As policy leaders struggle to solve the euro zone debt crisis, banks and their regulators in the U.S. are grappling with how to insulate the American financial system but are running into challenges preparing for a world of potential unknowns, such as how a default on Greece's debt would play out and what the knock-on impact would be.
Many analysts contend that on the whole, U.S. banks are better positioned to weather a storm than they were in the lead-up to the 2008 financial crisis. They argue that because our banks are not major holders of Greek debt and have stronger capital liquidity positions, the impact of a Greek default or deteriorating economic conditions in other European nations like Portugal, Italy, Spain, and France will be softened.
But U.S. regulators have begun to sound the alarm bell, envisioning more severe fallout from Europe. Hence Treasury Secretary Timothy Geithner's warning to European leaders last weekend that "the threat of cascading default, bank runs, and catastrophic risk must be taken off the table." Regulators are in daily communication with major financial institutions, trying to get a handle on the potential damage under different scenarios with no sure-fire stopgaps. They are also ratcheting up the pressure on European leaders to prevent a collapse.
A number of industry representatives, economists, and analysts argue that it is hard to gauge whether U.S. banks and regulators are adequately positioned to deal with such systemic threats.
"It's going to be very difficult to prepare for this because if Europe gets into deep trouble, the magnitude of the banking system exposure to Europe is so large it would just be overwhelmed by that," said Mark Zandi, the chief economist with Moody's Analytics. "It is very difficult to plan for that. That's why it's key that our policymakers work with European policymakers to try and solve this from a macro-economic perspective."
Since U.S. banks' direct exposure to Greece was only $7 billion as of the end of last year, according to the Bank for International Settlements, the bigger concern is whether a Greek default would cause banks in France and Germany, which hold much higher percentages of Greece's debt, to fail since they are more significant counterparties to U.S. banks.
U.S. banks' total exposure to the euro area totals some $2.7 trillion and exposure to France and Germany accounts for nearly half of that. The fear is a collapse would have a contagion impact on other economies and would reverberate through the U.S.
Michael Greenberger, a professor with the University of Maryland and a former trading director at the Commodity Futures Trading Commission, argued that regulators do not have a clear picture of the derivatives exposure of U.S. financial institutions, which is part of the reason U.S. officials are so terrified about Europe's precarious situation.
"They don't have a sense because, as was true on Sept. 15, 2008, there is no inventory on these transactions. It's opaque. There is doubtless phenomenal counterparty risk out there," he said.
(Derivatives regulations from the Dodd-Frank financial reform law are not expected to be in place until at least mid-2012.)
Greenberger said the threat is not just that default on sovereign debt could cause French or German banks to fail but that there is an unknown chain of counterparties that they insure for other credit derivatives like energy, currency, interest rate, or foreign exchange swaps, which could spark a rippling effect of chaos that dwarfs the 2008 financial crisis.
"All of the furor you are seeing is not just because some European banks hold too much sovereign debt, but that the exposure is interconnected around the world," he added.
But finding the right balance with risk management that fosters economic growth can be tricky, some industry representatives warned.
Uncertainty in the market has led to sharp swings with bank stocks taking hits that weaken their capital positions and exacerbate fear. With credit quality weak and bank regulators encouraging stronger buffers against losses and tighter lending standards, when the markets become more volatile, banks pull back.
Rodgin Cohen, a partner at Sullivan & Cromwell who represents many large financial institutions, said it is important for banks not to act precipitously and overreact in ways that could hurt shareholders and ultimately the economy more broadly.
"The most important issue is not to aggravate a situation by taking premature action," he said. "If banks don't lend, activity doesn't happen. When you have uncertainty, that is the worst of all factors for the market and for general businesses."
Former Fed Governor Mark Olson said American banks were likely making individual assessments on an ongoing basis for the risk posed by crisis in each European country and its spillover effects. "My guess is that the banks have already started to make some adjustments in their portfolio," he said.
This article appears in the September 27, 2011 edition of National Journal Daily PM Update.