Play sterling event risk through bank CDS, says RBC

The prospects of a minority-led UK government increase the potential for banks being impacted by sterling event risk, says Royal Bank of Canada in its latest credit research.

Following a period of initial spread widening amongst all UK-centric banks during a downside sterling event, RBC expects credit default swap spreads of the more exposed banks to underperform. In addition, strategists anticipate senior/subordinated credit default swap differential widening at HSBC and CDS curve compression between HSBC and other UK-centric banks. Investors that fear a sterling event are recommended to buy subordinated CDS on HSBC while selling senior CDS in advance of differential widening or outright buy HSBC protection while selling RBS protection across the curve.

A lower likelihood of fiscal consolidation under a coalition government may put downward pressure on sterling-denominated assets. Foreign currency mismatches may have a material impact on capital levels for some UK banks, say strategists.

All UK banks may lose value in a sterling event, as the credit markets react to a currency sell-off. However, a sharp and sustained sterling devaluation may produce new winners and losers in credit relative value.

Having assessed the net foreign assets and risk-weighted assets of each bank by currency, strategists believe RBS would be least impacted while HSBC could suffer a materially negative capital impact from a sterling event relative to other UK-centric banks. Barclays and Lloyds are likely to be less negatively impacted than HSBC, but more than RBS.