Anyone who has ever worked in international banking knows that risk management does not only look at sovereign risk per se but, much more so, at country risk as a whole. Country risk is defined as the amount of money which, if Greece were to fall into the Aegean, would fall into the Aegean, too.
The overall country risk/exposure is segregated into its major components: government risk, exposure to public sector companies, exposure to the banking sector, exposure to private sector companies, etc.
What matters in the final analysis is the overall country risk. Why? Because if there is a run on a country’s sovereign bonds (like the one which began in Greece in late 2009), it will automatically trigger a run on the entire country exposures: if lenders no longer want to buy Greek bonds because of lack of confidence, they will similarly no longer make loans to the Greek banking sector (and they will cancel existing ones when they mature).
Why is that the case with a country and not with a federal state of the USA? Because a country has its own jurisdiction. Argentina, for example, can nationalize an oil company whereas California cannot.
EU-leaders have so far only addressed the issue of sovereign risk. They have hardly done anything regarding the other components of country risk. But what is the point in curtailing (with great publicity) the amount of financing which the EU makes available to the Greek state when, at the same time, the ECB lends huge amounts of money to the Greek banking sector (with very little publicity)?
The ECB has felt that it had no other alternative if the collapse of national banking sectors was to be avoided. That is true. But it is not the job of the ECB to finance national living standards and/or capital flight! That should be decided by politicians who then carry the responsibility versus their voters.
A Central Bank requires investment grade collateral for its role as a lender of last resort. The ECB more or less gave up that requirement so that national banking sectors could be saved and they did this very quietly. That was wrong!
The ECB should have put (and could still do) an ultimatum to EU-politicians: “We give you 6 months to arrange financing for entire countries (instead of only national governments). Until then, we will make the necessary funding available. Thereafter we will make margin calls”.
What would have been the difference? The financial requirements of entire countries would have been put on the table and would have been subject to public debate. At least the following 2 consequences would have occurred:
* tax payers in surplus countries would have had transparency that they are not only financing budget deficits but, much more so, current account deficits and capital flight; and
* politicians might then have decided that it is smarter (and cheaper) to help deficit countries to develop their own national economies instead of giving them money to strengthen the economies of those countries which export to Greece.
Incidentally, this could still be done today.