Bank of England girds itself for Brexit

The countdown to Brexit continues. The Bank of England’s Financial Policy Committee (FPC) – the lesser known and lesser important cousin to the Monetary Policy Committee – released notes from its meeting on 23 March concluding that ‘Brexit is a risk’. They were revealing. How?

The FPC is planning for Brexit too. But its focus is not so much on providing liquidity in the banking sector during a financial crisis. It’s more focused on the long-term stability of the British financial system.

Does the FPC think Brexit is a risk?

It’s an important question. I’ll give the extended answer from the FPC. From the notes (emphasis added is mine):

The FPC has considered the channels through which uncertainty associated with the 23 June referendum on the United Kingdom’s membership of the European Union, and any period of extended uncertainty following the vote, could increase risks to financial stability.  

The Committee noted that the effect of uncertainty has been most marked in sterling spot and options markets. Looking ahead, heightened and prolonged uncertainty has the potential to increase the risk premia investors require on a wider range of UK assets, which could lead to a further depreciation of sterling and affect the cost and availability of financing for a broad range of UK borrowers.    

These pressures have the potential to reinforce existing vulnerabilities for financial stability. The UK current account deficit remains high by historical and international standards. The financing of that deficit is reliant on continuing material inflows of portfolio and foreign direct investment. Those flows have contributed to the financing of the public sector financial deficit and corporate investment, including in commercial real estate. Heightened uncertainty could test the capacity of core funding markets at a time when the liquidity of these markets has shown signs of fragility across advanced economies. In addition, the impact of a decision of the United Kingdom to withdraw from the European Union could spill over to the euro area, driving up risk premia and further diminishing the prospects for growth there. 

The Committee assesses the risks around the referendum to be the most significant near-term domestic risks to financial stability. It will continue to monitor the channels of risk closely and support mitigating actions where possible. In that regard, the FPC has considered the results of the 2014 stress test of major UK banks, which incorporated an abrupt change in capital flows, a sharp depreciation of sterling, a marked increase in unemployment and a prolonged recession. The results of that test, when combined with revised bank capital plans, suggested that the banking system was strong enough to continue to serve households and businesses during the severe shock.  Since then, UK banks’ resilience has increased further.
There’s a little something in there for everyone, really. As Charlie Morris noted last year, the pound is the first and most obvious victim of uncertainty about Brexit. The FPC simply connected the dots between Britain’s current account deficit, foreign direct investment to finance it, and the value of the pound. It’s not complicated.

The last bit is the most intriguing, for my money. The FPC suggests Brexit will be stressful for UK banks. Why else would it bring up the 2014 stress tests? It seems like a leap.

But then it suggests that the banks are stronger now than they were in 2014. And in any event, even with new bank capital requirements coming down the track… everything should be fine. So no problem right? More on that tomorrow.

Why the Atlantic alliance still matters

Also on the issue of Brexit, a quick story for you. I took a day trip to Greenwich over the long weekend to visit the National Maritime Museum. It was well worth it for two reasons.

First, Nelson’s great victories at Aboukir Bay in 1798 and Trafalgar in 1805 opened the sea lanes for British trade. The Battle of the Nile was about breaking Napoleon’s blockade of British trade with India. It made the Mediterranean a British waterway. Trafalgar did the same for the Atlantic, neutralising the French and Spanish fleets.

The second reason is that, secured by the Royal Navy, British trade (and the British Empire) only truly flourished because of trans-Atlantic trade. Tobacco, cotton, gold, coffee, sugar cane, rum, timber and molasses from the New World went into Britain as raw commodities. There, they were either consumed, saved, or turned into finished goods and exported with higher value added.

In all of this, Continental forces – the forces of centralisation and political union – were the enemy of British interests. Britain thrived because it chose to defend its interests. Had it taken the path of least resistance, it would have taken Napoleon’s offer for access to Continental trade in exchange for military and legal subservience.

Of course I’ve covered these issues in a superficial way. And the slave trade was both a dark stain on British and American history, as was the fruits of slave labour from the sugar cane and tobacco plantations of the Caribbean and the American South. But do you see my main point?

When Britain looks to the forces of centralisation in Europe, it always sees the same thing: ceding political power, a closed trade bloc, and the domination of the Franco-German interests. When it trades with the world, it thrives. If it worked in the past, can’t it work again?

Category: Brexit