Credit default swap insurance taken out by UK banks to hedge their exposure to sovereign debt defaults may prove worthless

Credit default swap insurance taken out by UK banks to hedge their exposure to sovereign debt defaults may prove worthless, financial analysts are warning.

The forecast also adds a cautionary note to claims that the UK and US financial systems have a low exposure to the debt crisis engulfing Greece, and comes as Britain's new risk watchdog, the financial policy committee (FPC), increased the pressure on banks to boost capital cushions.

Erik Britton, a former Bank of England economist and director of financial market consultancy Fathom, said: "If banks have taken out insurance with a hedge fund, are they comfortable that they will pay out in the event of a default? There is a chance that they have taken cover that is worthless. The banks could be facing a loss [on one side of their investment book] and they won't be able to claim the insurance [on the other side]. Then they may have to recapitalise."

The Britton scenario is a worst case, involving a swift default by Greece that pulls Ireland and Portugal into the crisis and then, possibly, Spain and Italy.

Most watchers assume that French and German banks are the most vulnerable to a Greek default. However, recent figures published by Fathom suggest that much of the eurozone's exposure has been passed to UK and US banks, which have in turn insured themselves in London and New York with hedge funds.

The report states: "Looking across the eurozone periphery as a whole, the total for the US is €193bn and the UK is €74bn. Core European banks' indirect exposure stands at only at €35bn. So the majority of the [insurance] guaranteeing periphery debt appears to have been underwritten by UK and US banks."

The comments came as Bank of England governor and FPC chairman Sir Mervyn King said a roadmap was still needed to show markets there was a way out of the Greek debt crisis, and the watchdog's first set of recommendations focused heavily on the risks posed by high-indebted eurozone states.

"Sovereign and banking strains are the most material and immediate threat," it said. "Market concerns remain over fiscal positions in a number of euro area countries and the potential for contagion to banking systems."

Credit analysts say that hedge funds, which have gambled on default, will be the only winners of a swift default scenario. No default, or a delayed default, will provide investors that have recently bought Greek bonds with profits.

Financial institutions typically insure against falling bond prices by taking out a credit default swap (CDS). The difference between a traditional insurance policy and a CDS is that anyone can purchase one, even those who have no direct interest in the loan being repaid. That means speculators, such as hedge funds, can use them to bet on defaults. Credit analysts estimate around €240bn of Greek debt will have to be written off.