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The Bank of England hits the panic button
6 July 2016
Stephen Bartholomuesz
The Bank of England hit the panic button overnight as evidence of the fallout from the Brexit vote within the UK economy begins to emerge. For those outside the UK and Europe, a major uncertainty is whether the developing financial stress will be confined to the region or if it has more global implications.
The Bank of England, after warning that the risks posed by Brexit were already beginning to crystallise and the outlook for financial stability was “challenging,” announced that it had decided to lower capital requirements for UK banks, allowing them to release £5.7 billion (about $10bn) of counter-cyclical capital “buffers” that the banks are holding. In theory, that could support as much as £150bn ($260bn) of additional lending.
In practice, whether the move has the BoE’s desired impact of supporting the UK system or not will depend on the banks’ willingness to actually lend more and the willingness of UK borrowers to borrow more in the face of the risks and uncertainties that have enveloped the UK economy since the Brexit vote.
If, as appears probable, the UK descends into recession and property prices fall and corporate failures rise, the capital bases of the banks and their capacity and appetite for new lending would also inevitably be eroded.
As the BoE’s Financial Stability Report indicated, the perceived risks of the vote (which caused the bank and the UK Treasury to warn of the potential for a deep recession ahead of the referendum) are beginning to materialise.
The pound has dropped to 31-year lows, UK share prices have fallen an average of about 20 per cent and foreign inflows of capital into an arguably overheated UK commercial real estate market have been falling away.
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Three big UK property funds, accounting for about 25 per cent of the £35bn ($60bn) UK property funds sector, have been frozen in the face of a wave of redemptions.
It was only in March that the BoE directed the banks to build their capital buffers. The aim was for the UK banks to build those stores of excess capital to one per cent of their total assets. Instead, having reached half that level, the new buffer has been set at zero per cent.
The bank has also relaxed European Union rules for insurers that force them to mark their assets and liabilities to market, concerned that they would respond to falling interest rates by dumping their riskier asset holdings like corporate bonds, adding to financial losses and stress by creating self-fuelling downward spirals in prices.
Its moves are a reversal of the post-crisis trends in bank and insurance regulation — and the UK was more aggressive than post in its approach to banking regulation after its taxpayers bailed out large slabs of its banking system — towards higher levels of capital and liquidity. In effect the BoE is deploying macro-prudential tools to try to mitigate the effects of the Brexit vote.
For the rest of the world, the direct impact of Brexit (or at least the immediate fallout) has been confined to the UK and Europe, where the mounting Italian banking crisis has gained greater scrutiny and immediacy.
It has been notable, however, that there have been some indirect effects on markets since the vote. Globally, the prices of risk assets and value of risk currencies has risen while bond yields have fallen.
That’s probably because investors believe the risks and uncertainties generated by Brexit will cause central banks around the world to cut official interest rates further or go deeper into unconventional monetary policy territory.
In the key case of the US Federal Reserve, the markets’ response could be interpreted as a signal that investors believe the Fed, worried about the potential spillover effects of the fracturing of the EU and, in particular, worried about the strength of the US dollar, will continue to defer any increase in US rates.
The BoE decision did, however, destabilise commodity and currency markets overnight. The euro crashed, the US dollar and Japanese yen strengthened, the Australian dollar and Chinese offshore yuan fell and oil prices slumped along with other commodities. Bond yields fell again. The decision generated a big “risk-off” moment in markets.
Global markets are fragile and vulnerable because valuations have been so stretched and risk premia so compressed by the global search for positive yield in the post-crisis environment of ultra-low and even negative risk-free rates. The awareness of the risks being taken for meagre returns is evidenced by the volatility that breaks out in response to any change in the perceived levels of risk in the financial system.
It is inarguable that the biggest and earliest real impacts of the Brexit vote will be seen — are being felt — in the UK itself, a relatively minor part of the global economy but a major player in the global financial system.
The implementation of the vote and the negotiations over the terms of the exit and the nature of the continuing relationship with Europe will take years.
The speed at which real economy and market effects have emerged in the days since the vote and the signal from bond markets that risks are rising and global growth, already modest, is likely to slow further, suggests that the ripples from the vote will spread beyond the UK, to continental Europe and generate some contagion effects elsewhere.
Brexit doesn’t look like a catalyst for another financial crisis but its knock-on effects on already-brittle economies and financial and commodity markets could still be quite significant and potentially quite destructive.