Yes, you should panic about Brexit

Plenty of people in markets and politics have been decrying the market reaction (or overreaction) to the Brexit vote, especially in Australia, 15,000 kilometres away from Britain and the European Union. But that’s ignorance at work, because they fail to look at our most exposed group: those big four banks and the nearly 40% of their funding they borrow each year from offshore.

Those credit lines remain viable, partly because Australia still has a triple-A credit rating, unlike Britain, which lost its last rating from Standard & Poor’s overnight; its rating was lopped two notches to AA, with a negative outlook, and Fitch knocked one notch off its rating to the same level, also with a negative outlook, meaning more cuts ahead. But the most worrying development wasn’t related to Brexit (and this why we should worry in Australia).

But the Italian banks will be the first victims of Brexit, and rescuing them will be important for Australian banks because if an Italian bank wobbles and has to be rescued in emergency circumstances, it will be Lehman Brothers replayed, with credit banks freezing and the Reserve Bank of Australia’s Committed Liquidity Facility being triggered to keep our banks liquid and able to operate.

[Brexit — the shockwaves spread out from a departing Britain]

The Italian government let slip that it is going to ask for EU exemption on state aid rules to allow it to inject up to 40 billion euros into the country’s struggling banks. A move several months ago to set up a good/bad bank arrangement to handle dud loans held by the banks has failed, even though 10 billion euros was set aside. The banks have 200 billion euros of dud loans, of which an estimated 85 billion are considered to be so bad they have little or no value.

The share price of Italian banks crashed for a second day overnight, with Intesa Sanpaolo off 12.5%, and falls of 12% for Banca MPS, 10.4% for Mediobanca, and 8% for UniCredit. These lenders have lost a third of their value since Britain’s vote on Thursday of last week.

UK bank shares are also under pressure, especially the government-controlled RBS and the partly controlled Lloyds. Barclays, the independent UK banking giant, has had its value fall 37% on Friday and Monday.

CYBG Plc — the UK bank once owned by the National Australia Bank, but now a separate company listed in Australia and the UK — has quickly emerged as a bellwether for the UK crisis in Australia; its shares slumped by more than 26% on Friday and Monday.

And watch that triple-A rating for Australia. While Moody’s and Fitch have both maintained our triple-A rating from them (but warned about spending and the budget position in coming years), Standard & Poor’s has been quiet and is understood to be waiting to the election result. It would not surprise some in the markets if S&P issued a formal warning in the next few weeks about Australia’s triple-A rating by putting us on a negative outlook given the huge spending pledges in the campaign (especially from the ALP), coming on top of the Brexit problems.

The government’s election finance audit today will be vital in S&P’s assessment, especially how the $48 billion corporate tax cut will be paid for in coming years. Both Moody’s and Fitch have already pointed to the need for more revenue as well as spending controls.

Moody’s, in fact, pointed out (after giving the 2016-17 budget a qualified tick) that the slower pace of fiscal consolidation (moving back to a surplus) had left the economy vulnerable.

“However, a slower pace of fiscal consolidation will leave public finances vulnerable to negative shocks, in particular a potential marked downturn in the housing sector and a reversal in currently favourable external financing conditions.”

We now have a looming crisis with Brexit, and if that spreads to the banks then the crisis becomes very real for Australia.