Calculating the cost of an euro catastrophe

I’m just on my way to meet author and finance scholar Nassim Taleb. These days it seems that all the swans are black. Certainly that was the impression I got from this morning’s press conference at the Bank of England.

“exceptionally threatening” and “exceptionally perilous” were two of the phrases used by the Governor and Deputy Governor of the Bank of England this morning when talking of the impact on financial stability of a potential Eurozone meltdown.

For months I have been in the “it will get sorted out” camp, mainly because sorting it out is clearly in Germany’s enlightened or even naked self interest. The waves of crushed confidence are now lapping at Germany’s door, affecting its industry.

But the catastrophe talk is ratcheting up as we countdown to the European Council next Friday.

So it is clearly right for British banks to be making contingency plans. I can’t imagine it’s a pleasurable exercise. The Bank of England wants the banks to limit bonuses and dividends and stockpile cash, though not so much that business lending is cut. It’s a rather difficult balancing act, and I wasn’t entirely sure that all the arms of Britain’s financial stability matrix were singing from the same hymnsheet.

Still as Danny Gabay, ex-BoE economist told me today, neither the Bank nor the Government feel they can calculate the impact of eurogeddon, so why should the banks. He has had a go, and suggests a loss of 7% of GDP, an impact of 1.5 times that of the Lehman collapse in 2008.

Of course the really big problem is that we have few tools to deal with this. Interest rates are already at their lowest. Do we have fiscal space for further bank recapitalisations that would inevitably be required? Gabay suggests that the BoE would have to move Quantitative Easing to a programme worth £1trillion. Remarkable, but worth bearing in mind.

One can only guess at what this eventuality would have done to the OBR’s numbers on Tuesday.  One thing can certainly be said. Britain can not afford for the euro to go down in a disorderly way.

Might the calculus of catastrophe actually suggest that a bit of extra help, might even be worth it? Politically unthinkable, yes. But look at table 2A of the FSR. The banking exposures to the PIIGS in total amount to 86% of our Big 4 banks core buffer funds (and that’s after taking into account existing write offs and provisions).The whole of the Eurozone? Well that’s nearly 300%.

Even in the worst case scenario not all of this will be lost. But it gives a sense of what’s up for grabs for this country in the coming days.

Follow Faisal Islam on Twitter: @faisalislam