary policy for the

Fed. Both domestic banks and branches
operating in the eurodollar market accept
dollars for deposit and hold dollar reserves,
but branches active in the eurodollar market
are unconstrained by domestic reserve re
quirements and interest rate ceilings.
When the Fed reduces the supply of re
serves, interest rates rise in both the domestic
and eurocurrency financial markets. But
because of interest ceilings in the U .S., rates
on many types of domestic bank deposits do
not rise. If deposit rates in the eurodollar
market rise while those in the domestic
market are constrained by ceilings, deposits
shift from domestic to eurodollar accounts.
When interest rates fall, the incentive to shift
funds into the eurodollar market is reduced
and the flow of funds abates (see INTEREST
RATES IN THE EUROCURRENCY MAR
KET).
Variations in this flow caused by changes
in the general level of interest rates make the
Fed’s job harder. Unanticipated flows of
funds from one type of account to the other
can partially offset the thrust of Federal
Reserve policy because the fraction of de
posits held as reserves in the domestic bank
ing system generally exceeds that of the

INTEREST RATES IN THE EUROCURRENCY MARKET
Interest rates in the eurocurrency and corresponding national financial markets tend to move
together in the absence of official controls to limit international capital flows. Many borrowers and
lenders feel that the financial services offered in the eurocurrency market are close substitutes for
those offered in national financial markets. They observe interest rates in these markets and are
prepared to shift their activities from one market to another when interest rate differentials change.
If government action causes interest rates in the United States to rise in relation to those in the
eurodollar market, then the cost of borrowing funds in the eurodollar market would fall in relation
to that in the national market. Borrowers would move from the national to the eurodollar market,
bidding up eurodollar rates. Likewise, depositors would move funds from the eurodollar to the
national market, increasing the supply of loanable funds and bidding down interest rates in the
national market.
This flow of funds would cease only when the interest rate differential equaled the cost
differential of operating in the regulated national market versus the unregulated eurodollar market.
This cost differential is determined primarily by the reserve requirements imposed by the Federal
Reserve. Fees for the provision of deposit insurance and constraints on the investment of funds also
increase the cost of banking in the U.S. relative to the eurocurrency market.

FEDERAL RESERVE BANK OF PHILADELPHIA

eurodollar system. The impacts of fund flows
on bank demand for dollar reserves make it
more difficult for the Fed to calculate the
effects of its operations on the monetary
aggregates. If the Fed fails to anticipate the
effects of its policies on deposit flows, then
its forecasts of the growth of the domestic
economy will be either too high or too low.
When the fluctuations in deposit flows be
come apparent, the Fed must compensate by
buying or selling securities in the open market.
Since a monetary policy based upon reserve
management is more effective the more pre
dictable the effects of open market interven
tion, many have argued for the extension of
reserve requirements to include deposits in
the eurodollar m arket.6
Unilateral Reserve Requirements Would
Fail. One reform would be to impose reserve
requirements on eurocurrency deposits, al
though not necessarily in the same magnitude
as on domestic deposits. But then shifts of
funds by depositors from domestic to euro
dollar accounts would affect total required
reserves. Thus under this approach the Fed
would have to anticipate the effects of its
open market operations on the structure of
bank liabilities and adjust its intervention to
produce the desired effect on transactions
balances.
As long as domestic and eurodollar de

posits are close substitutes, a preferred plan
would be to impose the same reserve require
ments on both kinds of deposits. In this case
deposit shifts would not affect total required
reserves. The effect of an open market trans
action to reduce the supply of reserves then
would not be complicated by deposit shifts.
But attempts by the Fed to impose reserve
requirements unilaterally by forcing the
branches of U .S. banks to hold reserves
against their eurocurrency deposits would
have little chance of success. These require
ments would make U.S. banks uncompetitive
in the market and they would be driven out
by unregulated foreign banks. The ease with
which the eurocurrency market can side
step unilateral efforts at regulation has led
policymakers to seek international coopera
tion on reserve requirements. But even these
efforts promise little near-term success.
The International Way. Two interna
tionalist approaches to eurocurrency market
reserve requirements have been tried. Under
the first, all nations would agree to impose
reserve requirements on the eurobanking
offices operating within their boundaries.
These reserves would be held on deposit
with the host country’s central bank, and, for
simplicity, the reserve requirements of each
nation on a given currency would be identical.
Banks operating in London and Paris would
have to hold the same dollar reserves for
equal quantities of eurodollar deposits.
The difficulty with this proposal is that it
would have to be accepted by all nations to
be effective. If one nation failed to participate,
the reserve requirements could be avoided
simply by transferring all eurocurrency
operations to the branches in that nation.
Under the second plan, each participating
monetary authority would impose reserve
requirements on all eurobanking offices,
wherever located, of banks having head
offices within its boundaries. These reserve
requirements on the head office would cover
the eurocurrency operations of all branches
and subsidiaries. London as well as Caribbean

