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No-Deal Brexit - problems for the credit market?

  • Ireland
  • General

09-01-2019

On 29 March 2019, the UK is to leave the EU. While the text of a withdrawal agreement has been agreed between the UK and the EU, the agreement has still to be concluded and ratified. The UK Parliament is set to vote on the agreement next week.

Political uncertainty in the UK may result in the withdrawal agreement not becoming effective and the UK leaving the EU without appropriate transitional arrangements being in place to ameliorate the impact of Brexit.  In other words, the UK would exit the EU on a “no-deal” basis.

The UK government has proposed that legislation be put in place in order to facilitate temporary permissions and recognition regimes which would allow institutions within the remaining EU countries (the “EU27”) to continue their activities in the UK for a limited time period after the UK’s departure from the EU, even if in the event of a “no-deal” and no transitional period.  It has also confirmed that for EU27 institutions wishing to maintain their UK business on a permanent basis, the temporary permission regime would provide sufficient time to apply for full authorisation from UK regulators.

The European Commission (the “Commission”) also appears to be cognisant of the disruption which will result in a no-deal scenario. Prior to Christmas the Commission published a set of 14 legislative proposals and other acts that are needed to implement its no-deal contingency plan.  These relate to a number of areas where no-deal would result in major disruption for citizens and businesses.  These include financial services.

It is important to stress that the Commission’s proposals (whether in relation to the financial services sector or otherwise) aim to reduce only the most severe damage resulting from a no-deal scenario. They are temporary in nature and will not mitigate the overall impact of a no-deal scenario or reduce the need for preparation by affected parties. Neither do they replicate the benefits of full EU membership or give equivalent transitional benefits which would otherwise form part of the proposed withdrawal agreement.

The temporary measures identified by the Commission in respect of financial services are limited:

  • a temporary and conditional equivalence decision for 12 months to ensure that there will be no disruption in the central clearing of derivatives.  This will allow the European Securities and Markets Authority (“ESMA”) to recognise temporarily central counterparties currently established in the UK, allowing them to continue providing services within the EU27 temporarily. This is on the basis that EU27 entities will need this time to put in place alternative arrangements with EU27 operators;
  • a temporary and conditional equivalence decision for 24 months with the aim of ensuring that there will be no disruption in services provided by UK central securities depositories.  This will temporarily permit the continuing provision of notary and central maintenance services to operators within the EU27. This will allow EU27 operators that currently have no immediately available alternative within the EU27 to fulfil their obligations under EU law; and
  • two delegated Regulations facilitating novation, for a fixed period, of certain over-the-counter derivatives contracts with a counterparty established in the UK to replace that counterparty with an EU27 established counterparty.  This would allow such contracts to be transferred to an EU27 counterparty while maintaining their exempted status and thus not becoming subject to clearing and margining obligations under the European Market Infrastructure Regulation (“EMIR”).  Such contracts, pre-dating EMIR, are exempted from EMIR requirements. The intention is that a change of counterparty will not change that exempted status.

While these temporary measures are welcome, they do not go as far as the UK’s own temporary permissions regimes.  Nevertheless, the hope is that for the purposes of derivatives clearing and contracts, as well as for depositaries, the very worst impact of a no-deal on those areas is mitigated at least for a temporary period.

However, such measures are temporary and limited in nature and do not address other issues which will arise for financial institutions in the context of a no-deal scenario. One such area is the provision of loans and ancillary services.

Lending volumes between the EU27 and the UK are simply enormous. According to Dealogic, in the 12 month period ending on 31 October 2018, UK lenders lent approximately €40.4bn of syndicated loans to borrowers within the EU27.  Conversely €32.2bn (approximately 29%) of UK syndicated credit was provided by institutions within the EU27.

Last month the Loan Market Association (the “LMA”) 1 set out some of the issues that will arise if the UK withdraws from the EU in a no-deal scenario and highlighted the risk of substantial market disruption arising as a consequence. The immediate issues identified by the LMA and not addressed by the contingency planning include:

  • Loss of ‘Passporting’ Rights

The single market for financial services permits financial services to be provided by EU institutions located in any EU member state to counterparts throughout the EU without the need to obtain a local licence within each individual member state.  Non-EU institutions do not benefit from these ‘passporting’ arrangements and the Commission has highlighted that UK based entities will lose these rights in the event of a no-deal Brexit. Consequently, a no-deal Brexit threatens the ability of UK based entities to continue to provide financial services within the EU27 unless they have the necessary local authorisations.

Difficulties are exacerbated as local licensing regimes differ markedly throughout the EU27.  Some countries, such as Ireland, have relatively light regulatory requirements for corporate lending (whether by way of origination or ownership).  Others require lenders to be licenced locally or passported in.

Ancillary services may also require local authorisation in certain EU27 countries.  So, for example, the issuance of letters of credit or third party guarantees in Ireland is an activity which is, in the absence of passporting rights, subject to local licensing requirements.

