The Bank of England (“BoE”) released its June 2018 Financial Stability Report that is prepared by the BoE’s Financial Policy Committee (“FPC”). The FPC is responsible for identifying, monitoring, and taking action to remove or reduce systemic risks affecting the UK financial system. Among other things, the Financial Stability Report summarizes the FPC’s outlook for UK financial stability, including its assessment of the resilience of, and key risks to, the UK financial system. The financial services sector in the UK employs more than a million people and accounted for approximately 6.5% of the value created in the UK economy in 2017. The City of London Corporation estimates that the broader financial services industry (including insurance firms) generated more than £70 billion in tax revenues in 2017, making up 11.0% of the national aggregate.
One of the key, longer-term risks that has been of ongoing significance for the FPC is the UK’s approaching exit from the EU (“Brexit”). The manner in which the UK leaves the EU will impact the UK’s financial system, given the UK’s leading role in the provision of multijurisdictional financial services, and concerns have been expressed regarding potential disruption to the free flow of financial services across borders (particularly UK–EU movement). However, the economy has had a robust reaction to Brexit and currently there are no signs of slowing down, with cross-border merger and acquisition transactions remaining very active.
While the FPC generally has a reasonably positive outlook on economic growth in the UK, in its June 2018 Financial Stability Report the FPC highlights three broad areas of concern stemming from Brexit: (1) legal frameworks for financial services, (2) preserving the continuity of outstanding cross-border contracts, and (3) avoiding disruption to availability of new financial services. In November 2017, the FPC published a checklist (the “Brexit Checklist”) that set out those actions that the FPC considered would mitigate risks of disruption to important financial services used by consumers and businesses to support their economic activity. The FPC regularly measures the UK’s progress against the Brexit Checklist.
(1) Legal frameworks for financial services
A large part of the UK’s legal and regulatory framework for financial services is derived directly from EU law, which means that, due to Brexit, all “directly applicable” EU law will need to be replicated in UK law to ensure consistency. The UK Government plans to do this by implementing the EU (Withdrawal) Bill, which became law on June 26, 2018. Of course, this is just the first step, and regulatory authorities will need to obtain necessary regulatory permissions and make subsequent updates to their own regulatory and policy rules to effect the required legislative changes. The FPC recommends an implementation period to allow regulatory “catch-up” and advises that this will reduce all of the risks outlined in the Brexit Checklist. In the absence of such an implementation period, the UK Government has committed to legislate, if necessary, to put in place temporary permissions and recognition regimes and to allow European Economic Area (“EEA”) entities to fulfil contractual obligations in the UK. This would allow EEA banks, insurers, and non-UK counterparties to continue their activities in the UK for a limited period after Brexit, even if there is no implementation period, thus mitigating a number of risks of disruption to UK financial services. The EU has not indicated a similar solution that would work in reverse. The implementation period has been agreed to in principle by the UK Government and the European Commission.
(2) Preserving the continuity of outstanding cross-border contracts
The FCP recognizes that certain cross-border contracts, including insurance contracts and uncleared and cleared over-the-counter (“OTC”) derivatives contracts, will remain core areas of concern in the context of Brexit. For example, following Brexit, insurers in the UK and the EEA may not be able to service their existing contracts (e.g., by paying claims to, or receiving premiums from, policy holders in other jurisdictions), and UK and EEA parties may no longer have the necessary permissions to service certain cleared and uncleared OTC derivative products. Many UK and EEA counterparties are currently required by EU law to clear contracts in certain products using central counterparties that are specifically authorized or recognized under EU legislation. In the absence of an agreement, UK central counterparties (e.g., LCH Limited, LME Clear Limited, and ICE Clear Europe Limited) would be able to serve EEA customers after Brexit only if they are “recognized” by the European Securities and Markets Authority (“ESMA”)—a process that is seen by many outside ESMA as being unclear. EEA clearing members and their clients currently rely heavily on central counterparties based in the UK (the UK currently clears approximately 90% of euro-denominated interest rate swaps). The EU has not yet announced an intention to allow UK counterparties to continue to service contracts with EEA counterparties and, absent such announcement, the FCP advises that the UK Government could mitigate the risk somewhat by allowing for the orderly transfer of EEA users out of the UK’s central counterparties.
(3) Avoiding disruption to availability of new financial services
In a common theme, the FCP indicated that certain financial services are particularly important to the general economic environment and therefore remain key risks in the context of Brexit. These financial services are, broadly, clearing services, banking services, and asset management. Each of these financial services is currently subject to extensive, diverse, and complicated EU and UK legislation and regulation. As with the regulation of key contracts discussed above, these financial services will benefit from an extended implementation period to allow participants to revise their operations—however, in the absence of an agreement or recognition by ESMA, participants will need to find new arrangements for future financial services in these areas. For example, some UK banks are in the process of restructuring their businesses and obtaining necessary EU permissions to operate EU subsidiaries. With respect to clearing services, the UK Government has committed to legislate, if necessary, regarding the recognition of non-UK central counterparties, including a temporary recognition regime, so that such central counterparties would continue to be able to provide clearing services to UK clearing members and clients in order to avoid disruption. A temporary permission regime is also being considered to allow asset management funds in the EEA to continue to be marketed into the UK, as well as for EEA banks to continue to operate in the UK pending authorization following Brexit. Unfortunately, the EU has not yet announced similar regimes.
The BoE remains optimistic about the performance of the UK economy in the context of Brexit and more generally.