Mistrust is clouding the atmosphere between European banks and US officials, as contagion hazard lurks.

Last Thursday August 18^th,  the Wall Street Journal writes an interesting story on the growing mistrust between the US Federal Reserve and large European banks with large American branches.  

The Fed is afraid that the enduring debt crisis in the Euro-zone makes that these European banks with American branches have increasing difficulties to roll-over their debt. Other parties that want to lend money to these banks, might not be sure of their counterparty’s asset quality; especially if they suspect large exposure to sovereigns bonds from the PIIGS countries or other troublesome investments. This could lead to increased interest rates that are well above the Euribor / Libor level, making borrowing of large sums of cash very expensive.

To avoid these higher interest rates, the parent companies in Europe could choose to withdraw cash from their American branches instead, to fulfill their European liquidity needs. This could lead to a shortage of cash at the American branches,  and thus to contagion from the European debt crisis to the US. In order to prevent this from happening, the Fed of New York held meetings with representatives of these European banks.

Here are the pertinent snips of the WSJ-article:

Fed eyes European Banks

Federal and state regulators, signaling their growing worry that Europe's debt crisis could spill into the U.S. banking system, are intensifying their scrutiny of the U.S. arms of Europe's biggest banks, according to people familiar with the matter. 

The Federal Reserve Bank of New York, which oversees the U.S. operations of many large European banks, recently has been holding extensive meetings with the lenders to gauge their vulnerability to escalating financial pressures. The Fed is demanding more information from the banks about whether they have reliable access to the funds needed to operate on a day-to-day basis in the U.S. and, in some cases, pushing the banks to overhaul their U.S. structures, the people familiar with the matter say. 

Officials at the New York Fed "are very concerned" about European banks facing funding difficulties in the U.S., said a senior executive at a major European bank who has participated in the talks.Continued lack of resolution over the sovereign debt crisis as well as disappointing earnings reports caused Italian, German, Spanish and French indexes to drop over the day. 

Regulators are trying to guard against the possibility European banks that encounter trouble could siphon funds out of their U.S. arms, these people said. Regulators recently have ramped up pressure on European banks to transform their U.S. businesses into self-financed organizations that are better insulated from problems with their parent companies, a senior bank executive said. In one sign of how European banks may be having trouble getting dollar funding, an unidentified European bank on Wednesday borrowed $500 million in one-week debt from the European Central Bank, according to ECB data. The bank paid a higher cost than what other banks would pay to borrow dollars from fellow lenders. It was the first time for that type of borrowing since Feb 23. 

Anxiety about European banks' U.S. funding comes amid broader concerns about whether Europe's struggling banks will be able to refinance maturing debt in coming years. Investors, wary of many European banks' holdings of debt issued by troubled euro-zone governments, are shunning large swaths of the sector. While top European banks already have satisfied about 90% of their funding needs for 2011, they still need to raise a total of roughly €80 billion ($115 billion) by the end of the year, according to Morgan Stanley.

The banks mentioned in the article were Deutsche Bank, Société Générale en Unicredit. Also Rabobank, the Dutch bank, has a large American operation.

I doubt, if the Fed has much to worry about, at this moment. For now, it seems more a hypothetical than a real problem and you might even think that the Fed is panicking.

What this article proves, however, is that the ‘extend and pretend’ policy of the Euro-zone countries towards the sovereign debt crisis of the PIIGS-countries, is turning into a catastrophe. The Euro-zone´s failure in finding a thorough solution for the European debt crisis, leads to a spreading mistrust in the financial world and subsequently to mistrust between Europe and the US. 

European banks that formerly had a rock-solid reputation in the US, are now suspected of being ‘future liquidity risks’, due to ‘cash being siphoned out’.

The Euro-zone must not wait until September with finding a further solution for the European debt crisis. There are about two credible options for the Euro-zone:

·         If the Euro-zone seriously wants to bail the PIIGS-countries out when these are in need, they need to have more bullets in their EFSF bazooka: maybe about €1,5 trn.

·        The other option is to take a 50% voluntary haircut on Greek debt and hope that that doesn´t lead to a financial meltdown, inside and outside Europe. Of course, this would only solve the Greek problem and it might even bring Spain, Portugal and Italy to the idea that they could do the same. The latter would in fact be the ´car crash´, as advocated by Todd Harrison of Minyanville (www.minyanville.com): debt destruction on a giant scale.

However, doing nothing – still the option of choice for politics in the Euro-zone, currently – seems like playing with fire: the forest fire that is now spreading from Europe to the US.