Brexit Beckons…and Aussie Banks in Need of More Capital…Again

3d image of flying pound money

It’s going to be wall-to-wall Brexit talk this week. The Brits hit the polls on Thursday, so you should have a pretty good idea of the outcome by Friday.

I have no idea what the result will be. But I suspect fear of the unknown will get the ‘remain’ vote over the line. Markets are punting on this outcome too as the week gets underway.

On resumption of trading this morning, gold dropped around US$15 an ounce, suggesting the market thinks the UK will lump it with the European Union (EU).

Based on the articles I read over the weekend, it seems every person of power and influence thinks the UK will practically disintegrate if it votes to leave. 

Here’s Paul Kelly writing about it in The Australian:

The strength of global opinion is revealing. The only conclusion is that leaving is seen as an act of strategic recklessness. US President Barack Obama has deliberately intervened to appeal to Britain to stay.

So have Japan’s PM, Shinzo Abe, Germany’s Angela Merkel and France’s Francois Hollande. Eastern European opinion is extreme for Britain to remain. German public opinion is strongly against Brexit. Malcolm Turnbull and John Key support the Remain cause, with Turnbull saying it is the wise option.

With a line-up of ‘remain’ opinion like that, it makes me want to side with the leave campaign. It sounds like they need some support.

Clearly, Britain remaining in the EU is a vote for the status quo. The world’s major nations don’t want to deal with the fallout if Britain decides to go its own way.

It’s clearly in their interests for the UK to remain. But this isn’t about anyone else. It’s about what the British people want. Or at least it should be. For what it’s worth, I hope democracy is the winner on the day. Let the people decide.

I just hope they don’t consume the opinions of the world’s ‘elites’ too much in the lead up. For example, last week, the BBC ran with this hyperbolic quote from President of the EU council, Donald Tusk:

“As a historian I fear Brexit could be the beginning of the destruction of not only the EU but also Western political civilisation in its entirety,” he told the German newspaper Bild.

Jeez. No pressure, leave voters. Feel free to vote, but you will bring down civilisation as we know it if you decide to go your own way.

This is the EU’s way of saying they will make things very difficult for the UK if they do decide to leave. They don’t want any other separatist movements emboldened by a leave vote. Make no mistake; the UK will be punished if they walk away from the EU.

Global stock markets won’t like it either. They’re worried, but they’re not pricing a Brexit outcome in yet. As I mentioned, stock markets are backing a ‘remain’ outcome as the week kicks off.

How could they price in a Brexit anyway? No one knows what such an outcome would look like, or what the flow-on effects would be.

Central bankers no doubt have their hand on the interest rate button should ‘leave’ gather any momentum, in the hope that another flood of liquidity will sooth the jitters.

The only problem with that strategy is that the additional liquidity will go straight into the bond market, pushing yields lower and, in many cases, even further into negative territory.

Why is this a problem?

Negative interest rates are slowly crushing the global banking system. This is especially a problem in Europe. European banking stocks are down around 25% so far this year.

That’s despite European Central Bank boss Mario Draghi reinflating the ECB balance sheet back to the highs of 2012. All that liquidity is going into government bonds, smashing bank profitability in the process.

Banks hold government bonds on their balance sheets. If these bonds generate a very low, or even negative, yield, it reduces banks’ earning power.

After the Brexit circus subsides, this issue of negative yields will become increasingly problematic for the global banking system.

And while it hasn’t hit the Aussie banking system just yet, we have our own issues to worry about.

That is, the second half of the year will see a renewed focus on capital raisings by the Big Four banks. As The Australian reports today:

A lull in the regulatory capital storm engulfing the major banks is set to end, refocusing attention on potential equity raisings as their surcharge for being a risk to the economy may be doubled and global rules are set in stone.

Put simply, the bank regulator APRA wants the banks to have greater capital buffers. According to NAB credit analysis cited in the article, the Big Four banks are around $30 billion short of ‘tier one’ capital, meaning that each bank needs to raise an additional $6 billion in equity on average.

That means more shares on issue and lower earnings per share in the future for the banks.

Perhaps that’s why the sector continues to languish. For example, benchmark bank stock Commonwealth Bank [ASX:CBA] is trading near its lows for the year.

As you can see in the chart below, CBA’s share price is really struggling. Following the early year selloff, it hasn’t been able to get above $80. Strong support remains around $70 but a break below here would be extremely bearish for the sector.

Source: BigCharts
[Click to enlarge]

Is the recent selloff related to Brexit jitters? Or are investors starting to price in a tougher regulatory environment, where banks will need to raise more capital in the months ahead.

We’ll find out soon enough. The Brexit news cycle will exhaust itself and the market will soon move on to a new set of worries.

In Australia at least, the banking sector could be a good candidate for the worrywarts.


Greg Canavan,
For The Daily Reckoning

Greg Canavan
Greg Canavan is the Managing Editor of The Daily Reckoning and is the foremost authority for retail investors on value investing in Australia. He is a former head of Australasian Research for an Australian asset-management group and has been a regular guest on CNBC, Sky Business’s The Perrett Report and Lateline Business. Greg is also the editor of Crisis & Opportunity, an investment publication designed to help investors profit from companies and stocks that are undervalued on the market. To follow Greg's financial world view more closely you can subscribe to The Daily Reckoning for free here. If you’re already a Daily Reckoning subscriber, then we recommend you also join him on Google+. It's where he shares investment research, commentary and ideas that he can't always fit into his regular Daily Reckoning emails. For more on Greg go here.

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