Brexit stress test

Stephen Cecchetti, Kim Schoenholtz

The UK’s Brexit referendum is providing us with the first significant test of the new regulatory system. This column asks whether banks have sufficient capital and liquidity to withstand the ‘shock’. Unless the global financial system as a whole is well capitalised, it remains only as strong as its weakest link. And while the UK authorities have done a reasonable job of strengthening their banks and financial system, a number of large European banks are seriously undercapitalised.

The UK’s Brexit referendum is providing us with the first significant test of our sparkling new regulatory system. Everyone knew about the referendum months in advance, giving them plenty of time to prepare. Yet, we are left with some fundamental questions related to global financial stability. Do banks have sufficient capital and liquidity to withstand the ‘shock’? Will financial markets continue to serve their key functions? Or, is the financial system only as strong as its weakest link? Will turmoil once again prompt liability holders to run, triggering asset fire sales and compelling central banks once again to do whatever it takes to keep avert a meltdown?

As the rating agencies might say, we are on ‘stress watch’ with a negative outlook.

Troubling signs

Market fluctuations in the immediate aftermath of the referendum were characterised by large currency swings and significant equity price declines, particularly in bank stocks. Aside from the banks, stock markets generally recovered. But, other troubling signs have emerged. In Britain, several open-ended property funds have suspended redemptions (Lazarus et al. 2016). It is doubtful that they could sell illiquid real estate holdings on short notice – except, perhaps, at fire sale prices. And in continental Europe, the strains are building on several large, systemic banks.

Let’s start with the UK property shock. The voters’ decision to leave the EU is hitting the commercial real estate sector, where credit is drying up. With real estate valuations expected to suffer, a run on open-end property funds prompted their managers to halt redemptions from more than half of the funds (which totalled £25 billion pre-Brexit).

While the value at stake appears limited, an open-end fund holding illiquid assets is a canary in the coalmine, and the willingness to run signals the extent of the liquidity shock. The news is analogous to that on 9 August 2007, when, reflecting uncertainty about the valuation of subprime mortgage assets, BNP Paribas halted redemptions from three funds (New York Times 2007). While there were concerns at the time, few people realised that this was the start of the worst financial crisis since the 1930s (for a chronology and summary, see BIS 2009).

The good news is that the Bank of England did prepare, using its micro- and macroprudential authority to require UK banks to increase their capital and liquidity buffers. The timely July 2016 Financial Stability Report (FSR) makes for reassuring reading (Bank of England 2016a), as do the scenarios for the current year’s stress tests (Bank of England 2016b). In the latter, the authorities require that banks have sufficient capital to withstand a 40% drop in commercial property prices, a 30% fall in residential property prices, an increase in unemployment from 5% to 9%, and a 6% drop in nominal GDP. Given the large improvement in bank capital positions since the crisis (the FSR estimates the asset-weighted average ratio of common equity tier 1 to risk-weighted assets exceeds 13%, compared to closer to 7% in 2012), one might think that matters are well in hand.

But that hopeful judgement assumes – contrary to fact – that nothing goes wrong elsewhere. Following the Brexit referendum, the plight of several Eurozone banks intensified sharply. For now, the two most obviously ill patients are Italy’s Monte dei Paschi di Siena and Germany’s Deutsche Bank.

The IMF, in its June 2016 Financial Stability Assessment Program (FSAP) for Germany, identified Deutsche Bank as the world’s largest contributor to systemic risk among the class of global systemically important financial intermediaries (IMF 2016). Using a very different methodology, the NYU Stern Volatility Lab ranks it number seven (behind three banks from Japan, two from China, and one from France). As the following plot shows, Deutsche Bank’s equity remains close to its lowest point since the data start, while the spread on its credit-default swaps – the cost of obtaining insurance on a five-year $10,000 senior bond – is near its highest, aside from a brief spike in 2011. At its current (5 August 2016) market valuation, the NYU Stern V-Lab’s systemic risk tables put Deutsche Bank’s leverage ratio at 108, and Monte dei Paschi’s at 208. (By comparison, the largest US banks have leverage ratios that are between 10 and 15.) With such extreme leverage, these banks’ equity and CDS prices are likely to remain volatile, while their market fluctuations may be dominated by the changing option value of a potential government bailout.

Figure 1 Deutsche Bank: Equity price (U.S. dollars) vs. credit default swap 5-year spread (basis points), 10 Aug 2001-5 Aug 2016

Sources: Yahoo Finance and Bloomberg.

