Originally published March 21, 2019
We are but 9 days away from the Brexit deadline. Britain has asked for an extension and the President of France denied it yesterday. I do not like calling "Wolf" but we may be headed for a crisis. What we know for sure, today, is that there is a massive amount of "Risk" on the table now, as the deadline approaches. Please do not minimalize the situation. You might pay dearly for your transgression.
The German chancellor, Angela Merkel, has said she will fight until the "final hour" of March 29 to avoid a no-deal Brexit, but admitted she cannot second-guess the outcome of an EU summit this week, due to the chaos in the British Parliament.
My gravest concern is the European banks and the European bonds currently governed under British law. Both could be in serious trouble. Both should be at the top of your radar screens!
European banks are poised to underperform in 2019, thanks to their inherent issues that not even the ECB, with their zero cost money, can cover up. The region's lenders have been hit by record-low interest rates and sovereign debt crises, such as in Italy. The initial negative reaction of their stocks to a new round of loans from the European Central Bank, which are expected to have less favorable terms than in the past, attests to how much some of these institutions are troubled.
European banks on the Stoxx 600 trade at 0.74 estimated price-to-book, about an 11% discount to the 10-year average. That compares with a multiple of almost 1.2 for S&P 500 banks. Italian lenders are cheaper still, thanks to bad loans and an overhang of political concern in the wake of last year's budget saga. They hold the EU's biggest pile of impaired debt which is one of the reasons why they have a 12-month forward price-to-book of less than 0.6.
If it is to be a "Hard Brexit" then none of us has any idea of just how bad it could get. We just have no idea of what types of interbank relationships/obligations are on the books. Moreover, we have no idea if British law or European law will be applied, if push comes to shove. If the British no longer recognize EU law and/or if the EU no longer recognized British law then we are in a very desolate no-man's land that could shove the banks, of both entities, into a major crisis. I am not saying that it "will" happen but I am sure saying that it "could" happen.
I also point out that as part of preparations for Britain's departure from European Union the British finance ministry has published a "Statutory Instrument" or "SI" to help transfer EU rules, like financial regulations, into national law to avoid a legal void on the first day of Brexit. Banks in the EU don't have to hold capital against holdings of their own government's bonds, a rule known as "zero risk weight," as such domestic debt is considered "risk free."
The British government said in its "SI" that if Britain leaves the bloc, with no transition deal, the EU would automatically become a "third country." This means that the "zero risk weight" rule would no longer apply to the branches of the EU banks in Britain. Therefore, this SI will remove preferential treatment for EU exposures, and possibly impair the balance sheets of the parent companies, of the EU banks.
This also brings "Counterparty Risk" into the equation. If you are a money manager it would be judicious to check and see what kinds of "Counterparty Risks" you now have and whether they are prudent. If things begin to fall apart then you will be very glad that you considered this issue, before it is too late. I issue my "Warning."
The other major issue is the rising threat of a no-deal Brexit for more than $115bn of European bank debt issued under English law. This debt would no longer comply with either British or EU laws and it "could" be a legal disaster. This would also apply to the Tier I and Tier II debt, CoCo bonds, issued in the same fashion, which would also become largely unregulated by anyone. It is estimated that approximately $140bn of these CoCo bonds, issued from European non-UK banks, are governed by English law. In a "Hard Brexit" the European Union might not recognize the British laws and so they might revert to national laws which would decrease the value of these bonds substantially, in my opinion. I advise you all to check your exposure here, as well!
I also point out the Germany's two largest banks are in merger discussions. One, or both, could be stricken by a "Hard Brexit" and the resulting possible disturbances to their balance sheets making some kind of merger, or buy-out, next to impossible. Plenty of "Risk" in this situation as well, in my view.
I also point out that American banks may not be spared the contagion here. We have no idea about their interbank relationships/obligations with the British banks or the European banks either. Further, we have no real idea about their "Counterparty Risks." It is because we just "do not know," that makes this situation so dangerous.
What you don't know CAN hurt you, I assert!
Editor's Note: The summary bullets for this article were chosen by Seeking Alpha editors.