The Greek government, especially, has provided social welfare benefits that it cannot afford. It has paid for them by borrowing money. Those who made the loans have now realized that they cannot be repaid…unless German and French taxpayers pay them back.
Why would northern European taxpayers be willing to pay back those who lent the funds to provide Greeks with general social welfare benefits? It is because it is their own banks that made many of those loans. The worry is that if the banks lose too much money on bad loans to Greece (and Portugal and Spain,) they will be unable to make loans to French and German households and firms. The result will be a return of the economy to recession.
What is the exposure of Euro area banks to these losses?
Daniel Gros and Thomas Mayer provide the following table:
Table 1: Exposure of euro area banks to the government as % of capital and reserves, 2009
What this means is that if all the European Union governments refused to pay any of their national debts, on the whole, the European banks would be insolvent. On the other hand, if they had just 29 percent more capital and reserves, they could take that massive loss.
More importantly, they point out that the public debs of Greece, Portugal, and Spain make up only a small portion of total European public debt.
Fortunately, the public debt of the three countries most at risk (Greece, Portugal and Spain) amounts to only about 14% of all public debt in the Eurozone.
While it is possible that European banks hold a larger proportion of debt of the countries most at risk, these figures suggest that the European banking system could withstand a substantial write-down of Greek debt. Let the Greeks default.
Because of the nature of capital regulation, any bank losses create the possibility of reduced lending–especially to business. Government regulation requires that when banks make loans to the business they have more capital than when they instead hold “cash” or government bonds. If a bank suffers a loss, it has less capital. If the regulators press the bank to return to the amount required by regulation, then the simplest way is to reduce new loans to business, and either leave repaid funds on balance with the central bank, or else purchase government bonds (presumably from Germany, France, or the U.S.) This change in the bank’s asset portfolio provides no additional capital for the bank, but by shifting to what the regulators consider less risky assets, the amount of capital required is reduced. The unfortunate side effect is that lending to business can be sharply reduced.
I think the solution is to suspend the capital requirements. The reason to have capital is to form a cushion against loss. When losses occur, capital and capital ratios should fall. As banks profit from their remaining good loans, they can and should gradually rebuild their capital and capital ratios.
The notion that governments should bail out those owing money to banks in order to prevent adverse consequences due to the operation of capital requirements is insane. Only slightly less insane is the prospect of the government bailing out banks so that capital regulations don’t cause a contraction in lending to sound borrowers.