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 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. 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, 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.
The U.K. and EU could enter into an Enhanced Equivalence arrangement on the following model.
 Managing Euro Risk: Saving Investors from Systemic Risk, Barnabas Reynolds, David Blake and Robert Lyddon, Politeia, February 2020.
 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.
 A Template for Enhanced Equivalence, by Barnabas Reynolds, Politeia, July 2017.
 The Bank Recovery & Resolution Directive 2014/59/EU.
 The Investment Protection Agreement between the European Union and its Member States and the Republic Of Singapore, 14 November 2019.
 Regulation (EU) No 648/2012.