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If Greece defaults on its debt, the direct secondary effects on financial institutions could be much worse than what we saw after the collapse of Lehman Brothers.

The collapse of Lehman Brothers sent shockwaves through the global financial system—in part because it revealed that the United States government was willing to let a large, interconnected, complex financial company go bankrupt. Panic erupted, threatening the financial stability of other companies.

But the actual direct effects were few. Lehman had some 600,000 derivatives contracts and hundreds of billions in outstanding bonds, but Lehman’s institutional creditors were generally required to reserve some capital against Lehman’s collapse. This greatly diminished the direct knock-on effects of Lehman’s bankruptcy. Capital cushions actually cushioned.

There is roughly 270 billion Euros in outstanding Greek sovereign debt. Banks—mostly European banks—hold around 100 billion Euros of Greek bonds. Insurance companies, pensions funds and central banks hold most of the other 170 billion. For the most part, these holders of Greek debt have not had to reserve any capital against losses. This means that most of the holders of Greek debt will feel the full brunt of the losses, which raises the question of whether they are adequately capitalized to take the loss.

European bank capital regulations treat Eurozone sovereign debt as riskless. This was, in effect, a subsidy to the riskier Eurozone governments—allowing them to borrow at far lower costs than they other would have faced. The spread between German and Greek debt fell to 20 basis points in 2004, thanks largely to this subsidy.

Banks, of course, loaded up on the riskier debt because it had slightly higher yields. They, in effect, adopted the view of regulators that the debt was risk free. It allowed them to earn higher yields without setting aside additional capital by lending money to borrowers whom the regulations disfavored.

This subsidy was extremely important to European governments. In the US, only 3 percent of government debt is held by banks. In Europe, 30 percent of government debt is held by banks. Without the subsidy, many Eurozone government would have had a much harder time selling their bonds.

(Incidentally, a similar regulatory delusion about risk applied to mortgages. Banks that held highly rated mortgage-backed securities had to set aside just half the capital they did for most other highly rated loans. So, of course, bank balance sheets were far overexposed to mortgages).

This high concentration of sovereign debt in European banks raises the possibility that the banks may be severely undercapitalized—and may require a government recapitalization or face failure themselves. Even the European Central Bank, which now holds a huge amount of Greek debt, may need to be recapitalized.

It is difficult to tell which European banks have the most exposure to a possible Greek default. And this could be a recipe for panic if a default occurs. Banks will know their own exposures but not the exposures of their counterparties. Fearing the worst, many may simply refuse to extend credit to potentially insolvent institutions. A great credit crunch could further imperil Europe’s financial institutions and economies.

But make no mistake. This is not a crisis caused by speculators or greed or capitalism. It is a crisis of governments and regulations, i.e. governments that borrowed too much and regulators that encouraged banks to lend those governments too much.

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