10 Things Community Banks Should Think About After Brexit

By Leonard J. DeRoma, Invictus Co-Founder

Britain has voted to exit the European Union .The Federal Reserve says it is monitoring the situation for potential disruption to the U.S. economy. Here are a few things (in no particular order) to think about as the world economy sails into uncharted waters:

• The dollar has strengthened versus the euro and pound.  The dollar strength will make it difficult for the Fed to raise rates significantly.  Why?  Because any increase in rates will bring additional strength to the dollar, which in turn makes our exports more expensive and less competitive.
• The dollar strength combined with the uncertainty in Europe will attract more foreign capital to the United States.  Safe money will invest in U.S. Treasuries and gold.  Other money will be attracted to hard assets such as commercial and residential real estate, as both wealthy individuals and companies look to park assets.  Already inflated real estate values could become even more inflated, particularly in high profile areas such as New York, Boston, San Francisco, and Miami.
• Rate volatility will continue.  The Volcker rule, which was required as part of the Dodd-Frank Act, affects the levels of bond inventory large banks can carry in trading assets.  The reduced inventory leads to less liquidity, which leads to more volatility.  That being said, the Federal Reserve issued a statement that it is prepared to provide dollar liquidity to central banks through existing swap lines. And it’s also conceivable that the Fed could discuss another round of quantitative easing, which would artificially alter economic growth.
• The trough in rates that commenced in the 2008-2009 recession will most likely continue for the foreseeable future. Rates have actually declined.  As of this writing, the U.S. Treasury 10-year note, a benchmark for many lending assets including home mortgages, is approximately 100 basis points below where it was a year ago.  More than anything else this will continue to put pressure on banks’ NIMs as banks write new loans and replace higher yielding, maturing loans.
• It will continue to be difficult to buy securities for liquidity or investment purposes that achieve the necessary or desired yields.  Banks with excess deposits having to acquire assets will simply find it impossible to replace or increase the size of the securities portfolio at adequate rates without taking on greater risk.
• Bank customers with international operations, revenue sources, or supplies may be affected.  While the largest 100 banks have both the most international customers and American customers with international revenues or operations, the community bank market is not insulated.  Banks need to examine their customer bases that have international exposure.  The risk to the customers and ultimately to the bank depends on the kinds of business, geographic markets, and exchange risk absorbed by those customers.
• Don’t be surprised if your regulator comes to you and asks about your exposure to European markets and whether you have a stress test that looks at the capital adequacy in the current scenario. While the CCAR and DFAST stress testing did not include a specific scenario for something like this, the success of the larger banks in passing the Severely Adverse Case both last year and this year provides some comfort to the regulators.  It might make sense to identify those customers with European exposure and apply a different set of stresses to them.
• It’s possible that regulators might increase capital requirements and tighten credit processes. Banks should do their best to negotiate their true capital requirements with regulators now.
• Weaknesses in large bank stocks may follow through to the community bank market, or community banks with little or no international exposure may do better. No one knows for sure, but equity markets will continue to be volatile.  This could change the traditional valuation of acquisition multiples for buyers and sellers.  However, proper analytics of the core lending portfolios will still be able to discern the wheat from the chaff in acquisition targets.  The volatility and reduced multiples could create interesting opportunities for banks with FreeCapital™.
• The success of the Brexit vote may increase the confidence of other European countries to dump its membership in the EU, which will cause more instability. Such a situation will bring more unemployment to Europe and reduce global growth; the U.S. will not be immune.

The only thing we know about the above list is that it will change.  These are very fluid times, and banks need to be prepared for both the problems and opportunities that arise.