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

Thursday, 18 Aug 2011 | 9:51 AM ET

While European banks still have hundreds of billions of reserves on deposit with the Federal Reserve, the rapid drawdown of those reserves in the past two months has raised concerns, according to a person familiar with the matter.

The Wall Street Journal reported today that the reserves of non-US banks on deposit and collecting interest at the Federal Reservedeclined from $900 billion as recently as July 13 of this year to $758 billion as of Aug. 3. While still well above where reserves were a year ago, that rapid decline in reserves could indicate that banks are having trouble funding their operations in the US, the person said.

My 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.

A spokesperson for the the Federal Reserve said it had no comment on this story.


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