The Domino Effect of Europe Bank Woes

Concerns over the health of European banks are rattling markets Thursday.

So it’s worth taking a closer look at which dominos are likely to start tumbling.

Investors are still quite spooked about the financial sector. When bad news about banks hits the headlines, there is a knee-jerk tendency to sell shares, redeem funds with exposure to the banks, and seek safe-haven.

Today’s Wall Street Journal story said that officials at the Federal Reserve have been in talks with the heads of European banks with U.S. businesses. This could be taken as a reassuring sign that regulators are proactively attempting to address potential problems. Lots of investors are probably going to take the most conservative view, however, viewing it as a sign of real problems.

This leads to selling, not just European bank shares, but U.S. bank shares. Why? Part of the reason is that we just don’t know how interconnected various financial institutions are with each other. But 2008 taught us that just because we don’t see the connections, it doesn’t mean they aren’t there.

There’s also the problem with hedge funds trying to hedge exposure to European banks. The short-selling ban on European banks makes hedging exposure more difficult. One response by some hedge funds will be to short U.S. banks as a proxy.

Large depositors are also likely to flee, withdrawing money out of European banks and putting them in U.S. banks. There’s no evidence of anything like a bank run underway, though at the margin, it’s likely the European banks are seeing withdrawals.

Then we have the prime money-market funds . The yield on these funds is so small right now that some smart people on Wall Street wonder why anyone has money in them at all. If you are being paid 0.04 percent for any amount of risk, why not just stick it in a risk-free account, perhaps a money-market fund that owns only Treasury bonds, or just buy Treasury bonds directly.

Yet there still is a lot of money in prime funds. Some of that is likely to be withdrawn by investors concerned about the exposure of the funds to the financial sector. Money-market funds are ordinarily a big source of short-term funding for both U.S. and European banks with dollar obligations. So fears about Europe or the financial sector translate into redemptions at money-market funds.
CNBC

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