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Brexit Question Raises Risks for U.K. Banks

The Bank of England's new countercyclical capital buffer shouldn't affect valuations, however.

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The Bank of England has warned that uncertainty over whether the United Kingdom will vote to leave the European Union has increased risks to financial stability. The BoE announced several related measures, including extra funding options to be available around the late-June vote, new stress test requirements, and an increase in the countercyclical capital buffer requirement to 0.5% from 0%. We're not concerned about the 0.5% countercyclical buffer and do not expect it to affect our fair value estimates for the U.K. banks; we think it can be absorbed by the banks' existing capital plans. U.K. banks reported capital ratios of 11.4%-15.5% at year-end, well above current requirements. We're further comforted by reassurances by the BoE that it plans to reduce other capital buffers and does not plan to increase requirements overall.

We've long said that we see a rocky road ahead for undervalued  Royal Bank of Scotland (RBS)/(RBS), and we think these risks are already more than priced into the shares. We think the bank has more than enough capital and reserves to absorb the credit and litigation charges we anticipate and emerge in 2018 with as much as GBP 20 billion of excess capital to distribute to shareholders through special dividends or repurchases. The shares are trading well below our fair value estimate, and we see significant upside for patient investors. For less risk-tolerant investors, we prefer the shares of  Lloyds (LYG) /(LLOY). This bank is clearly the strongest of the large U.K. banks. We think investors can be reasonably confident that its high litigation and regulatory charges are in the past, paving the way for attractive near-term earnings and dividend growth.

Most U.K. banks are either already explicitly expecting a countercyclical buffer requirement in their capital plans or are planning a large management buffer. For example, RBS' 13% common equity Tier 1 target ratio (its fully loaded CET1 ratio was 15.5% at year-end) includes a 2.2% management buffer. Lloyds hasn't laid out an explicit target but had a 13% fully loaded CET1 ratio at year-end and can absorb the new requirement.  Barclays' (BCS)/(BARC) capital plans assume a 0.5% countercyclical buffer plus a 1%-1.5% additional buffer; fully loaded CET1 was 11.4% at year-end.  HSBC (HSBC)/(HSBA) is probably the most stretched, capital-wise, although the countercyclical buffer will have less of an impact, as it is only being applied to U.K. assets. HSBC had an 11.9% CET1 ratio at year-end but faces higher capital requirements because of its status as a large global systemically important bank.  Standard Chartered (STAN) will be largely unaffected as most of its operations are outside the U.K. However, we think Standard Chartered's current capital base could be insufficient if loan losses are higher than we expect.

Although its plans are somewhat vague, the Bank of England said that while it intends to set the countercyclical buffer at 1% in a "standard risk environment," it also plans to reduce other elements "as possible" and that U.K. banks will not see their overall regulatory capital buffers increase.

We agree with the BoE that the possibility of Brexit--the British exit from the EU--increases risks for U.K. banks. Until recently, we had seen Brexit as unlikely. However, our concern has grown in the wake of the terrorist attacks in Brussels, as we think anti-immigration sentiment could tip the odds in Brexit's favor. For banks, we see risks in four key areas.

First is currency. The risk of Brexit is putting a lot of pressure on the pound, and we expect continued volatility. We see this as especially problematic for non-U.K. investors who may have unhedged investments in shares traded in other currencies, like American depositary receipts, or those who report results in currencies other than the pound.

Second, the question of Brexit, along with the high U.K. current account deficit, could increase funding costs for U.K. banks. This could have the largest impact on banks with large investment banks or runoff operations, like Barclays and RBS, as these are largely wholesale funded. We think banks dominated by retail operations and deposit funding, like Lloyds, will be less affected.

Third, we think uncertainty leading up to the vote--which would continue following a vote to leave--could cause people to hold off on making business decisions and investments, which could trigger a slowdown in the U.K. economy. This could lead to lower loan growth and higher loan losses. This risk has already affected RBS' timetable for the required divestiture of Williams & Glyn, and a vote to exit could further complicate it.

Finally, we think Brexit would probably decrease the importance of London as a banking center as global banks relocated some operations into the EU. We think this could decrease the scale and cross-firm synergies of banks in London, which could have a negative impact on the profitability of remaining U.K. investment banks, like Barclays.

Erin Davis does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.