This is a continuation of my first essay, How Greece Could Create Another Round of Systemic Risk Pt 1. That essay focused on how Greece, while a small player in the Eurozone, could trigger another round of systemic risk as a result of the interlaced European banking system.
Now this is where things get REALLY tricky. Because of the intertwined nature of the derivatives market, a Greek default could result in systemic risk for the simple fact that if one of the banks that goes down with Greece has extensive exposure to Spain as well, then things could get ugly very, VERY fast.
Indeed, as stated before, 70% of exposure to Portugal, Ireland, Greece, and Spanish debt is from foreign entities. The below chart from BusinessInsider does an excellent job of revealing just how big systemic risk is based on EU debt.
The above chart shows the bank exposure to peripheral countries debt as a percentage of GDP. For instance, UK bank exposure to Irish debt is roughly equal to a little over 6% of UK GDP, German exposure to Spanish debt is north of 5% of German GDP, etc.
To say that systemic risk is a MAJOR problem for the EU would be the understatement of the year. For instance, if Portugal defaults, Spain’s banks will get taken to the cleaners. This in turn could trigger a HUGE systemic collapse as exposure to Spanish debt is equal to 4% or more of GDP for Switzerland, France, Germany, the UK, and the Netherlands.
And it’s not as though the US is somehow free from this either. Altogether the US has $390 billion worth of exposure to PIGS (Portugal, Ireland, Greece, and Spain) debt. While not an enormous amount of money relative to US GDP (it’s roughly 3% or so), we must remember that the US commercial banks have over $240 TRILLION in derivative exposure on their balance sheets.
And 82% of this ($200 trillion) is related to interest rates.
This is why Europe is BIG deal: a collapse in the bond markets there would push interest rates through the roof and result in various interest rate spreads (LIBOR, Treasury to Swiss Franc, etc) going haywire, which in turn could trigger another “Lehman” type event in the derivative market.
Remember, the financial system is even more leveraged today than it was during the Tech Bubble. So a derivative collapse from anywhere could trigger a sharp sell-off as banks and institutions have to sell positions to meet margin/ redemption calls. Which in turn would result in more selling and so forth.
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