Europe’s banks are beginning to deal with the impact of the UK moving slowly but inexorably away from the European Union.
The immediate impact of the Brexit vote was a shock to banking share prices with £40bn wiped off the value of UK banks alone. Despite some recovery, as the surprise of the referendum result faded, this has left partially state-owned banks, like Royal Bank of Scotland and Lloyds, with share prices below their bailout values making it difficult for the government to complete their privatisation.
The Brexit vote also led to the Bank of England releasing its ‘rainy day’ buffer of $5.7bn and allowing banks to dip into their capital reserves in order to keep lending. Sure signs that normal times are over for the UK economy and the central bank expects more stress.
Following the referendum, the plight of several eurozone banks worsened sharply.
The problems in UK banks are dwarfed by the mayhem in the Italian banking sector where €200bn in non-performing loans saw share prices plummet 50% earlier this year. The banks at the centre of this crisis include Italy’s largest lender, UniCredit, and the world’s oldest and the country’s third-largest bank, Banca Monte dei Paschi di Siena (MPS).
The situation has left the Italian government contemplating a major banking sector bailout that would breach EU rules on state aid.
These issues are potential flashpoints that pose wider risks to the other banks in the eurozone and the rest of the continent. In fact it is providing the first significant test of the new regulatory system that was put in place following the last crash.
Questions about stability
“By any measure, a number of large European banks are seriously undercapitalised—with Italy’s in the lead. And, other financial systems are exposed to these problems.
Everyone knew about the referendum months in advance, giving them plenty of time to prepare. Yet, we are left with some fundamental questions related to global financial stability,” says Stephen Cecchetti, Professor of International Economics at the Brandeis International Business School.
“Do banks have sufficient capital and liquidity to withstand the ‘shock?’ Will financial markets continue to serve their key functions? Or, is the financial system only as strong as its weakest link,” asks Cecchetti.
“The UK authorities have done a reasonable job of strengthening their banks and financial system. They have taken to heart that a healthy banking system is the foundation for strong, stable and balanced growth.
“Unfortunately, unless the global financial system as a whole is well capitalised — which we doubt — the system remains only as strong as its weakest link. And, the increased post-referendum concerns evident in financial markets regarding several continental institutions appear warranted.”
The Brexit negotiations between the UK and EU look set to be both prolonged and complicated. The UK will be keen to preserve its access to the single market – including the financial sector – while the EU will want to extract concession in order to extend this privilege.
Challenges before banks
The UK’s vote to leave the European Union has added to the revenue challenges faced by European global trading and universal banks (GTUBs), according to Christian Scarafia, Senior Director, Financial Institutions at Fitch Ratings.
The rating agency says that higher market volatility and activity in certain asset classes, notably in foreign exchange, had bolstered sales and trading revenue for all European GTUBs in the short term. However, it expects increased economic uncertainty to lower transaction volumes in the medium term.
“Underwriting and advisory revenue is likely to be depressed as corporates postpone issuance and acquisitions until capital markets are more favourable and businesses adjust to the new operating environment. Subdued issuance and corporate actions could affect trading volumes, putting further pressure on profitability,” says Scarafia.
The two European banks most reliant on capital market activities are Credit Suisse Group and Deutsche Bank. They have sales, trading, underwriting and advisory revenue at about 50% and 40% of total group revenue, respectively.
In addition, these two banks, along with the UK’s Barclays Bank, are already undergoing substantial restructuring, cutting costs and reallocating resources as they adapt to more challenging capital markets and changed capital requirements.
The Brexit vote is expected to complicate staffing decisions further as it may cause relocations, particularly away from London, as well as adding to revenue woes.
Uncertainty about growth
The referendum result has added uncertainty about global economic growth with the International Monetary Fund calling it a ‘spanner in the works’ of global recovery and downgrading its forecasts.
However, the sharp depreciation in Sterling should be neutral to positive for earnings, says Fitch.
Scarafia says, “Most European GTUBs’ sterling cost bases are larger than sterling revenue. There is also the benefit from increased FX transactions. We expect the impact on regulatory capital ratios to be contained, as the groups at least partly hedge FX mismatches between their equity base, risk-weighted assets (RWAs) and leverage exposure.”
“Nevertheless, any large position losses could lead to a rating review if they indicate increased risk appetite or ineffective hedges.”
Fitch also expects net interest margins to remain under pressure, as central banks are likely to keep interest rates lower for longer.
Scarafia says, “The Brexit vote is also likely to have further delayed broader European economic growth, which would put pressure on European commercial banking revenue more generally.”
“The most significant long-term issue is maintaining the ability to sell products and services to the single European market, given most banks’ significant presence in London. But we expect any operational changes made to preserve this access to be only gradual and manageable. Banks based in the eurozone should be better placed, as substantial business is already undertaken from Frankfurt or Paris.”
The business of Brexit looks likely to be a long-running saga with many questions yet to be answered as the UK and EU disentangle themselves to a greater or lesser degree.