Eurodollars are dollars held outside the US regulatory jurisdiction. It has no connection with the ‘Euro’ currency. The post-World War II Bretton Woods system had capital controls to minimize currency instability and to manage the global shortage of dollars which served as a constraint on the private banks. As US became a large consumer market and imported goods, dollars outside the US grew significantly. With the implicit permission of UK authorities, the London banks sidestepped the fetters by accepting dollar deposits from the wealthy and lending in dollars. This was a source of dollar liquidity outside the ambit of Fed’s regulatory powers. As Tooze puts it:

“eurodollar accounts in London offered the basic framework for a largely unregulated global financial market. As a result, what we know today as American financial hegemony had a complex geography. It was no more reducible to Wall Street than the manufacture of iPhones can be reduced to Silicon Valley. Dollar hegemony was made through a network. It was by way of London that the dollar was made global.”

CRASHED: HOW A DECADE OF FINANCIAL CRISES CHANGED THE WORLD, ADAM TOOZE (2018)

As the old Bretton Woods collapsed and capital controls were lifted, these Eurodollar accounts were awash with dollars. In Tooze’s description: “Driven by the search for profit, powered by bank leverage, offshore dollars were from the start a disruptive force. They had scant regard for the official value of the dollar under Bretton Woods and it was the pressure this exercised that helped to make the gold peg increasingly untenable. When the final collapse of Bretton Woods coincided in 1973 with the surge in OPEC dollar revenue, the rush of offshore money through London’s eurodollar accounts became a flood.”

European banks held 20% of US subprime MBSs while two-third of the ABCPs issued by SIVs had European sponsors. These contracts were dollar denominated, both on the assets and liabilities side of the balance sheet which exploded. Eurodollar was their source of wholesale funding. The Chinese, Russian and Middle-eastern wealth funds looking for relatively safe and high-yielding assets invested heavily in the SIVs which offered complex short term dollar-denominated financial instruments like ABCP. Thus, eurodollar became an integral component in the market-based shadow banking system where it stood outside Fed’s regulatory ambit and in which the European authorities bet on the Fed bailing them out if the eurodollar funding froze.

In 2007, European banks had a dollar asset-liability mismatch of about $1 trillion, which the ECB couldn’t have dealt with, with its puny $200 billions, in the event of a collapse. The central nature of eurodollar in the system is further reinforced by ECB’s “audacious assumption” that, as Tooze notes, “collaboration would be forthcoming and in an emergency the Fed would provide Europe, and London in particular, with the dollars it needed. Given the scale of the offshore dollar business there could be no other answer.”

References:

1. Tooze, A. (2018). Crashed: How a decade of financial crises changed the world. Penguin.
2. Kapadia, A. (2019). Capitalism: Theories, Histories and Varieties, HS 449 (Class Slides). IIT Bombay, delivered Jan – Apr 2019

In market-based banking, asset side of a bank’s balance sheet is securitized and liabilities are based on wholesale borrowing such that the simple assets (loans, bonds, reserves) -liabilities (deposits, capital) balance of regular banking is scaled up into a chain of complex interconnected balance sheets of multiple intermediate entities which are outside the regulatory framework that governs banks, i.e. in the ‘shadows’. Before the crisis, banks would offload the loans to Special Purpose Vehicles (SPV) which securitized them as Asset-backed Securities (ABS) which combined with Credit Default Swaps (CDS) from insurance companies became Collateralized Debt Obligations (CDO). These CDOs, stamped dubiously by credit ratings agencies, were coupled with interest rate swaps (IRS) and liquidity puts by the owning bank.

The product were issued as short-term Asset-backed Commercial Paper (ABCP) by a Structured Investment Vehicle (SIV) or used as a source of funding in the repo market. Finally, the investment in ABCPs and repo came from money market mutual funds (MMMF) which were saddled with savings. However, the SPVs and SIVs were not state-regulated entities which allowed a toxic, subprime securities to grow at a “grotesque scale” while the complicated engineering of securitization which allowed banks to earn more through fees. In regular banking, this commodification of both the assets and liabilities side of the bank’s balance sheet wasn’t possible.

Regular banks have diverse sources of short-term borrowing in the form of depositors. While they are fragile because they borrow short and lend long, the market-shadow banking is much more fragile. This is because the primary source of funding from ABCP or repo was MMMFs, as Tooze write, “Lehman got its funding wholesale by tapping the cash pools and so too would the new mortgage lenders, including Lehman. This was the truly lethal mechanism at the heart of the crisis. Funds from money market cash pools were channeled into financing the holding of large balance sheets of MBS.” If this funding stopped, the system would crash as it did.

Moreover, in regular banking, all bad loans would sit on bank’s balance sheet as illiquid assets but couldn’t have taken down the financial system. In shadow banking, the securitizers held their own product, albeit off-balance sheet. This meant that risks were concentrated on a few large, unregulated balance sheets. As Tooze write, “contrary to the professed logic of securitization, hundreds of billions of private label MBS were not spread outside the banking system, but were stockpiled on the balance sheets of the mortgage originators and securitizers themselves.”

At the same time, to issue such risky loans in a regular banking system would have required the bank to adequate capital provisioning to account for risk. But the institutional setup of incentives in the shadow banking led to hardly any allocation of capital. In fact, as Tooze writes, “under the bank regulations prevailing until the early 2000s, assets parked off balance sheet in the SIV could be backed by a fraction of the capital that would be required if they were on balance sheet.” This would turn out to be one of the straws that broke the camel’s back and lead to a collapse of shadow banking.

References:

1. Tooze, A. (2018). Crashed: How a decade of financial crises changed the world. Penguin.
2. Kapadia, A. (2019). Capitalism: Theories, Histories and Varieties, HS 449 (Class Slides). IIT Bombay, delivered Jan – Apr 2019