European Banks Have Huge Reserves, So What's the Worry?

$2.5 trillion U.S. money market funds industry -- which supplies short-term dollar funding to banks -- has retreated from the euro zone in recent months, concerned that the continent's debt crisis is spiraling out of control.


That and the drying up of interbank lending has led to a trebling of dollar funding costs for euro zone banks in the last month. One bank was forced to borrow dollars at the European Central Bank on Wednesday.


In a dramatic shift, the U.S. branches of foreign banks became net borrowers of dollars from their overseas affiliates for the first time in a decade, Federal Reserve data released last week showed.


The Fed's New York branch -- which oversees U.S. units from many European banks -- is now asking for more information about whether the banks have reliable access to the funds needed to operate in the United States, the Wall Street Journal said.


New York Fed officials "are very concerned" about European banks facing funding difficulties in the United States, a senior executive at a major European bank who has participated in the talks told the Wall Street Journal.


sources say that the draw down in reserves has continued over the last few weeks. One group inside a major US financial institution estimates that the reserves are now down to just $600 billion.


That is still a very, very large amount of reserves—far beyond anything that would have been in place prior to the financial crisis. But it is the pace of the drawdown that is prompting inquiries from banking regulators, according to a source.


Banks do not ordinary need to lend out of their reserves to issue loans to customers. Instead, they typically back the loans they make to customers with funds borrowed from other institutions, including other banks and money market funds . When banks start lending out of reserves or dipping into reserves to pay for operations, it may indicate distress in the market for interbank lending.


Still, Wall Street sources I spoke with emphasized that their is no immediate need to panic. Reserves are still at extremely high levels, indicating that it is unlikely that banks will experience funding problems. What's more, by keeping an eye on reserve levels, Fed officials can detect potential problems.


"If there's a problem with one institution, the Fed officials will see the reserve draw down and can start talks with bank officials and European banking regulators," one Wall Streeter explained.