Shearman And Sterling

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April 21, 2020

Managing Eurozone Risk Post-Brexit


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The COVID-19 crisis threatens to stress test the world’s financial institutions in new ways. Firms are far more robust than before the 2007-8 financial crisis as a result of strong management action and global coordination amongst regulators on regulatory capital, collateral, liquidity and governance standards. The main central banks and regulators have put in place more sophisticated arrangements for collaboration than ever before. However, there remains a significant structural issue which needs to be borne in mind when navigating the current situation, which is the systemic risk arising from the arrangements underpinning the Eurozone.

Partner Barnabas Reynolds has co-authored a paper[1] which explains how EU laws and financial regulations result in systemic risk by erroneously assuming that Eurozone member state debt is risk-free. True sovereign paper, issued by a state in a currency it controls, forms the bedrock of the global financial system, since it comprises the purest form of collateral and source of liquidity in a crisis. It is an asset that can always be counted on, so it attracts no regulatory capital charge. However, no Eurozone state has the ability individually to control all central banking activities, due to the role of the European Central Bank. In particular, no state can guarantee that it will never default, by printing more money, in the way that properly-sovereign governments can. The result of EU law’s treatment of Eurozone member state debt as a risk-free asset is to create systemic risk, initially locally within the Eurozone but, because of the interconnectivities of the financial market, to a degree that puts the rest of the world at risk also.

As Mr. Reynolds and his co-authors discuss, the U.K. currently mitigates this risk through the Bank of England’s stress tests and other measures.[2] After Brexit, new arrangements may have to be found in the U.K. to mitigate Eurozone-related sovereign risks. This could be achieved by way of the U.K. Government’s proposals, initially conceived by Mr. Reynolds,[3] for Enhanced Equivalence under which a U.K.-EU agreement would be struck, building on the existing EU law concept of “equivalence.” A reliable, robust agreement would be entered into between the U.K. and EU, allowing for U.K.-based financial businesses to continue providing services cross-border, across the EU, under U.K. law—and vice versa—so long as equivalent high-level international standards are met. A summary of how this would work is set out in the Annex. This would be the safest, lowest-cost way to transition to a post-Brexit environment for the financial services industry.

Annex: Enhanced Equivalence

The U.K. and EU could enter into an Enhanced Equivalence arrangement on the following model.

  • For the U.K. to be able to mitigate Eurozone risk with minimum disruption, an Enhanced Equivalence deal needs:
    • To be contained in a Free Trade Agreement or Mutual Recognition Agreement
    • To have included in it commercial banking, primary insurance and infills for the other gaps in the current EU equivalence laws
    • To contain the following key elements:
      • To be referable to whether each party’s laws achieve the same high level outcomes—principally, those specified by the Basel Rules and IOSCO
      • They must be predictable, binding and subject to independent (expert) adjudication
      • They should contain arrangements for future collaboration—including on new developments such as the EU’s proposed Capital Markets Union
    • Key drivers for the underpinnings of the arrangement should be the avoidance of introducing systemic risk into the other party’s financial system, and the protection of consumers
  • Detailed arrangements must include:
    • A separate, severable, sub-sector by sub-sector approach
    • Binding provisions, with adequate notice periods for any exit from recognition in a particular sub-sector
    • Coverage across all financial sectors, allowing for the management of financial risk across those areas, given the interconnectivity of all types of financial service
    • The presumptive equivalence on day 1 for all new U.K. or EU financial services measures introduced
    • A “no cliff edge” provision—ensuring that any in-flight contracts run off to completion at the moment of any withdrawal of equivalence for a particular sub-sector
    • No “strings attached,” avoiding any politicisation or attempt to impose extraneous standards on the other party which go beyond the need for the avoidance of systemic risk and the protection of each party’s consumers
  • In order to assist the Eurozone on its current journey towards integration, the U.K. can offer:
    • To continue to apply low-risk weightings for Eurozone bonds for capital, collateral and liquidity purposes but subject to the U.K.’s ability to impose top-up capital charges and to take other counterbalancing measures
    • To permit the inward branching of EU financial institutions such that they continue to operate under the EU’s “home state” prudential regulation, despite this being based on the flawed assumption that the Eurozone’s sub-sovereign member state bonds are sovereign—and therefore EU regulation and home state supervision make no top-up capital adjustment for Eurozone risk carried by EU institutions
      • However, this should be subject to a systemic risk cap based on the size of the overall Eurozone risk exposure embodied in these institutions and the potential for seepage of this risk into the global financial markets
    • To allow consumer protection regulation to be determined by the host state, with a mechanic for the enforcement of reasonable penalties; “consumers” would be narrowly defined as genuine (individual) consumers
  • EU approaches which cannot be considered part of any Equivalence arrangement:
    • U.K. would not be a law-taker and should have the ability as a sovereign to determine its own legal framework. U.K. should have a choice to diverge from global standards if it see fit and risk non-equivalence in particular areas
    • EU laws relating to Eurozone monetary or other related policy would not become part of U.K. law or regulation; all regulation must be crafted by the U.K. solely in the interests of itself and in protecting the global market which it hosts
    • Cross-border recognition:
      • Caveated recognition of EU prudential decision-making, so that counterbalancing measures can be taken where necessary
      • The recognition of BRRD[4] resolutions only where these have been fairly applied across all creditors
      • The inclusion of a mirror to the EU-Singapore BIT provision[5] that equalises U.K.-based holders of EU/Eurozone debt with those in the EU/Eurozone itself
      • No use of the EU’s European Market Infrastructure Regulation[6] and related legislation to require U.K. clearing houses to take Eurozone (sub-)sovereign bonds or apply, or disapply, particular haircuts to such assets
  • No attempts to force business to each other’s market but the acceptance that market forces should determine where business is conducted


[1]  Managing Euro Risk: Saving Investors from Systemic Risk, Barnabas Reynolds, David Blake and Robert Lyddon, Politeia, February 2020.
[2]  Bank of England stress tests require banks to hold additional loss-absorbing capital to protect them—and the global market—from quite extreme events that might arise in the Eurozone, eg a 4% fall in Eurozone GDP, a 20% fall in Eurozone residential property prices and a 26% fall in commercial property prices. The European Banking Authority, which applies stress tests for the Eurozone banks, does not make any such assumptions. Nor does the U.S. Federal Reserve seek to address the issue either.
[3]  A Template for Enhanced Equivalence, by Barnabas Reynolds, Politeia, July 2017.
[4]  The Bank Recovery & Resolution Directive 2014/59/EU.
[5]  The Investment Protection Agreement between the European Union and its Member States and the Republic Of Singapore, 14 November 2019.
[6]  Regulation (EU) No 648/2012.

Authors and Contributors

Barnabas Reynolds


Financial Institutions Advisory & Financial Regulatory

+44 20 7655 5528

+44 20 7655 5528