Bank of England: Banks not prepared for Brexit

Officials at the U.K.’s central bank are pushing lenders to sharpen up their contingency plans as their branches in Britain could lose the right to operate after March 2019—a situation that would further jeopardise London’s position as Europe’s key financial centre.

EU banks provide around 10 percent of the corporate lending used by British companies, so if foreign banks lose access to these clients because of a change in regulations post-Brexit, they are at risk of losing revenue while U.K. businesses will find it more difficult to secure lending, warns the Bank of England.

The Prudential Regulation Authority (PRA), the U.K. regulator that ensures that financial firms control risks appropriately and hold adequate capital, is “engaging firms to improve the state of their contingency planning” so that they start their U.K. licence applications before the end of the first quarter of 2018.

Deputy Governor for Prudential Regulation Sam Woods has said that some 130 banks would need to apply for licences to continue operating in the United Kingdom. These banks have not been named.

In the official record of its last meeting on 20 September, which was released earlier this month, the Bank of England’s Financial Policy Committee (FPC) outlined the key risks that financial services firms face as Brexit looms and the measures that the sector has taken (or not) to prepare for the United Kingdom’s split from the European Union.

As part of its remit, the FPC has been assessing the risks of disruption to financial services arising from Brexit, and what preparations and actions could—and should—be made to mitigate them, however unlikely they may be to occur. This includes preparing for a scenario in which there is no agreement in place at the point of exit at the end of March 2019.

The main areas of risk that the FPC has been focusing on relate to the discontinuity of cross-border contracts (in particular, insurance and derivatives); restrictions on the sharing of personal data between the European Union and United Kingdom; and restrictions after Brexit on cross-border banking, central clearing, and asset management service provision.

In short, financial services firms have not done enough to appreciate the complexity of the day-to-day arrangements for operating after Brexit, and it may be too difficult to plan fully for the potential changes anyway. For example, the FPC believes that it will be difficult for firms “to mitigate fully” risks to the continued servicing of derivative contracts between U.K. counterparties and those based in the 27-member EU bloc. This is because after Brexit, firms may lose the permissions required to perform regular “life cycle” events in these contracts, such as trade compression or exercising options. The FPC believes that “tens of thousands” of counterparties could be affected, representing around a quarter of both U.K. and EU client uncleared derivative contracts, with a “notional value potentially totalling around £20 trillion (U.S.$26.3 trillion).”

EU WITHDRAWAL

Below is a look at the risks of disruption to financial services due to Brexit.
46. The FPC continued to assess the risks of disruption to financial services arising from Brexit so that preparations could be made and action taken to mitigate them. Consistent with its remit, the FPC is focused on outcomes that, even if they may be the least likely to occur, could have most impact on UK financial stability. This includes a scenario in which there is no agreement in place at the point of exit. 
47. The FPC was considering risks arising from: discontinuity of cross-border contracts, in particular insurance and derivatives; restrictions on sharing of personal data between the European Union and United Kingdom; and restrictions after Brexit on cross-border banking, central clearing and asset management service provision. Many of these issues pose risks to the provision of financial services in the European Union and United Kingdom. The FPC had reviewed the state of contingency planning across the financial sector, informed by responses to the PRA request for firms to detail their contingency plans. 
48. The FPC judged that it would be difficult for firms themselves to mitigate fully risks to the continued servicing of derivative contracts between UK and EU27 counterparties. In particular, after Brexit, firms may lose the permissions required to perform regular ‘life cycle’ events in these contracts, such as trade compression or exercising options. Tens of thousands of counterparties could be affected, representing around a quarter of both UK and EU client uncleared derivative contracts and notional value potentially totalling around £20 trillion. 
49. Impairment to the servicing of these contracts could disrupt market functioning and make it more expensive for firms and households to insure against risks. To continue to service their contracts firms would need to replace cross-border business by novating contracts to new entities with the necessary regulatory permissions. For each of the large dealers, this would require the agreement of 2,000-4,000 counterparties who may themselves need to secure agreement with other involved parties. There were no precedents for these types of multiple large scale novations within an 18-month period. 
50. A fully effective mitigant to these risks would require some form of bilateral agreement between the European Union and United Kingdom. The Bank was working with industry, and had consulted the International Swaps and Derivatives Association, to clarify the scope of potentially affected ‘life cycle’ events across key trading jurisdictions to identify legal mechanisms that might fix this issue. The two-way nature of derivatives meant that both UK and EU firms doing cross-border business may require appropriate permissions. A comprehensive solution was therefore likely to require the development and passage of legislation in both jurisdictions in order to protect the long-term validity of existing contracts. 
51. There were also operational impediments to firms’ plans to mitigate risks to the continuity of insurance contracts. Loss of authorisation could affect firms’ ability to continue to collect premiums and pay out on claims on outstanding insurance contracts, which in some cases extend for several years. 
52. Firms also lacked robust contingency plans to mitigate risks to financial service provision from possible barriers to the flow of personal data between the UK and EU27. Many firms currently relied on data centres located in the United Kingdom to provide financial services across Europe. Contingency plans were reliant on firms replacing contracts with new ones that included clauses permitting data transfer, but this could be difficult in the time available and such contracts may be subject to legal challenge. The continued free flow of personal data would require the United Kingdom and EU27 to recognise each other’s data protection regimes as ‘adequate’, as recognised by the Government’s recent position paper. 
53. The risk of disruption to wholesale UK banking services appeared to be slightly higher than previously thought, given that a number of EEA firms branching into the UK were not sufficiently focused on addressing this issue. Absent an appropriate agreement in place at the point of exit, EEA firms branching into the UK would need to apply for new authorisations from the PRA in order to continue to carry out regulated activities here. These branches accounted for around a tenth of lending to UK companies. Firms would need to start seeking authorisations in 2018 Q1. Their plans were also reliant on a greater degree of cooperation between the UK and EU. The PRA was engaging firms to improve the state of their contingency planning. 
54. The United Kingdom was an important global hub for central clearing activity and there remained significant risks from disruption to cross-border clearing activity between the UK and EU. Central counterparties (CCPs) located in the United Kingdom provided important services to EU clients across a range of markets. The European Commission had published a legislative proposal on the supervision of CCPs, which included draft provisions that could be used to deny EU firms access to ‘substantially systemically important CCPs’ unless they were located within the EU. 
55. CCPs and firms were therefore examining contingency options, including the potential to relocate some clearing activity from the UK in order to continue to provide services to EU clients. But such mitigants did not appear to be available in all markets, for example where the complexity and cost of any migration was significant. In the event of access restrictions in those markets, EU firms would therefore have to move their activity to another CCP, which was likely to be difficult to achieve before the point of EU withdrawal. So there remained a substantial risk of disruption of cross-border clearing activity. The Bank was continuing to engage financial market infrastructure and firms on their contingency planning. 
56. The Committee noted that the various issues it had identified posed risks to the provision of financial services in both the European Union and the United Kingdom. This suggested benefits of information sharing and a coordinated approach between the European Union and the United Kingdom in managing these risks, and a suitable transition period agreed in a timely fashion.
Source: BoE Financial Policy Committee

