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The screw tightens

2011-11-24 08:31:43

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.