Bank of England warns EU over Brexit risk to financial stability
The Bank of England has issued its strongest warning yet to the EU that its lack of adequate planning for Brexit has created growing risks for almost £70tn of complex financial contracts.
Threadneedle Street said the bloc had made only limited progress to protect the financial system and time was running out, with little more than six months before the UK is due to leave the EU.
Stressing the urgency of the situation in a statement from its financial policy committee, the Bank said: “In the limited time remaining, it is not possible for companies on their own to mitigate fully the risks of disruption to cross-border financial services.”
Sounding the alarm over financial derivatives – currently sold across the UK-EU border by banks to companies looking to protect themselves from movements in interest rates and changes in global markets – the FPC said Brussels needed to take urgent action.
Failure to make adequate preparations could mean the derivatives contracts, worth more than three times the value of the EU economy, are rendered illegal the moment the UK leaves the EU.
EU firms currently have about £69tn of outstanding derivatives contracts that are handled through a process known as “clearing” in the UK, while as much as £41tn mature after Britain exits the EU in March 2019.
The process of clearing involves banks organising their trades through a central third-party organisation – known as a clearing house – which takes on the risk of either party defaulting.
Clearing has become increasingly important since the financial crisis as the EU introduced rules forcing banks to trade greater volumes via clearing houses, with the idea of improving transparency and to avoid the confusion of banks going bust with complex webs of contracts with multiple parties – as was the case in 2008.
EU-authorised clearing houses must handle EU banks’ trades, but UK organisations such as the London Stock Exchange’s LCH handle the bulk of business and could fall outside the rules in the event of a hard Brexit. As much as 90% of EU firms’ interest rate swaps – one of the most common types of financial derivative – are cleared in the UK.
The UK has already taken action to arrange temporary permissions to grant EU banks access to the British market, although parliament has yet to pass the legislation with just months to go before Brexit. The Bank has previously issued warnings to the EU, but there is a growing sense of urgency.
Threadneedle Street warned the EU had shown little willingness to reciprocate the UK plan with potentially damaging consequences for financial sector risk, adding: “The need for authorities to complete mitigating actions is now pressing.”
The game of brinksmanship between the UK and the EU could be seen as a potential way for Brussels to grab more financial services industry activity away from the City of London to European financial centres such as Frankfurt and Paris.
British officials, however, believe the EU is ill-prepared to cope with the huge influx of derivatives business and that very few contracts have yet to be moved, despite repeat warnings over the potential risks.
There is also unlikely to be time to relocate the bulk of derivatives contracts to the EU before Brexit, given the complexity of the financial products, and that it would take a process likened by senior bankers to moving “nuclear waste”.