To most Americans, Europe’s sovereign debt crisis must seem remote and obscure. It started with Greece and spread to Ireland, Portugal and now Italy, the continent’s fourth-largest economy.
Why is a default by any of these countries so threatening? One answer is that one country’s default could trigger a chain reaction in other countries. A second reason is that defaults could bring down banks, which would suffer huge losses on their portfolios of government bonds. A banking collapse could in turn plunge Europe — and indeed the world — back into recession.
We got some sense of the dangers Friday when the European Banking Authority (EBA) reported on the health of 90 major European banks. One indicator of vulnerability: bank holdings of Greek, Irish and Portuguese debt. At the end of 2010, these totaled 194 billion euros ($272 billion at current exchange rates). The total included 98.2 billion euros of Greek debt, 52.7 billion of Irish debt and 43.2 billion of Portuguese debt. About 60 percent to 70 percent of the debt was held by banks of the home country: Greek banks, for example, were the largest holders of Greek debt. A large-scale default in any of these countries would probably doom the local banking system.
Just how vulnerable other countries’ banks might be isn’t clear from the report, which didn’t show banks’ total holdings of all European government debt. In general, the EBA report suggested that Europe’s banks are fairly strong. The EBA subjected the banks — covering about two-thirds of Europe’s banking system — to a “stress test” to see how they would fare if Europe suffered a deep recession. It found that only eight banks would have their “tier one capital” — generally, stockholders’ equity investment — reduced below 5 percent of assets, the danger point assumed by the EBA. These included five banks in Spain, two in Greece and one in Austria. However, another 16 banks were just above the 5 percent threshold. In general, a bank’s capital acts as a cushion against losses.
Last year, a similar stress test proved embarrassing when Irish banks had to be rescued shortly after receiving a passing grade. This year’s test was toughened, and standards were made more uniform across countries. (In 2010, regulators in different countries selected their own standards.) Still, the test did omit the largest threat to Europe’s banks: a default by a member country of the European Union. Without a default, the stress test didn’t require banks to take large write-downs on their bond portfolios. If they had, many more might have fallen below the 5 percent capital floor. So the stress test still leaves the main question unanswered: How safe are Europe’s banks?