Other ancillary services can form part of a loan package and may also be subject to bespoke local licensing, including the provision of hedging and payment services within the relevant EU Member State.

UK entities will need to ensure that on the withdrawal date they are properly authorised within each Member State in which they wish to operate and borrowers may find themselves in a tricky position if a particular service is no longer permitted post Brexit.

  • Validity & Enforceability of Agreements

English law governs the content of and the transferability of a large portion of syndicated loans within Europe and the vast majority of hedging agreements within the EU. English law governed finance agreements will continue to be interpreted by the English courts and a no-deal Brexit will not prevent those judgements from being made.

However, a no-deal Brexit may affect the degree to which those judgements are enforceable within the EU27. Absent an arrangement to the contrary, such judgements will no longer be automatically recognised throughout the EU27.

English judgements would then be in a similar position to judgements of non-EU countries. So, for example, the enforceability of a judgement of the courts of New York within the EU27 depends on the local law within the applicable Member State.

This is not ideal particularly in the case of existing finance agreements which were put in place before Brexit was contemplated and where the parties will have anticipated that those agreements would be capable of benefiting from a seamless and automatic enforcement regime throughout the EU.

Of course the same is true in the converse; absent arrangements to the contrary, judgements of the courts of EU Member States will not be automatically recognised in the UK.  This may cause complications for lenders where a finance transaction is documented on a cross-jurisdictional basis, eg. where a loan or hedging agreement is governed by English law but the security is governed by the laws of EU Member States (or vice-versa)2.

Last year the International Swaps and Derivatives Association (“ISDA”) published Irish and French law governed versions of its master agreements. It will be interesting to see the extent to which these versions of the ISDA Agreements will be utilised post-Brexit in documenting hedging transactions.

  • Netting

Currently EU Member States (including the UK) benefit from rules which protect collateral and netting rights of contractual counterparties. Unless reciprocal arrangements are put in place by the UK and the EU27, that regime will no longer apply.

  • Credit Ratings

Unless endorsed by an EU27 credit rating agency or certified in the EU under the Credit Risk Agency Regulation, entities within the EU will not be permitted to use UK credit ratings for capital purposes (eg. for the purposes of risk weighting). In the event of a no-deal, and if UK credit ratings are not determined to be the equivalent to that under the Regulation, then EU financial institutions using UK ratings for capital purposes may be subject to increased capital obligations and costs.

  • Data Transfer

The European General Data Protection Regulation (“GDPR”) governs the processing of personal data and information by which individuals may be identified. The UK will no longer be a EU “safe data” zone under GDPR.  Unless otherwise addressed this may result in difficulties for lenders if they wish to transfer personal data to UK entities, eg. in the context of a prospective transfer of a loan to a UK bank.

Changes in Organisational Structures

Of course, financial institutions have made and continue to make arrangements to continue to service their clients within the EU27 and the UK post-Brexit and in many cases have reorganised their businesses to facilitate this.  So, for example, HSBC France has acquired several subsidiaries from HSBC UK as well as various European branches as part of its preparations.  Other financial institutions have moved operations to the likes of Dublin, Frankfurt and Luxembourg.

Ireland is currently seeing a large increase in applications for financial groups seeking to move operations from the UK and Dublin is becoming an increasingly important hub for financial institutions previously based in the UK to service clients within the EU27. According to the Financial Times last week3  the Central Bank of Ireland is examining applications from significantly more than 100 financial institutions predominantly in asset management, investment and insurance.  Major players such as Barclays Bank and Bank of America Merrill Lynch have already received authorisations to increase operations within Ireland.

Conclusion

The contingency plans effected by financial institutions will continue to facilitate lending throughout Europe and the temporary concessions outlined by the Commission and the UK Government will mitigate some of the most serious disruptions to certain activities.

However, given the volume of lending between the UK and the EU27, anything which has the potential to disrupt the lending market, results in a diminished pool of available liquidity or renders credit more costly, will be of significant concern.  This risk will be increased if loan market participants do not have adequate time to adjust to any new legal and regulatory environment.

As we saw during the Financial Crisis, a disruption to, or the undermining of confidence in, the lending market can result in significant economic difficulties.  Given the symbiotic nature of the lending relationship between the EU27 and the UK, a no-deal Brexit scenario will potentially have a major and adverse impact on the lending market within Europe unless any impediments to continuing liquidity are quickly and satisfactorily addressed. 

Footnotes

1 The LMA is the trade body for the European syndicated loan market. The LMA is seen as the authoritative voice of the European loan market vis a vis lenders, borrowers, regulators and other interested parties. The aim of the LMA is to encourage liquidity in the primary and secondary loan markets.

2 Equally, the seamless recognition across the EU of UK insolvency processes and restructurings such as schemes of arrangement will no  longer be available (and vice versa). This could give rise to competing insolvency processes affecting the same debtor in different countries.

3 Financial Times 2 January 2019.

 

Disclaimer

This information is for guidance purposes only and should not be regarded as a substitute for taking legal advice. Please refer to the full terms and conditions on our website.

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