By: Dr. Lynn Reaser
The Federal Reserve is now worried that U.S. exposure to European banks is mounting while it is scrambling to find a way to protect the U.S. financial system from further chaos. Stocks have plummeted. Could it be as big a potential disaster as some are saying?
Fears are spreading that loans from European nations, the European Central Bank, and the International Monetary Fund will not be enough to solve the debt problems of debt-laden countries ranging from Greece to Italy.
As a result, these countries might be forced to ultimately default or restructure significant portions of their debt. Reductions in principals paid, lower interest rates, or an extension of maturities will all impose losses on creditors.
Bank creditors holding European sovereign debt are consequently at risk of seeing their capital eroded and their financial positions substantially weakened. A potential tightening of lending conditions, stock market losses, and fiscal austerity programs all threaten to start a negative feedback loop for the European economy with negative repercussions on the U.S.
The Federal Reserve is particularly concerned at this point that the U.S. arms of European banks might find funding from their parents in jeopardy. Access to funds could be further strained by the selling of European exposure by U.S. money market funds, a shutoff in funding from U.S. commercial banks, and the withdrawal of deposits by U.S. customers.
U.S. Banks are in better position than in 2008, but European banks are in a worse predicament. Lack of transparency plagues European banks. Investors do not know how severe the damage could be.
Globally, entanglement and contagion risk does not appear to be as severe as existed after the subprime crisis, but no one can be sure of the web of exposure and possible losses that might be incurred across the financial system.
The Fed is certainly prepared to keep its discount window open to borrowers and to provide swap lines or dollars that may be needed by the European Central Bank. However, investors are looking for a bigger safety net to be provided by the Europeans or more convincing long-term solutions to Europe’s debt problems. Stay tuned.