Britain is an island and doesn’t use the euro. But it will not be able to avoid the fallout if the euro explodes. The good news is that both the government and the Bank of England (BoE) realise that a break-up of a single currency is a real possibility. David Cameron, the prime minister, openly speculated on Wednesday about a break-up. Meanwhile, Mervyn King, the BoE’s governor, confirmed that the authorities have been discussing contingency plans — in particular, what banks should do to protect themselves.
UK banks have for months been trying to reduce their exposure to the euro zone. This involves both cutting their assets and funding themselves as much as possible locally. In the event that the single currency fragmented, it would not be enough to have matched euro assets and liabilities. It would matter whether those euros were matched on a country by country basis. A bank would not, for example, want to have borrowed in Germany and lent in Spain. Otherwise, it might find its liabilities in expensive deutschmarks and its assets in cut-price pesetas.
The biggest lending exposures are: RBS’s £39 billion to Ireland; Lloyds’s £14.9 billion, also to Ireland; and Barclays with £26 billion and £25 billion to Spain and Italy respectively. In some cases, for example RBS in Ireland, there are significant local deposits as well. And all three banks have tried to reduce their funding gaps by borrowing three-year money from the European Central Bank. RBS has raised £10 billion, Lloyds £11.2 billion and Barclays £6.5 billion. But the funding gaps have not been eliminated. And even this central bank funding may not be matched to lending on a country by country basis.
In the event of a euro break-up, Britain’s banks will need more help. This will involve liquidity injections by the BoE and possibly capital from the government. The UK economy will also need an adrenalin injection: more quantitative easing by the BoE plus some fiscal laxity by the government.
Further monetary easing would be controversial but justifiable given the deflationary forces that euro-geddon would unleash. Fresh taxpayer injections into the banks would further strain the nation’s finances and be unpopular politically. Still, this would be affordable while the government’s market credibility endures.
Hopefully, it won’t come to this. But it is wise to be prepared.