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Credit Insights

Brexit's Headwinds Not Enough to Sink Banks

While the consequences are broadly negative for the sector, today’s stronger financial system means we don’t foresee a crisis.

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We see the United Kingdom’s vote last week to exit the European Union as a clear negative for financial institutions in both the U.K. and the EU. We note statements by the International Monetary Fund indicating that the “net economic effects [for the U.K.] of leaving the EU would likely be negative and substantial” as firms and individuals postpone investment decisions until the new relationship between the U.K. and its trading partners takes shape and as firms move activities from the U.K. into future EU borders. However, with U.K.-focused bank shares off 30% and trading at half of tangible book value, it is worth noting that we think a full-blown financial crisis is unlikely. The U.K. financial system has strengthened considerably since the financial crisis. We see the U.K. banks as strongly capitalized, with highly liquid, well-funded balance sheets. We think the banks have sufficient liquid resources to withstand a temporary freezing of funding markets and note that the Bank of England stands ready to provide more than GBP 250 billion of additional liquidity to banks. Moreover, we do not anticipate that the vote will cause any large mark-to-market losses, similar to the losses taken on subprime bonds or Greek bank debt, that would consume significant portions of banks’ equity cushions.

Still, we think the near-term negative impact of Brexit on U.K.-focused banks will be significant. Formal assessments of the impact of Brexit on U.K. GDP predict anywhere from 4.0% (Minford 2016) to negative 14% (Bertelsmann Stiftung 2015) over the long term, although the bulk of studies anticipate a long-run impact of around negative 5%. Similarly, in its June 2016 Selected Issues report, under Brexit, the IMF projected GDP growth 1.5% and 4.5% lower than baseline in 2021 in its limited-uncertainty and adverse scenarios, respectively. We think revenue growth is likely to see an immediate impact. Recent upward trends in net interest margins are likely to halt, if not reverse, given falling credit demand and the increased probability that the Bank of England will cut interest rates. Moreover, near-term uncertainty, together with the possibility of lower long-term GDP growth, is likely to put negative pressure on loan growth. We anticipate that London’s loss of prominence as a financial center will put downward pressure on corporate and investment banking revenue, as London’s deep talent pools and interconnected relationships shift to EU locations.

Christopher Baker does not own shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.

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