British banks have had plenty of time to prepare for the worst

WHAT happens to banks, mortgages and interest rates in Britain if Greece quits the euro?

The good news is that British banks have had two years to write off Greek government debts and build up their capital reserves against a rainy day. A study by Capital Economics, a leading consultancy, claims that if Greece defaulted on all its remaining debts to British financial institutions, it would take up only 0.5 per cent of the banks’ reserve capital.

However, Greece leaving the euro might provoke panic in the rest of Europe, especially in the other big debtor countries, such as Spain, Italy, Portugal and Ireland.

Frightened depositors will drain their bank accounts, banks will stop lending to each other, governments and small businesses will find it harder to borrow and interest rates will jump. Britain will not be immune.

The biggest danger is probably a run on continental banks. Perversely, the UK might see some of this cash deposited here. But if any major European financial institutions went bust, British banks that had lent them money might incur losses. Certainly, European banks would stop lending to each other, which could leave UK banks desperate for liquid cash to meet short-term obligations. That is precisely the liquidity crisis that engulfed RBS and HBOS in 2008.

In this situation, expect the Bank of England and the European Central Bank (ECB) to step in with a massive injection of cheap loans for the banks. In fact, the ECB has just pumped €1 billion into European banks to head off just such a crisis – and UK banks were big takers. Barclays took €8.2bn to provide “funding stability” for its offshoots in Spain and Portugal.

How much extra cash the Bank of England and ECB would need to find after a Greek exit is anyone’s guess. Most probably, UK banks would weather the storm, as they are better capitalised and have fewer riskier loans than four years ago. But, starved of liquid funds, British banks would need to increase charges and mortgage rates.

What if you have a deposit with a European bank, such as Santander? Subsidiaries of any foreign bank taking deposits in the UK need to be licensed by the British authorities and are therefore covered automatically by the Treasury’s Financial Services Compensation Scheme (FSCS). If a bank fails, you will get back up to £85,000 per person per financial institution.

Higher interest rates in the wake of a Greek exit would benefit hard-pressed British savers. But equity markets would sink. Global stocks are down heavily since last weekend’s G8 summit did nothing to solve the euro crisis.

What about industry? If a Greek euro exit led to contagion and the insolvency of major Spanish banks, that could affect Spanish-owned companies in the UK, such as BAA airports, ScottishPower and O2. These acquisitions were funded by huge borrowings from Spanish banks. A crisis with these banks could affect the solvency of Spanish industrial holding groups and so of their UK subsidiaries.

The real question is how far the Greek contagion might spread. With a Greek exit, the markets will charge much higher interest rates on bond loans to other indebted eurozone countries, fearing they will also quit. That could become self-fulfilling.

UK banks hold some £200bn in loans to indebted eurozone governments apart from Greece. Defaults on a wider scale would threaten the entire UK banking system.