The deadline for Great Britain to complete its Brexit negotiations is six months from today. Unfortunately, I have seen little evidence that internationally active banks in Britain or elsewhere are prepared for the operational risks to which banks are exposed, especially as uncertainty rises about when Brexit negotiations will be completed and how. Neither banks nor regulators have been transparent with the market about their level of preparedness, something which should concern investors as well as rating agencies. In April 2016, a few months before the majority of British subjects voted in a referendum to leave the European Union, I wrote in a piece for American Banker’s BankThink, that US bank regulators should not wait until Brexit materialized to test the capital resilience of U.S. banks operating in the UK and of the U.S.-based subsidiaries of British banks. To date, no information has been made public about whether U.S. banks are ready for Brexit.
Operational risk, as defined by the international bank standards setter, the Basel Committee on Banking Supervision, (BCBS) is “the risk of direct or indirect loss resulting from inadequate or failed internal processes, people and systems or from external events.” Operational risk is one of the hardest risks to identify uniformly across an entire bank, and even harder to measure in a period of economic or market volatility, in order to allocate capital to withstand unexpected losses.
To my knowledge no regulator has asked banks affected by Brexit to describe specifically what provisions they have in place for operational risk issues that might arise when Brexit negotiations are complete. For example, here are just a few of my questions that I welcome banks’ risk managers and bank regulators to send me answers. If key personnel quit closer to March 2019 or shortly thereafter, do remaining professionals know how to make sure that transactions get done correctly and in complains with rules and regulations? In the event of market volatility, could there be problems acquiring complete data sets in a manner so that risk managers and bank regulators measure the actual level of a bank’s credit, liquidity, market, and operational risks? Could there be pricing or risk measurement system failures if not all the software licenses needed are domiciled in the UK? Could there be higher exposure to cybersecurity attacks if systems do not function well as Britain exists the European Union? Who at a bank knows exactly how posting and payment of collateral for thousands of transactions will work if significantly volatility arises? How will typical lending and trading processes will work at banks as Great Britain exits the European Union? Are banks prepared to manage all their relationships with outside vendors to whom they outsource projects such as auditors, accountants, financial trainers, and Information Technology professionals?
Much attention has rightly been placed on Brexit’s effect on the UK economy and British banks. Yet, Brexit is not just a problem for British banks. Brexit is changing the global financial services landscape. Given its standing as a financial center, numerous banks around the world, especially those that are internationally active, should be sensitive to the possible effect of potentially chaotic Brexit negotiations.
Unfortunately, to say that the negotiations between Great Britain and the European Union have not been going well would be an understatement. “It is hard to think how the negotiations could have gone worse, stated Alastair Winter Chief Economist at Daniel Stewart and Company, a London-based investment back. “Unravelling 45 years of integration was always going to be difficult and need up to ten years to implement. Most UK Government ministers have shown themselves to be ignorant of things like sales networks, supply chains and regulations.”
Additionally, the recent UK interest rate rise is not helpful. According to Dr. Adam Posen, President of the Peterson International Institute of Economics, interest rate hikes “will hurt UK GDP growth. The Monetary Policy Committee’s interest rate hikes are supposedly premised on wage pressures and growth above potential with no slack left, meaning a straight up domestic macro forecast. That forecast is dubious for a number of reasons though not overtly crazy, on its own terms. Probably unnecessary tightening on that basis alone.” According to Posen, the interest rate rise, however, is not the key challenge. “The Bank of England has been dragged partway back to the 1970s and 1980s by Brexit, because they no longer can count on Sterling and inflation expectations remaining anchored” explained Posen. The central bank “has to set policy with one eye on external stability for the UK, rather than solely for domestic outlook. Spokespeople for the Banks of England won’t really say this, though at times Carney has acknowledged this concern. So they have to tighten more than they would for domestic reasons alone, and are right to do so. Bad choices are all they have.”
According to Winter, “there is little chance of resolution by March 2019. Talk of ‘no deal’ is bluff and the most likely outcomes are ‘blind Brexit’ (status quo with details scarily left until after March) or withdrawal of notice to leave (simple delay).”
It is important to note that banks are very sensitive to economic and politic risks. Here are some of the key ways in which banks around the world are exposed to the UK. Foreign banks
- lend to UK banks, individuals and corporations,
- hold British bonds, stocks, and pounds,
- are counterparties to British financial institutions and corporations in financial transactions such as derivatives and repurchase agreements,
- have assets in custody and/or being managed by the asset management groups within British bank holding companies, and
- hold deposits at British banks.
Financial interconnections between globally systemically important banks cannot be underestimated. The Bank for International Settlements estimates that foreign bank and non-banks claims to the United Kingdom are about $3.8 trillion; 67% of these claims are held by foreign banks and the remainder are held by non-banks. The U.S. with claims of $771.57 billion and France with claims of $425.29 billion are the countries that are the most exposed to British banks and non-bank counterparties.
Banks in the UK are sensitive not only to their own domestic economic and Brexit challenges, but also, they are also the most exposed to economic developments in China and Hong Kong. According to Bank for International Settlements data, UK banks’ exposures to China and Hong Kong far exceed the exposures of the US, Euro area, Japan and Korea combined to China and, despite the UK economy being a 15th of the size of these economies combined. Given the slowdown in the Chinese growth rate, now exacerbated by escalating trade tensions with the U.S., this level of exposure to China will continue to put strain on banks in Britain, and by extension possibly to their financial counterparties.
When I asked University of the West of England, Bristol, Professor Daniela Gabor recently whether she thought Brexit complicated ongoing bank reforms, she responded “Yes, significantly. We already live in a world where there is reform fatigue, and that may impact the post-Brexit scenarios for finance.” In her view, there are two scenarios. In the first, “finance is scaled down and reoriented towards the domestic economy. In the other, finance promises to be a key anchor of external competitiveness, just as it did during the 1980s. It will be a difficult political bet for any government, including Jeremy Corbyn’s, to follow the first scenario. The second means a return to the pre-2008 world of globalized finance, of banks working closely with shadow banks to pursue quick profits, and persuading governments to treat them as ‘national champions’ that need support to be globally competitive. This race to the bottom brought us the global financial crisis, and it will bring another one.”
There is not time like the present for bank regulators to ask their large, internationally active banks to submit documentation describing how they will withstand operational risk challenges as we get closer to the Brexit negotiation deadline. Not requiring banks to be better prepared could carry significant adverse consequences not only to banks but the economy at large.
