Brexit: Implications for US banking and capital markets

The world turned upside down?

Financial institutions in the United Kingdom and Europe will bear the brunt of this event over both the short and long term, as the timetable for full separation is two years following the invocation of Article 50 of the Lisbon Treaty. What about their counterparts in the United States? Some very large US firms operate globally, with a meaningful presence in the United Kingdom and Europe. For them, the impacts are more direct and immediate. But many more US financial institutions are purely domestic, so the impacts of Brexit will be part of larger regulatory and economic forces that may emerge as the United Kingdom executes its departure.

In the remainder of this document, one of a series of reports spanning financial services, we will explore the implications of Brexit for banking and capital markets in the United States, looking at financial, regulatory, operational, and strategic considerations for US banking and capital markets executives. Those interested in understanding the impact of Brexit on other financial industry sectors are encouraged to review our companion pieces in this series.

Recalibration post-Brexit

The US banking industry’s mood shifted from self congratulation—all large US banks exceeded regulatory capital minimums in the Dodd-Frank Act Stress Tests
(DFAST) for the second consecutive year—to one of heightened anxiety about fallout from the Brexit vote. Even banks that do not have a presence in the United Kingdom or the European Union now have to consider myriad implications.

Many banks have begun executing contingency plans designed ahead of the vote. But more will obviously need to be done as the drama unfolds. Final outcomes
are, of course, unclear at this time, but our hypothetical base case assumes some fundamental conditions going forward:

• A prolonged and complicated negotiation process that fuels political and economic uncertainty.
• A higher degree of trade friction between the United Kingdom and the European Union post-separation.
• Less free movement of people between the European Union and United Kingdom due to immigration restrictions.
• A more complex and uncertain regulatory environment during the transition period as some EU rules are modified, replaced, or eliminated for UK specific regulations. 

Critical issues that US banks will face

Our analysis does not account for the worst case—such as a disorderly exit and further disintegration of the European Union itself. As Sir Winston Churchill said,

It is a mistake to look too far ahead. Only one link of the chain of destiny can be handled at a time.² 

In the coming weeks and months, US banks will face the following critical issues as the sense of urgency to execute the separation process gains steam:

1. Continuing political and economic uncertainty will hobble attempts to reliably reassess returns on equity (RoE) from UK and EU operations, potentially forcing a scaling back of investment commitments in the region.
2. The likely absence of a flexible “passporting” arrangement for transactions means business scale in each region will need to be resized for the new reality.
3. The costs and barriers of erecting and running a dual UK and EU business model will force a reevaluation of transaction booking models and the distribution of
   asset and wealth management products.
4. Earnings impact on US banks, even those solely focused on the domestic market, could be negative. US-based banks with meaningful revenues from and exposure to the United Kingdom and the European Union will obviously see a direct negative impact. More broadly, the general dip in business sentiment and potential weakening of global growth could cause domestic loan demand to sputter. Margins may also be pressured further by continuing low interest rates and a flatter yield curve as long-dated treasury yields decline.
5. US banks will have to balance the cost and speed of operational restructuring depending on how separation occurs (i.e., orderly or disorderly, immediate or gradual). Correspondent banking partnerships and vendor relationships with firms in the United Kingdom, and possibly even in the European Union, will demand close attention through the coming transition.
6. Regulatory standards in the United Kingdom could diverge and possibly become less stringent than those in the European Union, as London attempts to retain its status as a leading global financial center. Beyond impacting US banks that have a UK presence, this divergence may influence future investment decisions of domestic banks with international ambitions.
7. Resolution (“living will”) plans mandated by the DoddFrank Act will now need to account for impediments to resolvability that have emerged due to Brexit. These include legal and operational frictions to bankruptcy and operational continuity in resolution across jurisdictions. At a fundamental level, capital and liquidity improvements, alongside frequent stress-testing exercises, have raised US banks’ resilience to geopolitical shocks such as Brexit. Going forward, this very resilience may enable them to maintain and possibly even improve their competitive positioning.
   

²Simon Paige, “The Very Best of Winston Churchill—Quotes from a British Legend,” 2014.