Banks, regulators, policymakers and clients need to work together to ensure that the wholesale banking business is prepared for Britain's EU departure, according to a lobby group for the industry.
In a report published a week after British Prime Minister Theresa May started the two-year countdown to Brexit, the Association for Financial Markets in Europe stressed the need for actors ranging from banking clients to regulators to look beyond immediate self-interest.
"If each set of actors acts solely in response to its short-term incentives then the overall economic outcome will be clearly sub-optimal. In other words, Brexit implementation is a classic 'collective action problem' which requires coordination across all parties and clear expectations on outcomes and timelines in order to mitigate the risks to markets and avoid cliff effects," the report said.
It is essential that the two "public goods" of financial stability and market efficiency are preserved throughout Brexit negotiations, the report said. But this will be challenging given the "current lack of structure in the negotiation process," which has led many banks to prepare on the assumption of a "hard Brexit" in which Britain loses access to the EU's single market once it leaves the bloc.
Both the U.K. and the remaining 27 EU countries have signaled a willingness to agree to a "phasing-in" period of post-Brexit arrangements, AFME CEO Simon Lewis noted, adding: "The sooner that a phasing-in period is confirmed, then the smoother the adjustment process will be."
UK market dominance
Wholesale banking covers a range of services including derivatives, research, equity trading, fixed income, corporate finance and M&A advisory services. The U.K. is a major center for the industry, housing some £3.8 trillion of wholesale assets, of which 14% are owned by banks in the European Economic Area, 31% by British banks and 55% by lenders outside the EEA, according to the report.
Banks that use the U.K. as a base are responsible for roughly 60% of total EU capital markets revenues, AFME said, adding that it believes that the market capacity provided by these banks could be at risk if they are not given enough time to adapt to Brexit changes.
At present, banks domiciled in the U.K. can operate throughout the EU under the bloc's rules, yet much of this legal, regulatory and supervisory framework will become obsolete after Brexit, and there is little clarity at this stage about what will take its place. Given this uncertainty, AFME called for greater coordination from regulators, policymakers and banks when it comes to providing legal certainty, mitigating risks to financial stability, working out new supervisory policy and maintaining market capacity throughout the Brexit transition.
A hard Brexit could threaten the rights of EEA and U.K. banks to trade and interact freely with one another and could leave U.K. and EEA market participants operating under two entirely different legal frameworks. This would impact particularly on wholesale banks' deposit taking, derivatives, cash management, liquidity management and capital market services businesses, AFME said.
For example, changes may be required to derivatives contracts entered into before Brexit, while pan-European syndicated loan agreements might have to be separated into EU and U.K. participant components, which could decrease the overall capacity of funding available to companies, the report said.
Clearing could face barriers
Brexit will also create potential barriers to market infrastructure in both the EU and in the U.K., particularly when it comes to derivatives clearing. Given that over a quarter of global clearing activity goes through clearinghouses in the U.K., restrictions on EU-based banks clearing derivatives in London could result in major disruption to the market, the report said.
European officials have suggested that clearing of euro-denominated assets should take place within the eurozone. A European court in 2015 rejected a challenge to London's euro-clearing business, based on Britain's status as an EU member, but this could cease to provide a defense once Brexit is complete.
The report also warned that the Brexit process could create additional pressure on regulators both in the U.K. and the EU, and that financial markets could be affected by "supervisory bottlenecks".
As well as finding new ways to work together on prudential and supervisory matters, regulators will need to agree on how to deal with and potentially resolve banks in difficulty, the report argues. It suggested that EU authorities including the European Central Bank and Single Resolution Board come to a cross-border agreement with the Bank of England on how to plan for resolutions, share information and set requirements for so-called loss-absorbing capacity, designed to prevent recourse to taxpayer funding for bailouts.