®Although the monetary policy tools of the Fed
remain effective, the question of equity has been raised.
Are banks with eurocurrency market branches better
able to serve their customers during times of monetary
tightness than banks without? Some suggest that banks
with eurobranches can continue to provide loans to their
customers during periods of tight credit in the U.S.
by encouraging them to shift to the eurodollar market.
Banks without branches cannot provide credit directly
to their customers from this source. But there is a limit
to the quantity of funds that can be raised in the
eurocurrency market by participating banks for loan to
their clients without bidding interest rates up to their
levels in the domestic financial markets. Depending
upon how quickly rates adjust in the euromarket to
equalize borrowing costs, banks with eurobranches
may have very little competitive advantage.

BUSINESS REVIEW

MARCH/APRIL 1981

branches of United States banks, for example,
would be required by the Federal Reserve to
hold specified fractions of their eurocurrency
liabilities as reserves.7 Once adopted by the
major banking nations, this plan would
make it much more difficult for banks to
avoid reserve requirements, because the lo
cation of branch banking offices would be
irrelevant. Wide coverage could be achieved
through the agreement of a relatively small
number of countries.
But banks headquartered in nonparticipat
ing nations could upset the apple cart. Al
though they might be a small part of the
market at first, their eurobanking operations
would be very profitable compared to those
of the participating nations and they would
grow at the expense of the banks in partici
pating nations. Over the longer term, their
operations would make eurocurrency regu
lations less and less effective.
These reserve requirement proposals have
received mixed reviews from central bankers
around the world. Differences in financial
institutions and practices among nations
work against their adoption. Many nations
do not rely on reserve requirements to regu
late domestic banking activity and feel un
comfortable with plans to impose them in
the eurocurrency market. And they fear that
their banks would find it difficult to compete
in a world in which reserve requirements
applied to both domestic and eurocurrency

market operations. Many current market
centers would lose their importance as dif
ferences in regulation from nation to nation
diminished. Thus reserve requirements re
main only a long-term hope for the euro
currency market. Supervision is more likely
to become a reality in the short run.
MORE SUPERVISION
COULD STRENGTHEN THE SYSTEM
The risks faced in international banking
are pretty much the same whether a loan is
made at a domestic branch or through the
eurocurrency market, but bank examiners in
many countries do not have access to the
records of offshore branches. Thus it’s diffi
cult for them to tell whether banks are
maintaining adequate capital reserves to
finance their occasional losses. Those favor
ing the supervision of eurobanking argue
that these institutions must deal with many
different types of risk and that management
of these risks certainly is a matter of concern
to society.8
International Bankers Must Manage Risk.
One of the most elementary risks faced by
financial intermediaries arises from the
practice of borrowing short maturity funds
in order to finance longer maturity loans—
interest rate risk.9 The degree of risk varies
according to how closely asset maturities are
8A more detailed discussion of the risks faced by
eurobanks is provided by Edward J. Frydl, “The Debate
Over Regulating the Eurocurrency Market,” Quarterly
Review, Federal Reserve Bank of New York, Winter
1979-80, pp. 11-20.

