Brexit and investment banks

One of the biggest impacts of Brexit will probably be felt in the financial services industry and within that by investment banks as the EU’s central hub, London, will lose full access to the single European Market.

Foreign banks dominate in London’s investment banking business. Much of their business is conducted through branches which currently use the single European passport to provide services to the entire EU. It therefore comes as no surprise that investment banks’ biggest concerns about Brexit centre on market access: how will they be able to carry on cross-border business once the UK has left the EU? And to what extent they will be forced to set up new subsidiaries in key markets, or at least increase their presence on the ground?

In the immediate term, like most other businesses investment banks are hoping that the Withdrawal Agreement will be agreed providing for a transitional period to the end of 2020. Many feel that a hard Brexit (where the Withdrawal Agreement is not agreed) may damage their business, although the introduction of a temporary permissions regime by the UK Government may soften the blow at least for those EU investment banks that passport into the UK (there is no EU equivalent of the temporary permissions regime).

Unless UK investment banks are established in an EU27 it appears likely that their continued access to the EU27 in a hard Brexit scenario will be limited to instances where the European Commission has granted a positive equivalence determination under relevant EU legislation like MiFID II/MiFIR. The limitations of the Commission’s equivalence regime have been well reported and will not be discussed here. However, given the UK’s membership of the EU it is expected that positive equivalence determinations will be forthcoming although surprisingly the Commission has given little indication of this. In its White Paper on the future EU/UK relationship the UK discusses a form of mutual market access with the EU27 but it remains to be seen how far these proposals will go. From the EU perspective, it’s worth noting that the European Parliament has been reviewing the current equivalence process and it’s Committee on Economic and Monetary Affairs Committee approved a report in the summer which advocated a greater role for the EU institution and for equivalence decisions to be made via delegated acts.

As our earlier Brexit survey for the Association for Foreign Banks noted, a clear red line for many EEA banks operating in London was the requirement to subsidiarise post Brexit on the basis of increased capital and liquidity requirements, and the uplift in costs of doing business generally. However, the requirement to subsidiarise does not seem to be materialising, at least for wholesale banking in the UK.

Earlier this year when the PRA updated its approach to international banks it recognised that whilst branches offered less supervisory control than subsidiaries they were an important component of the global economy. Therefore the starting point for the PRA is that internationally headquartered banks can operate in the UK either as subsidiaries or as branches. However, there are a number of factors that will determine the PRA’s preference as to which route a bank must take. This includes whether the bank as a whole can meet the PRA’s Threshold Conditions and whether there is sufficient supervisory cooperation with the home state supervisory authority. Critically, where the bank expects to undertake significant retail activities in the UK, the PRA will expect a subsidiary to be established.

The UK’s approach to international branches may be a potential flashpoint with the EU. Sam Woods noted this when giving evidence to the House of Commons’ Treasury Select Committee earlier this year. Mr Woods said: “Our perspective is basically that retail activity, both insurance and banking, should be local, ring-fenced and in subsidiaries; wholesale finance is naturally cross-border and we should find ways to make that work within a suitable regulatory framework. That stems a lot from our history overseeing a major financial centre. Our [European] colleagues do not have that experience to the same degree, and that motivates a mind-set that is more local, more ring-fenced and more like what we do for retail, for everything. I think that is going to become a point of tension as we advance through this process.”

The European Central Bank’s (ECB) FAQs for relocating to the euro area certainly pick up on this theme of localisation. In response to a question on whether a bank can continue to provide services to customers in the EU from a branch in London post Brexit the ECB responds by saying that: “The ECB and the EU27 national supervisors believe that the purpose of branches in third countries is to meet local needs. The ECB and national supervisors do not expect that branches in third countries perform critical functions for the credit institution itself or provide services back to customers based in the EU.”

Differing approaches can also be seen as regards the supervisory approach to cross-border booking arrangements with the UK authorities opting for a more open internationalist approach in contrast with the EU again taking a more local approach.

In its August 2018 Dear CEO letter concerning cross-border booking arrangements the FCA said that it was open to a broad range of legal entity structures or booking models. These include the use of back-to-back and remote booking, provided their associated conduct risks were effectively controlled and managed. The FCA’s starting point is not to restrict business models but to understand the principles and practice involved and how the conduct risks that arise from them are managed. As such the FCA stated that booking models should comply with the following principles

• Firms should set out a clear rationale for their booking arrangements, document them and have them approved by the board.
• Risk management should be appropriate for the firm’s booking activities including hedging arrangements.
• There should be a broad alignment of risk and returns at the entity level.
• Firms should have adequate systems and controls in place to ensure that booking arrangements are followed.
• Firms should consider whether responsibility for oversight of booking arrangements should be explicit in statements of responsibilities.
• Booking arrangements should not be an impediment to the firm’s recovery and resolution.

The FCA added that it expected UK boards and senior managers to ensure that effective governance was in place to identify and mitigate the potential harm which could arise from modified booking arrangements.

