And now European banks are starting to panic as the oxygen is sucked out of the room

to run away




European banks are scrambling to find new sources of funding as traditional sources dry up, reports David Enrich of The Wall Street Journal.

For example, banks are now entering ”


liquidity

swaps” with each other, whereby they exchange illiquid assets that cannot be used as collateral for assets that can.

And in doing so, they are tightening the European financial system even further just when the crisis seems to be reaching its climax.

Specifically, traditional sources of bank funding in Europe, such as institutional investors and other banks, are becoming cautious as fears grow over the need for sovereign debt restructurings. When liquidity runs out, the only reliable source of funding is often the ECB.

But the ECB only accepts certain types of assets as collateral for loans, and some banks are short of those assets.

They therefore turn to investment banks and other “counterparties” who have them. And they enter into “swap” agreements in which they exchange their assets for the assets of the counterparties, then store these latter assets to use as collateral.

And it’s a good plan…until the music stops and a big “match” fails.

When a major counterparty fails, it can set off a chain reaction in which every bank and trading partner on the continent (and elsewhere) immediately starts scrambling to grab cash and more liquid assets. And then Europe will be exactly where the United States was in the fall of 2008.

What could stop the slide? The ECB could step in and start accepting different types of assets as collateral. Or step in and buy enough bonds from eurozone countries to bring interest rates down to sustainable levels.

None of these measures would be a long-term solution: there would still be far too much debt and unsustainable budget deficits for some large European countries. But it would ease the crisis.

All eyes are therefore on the ECB.

Read the WSJ article here >