How Brexit Raises Risk of Financial Instability for U.S.

July 26, 2016

The U.S. financial system faces greater potential instability due to Britain’s decision to leave the European Union while low and negative interest rates also raise risks, a U.S. government monitor said on Monday.

In its biannual update on U.S. stability, the Office of Financial Research said overall risks “remain in the medium range but have been pushed higher by the United Kingdom vote to exit the European Union.”

Risks have been in that range for at least 18 months, said Richard Bermer, director of the office, which provides regulators with analyzes intended to help prevent a major financial crisis, at a press conference.

Bermer added, though, the Brexit vote’s effects could be felt in the United States for a while, as finalizing details of Europe’s divorce will take years.

“Larger shocks to confidence are possible as those deliberations and negotiations play out,” he said. “Because the U.K. economy, and especially the U.K. financial system, are highly connected with the rest of Europe and United States, severe adverse outcomes in the U.K. and spillovers to Europe could pose a risk to U.S. financial stability.”

Britain’s referendum roiled markets last month, sending long-term interest rates in the United States, the United Kingdom and Germany to historic lows. Of late, markets have returned to more stable footing.

The office found financial claims from U.S. banks, insurance companies, asset managers, hedge funds and others on U.K. entities total $2.1 trillion, or 11.3 percent of the U.S. economy. Claims on European Union entities, minus the United Kingdom, total $2.9 trillion, or 15.9 percent of U.S. GDP. Those numbers do not include derivatives or guarantees.

Brexit upheaval could make banks vulnerable, as a downturn in the British economy would likely slow down loan growth, Berner said. Banks are already under pressure from low interest rates, although Berner said they are more resilient than a decade ago.

“Long-term U.S. interest rates have declined to ultra-low levels, which can motivate excessive risk-taking and borrowing,” he said. “Many key foreign interest rates are now negative with uncertain consequences for financial stability.”

Long-term U.S. interest rates have fallen markedly since 2014, partly due to falling and negative rates in Europe, and Brexit could “prolong negative interest rate policies in the euro area and elsewhere,” the office found.

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