SSM pronouncements on Brexit

SSM pronouncements on Brexit

What will change for SSM banks in their relationship with the City of London, or for UK banks in their relationships with continental Europe?

Partner, ECB Office, Lead for Deal Advisory

KPMG in Germany

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The SSM has said relatively little publicly on the impact of Brexit. Sabine Lautenschläger, vice-chair of the ECB Supervisory Board commented in July: “The good news is: there have been no funding, liquidity or operational problems in SSM banks since the referendum. Operationally, financial markets have been functioning well”. She acknowledged, however, the risk that “a prolonged period of uncertainty about the future relationship of the UK with the EU creates a wait-and-see mood”.

During this ‘wait-and-see’ or ‘pre-Article 50’ period, what will change for SSM banks in their relationship with the City of London, or for UK banks in their relationships with continental Europe?

London as ‘Europe’s Investment Banker’

In the last few days, we have heard Mark Carney (Bank of England), in response to comments from Mario Draghi (ECB), warning the rest of Europe that it would lose ‘crucial’ financial services if it prevented European countries from doing business in London. He further acknowledged that an ‘orderly transition’ will minimize the disruption to the City and the rest of European business.

Based on 2015 data, 74% of EU OTC derivative trading and 78% of EU27 capital markets activity is conducted in the UK. Consequently exposure to Brexit represents a risk for many SSM banks. The ECB will be expecting impacted banks to show, during the 2017 supervision cycle, evidence of planning for multiple Brexit scenarios and the ability to withstand a ‘downside’ case. Brexit also represents a risk to the Capital Markets Union project, one of the European Commission’s key priorities for the financial services sector.

While the volatility in the financial markets that followed the referendum on 23 June has largely receded (with the Italian ‘No’ vote on 4 December now taking the limelight), further episodes of volatility are likely on the ‘Brexit’ flightpath.

Impacts on SSM banks

Impacts on SSM banks could include lower GDP growth (UK and EU), higher funding costs and higher costs of creating and selling financial instruments. In a period where SSM banks are besieged by low interest rates and a weak ‘macro’ backdrop, Brexit has compounded the expectation of ‘lower for longer’. This was highlighted in a high-profile ESRB study of the impact of low interest rates on the financial system, published on 28 November.

On a longer term basis, will Europe’s financial system be re-drawn? Many SSM banks have shaped their business models to include branches in the City of London, to be members of the largest, most capital-efficient EU clearing & settlement hub. These branches are able to perform a large proportion of their ‘parent’ bank’s capital market operations, in London, benefitting as EU branches from fungible capital and liquidity subject to local supervisors’ requirements.

Passports, trading-hubs and netting

If the political agreements that will be made once Article 50 is triggered mean that the UK will in due course leave the Single Market, such branches may lose their ‘passports’. Any requirement to convert City of London branches into UK subsidiaries, or to separate the clearing of Euro denominated financial instruments from central counterparties such as the LSE & LCH Clearnet is likely to lead to additional capital requirements (due to restrictions on banks’ ability to perform multi-currency & asset-class ‘netting’). In addition, banks may need to implement substantial change projects, to transfer sections of their balance sheet from London to other locations, which can be a legal & operational marathon.

What will be the impact of potentially losing ‘passports’ on banks’ requirement for licences? In KPMG member firms' view, this impact will be quite limited for the larger UK or American banks, most of which already have established subsidiaries in SSM locations, in addition to their London hubs. A greater impact will be felt by banks from Japan, Canada, or Asia, who currently passport from London to the EU. Some are searching for a new European base, and depending on political developments, may initiate licence applications.

Could the SSM cope with a sudden influx in applications? From KPMG member firms' informal conversations in Frankfurt, the SSM is gearing up for applications, but also intends to ‘deprioritize’ banks who apply for licences only as an insurance policy against losing passports, rather than having the clear intention to use licences once awarded. The SSM may therefore seek assurances from banks that they intend to use a licence, before prioritizing their application.

Conclusion

Rather like a piece of software that has evolved over multiple releases, the EU’s financial eco-system has built up over generations, with London as the investment banking hub. The twin challenges of re-configuring the system for a post-Brexit world, while launching a Capital Markets Union that creates new financing options for tomorrow’s job-creators, will require sustained thought and effort on both sides of the English Channel, for some time yet.

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