Consequences of the United Kingdom exit from the European Union

Introduction

During the referendum 2016, 52% of British citizens supported the withdrawal of the United Kingdom from the European Union (EU) (Edmonds, 2018). The decision of leaving had created significant impacts on the UK financial sector. According to the PwC report (2016), financial sector is identified as banking and financial services transactions including monetary intermediation, pension funding and insurance services.

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In 2016, the UK’s trade surplus with the EU in financial sector was £20 billion with leading professional services including currency trading, international insurance and cross border financing (Edmonds, 2018; PwC report, 2016). All these estimations has illustrated the materiality as well as high extent of exposure of this sector to the British economy (Fleming & Young, 2016). 

SECTION I: POTENTIAL IMPACTS OF BREXIT ON INDIVIDUAL UK BANKS AND THE WHOLE FINANCIAL SECTOR

Post-exit agreements between the EU and the UK had created prolonged uncertainty and hesitancy for the UK banks in particular and financial sector in general (Schoenmaker, 2017). As a result of uncertainty, banks and other financial institutions have to face high market volatility such as sovereign risks or sterling depreciation (Fleming & Young, 2016). 

1. Sovereign credit risk

Sovereign risk focuses on the nation’s ability to return its debt and measures the political and financial stability of a nation (Poonsiri, 2016). With the decision to leave the EU, British’s sovereign risk rating had been downgraded by all three big agencies (Moody, Fitch and S&P) due to the sensitive reaction of market towards the “no deal” scenario (Haidar, 2012; Aktug, Nayar & Vasconcellos, 2013). 

To the extent of the whole financial sector, sovereign risk decreased the attractiveness of the UK assets to foreign investors, and hence resulted in abroad earning deduction (PwC report, 2016). In fourth quarter of 2016, Property and Equity Funds witnessed the bad performance with withdrawing of around £10 billion (Investment Association, 2017).

With the strong ties between government and bank, sovereign lower rating also reduces domestic bank rating, which reduce the investor confidence and they are likely to withdraw funds from the bank (Faia, 2016; Boz, D’Erasmo & Durdu, 2015). To attract investors to join in the “contractual agreement”, banks are pushed to offer higher rate in short horizon. This channel raises banks’ funding expenses (Faia, 2016). 

Besides, banks also used government bonds as collateral to assure wholesale funding (BIS). When these assets reduce in value, banks encountered liquidity constrains and challenges for funding (Bank for International Settlements, 2011). Lastly, shortfall in government debt will impair banks’ balance sheets values and require them to raise equity ratios to cover possible exposures (Beau et al., 2014). 

2. Sterling depreciation

Since the Brexit decision in 2016, the sterling has depreciated by 10,6% compared to the US dollar and 14.5% compared to euro in nominal value (Bardalai, 2017). Therefore, it would decrease the value of sterling assets portfolio of foreign investors, and then created the capital outflows from financial sector. The Europe ex-UK allocation decreased from 26% to 23% in 2016 (Investment Association, 2017). 

Moreover, descend in sterling would raise the value of British banks’ foreign assets, which affect negatively banks’ capital ratio (Noonan, 2016). In other words, when banks’ capitals are set by domestic currency while their assets own portfolio of foreign currency, their capital ratio will decrease in case domestic currency depreciates (European Banking Authority, 2017). Therefore, domestic banks’ capital circumstances might be inferior (Noonan, 2016; Bank for International Settlements, 2016). 

3. Business confidence

Uncertainty about the volatility of financial market was the largest constraints for business confidence in investment (Deutsche Special Report, 2016). As a result, number of CFOs consider post Brexit is not a favourable time to take risks increased from 25% to 51% in 2016 (Stewart, De & Cole, 2016). Especially, the proportion of CFOs would raise investment has descended from 58% to 26% (Stewart, De & Cole, 2016). Lower investment activities might result in lower demand for loans and debt issuance, and then lower interest turnover and banking fees as well as profit for the whole financial sector (Deutsche Special Report, 2016; PwC report, 2016). 

