Euro Crisis : The case of Bank runs

BANK runs don’t always involve small depositors queuing round the block. As we saw in 2008, institutions can withdraw their money with devastating effect.

US money market funds are exiting the euro zone in what can only be described as a stampede. The rating agency Fitch says that the funds’ exposure to euro zone banks has dropped by 33% since May this year, and is now 78% down on its May 2011 level. (French exposure is down 88% since May 2011.) Just over 8% of all their assets are now in the euro zone, compared with nearly 40% in 2009.

Britain, though not in the euro zone, has not been spared in the rush. Money market exposure is down 23% since May 2012 and 56% down on May 2011. Luckily, few banks are now that dependent on money market fund; the biggest exposure is at Svenska Handelsbanken (money funds have actually increased their exposure to the Nordic area since May).

This looks like a classic reputation problem; managers know that investors have read all the bad headlines about Europe and will be worried if their fund is too exposed. Instead of Europe, money market funds are piling into Treasury bills and Japanese debt, despite the very low yields on both.

We can draw from the above that the American investors (meaning banks and fund managers) don’t want to be exposed to EZ banks because of the potential for currency re denominations from euros to a national currency and the subsequent devaluation of those currencies. This would lead to big loses for those investors because the currencies for many nations, especially those in southern Europe, would devalue so quickly that your $1 million investment in a southern European bank could become $500,000 due to currency devaluation of potential new southern European currencies. Northern European banks face a risk due to exposure to southern Europe, but these banks have an even larger and more dangerous exposure to southern Europe. Not only are northern European investors exposed to devaluations, but the banks themselves have exposure through loans. The re-denomination of the loans into a devaluing currency could cause banks in northern Europe to receive less money than they actually gave out in loans. This would be catastrophic for those banks because banks with less money than they lend tend not to last that long. Even though they have their own currency Britain’s banks face this problem because they own and have exposure to a lot of assets denominated in Euros across the entire Euro Zone. So basically the US can pull most of the way out, the UK part of the way out, and the rest of the Europe is stuck most of the way in.

To avoid this the investors are just pulling out now to avoid this. Worst case they figure they can always just reinvest later after the new exchange rates settle into their true range or the Euro is saved. While this isn’t good news for the European financial system, it is a necessary step for American banks to protect themselves. European banks have fewer ways to avoid exposing themselves since the loans are already given out, but investors can always move their money into more reliable places like China, Japan, and the US.

In a sense, this could actually be good news. Euro zone periphery markets have clearly absorbed a massive capital flight – if US money markets have already cut their exposure by 33%, there isn’t so much room for further capital flight. And it would seem that rising rates in Spain and Italy are caused by Spanish and Italian banks being forced to simultaneously sell of their liquid assets (government bonds) to pay off money market capital calls. Especially given the decent current account positions and low primary deficits (substantial surplus in Italy’s case), the only open question is the banking system. Perhaps, if this is driven more by panic and flight than by fundamentals – and if a third of all possible flight has happened since May this year – we will see rates fall back in 2013.

As long as the Germans prevent the ECB from behaving like a true Central Bank, these speculators find an ally with the Euro-zone and therefore an easy target. And Spain and Italy will continue to look riskier than the UK or the US (a ridiculous proposition). That was the point of Draghi’s grim words this week. If necessary, he will tell the Germans to go to hell in order to save the Euro.

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