Dangers of Messy Brexit Without Insurance Deal Highlighted by Bank of England

November 28, 2017 by

British banks may have unanimously passed Bank of England stress tests, but that clean bill of health came with concern about a messy Brexit, courtesy of Governor Mark Carney.

The central bank told lenders to add another 6 billion pounds ($8 billion) to their capital buffers and may increase their requirements again next year because it’s worried that the combination of a no-deal Brexit without a transition period and a global recession could strangle the flow of credit to the economy. Lloyds Banking Group Plc shares sank as the worst-case scenario highlighted the domestic-focused bank’s exposure to consumers.

Barclays Plc and Royal Bank of Scotland Group Plc were the weakest of the seven major U.K. banks in the exercise, although they weren’t ordered to raise additional capital or change their strategies in light of actions they’ve taken since the end of last year. Both fell below their systemic reference point, a higher threshold that reflects their global significance.

“The combination of a disorderly Brexit, a severe global recession and stressed misconduct costs could result in more severe conditions than in the stress test” and restrict lending, the central bank said Tuesday. However, if Brexit were to occur with a healthier world economy and fewer fines, banks could continue to support the economy through Britain’s exit from the European Union, the BOE said.

It’s the first time all the banks have passed the tests with no need to strengthen their capital position. In a press conference after the stress tests, Carney doubled down on his warning that anything less than a smooth Brexit transition risks wreaking financial disruption. The governor has frequently highlighted the risks of Brexit before and after the vote in June last year, earning him the ire of some pro-Brexit Conservatives.

The additional 6 billion pounds of capital must be added due to an increase in the BOE’s counter-cyclical capital buffer to 1 percent from 0.5 percent. The measure is meant to guard against banks’ tendency to boost lending in boom times and then slash it in a bust, potentially exacerbating an economic slowdown by denying companies credit when they need it most.

“Until we have resolved our remaining major legacy conduct issues and non-core portfolio interests, we will continue to show stress test results weaker than our long-term targets,” RBS Chief Financial Officer Ewen Stevenson said in a statement. Barclays said the results reflect “litigation and conduct issues” which the bank is aiming to resolve.

The other banks in the test — HSBC Holdings Plc, Lloyds, Nationwide Building Society, Santander U.K. Plc and Standard Chartered Plc — all passed the health check, which was based on end-2016 data.

Lloyds, whose shares slid as much as 3 percent, had to dip twice as deep into its capital reserves when compared with last year. The BOE modeled a higher rate of consumer loan losses, exacerbated by the lender’s purchase of MBNA’s 7 billion-pound U.K. credit-card business last December.

“Rising capital requirements through a combination of increasing regulatory buffers and the stress draw down have raised concerns that some banks’ current capital targets may not be sufficient,” analysts at Barclays said in a note. “Lloyds is the most affected,” with the minimum requirement its for common equity Tier 1 ratio, a measure of financial strength, potentially rising to 15 percent compared to the company’s 13 percent target, they said.

Other bank stocks were mixed, with Barclays, which passed the stress test with the slimmest margin, down as much as 1.8 percent; HSBC, which fared the best, rose as much as 1 percent. RBS was little changed.

Combined, the seven lenders would incur losses of about 50 billion pounds in the stress scenario, a level that the BOE said would have wiped out their common equity capital a decade ago. All banks stop paying dividends, bonuses and their additional Tier 1 debt coupons under the scenario.

The 2017 stress tests included U.K. and global economic slumps, the pound crashing 27 percent versus the dollar, house prices devaluing by a third and another 40 billion pounds of misconduct charges. The BOE’s Financial Policy Committee said even in that scenario, banks are resilient enough to keep lending to consumers and businesses, based on current capital and leverage levels.

The FPC, which Carney also leads, said it’s continuing to assess threats to financial services related to the withdrawal from the EU. It warned it will be difficult for institutions to fully mitigate risks on their own, and a “timely agreement on an implementation period” would help.

The BOE also highlighted potential problems if no deal is struck on insurance contracts, which could result in 36 million British and European policyholders having their cover voided. It reiterated its warning about the fragmentation of derivatives clearing from London, saying as much as 26 trillion pounds of outstanding contracts could be left hanging without an agreement.

Those warnings pile pressure on Prime Minister Theresa May, who is heading toward a crucial deadline at a December EU summit to make progress on Brexit. The slow movement in negotiations means companies are still awaiting clarity on the U.K.’s new trading arrangements and the transition to them.

Though Brexit dominates when it comes to domestic threats seen by the FPC, it also highlighted the pace of consumer-credit growth — currently close to 10 percent — and the current-account deficit. Globally, the FPC said risks from global debt levels, stretched asset valuations and misconduct costs “remain material.” It also warned about threats to banks’ operating models from financial technology innovations, while also signaling concern about the industry’s ability to execute cost-reduction plans.

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