While American financial institutions have sought to limit any damage by reducing their loans and thus lowering their direct exposure to Europe’s problems, the recent rescue of the Belgian-French bank Dexia shows that there are indirect exposures that are less known and understood — and potentially worrisome.

Dexia’s problems are not entirely caused by Europe’s debt crisis, but some issues in its case are a matter of broader debate. Among them are how much of a bailout banks should get, and the size of the losses they should take on loans that governments cannot repay.

Among Dexia’s biggest trading partners are several large United States institutions, including Morgan Stanley and Goldman Sachs, according to two people with direct knowledge of the matter. To limit damage from Dexia’s collapse, the bailout fashioned by the French and Belgian governments may make these banks and other creditors whole — that is, paid in full for potentially tens of billions of euros they are owed. This would enable Dexia’s creditors and trading partners to avoid losses they might otherwise suffer without the taxpayer rescue.

Whether this sets a precedent if Europe needs to bail out other banks will be closely watched. The debate centers on how much of a burden taxpayers should bear to support banks that made ill-advised loans or trades.

Many on Wall Street and in government argue that rescues are essential, to avoid the risk of destabilizing the financial system — with one bank’s failure to pay its obligations leading to problems at other banks. But others counter that the rescue of Dexia is reminiscent of the United States’ decision to fully protect big banks that were the trading partners of the American International Group when it collapsed, a decision that was sharply questioned and examined by Congress.

Critics warn of a replay of the financial crisis in autumn 2008, when governments used taxpayer money to shore up troubled companies, then allowed them to transfer those funds to their trading partners to protect those institutions from losses. In using public money to rescue private institutions, these critics say, policy makers effectively rewarded banks that traded with companies that were in trouble, rather than penalizing them, and that encouraged risky behavior.

“The question is did the A.I.G. experience and the bailouts generally contribute to the current situation?” asked Jonathan Koppell, director of the School of Public Affairs at Arizona State University. Would the banks, he continued, “have had a different view in dealing with Greece — or with Dexia for that matter — if those who had dealt with A.I.G. hadn’t been made whole?”

Given the global and interconnected nature of the financial system, institutions around the world have other types of indirect risk to European debt problems. But the scope of these ties is not fully known, because the exposure is hidden by complex transactions that do not have to be reported in detail.

Dexia, which was bailed out by France and Belgium once before, in 2008, is just a small piece of the broader European debt and banking turmoil. But its collapse comes at a critical point, as European officials are meeting this weekend to work out how taxpayer money should be used to resolve the Continent’s debt crisis.

The most acrimonious debate has been over the amount of losses banks should suffer for lending hundreds of billions of euros to countries that may not be able to fully repay. In the case of Greece, big lenders in Europe have tentatively agreed to swallow modest losses on what they are owed, but are resisting proposals that would force them to take a much bigger hit. Even if they accept losses, they may then seek tens or hundreds of billions in capital infusions from their governments.

As the Dexia bailout deal closed last week and was approved by the French Parliament, officials overseeing the restructuring say that the bank will meet all of its obligations in full. Alexandre Joly, the head of strategy, portfolios and market activities at Dexia, said in an interview that the idea of forcing Dexia’s trading partners to accept a discount on what they are owed “is a monstrous idea.” He added, “It is not compatible with rules governing the euro zone, and it has never, ever been considered to our knowledge by any government in charge of the supervision of the banks.”

Article source: http://www.nytimes.com/2011/10/23/business/dexias-collapse-in-europe-points-to-global-risks.html?partner=rss&emc=rss