Europe’s most important central bankers are at loggerheads over one of the continent’s biggest economic judgment calls: does a disorderly Brexit pose a financial stability risk?

For Mark Carney, Bank of England governor, a messy and severe Brexit could be a “Jenga” moment, where the legal architecture for financial flows collapses, hurting the City of London’s European customers even more than Britain itself.

Mario Draghi, meanwhile, is largely unfazed. The European Central Bank governor has told EU-27 negotiators he is unworried about financial risks from a mobile industry that is adapting to new circumstances. Far from a stability threat to the eurozone, Brexit costs will be containable — and concentrated in Britain.

Whether bluff or negotiating bluster, these arguments will shape the balance of power in Brexit talks, and potentially determine whether Britain remains the EU’s main financial centre even from outside the bloc.

What are the potential risks?
Mr Carney’s argument turns on hedging. Without a market access agreement, European banks and businesses would find it harder to tap Europe’s dominant derivatives market and find essential products to manage balance sheet risks.

“There are currently deep hedging markets,” he said. “If we’re caught in the collective position on both parts of the channel where the main counterparties can no longer dynamically hedge, that takes out capacity, holds up transactions and can cause unforeseeable moves in markets with collateral implications.”

A hard fall out of the bloc carries other potential risks. It might drain market liquidity, raise doubts over the validity of cross-border insurance contracts and generate needless alarm by obscuring financial exposures.

Economic ructions from sudden shifts in capital flows are another worry. A House of Lords committee recently concluded that the sheer interconnectedness of the UK-EU financial system “presents serious difficulties” in even gauging the impact of dramatic legal changes.

Instability would come in part from the difficulty of meeting the EU’s own financial rules post-Brexit. These require some types of interest rate swaps and derivatives to be traded on regulated markets and passed through clearing houses. If London were cast into the regulatory wilderness, European firms would need to scramble for new solutions to fulfil their obligations.

For Simon Gleeson, a partner with Clifford Chance specialising in financial regulation, the prospect bears out Mr Carney’s warning. “In very broad terms, about 20 per cent of the City of London’s volumes come from the EU. So in a hard Brexit scenario, the City loses 20 per cent of its volumes overnight,” he said. “That hurts, but it is all it does.”

The EU, however, faces a more daunting challenge: “A normal retail bank has funding that is mostly floating rate, in the form of deposit accounts, and lending that is almost all fixed rate, so if it can’t hedge its interest-rate exposures it is potentially highly unstable.”

Are the EU-27 alarmed?
Not yet. Hard as Britain has tried to make the point, the reaction in Brussels and Frankfurt has ranged from curiosity to outright rejection. Burkhard Balz, a German centre-right MEP and leading member of the EU parliament’s economy committee, said Mr Carney “has to say something like that” to better position Britain in upcoming talks. “From my perspective he is definitely wrong.”

One eurozone central bank governor told the FT that the ECB’s governing council had not discussed Mr Carney’s comments, saying that financial stability risk from the UK exit “certainly isn’t the ECB’s number one priority . . . the effect of Brexit on EU banks isn’t expected to be that large”. Brexit was barely mentioned in the ECB’s latest financial stability report.

Another central bank governor puts it even more succinctly: “If you were the governor of the Bank of England, if I were governor, then we would both say that wouldn’t we? . . . I don’t see where the financial stability risk is.”

Some smaller member states — and a few more nervous senior eurozone officials — are more alive to the potential dangers. But for now these concerns relate to ensuring minimising costs rather than saving the system. A study by the Bruegel think-tank “conservatively” put the cost of the EU-27 relying on a fragmented wholesale financial market at €6bn-€12bn for households and corporates. That would be on top of the “possibly greater” cost of losing access to London’s relatively efficient financial market.

Why are they so relaxed?
Eurozone central bankers are sanguine for three main reasons: they see the risks as moderate, believe the worst effects can be mitigated and that the EU controls the regulatory levers to respond if the dangers are greater than expected.

One assumption is that multinationals and EU banks would still access services in UK, albeit at potentially increased cost. Options include making use of subsidiaries based in the UK or turning to non-European banks to act as intermediaries within a clearing house.

Indeed financial groups are also busy preparing for Brexit — and reducing the risks it poses. “The good news for the EU is that two years is a reasonably long amount of time that will not allow firms to make all arrangements to serve all their clients in exactly the same way as before, but that will allow many firms to make arrangements for many of their clients,” said Nicolas Véron of the Bruegel think-tank.

The EU can change the rules if it wants to. Currently banks face higher capital requirements if they use clearing houses in jurisdictions not deemed “equivalent”. That is a problem, but Europe could theoretically change them in a situation where they are doing more harm than good. One senior EU finance ministry official argued that “nothing will prevent users of swap contracts from continuing to do it”.

Europe also has the choice of invoking a last-minute fallback plan if it has underestimated the Brexit risks. In an emergency it can always deem the UK’s financial rules as broadly equivalent and virtually overnight erase any financial blowback. Significantly, that decision can be taken at a late stage in the exit negotiations. The EU-27 would never expect London to refuse their offer.