Concern mounts over a no-deal Brexit

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By:
Peter Lee
Published on:

The UK financial establishment says it can cope if the UK crashes out of the EU, but behind the scenes panic seems close.

Andrew Bailey, chief executive of the Financial Conduct Authority (FCA), was channelling the Dunkirk spirit at the Mansion House last night – all self-deprecation, bad jokes, plucky little British chap ­– as he reported on the UK market regulator’s preparations for a range of Brexit outcomes, from an implementation period that smooths transition to a hard and sudden exit.

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 Andrew Bailey, FCA

“I was amused the other day when someone asked in Parliament if the FCA had adequate resources to deal with this,” bantered Bailey. “It was the same day that we put out 900 pages of consultation documents on Brexit preparations for no deal, which is good going in a single day even by our standards.” 

So, he thinks we, or at least the FCA, can handle it. 

But he did, once again, press the urgent need for the FCA’s EU counterparts to put in place Memorandums of Understanding (MoUs) to support cross-border supervision of firms and markets and continuation of clearing, pointing out that the FCA is a significant sharer of cross-border data and passes on around 70% of transaction reports it receives to counterparts across the EU.

Bailey said: “This technical, regulator to regulator coordination is essential to minimize disruption in a no-deal situation.”

He also was at pains to present the FCA as a protector of all consumers of financial services from firms it regulates and not just UK ones. He pointed out: “We have given our public support to the statement by Lloyd’s of London that in the event of the UK leaving the EU with no transition or implementation period, Lloyd’s underwriters will continue to honour their contractual commitments including the payment of valid claims.”

That seems only reasonable to us, but for Bailey it goes to the heart of treating customers fairly. He says: “To be clear, this is not to deny there are cliff-edge risks to a sudden and hard Brexit transition, there are. But the time to analyze them is over. We have to deal with them and solve the problems we face.”

Bailey went on to emphasize that the FCA has made it clear to the large international banks operating in the UK that for non-EU clients they should only consider moving activity away from the UK if it is demonstrably in the interests of the client to do so. 

We are sure there is nothing remotely self-interested in this. Indeed, so sharply and resolutely focused on customers is Bailey, that the head of the UK’s lead regulator almost sounds as if he works for an investment bank already.

What Euromoney takes from all this is just how normal it has suddenly become to discuss the practicalities of a no-deal Brexit. Everyone we speak to emphasizes that such an outcome is not their base case expectation and then goes into agonizing detail of what may happen.

Theresa May has apparently decreed that no-deal plans must start to roll out in the next three weeks. To give an idea of what that might be like, the FT and ITV have reported that transport secretary Chris Grayling astounded UK cabinet colleagues this week with ideas to hire ­– from goodness knows where ­ – a flotilla of ships to bring food and medicine to smaller UK ports in the event of a standstill on the main lorry route from Calais to Dover in the event of no deal.

How would this look for UK banks?

RBS announced in its third quarter results that it had already taken a £100 million charge in relation to what it calls a more uncertain economic outlook as hopes of an orderly Brexit fade. It also explained that as a further precaution it was maintaining very high levels of liquidity, even though not deploying these into loans or other earning assets is fundamentally hurting net interest margin and reported profits.

Chief executive Ross McEwan presents the dangers of no-deal in existential terms. “We fell over 10 years ago,” he says, “and this bank wants to go into whatever happens in a very strong position going forward.”

Andrew Coombs, banks analyst at Citi Research, is the latest to take a stab at quantifying the potential impact across the whole sector. For the bank’s economists, no deal is not the base case: of course it isn’t. But if it happens, Coombs sees three main consequences for UK banks’ domestic earnings. 

First would be a 5% cut to UK GDP in the next two or three years and a consequent contraction in loan demand, cutting 3%-9% of earnings. Second, interest rates would stay lower for longer removing 2%-7% of earnings. Finally, most significantly and hardest to quantify, asset quality would deteriorate due to higher unemployment, especially on unsecured consumer loans and SME loans.

IFRS9 would likely accentuate the reporting of these losses. Call that another 10%.

While bloody, this all sounds rather optimistic to us. UBS, for example, predicts a possible 10% loss of output in the event of no deal, much of the impact coming in the first 12-18 months.

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Jes Staley, Barclays
But even if you ignore the hit to bank capital – and Coombs does not go into the dreary details of declining collateral asset values – Citi’s analysis suggests as much as 25% of domestic earnings would be lost almost at a stroke. And while some of this may now be beginning to be priced into higher implied equity risk premia for UK banks – up to 9% from a low of 6% – Coombs adds: “It is fair to argue that consensus earnings estimates do not reflect this, being flat to the time of the exit vote.”

UBS analysts see bigger risks than collapsing asset values in uncertainties about UK banks' links to Europe’s financial plumbing – which for decades has been built round London – and access to clearing and trade repositories as well as continuity of contracts.

UBS analysts also worry much more than their Citi counterparts about the perverse impact on banks of likely Bank of England efforts to protect the economy. “Interest rate hedge portfolios – which depend on five- to seven-year swap rates remaining at around current levels – are responsible for around 20% of bank sector profits. If the long end of the yield curve sold off on liquidity injections, this source of profits would reduce over a period of 3-5 years.”

With UK banks just starting to report third-quarter earnings as Euromoney went to press, Jes Staley, chief executive of Barclays, while updating analysts on the bank’s plans to transfer EU operations to Ireland, also offered some hints on increasing risk aversion, for example in taking a conservative approach to UK credit card balances.

Staley says: “Our levered loan exposure from financing activities in the UK has actually dropped 25% in the last two years.” This may count as not before time. He adds: “I should say that we are not seeing yet any concerning signs of stress among our UK consumers or business customers, nevertheless, we feel very well positioned to cope with that situation should it arise.”

But it also sounds as if he’s trying to prepare investors for an unpleasant outcome. Staley says: “We are very focused on the impact, particularly in the supply chain in the UK and what may happen in that supply chain. We're a major player in the agricultural industry across the UK – £1 in every £4 lent to farmers in the United Kingdom comes from Barclays. And the agriculture sector may be one of the most impacted sectors in Brexit.”