Preparing Britain's Banks for a Disorderly Brexit
Later this month, the Bank of England will publish the results of new stress tests on the U.K. banking system. With Britain facing the risk of a disorderly exit from the European Union, the exercise is even more important than usual.
A so-called cliff-edge Brexit is looking more likely. This could cause a sizable fall in gross domestic product, a sharp drop in the value of sterling, and a steep increase in interest rates.
If the new tests show that banks have too little capital to withstand such a scenario, the regulators will need to insist on prompt corrective action.
The British economy has already slowed, and there may be worse to come -- which could tempt supervisors not to press too hard. They might fear, in particular, that lenders would restore their capital ratios by shedding assets rather than adding equity (which would dilute the interest of their existing owners). If that happened, it would add to the short-term downward pressure on growth, and be partly self-defeating.
There’s no real dilemma here. The central bank shouldn’t compromise when it comes to the safety of the banking system -- and, in fact, it doesn’t need to. It could force banks to make good any capital shortfall by raising equity rather than by curbing loans. And, should the need arise, it could support demand by keeping monetary policy loose.
It's to be hoped that the U.K. comes to an agreement with the EU that allows an orderly departure, so that this worst-case scenario never comes to pass. In that event, supervisors could relax their earlier demands. Until then, the purpose of the stress tests is to expose risks -- and prepare for them.
--Editors: Ferdinando Giugliano, Clive Crook
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