Europe's debt crisis poses serious risks to the unfolding economic recoveries in the United States and around the globe, a Federal Reserve official said Thursday.
Federal Reserve Governor Daniel Tarullo, in remarks to a House subcommittee, said the timing of Europe's problems on the heels of the global financial crisis is a "potentially serious setback."
If the crisis were to crimp lending and the flow of credit globally, triggering more financial turmoil, that would endanger both the U.S. and global recoveries, he said.
"Although we view such a development as unlikely, the swoon in global financial markets earlier this month suggests it is not out of the question," Tarullo said.
In a worst case scenario, financial turmoil "could lead to a replay of the freezing up of financial markets that we witnessed in 2008," he said.
For now, Tarullo said there are good reasons to believe U.S. banks and financial institutions can withstand some fallout from European financial difficulties.
In the past year, the Fed has pressed the biggest U.S. banks to raise additional capital, giving them a stronger cushion against potential losses in the future. The direct effect on U.S. banks of losses stemming from exposure to overextended governments in Greece, Portugal, Spain, Ireland and Italy "would be small," he said.
Almost all of the U.S. exposure is held by 10 large bank holding companies, Tarullo said. Their balance sheet exposure of $60 billion accounts for only 9 percent of the core capital that regulators value the most, known as Tier 1 capital. He didn't identify those banks.
However, if problems were to spread more broadly through Europe, U.S. banks would face larger losses as the value of traded assets dropped and loan delinquencies mounted. U.S. money market mutual funds and other institutions, which hold a large amount of commercial paper and certificates of deposit issued by European banks, would likely also be affected, he said. Commercial paper is an important short-term financing mechanism companies rely on to pay for salaries and supplies. It practically dried up during 2008 financial crisis.
Tarullo said a moderate economic slowdown across Europe would slow export growth, weighing on the U.S. economy "by a discernible, but modest extent." However, a deep contraction in economic activity in Europe — along with severe financial problems — "would have the potential to stall the recovery of the entire global economy."
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