Britain's top banks have tens of billions of euros in exposure to the risk of countries leaving the euro or the currency union breaking up entirely, despite intense pressure from the UK financial regulator to tackle the problem.
This "redenomination risk" is evident at Santander UK, Royal Bank of Scotland and Barclays, although much of it has been hedged, according to data published by the banks in response to the regulator's demands.
European Central Bank President Mario Draghi detailed plans on Thursday to buy government debt of struggling countries such as Spain and Italy to back up his promise to do "whatever it takes" to preserve the euro.
Savers have already withdrawn billions of euros from Greek banks, fearing the country might leave the common currency and that their deposits would be converted into new drachmas.
If a country left the euro zone it would introduce a new national currency which would probably plunge, hitting the value of banks' euro-denominated assets. Capital controls could also be introduced, making it hard or impossible to take funds out of the country.
Banks outside the euro zone have stepped up efforts in recent months to mitigate their redenomination risk, notably by trying to balance their assets and liabilities in each country, raising concern this will hurt cross-border trade and flows.
Achieving this balance in each country means that if a state were forced out of the euro and its new currency tumbled, the loss in the value of a bank's assets there would be offset by the loss in the value of its liabilities.
Redenomination risk lies in the fact that banks have yet to achieve this balance. Liabilities such as savers' deposits in one euro zone country may be matched by assets such as loans to clients or government bond holdings in another.
If an upheaval in the euro zone caused a bank's assets in one country to devalue abruptly while its matching liabilities elsewhere remained stable, the institution faces losses.
The requirement by Britain's Financial Services Authority (FSA) to disclose this risk underlines how seriously it is treating the possibility that one or more country could leave the euro or that the currency fails altogether.
A PARTICULAR CONCERN
Britain's major banks said in recent half-year results that the threat of a break-up was real, and the FSA has told them to prepare actively for a major euro zone problem.
HSBC said it had set up a Euro zone Major Incident Group and "there is a significant risk of one of more countries leaving the euro". RBS said this was "a particular concern" and could lead to a complete break-up of the union.
Santander UK, a subsidiary of Spain's Santander, said in a regulatory filing this week it had 35 billion pounds more euro-denominated liabilities than assets, but it had hedged almost all of the exposure, leaving it with a net exposure of 100 million pounds.
"As a result of the continuing distressed conditions experienced by the peripheral euro zone countries, there is an increased possibility of a member state exiting from the euro zone," the bank said.
Its euro-denominated liabilities mainly consist of debt it has issued for its medium-term funding needs and would include covered bonds sold to investors in Germany. It said having diverse funding was prudent.
It said the FSA had required all major banks to disclose their position, and its exposure to peripheral euro zone countries was less than 0.5 percent of its balance sheet.
Barclays cut its funding mismatch in Spain to 2.5 billion pounds ($4 billion) at the end of June, from 12.1 billion at the start of the year. That included taking 8.2 billion euros of long-term cash from the ECB, which was an about-turn on its previous strategy, and by taking more deposits in Spain.
Barclays's funding mismatch in Spain, Portugal and Italy was 22.8 billion euros at the end of June. RBS had a 24 billion euro funding mismatch in Ireland and Spain, and said it was aiming to cut its Spanish mismatch significantly.
The FSA's focus on denomination risk follows previous pressure on banks to cut their holdings of euro zone sovereign bonds and test their business for other impacts from a country leaving the currency bloc.
That continues, and includes stress tests on how it would affect customers, systems, processes and staff.
Banks admit the impact is impossible to predict accurately, however, especially on clearing and payment systems, the exposure to other banks, and legal uncertainties.
HSBC said it would suffer a greater impact from an exit of Greece, Italy or Spain from the euro zone than if Ireland, Portugal or Cyprus left, and said steps to reduce its redenomination risk had left it with a minimal funding mismatch.
Copyright 2012 by Reuters. All rights reserved.