Karen Shaw Petrou memorandum to the Federal Financial Analytics clients on why brexit hasn’t battered big banks.

TO: Federal Financial Analytics Clients
FROM: Karen Shaw Petrou
DATE: June 24, 2016

Why Brexit Hasn’t Battered Big Banks

There are two types of train wrecks – fiery crashes sparked by careening locomotives and slow-mo ones in which trains go off the tracks one by one with far less harm to life and limb. One doesn’t want to be in either, but slow-mo beats the alternative. So far, Brexit is a slow-mo macroeconomic wreck, which only seems good because we’ve been spared a fiery one. Why is Brexit in 2016 different than 2008’s Lehman implosion? In 2008, big banks went up in a puff of smoke when market first movers didn’t trust their liquidity. In 2016, counterparties appear confident that GSIBs, especially those in the U.S. and U.K., can circulate the market’s lifeblood of intraday and overnight funding. Lots of losses are still to come, but not those that create a cascade of financial insolvencies turning all too quickly into a cataclysmic crisis.

We can debate all day long if GSIBs are indeed as safe as they seem. What matters is that, at least so far, markets think they are and thus are behaving relatively normally across the payment, settlement, and clearing system. Central-bank promises are of course comforting, but I don’t think they’re the reason for relative calm. Central banks promised the world in 2008, but first movers wanted their money, wanted it now, and didn’t want to wait to be sure their immediate counterparty would be there to hand it over when the central bank opened the spigot. Now, they are.

Perhaps coincidentally, one reason for this sang-froid is yesterday’s FRB release of the Dodd-Frank Act stress-test (DFAST) results. Banks from giant to just pretty big did far better than most thought possible under the grueling severely-adverse scenario posited in the 2016 round. With a hypothetical proven, markets expected resilience and didn’t test the second-order ones that require good guesses about when and with how much a central bank will come through.

Are GSIBs as resilient as they seem? Even Paul Bunyan was felled at the end, and the GSIBs still face challenges in a slow-mo wreck. Over time, these are the macroeconomic ones already being priced into stock prices. Nearer and more frighteningly might come strains resulting from recent market transformations like the financialization of commodities and other once hands-on-the-plow activities. This transformation shifts leverage and liquidity risk far outside the ambit of GSIBs and most central banks, making global markets fragile even if GSIBs stand firm.

But, for now some facts to make you feel better. In his testimony yesterday before the Senate Banking Committee, president of The Clearing House Greg Baer provided startling data on where the largest banks stand eight years after the crisis. Looking at his 24 big-bank members, Mr. Baer noted that, “In dollar terms, tier 1 common equity nearly tripled from about $326 billion to $956 billion over the past seven years.” He also cites new FSOC data showing that U.S. banks with over $700 billion in assets now hold approximately thirty percent of their balance sheet in high-quality liquid assets like sovereigns and agency paper.

That’s a lot. Indeed, it’s so much and so costly that many financial activities are migrating to non-banks, the same ones that may well not prove as resilient under Brexit stress. A recent FedFin paper explores this issue in depth and a forthcoming one will look at another critical issue – the financial-inclusion and income-inequality effects of the redesigned U.S. financial system. Nice, though, to have the luxury of long-term thinking – one wrought at great cost to GSIBs but now at considerable benefit to the rest of us.

Brexit, Big Banks