Brexit and the UK’s future relationship with the EU are critical issues for the UK-based banking sector, and of course for the wider economy it serves. The UK-based banking sector is a significant contributor to the UK economy. In 2018, the financial services sector contributed £132 billion to the UK economy, 6.9% of total economic output. The sector contributed £29 billion in tax in 2017/18.
The UK government’s Brexit White Paper in February 2017 further noted the reach of the sector beyond the City, saying, “The financial services sector is an important part of our economy. It is not just a London-based sector; for example, two thirds of financial and related professional services jobs are based outside the capital, including 156,700 in Scotland, 54,300 in Wales and 32,000 in Northern Ireland. The UK is a global leader in a range of activities, including complex insurance, wholesale markets and investment banking, the provision of market infrastructure, asset management and FinTech.”
Hence Brexit is top of mind for most banks, not just in the UK, but also in Europe and, indeed, across the globe.
Given the current situation, there remains confusion, with many unanswered questions. Banks and other financial institutions operating within, from and into the UK now face a period of market volatility and weakness together with prolonged uncertainty with some of the important details may only be settled towards the very end of the negotiations.
Uncertainty in banking sector and among the business community is understandably very high. This means that banks will have to work on potential and alternate outcomes, depending on how it all unfolds.
In this article, we try to pull together Brexit’s impact on banks (although bear with us if something has changed since we put it together!).
UK banks and Brexit: no indication of what will happen
Whether it is a deal or no deal Brexit, there is little foresight on the impact on banking post Brexit. Even the new withdrawal agreement has nothing in there about banking.
Jerry Norton, Vice-President, Financial Services at CGI shares: “In the document outlining the basis of the UK’s future relationship with the European Union, there is only a passing reference to the financial industry, along the lines of we will seek to have a close, open and harmonious future together. This is in the realm of known unknowns and means there is little to no clarity at all for the banking industry.
“For example, currently, a German asset manager can sell products in the UK through the EU passport arrangement, and, as a contingency, may have already set up a UK legal entity to enable it to continue to sell in the future. However, it has no idea if its products will comply with potentially new UK rules post transition. While it may have done enough to cope with a “no deal,” it cannot act on anything post-transition day.
“Another example is London’s role in clearing many European originated or European denominated contracts. Presently, many of these contracts cannot be cleared in Europe as the capability does not exist, so temporary arrangements have been set up to allow a type of regulatory equivalency to allow banks to clear in London even in the event of a hard UK exit.”
Impact of Brexit on banks and banking: ecosystem impacts
The UK-based financial services sector has developed over many years into an interdependent and interconnected ecosystem. This ecosystem comprises a large variety of financial and related professional services firms working together. This ecosystem has enabled the UK to build an environment conducive to innovation and growth, providing a platform with which to maximise the potential growth opportunities that could arise from the UK’s exit from the EU.
According to a study by Oliver Wyman and commissioned by TheCityUK: “The high level of interconnectedness within this ecosystem means that the effects of any exit from the EU agreement are likely to extend beyond business done directly with EU clients. Impacts to one part of the ecosystem will invariably have knock-on effects elsewhere. For example, a firm that loses its EU customers may no longer have the scale to operate profitably in the UK, and so exit altogether. Or an activity that needs to operate adjacent to another linked activity may have to relocate if the activity it is collocated with were to leave the UK as a result of its exit from the EU.
“It is clear that for each individual transaction in the ecosystem there are a number of related activities. If any of these activities or transactions was to be restricted or forced to migrate there would be knock-on impacts to any adjacent and potentially subsequent activities, which could lead them to leave the UK in order to retain the benefits of being part of this ecosystem.
“Assessing the impact of ecosystem risks is imprecise, but it is reasonable to assume – particularly in the context of this changed environment – that some of these risks might crystallise, especially over the medium to long term (the next five years and beyond).”
No deal Brexit effect on banking: passporting and equivalence
The biggest challenge that a no deal exit creates for financial services is the sudden loss of passports. The EU passporting system for banks and financial services companies enables firms that are authorised in any EU or EEA state to trade freely in any other with minimal additional authorisation. These passports are the foundation of the EU single market for financial services. Once the UK has left the EU and the EEA it would become a third country and these limited regimes may in principle be available.
