The Brexit Diary: the scent of fear and the need for new thinking

07 July, 2016

It has been easy for politicians, and more than a few economists, to argue the macro future of the economy, but ultimately, for many small to medium sized businesses their real risk manager is their relationship manager or banker.

It has been widely reported that a number of UK commercial real estate investment funds have entered restricted withdrawal phases limiting investors’ ability to exit and liquidate their holdings – i.e. get their money out. Obviously, this is about stopping a race for the door where the first out maximise their proceeds at the expense of the last out. I could argue that such long-term investments shouldn’t legally be allowed to be wrapped, regardless of illiquidity warnings, in the short-term structure of communal investment funds and regulators will undoubtedly be thinking about this, but that is wrong as it would ultimately deny many smaller investors a chance to participate in illiquid investments. I was badly burnt on this type of investment in the late 1980s property crash and learnt a great lesson on illiquidity!  But the current race for the door has other implications beyond revaluations and estimates of business activity post-Brexit. This race to exit introduces the smell of fear, i.e. when investors begin to search for the next asset category that could be hit by a race for the door.  Where might it go next? 

Commercial real estate is often an early hit or visible inflection point with a perceived view of economic slowdown or uncertainty; reduced economic activity will reduce the demand for space. In the 2007-2008 turndown property and property lending lead the way to exposing poor liquidity (funding stability) and capital provision (loss capacity) at banks; regulators and traditional banks have worked hard to fix liquidity, capital, and lending standards and we are likely to slowly see who has taken up some of the risks the banking system has exited. But that doesn’t mean banks can be complacent or that some banks aren’t going to encounter difficult times. The risks arising are likely to be very different from what we have experienced in recent crises and Brexit is likely to introduce a vast array of new risks in banking and finance.

We didn’t need Brexit to start focusing on the risks associated with long-term low interest rates, and I expect we will see many senior members of society that have taken on higher yielding and higher risk investments over the past few years as rates of return on basic savings products have declined; will this be increased with further rate decreases? False investment selling from non-banks should be carefully watched for. How much more difficulty will it be for banks to earn a return with lower rates and declining demand for credit? If bank profitability is likely to suffer and regulators become more restrictive on bank dividends, the desirability to own banks’ shares will decline, likely followed by further share price declines, and could raise questions of viability – though we are not near this point it similarly illustrates a cascade of risks with unintended consequences.

I marvel about how much of what I studied and worked with in banking, finance, and regulation may no longer apply and these are being sorely added to with Brexit uncertainty. Negative interest rates were explicitly impossible according to some of the widest used textbooks, but here we are. A good deal of our regulatory upgrade and new framework, in hindsight, seems to have been based on higher interest rates. Much of the recovery and resolution regimes now part of banking assume that banks could re-organise themselves and sell specialised bonds to institutional investors; many banks haven’t, particularly in Italy, adding to their risks.

Coming back to Brexit, much of the positive economic argument is based upon an export boom catalysed through a reduced exchange rate for sterling. My old textbooks explained how this worked with many manufactured goods – particularly those with limited foreign content, but there were no examples for services businesses which are the core of the UK’s business activity. Will they be able to export more? An argument of many Brexit supporters was that immigrant labour reduced or depressed wages. If immigrant labour becomes unavailable and UK employers must raise wages to compete for domestic labour, costs will increase; will you pay more for your morning coffee, lunchtime sandwich, or evening salad that will absorb these increased labour prices? It has been easy for politicians, and more than a few economists, to argue the macro future of the economy, but ultimately, for many small to medium sized businesses their real risk manager is their relationship manager or banker and life is not getting any easier for these men and women. They need some new thinking. We’re doing our best to upgrade our learning resources and hopefully we’ll get there.

Dr Peter Hahn is the Henry Grunfeld Professor of Banking at ifs. You can read his entire series on Brexit and it's implications here.