How Brexit Could Hurt U.S. Banks

Immediately after the recent terrorist attack in Brussels, a number of market signals showed an increase in the probability that British voters could exit the European Union. Leaving the European Union will reduce the free movement of people into Britain, which some hope would reduce the threat of terrorism.

Britain leaving the EU, commonly referred to as Brexit, is very likely to have a negative effect on British corporations and U.K. banks. Additionally, because of how interconnected the world of banking is, large internationally active U.S. banks should also be wary of Brexit.

Alastair Winter, chief economist at the London-based investment bank Daniel Stewart, told me recently, "Over 40% of U.K. trade in goods and services is with other EU member countries," driving the conclusion "that corporates would be very affected" by Brexit.

In a recent report about the creditworthiness of British companies, Moody's stated that 'U.K. and non-U.K. companies could curb investments until the [Brexit] uncertainty is resolved. It is likely to take at least two years for the EU Treaty to cease to apply if the U.K. votes to leave and negotiating alternative agreements would be a protracted and complex process." Moody's has already warned that it could lower the credit rating of the U.K., since Brexit would slow down the U.K.'s growth even further. The downgrade would increase the sovereign's cost of borrowing and would eventually also increase the cost of borrowing of British corporations and banks.

According to the British Bankers Association's survey of domestic and foreign banks in the U.K., "almost 60 percent of banks that responded to the survey on the EU referendum believe Brexit would have a negative impact on their organisation, with 26 percent saying the impact would be significant."

British banks' earnings have already been under pressure because of the numerous fines that the banks have had to pay or for the provisions that they have set aside due to litigation costs. In a March 22 report, Moody's stated that "litigation and conduct remediation charges continue to pose downside risks for the U.K.'s five largest banks." The litigation charges for Lloyd's Bank, Barclays, Royal Bank of Scotland, HSBC and Santander U.K. have become recurring items and continue to affect their profitability, which Moody's says hurts their creditworthiness.

Although the risks of Brexit are playing out more directly in Europe, U.S. banks and their regulators should not grow complacent. The threat is very real here due to interconnections between the U.S. and British banking sectors. U.S. banks also lend to domestic and foreign companies that are counterparties to British transactions. Regulators and other market participants for too long have viewed country risk as emanating from emerging markets. But they might want to look across the pond.

According to data from the Federal Financial Institutions Examination Council, 90% of U.S banks' foreign exposures are to U.K. corporations and banks.

U.S. bank regulators should exercise their authority to require the eight U.S.-based global systemically important banks to prove that they can quickly and accurately calculate their current credit exposures to the U.K. to provide certainty that they are sufficiently capitalized to withstand unexpected losses. It is these eight behemoths that are the most interconnected to both the British financial sector and the British economy.

In 2013, the international bank standards-setter, the Basel Committee on Banking Supervision, released the Principles for Risk Data Aggregation, commonly known as BCBS239, which provide guidance to banks and bank regulators to test banks' ability to calculate their credit, market and concentration risks in periods of economic or market stresses. Global systemically important banks are supposed to comply with these principles this year. The looming threat of Brexit presents regulators with a more immediate justification to ascertain whether banks can comply with the risk data standards promptly and accurately.

Meanwhile, several British banks — including HSBC, Barclays, Royal Bank of Scotland and Lloyds — have a sizable presence here, meaning they are extremely interconnected not only to large U.S. banks but also to U.S. companies and individuals. It is imperative that U.S. bank regulators verify whether these banks are independently well capitalized and liquid. Should those U.K. banks run into Brexit-related difficulties, it is also important to determine whether they can provide guarantees to their U.S. subsidiaries, or whether it is actually the U.S. subsidiaries that would have to help their British parents.

U.S. bank regulators should also be monitoring whether internationally active U.S. banks and British bank subsidiaries in the U.S. are calculating increased risk in their portfolios influenced by Brexit. Increased risk-weighted assets would show bank regulators that banks need to increase their capital to survive unexpected losses.

When Lehman Brothers was imploding in August and September 2008, bank regulators asked major banks if they could calculate their risk exposures to the investment bank. Bank regulators discovered that banks were incapable of calculating those exposures in a period of market stress because of the banks' poor risk data collection and weak technological systems.

Banks regulators should not wait until Brexit materializes to test the capital resilience of U.S. banks and the U.S.-based subsidiaries of the British banks. We have already seen this movie and are still living with the bad ending.

Mayra Rodríguez Valladares is managing principal at MRV Associates, a New York-based capital markets and financial regulatory consulting and training firm.