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Update: This post was written on Sept. 14. On Sept. 15, the European Central Bank, along with other central banks from around the world, announced a new lending program to fight the slow-motion run on Europe's banks. Here's more on that program.
Fear can wreck a banking system and cause havoc in an economy. That's why the recent worries about big French banks are so important, and so scary: Even without a Greek default, Europe could slide into a financial crisis.
For the past few months, what The Economist called a slow-motion run has been underway for big French banks. It looks different than the classic bank run, where ordinary people lose confidence in a bank and rush to pull their money out. That's because big European banks are different from traditional, Main Street banks.
At a Main Street bank, regular people put money in savings and checking accounts. This is, in effect, a short-term loan to the bank. The bank then takes that money and makes long-term loans to other regular people in the form of mortgages, small-business loans, and the like.
Big European banks work sort like that — but on a much, much bigger scale.
Big institutions like money-market funds lend billions of dollars to big European banks. These are short-term loans of a month or so.
The European banks take that money and make huge, long-term loans to big companies national governments. That includes loans to Greece (in the form of Greek bonds) and other countries with financial troubles.
Recently, many of the big institutions that lend money to French banks have grown worried about the banks' loans to Greece and other countries. So they've started pulling their money out of the banks.
For example, U.S. money market funds reduced their deposits in French banks by about a third between May and August of this year, according to one recent analyst report — that's tens of billions of dollars they've pulled out of French banks.
So far, French banks have been managing. They've been paying higher interest in order to borrow from other sources. In a pinch, they can also borrow from European Central Bank. This may allow them to muddle through, particularly if European leaders come up with a bigger, bolder bailout plan for Greece that eases investors' worries.
But if the slow-motion bank run continues, the banks may ultimately be forced to sell off bonds and other assets they hold. If several banks are forced to sell assets at the same time, the price of those assets will fall. It's simple supply and demand.
As Gary Jenkins of Evolution Securities put it when I talked to him this morning: "If all the banks go, who is buying?"
In the language of finance, this can push a bank from liquidity to insolvency.
At the beginning, the bank is fundamentally sound, but can't come up with enough money to meet its short-term needs. It has liquidity problems.
So it's forced into a fire sale of its assets. This drives down the assets' value. The fall in value means that the bank is no longer fundamentally sound — it's insolvent. In plain terms, the bank is bust.
The big French banks are too big to fail. So instead of going bust, they would get a bailout from the French government.
But this would likely be an ugly, scary process. It would cause more fear, and more problems, in financial markets throughout Europe and beyond. It could, in short, be another financial crisis.