How Bad Will Brexit Be for Banks, Credit Markets?

The effects are being felt already, but whether that's a short-term reaction or a harbinger of much more to come is unknown.
Christopher WhalenJune 30, 2016
How Bad Will Brexit Be for Banks, Credit Markets?

In the wake of the U.K.’s vote to leave the European Union, equity market valuations for many EU banks have tested recent lows. The only certainty is that enormous amounts of time, money, and other resources will be spent accommodating this change, should the U.K. proceed with the exit.

Christopher Whalen

Christopher Whalen Financial services

For the U.S. and EU banks in the rated universe of Kroll Bond Rating Agency (KBRA), there does not appear to be any suggestion of an immediate rating change. But when the tectonic plates of nations and markets shift, inevitably commerce and finance suffer, which means weaker revenue and earnings for lenders.

This reality is already seen in revisions to sell-side earnings estimates for major global banks. The disruption to commercial and legal structures caused by the extraordinary legal process that looms ahead will not, KBRA believes, cause systemic contagion à la Lehman Brothers, as some analysts have worried. But it does threaten a slowdown in economic activity that could materially impact volumes and earnings in the global banking industry.

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Global commercial and financial activity in the non-bank sector is likely to be negatively impacted as well, possibly causing the Federal Open Market Committee (FOMC) to delay further increases in benchmark rates.

Among the chief immediate results of the U.K. referendum is that market volatility has increased and is likely to continue to be amplified by the announcements and events that will unfold over the next several years.

Since the process is unfamiliar to both investors and political leaders, the chance that there will be surprises along the way is high. And greater uncertainty leads to wider credit spreads, a fact that KBRA believes could have an adverse effect on markets that were just starting to recover from the dismal results in the first quarter.

On the macro front, the U.K.’s exit from the EU will affect the credit profiles of both, and their markets and financial institutions will be under intense scrutiny going forward. Indeed, the fact of an EU member nation invoking the right to secede raises fundamental questions about the viability of the EU federation going forward.

Meanwhile, the U.K. must make its own way in the global commercial and credit markets. The credit market concerns about the EU and U.K. will only add to downward pressure on the pound and euro in global currency markets and increase pressure to resolve issues such as excessive public sector debt and low bank capital. KBRA notes, for example, that the Italian government has publicly stated its intention to make direct capital infusions into banks.

The currency weakness and political uncertainty in the EU will tend to add even greater upward pressure on the dollar, as investors seek shelter in the United States. Even though many asset classes have shown marked price appreciation in recent years, hard assets, such as commercial real estate, may be poised for further gains due to increased foreign capital inflows to the United States.

Another significant concern for banks comes on the regulatory front. U.K. banks were supposed to complete their “ring fencing” planning for regulatory purposes by September. Now, the entire process for documenting the systemic risk profiles of U.K. and EU banks, including affiliates of U.S. banks, will need to be redone at significant expense. Broader, more complex issues of financial supervision will need to be addressed on both sides as the U.K. withdraws from the EU’s prudential supervisory system.

KBRA believes that investors ought to take a measured approach to assessing the likely impact of Brexit. Many of the issues identified by news commentaries may turn out to be irrelevant, while other, as-yet unidentified issues may turn out to be very significant.

There are many nuances to this situation, such as the quick response by the EU ministers after the UK referendum. European Commission President Jean-Claude Juncker has said he’d like to get started on the exit immediately. Details that are yet to be known will greatly affect the ultimate outcome. Thus, investors, markets, and business leaders face prolonged uncertainty.

Most KBRA-rated U.S. banks are domestically focused and will be affected only indirectly by this event. The largest effect stems from the likelihood that the FOMC will delay further increases in short-term interest rates. Consequently, net interest margin (NIM) pressure for U.S. banks will continue, given the prospect of stagnant short-term rates combined with the potential for a further flattening of the yield curve.

A flatter yield curve will negatively impact investment portfolio yields and could pressure bank management to improve yields by increasing portfolio duration and shifting portfolios to higher yielding/higher-risk positions.

KBRA notes that small to midsized U.S. banks continue to have more resilient NIMs, thanks to better prospects for loan growth compared with larger institutions. Nonetheless, NIM pressure will force banks to embark on additional efficiency measures and tempt management to increase return on equity via more shareholder-friendly capital management.

In addition, U.S. banks could see rising asset quality problems over time if the European uncertainties result in a meaningful decline in the global economy.

The already strong liquidity of major U.S. banks will likely improve from further inflows of international funds. However, capital markets revenues may suffer in the second half of 2016, given the prospect for a slowdown of equity and debt underwriting as well as mergers and acquisitions.

Customer-related trading volumes will likely decline, particularly in higher-risk products such as leveraged loans and high-yield debt, as well as European-related exposures. Increases in foreign exchange trading and hedging products could partially offset these declines.

Major U.S. banks with sizable London offices also face significant uncertainties and costs associated with reconfiguring their European operations.

Christopher Whalen is senior managing director and head of research for Kroll Bond Rating Agency.