Andreas Dombret: What does Brexit mean for European banks?
Keynote speech by Dr Andreas Dombret, Member of the Executive Board of the Deutsche
Bundesbank, at a conference of the Association of German Banks and the Center for
Financial Studies, Goethe University Frankfurt, Frankfurt am Main, 13 July 2016.
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Introduction
Ladies and gentlemen
One of the words which were mentioned most during the last few days was"confusion",
followed by "uncertainty". Both terms express what many people felt after the British vote to
leave the European Union - which was not consistent with what experts had expected just
before the event. The Brexit could certainly mark a turning point for Europe.
As Jürgen Habermas, the German philosopher, put it in the German weekly newspaper "Die
ZEIT": "I didn't expect populism to beat capitalism in its country of origin. In view of the
banking sector's existential importance for the UK and the media and political power of the
City of London, it seemed unlikely that questions surrounding identity would triumph over
other interests."1
We were all in the financial sector somewhat confused on the morning of 24 June and
probably still are, given the many unanswered questions we are now facing. The full
consequences of Brexit will only become evident as time progresses - because formal
relations between the United Kingdom and the EU will be decided by a negotiation process
that has not yet begun. So far, a British motion to leave the European Union according to
Article 50 of the Treaty of the European Union has not been made.
Only after this process has been settled will we be able to better assess the full
consequences of this vote - both in economic and political terms. But people are seeking
orientation and want to discuss the matter. Therefore, panel discussions such as the one
being held here today are of immense value, and I wish to thank both the Association of
German Banks as well as the Center for Financial Studies for their initiative.
Let me use this opportunity today to comment both on the potential eco-nomic and political
consequences of the United Kingdom's referendum decision.
Banks face immediate economic consequences
While the Brexit decision has caught most Europeans off-guard, its immediate financial
consequences have materialised as predicted.
All in all, the reaction of financial markets to the Brexit news was by and large consistent with
expectations. The news evidently came as a surprise, but there was no panic: The British
pound came under downward pressure, as did bank shares and real estate funds with
investments in the City of London or in the rest of the UK. In addition, country rating
adaptations did not come out of the blue. The Euro Stoxx 50 displayed heightened volatility
as the referendum day approached, but remained range-bound between market tensions
earlier this year and in August of last year. Stock prices dropped sharply on the day after the
referendum; however, the situation had already calmed down by the afternoon.
A closer look reveals that shares of many financial institutions have dropped strongly since
the referendum, and valuations still remain significantly lower than shares of non-financial
sectors - not just in the UK but also in the rest of the euro area. This is a sign that other,
more deeply rooted structural problems prevail in the European banking sector. I will touch
upon one of these issues later on in my speech.
However, most banks had taken the possibility of a Brexit sufficiently seriously and therefore
made careful preparations. Supervisors had asked them to assess the risks associated with
their holdings of stocks, bonds and foreign currency in good time. As such, banks were
forced to make contingency plans. Thanks to stricter capital and liquidity regulations, banks
are in considerably better shape today than at the outset of the global financial crisis in 2007.
In this context, I wish to pay tribute to the professional approach of the Bank of England
before and after the referendum - which demonstrated excellent preparation as well as
execution on its part. The ECB and other central banks, too, declared that they would stand
ready to supply liquidity should the need arise. However, up to now, no provision of
additional liquidity has been necessary.
All of the actions taken have certainly helped to ward off stronger financial market reactions.
But this doesn't necessarily imply that the financial markets have already found their new
equilibrium. Nobody can rule out further movements in prices or shifts of funds from one
asset class to another. Nevertheless, one can be cautiously optimistic that - regarding the
financial markets - a panic reaction to Brexit is rather unlikely at present.
Indisputably, it is to a large extent the United Kingdom that will have to bear the
consequences of the referendum. Consumer confidence declined rapidly. Already in May,
2
the Bank of England expected UK GDP growth to slow down to 2 percent in 2016 as a
result of heightened uncertainty - new forecasts in the wake of the referendum are of course
bound to paint a gloomier picture. For the EU as a whole, European ministers of finance
have reduced their growth expectations by 0.2 to 0.5 percent for 2017.
