Fed Official Warns of Risk to U.S. of European Bailout

WASHINGTON (AP) -- 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," said Tarullo.
As he testified, Wall Street took another nosedive on European debt fears. The Dow Jones industrial average was down 376 points when the market closed.
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. That contributed to the worst global recession since the 1930s.
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."
To contain the European crisis, the Fed on May 9 agreed to supply European central banks -- and the Bank of Japan -- with much-in-demand dollars in return for foreign currencies. The "swap" arrangements were aimed at easing short-term financing strains.
European banks need dollars to lend to companies across the continent. European companies that have operations in the U.S. pay their employees in dollars and buy raw materials with the U.S. currency. Also, oil and other commodities are priced in dollars around the world.
Under the swap program, Tarullo said the European Central Bank will repay a $9.2 billion loan to the Fed on Thursday. Tarullo said the ECB requested a new $1 billion loan and the Bank of Japan wanted $200 million. That makes $1.2 billion outstanding under the swap program. Federal Reserve filings haven't yet been updated to reflect the new figures, a Fed spokeswoman said.
Tarullo said the Fed isn't considering taking other relief actions.
However, a growing number of economists now believe that the Fed will keep interest rates at record lows well into next year, or possibly into 2012, to help protect the United States from fallout due to the European crisis.