With the Brexit divorce date growing nearer, it remains possible that the U.K. will exit the European Union without a deal establishing the terms of their relationship going forward.
That’s an alarming prospect for banks, as a no-deal Brexit wouldn’t allow for a transition period and could cause chaos in financial markets.
1. Why is this such an issue for banking?
Because Brexit imperils the longstanding working relationships between the City of London financial district and firms on the European continent. Earlier hopes of maintaining the ties through regulatory cooperation and of keeping the so-called passport came to nothing. And even as many U.K. firms have applied for EU licenses and started to shift operations inside the bloc, banks on either side of the English Channel are hoping to avoid a cliff-edge plummet into uncharted territory on the morning after Brexit.
2. What’s the current plan to avoid chaos?
EU officials in Brussels are urging the financial industry to prepare for any outcome and told member states to consider national contingency measures. Yet the European Commission, the EU’s executive arm, hasn’t announced any concrete plans for financial services, saying it needs to see the report of a joint working group between the European Central Bank and the Bank of England to know what the biggest risks to financial stability are.
3. What areas are most worrisome?
The financial industry and U.K. regulators warn that Brexit poses a threat to trillions of pounds of existing derivative and insurance contracts. Other pressing concerns include access to market infrastructure in London, debt issued by EU banks under English law, the flow of data across the Channel and potential new capital requirements for banks. Each of those has unique complications.
4. What happens to existing contracts between U.K. and EU firms?
They won’t necessarily become invalid the day after Brexit. The problem is the activity needed to service them. Some so-called life cycle events, such as extending the maturity of a trade, could require an EU license — which U.K. firms are about to lose. The industry says that grandfathering existing contracts would be the preferred fix as part of any Brexit deal. Short of that, national EU regulators may be pressed to grant temporary licenses to British companies, something that U.K. regulators are already preparing to do vice versa. But authorities in France, the Netherlands and elsewhere currently lack the power to do so.
5. What market infrastructure is in London?
The majority of euro-denominated derivatives clearing currently takes place in London. Should the U.K. depart without a deal, and absent any action by EU authorities, banks could find themselves in breach of regulations that require them to use only recognized venues to clear their derivatives. And banks warn that the sheer volume of the business makes it impossible to transfer all positions to a venue in the EU in time. Also, traders in British stocks would have to redirect dealings in important securities inside the EU if the commission in Brussels doesn’t recognize the U.K.’s rules as equivalent.
6. What’s the problem with debt issued by EU banks?
They often relied on London’s capital market to issue debt, or at least sold securities under English law because it was universally accepted by international buyers. They also did so when issuing bonds that can be used when they run into trouble, which is a regulatory requirement to protect taxpayers from paying for future bank failures. Without any steps by authorities, a big chunk of banks’ issuance could cease to be counted toward these requirements. In the worst case, firms would be forced to re-issue the debt under different conditions. To solve the issue, authorities responsible for handling bank failures could strike an agreement that makes sure they recognize each other’s actions, according to the Association for Financial Markets in Europe, a lobby group.
7. Can’t data still flow between the U.K. and the EU?
Not necessarily. Under the EU’s new data-protection regime, firms can’t just send any personal information outside the bloc. Regulators have warned banks to check where the personal data they handle is stored and to take “mitigating actions” if needed. British lawmakers have called on the EU to issue a so-called “adequacy decision” under its data regulations, which would allow the continued flow of data between the U.K. and the EU.
8. What could a no-deal Brexit mean for capital requirements?
In theory at least, an EU bank’s exposure to a non-EU country such as post-Brexit U.K. requires more capital behind it. In a similar vein, the U.K. government has warned British firms that they may no longer treat EU sovereign debt as risk-free if there is no Brexit deal. Both sides could decide that exposures in each others’ jurisdiction don’t present increased risk, which would extend the status quo. In the EU, this step also would fall to the European Commission, which has in the past issued such equivalence decisions for countries including Brazil, China and Saudi Arabia.