Offshoring the euro: London calling?

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Robert McCauley is a non-resident senior fellow at Boston University’s Global Development Policy Center, and a research associate at Oxford’s Faculty of History. This post draws on a SUERF Policy Note.

London remains an under-appreciated euro success story, carving out a massive role in the currency despite the impact of Brexit, the death of Libor and European efforts to shift more activity back to their own countries.

For over-the-counter (OTC) trading in euro-denominated interest-rate derivatives like swaps, London’s market share is still double that of all the euro area financial centres combined. Even in international banking in the euro, London runs neck-and-neck with all the euro area centres combined. And the City could soon be doing even better in euro banking.

A sizeable caucus of central bankers in the Eurosystem want to stanch widening losses at the national central banks by imposing large unremunerated required reserves against deposits. The losses reflect the negative interest margin on low-yielding bond portfolios financed by excess reserves on which the Eurosystem is paying 4 per cent.

The European Central Bank has already decided to cease remunerating the 1 per cent required reserves. With a base of €15tn of reservable deposits, that decision cost euro area banks the current ECB deposit rate of 4 per cent on required reserves of €150bn. In other words, the ECB clawed back a cool €6bn a year from banks. 

So large are central bank losses in the euro area that some are suggesting required reserves of 5-10 per cent — or even 15 per cent. Leading the charge is Paul De Grauwe, who holds the John Paulson Chair in European Political Economy at the London School of Economics (his magisterial book The Economics of Monetary Union is now in its 12th edition).

In September, the Bundesbank invited De Grauwe to give a lecture on “The role of central bank reserves in monetary policy.” He argued that the ECB could still control short-term rates after raising required reserves to 10 per cent of deposits or more by paying its deposit rate at the margin on excess reserves. 

What matters for London is, who pays for the unremunerated required reserves? 

Call these a tax. At a 4 per cent interest rate, a 10-15 per cent unremunerated required reserve is a tax on intermediation of 40 or 60 basis points. The tax can fall on bank shareholders, bank borrowers, or bank depositors, or some combination of them. 

Many follow De Grauwe in assuming that bank shareholders will pay the tax. They are an easy target: the ECB rates took the elevator up, but bank deposit rates are going up the stairs. Moves to tax banks in Spain and Italy drew on the popular impatience with banks not passing on higher rates to depositors.

However, a little history helps to answer the question of who will actually pay.

The eurodollar market grew in no small part as a way for first Europeans and later Americans and Asians to avoid paying the cost of the Fed’s reserve requirements. The Fed imposed unremunerated reserve requirements on large US deposits at varying rates until 1990. 

In the 1970s and 1980s, banks arbitraged between funding themselves with eurodollars or with big New York certificates of deposit. They issued liabilities in the cheaper market, or even borrowed in the cheap market to place in the pricier market. 

The banks thus tended to equalise the “all-in” cost of funds in New York — including the cost of reserve requirements and deposit insurance — with the cost of funds in the offshore eurodollar market, where no reserves were imposed.

The upshot of such arbitrage, then and now, is that the immobile depositor pays the tax. If the ECB imposes a 10 per cent required reserve with rates at 4 per cent, Dutch-headquartered bank ING could offer its internet banking clients in the euro area a choice between a local deposit or a London deposit yielding about 40 basis points more. 

In addition, French SICAVs (investment vehicles with variable capital) or Luxembourg euro money market funds could bundle households’ and firms’ euros into portfolios. These so-called shadow banks could funnel the euros into banks outside the euro area, including branches of euro area-headquartered banks. These liabilities would be not subject to the Eurosystem tax.

Cat and mouse would be the order of the day. The ECB might include in the base of required reserves not only nonbank deposits, but also euros that banks borrow from banks outside the euro area. Banks could end-run that one too. They could book euro loans as well as deposits in London.   

The US experience with a widening of the base for deposit insurance in 2011 suggests that incentives as large as 40 basis points could move trillions of euros to London and other offshore centres. The post-crisis Dodd-Frank Act imposed just an 8-10 basis point levy. Half a trillion dollars moved from offshore deposits to onshore deposits within months. 

Depositors with more money would be more likely to evade the tax by shifting their euro deposits offshore. Those promoting a tax on banks’ shareholders might instead succeed in imposing a regressive tax on smaller depositors.  

As a result of the relocation of deposits, the tax would raise the income of euro area central banks by less than its proponents promise. Three or four trillion euros out of the current base of €15 trillion of reservable euro area deposits could end up in London.

Euro area depositors won’t all sit still for large, unremunerated required reserves. Those that do, will pay the tax.