By Katy Migiro

NAIROBI, Feb 19 (Thomson Reuters Foundation) - Somali families are panicking and businesses are running short of funds two weeks after the last major U.S. bank stopped transferring money to the fragile Horn of Africa country, development groups said.

Somalia has no formal banking system due to decades of war, so Somalis living abroad use money transfer companies to send some $1.3 billion home each year - far more than the country receives in aid, Oxfam and Adeso said in a report on Thursday.

Merchants Bank of California closed its accounts with Somali-American transfer companies on Feb. 6, cutting off a lifeline to millions in a country plagued by widespread hunger, recurrent drought and an Islamist insurgency.

Virtually all major U.S. banks have ended remittance services to Somalia over the last few years because of regulations that hold banks responsible if they transfer funds to "terrorist" groups like Somalia's al Shabaab.

Merchants Bank handled 60 to 80 percent of the money sent to Somalia from the United States, which is the country's biggest source of remittances, Adeso and Oxfam said.

"There has been quite a lot of panic from the diaspora with some (money transfer) branches actually being closed," said Degan Ali, the Somali-American executive director of the charity Adeso. "There is a bit of scrambling trying to find alternative (money transfer operators) to work with."

The Somali community in the United States has started a Twitter campaign using the hashtag #IFundFoodNotTerror.

"The money I send back to Somalia helps my siblings go to school," tweeted Ifrah Ahmed. "They are not terrorists."

Some 40 percent of Somalis rely on remittances for daily needs, such as food, medicines and school fees, Adeso said.

Blind and white-haired, Hassan Hussein Bulale's only source of income is $50 a month from a relative in the United States.

"If that money stops, it will be devastation," the elderly man, who lives in the city of Hargeisa, told Oxfam.

While most transactions are a few hundred dollars sent to needy family members, it is Somali businesspeople and traders, trying to transfer thousands of dollars, who have started feeling the impact of the Merchants Bank account closures.

"Cash-flow is becoming a problem in the system," said Adeso's Ali. "(The) pipeline of cash coming in from the U.S. is decreasing."

Somalia's remittance crisis has been intensifying for years. Britain's Barclays Bank closed its accounts with Dahabshiil, the largest Somali money transfer company, in 2014.

In Australia, Westpac, the only bank partnering with Somali remittance companies, is due to close their accounts at the end of March, the report said.

"We are just lurching from crisis to crisis", said Ed Pomfret, Oxfam's Somalia campaign manager. "These governments need to take action."

Britain has been working with the World Bank on a "Safer Corridor" initiative to tighten the scrutiny of Somali money transfers through measures such as biometric identity cards for recipients in Somalia.

It has also told banks dealing with Somali money transfer companies that they will not be prosecuted if money ends up in the wrong hands if they can show they have undertaken due diligence.

But the U.S. government is not matching these efforts to ensure money continues to flow into Somalia, where 3 million people - about a third of the population - require aid, campaigners said.

"This should be a real priority because otherwise... it is going to be a lot more expensive in terms of the aid that is needed," Pomfret said.

Somalia endured famine in 2011, during which more than 250,000 people died. Malnutrition rates remain at emergency levels in several parts of the country as fighting continues between the Western-backed government and Islamist militants.

(Reporting by Katy Migiro, Editing by Alisa Tang)