Are we seeing a liquidity crisis develop in Europe?

I don't think so but it all comes down to bondholders and money market investors. The real question, as was the case in America, is how much money taxpayers are willing to to transfer to bondholders if banks holding dubious assets (in this case, Greek and possibly other government bonds,) take losses. The Wall Street Journal ponders the issue:

Despite a €110 billion ($138.92 billion) bailout package for Greece, concerns about lending to banks have re-emerged as worries about a looming Greek debt default—or bond restructuring—have spread to other countries, such as Portugal and Spain.


"The risk that we move towards a liquidity crunch situation is substantial," said Marco Annunziata, chief economist at UniCredit Group. "I don't think it's a high risk at this stage but tensions are mounting rapidly and it's definitely something that one should be prepared for."

Investors, such as money-market funds, which have traditionally satisfied the bulk of banks' short-term cash needs, have become concerned that those banks may lose large amounts of money on their holdings of debt issued by these euro-zone governments or go bust if the event of a government default. As a result, they are switching cash from banks to safer assets, such as government bills.

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Some traders and analysts say European banks are finding it especially difficult to raise dollars given that U.S. money-market funds, already reacting to imminent regulations requiring them to lend for shorter periods, also are shifting cash to short-dated government bills from European bank commercial paper due to concerns about bank losses.

Of the $850 billion in bank-related paper held by these funds, it's possible they could shift $100 billion to $200 billion to government bills and secured transactions such as securities repurchase agreements, or repos, accord to Barclays Capital.

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Many money-market traders say, however, the impact of this liquidity crunch will be less severe than in August 2007, when funds stopped lending to banks due to concerns they held pools of toxic subprime debt. That is because central banks have developed mechanisms to respond quickly by injecting long-term cash to soothe funding concerns.


They say the ECB may reintroduce unlimited cash at six-month or one-year tenders, having stopped such offerings at the end of last year. The central bank currently offers unlimited funds through one-week tenders, and banks compete for cash offered in three-month offers.

They say the ECB could also remove the minimum credit rating requirements on the securities it accepts as collateral against these loans, as it did for Greek debt, so they would be able use euro-zone government bonds to borrow cash even if these securities are heavily downgraded.

For those not following macro issues, keep in mind that this story deals with liquidity problems at banks—this is not the same as the funding problems that may or may not be faced by some governments, such as the Greek government.
 
Liquidity problems at banks would likely be worse than government debt problems (I am talking about economic impact; politically, government debt problems are more damaging.) The reason I say this is because the government debt issues are isolated for the most part to a few small countries. For instance, Greece is something like 2%(?) of Europe's GDP.
 
In contrast, if investors, particularly money-market investors and various others who are very-risk-averse start fleeing banks, it can impact all countries. The bank losses are not limited by nations. If Greece defaults or restructures its debt, the loss will be taken by banks in, say, France and Germany. Investors won't be just avoiding the Greek banks but also the French/German/etc banks.
 
 
Overall, I don't think we will see a severe liquidity crisis in Europe unless Spain attempts to restructure its debt. Yet, anything can happen. Europeans are more left-leaning and hence likely won't be fans of bailing out banks. In contrast, Americans are more "neo-capitalist"* and were willing to bail out banks and handed out free cheques to all the big financial institutions. In an ironic twist, it is quite possible to see Europeans avoid bailing out banks while Americans continuously bail out any failing financial institution.
 
 
 
Foot Note:
 
* I just made up the term neo-capitalist and am using that to refer to people who are heavily in favour of capitalism but are also willing to socialize losses. This differs from traditional capitalism where the gains, as well as losses, accrue largely to the capitalists and their agents (i.e. managers and executives.)