Brexit Stress Test

The U.K. 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. Or, to mix metaphors, numerous lights are flashing yellow, so we are worried.

Market fluctuations in the immediate aftermath of the referendum were characterized 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. 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 U.K. 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 (valued at a total of £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 quickly signals the extent of the liquidity shock. The news is analogous to that on August 9, 2007, when, reflecting uncertainty about the valuation of subprime mortgage assets, BNP Paribas halted redemptions from three funds. While there were concerns at the time, few people realized that this was the start of the worst financial crisis since the 1930s. (For a chronology and summary, see here.)

The good news is that the Bank of England did prepare, using its micro- and macro-prudential authority to require U.K. banks to increase their capital and liquidity buffers. The timely July 2016 Financial Stability Report (FSR) makes for reassuring reading, as do the scenarios for the current year’s stress tests. 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 percent, and a 6 percent 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 judgment assumes—contrary to fact—that nothing goes wrong elsewhere. Following the Brexit referendum, the plight of several euro-area banks intensified sharply. For now, the two sickest 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. 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 is currently at 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 at its highest, aside from a brief spike in 2011. At its current (July 8, 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 U.S. banks have leverage ratios that are between 10 and 16.) 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.

Deutsche Bank: Equity price (U.S. dollars) vs. credit default swap 5-year spread (basis points)

Sources: Yahoo Finance and Bloomberg.

Sources: Yahoo Finance and Bloomberg.

Indeed, by any measure, a number of large European banks are seriously undercapitalized—with Italy’s in the lead. And, other financial systems are exposed to these problems. Consider, for example, the case of U.K. intermediaries. According to cross-border data from the Bank for International Settlements, at the end of 2015 U.K. financial institutions had “total claims” on euro-area counterparties of $610 billion, of which roughly $125 billion was exposure of U.K. banks. Importantly, there are 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 U.K. banks is shy of $350 billion, this poses a significant risk.

Financial exposures to euro-area and U.K. counterparties (U.S. dollars in billions), end 2015

And the interconnections go well beyond U.K. institutions. As the table highlights, the intermediaries in Japan and the United States also are significantly exposed—both directly to those in the euro area, and indirectly through their U.K. exposures. For example, the U.S. 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.

Our conclusion is that people should worry. Despite the locus of the Brexit shock, the U.K. financial system itself has not been the initial focus. From what we can tell, the U.K. 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.

Unfortunately, unless the global financial system as a whole is well capitalized—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. 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—and that their largest counterparties are at risk. (For a discussion of why global financial resilience requires cooperation, see here.)

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 runs last week on U.K. 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.” Stay tuned.