Why UK Banks Are Not Immune To Eurozone Woes

Will lenders have to accept that they won't get their money back from Greece?

The Bank of England points out that there is an 80% probability that the Greek government won't be able to repay all its debt, based on the current market price for insuring Greek sovereign debt.

For Portugal, investors put the probability of default at some point over the next five years at just under 50% and for Ireland the default probability is a little bit less.

As for the market odds on what eurozone ministers regard as the Armageddon scenario, default by Spain, they're around 40% at any time before 2016 if preceded by Ireland or Portugal going bust, but less than 30% if Greece goes down.

That implies potential contagion from Greece's woes may be less devastating than from Portugal's and Ireland's - which may or may not be a comfort.

Now investors, just like bookies, can be wrong. But a banker or investor who ignores the market odds is probably more foolish than a gambler who bets whatever the price offered in the betting shop.

So if you are a banker or an investor and you have an exposure to these financially overstretched countries, and you don't have a death wish then you would probably be advised to make sure you have sufficient spare capital to absorb 80% of whatever losses would be generated by a Greek default, 50% of Portuguese losses given default, and (perhaps) 45% times 50% of Spain's write-offs from default (keep up!).

Falling dominoes

Here's the thing. It is not at all clear that Europe's banks are making adequate preparation to cope with such potential pain.

In the tests of the stresses they can absorb, being overseen by the newly created European Banking Authority, they have been told - for the first time - to make some provisions for potential losses on the 80% of their sovereign exposure which is held in their so-called banking books.

But it is not at all clear that banks are being asked to protect themselves against either the worst that could happen, in respect of Greece, Ireland, Portugal and Spain - or indeed what may in fact happen.

Which is why Sir Mervyn King, the Governor of the Bank of England, made clear that he doesn't take enormous comfort from big UK banks' relatively limited direct exposure to Greece, Portugal, Ireland and Spain.

According to the Bank of England's analysis, if every single one of those countries went bust and wrote off 50% of their sovereign debt, banking debt and non-bank private-sector debt, that would wipe out around half the capital in the UK banking system - which is another way of saying that, in theory, the majority of our banks would limp on.

What is the probability of all those dominoes falling in that way?

It might be higher than we care to know. But British banks must have done something right that such a catastrophe wouldn't eliminate 100% of their capital.

But it is not only the direct loans to these countries that could do severe damage to our banks.

Sir Mervyn puts it like this: "experience has shown that contagion can spread through financial markets especially when there is uncertainty about the precise location of exposures. A UK bank could have lent to a bank that itself had lent to a bank that in turn was exposed to sovereign risk."

Forgive and forget

So if a British bank has a big exposure to a French bank which is undermined by its exposure to Greece, that could be a problem for said British bank.

And, in the crisis of 2007-8, we learned something else about how modern banks can bring down themselves and the rest of us with them: in an interconnected banking world, it is uncertainty that can be the worst poison.

The point is that those who lend to banks can't be sure where the fatal direct exposures to Greece, or Portugal, or Ireland lie. Which is why in a time of panic they may well stop lending to any bank which may have a direct or indirect exposure.
It is in that way that Greece's solvency crisis can become a liquidity crisis for the banking system - and can even wreak havoc for British banks that have lent relatively little to Greece.

By the way, Sir Mervyn made clear he hasn't got a huge amount of confidence that eurozone ministers have yet come up with a plan to cure the disease that underlies all of this, the excessive amounts that the Greek government has borrowed.

Sir Mervyn said that lending more money to Greece, the eurozone's current strategy, is only useful if it buys time to somehow make those debts affordable.

And there are only two ways that can happen.

Either Greece's relatively weak and small private sector has to be supercharged such that it starts generating current account surpluses that would allow the country to service the enormous debts - which seems unlikely to happen any time soon.

Or lenders to Greece have to accept that they're not going to get all their money back - and Greece's debts would be "forgiven" or reduced to a level it can afford.

Either way, Sir Mervyn noted that Greece has a solvency problem that has not yet been solved.