By Colin Barr
June 14, 2010

Possible sovereign debt defaults make for a big headache for European lenders.

Banks in France and Germany alone have nearly $1 trillion in exposure to the staggering economies of southern Europe, according to a report issued Monday by banking watchdogs.

The Bank of International Settlements report says German banks have 12% of their capital in government bonds issued by the three hard-hit southern European countries. But France isn’t far behind, with 8% of capital exposed to the public sectors of the three stressed nations.

All told, banks in the 16-country euro zone had $1.57 trillion of exposure as of March 31 to four countries facing what the report delicately calls “market pressures” — rising interest rates spurred by concerns about whether they’ll make good on their obligations.

These have been most visible in Greece, which secured a massive aid package and retreated from the debt market this spring after interest rates on its debt spiked into the mid-teens.

But Europe’s banks have bigger troubles, the BIS report shows. Together they have $727 billion of exposures to Spain, $402 billion to Ireland, $244 billion to Portugal, and $206 billion to Greece, the BIS said.

The report defines exposures as loans, loan commitments, and derivatives contracts. Those numbers measure how much the banks would have at stake in the event of a default by the southern European governments, which face market pressure to implement unpopular austerity measures such as tax hikes and pay cuts.

A wave of outright defaults appears unlikely now, with the European Union and the International Monetary Fund providing aid and policymakers pledging to work together. But even the BIS notes that the recent episode is reminiscent of the credit bust.

“While the broad outlines are similar, the Greek downgrade on 27 April and the subsequent market reaction may have more in common with the start of the subprime crisis in July 2007 than the collapse of Lehman Brothers in September 2008,” the BIS said.

The implication is that policymakers, sufficiently chastened by the events of late 2008, will be able to forestall a replay of Lehman. But economic growth in Europe is expected to remain tepid in coming years, and the scale of the banks’ exposure to troubled European government bonds is daunting.

The big fear is that a default somewhere in Europe could lead to another round of bank insolvencies, further stressing markets and complicating the fiscal picture with another round of bailouts.

Belgian banks have exposures amounting to 5% of their so-called Tier 1 capital. Banks in Italy, the Netherlands, and Switzerland are less exposed, with less than 3% of capital standing behind loans to the stressed southern nations.

Banks in the United States have less than 1% of capital at risk in Greek, Portuguese, and Spanish government bonds. Few banks in the United States have disclosed how much they could lose in a default by a European government, though Bank of America

has said its exposure is minimal.

While the Germans would be hammered by a default in the south, British banks would be hit hard by one in Ireland. U.K. banks have $230 billion of exposure to Ireland, which has been cutting spending but still faces questions about its finances, while German banks have $177 billion.

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