The FPC believes that impairment to the servicing of these contracts could disrupt market functioning and make it more expensive for firms and households to insure against risks. To continue to service their contracts, firms would need to replace cross-border business by reassigning (novating) contracts to new entities with the necessary regulatory permissions. For larger players in the market, this would require the agreement of 2,000-4,000 counterparties who may themselves need to secure agreement with other involved parties.

The FPC says that there are “no precedents” for these types of multiple, large-scale novations within an 18-month timeframe, and that any fully effective mechanism to mitigate these risks “would require some form of bilateral agreement between the EU and U.K.” This would involve legislation being drafted in both jurisdictions, not only for present business to continue as normal, but also to “protect the long-term validity of existing contracts.”

There are other operational impediments to firms’ plans to mitigate risks to the continuity of cross-border insurance contracts. For example, loss of authorisation could affect firms’ ability to continue to collect premiums and pay out on claims on outstanding insurance contracts, which in some cases extend for several years.

Firms also lack robust contingency regarding possible barriers to the flow of personal data between the United Kingdom and the remaining 27 EU member states. Many firms currently rely on data centres located in the United Kingdom to provide financial services across Europe, and current contingency plans tend to rely on firms simply replacing contracts with new ones that include clauses permitting data transfer. Post-Brexit, however, the continued free flow of personal data will require the United Kingdom and EU27 to recognise each other’s data protection regimes as “adequate.” Otherwise, such contracts may be subject to legal challenge. And the chances of resolving this issue quickly are slim in the tight deadline that the United Kingdom has before exiting the European Union.

The risk of disruption to wholesale U.K. banking services also appears to be “slightly higher than previously thought” because a number of financial services firms from the European Economic Area (which includes non-EU countries such as Norway and Iceland) branching into the United Kingdom are “not sufficiently focused on addressing this issue.” The FPC also says that many banks’ Brexit contingency plans may be overestimating the closeness of the relationship that the United Kingdom might have with the EU come 2019. The report found that firms’ plans were “reliant on a greater degree of cooperation between the UK and EU,” and added that, as a result, “the PRA was engaging firms to improve the state of their contingency planning.”

If there is no appropriate agreement in place at the point of exit, the FPC warns that EEA firms branching into the United Kingdom would need to apply for new authorisations from the PRA in order to continue to carry out regulated activities there. These branches account for around a tenth of lending to U.K. companies. The FPC says that firms will need to start seeking authorisations in the first-quarter of next year if they want to ensure that they can continue to conduct business.

Cross-border clearing and settlement services also face “significant risk” of disruption. The United Kingdom is home to a range of central counterparties (CCPs) that provide important clearing services to EU clients across a range of markets. The European Commission, however, has published a legislative proposal on the supervision of CCPs, which includes draft provisions that could be used to deny EU firms access to “substantially systemically important CCPs” unless they are located within the European Union.

CCPs and firms are examining contingency options, including the potential to relocate some clearing activity from the United Kingdom in order to continue to provide services to EU clients. But such remedies do not appear to be available in all markets, says the FPC, particularly where the complexity and cost of any migration is significant. In the event of access restrictions in those markets, the FPC warns that EU firms would have to move their activity to another CCP, which is “likely to be difficult to achieve before the point of EU withdrawal.”

The FPC believes that financial services firms have underestimated the level of disruption that Brexit is likely to cause, which in turn has led to a lack of general preparedness. As a way forward, the Bank of England committee believes that there needs to be greater information sharing between firms and regulators to ensure continuity, as well as a better coordinated approach between the European Union and the United Kingdom in managing these risks. It also emphasises the importance of having “a suitable transition period agreed in a timely fashion.”