As financial markets brace for the possibility of a Greek debt default, economic officials here are sketching out doomsday scenarios in a grim acknowledgment that even the world's strongest economies are vulnerable.
With Greece shelling out record interest rates, and with some frustrated investors pushing for a default, economists fear that the collateral damage from a credit event could reach these shores. By virtue of our connections to institutions throughout Europe and our reliance on credit, British banks bear heavy indirect exposure to Greece, setting them up for significant losses if the currently perilous Greek debt situation were to evolve into a full-blown crisis, the UK central bank said in a news conference late last month.
No one, in other words, is immune.
"It's this issue of interconnectedness in the financial system that policymakers are so worried about," said Richard Barwell, a London-based economist at Royal Bank of Scotland. "It's difficult for anyone to be convinced their balance sheet is secure unless they know that the people they've lent to, and the people that they've lent to, all their sheets are secure, too."
"At the end of the day," he added, "that's how you can get those cascades of defaults."
After European finance ministers approved the latest installment of Greece's bailout package Saturday, concerns remained about the troubled nation's ability to repay its mounting debt, which is projected to total 160 percent of the country's economic output this year. For many investors and economists, the question isn't whether Greece will default, but when.
The emergency aid extended to Greece is widely seen as a time-buying measure, and not a long-term solution. Greece likely cannot service its debt on its own, with its 10-year paper yielding nearly 16.5 percent, and its two-year debt throwing off more than 26 percent, according to Bloomberg data.
But efforts to hammer out a longer-term fix have been stymied. French President Nicolas Sarkozy outlined a plan last week for banks to stretch their short-term Greek debt into long-term bonds, offering Greece some interest-rate relief. But such a plan would impose losses on creditors and would constitute a default, the ratings agency Standard & Poor's said Monday.
If a default were to spark a broader crisis, weaknesses among Greece's immediate creditors could quickly spread.
"If UK banks are exposed to banks in France which are themselves exposed to a bank in Germany, which is then exposed to Greece, that's another indirect exposure," said Mervyn King, governor of the Bank of England, during the news conference. "There's an infinite regress here."
The direct exposure of UK banks to Greece was relatively small at the end of 2010, at about £12 billion at the time, according to the latest figures from the Bank for International Settlements.
But indirect exposure potentially dwarfs that figure. If significant damage were to spread other countries' private sectors, UK banks could face severe strains, suggests a June report from the Bank of England.
The banking sector's claims on the non-bank private sectors of Spain and Ireland combined constitute about half of those banks' so-called Tier 1 capital, the money banks set aside to cushion against losses, according to the report.
As for UK banks' claims on France and Germany, those together represent about 130 percent of Tier 1 capital, the report says.
"You just don't know all the interbank connections," said John Whittaker, an economist at Lancaster University Management School. "It's like when Lehman went down. Nobody knew who was indebted by how much to who else."
The years after the financial crisis have seen a host of weak European banks become even weaker. Now, the credit ratings on Europe's 100 largest banks span the widest range in 30 years, according to S&P, the Bank of England said.
Calculating the total magnitude of the UK's exposure to a broader meltdown is impossible, King said. Moreover, any crisis would likely be worsened by a broader loss of confidence, affecting a range of institutions, he added. Creditors would flee and markets would likely freeze, heaping pain on beleaguered governments.
"There's a risk that if something went wrong, you may get a drying of liquidity more generally," said Simon Hayes, chief economist at Barclays Capital.
Or put another way, creditors might decide they "simply don't understand the complexity of the interconnectiveness of these exposures, and just won't take the risk of lending," King said at the June 24 news conference.
Such a panic would likely affect the world's strongest economies. If the crisis spreads here, it would likely also touch the United States, said Barwell, the RBS economist.
"The price of a whole range of risk assets would fall," he said. "There are these huge channels that certainly come into play, which won't get captured by the simple numbers."