Some recent EU legislation has included some third country regimes which allow non-EEA firms to provide services into the EEA if their home country regulatory regime is equivalent to EU standards. Equivalence sometimes also requires reciprocity (for example, European Market Infrastructure Regulation (EMIR), Central Counterparty (CCP) equivalence). These regimes cover a more limited range of services and provide fewer additional rights than the existing passports for EU firms and may also be subject to additional conditions. Unlike an EEA passport, the rights under these regimes can be withdrawn at any time if a home country deviates materially from EU standards. EU legislation generally requires that the European Commission makes the determination of equivalence, but in some cases, this may be left to Member States or their national regulators.
Becoming a third country with respect to the EEA, means not having standing to the Court of Justice of the European Union (CJEU), and has significant regulatory consequence with regards both single market access passporting rights and regulatory equivalence.
There are essentially three broad options relating to Brexit and banks:
- Continuing with current passporting arrangements
- Negotiating a new equivalence regime
- Departure from the EU with no deal and subsequently arranging equivalence agreements.
No deal Brexit effect on banking: operations implications
In recent years, banks have seen a spate of regulation and structural change that has had major implications for many areas of their operations. Brexit has the potential to see even wider ranging impacts. Under a hard Brexit scenario with a two-phase transition, where UK entities must respond twice to changes in operating model and regulation, banks will need to implement significant change across the full range of businesses and supporting functions.
Against the backdrop of significant change that Brexit presents, banks are already dealing with the implementation of a raft of mandatory regulatory driven requirements. The prioritization and management of this large backlog of change across teams and applications that are intrinsically inter-related becomes complex and time consuming.
Most of the impact for operations will be driven by the way in which the model is defined to support the booking and risk management of transactions undertaken with EU clients.
According to EY, there are four primary models that may be used, namely:
- Agency trading
- Principal trading — back-to-back intraday risk transfer to the UK
- Principal trading — back-to-back end-of-day risk transfer to the UK
- Principal trading — full risk management in the EU
Each of these models have their own implications for how the EU entity would operate. While none of these booking models are new, the combination of models used will require a range of controls to ensure that all business and associated risk is being managed and closed out appropriately. The complexity that this creates will have implications for operations in a wide range of areas which will require consideration of questions around booking controls, regulatory reporting, client migration, management of settlement locations and settlement instructions cross entity reconciliation, cash and collateral management, network management, cancellation and amendment scenario and training and talent.
How are banks preparing for Brexit?
Individual banks must not only examine the high-level impact of Brexit in all its forms, but also take initial steps to create contingency plans and mitigate known issues. Banks are currently responding in the following ways:
- Worst case planning: Given the level of uncertainty and the significantly greater implications of a hard Brexit, most banks are planning for this as a worst case and considering operating model designs that allow them to continue to provide European client coverage in an environment where UK entities do not have access to the European market. With the European Banking Authority (EBA) providing guidance that suggests it will not tolerate the setting up of empty shells within the EU to provide this access, firms are considering options to extend existing entities or create new ones within the EU with the appropriate management, governance, staff and infrastructure to control the risk that they generate. This becomes more complex when considering the ambiguity still existing around the nature of restrictions for cross-border payments between the UK and the EU, and the rules for accessing EU-approved central counterparties (CCPs).
- Delaying: In many cases, the level of uncertainty surrounding the outcome of Brexit is causing banks to delay the full inception of implementation activities. While a high level of impact analysis may have been performed and a high-level operating model defined, many of the more detailed aspects of the implementation, where requirements are not clear, are being deferred until more is known. The European Council summit on 22 and 23 March 2018 provided some guidance regarding the potential arrangements for transition and end-state, however much negotiation remains to determine the ultimate deal.
Impact of Brexit on Banks and Banking in the UK will partly be determined by the agreements between governments and regulators on many pieces of legislation, and how firms respond to this shifting landscape. It will vary dramatically with how much access to the EU is retained.