The Brexit Diary: The conundrum facing UK banks

02 August, 2016

The last few weeks, whether related to Brexit, European bank stress tests, or the overall world economy, have demonstrated a greater value to international diversification.

A better conflicting Brexit banking theme couldn’t have come along than one I’ve noted over the past few days. It started with a bit of somewhat misleading information from a consulting company that suggested EU banks operating in the City post-Brexit would need to raise a substantial amount of equity capital to continue operations. The equity requirement was based upon those EU banks converting their City businesses into full-fledged UK licenced, and appropriately capitalised, banks. But surely these banks already have that equity capital supporting their business, it is just part of their capital funds supporting their whole business? To say otherwise is to imply the banks are currently not sound institutions.

The argument would be that the EU banks would have to specifically allocate and move the capital (and effectively ring-fence it) to their City business. Of course this would create vast inefficiencies, for example if a bank had reduced opportunity in the City and more in EU, the bank could not easily allocate or make use of its equity capital toward its changing risks. This would lead to EU banks effectively having more capital than might be economically efficient, lower profitability, etc. Regardless, the Bank of England has now reportedly said that it won’t require such separate capitalisation – hopefully, helping these EU banks to have a longer term City perspective and maintain their diverse international activities. However, that may not be the same for certain UK banks operating in the EU due to UK legislation and regulation.

The UK Government Independent Commission on Banking recommended the concept of ring-fencing or separating, largely, retail businesses from other banking businesses and this is due to became UK law (in process of implementation). The ring-fence requirements allow the UK banks to have certain retail-related (as I define it) EU businesses to be part of their separately capitalised ring-fence banks. Such EU businesses of UK banks may now fall victim - of both UK rules limiting non-UK activities in ring-fence banks, and potentially EU constraints on foreign banks (UK post-Brexit), perhaps requiring the separate capitalisation of these businesses. Of course, if separate capitalisation is the case, the UK’s banks will suffer inefficiencies and profitability constraints. Does this matter and why should we care?

The last few weeks, whether related to Brexit, European bank stress tests, or the overall world economy, have demonstrated a greater value to international diversification. Purely domestic banks, by definition, cannot escape ties to the domestic economy. The conundrum potentially facing UK banks encourages their further international business withdrawal. Since the 2008-2009 financial downturn, international banks have substantially reduced their international activity – and mostly for good reasons – but perhaps the above contrast indicates a turn of view that international diversification is desirable albeit requiring much greater controls than historically applied?

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.