Britain's banks may potentially have huge hidden exposures to beleaguered Greece through their lending to other institutions, Mervyn King warned yesterday.
The Bank of England Governor was speaking as he unveiled its latest Financial Stability Report, which highlighted the eurozone debt crisis as the biggest threat to Britain's financial stability.
But he also tightened the screw on bonuses, saying: "When the good times come that is not time for banks to relax and pay out big dividends and bonuses." Rather, he said, they must work on building up their reserves.
Mr King added that, while UK banks had "remarkably low" direct exposure to Greece, "experience has shown that contagion can spread through financial markets especially when there is uncertainty about the precise location of exposures".
The Governor said: "A UK bank could have lent to a bank that itself had lent to a bank that in turn was exposed to sovereign risk."
He highlighted the "heavy exposure" of Britain's banks to their equivalents in Germany and France, which have much greater involvement with Greece, and could spread the contagion of a Greek default back here.
According to the report, British banks' combined claims on France and Germany represent about 130 per cent of their core tier-one capital, with close to half accounted for by loans to French and German institutions. But asked if Greece could become "the next Lehman Brothers", Mr King said: "It doesn't have that much in common other than that it's a mess."
The same fears over hidden exposures could be true of other teetering economies at Europe's fringes such as Portugal and Ireland, both bailed out, or risky economies such as Spain. As a result of the concerns, the Financial Services Authority will order British lenders to come clean about their true exposures to financial crises around Europe as part of their regular reporting. This was one of six recommendations made by the Bank's new Financial Policy Committee, all of which were agreed unanimously and accepted. On the issue of bonuses, Baron Turner of Ecchinswell, who sits on the committee as chairman of the FSA, said he would not cap how much banks could pay out, arguing that each company's circumstances would be different.
But both he and Mr King said regulation would play a role in forcing banks to focus on building up reserves when their earnings are strong. They said they wanted to be sure banks which followed regulators' guidelines did not suffer if rivals chose to ignore the rules and began making bumper payouts.
Further recommendations included a call for the FSA to extend its work on loan forbearance, where lenders ease pressure on corporate and individual borrowers who find themselves under stress. The committee wants banks to set aside cash to cover them if these loans ultimately default. But Mr King stressed that he did not want to see banks reining in forbearance – a factor which led to a low level of defaults and repossessions during the recession.