An overview of the Eurocurrency interbank market

The functions of the interbank market The Eurocurrency interbank market has at least four related functions. First, the interbank market is an efficient market system through which funds move from banks in one country to banks in other countries. Second, the interbank market gives banks an efficient mechanism to buy or sell foreign-currency assets and liabilities of different maturities in order to hedge their exposure to interest rate and foreign-exchange risks. Third, the interbank market is a convenient source of additional loans when banks need to adjust their balance sheets either domestically or internationally. Fourth, because of this market, banks sidestep regulations on capital adequacy and interest rates prevalent in many domestic banking markets.

Risks of participating banks Participating banks in the Eurocurrency interbank market face at least five different risks: (1) credit or default risk, (2) liquidity risk, (3) sovereign risk, (4) foreign-exchange risk, and (5) settlement risk. First, credit risk is the risk that a borrowing bank may default on its interbank loan. This risk is a concern because interbank loans and deposits are not secured. Second, liquidity risk is the risk that other banks may withdraw their interbank deposits suddenly. Here, the bank may have to sell off illiquid assets for less than their face value to meet its deposit drain. Third, sovereign risk is the risk that a foreign country may prevent its banks from repaying interbank loans or deposits received from banks in other countries. Fourth, foreign-exchange risk is the risk that a bank participant in this market will gain or lose due to changes in exchange rates. Fifth, settlement risk is the risk of a breakdown or nonsettlement on the major wire-transfer systems.

Regulators and analysts have expressed some concern about the stability of this market for two major reasons. First, interbank funds have no collateral. Second, central bank regulations are inadequate. These two factors expose the market to potential "contagion"; problems at one bank affect other banks in the market. This kind of contagion ultimately threatens the market's stability and its function.

Minimum standards of international banks With the global crisis created by the collapse of several international banks in the 1980s, bank regulators throughout the world agreed that something had to be done to protect against future massive failures. The Basel Committee, under the auspices of the Bank for International Settlements and the central-bank governors of the "Group of Ten" countries, reached an agreement on minimum standards in 1988 for international banks and their cross-border activities. The Bank for International Settlements is a bank in Switzerland that facilitates transactions among central banks. This agreement established an international bank capital standard by recommending that globally active banks had to maintain capital equal to at least 8 percent of their assets by the end of 1992. The accord distinguishes between more and less risky assets, so that more capital would be held against investments with greater risk. As a result, the 8 percent standard called for in the accord applies not to a bank's total assets but to its risk-weighted assets. Safe government bonds or cash, for example, receive a zero weight in calculating aggregate risk exposure, whereas long-term lending to banks and industrial companies in emerging markets receives a 100 percent weight. Such minimum capital standards are meant to work in conjunction with direct supervision of banks and basic market discipline to restrain excessive risk-taking by banks that have access to the safety net.

Several important limitations of the current framework have become apparent over time. For example, one major drawback of the current capital adequacy standard has to do with the fact that the regulatory measure of bank risk (risk-weighted assets) can differ significantly from actual bank risk. Because the current framework provides only a crude measure of bank risk, it sets minimum capital requirements that do not necessarily reflect a bank's true economic risks and thus are inappropriate for regulatory purposes. In order to address such shortcomings, the Basel Committee proposed a new capital adequacy framework in 1998. This proposal consists of three pillars: minimum regulatory capital requirements that expand upon those in the 1988 Accord, direct supervisory review of a bank's capital adequacy, and the increased use of market discipline through public disclosure to encourage sound risk management practices.

In April 2003, the Basel Committee on Banking Supervision released for public comment the new Basel Capital Accord, which will replace the 1988 Capital Accord. These international agreements among banking regulators attempt to set regulatory capital requirements that are comparable across countries. On July 11, 2003, the Federal Reserve of the US issued an interagency advance notice of proposed rulemaking to seek public comments on the implementation of the new Basel Capital Accord in the USA. The new accord, popularly known as Basel II, rests on the three "pillars" described in the above paragraph. Basel II, to be implemented in 2006, maintains the 8 percent equity capital as the minimum standard, but it changes the way in which the capital standard is computed in order to consider certain risks.

The "three Cs" of central banking The recent movement toward a highly integrated global financial system has caused bankers to develop "three Cs" of central banking: consultation, cooperation, and coordination. Central banks are important participants in the consultation, cooperation, and coordination process due to their key role in monetary and exchange rate policies (see Global Finance in Action 11.1).

Consultation involves not only an exchange of information, but also an explanation of current economic conditions and policies. By reducing the information uncertainty, this process enhances the understanding of what is going on in the world at large and it can successfully contribute to the policy-making process.

In cooperation, countries retain full national sovereignty, but decide voluntarily to allow the actions of the other countries to influence their own decisions. While the central banks make sovereign decisions, they may agree to certain mutually advantageous courses of action and even engage in certain joint efforts that are agreeable to all parties.

Finally, central bank coordination requires individual central banks to relinquish some or all decision-making powers to other countries or international institutions. Some loss of national sovereignty is inevitably involved.

Global Finance in Action 11.1

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