How Will Brexit Impact Bank Stocks

The United Kingdom's decision to separate from the European Union has triggered heightened volatility in the global stock market. But no sector has been hit harder than banks, and especially universal banks.

In this clip from the Industry Focus: Financials podcast, The Motley Fool's Gaby Lapera and John Maxfield discuss why this is the case, focusing in particular on banks with traditional banking operations in the United States as well as investment banking operations in the United Kingdom.

A full transcript follows the video.

This podcast was recorded on June 27, 2016.

Gaby Lapera: Can you give our listeners a little bit of background on what has happened to bank stocks since Brexit?

John Maxfield: Bank stocks, we kind of touched on this at the beginning, the S&P 500 now's something like 5%-6%, the FTSE is down something like the same amount, since the Brexit vote, but bank stocks are down twice if not a little bit more than that. The KBW Bank Index, again, this tracks the 24 large-cap banks in the United States. It's down 11.2% since then, since the closing price on -- I think last Thursday -- which we learned the results of Brexit, Thursday after trading hours had closed. It's down by 11.2%, Bank of America (BAC 1.51%) is down 12%. They're being hit roughly twice as hard as stocks in general.

Lapera: Yeah. You might be asking yourself why. There's a bunch of reasons why. Partially it's just that the financial system is so global and interconnected now that what happens in Great Britain unfortunately has a pretty big impact on what happens here in terms of our banking.

Maxfield: That's exactly right. If you look at the reason they're being hit hard, banks are being hit hard, let's just go through it. There's four or five. The first is that this uncertainty in the global economy is causing volatility in the asset market, so debt and equity markets. This volatility is causing trading revenue and investment banking fees to fall at the major universal banks. That's the first thing.

The second thing is that by impacting the confidence of businesses in terms of being able to have any idea what everything is going to look like out of this, it's reducing their incentive. It will reduce their incentive to invest in their businesses. When you reduce a business's incentive to invest in its businesses, you will necessarily reduce the demand for loans. We've talked about this in the past. Banks, what they do, they make money essentially by selling loans. If there's less demand for loans, they're going to make less money.

Third, your higher dollar. The pound fell, the euro fell, the Chinese yuan has fallen. The only one that has increased relative to the dollar is the Japanese yen. What happens when the dollar increases even further in value than it has been since the financial crisis is that that reduces U.S. exports, it hits profits of large U.S. based multinational companies that are earned in other countries. All this stuff lowers economic activity. If you lower economic activity, again, that will translate into lower demand for loans, and it could also translate, in fact, into higher loan losses if this were to push the U.S. economy into a recession or something along those lines.

Lapera: Right. Hold on. Just so listeners know, the reason that this is happening, why the pound going down and the U.S. dollar increasing is not great for the United States, you think, "Oh, our currency is getting stronger, that's good," [but] it makes our products more expensive for people to buy abroad so they're less likely to buy them. Companies make less money. 

Additionally, with the loans, if the loan amount is in dollars but you're paying it back in a different currency ... You're going to have to make a lot more to pay that back now.

Maxfield: Yeah. To that point if you look at like a JPMorgan Chase (JPM 0.95%), it's got something like $50 billion worth of cross-border exposure to the European continent so you have loans that are being paid back in dollars, but are priced over there in their own currency. As those lose it's going to be harder to service that debt.

Lapera: Yeah. This all impacts interest rates as well right?

Maxfield: That's exactly right. The final two things -- and this is a big thing -- for a long time there was conversation that the Federal Reserve was on the verge of increasing interest rates as unemployment had dipped below 5%, inflation was starting to show signs of life again. The Federal Reserve came out last week, actually before the Brexit vote, and said after the May jobs report which showed the lowest increase in jobs growth on a monthly basis in over five years, the Federal Reserve came back and said look we're actually going to be less aggressive in terms of raising rates. We're not going to raise them in June at the very least.

Now with the Brexit vote and all that's happening, that is going to probably further delay that timeline. The reason that matters for banks is because banks make money obviously off their loan portfolios and a lot of their loan portfolios are indexed to the current interest rates. As interest rates go up, they will earn more interest income from those portfolios which will then boost their revenue. As interest rates stay low, it just produces a stagnant revenue environment for banks.

The final reason that this is bad for banks is that, and this is with respect to universal banks, for those that have both commercial and investment banking operations, is because -- and particularly ones that have large bases in London, which is JPMorgan Chase, Bank of America, Goldman Sachs, Morgan Stanley -- all those big fancy high finance banks in the United States, they're going to have to, assuming this goes through, they are going to have to probably move a lot of their people that are based in London to the European continent.

What our banks would do is they would send their employees to London with passports to which is a major financial center, but then they could operate anywhere in the European continent because the passport was good anywhere. Now they're going to have to send them actually into the European continent assuming the referendum actually gets put into effect, and that will cost money just because they're having to reorganize their operations.