In contrast the ECB has taken a fairly conservative approach to booking models and empty shells. Essentially its position is that banks in the EU27 should be capable of managing all material risks potentially affecting them independently at the local level, and should have control over the balance sheet and all exposures. The bank must be in a position to be able to respond directly and independently to enquiries by the ECB and relevant EU27 national supervisors on all activities affecting the bank and provide information swiftly. In addition, governance and risk management mechanisms must be commensurate with the nature, scale and complexity of the business and fully comply with EU legislation. Establishing an “empty shell” entity is not acceptable to the ECB.

The ECB’s FAQs on Brexit specifically mentions the back-to-book booking model. It states that the ECB and EU27 national supervisors would expect that part of the risk generated by all material product lines should be managed and controlled locally. For market risk, this might mean eventually establishing permanent local trading capabilities and local risk committees, as well as trading and hedging risks with a diversified set of external counterparties.

The ECB adds that supervisory expectations vis-à-vis booking models will be applied proportionately according to the materiality and complexity of each individual institution’s activities. This means that large banks, with a high level of interconnectedness and complex capital market operations, will be subject to higher supervisory expectations and assessments.

Following the financial crisis important international reforms were put in place which introduced a clearing requirement for standardised over-the-counter (OTC) derivatives. To incentivise standardisation, policymakers increased capital requirements for non-standardised uncleared derivatives positions. As a result of these efforts, the central clearing of OTC derivatives has grown significantly.

In 2011 the ECB argued that central counterparties (CCPs) that clear and settle large amounts of euro-denominated transactions should be located in the euro area with full managerial and operational control. In response the UK Government filed a law suit challenging the ECB’s location requirement arguing that it could not apply such requirements under the Treaty on the Functioning of the EU (TFEU). In March 2015, the UK Government won its legal battle. However, with the UK becoming a third country post Brexit, euro denominated clearing has again come into the spotlight.

Partly in response to Brexit, the Commission has issued a legislative proposal for a Regulation making amendments to the European Markets Infrastructure Regulation (EMIR) relating to, among other things, the requirements for the recognition of third country CCPs. The Commission proposes that third country CCPs determined to be systemically important should be subject to stricter conditions than those that currently apply for third country CCPs. In addition, the European Securities and Markets Authority may recommend to the Commission that the risks posed by a systemically important third-country CCP to the EU’s financial stability are so great that it should not be recognised and, consequently, if it wishes to provide clearing services in the EU, it should be authorised and established in an EU27 Member State.

The ECB is also playing an important role in the legislative proposals. In June 2017 the ECB adopted a recommendation that Article 22 of the Statute of the European System of Central Banks and of the ECB be amended to give the ECB the power to make regulations relating to clearing systems for financial instruments. This would give the ECB the power to regulate CCPs. In particular, the Eurosystem (the ECB and central banks of eurozone Member States) would have the power to monitor and assess risks posed by CCPs clearing significant amounts of euro-denominated transactions and the ECB would be able to adopt additional requirements for those CCPs. In October 2017, the Commission adopted an opinion generally agreeing with the ECB’s recommendation which is now being considered by the European Parliament and the Council of the EU.

Adding another layer of complexity is the Commission’s legislative proposals to require large non-EU banks to establish an intermediate parent undertaking in the EU, also known as an EU intermediate holding company (EU IHC). The idea behind this legislative proposal is to improve EU supervision, resolution and financial stability but in practice the market sees it as a response to the US’ IHC rules. Whilst the legislative proposals are currently undergoing trilogue it appears that removing the requirement is not on the table and instead negotiations are focussing on the scope of the requirements.

Under the Commission’s original proposals third country banking groups with two or more institutions in the EU will be within scope if they fall into one of two categories: (i) global systemically important banks automatically fall in scope; and (ii) other third country banking groups are covered if the total value of their EU assets are EUR 30bn whether from branches or subsidiaries. In September it was reported that the Council of the EU was of the view that the asset threshold should be raised from EUR 30bn to EUR 40bn whereas the European Parliament wished the original threshold to remain. Significantly, both the Council and the European Parliament agreed to allow a dual-IHU structure where home country regulations require deposit taking and investment banking to be separated. This means that some groups may be able to set up separate IHUs for the deposit taking and investment banking parts of their business, in line with their home country rules. It was also reported that the Council proposes an implementation period of four years. This may provide some comfort but the experience of establishing an IHC in the US, and the ongoing ring-fencing reforms in the UK, suggest that those are complex and lengthy processes.

The Commission is committed to putting into place all the building blocks for the Capital Markets Union (CMU) by mid-2019. In March 2018, the Commission published a communication: Completing the Capital Markets Union by 2019 – time to accelerate delivery. In this communication the Commission stressed that the need to progress with the CMU was made “even more urgent by the future departure of the UK”. It added that as a consequence of Brexit, there was a need for the EU27 to make “an even stronger push for more developed, integrated and better supervised capital markets.”

In July 2018, Finance Ministers from eight countries including the Netherlands, Ireland and Finland signed a joint statement saying that the CMU was “essential” and that it had become “all the more important” because of Brexit. Noting the May 2019 European Parliament elections, which will shut down legislative work in Brussels for several months, the group called on policy makers to “target and prioritise” certain important CMU measures that can realistically be completed in the time that remains.