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November 14, 2018

IMF published its staff report and selected issues report under the 2018 Article IV consultation with United Kingdom. Progress toward Brexit preparations for the financial sector in the UK is one of the key issues addressed in the staff report. Additionally, the selected issues report focuses on the long-run economic impact of Brexit and discusses policies to facilitate the structural transformation implied by the estimated variation in sectoral impacts.

The IMF Directors noted that in case of a disorderly Brexit, policies should seek to safeguard macroeconomic and financial stability. Directors welcomed the authorities’ readiness to take actions to minimize market disruptions, including by ensuring that the financial system has adequate liquidity. Directors encouraged the authorities to maintain robust prudential and supervisory standards after Brexit. They welcomed the authorities’ efforts to proactively help financial institutions prepare for Brexit and their commitment to creating temporary permission and recognition regimes that would guarantee EU financial institutions the ability to continue to operate in the UK for a limited period after departure. They also underscored the importance of continued close cross-border cooperation in the future to maintain financial system stability.

The staff report concludes that the UK financial industry will be significantly affected by Brexit. Banking activities—including mortgages, cross-border banking, and deposit taking—will be most affected by the loss of passport rights. However, the asset management industry may see a smaller impact, as its activities could benefit from the existing third-country frameworks, although approvals will have to be granted. The authorities are working with financial institutions to prepare for Brexit. There has been significant progress in converting relevant EU financial-sector legislation into UK law, including the preparation of secondary legislation, where needed, and the replication of EU institutional capacity. The UK government has committed to bring forward the legislation to create temporary permissions regime to allow the European Economic Area financial services firms and funds to continue their activities in the UK for a limited time period after the UK has left EU, providing a backstop in case a Brexit agreement is not ratified. EU policymakers have also issued advice to financial institutions to step up preparations for a cliff-edge Brexit. Risks to financial stability include both direct effects from potential disruptions to the provision of financial services and indirect effects from macroeconomic shocks.

The 2017 annual cyclical stress test of BoE suggests that the major UK banks are sufficiently well-capitalized to withstand a range of macroeconomic shocks that could be associated with Brexit. Additionally, the countercyclical capital buffer (CCyB) rate needs to be kept under review to ensure it reflects shifts in the overall risk level. A timely adoption of the Basel III final agreement, along with the implementation of BoE's guidance on the use of hybrid models for estimating risk-weights should help reduce the variability of risk-weights among banks. Meanwhile, bank-specific capital buffers should continue to be adjusted, when necessary, to match the individual risk exposures of banks. BoE noted that domestic banks' capital ratios have tripled since the end of 2007 and are at an adequate level to withstand a range of shocks, including those that could be associated with a disorderly Brexit. The authorities also noted that the macro-prudential requirements on mortgage lending implemented in 2014 should mitigate risks from high household leverage. Furthermore, the ring-fencing of banks would help ensure that banks can be resolved without resorting to public funds.

The assessment reveals that the authorities are committed to implementing prudential and regulatory policies after Brexit that meet or exceed international standards, independent of the outcome of the EU withdrawal negotiations. The authorities emphasized that contingency planning in the financial sector is advancing. The temporary permissions regime, which is awaiting parliamentary ratification, and other legislation will ensure that European Economic Area financial firms currently operating in the UK via a passport can continue to conduct regulated activities as normal for up to three years after the exit. However, the authorities stressed the risk that cross-border derivative and insurance contracts could be affected by the loss of passporting rights in the absence of something analogous to a temporary permissions regime on the EU side. The assessment highlights that potential risks related to market-based finance bear close monitoring.

The ongoing effort of authorities to collect information on leverage outside the banking system and assess potential vulnerabilities has been welcomed. BoE is developing a system-wide stress simulation covering hedge funds, dealers, insurance companies, and other non-bank firms, as part of its work on assessing potential stability risks beyond the banking sector. It is recommended that efforts to actively monitor and mitigate cyber security risks should also continue.The recent adoption of the second Markets in Financial Instruments Directive (MiFID II) framework has helped strengthen investor protection and transparency. Adequate capitalization, temporary permissions, and ensuring liquidity provision could help mitigate financial disruptions associated with a potential disorderly Brexit. In the event of stress in financial markets, BoE will need to ensure that the financial system has adequate liquidity. The annual stress test in 2018 should be used to gauge the strength of the banking system to withstand a combination of possible risks associated with Brexit. 

The staff report also emphasizes that regulatory and supervisory cooperation between the UK and EU authorities will be crucial to maintaining the integrity of cross-border transactions and business. A technical working group, chaired by the heads of BoE and ECB, has been established to discuss Brexit-related financial stability risks in the period around March 30, 2019. As suggested in the 2018 EU Financial Stability Assessment, authorities in the UK and EU should work together to ensure legal continuity in insurance and derivative contracts, along with proper data-sharing to avoid cliff-edge effects. The potential loss of euro-denominated derivatives clearing permissions for EU banks on UK-based central counterparties (CCPs) could generate short-term financial stability risks related to the continuity of existing contracts as well as netting efficiency losses related to the fragmentation of derivatives clearing. Changes in the regulation and oversight arrangements for euro-denominated derivatives clearing on UK-based CCPs will require careful design to ensure smooth functioning of derivatives clearing. A continued prudent approach to supervision would be important to maintain financial stability.


Related Links

Keywords: Europe, EU, UK, Banking, Securities, Brexit, Article IV, Financial Stability, Insurance, Stress Testing, Basel III, Temporary Permissions Regime, IMF

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