7AIthough reserves would be held in the same cur
rency as the deposits, the location of the reserve
accounts is an issue still to be resolved. More information
on this proposal is available in “A Discussion Paper
Concerning Reserve Requirements on Eurocurrency
Deposits,” April 1979, prepared by the staff of the
Federal Reserve Board. Further discussion of the issues
associated with the reserve requirement proposal ap
pears in Dale W. Henderson and Douglas G. Waldo,
“Reserve Requirements on Eurocurrency Deposits:
Implications for Eurodeposit Multipliers, Control of a
Monetary Aggregate, and Avoidance of Redenomination
Incentives,” International Finance Discussion Paper
No. 164, July 1980, Board of Governors of the Federal
Reserve System, Washington, D.C.

9The practice of maturity mismatch in the eurocur
rency market developed between 1973 and 1977. While
data for 1973 show little maturity mismatch, the data for
1977 indicate a level comparable to that attained by
commercial banks in the United States. During Novem
ber 1977, 78 percent of eurobank deposits in the U.K.
had less than three months to maturity, while 59 percent
of eurobank assets had less than one year to maturity.
Jane Sneddon Little, “Liquidity Creation by Euro-banks:
1973-1978,” New England Economic Review, Federal
Reserve Bank of Boston, January/February 1979, pp.
62-72.

FEDERAL RESERVE BANK OF PHILADELPHIA

matched to liability maturities.
When a bank extends a loan for three
months at a fixed rate of interest, for example,
it must decide whether to fund that loan
piecemeal through a series of short-term
deposits or to seek a three-month deposit and
fund it all at once. If the three-month fixedrate loan is financed by a three-month fixedrate deposit, then maturity mismatch is
avoided and interest rate risk is obviated: the
profitability of the loan is unaffected by
interest rate fluctuations during its term. But
if a two-month deposit is used to fund the
loan initially, then, after two months, fi
nancing must be arranged for the remaining
one-month term of the loan. The interest rate
on the one-month deposit necessary to com
plete the financing is not known until two
months hence, and unanticipated increases
in the interest rate paid to depositors during
this time could lead to a loss on the loan.
Banking regulators are concerned that pru
dential limits on the mismatch of banks’
domestic portfolios might be circumvented
by increasing the mismatch of their eurobanking portfolios.
Also, just as in the domestic banking
system, there is always the chance of loan
default in the euromarket. But since the
nationality of the borrower often differs
from that of the lender in this market, the
chance of default is affected not only by
economic conditions at home, but also by
economic and political developments abroad.
Thus eurobanks must monitor events far
from home. 10 In principle, the risks associated
with international lending can be accommo
dated as long as the interest rates charged on
loans to other countries are high enough to

allow banks to accumulate adequate loss
reserves. But some participants in the market
argue that loan rates have not been high
enough. They claim that government subsidies
enable many banks to bid the eurodollar loan
rate below the level necessary to provide
adequate reserves.
Another risk associated with international
banking involves the possibility of unex
pected movements in exchange rates. Con
sider a eurobank with a portfolio of $35
million in eurodollar deposits, $30 million in
eurodollar loans, DM 10 million in eurodeutsche mark deposits, and DM 20 million
in eurodeutsche mark loans. At an initial
exchange rate (DM/$) of DM 2.0, this port
folio is long in Deutsche marks (DM assets
exceed DM liabilities) and short in dollars.
The bank is purposefully exposing itself to
exchange rate risk in anticipation of an
appreciation of the Deutsche mark (a reduc
tion in the DM/$ exchange rate). If this
appreciation occurred, the dollar value of
assets would rise faster than the dollar value
of liabilities, and the bank would earn a
profit. If, however, the Deutsche mark un
expectedly depreciated so that the DM/$
exchange rate rose to DM 2.5, then the bank
would suffer a $l-m illion loss. A bank with
$30 million in eurodollar deposits and loans
and DM 20 million in eurodeutsche mark
deposits and loans has no exposure to ex
change rate risk. Neither appreciation nor
depreciation of the Deutsche mark changes
the bank’s net w orth.* Exchange rate risk
11
was a factor in the failure of one major

the long run it would be ineffective. Funds withdrawn
from eurobanks with United States parents and redeposited elsewhere would flow through the interbank
placement market. The only loss to U.S. eurobanks
would be the extra cost of securing interbank funds over
direct deposits.

