The problem of sovereign debt risk has reared its head in Dubai, in Greece, and in other European countries, prompting concern that it could worsen and spread. At a minimum, the market may force more austere budgets in those countries with the most severe debt problems, which could slow economic growth and, therefore, undermine the profitability of banks.

In Putnam Global Financials Fund, by the end of February, we had reduced exposure to European banks and to investments in countries that we believed were most at risk. Our responses were in part due to the possibility that sovereign risk may become more acute and widespread. We believe these concerns are not yet reflected in stock valuations in these markets, especially compared with the valuations of financial stocks in the United States or Asia. I believe this also demonstrates the value of our global comparative framework at Putnam Investments and our worldwide investment flexibility.

We would not minimize the potential negative consequences if this sovereign debt crisis deteriorates. Since the bankruptcy of Lehman Brothers, the funding gap created by the excessive leverage of the European banking system has so far been plugged by the unprecedented liquidity measures provided by sovereign governments. Essentially, a large portion of the funding of the financial system has been passed from the private sector to governments, both directly and indirectly. Many governments now have spiraling fiscal deficits. This is not necessarily a problem as long as confidence and credibility remains. However, the crises in Dubai last November and in Greece thus far in 2010 show that when the markets lose confidence the situation can rapidly spin out of control.

Rising sovereign risks can have a direct impact on the costs of bank’s funding, thereby reducing profitability. The response in Europe to stabilize the Greek situation has been helpful and has alleviated market fears in the near term. Nevertheless, a long-term solution is still unclear, particularly if Greece fails to deliver on its fiscal targets.