In the economic growth forecasts presented by the Eurosystem, a Brexit was one of the
downside risks to the projections. The impact on medium-term economic growth will depend
strongly on expectations concerning the long-term economic consequences of the
referendum, which in turn will hinge on the outcome of the exit negotiations. The chain of
causality runs from the single market to productivity: The more restricted access to the single
market becomes, the more trade will be inhibited and the more productivity will be curbed -
both in the UK and the EU.
In any case, while the impact of Brexit on growth will be negative, fears of a fall in growth in
the euro area by, say, 0.6 percentage point in 2017, as predicted by Consensus Economics,
seem exaggerated.
Political vagueness within the reach of vision
What does the referendum result imply for the future of the pan-European financial system?
In some ways, I would expect clear consequences.
Here, I refer, in particular, to the pulling power of London as a platform for European bond,
derivative and forex trading. Banking supervisors take a critical view of the fact that euro
activities are mainly based in London and therefore outside the euro area. This criticism has,
of course, intensified since the referendum. The same can be said for clearing business and
central securities depository services, at least for euro-denominated business. Supervisory
authorities would need to be a lot more tolerant if this business were allowed to be conducted
not just outside the euro area but outside the EU altogether. Truth be told, that's a level of
tolerance I can neither imagine nor support.
Against this backdrop, the announced merger plans of Deutsche Börse and the London
Stock Exchange need to be re-evaluated. The outcome might seem bizarre at first glance,
but the referendum has given positive impetus to, and even bolstered, the economic
rationale behind such a merger. Once the UK has left the European Union, bridges between
both economies will be more important than ever before. The announced merger of LSE and
Deutsche Börse has the potential to become such a bridge.
Clearly, the Leave vote poses new challenges for the corporate governance of the merger:
The parties concerned need to find a governance structure which balances all reasonable
interests - even at the expense of synergies. Furthermore, I am convinced that, in the
medium term, euro clearing cannot take place to the existing extent in London - Frankfurt
would be the more appropriate alternative. The Referendum Commission set up by Deutsche
Börse and LSE is now being put to the test in terms of its ability to work calmly, and needs to
keep in mind the economic rationale of the proposed merger which has gained greater
credence through the Brexit vote.
But uncertainty following the Brexit decision is much less due to economics and much more
due to politics. Indeed, almost all the economic consequences are associated with political
uncertainty. As we all know, economic uncertainty is a product of political uncertainty. The
fact that the mechanics of leaving the EU are laid down in Article 50 of the Treaty of the
European Union is well-known to most people by now, but it only governs the negotiation
process without changing the complexity of its nature in any way. Clearly, the practical
implications of a Brexit depend to a large extent on what will be agreed upon in Brexit
negotiations.
And this is also true with respect to banks on both sides of the Channel. Many institutions
have shaped their business models in accordance with the cooperative financial framework
in the EU. European banks based on the continent operate in the UK market and have
branches in London. The City of London is also home to a great number of non-European
institutions which use the passporting regime of the EU to conduct business in any other EU
country, making London a hub for the entire European banking market.
So what could happen with respect to the passporting regime once the negotiation period
has ended? One thing is clear: It will very much depend on politics.
In the event that the United Kingdom decides to remain a member of the European
Economic Area (EEA), not a great deal would change for banks and enterprises on both
sides of the Channel. EU rules for banking super-vision equally apply to members of the
European Economic Area. Current supervisory powers would likewise remain unaffected.
Naturally, EU membership does not only cover free trade. It also means applying the full
body of EU legislation, a key component of which is freedom of movement. On the one hand,
financial institutions in London have bene-fited from the stream of human capital from the
mainland. On the other, the negative consequences that it is claimed arise from free
movement are issues that numerous "Brexiteers" in the run-up to the referendum have cited
as reasons why they believe the UK should leave the European Union. For some,
EEAmembership is regarded as the equivalent of jumping from the frying pan into the fire. Many
other forms of cooperation are therefore also imaginable, including established models such
as the WTO framework.
