Brexit does not kill the Financial Markets: An Ode to Regulatory Oversight

Friday, but not “Black Friday”

During the early trading hours of Friday, June 24, following the announcement of the result of the Brexit referendum, several hundreds of billions Euro were wiped off the European stock markets. Banks got punished badly by the market; Barclays, Lloyds and RBS immediately gave up one-quarter of their market value. The Bank of England, in an immediate reaction to the looming crisis, announced to provide an additional quarter of a trillion Pounds in liquidity. But neither was the event overly contagious (the German DAX index merely lost 5-6% after the dust had settled a few days later); nor did it cause a collapse of banks and other financial institutions.

Stability of the banking sector according to bank supervisors

Back in 2013, as part of a comprehensive assessment mandated by the ECB and carried out in Germany by the Federal Financial Supervisory Authority (BaFin) and the Deutsche Bundesbank, a stress test based on adverse macroeconomic scenarios was applied. The adverse scenario modeled “a global financial shock that weakens the real economy, leads to a renewed divergence in European government bond yields and creates funding difficulties for credit institutions”. The regulatory exercise produced the comforting result “that German banks are well capitalised overall even under the tighter conditions of the adverse scenario”. According to the study, roughly EUR 30 billion in CET1 capital would get wiped out for all German banks together in the stress test scenario.

Indeed, Brexit turned out as precisely such a “global financial shock” that regulators vaguely anticipated years ago and tried to immunize the banking industry against. To illustrate how regulators’ efforts have strengthened banks, we are focusing on three L’s:

“L” for Level-3 financial assets

A “level-3” designation of bank assets means that their value is based on unobservable inputs and the valuations could be vulnerable to adverse changes in the underlying assumptions. For example, Deutsche Bank estimate that when using alternative parameters for valuing their roughly EUR 30.8 billion level-3 assets (as of June 30, 2015) the valuation could decline by some EUR 3.2 billion, which is about 10% of the assumed value of level-3 assets or about 15% of Deutsche Bank’s market cap. (Coincidentally, Deutsche Bank’s market value dropped on Friday by EUR 3 billion.) Some banks have had enough foresight to scale down level-3 assets, as Commerzbank’s comparably low EUR 5.9 billion position illustrates. Regulatory pressure to shed some light on illiquid level-3 assets has likely compelled banks to reduce positions, saving them from now having to create “bad banks” filled with impaired illiquid assets as a result of Brexit. Going forward, investors may (and should) demand from European banks to become even more forthcoming with information about the decomposition and specifics of level-3 assets.

“L” for Leverage

Adjustment to stricter capital requirements since the financial market crisis has helped stabilize the banking sector as a whole. At the time of their collapse, both Long Term Capital Management (LTCM) and Lehman Brothers had a leverage ratio of roughly 30. European bank shares are still, for the most part, “high-beta” stocks, meaning that for any given market (index) move, bank stocks move by a disproportionally higher degree. For example, Barclays’ market beta can be estimated to be roughly 2.5 – if the market tanks by, say, 10%, Barclays is expected to drop by 2.5-times that amount, or 25%. Leverage is a good thing when times are good, but not so much when the economy is heading south. Just like Wells Fargo, a “boring” bank by Wall Street standards, has become the world’s most valuable bank (by market capitalization), European banks with low leverage ratios will likely move up the list in bank rankings, while more leveraged players are losing ground.

“L” for Liquidity

If there is one thing the Lehman crisis has taught the financial markets, it is that “Liquidity Is King”. In the aftermath of the financial crisis of 2008, central banks have stepped in as liquidity providers, offering funding for various assets. As a consequence, a key question for each asset class has become: Is it an eligible collateral to the ECB? It remains to be seen how the transitioning of UK-assets from former EU to future EEA (European Economic Area) instruments will impact their re-financing ability, especially after being potentially downgraded by rating agencies in the process. Clearly, the Bank of England has already acknowledged the need to step in, promising an additional quarter of a trillion Pounds in liquidity. Having adjusted to stricter liquidity requirements by the regulators, European banks have already reduced their liquidity risk since 2008 and have, to some degree, become less dependent on life support from central banks.

Thanking the regulators…

The Brexit referendum may serve as a wake-up call to all European banks that have not yet sufficiently enhanced their resilience against global financial shocks by acting on the three L’s: Unwinding level-3 assets; reducing leverage; and focusing on liquid assets. As it turns out, bank supervisors’ pressure on banks to implement this program ever since the financial market crisis in 2008 was more than just annoying rules and regulatory handcuffs. Given how much worse Brexit would have impacted banks if they had had a pre-2008 balance sheet, the benefits from regulatory reforms may now have proven to have outweighed its costs. Banks may (quietly) thank regulators.