10The existence of country risk on the liability side of
the eurobanking balance sheet has also been suggested.
The claim is that deposits by OPEC nations could be
used as a weapon against the nations involved in
eurobanking, and particularly the United States. In the
short run this weapon could be used to disrupt the
normal operations of the eurocurrency market, but in

11For a discussion of exchange risk and eurocurrency
banking see Marcia Stigum, The Money Market: Myth,
Reality, and Practice (Homewood, 111.: Dow JonesIrwin, 1978), pp. 134-136.

BUSINESS REVIEW

MARCH/APRIL 1981

international bank in 1974—the Herstatt
Bank—and it continues to be of vital concern
to banking regulators.
Those favoring the supervision of the
eurocurrency market point to these risks and
argue that a bank’s management of these
risks in offshore markets should be super
vised just as in the domestic market. Not all
the sources of risk are of equal concern, but
some of them unquestionably require careful,
constant management.
Cooperating in Supervision. Most nations
agree that eurobanking operations should be
more carefully supervised. But just as in the
case of reserve regulations, unilateral action
to supervise eurocurrency banking more
strictly would have little effect. Increasing
the extent of banking supervision in one
nation could limit the ability of the banks of
that nation to compete in the marketplace
but have little overall effect on eurocurrency
banking.
Thus the banking supervisors of many
developed nations have engaged in negotia
tions to coordinate a supervisory approach
to eurobanking. Following their April 1980
meeting, for example, the central bank gov
ernors of the Group of Ten countries and
Switzerland called for
“the supervision of banks’ inter
national business on a consoli
dated basis, improved assessment
of country risk exposure, and the
development of more compre
hensive and consistent data for
monitoring the extent of banks’
maturity transformation.”12
They resolved to monitor the eurocurrency
market more closely in the future by estab
lishing a special committee to review the
international banking statistics published by
the Bank for International Settlements.

The Federal Reserve currently collects
balance sheet data from domestic banks and
their offshore branches and consolidates this
information to produce an overall picture of
each bank’s financial health, but some
European central bankers are uncomfortable
with consolidation in spite of their reliance
on balance sheet data for the supervision of
domestic operations. Progress is being made,
however, and the extension of bank super
vision to the eurocurrency market has come
a long way.
Thus while euromarket reserve require
ments have made little headway, a consensus
on the need for international supervision of
offshore banking markets appears to have
been reached. And this is the area in which
the greatest short-term gains can be expected.
CONCLUSION
The rapid growth of the eurocurrency
market over the past decade has raised con
cerns about two issues: the effectiveness of
monetary policy and the soundness of the
banking system. Extending reserve require
ments to the eurocurrency market would
strengthen the link of reserves to deposit
balances in this growing offshore market,
but progress in international negotiations to
adopt a reserve proposal has been slow.
Nations conduct their monetary policies in
many different ways, and some are not
prepared to accept an international agree
ment that would limit the attractiveness of
the eurocurrency market and drive business
away from existing eurobanking centers.
The consolidation of balance sheets has
been proposed to help fill the information
gap created by the movement of international
banking off shore. This supervision would
help to insure that bankers are as prudent in
managing their exposure to the risks of
international banking as they are in managing
domestic risks. Here, despite international
differences, there has been some movement,
with several major banking nations agreeing
to consolidate.

12Press communique issued by the central bank
governors of the Group of Ten countries and Switzer
land, April 15, 1980, and reprinted in the International
Currency Review 12 (September 1980), p. 17.

FEDERAL RESERVE BANK OF PHILADELPHIA

has pointed out the vast differences among
the regulatory policies of nations, and nations
have been unable to agree on a single ap
proach to the regulation of the eurocurrency
market. Success in the future will depend
upon the adoption of more uniform systems
to deal with the policy tasks of controlling
money growth and insuring bank soundness.

The birth of the eurocurrency market was
an important innovation in finance, and over
the past two decades this market has become
a vital part of the international financial
system. As it has matured, national authori
ties have become interested in bringing its
operations into line with their present sys
tems of bank regulations. So far, this exercise

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Full text of Business Review (Federal Reserve Bank of Philadelphia) : March/April 1981

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