12/12/2011 06:19 pm ET

Europe Crisis Drags On, Raising Concerns About U.S. Banks

Concerns about a global slowdown sharpened on Monday as markets cast a vote of no confidence in Europe's leaders. Economists and analysts expressed worries that the European problem is spreading to American banks. Any further shock to the system could spur a credit crisis, they said, raising the possibility that the Federal Reserve would have to step in to prop up banks.

Though most U.S. banks said that they have limited exposure to Europe's troubles, economists and analysts counter that financial institutions are substantially vulnerable. At issue is not just how exposed each bank is to Europe, but how exposed their financial partners are.

"You may not be holding any problem debt yourself, but your counterparty could be experiencing distress, and the relationship is no longer on firm footing," said John Jay, senior analyst at Aite Group, a financial research firm. "If you're an American bank, and global in nature, undoubtedly you are dealing with someone who holds that sovereign risk."

By Monday morning it was clear that the most recent European pact didn't reassure investors, as had been hoped. Every country in the European Union except for the United Kingdom agreed on Thursday night to sign a treaty that would raise the penalties for a country running a higher deficit or debt than allowed. The S&P 500 fell 1.48 percent, and the Dow Jones Industrial Average plunged 1.34 percent (a 162.87 point drop) on Monday. The DAX in Germany plunged 3.36 percent, and the CAC 40 in France fell 2.61 percent.

"They are doing window dressing right now. No matter what they say, they will still be backsliding," said Frank Trotter, president of online bank EverBank Direct, of European leaders.

American banks' vulnerability to the crisis in Europe is "substantial across the board," said Nicholas Economides, economics professor at New York University's Stern School of Business. One negative event in Europe, such as a failed bond auction or an announcement by Greece that it needs a larger writedown on its government debt, could spur a credit crisis in the United States, he said. "They cannot sustain another big shock," Economides said of American banks, which are still recovering from the global meltdown of 2008.

With a weak pact in place, investors are worried about any kind of Lehman-like shock to the system. Back in 2008, when Lehman Brothers filed for bankruptcy, it led to a "credit freeze," banks were afraid to lend to each other and the financial system ground to a halt until the Federal Reserve stepped in and greased the wheels by lending.

The direct exposure of banks to Europe is modest relative to banks' total assets. U.S. banks held $1.48 trillion in exposure to all of Europe as of the end of June -- this includes government debt, insurance on that debt, as well as loans to European business -- according to the Bank for International Settlements. In comparison, FDIC-insured financial institutions hold $13.8 trillion in assets. Bank of America said it has a total $14.6 billion exposure to the five eurozone countries in danger of default; the bank holds $2.26 trillion in total assets.

Still it's not clear that risk can be cleanly contained to banks' direct exposure. Since banks are valuing their assets at face value rather than market value, trust will break down between banks in the event of a credit crunch, said Gabriel Palma, economics professor at the University of Cambridge. Even though American banks are not nearly as exposed to European sovereign debt, he said, they will be just as vulnerable to that breakdown in trust.

"If there is another credit crunch, it will not really matter that much how much you actually own sovereign debt," Palma said. "Because nobody trusts each other, because they hide their risks so well and so deep ... no bank in the world will get any money from anybody else."

Palma said that if there is a credit crisis in Europe, it will be "100 percent necessary" for the Federal Reserve to lend cheap money to American banks to keep them operating.

Already credit is tightening up for small business owners. "What's going on in Europe is part of the equation that helps banks determine when to issue a loan, and there's a real concern that U.S. banks are going to take a hit," Bernard Baumohl, chief global economist of the Economic Outlook Group, an economic forecasting firm in Princeton, N.J., told HuffPost Small Business. "There could be spill-over into the U.S. banking system, and with that dark cloud hanging over the global and U.S. economy, it's understandable why small businesses are not the client of choice for big banks. They don't want to go with what they perceive is a risky customer."