The Greek Crisis, the US Financial System, and Adverse Selection?

By Clynton R. López F.  June 22, 2015

clyntonr@ufm.edu

Translated from Spanish by Andrés Contreras

Greece’s delayed payment on its debt, its possible default, and an eventual exit from the euro have been some of the most widely covered news stories in the media over the last weeks. What would be the implications of a Greek default? What would be the implications of an eventual Greek exit from the euro? This analysis focuses on the possible consequences that such events may have across the Atlantic, specifically for the United States.

 The first question directly affects banks in the United States. US banks (and practically all banks in the world) generally invest in sovereign debt issued by OECD member countries for treasury management and due to regulatory incentives. OECD countries have policies in place that rank them at a theoretical level of transparency regarding taxation and money laundering, among other issues. If American banks invest in bonds issued by non-OECD countries, they would face higher capital requirements, thus having to reserve capital equal to the amount invested in the bonds. This obviously has a negative effect on a bank’s capital-to-risk weighted assets ratios. For this reason, US banks would likely prefer to invest in bonds issued by OECD members. For instance, they would invest in Greek bonds before investing in Guatemalan bonds. Guatemala’s most recent credit rating is a BB (FITCH), while Greece is rated CCC (FITCH). Yet, Guatemala is not an OECD member. It’s no surprise then that the country with the second largest bank exposure to Greek debt is the United States.

Chart 1 shows the ranking of foreign bank exposure to Greek debt by country. The top three countries in terms of exposure are also three of the largest economies in the world and arguably have the three most important banking industries in the West. Is USD 11 billion in US bank exposure to Greek debt relevant? We must consider the Federal Reserve’s H.8 Report on Assets and Liabilities of Commercial Banks in the United States, which reports a little over USD 129 billion of investments in other securities. US bank exposure to Greek debt at USD 11 billion represents only 7%[1] of US bank investments in other securities.

 Chart 1[2]

 

 

MILLIONS OF EUROS OK? No me permite acceder al archivo para cambiar los nombres de países a ingles.

 

By recalling and slightly modifying the meaning of the phrase “adverse selection,” we can use it to assess the overall behavior of US banks. It’s generally accepted that the US banking sector is more aggressive and assumes more risk and maturity mismatch than any other. But it’s also true that it’s one of the financial systems with the most increasing regulation. Since the 1970s there has emerged a wave of second generation banking regulations[3], somewhat unseen, but very real for banks. It began with Anti-Money Laundering Act, then the Bank Secrecy Act, the Reinvestment Community Act, followed by the US Patriot Act in 2001, and more recently, the Dodd Frank Act after the subprime crisis and the Foreign Account Tax Compliance Act (FATCA). This last one not only adds a compliance burden for US banks (i.e., due diligence of correspondent banks), it also imposes a large administrative burden on foreign banks.

 

All these regulations are supposed to reduce banking risk through restrictions, risk analysis, and a supposed reduction in money laundering. But they probably don’t accomplish this goal. We need not look further than the large fines imposed on the banking sector over the last few years, starting with Wachovia Bank’s famous (or infamous) 160 million dollar fine for allegedly laundering billions for Mexican drug cartels, followed by UBS’s fine of close to one billion dollars for helping US citizens hide assets abroad and evade taxes, and more recently the large fine levied against a group of banks for rate rigging. So how many people are in jail for these scandals? As far as we know, not one person has been criminally charged, although the prosecutors reserve the right to do so. This has likely changed the landscape for banks, but in the opposite way. In order to compensate for higher costs of regulation, the need for higher return investments (and higher risk) and higher overall profitability (maturity mismatch) has become increasingly acceptable. This probably induces banks to reject conservative investments and more prudent management in order to pay for regulatory burdens and heavy fines. This may explain why American banks invest in risky Greek government debt. An adverse selection driven by regulations.

 

What will happen to the euro/US dollar exchange rate? (see chart 2). There are two hypothesis: (1) The European monetary system is shielded and will clean up with a Greek exit, and the euro will strengthen. The last month has seen a slight upturn in the value of the euro. (2) The real liabilities and contagion will have greater consequences than expected and the European monetary system will be affected if Greece defaults. This could result in a flight to quality from the euro and into the US dollar or other currencies. This could imply a devaluation in the euro against the dollar. Past experience has taught us (at least that’s my interpretation), that the consequences of debt in international financial markets are always complex. Let’s wait to see if Greece defaults on its debt.

Chart 2[4]
 

 

 

 

[1]. Prepared with data from http://www.federalreserve.gov/releases/H8/current/ through June 19, 2015.

[2]. Information from the Bank for International Settlements, referenced in http://www.theguardian.com/world/datablog/2015/jun/19/the-greek-debt-what-creditors-may-stand-to-lose.

[3]. The first generation of regulations began in the 1930s with the creation of the Federal Reserve, the Glass Steagall Act, and others.

[4]. Monthly data from https://research.stlouisfed.org/fred2/series/EXUSEU/downloaddata.