European banks have reduced their exposure to Britain since it voted to leave the EU, removing 350 billion euros of UK-related assets from their balance sheets in just 12 months.
The 17% reduction in UK-linked assets shows that banks across the bloc are hedging against the threat of potential losses if the UK leaves the EU without a deal in 16 months, triggering uncertainty over financial contracts.
Official EU data released on Friday shows banks in the other 27 EU countries reduced their total UK-related assets from 1.94 billion euros to 1.59 billion euros between the referendum on Brexit in June 2016 and June 2017.
Bank liabilities also fell over the same period, from 1.67 billion euros to 1.34 billion euros, according to the figures. The trend is expected to increase before the March 2019 deadline for departure from the UK.
The new details of European banks’ intertwining with the UK were included in a report by the European Banking Authority, the supervisor of banking supervisors in the EU which is set to move from London to Paris due to Brexit.
The EBA has admitted that the risk of a Brexit “on the edge of the cliff” is the main cloud hanging over the whole of the European banking system – and not just that of the United Kingdom.
A third of banks surveyed by the EBA as part of its annual risk assessment exercise were concerned about the legal risks presented if the UK were to exit the EU without a deal. These included legal uncertainty around derivatives and other financial contracts, data protection and how court orders might be enforced.
“It is important that banks and their counterparties, as well as consumers and public authorities, consider appropriate mitigation measures and contingency plans to address these concerns,” the EBA said. “These risks may, in the short term, jeopardize the continuity of cross-border financial flows and services between EU27 and UK financial service providers.”
Banks that already have EU licenses have an added incentive to do their European derivatives business outside the UK, as this is much less of a problem than moving derivatives trading from their UK entities to European entities after Brexit.
Banks have cut their holdings of UK-exposed derivatives by 35% on the year since the Brexit vote, the biggest asset class to shrink, the EBA said.
“The 35% year-on-year decline in derivatives exposures between EU27 banks and the UK is substantial and shows that some risk management strategies are being adjusted well before March 2019,” said Marcus Evans, Partner at KPMG LLP.
The Bank of England has repeatedly warned of legal uncertainty hanging over vast amounts of derivative contracts and insurance policies in the event of a hard Brexit.
UK banks hold around £20,000,000 of total paper value of derivatives with a cross-EU element, around a fifth or all of their holdings. EU financial institutions hold a similar amount of derivatives with a UK element, according to previous BoE estimates.
Meanwhile, the EBA signaled that uncertainty over the future of monetary policy was also a concern in what was otherwise a picture of improving health for European banks, according to data it said. has collected from 132 banks across the bloc.
Overall, the past year has produced an increase in banks’ average return on equity, while non-performing loans, or NPLs, have declined as a proportion of their overall balance sheets and their capital ratios have increased slightly. .
The EBA said the average return on equity rose from 4.5% in June 2016 to 5.4% in June 2017, while stressing that this was still well below the cost of equity by around 10% for most banks.
But the specter of bad debt still hangs over the continent. The burden of NPLs eased after several banks sold large chunks of their bad debt portfolios, reducing the ratio of NPLs to total loans from 5.4% to 4.5%. However, the EBA said that a third of banks in the EU have NPL ratios above 10%.
The banks with the highest NPL ratios are found in Greece, Cyprus, Italy and Portugal. The amount of provisions banks have taken to cover their bad debts has risen to 45% of their total bad debt portfolios.
Average Tier 1 capital ratios for banks were 14% at the end of June, down from 13.1% a year earlier. The EBA said this mainly reflected asset disposals and the reduction of bank balance sheets rather than large injections of fresh capital.