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To Brexit or not to Brexit:

To Brexit or not to Brexit

So what is next?

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Imagine the following scenarios:

An exchange rate loss of 5-10% for the British pound, several interest rate hikes by the Bank of England, a change in the reporting process for derivatives, an abrupt change in the core banking strategy, and more. All these scenarios may turn into reality as a result of the UK's unsmooth withdrawal from the European Union. In particular, recent negotiations have been fraught with uncertainty, and at the time of writing this article, it was still completely unclear whether, how and when Brexit will be implemented and what the specific consequences will be. There are two possible scenarios: either a hard Brexit on the 29th of March or a possible extension of the deadline with the hope of clearing up all outstanding issues between the EU and the UK.

But what does Brexit mean for treasurers in particular? What are the implications on the way treasurers do business? How will business relationships be affected? 

While far from easy questions, they certainly touch upon some of the issues that treasurers need to consider in order to be prepared for the future. In this article we would like to discuss some of the issues relevant to your treasury.

Questions in regard to financing

Financing is one of treasury's core functions. Due to its complexity, financing also has an impact on many other treasury areas, such as cash and liquidity management, foreign exchange and interest rate management or bank relationship management. Financing is often used to meet liquidity needs and is provided either by banks or by capital markets. Both would be severely affected by a no-deal Brexit. This could put treasurers in an undesirable situation where they have a liquidity deficit that cannot be covered. And since we have often seen profitable companies go bankrupt due to liquidity problems, avoiding this situation should be paramount for all treasurers. The following questions can help avoid this situation:

  • How will a no-deal Brexit affect the overall financing strategy? Is a change in the capital structure necessary (debt vs. equity)? 
  • Were scenario and gap analyses performed and were relevant interest rates and exchange rates benchmarked to assess their impact on cash flow in case of a change in financing costs due to revaluation and changed spreads?
  • Should a smaller financing room for credit lines and/or stricter covenant criteria be expected? How likely is it that credit lines will be canceled?
  • Have alternative financing sources been considered in the context of a possible credit crunch in the UK? 

Although it is impossible to provide a one size fits all answer to all of these questions, the following points should nevertheless be considered when searching for a solution:

  • Structure of the credit portfolio
    • What are the percentages of medium and long-term loans?
    • What are the committed and uncommitted loans?
    • What are the base currencies for the loans?
  • The current low interest rates may change, hence affecting financing costs. This must be closely monitored with a thorough sensitivity analysis to verify the impact on cash flows.
  • In order to avoid covenant breaches, it is imperative to closely monitor all covenant criteria and execute multiple scenario analyses.

The company's capital structure in terms of debt, equity and credit portfolios and underlying currencies must be analyzed appropriately. For instance, a situation could arise where the Bank of England and the European Central Bank take two opposing approaches on interest rates, which could then have a significant shock on liquidity, interest expenses and credit prices.

In addition to evaluating the company’s financing and its sources, there should also be a thorough assessment of the usual external providers of financing: the banks. This leads us to Bank Relationship Management.

Questions regarding Bank Relationship Management

Brexit will affect banks in a very similar way to companies, which means that banks may also have to change their strategic direction and risk appetite. In such a situation, they tend to re-evaluate their current customer base, much like treasurers could re-evaluate their banks.

In this situation, treasurers may want to ask the following questions:

  • What could a change in corporate strategy mean for existing banking relationships?
  • Will banks continue to meet the investment criteria even after a change in their credit rating?
  • How will changes in the banks’ strategy and risk appetite affect us?
  • What is the impact of Brexit on the banking sector in the UK in general? 

The following two externally driven questions as a result of a changed banking strategy are also important:

  • What happens if a bank decides to withdraw from certain countries? 
  • And what happens if a bank changes its risk appetite and decides to focus only on a few core industries and customers? 

For treasurers, this may mean unwanted changes in business activities and have implications on the company's core banking strategy.

