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Nov 23rd 2011, 13:26 by C.O. | LONDON
ONE can almost hear the gates clanging: one after the other the sources of
funding for Europe s banks are being shut. It is a result of the highly visible
run on Europe s government bond markets, which today reached the heart of the
euro zone: an auction of new German bonds failed to generate enough demand for
the full amount, causing a drop in bond prices (and prompting the Bundesbank to
buy 39% of the bonds offered, according to Reuters).
Now another run more hidden, but potentially more dangerous is taking place: on
the continents banks. People are not yet queuing up in front of bank branches
(except in Latvia s capital Riga where savers today were trying to withdraw
money from Krajbanka, a mid-sized bank, pictured). But billions of euros are
flooding out of Europe s banking system through bond and money markets.
At best, the result may be a credit crunch that leaves businesses unable to get
loans and invest. At worst, some banks may fail and trigger real bank runs in
countries whose shaky public finances have left them ill equipped to prop up
their financial institutions.
To make loans, banks need funding. For this, they mainly tap into three
sources: long-term bonds, deposits from consumers, and short-term loans from
money markets as well as other banks. Bond issues and short-term funding have
been seizing up as the panic over government bonds has spread to banks (which
themselves are large holders of government bonds). This blockage has been made
worse by tighter capital regulations that are encouraging banks to cut lending
(instead of raising capital).
Markets for bank bonds were the first to freeze. In the third quarter bonds
issues by European banks only reached 15% of the amount they raised over the
same period in the past two years, reckon analysts at Citi Group. It is
unlikely that European banks have sold many more bonds since.
Short-term funding markets were next to dry up. Hardest hit were European banks
that need dollars to finance world trade (more than one third of which is
funded by European banks, according to Barclays). American money market funds,
in particular, have pulled back from Europe. Loans to French banks have plunged
69% since the end of May and nearly 20% over the past month alone, according to
Fitch, a ratings agency. Over the past six months, it reckons, American money
market funds have pulled 42% of their money out of European banks. European
money market funds, too, continue to reduce their exposure to France, Italy and
Spain, according to the latest numbers from Fitch.
Interbank markets, in which banks lend to one another, are now also showing
signs of severe strain. Banks based in London are paying the highest rate on
three month loans since 2009 (compared with a risk-free rate). Banks are also
depositing cash with the ECB for a paltry, but risk-free rate instead of making
loans.
That leaves retail and commercial deposits, and even these may have begun to
slip away. We are starting to witness signs that corporates are withdrawing
deposits from banks in Spain, Italy, France and Belgium, an anlayst at Citi
Group wrote in a recent report. This is a worrying development.
With funding ever harder to come by, banks are resorting to the financial
industry s equivalent of a pawn broker: parking assets on repo markets or at
the central bank to get cash. We have no alternative to deposits and the ECB,
says a senior executive at one European bank.
So far the liquidity of the European Central Bank (ECB) has kept the system
alive. Only one large European bank, Dexia, has collapsed because of a funding
shortage. Yet what happens if banks run out of collateral to borrow against?
Some already seem to scrape the barrel. The boss of UniCredit, an Italian bank,
has reportedly asked the ECB to accept a broader range of collateral. And an
increasing number of banks are said to conduct what is known as liquidity
swaps : banks borrow an asset that the ECB accepts as collateral from an
insurer or a hedge fund in return for an ineligible asset plus, of course, a
hefty fee.
The risk of all this is two-fold. For one, banks could stop supplying credit.
To some extent, this is already happening. Earlier this week Austria s central
bank instructed the country s banks to limit cross-border lending. And some
European banks are not just selling foreign assets to meet capital
requirements, but have withdrawn entirely from some markets, such as trade
finance and aircraft leasing.
Secondly and more dangerously, as banks are pushed ever closer to their funding
limits, one or more may fail sparking a wider panic. Most bankers think that
the ECB would not allow a large bank to fail. But the collapse of Dexia in
October after it ran out of cash suggests that the ECB may not provide
unlimited liquidity. The falling domino could also be a shadow bank that
cannot borrow from the ECB.
Europe s leaders are certainly aware of the dangers and are working on
solutions. But it would not be the first time that their efforts are overtaken
by events.