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European banks have cut their exposure to Britain since it voted to leave the EU, removing €350bn of UK-related assets from their balance sheets in just 12 months.
The 17 per cent reduction in UK-related assets shows that banks across the bloc are protecting themselves against the threat of potential losses if the UK crashes out of the EU with no deal in 16 months’ time, triggering uncertainty over financial contracts.
Official EU data released on Friday showed banks across the 27 other EU countries reduced their total assets tied to the UK from €1.94tn to €1.59tn between the Brexit referendum in June 2016 and June 2017.
Banks’ liabilities also decreased over the same period, dropping €1.67tn to €1.34tn, the figures showed. The trend is expected to increase ahead of the March 2019 deadline for the UK’s departure.
The fresh details of how intertwined European banks are with the UK were included in a report by the European Banking Authority, the supervisor of bank supervisors across the EU which is set to move from London to Paris because of Brexit.
The EBA conceded that the risk of a “cliff edge” Brexit was the main cloud hanging over all of Europe’s banking system — and not just over that of the UK.
One-third of banks the EBA polled for its annual risk-assessment exercise were concerned about the legal risks presented if the UK were to crash out of the EU with no deal. These included legal uncertainty around derivatives and other financial contracts, data protection and how court judgments might be enforced.
“It is important that banks and their counterparties, as well as consumers and public authorities, consider appropriate mitigating actions and contingency plans to address these concerns,” the EBA said. “These risks may, in the short term, endanger the continuity of cross-border financial flows and services between financial service providers in the EU27 and the UK.”
Banks that already have EU licences have an added incentive to do their European derivatives business outside the UK, because it is far less trouble than moving derivatives trades from their UK entities to European ones after Brexit.
Banks slashed their holdings of derivatives with exposure to the UK by 35 per cent over the year since the Brexit vote, the biggest asset class to decrease, the EBA said.
The Bank of England has repeatedly warned about the legal uncertainty hanging over vast amounts of derivative contracts and insurance policies in the event of a hard Brexit.
UK banks hold about £20tn in total paper value of derivatives with a cross-border EU element, or about one-fifth or their entire holdings. EU financial institutions hold a similar amount of derivatives with a UK element, according to previous BoE estimates.
Meanwhile, the EBA flagged that uncertainty over the future of monetary policy was also a concern in what was otherwise a picture of improving health at European banks, according to data that it gathered from 132 banks across the bloc.
Overall, the past year has produced an increase in the banks’ average return on equity, while non-performing loans, or NPLs, fell as a proportion of their overall balance sheets and their capital ratios increased slightly.
The EBA said average return on equity increased from 4.5 per cent in June 2016 to 5.4 per cent in June 2017, while pointing out that this still remained far below the roughly 10 per cent cost of equity for most banks.
But the spectre of bad loans still lingers across the continent. The burden of NPLs eased after several banks sold big chunks of their bad debt portfolios, taking the ratio of NPLs to total loans down from 5.4 per cent to 4.5 per cent. However, the EBA said a third of EU banks have NPL ratios above 10 per cent.
The banks with the highest NPL ratios are in Greece, Cyprus, Italy and Portugal. The amount of provisions that banks have taken to cover their bad loans increased to 45 per cent of their total NPL portfolios.
The average common equity tier one ratios of the banks was 14 per cent at the end of June, up from 13.1 per cent a year earlier. The EBA said this mainly reflected asset disposals and shrinking of bank balance sheets rather than major injections of fresh capital.