On 24 November the European Banking Authority published its Risk Assessment Report on EU banks, along with an associated transparency exercise. The mostly dry analysis contained a statistic that prompted a flurry of headlines from financial news outlets.
“European banks slash UK-related assets by €350bn after Brexit vote” wrote the Financial Times, while Bloomberg said, “Brexit Spurs European Banks to Trim Exposure to U.K. Assets”.
The EBA data that sparked these headlines was a before-and-after Brexit comparison of EU bank exposure to the UK. In June 2016, the data showed the total asset exposure of these banks to UK counterparties stood at €1.935 trillion, which had dropped to €1.585 trillion a year later – a €350bn decline.
So did the EU banks really cut back UK exposure in the way implied by the FT and Bloomberg?
Risky Finance has imported the EBA’s data into its visualisation tools, allowing a bank by bank analysis of credit exposures to particular countries. Whether domestic banks are included or excluded from the analysis, at first glance the data confirms the decline in UK exposures highlighted by the EBA in its report. [see chart] But this figure needs careful interpretation.
A better explanation of the EBA data is that it was a combination of two things: a foreign exchange effect, resulting from the decline in sterling against euro after the Brexit vote, and the impact of rising interest rates. To understand why, take a closer look at the EBA’s numbers.
According to the regulator, the decline in UK exposures was only observed in derivative positions on both the asset and liability side. Loans and deposits were essentially unaffected. And based on the way that banks account for financial instruments on their balance sheets, this is exactly what you would expect to see with the Brexit-related currency swing.
Consider the loans first. Loans not held for trading are recorded at historical cost, and are converted into the bank’s home currency at the time of issue. In other words, Brexit-related currency swings shouldn’t affect the reporting value of sterling-denominated loans. If loans or deposits were hedged, then that would show up in the derivatives exposure.
Now consider the derivatives. Large EU banks have built up considerable UK derivative exposures over the years as they competed for a piece of the action in the City. For example, Deutsche Bank was for many years one of the top market makers in sterling interest rate swaps and options, transacting multi-billion pound trades with UK customers such as insurer Aviva.
These positions are recorded in accounts and regulatory statements at market value, converted into the bank home currency at the reporting date. After the Brexit vote, Deutsche’s sterling swaps and options would suddenly have been worth a lot less when measured in euro.
How much of this activity shows up in the EBA’s numbers? We can assume that most trades between EU banks and UK end-users (like Aviva) would be sterling-denominated.
What about trades involving other currencies? (This would be most significant for inter-bank exposures, for example BNP Paribas and Barclays trading dollar swaps with each other). Here the interest rate effect is apparent. Between June 2016 and June 2017, ten-year dollar swap rates increased by 100 basis points, while euro swap rates increased 60bps.
For derivative dealers with large legacy swap positions, the impact has been to shave trillions off the accounting valuation of their derivative exposures. While the EBA refuses to divulge its detailed derivative data, we can track the effect in the Risky Finance banking database. [see chart 2]
Combining this interest rate effect with the 12 percent decline in sterling-euro between June 2016 and June 2017 should easily explain the 18 percent decline in UK exposures observed by the EBA. And if it doesn’t, remember also that large EU banks – such as Deutsche – have been reducing derivative exposures across the board as they cut back on trading activity.
There is no need to invoke any image of banks ‘slashing’ UK exposure. By using such language, news organisations expose themselves to charges of laziness, misinterpreting data for the sake of a Brexit lede.
In response to Risky Finance, an EBA spokeswoman said, “we do not provide any interpretation of the data to news organisations. This report has always been praised for the high level of transparency and for the granular data provided.”