The financial crisis, which began in the United States, is having a cascading effect on major economies in the world. After the U.S., the epicenter of the crisis shifted to the European Union countries where the sovereign debt problem still exists at large.
This article focuses on the United Kingdom, which has the potential to become the epicenter of the next big crisis. I am of the opinion that the financial sector in the U.K. can trigger a massive crisis followed by a sovereign debt crisis.
To put things into perspective, the chart below gives the total assets of commercial banks as a percentage of GDP and total assets of four largest commercial banks as a percentage of GDP.
The objective of the chart is to give readers an idea of the significance and the concentration of the financial sector in the U.K.
The too-big-to-fail financial institutions in the U.K. might just become too big to bailout in the event of any banking crisis.
The U.K.'s top four commercial banks' total assets as a percentage of GDP stands at 350% compared with approximately 50% for the United States.
As a result of this, the total debt to GDP for the U.K. stands close to a staggering 1000%. The same is shown in the chart below from Anthony B. Sanders TARP testimony.
It is not just the debt in the financial sector; the household debt (relative to income) is the highest for the U.K. when compared with the United States and the euro area.
A high level of household debt is a serious reason to be concerned for a country where unemployment has increased from 5.4% in 2008, to 8.0% as of May 2012. Further, the unemployment rate for people between 15-24 years has surged to 21.5%.
Further, according to the Financial Stability Report (June 2012) by the Bank of England -
The major UK banks have exposures of £1.1 trillion to UK households, around 15% of total assets. Around 90% of these exposures are secured against residential property. The scale of these exposures means that even a small change in write-off rates could have a significant impact on profitability. One plausible trigger could be a tightening in credit supply, leading to an increase in arrears and downward pressure on house prices. There is some evidence that in recent months a tightening in credit supply has been under way. But house prices have remained broadly flat in nominal terms over the past year.
I am of the opinion that lending standards will remain relatively tight in the current scenario and if the U.K.'s economic activity does not improve, housing prices can witness meaningful downside. In such an event, large banks will be exposed to huge losses with most of the household loan backed by residential property.
The potential problem for the U.K.'s banking system does not end here. The U.K. banks are also vulnerable to the sovereign debt crisis in the euro area countries.
The total exposure of banks in the U.K. to sovereigns, banks and non-bank private sector borrowers in vulnerable euro-area countries stands at 81% of core tier 1 capital.
Although the banks have made provisions for potential losses, the risk of further losses remains in a depressed economic environment.
The extent of perceived risk of the UK's financial system is evident from the systemic risk survey, which indicates that a growing number of participants are worried about sovereign risk.
Talking about the sovereign crisis, besides the threat to the U.K.'s financial system from the euro-area sovereign crisis, U.K. can also face a potential sovereign crisis in the future.
Government debt to GDP in the U.K. has ballooned from 54.8% in 2008, to 85.7% in 2011.
If economic growth in the U.K. remains weak, government debt to GDP has the potential to cross 100% in the next 2-3 years. Therefore, the U.K. can potentially have a banking crisis followed by a sovereign debt crisis.
In the midst of all these financial problems, the last chart seems like the last nail in the coffin. The chart gives U.K.'s competitiveness indicator visa-a-vi the euro area.
Chart Source: Bank of Spain (ECB and WTO)
With an increase in the index implying loss of competitiveness, the U.K. has been losing on competitiveness compared with other countries in the euro area.
All these factors combine to make a perfect disaster recipe for the United Kingdom. In such a scenario, U.K. banks and currency need to be avoided. I would not be surprised to see U.K. being downgraded by leading rating agencies within the next one year.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.