Fed watching Brexit developments; will continue to emphasize strong capital, risk management practices

The implications of a “hard Brexit” could be troubling to the global financial system, federal financial regulators warned Tuesday, and for that reason they will continue to stress strong capital levels and risk-management practices.

During a meeting of the Financial Stability Oversight Council (FSOC) Tuesday at the Treasury Department, regulators – including Federal Reserve Chairman Jerome H. (“Jay”) Powell – noted implications for the U.S. financial system for the withdrawal of the United Kingdom from the European Union (known as “Brexit”) widely expected to occur next year. A “hard Brexit” envisions an agreement where the UK would leave not only the EU but also the EU’s Single Market (of which non-EU countries are also members) and the EU Customs Union (of which non-EU countries are also members).

“There is some uncertainty about the course of events going forward, and for this reason we will continue to support strong capital levels at U.S. banks and strong risk-management standards at critical financial market infrastructures,” Powell said.

The Fed chairman said the largest U.S. banks (the global systemically important banks, or G-SIBs) with material exposures in the U.K. are implementing plans for business continuity, and he said they are executing long-term changes to operations, assuming they may lose passporting rights to EU as a result of Brexit.

He noted, however, that U.S. banks’ exposure to the UK are small relative to their capital levels. But that’s not the case for U.S. banks’ exposure to the EU, which he called “more significant.”

“That suggests that a slowdown in the EU economy following Brexit could indirectly affect those banks and their profitability,” Powell said.

He said the Fed is monitoring legal developments – including continuity of OTC derivative contracts, ability of central counterparties in the UK to continue to clear derivatives for EU clearing members and their customers, and the ability of UK-domiciled payment systems to continue to provide cross-border settlements in certain EU jurisdictions.

“The large size of these key markets and activities suggest that continued uncertainty in these areas increases the importance of reaching effective solutions to avoid financial stability risks,” Powell said.