SECTION II: RESPONSES TO LIMIT THE IMPACT OF BREXIT

1. The roles of authority

1.1. The adequacy of regulatory provisions to the UK financial sector

In the context of Brexit, it was witnessed the downturn in the UK supply capacity. Aggregate demand in short horizon then decrease led to “margin of spare capacity” and raise unemployment rate. As a result, Monetary Policy Committee (MPC) has loosened monetary policy by setting inflation target at 2% and providing supportive package including reducing Bank rate to 0.5% through Term Funding Scheme as well as purchasing government bonds of £60bn and corporate bonds of £10bn. By this way, it would increase asset prices, decline relevant risks and encourage financial activities.

On the other hand, there are a wide range of macroeconomic risks driven from the Brexit like sterling depreciation or sovereign credit risks, which might affect the economy growth of Britain (Bank of England, 2017). As a result, FPC linked macroeconomic risks result from hard Brexit to the stress test scenario 2017 to assess the resilient of the whole financial system and hence have well preparation to tackle them (Financial Stability report, 2017). Stress test 2017 concluded that it would be struggle for financial firms to mitigate risk immediately and absolutely, FPC therefore considered to arrange transitional agreement in given period to stabilize the financial sector. 

With the combination of tightening stress test requirement and loosening fiscal policy, the whole financial sector is measured to be resilient in a hard Brexit and be able to support for the whole economy. Under the responses of government, business optimism kept raising to 10% in 2017 (compared to -60% in 2016). However, MPC had to balance the trade-off between economy growth and inflation pressure in the long run. Despite creating impermanent above-target inflation, easing monetary policy could boost economic growth, limit the level of spare capacity and raise aggregate demand within forecast period (Bank of England, 2017).

1.2. Policy changes helping reduce credit risk exposure of UK banks

In the stress test scenario, BoE will assess whether UK banks meet the requirement of capital and leverage positions when encountering macroeconomic risks including effects from hard Brexit (International Monetary Fund, 2017). If bank’s capital ratio did not satisfy the requirement, British authority will support and deliver necessary actions (Lloyd Annual Report, 2017).

Specifically, Bank of England had systematically strengthened UK bank’s balance sheet with the supportive package of more than £130bn in capital and £600bn of cash and liquid assets in reserve. Consequently, considerable capital and huge liquidity create the favourable conditions for banks to expand their loans to corporates and households within difficult periods (Edmonds, 2017).  Secondly, the Committee had raised the CCyB rate to 1 in order to ensure the level of capital buffer of UK banks to absorb possible defaults from unexpected events of Brexit (Bank of England, 2017). 

2. Banks’ safeguards 

As can be seen in the analysis above, uncertainty resulted from referendum might lead to a downward in the UK economy, which created conditions to higher credit risks for UK banking system (Deutsche Special Report, 2016). 

With the uncertainty result from the UK referendum, UK banking system can conduct their own stress testing based on the official requirement of Bank of England for the sake of measuring the possibility of Brexit impacts as well as examine banking capability of overcoming such challenges (Bank of England, 2017).

Then senior authority will monitor tests’ results and deliver planning actions to strengthen their balance sheet (Bank for International Settlement, 2009). Besides, they also review all loan agreements and credit facilities which are considered to have possibility of default and then consider the probability of termination of such contracts (Edge, 2018). 

As a result, with the immediately actions, market valuation of UK banks’ equity has been improving since the mid-2016 (International Monetary Fund, 2017). UK bank’s liquidity and funding positions are also at the stable level with high sufficient liquid assets to meet the Liquidity Coverage Ration requirement (Barclays Annual Report, 2017; Lloyd Annual Report, 2017). Especially, Defaults on consumer debt witnessed the reduction with the write-off rates decreased from 5% to 2% (Bank of England, 2017). In essence, with the effectiveness in banks’ immediate reactions, the stress test 2017 confirmed that UK banking system is resilient when facing uncertainty problems of post Brexit (Bank of England, 2017). 

Conclusion

It cannot deny that Brexit can bring attractive advantages for the UK including accessing emerging markets in Asia, having large labour supply with high skill and low costs. Nonetheless, in the short and medium term, leaving the EU had posted considerable uncertainty and hesitancy for UK financial sector in particular and the whole economy in general.

As a result, UK government and other authorities including Bank of England and Monetary Policy Committee had released immediate actions to mitigate the effects of EU referendum including easing monetary policy, tightening requirements in stress test and providing support packages to improve banks’ balance sheets. Individual banks and other financial institutions also created plans and safeguards to maintain theirs resilience in hard environment.



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