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Opinion Pieces

UK Banking and Unintended Consequences

When voters in northern England chose on the 23rd of June to leave the European Union, they could not possibly have understood the negative consequences for UK banking. Nor, to a large degree, did they seem to care. On the ground, Brexit leaders had focused on the issues of immigration and jobs, whilst naysayers had focused rather on European citizenship and on the benefits of free trade.

 

uk-banking-unintended-consequencesIt was only bank executives and some vigilant economists who attempted to argue the consequences on the financial markets and the ripple effects that would then ensue. The average voter paid little attention to those they perceived as the City of London elite, following the turbulence of the last eight years of post Financial Crisis blues.

 

Nevertheless, just one month after the vote, UK Banking – constituting more than twice the share of the UK economy that it constituted merely 25 years ago – has already been sharply and negatively impacted. There have been four key effects of Brexit on the UK banking industry and these will have lasting impact.

 

Firstly, the UK’s inclusion in the European Union has allowed their banks – Lloyds, HSBC, Barclays and RBS – to “passport” their services across the entirety of the European Union member states. In practice, the removal of this “passport” once Article 50 is invoked will mean that jobs, back-office through front-office operations, the recognition of revenues, profits and the payment of tax will be significantly distorted. In essence, some of these aspects of the UK banking business model will have to be moved out of the UK, particularly in respect of lending and trading activities taking place “offshore”. The long term impact will be a loss of jobs and a reduction in competitiveness.

 

Secondly, the market’s perception of the negative impact on the UK economy in general has led to a flight to quality, which in turn had led to increased demand for mainland European bonds and equity. Particularly in respect of German bonds, this has led to the inverse relationship between the price of bonds – driven by increased demand – and the yield on these bonds, being magnified.

 

Lower yields, and in many cases negative yields on long-dated bonds, have meant that there is a price compression effect in the treasuries of banks whose role is to fund asset creation through liability management. In simple terms: it is much harder now for banks to make the same nominal profits they previously did, since the spread between loan rates and funding rates is compressed. Several major European banks have already used this as the primary excuse for depressed quarter two earnings.

 

Thirdly, for UK banks in particular, the fact that sterling has plunged significantly against all major currencies, especially against the euro and the dollar, has meant that capital held in sterling against European loans has lost value and needs to be immediately topped up. As capital is topped up in sterling, so return on capital will be depressed, and in turn return on equity for UK domiciled banks will be reduced. This will mean that these banks will now have a reduced ability to lend further. And, in turn, these banks will then become less attractive entities for investment than some of their European and US counterparts.

 

Fourthly – and as an adjunct to this increased consumption of capital on existing loan books – these banks will somewhat counter-intuitively become more risky institutions. As of this moment, we wait with anticipation for the results of the European banking stress test results to be released this very evening. These stress tests, conducted by the European regulator, pose the question as to whether each bank, based on its own balance sheet at the moment, would still hold sufficient capital were a series of instantaneous and perfectly correlated negative externalities to occur. These hypotheses include radically increased loss rates on loans, share price declines, GDP erosion and increased unemployment.

 

Recall that these tests are based on hypothetical changes – or deltas – to existing balance sheets. This means that in compiling these stress test results, UK banks will need to simulate negative stresses on already stressed macro-economic factors, which will mean a sort of double-whammy effect on their balance sheets.

 

In order to ensure that they don’t fail these stress tests – which would have dire consequences on reputation as well as on their ability to pay shareholder dividends – they will need either to increase capital or decrease lending. A decrease in lending will mean less profit. An increase in capital will mean a decrease in return on equity, making capital itself then more expensive. Perversely then, the combination of an actual stress event with a hypothetical stress event, will result in making UK banks far less attractive as investment choices in balanced portfolios.

 

Portfolio managers in turn, unless they perceive these stocks to become ridiculously cheap, will steer clear of them for some time, excluding them from their portfolios. These are the portfolios that are managed in the main on behalf of retirement funds, unit trusts, and endowment policies. That is to say, on behalf of the voters in northern England who voted to leave the European Union.

 

Should these voters be approaching retirement age they may well find that their lifetimes’ worth of diligent savings have been substantially eroded. Unfortunately, in spite of all of the discussion to the contrary, they will not be given the chance to rethink their choices. Brexit is final. Sure, trade agreements can be negotiated on an individual basis with friendly neighbours. But the effect on UK Banking will lead to a permanent re-alignment of investor expectations.

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