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For the past couple of weeks, the forex market has been focusing on the European sovereign debt crisis.

For now, let’s set our eyes on the U.K. banking sector. After doing a little digging, it seems that the eurozone ain’t the only economy with skeletons in its closet.

Refinancing Risks

One of the bigger challenges that U.K. banks are facing is the risk of not being able to refinance or swap their old loans for more favorable loans.

In its financial stability report last June, the Bank of England revealed that the largest U.K. banks need to pay off or refinance around 750 billion -800 billion GBP worth of term loans and liquid assets by the end of 2012. Ack!

If the ginormous amount alone isn’t enough to give the large banks sleepless nights, they also have to consider the tight conditions of the U.K. economy.

The U.K.’s banks have a collective interest to sustain an accommodating lending environment so that businesses won’t get all choked up in times of financial market uncertainty. This could mean more relaxed credit standards and even fewer profits.

Foreign Bank Exposure

Another problem for U.K banks is that they are heavily exposed to foreign banks.

At the top of the list is the U.S., which reportedly accounts for 25% of all U.K. foreign loans.

Take note that the majority of those loans are closely tied to the U.S. housing market, which, sad to say, isn’t exactly sparkling like Jordan’s new crib. Just last month, pending, new, and existing home sales data all came in worse than anticipated.

It’s no secret that some fear a potential double-dip recession, with the housing market at the center of it all.

To add even more pain to British banks’ buttocks is that they are also exposed to a couple of countries that have hogged the spotlight recently. Lloyds Banking Group, one of the largest in the U.K., has about 4% of all their loans in Ireland.

Remember, Ireland has said that most of their problems are in Irish banks’ debts, and not the government, so this is something to keep an eye on. It wouldn’t surprise me if a majority of that total ends up in bad (unpaid) debt!

Moving further East, Korea could also be posing a problem for another U.K. powerhouse, Standard Chartered. The banking group’s Korean acquisitions have shown a 0.46% pre-tax return-on-asset (ROA) figure, which is pretty dismal compared to the 1.4% number posted by the rest of the group.

Recall that ROA is a measure of how well a company uses its assets. Hmm, I wonder if the recent tension on the Korean peninsula will become threaten business activity in the coming months.

Sovereign Debt

Buying government securities used to be one of the safest investments anyone could make. In fact, they were even sometimes as liquid as cash. Now, with the U.K. running a huge budget deficit all the financial problems surrounding Greece, Portugal, Ireland, and Spain, this isn’t the case anymore.

Among the three risks U.K. banks face, I feel that this is the biggest one. The cost of insuring government debt from default has actually risen to more than insuring commercial banks. This is quite scary, as the holdings of the four major U.K. banks are estimated at around 10-20% of the U.K.’s public debt.

To give you an example of how exposed U.K. banks are, let’s take another look at Lloyds. It is estimated that approximately half of the government debt in their coffers is from the U.K.

A significant rise in the cost of insurance could hurt the profits of the U.K.’s major banks, which could harm the overall recovery of the banking sector.

As you can see, the U.K. banking system is facing some serious problems. Refinancing, foreign bank exposure, and ginormous debts will are all risks that cannot be ignored, and I can only hope that the government officials get creative fast and iron out these obstacles.