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U.K. banking stocks are getting crushed today. Lloyds Banking Group (LYG 0.80%), Barclays (BCS 1.54%), and Royal Bank of Scotland Group (NWG 0.58%) are down by 25%, 20%, and 22%, respectively, as of 1:20 p.m. ET on Friday. It's all about Brexit -- the shocking decision by U.K. residents to leave the European Union.
This is something of a panicked response by investors, who have clearly chosen to sell first and ask questions later. As some of the U.K.'s largest banks, these three are being sold off partly because of their exposure to European financial markets.
Volatility in financial markets has been incredible since Britons voted on whether the U.K. should remain part of the European Union. The British pound is down nearly 9% against the dollar today alone. To put that in perspective, the Pound fell just 4% when Soros made his famous trade that "broke the Bank of England."
There are, of course, secondary effects of Brexit. Banks, which have suffered through low interest rates across the globe, are getting hit hard today as safe-haven assets like government bonds surge in value. 10-Year U.K. Gilts that yielded about 1.37% yesterday now yield just 1.07%.
The rush to safe-haven assets is driving down yields, and compressed yields are a bank's worst nightmare. All loans, of course, are written with a spread over the so-called "risk-free" rate on government bonds. When government bond yields drop, loan yields should follow; bad news for the U.K. banks. Some analysts are suggesting that the Bank of England, which has held its benchmark rate at 0.50% since 2009, could bring its benchmark interest rate to 0% in an effort to stave off recession.
Speaking of recession -- the primary concern right now is how the decision to leave the European Union will affect the U.K. economy, and naturally the biggest banks' borrowers. Before the vote, the IMF said point blank that a vote to leave would send the U.K. into recession next year, and that it could erase up to 5.5% of GDP under the IMF's worst-case scenario.
For lenders like Lloyds Banking Group, Royal Bank of Scotland, and Barclays, a recession would bring an increase in loan losses at a time these three banks are already earning low returns on equity. U.K. banks are still in bad shape. Emergency investments by the government in Lloyds Banking Group and Royal Bank of Scotland as part of a response to a 2008 crisis still haven't fully made it back into private hands (Royal Bank of Scotland is still more than 70% owned by the U.K. government).
What ultimately comes of Brexit is impossible to say. Though the U.K. decided to leave the EU in a vote that took place on a single day, the actual mechanics of leaving the European Union will take two years or more as new agreements on trade, immigration, and other issues are written to replace those that currently exist as part of the U.K.'s EU membership.
