One year on from the triggering of Article 50, and despite the headwinds caused by the political instability, the UK and EU27 countries have managed to agree on a transition period that will allow financial services firms to continue to benefit from passporting permissions until the end of 2020. While this political agreement creates a framework for interim financial planning, there are still several outstanding discussion points, including the exact terms of the future relationship, that are unlikely to be decided before October 2018.
With the frequently-cited quote first spoken by the UK’s chief Brexit negotiator David Davis in relation to the discussions: “nothing is agreed until everything is agreed” looking more appropriate than ever, Brickendon Director Cagri Onur looks at what this means for financial services firms and how they should be preparing to ensure they remain ahead of the game in the post-Brexit world.
Brexit next steps
The key for banks is their contingency plans. While the negotiating parties move on to the next phase of discussing the future relationship, banks will need to continually review their plans with the regulators. They will watch closely to see whether the EU and UK regulators allow more time for contingency planning and need to make a decision of whether to take more time or to continue with the implementation of their original programmes if they consider there to be a competitive advantage, or cost effectiveness, in doing so.
A major part of the banks’ contingency planning is dedicated to the booking model and risk management in the future state. Many banks are now considering transferring the risk back to a hub as part of a back to-back-model. In order to better understand this model, we need to look into the recent history of the centralised risk management in global banks.
Until the financial crisis in 2008, global banks sought to grow their business by increasing their client reach through many legal entities around the world. At the same time, they kept their risk centralised globally with back-to-back booking models, whereby the client-facing trade was booked in the entity of the client, and the risk of the trade was transferred to the central hub to be managed in a consolidated and centralised fashion. This allowed banks to grow quickly in many locations without the need to establish risk management and operations centres in these new locations. Following the financial crisis, regulators began to criticise this model and demanded simplification of legal entity structures. As a result, many global banks moved to more simplified regional risk-management models. During this process, London consolidated its position as their European hub due to the UK being part of the EU. Now, with Brexit, banks are once again being forced to consider other alternatives to continue their operations in the most cost effective and least disruptive method.
While transferring the risk with hedging or back-to-back trades appears to be a very attractive option, especially in the short-term, the regulators are wary of the risks this model can cause to the financial markets in the country where the client-facing entity is located. The regulators would, at minimum, require that appropriate controls are set in place and that the client-facing entity has the ability to wind down these positions in an orderly fashion in case of resolution.
The European Central Bank (ECB) and the European Securities and Markets Authority (ESMA) have already made their views on empty shells/letterboxing entities clear on several occasions. In a newsletter in February 2018, the ECB highlighted the following key areas that it would be looking for when reviewing the risk models in the banks’ contingency plans:
- Banks will need to have an adequate level of internal governance, staff and functions in their EU entity, with the appropriate onsite management, front-office and risk-management functions.
- The EU entity will need to have business contingency arrangements to be able to gain access to financial market infrastructure without being fully dependent on the group.
- The EU entity will need to have a crisis management plan and should have a certain level of onsite trading and hedging capability.
- Banks will need to have a plan to transfer or set up pricing, trading, hedging and risk-management capabilities in their EU entities with sufficient controls and adequate oversight of the balance-sheet risks.
Booking and risk-management models
These key guidelines, clearly stated by the ECB, are expected to also be considered by the Prudential Regulatory Authority (PRA) when it reviews the contingency plans of the European banks seeking to continue serving their clients in the UK. In order to be ready for the post-Brexit and post-transition era, banks should ensure they define the right booking and risk-management model to have a better chance of receiving approval from the regulators. Banks should:
- Document the current and future booking models for each asset class.
- Ensure that the new/enhanced entity is well capitalised, and has sufficient liquidity and funding.
- Prepare relocation plans to ensure sufficient level of trading, risk management and governance capabilities are onsite in the new/enhanced entity.
- Prepare plans for crisis situations where the new/enhanced entity can manage its risk locally without full dependency on the group.
- Demonstrate that an orderly resolution will be possible in the cross-border entity booking model.
- Ensure the senior management fully understand the future-state model and are able to explain it to the regulators clearly.
- Support the model with strong front-to-back controls.
Over the next six months, the Brexit negotiations will focus on even more challenging issues, such as the Irish border, cross-border trade and dispute resolution in the absence of a single market. Until these points are agreed between the UK and the EU27, which is not likely to happen until October 2018, there will not be any further clarity on how cross-border financial services will operate after the transition period. In the meantime, banks will need to continue finalising their contingency plans with the limited information they have. As always, preparation is key.
To find out how we can help you ensure your business remains ahead of the game in the preparations for the uncertainty surrounding the post-Brexit future, read our insight papers: