Bank of England's warnings ring true as Brexit slams UK banking stocks

Construction cranes stand on the horizon beyond the Bank of England in the city of London.
Construction cranes stand on the horizon beyond the Bank of England in the city of London.PHOTO: AFP

LONDON (BLOOMBERG) - Mark Carney's warnings that Brexit could inflict a fresh crisis on the UK's banking sector may be coming to pass, and it's up to him to try stop it.

As the Bank of England governor chairs a meeting of financial stability officials on Tuesday (June 28), the industry they oversee has been battered by investors. Britain's vote to leave the European Union has ripped through markets, with UK bank stocks suffering their biggest two-day decline in seven years.

Mr Carney cautioned months ago that the referendum was the "biggest domestic risk to financial stability" and said in May that a Brexit vote could lead to a recession, comments that proved controversial in a vitriolic political battle. The remarks also signaled he wasn't taking any chances with the strength of the BOE's planned defenses against a referendum fallout.

One of those emergency measures will be tapped on Tuesday, when the BOE offers funds in exchange for collateral at an extra auction, giving banks a chance to grab cheap cash for a fourth time this month, instead of the usual single operation. While banks sought just £370 million (S$666.6 million) last week, the vote result has heightened economic and political insecurities and eroded confidence in lenders.

"Carney needs to make sure markets carry on functioning effectively at a time when political chaos has the capacity to shock investor confidence," said Ian Gordon, an analyst at Investec in London. "Liquidity is not the biggest concern for UK banks these days, but additional drawing rights provide a further level of reassurance. Even though it may not be used in huge volumes, doesn't mean it isn't sensible."

In addition to special auctions, Mr Carney was quick to respond to the referendum result last Friday, declaring that the central bank is ready to make £250 billion available to the financial system. It also has swap lines to lend in foreign currency if required.

"So far, Carney has said what you'd hope to hear from him - all the right things about detailed preparations, backstops and extra liquidity," Mr Gordon said. "In fact, he's given all the sorts of reassurances Mervyn King needed to do back in 2007 when the banks were in a far worse situation," in the midst of the financial crisis.

On Monday, Chancellor of the Exchequer George Osborne added his voice to soothe investors and the public, saying that banks' capital requirements are "10 times what they were" before.

"Unlike eight years ago, Britain's financial system will help our country deal with any shocks and dampen them - not contribute to those shocks or make them worse," he said.

That's proved little help so far, with political uncertainty compounding the economic factors. Conservative Prime Minister David Cameron announced his resignation last week after the referendum, while his opposite number, Jeremy Corbyn, has been called on to step down as Labour Party leader.

Meanwhile Barclays and Royal Bank of Scotland Group have felt the brunt of the sell-off, falling more than a third since the "out" vote, and trading was halted in both stocks on Monday. Lloyds Banking Group, which was bailed out along with RBS during the 2008 crisis, recorded almost its entire 30 per cent year-to-date decline in the past two trading days. The pound is at a 31-year low, and many economists forecast the economy will slide into a Brexit-induced contraction.

The turmoil, and its potential impact on banking stability, is likely to dominate the meeting of the Financial Policy Committee, an 11-person panel set up after the financial crisis as part of an overhaul of oversight. Officials usually release a statement in the days after their gatherings, and are scheduled to do so along with the BOE's latest bi-annual Financial Stability Report on July 5.

"The focus is more on the Bank of England because they're the actor in the markets who can perhaps do more," said Andrew Sentance, senior economic adviser at PricewaterhouseCoopers and a former BOE policy maker. "In terms of the situation facing the banks, they've got to be prepared to provide liquidity if needed."

The committee said in March that "heightened and prolonged uncertainty" could increase investors' risk pricing of assets and "affect the cost and availability of financing for a broad range of UK borrowers."

The International Monetary Fund has since warned that Brexit could cause a potential credit squeeze if liquidity markets dry up, which could deter spending and investment.

Compounding all that, uncertainty surrounding the UK and its new relationship with the EU will undermine confidence and deter investment. Goldman Sachs sees the economy slipping into a recession by early 2017, which could reduce consumer spending and demand for mortgages and car loans.

"I think it's very probable now that the UK is going to head to recession," said Danny Blanchflower, a former MPC member who is now at Dartmouth College in the US. "It's the classic Keynes animal spirits. If the people think it's going to go down, it's going to go down."