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INSIGHT-U.S. readies defenses against Europe spillover
* Hoping for the best, preparing for the worst on Europe
* Total US bank exposure to Europe tops $4 trillion
* US supervisors canvass banks, check risk controls
* Fed to stress-test banks in next few weeks
* Emerging economies start cutting interest rates
* World Bank warns countries to ready for long haul
By David Lawder and Glenn Somerville
HONOLULU/WASHINGTON, Nov 13 (Reuters) - The United States is ramping up attempts to safeguard its financial system from a worsening of Europe's debt crisis, joining nations in Asia, Latin America and elsewhere in trying to build firewalls.
U.S. policymakers, alarmed by the political upheaval in Italy and Greece, are digging deep into the books of American banks to find out how exposed they might be to euro zone creditors and the plunging value of sovereign debt.
Officials were stung by the implosion of Wall Street firm MF Global, which gambled and lost on European debt, and they are working on contingency plans for a worst-case scenario should another financial firm crumble.
A senior U.S. Treasury official said regulators are contacting big U.S. financial institutions to make sure they are scaling back exposure to Europe and are ready for a potential worsening of the crisis.
The Financial Stability Oversight Council, an inter-agency group set up after the 2007-2009 financial crisis, was trying to identify specific firms that could be hit by financial turbulence and then sort out ways that each one can fortify its balance sheet, the Treasury official said.
While the Treasury has been at pains to say that direct U.S. bank exposure to European countries now receiving bailout aid -- Greece, Ireland and Portugal -- is moderate, once the debt of Italy and Spain, plus credit default swaps, and U.S. bank indirect exposure through European banks are added, the potential sum could exceed $4 trillion.
"As such, the potential for contagion to the U.S. financial system is not small," the Institute of International Finance, the lobby group for major international banks, said last week.
Hedging and netting would limit the true size of any losses, so the $4 trillion figure would be the outer edge of U.S. total exposure.
U.S. banks had about $180.9 billion of debt from Greece, Ireland, Italy, Portugal and Spain on their books at the end of June, based on Bank for International Settlements data. Italy accounted for the largest chunk, more than $250 billion. Guarantees and credit derivatives added another $586.6 billion, bringing the total to $767.5 billion, the IIF said.
There is a secondary level of exposure that is potentially more worrying -- through international banks lending to each other. Here the greatest risk stems from Italy and France. International bank claims on Italy total $939 billion, and French banks account for well over one-third of that, BIS data show. French banks also rely heavily on short-term loans from other international banks for their daily operations. If Italian debt slumps even further, causing deeper losses for French banks, international banks could stop lending to France. The losses would ripple through the whole global financial system.
The United States learned the hard way how these indirect financial linkages work when imploding credit default swaps forced it into a $180 billion bailout of insurance giant American International Group (AIG.N) in 2008 to prevent further contagion in the banking sector.
The danger is that a steep drop in sovereign bond prices prompts similar margin calls at banks that could snowball into a seizing up of credit, the lifeblood of an economy.
European banks hold some $3.5 trillion of euro-zone sovereign bonds and U.S. banks have significant direct exposure to their European peers, the IIF said in a report.
Federal Reserve Chairman Ben Bernanke was frank last week about the risks: "It is not something that we would be insulated from ... I don't think we would be able to escape the consequences of a blow-up in Europe."
JPMorgan Chase (JPM.N), the largest U.S. bank, holds about $44 billion in debt of troubled euro-zone nations -- Greece, Ireland, Portugal, Spain and Italy -- and Citigroup (C.N), the third largest, has $24.3 billion, said Dick Bove, a banking analyst at Rochdale Securities in September.
MF Global's fall gave a taste of how contagion can rip through the financial system. Brokerage Jeffries Group Inc's JEF.N shares plunged on concerns about exposure to Europe. The shares stabilized after the firm clarified its position.
CHECKING THE BOOKS
Fed Vice-Chair Janet Yellen said a new round of stress tests of U.S. banks will start in "a couple of weeks" to check their resilience should the value of their assets plunge.
"In light of such international linkages, further intensification of financial disruptions in Europe could lead to a deterioration of financial conditions in the United States," she told a Chicago audience on Friday.
"We are monitoring European developments very closely, and we will continue to do all that we can to mitigate the consequence of any adverse developments abroad on the U.S. financial system," she added.
Stress tests could lead to some banks raising more capital. The Financial Industry Regulatory Authority told MF Global to boost its net capital in August following concerns about its exposure to European debt.
A Fed survey last week showed that about half the top U.S. banks had loans to European banks or were extending credit to them. If European banks ran into trouble and were unable to repay their loans, U.S. banks could face sizable losses.
The chief economist for ratings agency Moody's Investors Service, Steven Hess, said last week that so far there were no signs that banks were unwilling to lend to one another.
"If ... the crisis becomes much worse and includes Italy for example -- and this is all if, not a forecast from the part of Moody's -- if that were to happen, you could see the financial system in the United States ... suddenly suffer problems," Hess told the Reuters Washington Summit.
Should that happen, the United States can turn to tools it honed during the financial crisis of 2007-2009, said Nellie Liang, director of the Fed's Office of Financial Stability Policy and Research.
"We were creative that time, and we could be creative this time," Liang said. "But I think, just step back, the first line of defense is doing proper risk management and supervision."
U.S. money market funds, for example, already have pulled back significantly from European debt exposure under the watchful eye of regulators, she said. Their holdings of European paper totaled $384 billion in September, down 30 percent from June when alarms were first rung, the IIF said.
Regulatory reforms have given the Fed much more authority to watch over and investigate financial firms considered so large that they could disrupt the whole financial system.
U.S. impatience over Europe's inability to quash the spreading risk is palpable. Treasury Secretary Timothy Geithner tried again on Thursday to press for more decisive action.
"It is crucial that Europe move quickly to put in place a strong plan to restore financial stability," Geithner said in Hawaii, echoing the views of other finance ministers attending the Asia Pacific Economic Cooperation summit.
"It is not being dealt with forcefully," Philippines Finance Minister Cesar Purisima said at the summit.
APEC finance ministers agreed to shore up their economies to protect against any damage and underpin growth.
These steps might include imposing capital controls to prevent a rapid outflow of cash that would destabilize an economy, lowering interest rates or fiscal stimulus.
For the Philippines, Purisima told Reuters he is prepared: "We have a lot of fiscal space if we need it ... Whatever is necessary, we will be doing, our interest rates are low." --
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