Assessing Risk

ECB Bracing for Brexit

epa04818422 European Central Bank (ECB) President Mario Draghi (L) and British Prime Minister David Cameron (R) during European heads of state and governments summit at the EU Council headquarters in Brussels, Belgium, 25 June 2015. The EU summit is expected to be dominated by the migration situation and Greece, plus Britain's renegotiation of EU membership. Greek Prime Minister Alexis Tsipras expressed confidence that a deal to avert bankruptcy for his country can still be found. EPA/OLIVIER HOSLET [ Rechtehinweis: usage Germany only, Verwendung nur in Deutschland ]
ECB President Mario Draghi (L) and British Prime Minister David Cameron (R).
  • Why it matters

    Why it matters

    A British exit from the E.U. would send shockwaves through the European financial system, and banking supervisory authorities are drafting contingency plans.

  • Facts

    Facts

    • Financial sources told Handelsblatt the possible impact of Brexit on Europe’s banks has become one of the top issues for ECB supervisors.
    • There is concerns focus on currency volatility and losses from pound-denominated loans and from currency hedging contracts.
    • Bankers want the ECB and the U.S. Fed to make emergency liquidity available to banks if there is a Brexit.
  • Audio

    Audio

  • Pdf

 

There’s been no shortage of warnings about the implications of Britain’s exit from the European Union. The chief executive of U.S. banking giant  JP Morgan, Jamie Dimon, said last month that Brexit could lead to “massive dislocation,” Bank of England Governor Mark Carney said there could be a financial crisis and economists have predicted a severe recession.

The European Central Bank has yet to make a statement on the Brexit referendum looming on June 23. But it regards Britain leaving as a serious threat to the stability of the European financial system.

Financial sources told Handelsblatt that the possible impact of Brexit on Europe’s banks has become one of the top issues for the ECB supervisors in recent weeks. One central banker described a Brexit as “the biggest danger for financial stability this year.”

To avoid nasty surprises, the ECB is closely examining individual banks and has been asking big banks in particular about the possible risks resulting from a Brexit, the sources said.

One central bank source said the ECB was talking about conceivable risks “with larger banks as part of ongoing supervisory talks.” The source added: “In this context Brexit is an issue.”

The ECB declined to comment.

Senior bankers said the supervisors want to know how well the banks are prepared for Britain quitting. One of the questions is how well the currency trading systems are prepared for the extreme market volatility that Brexit could trigger.

“In the coming weeks the banking supervisors will ask for more detailed information from banks and push this issue more forcefully,” said one insider.

Andreas Dombret, a board member of the Bundesbank, the German central bank, confirmed that supervisors were talking to banks about Brexit. “It would be bad if a supervisory authority weren’t thinking about this,” he said.

The possible impact of Brexit on Europe’s banks has become one of the top issues for the ECB supervisors in recent weeks

Possible losses from foreign currency loans or from currency hedging contracts for corporate customers are also being addressed.

When euro zone banks issue loans in British pounds, they take a currency risk but in many cases banks aren’t insured for those risks.

“Many bankers no longer hedge themselves against this risk for the entire duration of their loans,” said one bank manager. That’s because international accounting rules force banks to value derivative hedging instruments at current market prices which can be extremely volatile. That exposes banks to significant paper profits or losses. “That’s why banks often do without such hedging,” said one banker. To lessen the danger of foreign exchange-related losses, banks may scale down their lending in the coming months.

Opinion polls point to a neck and neck race between opponents and supporters of Brexit. June 23 could be a fateful day for the E.U. and for financial markets. Mr. Dombret said Britain leaving the E.U. posed a serious risk to financial stability. “If you’re asking in terms of a shock, a potential Brexit is very dangerous,” he said.

 

Ray Egan also known as John Bull burns a 10 euro note outside of the Bank of England during an anti-euro demonstration to mark the 10th anniversary of the single currency in London on January 1, 2009. AFP PHOTO/Ben Stansall (Photo credit should read BEN STANSALL/AFP/Getty Images)
An anti-euro demonstration outside the Bank of England in 2009. Source: Getty Images

 

Europe’s banking watchdogs don’t want to be accused of having highlighted the dangers too late. A look back at January 2015 explains why supervisors are so worried. That’s when the Swiss central bank took the surprise step of abandoning its three-year-old cap on the Swiss franc, arguing that defending the 1.20 per euro ceiling had become too costly.

The franc appreciated sharply and a number of banks lost hundreds of millions of euros, partly because their trading systems couldn’t cope with the turmoil.

Banks and supervisors are still haunted by the Swiss franc shock so it’s little wonder that they’re bracing for the financial impact of Brexit. One senior banker said: “Brexit and its possible consequences are being discussed in all major banks.” Many banks were examining the possible impact of Brexit on their business, the banker said.

The dangers of Brexit go far beyond currency turbulence. Britain, the E.U.’s second-largest economy, has deep trading links with the rest of the 28-nation bloc so a recession in Britain, or the withdrawal of foreign investments from it, could hurt European banks.

Mr. Carney, the governor of the Bank of England, said this week a vote for Brexit would deliver a short-term hit to growth and sterling, and foreign investment would probably also fall.

“If you’re asking in terms of a shock, a potential Brexit is very dangerous.”

Andreas Dombret, board member, Bundesbank

He said some big financial firms might move business out of Britain if the country did not secure the same kind of access it currently has to the E.U. He warned that negotiations to ensure that could take “a very long time.”

An exodus of financial firms could have a serious impact on the entire British economy. The financial sector accounts for 12 percent of Britain’s GDP and pays 66 billion pounds in tax, more than any other industry.

A Bloomberg survey of economists last month found that the probability of a recession spiked to 40 percent in the event of an “out” vote, three times higher than if the British vote to stay in.

Adam Posen, a former member of the Bank of England’s Monetary Policy Committee, in January described the forthcoming vote as a “horrible, self-inflicted wound.”

He said the Bank might have to raise interest rates very sharply and rapidly to support the pound if foreign investors pull capital out of Britain amid Brexit fears. Such rate hikes would heighten the risk of recession.

Mr. Carney said banks could expect liquidity help from the Bank of England in June. “The statements by Carney were just right. Special liquidity is needed to avoid a run on the banks,” said Jens Kramer, an economist at German bank NordLB.

But foreign banks will only have access to that liquidity if they conduct their business from London. “That applies to larger banks but not necessarily to medium-sized banks such as many Landesbanken,” one bank manager told Handelsblatt, referring to publicly-owned regional banks.

Bankers are especially worried about the impact of Brexit on currency trading, said a source at another bank. The market is expected to become increasingly unpredictable after Easter and banks are hoping for help from the ECB to cope with the likely volatility.

To Be or Not to Be-01

 

“The ECB should also make special liquidity available to banks in the euro zone, just like the U.S. Fed should for U.S. banks,” said Uwe Burkert, chief economist at Landesbank Baden-Württemberg (LBBW).

According to Mr. Dombret of the Bundesbank, the negative impact on European banks may depend on how long the “divorce negotiations between the E.U. and Britain will last.”

Brexit will lead to a large number of agreements being dissolved. “The E.U. can’t be generous in this issue because then there would be a big danger of other countries following suit,” he recently told a Handelsblatt conference in Frankfurt.

 

Yasmin Osman covers the banking sector from Frankfurt. Daniel Schäfer heads the paper’s financial pages. Michael Maisch, deputy bureau chief in Frankfurt, contributed to this article. To contact the authors: osman@handelsblatt.com, schaefer@handelsblatt.com, maisch@handelsblatt.com

We hope you enjoyed this article

Make sure to sign up for our free newsletters too!