'Mother of all bank runs' has already begun in eurozone

Uncertainty over the future of the eurozone runs high, despite last week’s high-on-hot-air agreement on moving towards greater fiscal union. And that uncertainty is driving European banks into a severe liquidity crunch that could cause the region’s entire banking system to collapse, analysts fear.

The early warning signs of such a liquidity seizure are already showing up in the troubles that European banks face in raising short-term liquidity. French, Italian and Spanish banks have run out of collateral (typically US Treasures) that they put up to finance short-term loans, and have been forced to pledge their gold reserves in order to secure dollar funding, reports The Telegraph.

Some European banks have resorted to selling foreign assets to meet their capital requirements; others have cut back on their lending to industry.

Money is to the economy what blood is to the human body. So long as both are circulating smoothly, they’re doing fine. But when liquidity starts to choke in the veins of the economy, as is happening now, it points to a coming seizure. Which is the worry that keeps bankers and analysts up at night these days.

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The “collateral crunch” has come about because the banks’ traditional means of raising funds are running dry as investors, worried about the survival of the euro, are pulling out their savings or are easing up bank bond purchase.

Essentially, what this signals is that investors are beginning to lose their faith in the banking system, and have begun a ‘bank run’ that could snowball into a full-blown crisis.

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Even the market for short-term interbank lending is seizing up. The Economist reports that US money-market funds have reduced their lendings to European banks by more than 40 percent in the past six months.

According to rating agency Fitch, even European money markets funds are reducing their exposure to banks in France, Italy and Spain.

Just last week, rating agency Moody’s raised the red flag over French banks, cutting their debt ratings citing the heightened difficulties that the banks faced in raising funding and the worsening economic outlook. “Liquidity and funding conditions have deteriorated significantly,” Moody’s said.

In September, French banks witnessed a flight of capital to the tune of 100 billion euro after US money-market funds, wary of French banks’ exposure to peripheral economies and to Italy, turned off the liquidity tap.

Also last week, the European Banking Authority (EBA) said that the region’s banks must raise 114.7 billion euro in extra to withstand the eurozone debt crisis.

The undercurrent of nervousness about the euro, and the lingering risk that one or more countries may yet opt out of the eurozone, has additionally prompted a flight of capital away from peripheral southern European economies, which could trigger a larger bank run.

Bloomberg reports that European companies have initiated contingency plans in the event of an unravelling of the euro. Among the measures they’ve set in motion: moving money out of Spain and into Germany, transferring their headquarters from southern Europe to the north; cutting investments; and, in extreme cases, going out of business.

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One CEO quoted in the report said he did not “trust Spain will remain in the eurozone… We moved our cash and deposits (from Madrid) to Germany because Spain will come back to the peseta.”

Others too have sighted similar symptoms of capital flight. “Corporates are withdrawing deposits from banks in Spain, Italy, France and Belgium,” a Citigroup analyst wrote in a recent research report. “This is a worrying development.”

What is the risk from a prolonged liquidity crunch?

The first is that banks could turn off their own lending tap, which could affect businesses and borrowers and trigger a downward spiral in the economy. Bad as it is, the second prospect is rather more catastrophic: a bank failure, speculation about which abounds in the market, could trigger panic of the sort we saw in 2008.

Human psychology could accentuate that problem: the fear that a bank could go under will likely trigger a stampeding by investors to pull out their money. Even if the bank was not initially at risk, a bank run of this sort, when investors pull out their money simultaneously, is more likely to tip it over.

Likewise, market panic triggered by this collateral crunch would also suck out the air of liquidity in markets around the world as investors flock to safe havens. To an Indian economy that is already in hot water , that could mean a sharper fall in the rupee as foreign investors, already disenchanted with India, head for the door.