The UK voters’ decision to exit the EU came as a surprise to many observers, as well as the markets, with the “Leave” campaign even hinting at defeat as the polls closed. The Wall Street echo chamber view that it would make no sense in the end for the UK to leave was just that. The vote has unleashed political, economic, and financial uncertainty that will play out over the months ahead with attendant risk premia rising for affected currencies, equity and fixed income markets, sectors, and individual firms. Market values for banks, insurance companies, and asset managers dropped Friday from 5% to over 30%, with UK firms understandably hit the most and those less reliant on UK-based revenue sources impacted the least.
- Stepping up while stepping out. Central banks and market makers stepped up to provide liquidity as the carnage was unfolding and regulators made it clear they were in close consultation with the industry. As a result, the immediate global asset price adjustment in response to the vote was generally orderly and markets functioned well. The prospect of economic slowdown spawned by political, economic, and investment uncertainty will necessitate a continuation of current monetary policy accommodation and vigilance by regulators for financial fragility due to credit risk migration, downgrades, and resultant collateral calls. In turn financial institutions, which are much better capitalized and more liquid than before the 2008-09 financial crisis, will be focusing in the days and weeks ahead on helping their clients adjust to the new reality.
- No macroeconomic relief in sight. Financial institutions, especially banks, have been laboring for some time under zero/negative interest rates, low volatility, and currency and commodity imbalances (albeit in a benign credit environment). The macro picture has suddenly darkened, reducing the likelihood of rate relief, at least in the US, any time soon. At the same time credit costs seem poised to rise and investment spending poised to decline. Consequently, the earnings prospects for financial institutions of all stripes will continue to be challenged. We expect hyper focus on the expense line with concomitant pressure on staffing levels and technology spending.
- No speedy exit. The formal exit of the UK from the EU will take time and is fraught with uncertainty over specifics. The rules governing cross-border business conduct, prudential requirements, and market operations are all to be negotiated once the UK has formally sought its exit. US banks, insurance companies, and asset managers are all heavily invested in the UK. While some firms have already indicated they will likely need to move staff and operations, they will be quite deliberate in making those decisions. In addition, they will need to weigh carefully the complications of differing regulatory regimes. Regulatory authorities will be watching the potential impacts to safety and soundness, especially how changes to global operating and legal structures will require reworking of resolution plans. Typically markets reward first movers, but there is considerable risk of regrettable decisions here without knowing to what extent the terms of UK engagement with the EU will change.
- Will US banks stay? With operating costs in London high, and the benefits of being part of the union now receding, US banks most certainly will be looking elsewhere. Approximately 50% of trades booked in London are executed in Asia, so it will be natural for US banks to consider looking East to better align their client activity with their global and EMEA operating models. Furthermore, some smaller non-US players will likely begin to wind down UK operations altogether given their limited global revenue from EMEA (even the largest US banks derive at most 15% of their revenue from EMEA). In the end, Asian financial centers and banks could be surprise winners. Frankfurt, Paris and Dublin, however, stand to gain as financial centers as the Brexit details unfold. We expect this reality to factor into the negotiations with the UK (and each other) in the months ahead. Despite some short-term pain, US banks will likely turn their optionality into long-term gain.
- Who’s next? The emerging big concern over the Brexit vote is where will it end? With elections coming up in the year ahead on the Continent and early indications that old decisions could be revisited (e.g., Scottish independence), it is possible that voters will continue to be asked to consider the benefits and costs of union. While the geo-political benefits of union are compelling to many, the economic and social benefits often feel less so in a region that continues to suffer from slow growth, fiscal imbalances, structural weaknesses, and demographic challenges (e.g., aging and migration).
This post comes to us from PwC. It is based on their First Take, which was published on June 27, 2016 and is available here.