For banks, a situation in which the UK were to become a third country would allow for a
spectrum of outcomes, depending on what is negotiated. At the lower end of cooperation, an
ordinary third country status would require UK banks and banks from foreign countries to
obtain licenses for their branches in any given EU country. Also, working capital would be
required as a basis for supervision - I may ascertain this at least with respect to Germany.
This should indeed give incentives to banks from third countries to establish subsidiaries in
only one EU country and in this manner avoid the need to acquire more than one license in
the EU.
Even so, the ordinary third country statues may significantly interfere with the current
business models of banks. For those foreign banks that currently use their UK subsidiaries
as a hub for the European market, the UK serving as a third country would compromise their
business models in the EU.
Certainly, there would still be room for further bilateral agreements. Thus, German authorities
could grant exemptions to foreign institutions. For banks with a British license, a more
favourable supervisory treatment is conceiv-able. Supervision might even be performed in a
manner akin to if the UK were an EEA member. But this hinges upon several requirements.
Most importantly, the UK would have to follow the internationally approved canon of
supervisory policies. If this were the case, EU members would want to protect themselves
against any form of regulatory arbitrage. Also, this would require substantial, political
willingness on both sides. However, such political goodwill might suffer if and when Brexit
goes ahead. We will have to wait and observe.
Generally speaking, we cannot make reliable predictions about the future legal framework for
banking across the Channel. Planning uncertainty is bound to be costly. Businesses on both
sides of the Channel are unable to make any longer-term plans as long as these conditions
haven't been clarified. On the other hand, location shifting takes time and encourages banks
to react well ahead of political certainty. Also, it's very much up in the air whether the spell of
uncertainty will be over after two years or whether the negotiating parties will have agreed,
by mutual consent, to extend the negotiating period.
Moving forward with uncertainty
Ladies and gentlemen, the bottom line of my message is simple: Whatever the legal outcome
of Brexit negotiations may be - it better be arranged swiftly. For banks, as for the economy
as a whole, any uncertainty should be kept to the very minimum.
In the course of negotiations, both sides will probably be keen to maintain the existing trade
links. But, at the same time, there should be no doubt that the EU should resist any efforts by
the UK to cherry-pick the most beneficial terms. So, in all likelihood, individual arrangements
granting access to the EU markets won't be possible without concessions being made.
While negotiations have not even started, there are some definite conclusions to be drawn
from the referendum result:
• Financial institutions have to prepare for a scenario in which euro-denominated
trading and clearing is unlikely to have a future outside the EU.
• Regarding the merger between Deutsche Börse and London Stock Exchange, the
referendum outcome has even strengthened the economic rationale. But in order to
reap the benefits, contracting partners should now invest in a well-balanced
governance structure.
• Financial actors in Europe have so far succeeded in digesting the somewhat
surprising referendum result. Even ongoing volatility should not serve as an excuse
to bypass the pillars of financial stability we have only just set up in the EU.
Please let me shortly expand on this last, but important point. I am referring, in particular, to
the challenge of actually making investors in banks liable in case of a bank failure, a concept
also known as "bail-in". For that purpose, a codified bail-in mechanism now exists, which has
been fully operational since the beginning of this year. If we allow states to provide
discretionary aid to their banks, this impedes a core element of the bail-in regime, namely its
credibility.
If the bail-in mechanism were to be exposed or even dismantled, markets would no longer
exert their disciplinary function. The management of banks will always be likely to maintain a
safety buffer over and above supervisory capital requirements as they face resolution in case
of falling short of these requirements. If bank supervisors were to observe the dismantling of
the bail-in mechanism, I am convinced the logical and necessary consequence would be for
supervisors to raise capital requirements so as to compensate for the lack of market
discipline.
In face of the Brexit referendum and the critical attitudes expressed towards EU governance,
making our rules more trustworthy should be of even greater concern. The Brexit vote must
under no circumstances serve as an excuse to delay reforms or even undo achievements in
European integration. Instead, the EU should listen to this wake-up call and react
appropriately.
Please allow me one last, and personal, remark: I -probably speaking for most, if not for all of
my German colleagues - will greatly miss our British counterparts in European institutions;
not at least because of their orientation towards stability and free market economy. But,
fortunately, as central bankers, we will continue our collaboration at many other levels such
as the G7, the G20, the IMF and the BIS.