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ViewpointOctober 3 2016

The challenge of Brexit: banks’ resilience is no excuse for complacency

The UK's Brexit vote in June came as a blow to most in the EU, but the lack of widespread financial shock in the immediate aftermath of the vote showed how the improvements made to the euro area's post-crisis banking sector are paying off. France's central bank governor looks at why this was the case, but warns there is no room for complacency and calls for further progress on the economic part of the EU’s agenda.
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Francois Villeroy de Galhau

The vote of the British people in favour of Brexit was bad news for the UK, and for Europe. The victory of the “leave” camp has opened a period of uncertainty and we now have to face up to this new challenge.

The immediate consequences were of a financial nature: in addition to the sharp fall in the British pound, stock prices experienced strong corrections, especially in the banking sector. But there was no widespread panic: financial markets did not freeze up; stock prices returned to their mid-June levels from as early as end-June, or mid-July in the case of bank stocks; and the British pound rapidly stabilised at about 10% below its pre-referendum level.

Resilience of the banking sector

This subdued post-Brexit financial shock is first attributable to the high level of co-operation between central banks. However, there is another aspect that should not be overlooked: the European banking system as a whole – and the euro area banking sector in particular – is now far more resilient to financial and economic turmoil than before the 2008 financial crisis. Over the past few years, banks in the euro area have materially raised their own funds and improved their balance sheets. The 2016 EU-wide stress test conducted by the European Banking Authority clearly demonstrates their increased resilience. At end-2015, the average common equity Tier 1 (CET1) capital ratio of the 37 significant banks of the euro area that were tested – covering about 70% of all banking assets – was 13%, which is 180 basis points higher than in the 2014 stress test.

As a result, the euro area banking system as a whole would be well placed to weather a particularly severe macroeconomic shock: under the adverse scenario in the 2016 stress test, banks’ CET1 capital ratio would remain at an average of 9.1%, compared with 8.6% in 2014. This is all the more crucial given that the banking system is at the heart of the financing of the euro area economy.

Substantial strides have been made in recent years to enhance the resilience of the banking sector.

First, banking regulation has been considerably strengthened: the Basel III reform has increased the ability of banks to withstand shocks and improved their risk management. In practice, European banks’ financial structure has greatly improved since the crisis. There are still some issues with certain banks – regarding non-performing loans in Italy for instance. These need to be addressed but are manageable if dealt with in a timely manner.

Second, additional steps have been taken to ensure greater financial stability in the euro area, with the setting-up of the banking union: harmonised supervision under the single supervisory mechanism has reduced the likelihood of bank failures; and, should they occur, the single resolution mechanism has made it easier to manage them without the use of taxpayers’ money. This new architecture has also contributed to a severing of the link between domestic banks and sovereign debt, a problem that was at the heart of the euro area crisis.

Strong buffers

As an example of the progress that has been made, major French banking groups more than doubled their CET1 capital ratio between end-2008 and end-2015 – from 5.8% to 12.6%, which is an additional €143bn of the highest quality form of capital. Moreover, they have built up strong liquidity buffers. Their liquidity reserves increased by €359bn between end-2011 and end-2015; and all French banks already comply with the liquidity coverage ratio (LCR) requirement – well ahead of the Basel III deadline. In addition, their non-performing loans ratio is low (about 4%) and their profitability has proved resilient.

The French banking system is actually one of the soundest in Europe and in advanced economies. And French banks’ business model undoubtedly plays a role. Their diversified range of business lines makes them less vulnerable to specific economic shocks; the higher proportion of fees and commissions in their total revenue, as compared with their European peers, mitigates the impact of the squeeze on net interest margins caused by the low interest rate environment; and the healthier state of their credit portfolios means they have a moderate cost of risk. This is particularly the case with regard to housing finance, thanks to the good practices observed across the French banking sector: selecting borrowers on the basis of their ability to repay, prioritising fixed-rate loans, and using guarantees rather than mortgages.

What next?

The full consequences of the Brexit vote are still difficult to assess for three reasons: this is an unprecedented decision; the new legal and economic framework between the UK and its former partners still needs to be defined; and negotiations between the EU and the UK are expected to take some time – two years from the time the UK gives notice of its withdrawal. However, neither the current transitional phase, nor the resilience of the European banking system after the UK referendum, should be used as an excuse for inaction.

With this in mind, there are two priorities. The first is to reduce uncertainty to a minimum. As we know, uncertainty is detrimental to the financial and economic sector: if investors do not know which rules will apply a few years down the line, they will postpone their investment decisions. With regard to the Brexit decision, this means preparing the new trade deal between the UK and the EU in a swift, orderly and consistent manner – the quicker, the better. Even though we cannot make any assumptions at this stage as to the outcome of the negotiations, we can still state clear principles and stick to them: there should be no cherry-picking and no free-riding. For the UK to maintain access to the single financial market, all the usual EU rules should be strictly respected. Without this, financial institutions based in the UK would have to adjust their legal and operational frameworks in order to continue to operate in Europe.

The second priority is to make progress on the economic part of the EU’s agenda, independently of Brexit negotiations. Following the Brexit decision, the UK economy is expected to slow down and there will probably be some fallout for the euro area, although the impact will be more modest than in the epicentre in the UK. Given these circumstances, it has become even more urgent to unlock Europe’s growth potential. Right now, we lack productive investment, while, at the same time, we are experiencing a savings glut – the current account surplus of the euro area exceeds 3% of gross-domestic product (GDP). And this discrepancy is the fundamental reason behind our current ultra-low interest rate environment.

Financing and Investment Union

Our efforts should thus be directed towards better channelling savings into the financing of innovation, which is key to growth. To do so, we need a 'Financing and Investment Union' at EU27 level, in which the banks would play their full part. This union should bring together all existing initiatives – the capital markets union, the Juncker plan and the banking union – in order to generate synergies targeted at two objectives.

First, diversifying businesses’ sources of financing, to better meet their needs. This does not mean forced disintermediation; but we need to make it easier to finance innovative investment through equity. Europe is lagging behind in this field: the equity share of corporate financing is half as large as in the US – only 52% of GDP in the euro area, versus 121% in the US.

The second objective should be to increase the resilience of the euro area through greater capital market integration. This form of private risk sharing is the best way to cushion against asymmetric shocks in a currency union. For the EU as a whole, the Financing and Investment Union would be a significant step forward; for the euro area, it is an imperative.

François Villeroy de Galhau is governor of Banque de France.

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