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How banks magnify euro risks

To see what I mean, let’s consider European banks’ cross-border exposure to Greece, Italy, Portugal and Spain. According to the Bank for International Settlements, this exposure is just under $1.9 trillion; this includes direct lending, holdings of government bonds, derivatives and credit guarantees and so on. Of this, Switzerland and the UK are exposed to $74.3bn and $316.6bn respectively, which leaves almost $1.5 trillion (almost €1.2 trillion) for other countries, almost all of which are in the euro area.

Now, if these four nations were to leave the euro area, it’s quite possible that half this money would be lost, either because the debts would be repaid in very cheap drachmas, pesetas, escudos and lira, or because it would just be defaulted upon. So we have a potential loss of around €600bn.

Banks' exposure to southern Europe, $bn end-2011
All European banksSwiss banksUK banksRest of Europe
Source: BIS

Is this a lot or a little?

Viewed from perspective, it’s a huge sum. It’s equivalent to over a quarter of the capital of euro area banks. Such losses would imperil the weakest banks, require huge capital injections – almost certainly from governments – and lead to a further reluctance of banks to lend to even high-quality borrowers. We’d have a repeat of the crisis of 2008-09.

Even the slight chance of this is already having nasty effects. The fear of the inability to get credit in future is deterring firms from expanding and is encouraging them to build up cash. And the fear of needing cash themselves, or of not being able to recall loans from stricken banks, is making banks reluctant to lend to each other as well as to firms and households. This is forcing up interbank rates, thus raising costs for those borrowers who can get loans; as the Bank of England has said, the euro crisis will raise mortgage rates.

These effects - plus the small probability of a euro break-up actually happening - are obviously bad for all shares, not just banking ones.

However, viewed from another perspective, €600bn is a paltry sum. Imagine that such losses were spread evenly across all euro area households. The same amount would be lost, but its effects would be small. Economists at the ECB estimate that a €1 fall in wealth leads to a 1.4 cent drop in spending; this is consistent with US evidence and a little lower than the UK. This means that a €600bn loss would cut annual consumer spending by €8.4bn, which is less than 0.1 per cent of euro area GDP. Yes, it’s 0.1 per cent every year. But this is a long way from catastrophe.

This is no mere thought experiment. Recent history tells us that huge losses can have small economic effects, if they are widely dispersed. Between March 2000 and October 2001, investors in US equities lost $4.7 trillion. That’s six times as much as banks stand to lose from a euro break-up. But such losses caused only the mildest of recessions.

The message here is simple. The dangers posed by a break-up of the euro do not lie in the monetary sums involved. Instead, the problem is that the losses will be concentrated in a few highly leveraged organizations, the collapse of which would have horrible knock-on effects onto the whole economy.

Which is why I say banks are means for transforming small risks into large ones.

Now, you might think this sounds like yet another argument against the fractional reserve banking system which gives us such dangerously leveraged organizations.

I’m not sure. Imagine that we didn’t have such organizations. Every pound or euro borrowed would then have to come from some pre-existing savings (whereas under our current system banks create loans and these lead to higher savings). Such a world would almost certainly be one in which real interest rates are higher. Yes, this would deter government borrowing and speculation – which you might think would be no bad thing. But it would also choke off real, productive investment. We’d all be safer from banking crises – but at the expense of being poorer. In this sense, there’s a trade-off between prosperity and security. Of course, it is an entirely legitimate question where one chooses to make this trade-off – which is what debate about banking regulation is fundamentally about. There is, though, a danger that right now, the costs of this trade-off – financial insecurity – loom much larger than the benefits, of (past?) higher growth.

Another thing: that $316.6bn of UK exposure is equivalent to just under £200bn. The loss of half of this would be equivalent to a loss of just over 15% of UK banks’ capital, which stands at £646.7bn, according to Bank of England data. In this sense, UK banks are less directly exposed to a euro break-up than euro area ones, but still on the hook for a big amount.