Indeed, by any measure, a number of large European banks are seriously undercapitalised. And, other financial systems are exposed to these problems. Consider, for example, the case of UK intermediaries. According to cross-border data from the Bank for International Settlements, at the end of 2015, UK financial institutions had ‘total claims’ on Eurozone counterparties of $610 billion, of which roughly $125 billion was exposure of UK banks. Importantly, there is additional ‘potential claims’ exposure of similar scale ($594 billion) in the form of derivatives, guarantees and credit commitments. Given that total capital in the top four UK banks is shy of $350 billion, this poses a significant risk (see the FDIC’s Global Capital Index).

Table 1 Financial exposures to Eurozone and UK counterparties, end 2015 (billions of US dollars)

Source: BIS Consolidated Banking Statistics Table B4.

And the interconnections go well beyond UK institutions. As the table highlights, intermediaries in Japan and the United States also are significantly exposed – both directly to those in the Eurozone, and indirectly through their UK exposures. For example, the US institutions have ‘total claims’ exceeding $1 trillion plus ‘potential claims’ of an additional $1.4 trillion. Keep in mind that since the ‘potential claims’ are composed largely of over-the-counter derivatives, these exposures are most likely versus the largest European banks as they dominate this business. To put it simply, linkages in the global financial system mean that stresses in continental Europe can spread quickly.

Concluding discussion

Our conclusion is that one should worry. Despite the locus of the Brexit shock, the UK financial system itself has not been the initial focus. From what we can tell, the UK authorities have done a reasonable job of strengthening their banks and financial system. They have taken to heart that a healthy banking system is the foundation for strong, stable and balanced growth. As we wrote recently, strong banks lend to healthy borrowers, weak banks don’t (Cecchetti and Schoenholtz 2016a).

Unfortunately, unless the global financial system as a whole is well capitalised – which we doubt – the system remains only as strong as its weakest link. And, the increased post-referendum concerns evident in financial markets regarding several continental institutions appear warranted. Their regulators have been less rigorous and less rapid in their application of the new, stronger, international capital standards embodied in Basel III (Cecchetti and Schoenholtz 2016b). This lack of coordinated enforcement means some very large institutions are precariously exposed even to modest negative shocks – a weakness that is clearly apparent from recent data – putting their largest counterparties at risk, too. (For a discussion of why global financial resilience requires cooperation, see Cecchetti and Tucker 2016).

The question is how virulent the stresses will become. Will the lack of capital and worries about new losses lead to runs on weaker intermediaries (like the post-referendum runs on UK property funds)? Will derivatives counterparties seek, as they did versus Bear Stearns in 2007, to ‘novate’ away from the weakest players in the over-the-counter market? Will other derivatives dealers set limits on their direct exposure to these firms, compelling a round of disorderly deleveraging? We hope not, but hope is not a sound basis for policy or investment plans.

As the late, great Rudi Dornbusch said: “The crisis takes a much longer time coming than you think, and then it happens much faster than you would have thought."1 Stay tuned.

Editors’ note: An earlier version of this column appeared on www.moneyandbanking.com.

References

Bank for International Settlements (2009), 79th BIS Annual Report 2008/09, Chapter 2.

Bank for International Settlements, Consolidated Banking Statistics.

Bank of England (2016a), Financial Stability Report No. 39.

Bank of England (2016b), "Stress testing the UK banking system: key elements of the 2016 stress test", March.

Cecchetti, S. G. and K. L. Schoenholtz (2016a), “Bank Capital and Monetary Policy,” www.moneyandbanking.com, 20 June.

Cecchetti, S. G. and K. L. Schoenholtz (2016b), “Are European Stress Tests Stressful Enough?,” www.moneyandbanking.com, 8 August.

Cecchetti, S. G. and P. M. W. Tucker (2016), “Is there macroprudential policy without international cooperation?” CEPR Discussion Paper No. 11042.

IMF (2016), "Germany: Financial Sector Assessment Program", IMF Country Report No. 16/189.

New York Times (2007) “BNP Paribas suspends funds because of subprime problems,” 9 August.

Lazarus, D., A. Pearce and E. Pfeuti (2016), “More Fund Managers Suspend U.K. Property Fund Trade,” Wall Street Journal, 6 July.

Endnotes

1 http://www.pbs.org/wgbh/pages/frontline/shows/mexico/interviews/dornbusch.html