Greece shakes the markets again as Bank warns of eurozone shocks

Fears that the Greek government may soon have to tap its €110bn eurozone/IMF rescue package sent the cost of insuring Greek government bonds against default soaring to record highs yesterday – and hit UK banks shares in London badly, thanks to the "contagion" factor.

The latest crisis to hit the eurozone's financial system came as the Bank of England warned that the British banks remained vulnerable to shocks from the single currency area, and faced an £850bn funding gap over the next few years, the largest among the advanced economies.

The Bank said: "Banks' long-term credit ratings benefit from the implicit support given by governments. A broad-based rise in sovereign risk concerns would reduce the perceived value of such support to banking systems. This would tend to put downward pressure on banks' credit ratings. UK banks are among those vulnerable to these pressures."

At more than 10 percentage points the credit default swap premia – in effect an insurance premium on Greek government bonds – yesterday spiked higher even than it did during the May crisis. It signals the near-certainty among market players that a Greek default, or "restructuring" is inevitable and may arrive sooner than expected. The imminent withdrawal of one of the European Central Bank's special schemes has apparently spooked investors.

As has happened frequently before, the euro was pushed sharply down against the dollar on fears that the "contagion" may spread. Sterling reached a 19-month high against the euro: Spanish CDS also went higher yesterday.

Greece is framing legislation to set up a €10bn (£8bn) euro support mechanism to bail out her banks if, as is virtually certain, they cannot raise funding on the international markets in the conventional way, especially now that 12-month ECB funding facility is due to be wound down on 1 July. The €10bn would come from the €110bn emergency loan package from the IMF and Greece's eurozone partners. "The purpose is not to provide liquidity support," the Deputy Finance Minister Philippos Sachinidis told MPs. "The aim of this initiative is to deal with a collateral problem... the banking system is facing the backwash of the fiscal crisis."

Mr Sachinidis said that the €10bn will be sufficient to accommodate any losses under stress-test scenarios, due to be published by the European authorities for banks across the Continent, a move welcomed by the Bank of England as an important step towards confidence-building and transparency and confidence-building.

In its Financial Stability Report, the Bank said: "UK banks need to maintain resilience in a difficult environment, while refinancing substantial sums of funding; they have a collective interest in providing sufficient lending to support economic recovery; and they will need over time to build larger buffers of capital meet more demanding future regulatory requirements".

Some £850bn in refinancing will need to be found by 2012, at a time when official support such as the Special Liquidity Scheme is being ended.

The new Basel rules, say the Bank, will be agreed in the autumn, but the Bank favours a gradual transition.

The possibility of a European financial conflagration is edging closer – and could be more serious than the 2008 post-Lehmans collapse, given that sovereign debt and government borrowing helped trigger this crisis in the first place and makes state-sponsored bank rescues much less credible or likely.