Hamish McRae: Threats banks face from the 'natural stress test'

Systematic risk. That is the horror of central bankers: that some event or combination of events takes place that destabilises the whole financial system.

During the 1970s the Bank of England organised the "lifeboat" to rescue the fringe banks, for fear that were they to go under, there might be a run on a clearing bank. But when Barings failed, it decided not to mount a rescue, judging rightly that there was no systemic risk to the banking system.

Both those instances of potential systemic risk were triggered by the potential failure of an institution or institutions. But in the 1970s the core of the problem was macro-economic: the surge first of inflation then the rise in interest rates aimed at choking it off. The first encouraged a surge in lending to property companies; the second led to the surge in bad debts when the economy turned down and many of the companies could no longer service the loans. With Barings problem was, as in the film's title, a rogue trader.

Obviously the former is potentially much more serious for it is likely to affect all institutions – and it is likely to happen just as an economy starts to turn down. That moment, the transition from boom to, well if not bust, certainly a sharp slowdown, is "a natural stress test". We are having one now.

That phrase comes from David Clementi, deputy governor of the Bank of England, in the Bank's Financial Stability Review. Every six months it publishes a report on the stability of the world banking system. This seeks to point out potential problems before they arise, or at least before they threaten to become systemic. The report points out that most banks have made good profits in recent years and accordingly are well capitalised. So the world financial system has so far been resilient to the strains of recent months, in particular the downgrading of the share prices of telecommunications and high-technology companies. But if world economic growth turns out to be worse than at present expected, the strains would mount.

The Bank identifies five main sources of risk. One is uncertainty about the US outlook. Not only could growth prove worse than currently expected, but there is a large imbalance in the US current account, which has to be financed by capital inflows (see left-hand graph).

Second, there has been the collapse of share prices in technology, media and telecommunication companies, the so-called TMT sector. Third, there are the specific problems of Japan, where there is the combination of a weak economy and bad debt problems in the banks.

Fourth, there is the valuation of equity markets in general, which (excluding TMT) have not fallen, but are clearly vulnerable. And finally, there has been a sharp deterioration in the prospects for many emerging markets (see right-hand graph), in particular the East Asian countries that are reliant on hi-tech exports to the US.

Central banks are paid to worry about the stability of the banking system: it is one of their jobs. But should we worry too?

As far as the UK is concerned the answer is surely no. By design or luck we have extremely strong banking institutions. We have some weaker insurance and life assurance groups, as the problems of Equitable Life and now Independent Insurance remind us. But our banks and building societies are as strong as any. True, household debt is high by historical standards and company debt high-ish, but mortgage debt is average and, so far at least, the proportion of non-performing loans (a nice way of saying loans where interest is not being paid) is low.

But we should not preen ourselves that all is well just because the UK is all right. Remember the David Low cartoon in 1932? A group of people representing debtor countries of central Europe are sitting in the sinking end of a rowing boat in a stormy sea. The creditor countries at the dry end are saying: "We don't need to do anything; it's not us who are sinking."

In the 1930s the most serious banking problems actually were in the US, where the collapse of many banks inhibited the ability of the economy to recover. People lost their savings; companies lost their assets; recession turned to depression as a result.

That is not going to happen now. Were that sort of catastrophe threatened, the world's central banks would pump in money to support the banking system. The more likely danger is that the rest of the world catches some version of the Japanese disease.

The problems of the Japanese banking systems are complex. Some lie in the over-close relationship between companies and their bankers, others in the extent to which cheap loans have been badly spent by borrowing firms. Others stem from the falling prices not only of assets but also ordinary goods and services. But the immediate practical problem now is that the banks have made so many bad loans to dud companies that they are terrified of making new ones, even to good risks.

The result is not catastrophe but rather paralysis.

Neither Europe nor America is anywhere near the Japanese situation. The excesses in the US are less marked and American companies are already taking the tough restructuring decisions that Japanese companies in general failed to do. And while German banks in particular mirror the Japanese structure of shareholding links between banks and companies to some extent, both the balance sheets and the lending quality of German banks are much stronger.

So no panic yet. But it would be naïve to pretend that these growing financial pressures would not inhibit economic growth. They will. Look at a company like BT, forced to sell assets and split itself into two in order to cut its debt mountain. It is not likely to splurge out on new investments. At the moment even telecom companies with much stronger balance sheets are scratching around wondering which investment projects to postpone to conserve cash.

Every economic cycle has its share of financial disasters. Large companies will go under – not just the little dot.coms whose demise helps fill the financial pages at the moment. Some large banks may need to be rescued, though I would be astounded if any were in the UK. But will there be a systemic collapse? No – but the central banks are right to be concerned.