Financial Recovery Process at Risk in a "Cliff-edge" Brexit

Defaulting to World Trade Organization rules would be a far cry from the rules of the EU single market

Published: March 14, 2018

Author: Dorothy Livingston

Brexit came a step nearer in December 2017 when the European Union agreed that “sufficient progress” had been made in developing the terms on which the United Kingdom would leave the European Union. Negotiations are now turning to the prospect of a transitional period, scheduled to begin in March 2019 and end in December 2020. The aim is, by March 2018, to have agreed on the terms of that transition and on as much of the text of the withdrawal agreement as possible. This is a tall order, even without the complications of political divisions that are evident in the United Kingdom.

The parties are also aiming for October 2018 to have agreed on the framework for a long-term trade relationship after transition, at which point the United Kingdom will be outside both the EU single market and any form of Customs Union. Although both sides describe this as “CETA plus” (the number of pluses is rather greater in the UK description), it seems clear that the European Union is intending to stay close to CETA’s low base on financial services and is not intending an ultimate outcome that includes a comprehensive agreement on financial regulation, which would allow UK-based financial services businesses to operate as if they were still in an EU member state participating in the single market. 

It is not entirely clear that the status quo will continue through transition, particularly if the United Kingdom continues with its recently announced intention to not fully accept freedom of movement of people — one of the European Union’s fundamental four freedoms — during transition. In addition, the United Kingdom announced that lesser status will be applied to EU migrants and their dependants arriving in the United Kingdom during transition than to those arriving before the end of March 2019. Acceptance of this freedom from an EU perspective is linked to an across-the-board relationship covering goods and services.

After an agreement is reached, the European Council, European Parliament and UK Parliament each have to approve the withdrawal agreement. If and when that approval process is complete, it should be clear whether there will be a transition period or whether the United Kingdom is heading toward a “cliff-edge” leap out of the Union, in which case, trade relations would default to the World Trade Organization’s rules. For financial services, this would be a far cry from the rules of the EU single market.

What Will Happen to the Bank Recovery and Reconstruction Directive?

The treatment of the EU Bank Recovery and Reconstruction Directive (BRRD) is likely to echo other parts of the EU financial services regulatory framework. Member states may cease to recognize the United Kingdom’s authority to extend its resolution processes to parts of a banking group within the European Union — this would happen by the end of the transitional period and potentially as soon as March 2019. At that point, it would become a matter for the different legal systems of the 27 remaining EU member states, with different responses possible in every state.

The United Kingdom has the freedom to preserve the recognition of rescue and recovery proceedings by EU resolution authorities of financial institutions regulated within the European Union. This is likely to be its initial position, but the UK government will have the capacity to remove this recognition if it is not reciprocated. 

Resolution of a Bank Operating in the European Union and the United Kingdom

If a financial institution operating both in the United Kingdom and the European Union (many institutions are in this position) requires rescue and recovery measures for its whole business in both regulatory jurisdictions, then suboptimal outcomes may result. If a bank has substantial UK business, there might be two processes, or, in the absence of an intermediate holding company for the bank’s EU subsidiaries, a multiplicity of processes. Disputes over which administrator can deal with assets are likely. The failing international group is more likely to be dismembered with separate “bail-ins” passing ownership of continuing business to different groups of investors, although there is some risk of a break-up of the group in any event. There is also an increased risk of contagion spreading to affected counterparties, as different groups of creditors may be treated differently.

Why Does It Matter?

It is important to remember that the BRRD is an important step in managing financial crises affecting banks and financial institutions. It is a response to the financial turmoil of 2008 and 2009, in which many financial institutions across the globe required major recapitalization and reorganization, or failed completely. These included:

  • major American institutions such as Merrill Lynch, which was taken over by Bank of America and Lehman Brothers, and failed;
  • British banks such as the Royal Bank of Scotland, which was rescued by a government takeover, and Northern Rock, which was partially sold off and partly run down in government ownership; and
  • European banks, ranging from the Bank of Ireland in the west to the Cypriot banks in the east. The world’s oldest bank, Italy’s Banca Monte dei Paschi di Siena, having survived the initial crisis with Italian government support in the shape of “Tremonti bonds,” needed further measures as late as 2016, while many others across Europe survived the crisis with support from the European Central Bank and other central banks.

In that context, the United Kingdom rapidly established legislation specifically to facilitate the reconstruction of failing banks in the shape of the Banking Act 2009, of which many features are reflected in the BRRD. The whole episode showed that effective international cooperation could improve outcomes and reduce instability.

What Could (and Should) Be Done?

The European Union and the United Kingdom have the capacity to preserve mutual recognition of each other’s resolution processes. This would be in line with the recommendations of the Financial Stability Board, supported by the Group of Twenty (G20) developed economies (including the United Kingdom and major EU countries), which urged the establishment of effective processes to manage the reconstruction of international banking groups. The BRRD is the most comprehensive example of what they had in mind, but their recommendations were most definitely not to limit cooperation within the confines of a single trading bloc. Unfortunately, that would be the effect of the European Union turning its back on cooperation with the United Kingdom.

As soon as the United Kingdom becomes a third country, distinct from the European Union, both parties should use the powers in BRRD article 93 to agree to continued cooperation and respect for each other’s recovery and resolution processes for financial institutions. An agreement of this nature could be used as a model to extend international cooperation in recovery and resolution with other G20 jurisdictions.

The opinions expressed in this article/multimedia are those of the author(s) and do not necessarily reflect the views of CIGI or its Board of Directors.

About the Author

Dorothy Livingston specializes in EU law and regulation. She was a partner at Herbert Smith LLP from 1980 to 2008, initially in the Finance Division and then in the Competition Regulation and Trade Department, where she is now a consultant of the enlarged firm, Herbert Smith Freehills LLP (HSF).