Brexit: What is the ECB Reaction?

Brexit: The ECB Reaction

Following the referendum of 23 June 2016, Europe’s largest financial centre may soon sit outside the EU. A scenario that few had planned for has become reality.

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The ECB’s governing council met on Thursday 21 July 2016 to discuss its response to Brexit, noting that market stresses from Brexit have been contained. Our informal conversations with the ECB have revealed a wide spectrum of reactions. On the one hand, Banking supervisors from DG1 & DG2 appear unperturbed, viewing Brexit as a British political crisis, rather than an immediate threat to Europe’s financial system; new entities may require supervision in due course, but this will take time.

On the other hand, ECB Financial Stability teams view Brexit as a trigger exposing banking sector vulnerability, not just among UK banks but also (particularly) across the Italian and Portuguese sectors. This is creating jitters at the ECB, just days before EBA Stress Test results are published on 29 July.

Why has Brexit hurt banks in continental Europe? At least two unforeseen factors are at work: first, Brexit has triggered a further lowering of the yield curve; second, it prompted a ‘flight to quality’ by investors.

For banks that were already struggling with chronically low interest margins, such additional pressures can push them towards non-viability. Based on FTSE bank sector indices, Italian banks lost approximately 19% of their market value between June 23rd and June 24th, compared with a 10% fall for UK banks. Banking rules set by Brussels and Frankfurt are also under scrutiny. Matteo Renzi has re-launched a debate with Brussels about Italy being allowed to circumvent BRRD ‘bail-in’ rules to recapitalise its banking sector. He may have found an ally in Mario Draghi, who supports recapitalisation. The ECB also faces pressure on its quantitative easing programme, due to self-imposed rules not to buy bonds with a yield of less than minus 0.4% (matching the rate paid by the ECB on deposits). More than half of eligible German bonds now yield less than this threshold, so are ineligible for QE purchase.

Understanding what Brexit will mean

To understand further what Brexit will mean, we first need to know what Brexit is. The new UK Prime Minister, Theresa May has provided a circular reference: “Brexit means Brexit”. This hides a number of options and scenarios, in particular for the financial sector.

Banks are currently trying to maximise the ‘optionality’ that will be available to them in an unknown future. The factors they need to plan for include:

  • Euro clearing: 45 percent of global OTC Euro FX transactions are traded in the UK, three times more than on the continent (similar ratios apply in the OTC interest rate derivatives market). A legal challenge to London’s euro-clearing dominance was made by the ECB in 2011, but was overturned by the ECJ in 2015 which concluded that Euros could be cleared anywhere in the Single Market. Were this legal case to be re-run with London outside the EU, there is a higher probability of the ECB winning its legal argument. Banks with Euro clearing & settlement operations may then need to relocate from London to the continent and clear Euros separately from other currencies (including Sterling, US Dollars & Renminbi).
  • Passporting: under a number of EU Directives and Regulations, banks are currently able to apply for a licence to manufacture or distribute financial products in one EU country which can be ‘passported’ across the EU. Currently 75 percent of EU trading under MiFID passporting rules is done by UK-based firms. Such passporting rights could be modified, or removed altogether for UK banks operating in the EU (and vice-versa). There are a smorgasbord of possibilities here, as unlike people, banks have multiple ‘passports’ and the future rules applying to each type of passport could vary.

Before we exaggerate the impact of Brexit, however, it is worth noting that Europe’s journey towards a Single Market for financial services is only partially complete. Anyone who has tried to move their current account, or pension, from one EU country to another will know this. The areas of banking where passporting operates most effectively, which would therefore be most impacted by a ‘hard-Brexit’ include securities markets trading, payments services and wholesale funding markets.

Client preference

On both of the Euro clearing and Passporting points, the preference of clients and market participants seems clear: they would prefer to continue trading and working in London, to keep the economies of scale inherent in the world’s largest financial centre. Trading & clearing different asset classes across multiple financial centres would require, in aggregate, significantly more collateral to be posted (by capital constrained banks), due to reduced potential for netting. It would also require clients to undertake trades under multiple legal & insolvency frameworks, which are in some cases ‘untested’ by legal precedent.

There are therefore powerful forces for London’s survival, combined with strong political pressures for change. With the final outcome so uncertain, what should clients do now?

As well as performing analysis for a range of scenarios, it can be advisable to analyse the ‘critical path duration’ of potential projects. Banks may then conclude that some projects need to start straightaway, at least as a contingency measure. This can include launching Eurozone bank licence applications and considering what system changes might be required, if data on EU clients can no longer be stored in London. Eurozone banking licence applications are complex, requiring (as in most jurisdictions) at least one year to complete and approvals from both national supervisors and the ECB SSM.

At a minimum, banks should stay fully informed of the latest developments.

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