Brexit: Is the Financial System Ready?

Sebastian Röing (PIIE)
June 30, 2016 12:00 PM

“Some market and economic volatility can be expected as this process unfolds. But we are well prepared for this.” Those were the words of Mark Carney, governor of the Bank of England, following the UK referendum on EU membership last Friday. As PIIE President Adam Posen previously argued, those words were well chosen. There has been contingency planning at both the Bank of England and the UK Treasury. Stress tests reveal that UK commercial banks have relatively robust capital buffers against unexpected shocks.

That Brexit was an unexpected shock is a puzzle. Everybody knew that the UK referendum was coming, and the polls had been close for a long time. The initial reaction in the financial markets was severe. Why, then, did the risk of a potential UK exit from the European Union not feature more prominently in recent financial stability reports published by the world’s leading central banks and other institutions charged with monitoring global finance for signs of vulnerability?

From a selection of 11 major financial stability reports, six omit the risk of a Brexit completely, perhaps most notably the International Monetary Fund’s Global Financial Stability Report of April 2016. It is especially odd given that the IMF’s World Economic Outlook, the companion document, mentions the referendum in the executive summary. While neither report included Brexit in the baseline scenario, it is not clear what we are to make of the difference between the two assessments. Other financial stability reports that omit the risk of Brexit include the Bank of England’s Financial Stability Report of December 2015, Bank of Italy’s Financial Stability Report of April 2016, and the 2015 Annual Report to Congress issued by the US Office of Financial Research in December 2015.

When Brexit is mentioned, it is usually in a brief comment, bundled with uncertainty around the US presidential election, as in the European Central Bank’s Financial Stability Review of May 2016. The Bank for International Settlements’ March 2016 report mentioned Brexit only in passing, saying that it had been partially priced into commodities but that “shifting expectations of monetary policy, the evolution of borrowing costs in major currencies, and further credit-fueled stimulus in China” were the underlying factors for financial turbulence in early 2016.

Financial stability reports are a ubiquitous feature of the post-2008 landscape. Only seven out of the 11 institutions surveyed here even published financial stability reports before the 2008 financial crisis. The reports are a response to the increased demand for continuous monitoring of the banking, financial, and payment systems with an eye to preventing the next financial crisis. They provide a platform for policymakers to explain concerns about financial stability to a wider audience, and they allow institutions to account for financial risks facing trading partners and other countries.

Table 1 below summarizes the view on Brexit risks in all the financial stability reports surveyed. Only the central banks of Sweden and Denmark considered Brexit as a risk worthy of mention in the executive summary.

Once again, this limited sample does not suggest that the institutions surveyed have not done their contingency planning. It is just odd that Brexit isn’t mentioned in several of the most recent, major financial stability reports. And since those reports are framing documents that give the public insight into the collective thinking of policymakers, it begs the question whether Brexit simply was not on the stability guardians’ minds. Maybe, like many other economists trained in rational decision making, they simply thought voters would come around and vote to remain in the European Union—or that the shock of a Brexit would be small or easily contained.

Whatever their reasoning, the result was an unexpected shock to the financial system, which will have consequences that we cannot yet predict. In such a situation, it is comforting to learn that the Bank of England is well prepared. Meanwhile, it is time to prepare for the next shock. Not all risks come with a three-year-long announcement.

Table 1 Summary of Views on Brexit Risks in Financial Stability Reports

Institution

Publication

Date

Biggest risk

Mention Brexit?

Bank of England

Financial Stability Report

December 2015

Emerging-market asset prices

No

International Monetary Fund

Global Financial Stability Report

April 2016

Emerging-market asset prices and sluggish growth in China

No

Bank of Italy

Financial Stability Report

April 2016

Commodity prices and emerging markets

No

Bank of France

Financial Stability Review: Financial Stability in the Digital Era

April 2016

Cybercrime

No

Bundesbank (Germany)

Financial Stability Review 2015

November 2015

Asset prices given expansionary monetary policy

No

US Office of Financial Research

2015 Annual Report to Congress

December 2015

High risk taking in a low interest rate environment

No

European Central Bank

Financial Stability Review

May 2016

Emerging-market asset prices

Yes, briefly on page 21, bundled with US presidential election

Bank for International Settlements

86th Annual Report

March 2016

Shifting expectations of monetary policy, the evolution of borrowing costs in major currencies, and further credit-fueled stimulus in China

Yes

Financial Stability Oversight Council, US Department of the Treasury

2016 Annual Report

March 2016

Commodity prices and sluggish growth in China

Yes, briefly on page 128

The Riksbank (Sweden)

Financial Stability Report 2016:1

January 2016

Political uncertainty and sluggish growth in China

Yes, in executive summary

Danmarks Nationalbank

Financial Stability 1st Half of 2016

May 2016

Political uncertainty and asset prices

Yes, in summary

Sebastian Röing is a master’s student at the Stockholm School of Economics and a 2016 fellow in the Wallenberg International Fellows program at Georgetown University. He is also a summer intern at PIIE, working with Anna Gelpern.