Brexit's Headwinds Not Enough to Sink Banks

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.

We anticipate that operating costs will increase as banks prepare for the U.K. to leave the EU. We think U.K. banks may need to establish subsidiaries within the future EU borders in order to continue to serve their international customers without EU passporting privileges. We think Barclays BCS will be affected significantly, given its large international corporate and investment banking businesses. Should Scotland eventually move to exit the U.K. in favor of the EU, Lloyds Banking Group LYG and Royal Bank of Scotland RBS could face costly relocations of their Edinburgh headquarters.

We think credit costs for the U.K.-focused banks are also likely to increase from recent very low levels. We think that London is likely to lose some of its prominence as a financial center and that housing prices may soften as demand for housing falls. We see the high end of the London real estate market, real estate development, and buy-to-let lending as most vulnerable to losses, along with consumer credit, should unemployment increase. However, absolute levels of losses on retail mortgages are likely to be manageable, given low loan/value ratios on both a mark-to-market and flow basis.

While short-term funding costs may decrease if interest rates fall, we think long-term funding costs could increase as demand for U.K. bonds, such as the euro-denominated mortgage-backed securities issued by U.K. banks, falls. EU banks have historically been major buyers of these bonds, as they currently count toward the banks’ liquidity coverage ratios. However, these bonds will not be eligible after Brexit. U.K. banks may also be less well positioned to compete for corporate deposits after Brexit.

We anticipate that U.K. banks may face an exodus of employees who are not U.K. citizens, as it is unclear whether they will be permitted to work in the U.K. when Brexit is finalized. We think this risk is most acute for banks competing in international markets, such as investment banking and asset management.

On the flip side, Brexit could create opportunities for regulatory arbitrage to the U.K.’s benefit. We see it as unlikely, but U.K. regulators could elect to protect London’s financial services business by loosening regulations to allow, for example, greater variable pay for bankers or greater risk-taking by financial institutions. We see such a move as contrary to the direction of U.K. regulation post-financial crisis, and note that a loosening of regulation would probably be a credit negative.

With respect to the global U.S. banks, we expect more-muted business effects to result from the Brexit vote. The most observable near-term impact of higher market uncertainty for the global bank peer group will be wider bond spreads, which can lead to higher funding costs. But we do not foresee market conditions deteriorating so rapidly that a crisis of confidence develops with respect to the U.K.-focused banks, causing counterparty credit fears to develop across the broader banking sector. Relative to 2007, today’s higher capital ratios, lower risk balance sheets, less dependence on short-term wholesale funding, and higher liquidity coverage levels bolster our confidence in the global bank sector. We also point to the European Central Bank’s EUR 80 billion per month or an annualized EUR 960 billion bond-buying operation, including approximately EUR 10 billion per month of corporate bonds, as support for market liquidity. Because most of the exposure of global U.S. banks is limited to financial markets and certain commercial sectors, we do not expect large loan losses to develop, causing material charge-offs and balance sheet holes that would need to be filled with more capital.

We reiterate our overweight bond recommendations on Citigroup C and Goldman Sachs GS, as both companies’ 10-year bond spreads are roughly 15 basis points wider on the day and company fundamentals remain intact. We do, however, expect volatile markets to depress trading results and investment banking activity specific to the U.K. during the remainder of the year. Costs to the banking sector that are less material and harder to isolate include higher occupancy costs associated with operating facilities in both the U.K. and continental Europe as employment and trade treaties will probably need to be renegotiated.

Following the eight U.S. global systemically important banks--Bank of America BAC, Bank of New York Mellon BK, Citigroup, Goldman Sachs, JPMorgan Chase JPM, Morgan Stanley MS, State Street STT, and Wells Fargo WFC--the larger U.S. regional banks maintain limited international exposure, let alone direct U.K. loans. In fact, even Wells Fargo, the third-largest U.S. bank by asset size, had only 6% of its loan book at year-end outside the United States. As a result, we see negligible direct effects on U.S. regional banks.

Building upon the signals the U.S. Federal Reserve sent to the markets in its June 15 Federal Open Market Committee meeting, following the Brexit vote we now expect the Fed to maintain its benchmark federal funds target rate at 0.25%-0.50% for an even longer period in an attempt to maximize market liquidity. This lower-for-longer stance is problematic for most banks that remain asset-sensitive in that they are able to reprice their assets (for example, loans and securities) faster than the funding for those assets (for example, deposits and borrowings). Net interest income on bank assets constitutes 40%-80% of bank revenue, with regional banks like Zions Bancorp ZION, SunTrust STI, and Regions Financial RF representing the higher end of the range and global banks like JPMorgan and Citigroup representing the low end.

At a broader level, Brexit illustrates the fragility of the European project. It is certainly plausible that other countries could agitate to leave the EU if nationalistic sentiment develops or the cost of membership becomes too high. At a minimum, we expect progress on a European banking union that includes unified regulation and deposit insurance to grind to a halt. Stalled progress in these areas could highlight asset quality weaknesses and modest capital levels of banks in Europe’s periphery, contributing to higher funding costs for those banks. It also highlights the importance of populism in political discussions of economic issues. We see a risk that the U.K.’s vote to leave the EU could bode poorly for Italy’s October referendum on constitutional reforms, for example. It may also lend support to anti-euro groups in France, the EU’s second-largest member.

In addition to the impact of Brexit on the U.S. banking sector, we will be monitoring the effect of higher oil prices on bank profits and asset quality during the second quarter. Lower oil prices during the trailing 12 months have contributed to deteriorating credit quality of certain banks’ commercial and industrial loan portfolios and higher loan-loss provisions, which has detracted from profits at companies including Capital One Financial COF, JPMorgan Chase, Wells Fargo, and Comerica CMA. We expect the rebound in the price of oil to around $50 per barrel from the high $20s of February to stem the profit bleeding at banks and contribute to stabilizing asset quality. Based on first-quarter data, our stress testing indicates that even in a severe scenario in which realized loss rates on energy loans reached 30%, projected losses to bank capital would be manageable at around 3% of common equity Tier 1 capital.