Muscat: Less than six months remain until the UK is due to exit the EU in March 2019. Nevertheless, financial institutions (FIs) find themselves preparing for Brexit with few of the basic political questions answered — questions that will guide future economic performance as well as regulation and policymaking, S&P Global Rating said in its latest report.
The report is titled 'Countdown To Brexit: Financial Institutions Are Past The Point Of No Return.
S&P further says that some FIs have now reached the point of no return, and have started to trigger aspects of their contingency plans — such as cross-border legal entity mergers and the establishment of additional licensed entities. Such actions are unlikely to be reversed even if the UK, against all expectations, decided to stay in the single market and/or EU. As the autumn progresses, sustained uncertainty about the political outcome will lead FIs to take further steps in order to position themselves for what they have to assume will be a disruptive Brexit in March 2019.
For rated FIs, the report said, the most immediate implication from Brexit is one of risk mitigation. In this respect, the significant uncertainty, so late in the day, about the extent and terms of any political agreement is hugely unhelpful for FIs. While S&P sees the industry as increasingly well prepared in many respects, FIs and their regulators still have a lot of work to do and, if there is no political deal that allows an orderly transition, they would have precious little time to deliver.
Deal or no deal?
S&Ps base case continues to envisage that the politicians will reach a withdrawal agreement that allows for a period of continuity, covering the period until end-2020. At the very least, this orderly outcome would buy some time to thrash out the details of a deal on the future relationship post-2020. It would also allow FIs more time to adjust and phase the implementation of their Brexit plans. In this scenario, S&P anticipates a moderately supportive macroeconomic and funding market backdrop suggestive of a very limited near-term deterioration in the creditworthiness of UK and European FIs — as S&P's stable outlooks on the vast majority of them suggest. The post-2020 political, economic, and regulatory landscape would remain important, however. The report further said that if the UK and EU fail to conclude a withdrawal treaty and political agreement on the future relationship, this could lead to a disruptive Brexit in March 2019. The likelihood of such an outcome remains significant, and the slow progress of both the UK and EU to coordinate their "no deal" safeguarding measures risks exacerbating the inevitable disruption that would arise. That said, even in a "no deal" outcome, mitigation policies — for example a temporary equivalence recognition for FMIs and derivatives counterparts — could be implemented in order to alleviate disruption.
Understanding the risks
In S&P's view, UK banks would be the most vulnerable banks under a disruptive Brexit. While other largely open European economies, like Ireland, Belgium or The Netherlands, could also feel the impact of a disruptive Brexit, the rating agency would expect banks in these countries to be able to accommodate it. Looking across the industry, without mitigation financial stability risks could yet crystallise — notably around the service continuity for cleared and uncleared derivatives — but this depends on a future regulatory/political (rather than market) solution.
Another issue is around data sharing. As data controllers, FIs cannot do this easily with third country parties unless that country's legal framework is deemed to offer equivalent protections as under the EU's general data protection regulation (GDPR).
For the UK, a disruptive Brexit could likely lead to a domestic political crisis and in turn the economy contracting, leaving the property market vulnerable if unemployment rose abruptly, the report said.
While S&P recognises on the whole that UK banks' earnings and balance sheets are solid and provide a substantial cushion to withstand potential turbulence from political and economic events — indeed these strengths contribute to S&P's current stable view of the sector — their current ratings and/or outlooks may not prove to be consistent with a disruptive Brexit accompanied by a severe economic shock.
Specifically, macroeconomic weakness that manifests itself in higher unemployment, lower investment, and retreating consumer spending could lead to rising personal and corporate insolvencies and weaker collateral values. In time, this would likely play through in bank asset quality and activity levels, undermining their earnings and, possibly, capitalisation to a modest degree. In S&P's view, these factors would be relatively greater for smaller lenders given their business focus on UK retail banking or property-related lending. Wholesale market disruption would be unhelpful for the sector as a whole — not least because the larger UK banks in particular actively use the US and other non-UK debt markets. Spread widening or funding disruption for the banks and other UK corporates could be more acute if the market perceived the UK sovereign to have weakened. The Bank of England (BOE) explored major UK banks' potential resilience to a similar but potentially more severe macroeconomic downturn scenario in the sector stress test in late 2017 — a scenario that they have re-run for their 2018 exercise. Under this lens, the banks appeared resilient in 2017, and S&P expects a similar result this time also.
The larger UK banks will also feel the effects of Brexit from a licensing and client service perspective, though S&P sees this as a much lesser concern than the macroeconomic implications described above. The UK banks most affected here are HSBC and Barclays, given the extent of their business activity across the EU27. While S&P understands they have significant work still to do to complete their planned migration of activity and personnel into the EU27, they are leveraging their existing EU27 subsidiaries for this purpose, and appear relatively well advanced in their execution. That said, delays in regulatory approvals of licence applications for some banks could result in a need to hold back on some lines of business for European customers.
Ultimately banks are a function of the economy which they serve. Investment-grade bank ratings take a long-term view of creditworthiness and imply that a highly rated bank can withstand a typical recession, perhaps with only a one-notch downgrade during the period, absent bank-specific problems. S&P is generally supportive view of UK bank capitalisation, asset quality, and funding and liquidity profiles, and the Bank of England's stress test data, support this view.
Under S&P's base case of a non-disruptive Brexit, S&P does not anticipate any substantial rating changes for UK banks. This reflects a degree of greater comfort since June 2016: to reflect significant uncertainties after the referendum, S&P initially assigned negative outlooks to many of the banks, but revised them to stable in late 2017. It also reflects our view that the banks' building of substantial capital and liquidity buffers and proactive treasury management (eg in front-loading issuance activity) has left them far better able to deal with such problems.