Treasurers can try to counteract legal uncertainty and ambiguity by shifting business from UK banks to continental banks. Before doing that, however, there are specific points that treasurers should consider first:

  • Possible changes in bank partners and revisions of the approved bank list
  • Communicating with relationship managers for early advice on when a bank might withdraw from a particular business area
  • Creation of a strategy to address the segregation of banking within and outside the EU and within the Eurozone
  • Monitoring of banks’ credit ratings, as a change in the credit rating could mean that current investment criteria are no longer met

And last but not least, transferring existing derivative transactions from the UK to continental banks could have undesirable accounting effects. According to IFRS 9, a change of bank means a significant change in business parameters and thus the derecognition of the previous transaction and the recognition of a new transaction. For this reason, the existing hedge accounting would have to be terminated and a new hedging relationship should be designated. This can only be avoided by relocating to a branch of the UK bank which has the same credit risk as the London head office.

Questions regarding counterparty risk

Just as banks evaluate their customer base and risk appetite, companies and treasurers must also evaluate their counterparty risk. This is because a changing economic environment may affect creditworthiness. Some investments previously considered attractive will now become riskier and may no longer meet the company's risk policy. The main questions that need to be asked here are therefore:

  • How will counterparties' risk profiles change if their credit ratings change?
  • Are there any scenarios addressing a potential change in hedging costs?

Treasurers can counteract this in several ways. When assessing the approach, the following aspects should be taken into account:

  • Thorough analyses to check if any additional collaterals from the counterparties will be needed
  • Monitoring the impact of credit rating changes on subsidiaries

Questions on derivatives and regulatory requirements

Brexit will also lead to changes in the regulatory environment, such as in the reporting process for derivatives. The European commercial register Regis-TR has already announced the introduction of a new UK commercial register, which will also serve British companies.

As of today, it is expected that a separate UK register will exist as of the 1st of April 2019. For self-reporting entities, however, this initially only means that the counterparty must be stated as "non-EU" so that the register does not attempt a reconciliation.

The following must therefore be observed:

  • As of the 1st of April 2019, it is likely that UK companies will no longer have to report their derivatives to Regis-TR under EMIR, but rather to a trade repository recognized by the UK supervisory authorities under UK law.
  • Regis-TR has created a separate Trade Repository for this purpose.
  • The reporting is expected to be very similar, but not identical.
  • On-behalf reporting is possible, but must be made to the UK-TR – a cross-reference to EU-TR is not possible.

With a variety of instruments that can be used to hedge risk, the main question should be here:

  • Which instruments should be used to hedge expected currency/interest rate fluctuations? Options or forwards?

Many companies use forwards because they do not require premium payments. Options, on the other hand, are a good way to protect against downturns, but given their higher volatility, the cost could be significant. One strategy could be to identify the worst exchange rate your company is willing to accept and then set the strike price accordingly.

 

Questions for Cash Managers

Cash managers need to examine the impact of Brexit on their business. As many companies have cross-border activities, this is where international cash management comes in. One of the main questions cash managers need to ask themselves in this context is:

  • How will Brexit affect my overall cash management strategy?

When answering this question the following should be considered: 

  • Advantages versus disadvantages of different types of cash pools (for example, notional pools vs. zero-balance agreements).
  • In times of uncertainty, there is usually a tendency to accumulate more liquidity, for example to reduce counterparty risk, to have the needed operational flexibility, or to create buffers for unplanned crises or acquisition opportunities. Treasurers must consider the ramifications of excess cash until conditions normalize.

So what is next?

Whether a hard Brexit or an extension takes place, you should be prepared. Ideally, you should have started and maybe already completed preparations for many possible scenarios, including a "No-Deal Brexit". Are you ready to face a no-deal Brexit scenario? One thing that is clear is that the Brexit will not end on the 29th of March. You should be prepared for a long and complex process.

Source: KPMG Corporate Treasury News, Edition 89, March 2019

© 2019 KPMG AG Wirtschaftsprüfungsgesellschaft, ein Mitglied des KPMG-Netzwerks unabhängiger Mitgliedsfirmen, die KPMG International Cooperative (“KPMG International”), einer juristischen Person schweizerischen Rechts, angeschlossen sind. Alle Rechte vorbehalten.

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