Perhaps the biggest cultural change since the credit crunch is that the Financial Services Authority (FSA) now takes the long view of financial history and insists that banks prepare for once-in-a-century financial catastrophes – the kind of disasters that regularly happen, but only after memories have dimmed of the preceding one.

So the watchdog’s latest financial risk outlook instructs bank to make sure they have sufficient capital to withstand losses generated by the following scenario:

“A further decline in GDP of 2.3% from the end of 2009 to the end of 2011, with gradual recovery thereafter. Alongside this fall in GDP, the scenario includes a rise in unemployment to a peak of 13.3% in 2012, and allows for a ‘doubledip’ in property prices, with house prices falling by 23% from current levels and commercial property by more than 34%.”

Now, for the avoidance of doubt, the FSA is not forecasting that the UK will re-enter recession. In fact its so-called “central” projection (what it thinks most probable) is that there will be a “V” shaped recovery, with GDP growth accelerating this year, to 1.4% in 2010 and 2.2% in 2011.

This “central” projection is no more sophisticated than the mean of professional forecasts. And they have been pretty wide of the mark in recent years.

So a prudent FSA – which wants to avoid a repeat of 2008’s near collapse of the banking system – has to make sure that our banks have enough of a buffer of capital to cope with a lot worse than what economists expect.

Do Britain’s banks currently have enough capital to absorb additional losses generated by a second recession and further sharp falls in asset prices?

Probably. The FSA insists they hold core tier one capital – which is basically pure equity – equal to a minimum of 4% of loans and other assets weighted according to the Basel Committee’s widely criticised rules.

Right now the core tier one ratios of all our biggest banks is more than twice that. Most of them have ratios greater than 10%. Lloyds has the lowest ratio of the pack at 8.1%.

Which is not to say that they are invulnerable.

The FSA, for example, believes that the sharp falls in interest rates engineered by central banks to resuscitate the global economy may be disguising rather than solving the repayment difficulties being experienced by some borrowers: for arithmetic reasons it takes longer when interest rates are at record low levels for any borrower that stops repaying to cross the arrears threshold that sets alarm bells ringing in a bank’s head office and at the FSA.

All that said, if the FSA’s worst fears materialise and we enter a second recession (which plainly in the light of today’s weak industrial production figures is not inconceivable), we should be worrying about other things than the solvency of our banks (although those other things, such as the credit-worthiness of the government and social cohesion, aren’t exactly trivial).

View full post on BBC NEWS | Peston’s Picks