Many EU banks are in the midst of their Brexit planning. Obviously, their micro-level decisions are driven by what is happening in the Brexit negotiations on the macro level. Put more precisely, their decisions are driven by their current and cautious predictions of what will happen on the macro level. From the perspective of the governmental Brexit negotiation teams, this means that time is of the essence. If they wish to effectively create the “right” incentives for the banks, they must concentrate on signals with a current impact on predictions, rather than eventual outcomes.

This observation can be broken down into three elements:

I. Observation 1: The Two Years Are Not Two Years

I would argue that my observation holds true for both, UK banks currently active in the EU 27, and vice versa. For the sake of simplicity, I use one specific stylized set of facts:

Put yourselves in the shoes of the management of a US bank with a licensed UK subsidiary using EU passporting privileges to (a) do cross-border business out of the UK into certain continental EU-27 Member States and (b) having branches in others – in the practitioner’s lingo “using the UK sub as the EU hub”. Currently, this means that only one EU banking license is needed, namely the one in the UK. After the UK government has served its notice under Art. 50 TFEU on 29 March 2017, this set-up is stable until Q1 of 2019.

Beyond that, there is uncertainty. The risk is that, post-Brexit, there will be no passporting, and no functional equivalent established as a result of the Brexit negotiations. Arguably, this risk is small. But in the shoes of the board members in my example, having someone pointing out this low probability is not helpful. Rather, by deducting the expected implementation-period of their likely Brexit strategy from the two years set out in Art. 50 para. 3 TFEU, they will get to a rather early point in time for their “go/no-go”-decision. All that counts is their prognosis horizon at that point in time.

To the extent the outcome of the macro-level Brexit negotiations is still uncertain as of that “go/no-go”-date, they better err on the side of caution. In most jurisdictions, this is not only common sense, but is also the message of the law. Fundamentally endangering the sustainability of a company’s business model is, as a rule, prohibited. If the magnitude of a risk is such that its realization would make it impossible – in our case: illegal in certain countries – to continue trading, then this risk must be avoided, even if the probability is low. Therefore, in the face of uncertainty, the banks’ managements will need to assume a very hard Brexit, i.e. no passporting post-Brexit, and no useful functional equivalent.

II. Observation 2: The Critical Window Is No More Than Six Months

In this scenario, the management in my example is left with four options. These are, radically simplified, as follows:

  • Wind-down: they can discontinue, as of March 2019, all EU-27-activities locally requiring a banking license.
  • Equivalence Application: They can apply for recognition under an equivalency regime. For core banking activities such as lending and taking deposits, there is no such regime on the EU level. Consequently, this application will need to go to each national regulatory authority for each of the EU 27 Member States in question. If granted, it will be a basis for soliciting institutional customers cross-border. It will not be sufficient for retail, or for putting people permanently on the ground. Also, of course, there is always the risk that it may be unilaterally withdrawn, if and when the respective national regulator is not (anymore) satisfied with the UK regulatory system to be “equivalent” to its own.
  • Branch: Alternatively, management can apply for a national branch license. In most Member States, this process is similar to applying for a full banking license (and it has the disadvantage that from a branch you cannot passport). Thus, you might as well go straight for:
  • a Subsidiary with a full banking license which will then be your new EU hub, functionally replacing what you used to have in the UK.

Establishing a branch and subsidiary will take 12 to 18 months, the latter involving not only the local regulator, but also the ECB. For both, you need local substance. Often, you will thus need to move banking assets (and liabilities) cross-border. Many of the tools for doing so, such as the cross-border merger, are currently available under EU law. Being cautious means assuming that such EU-tools will disappear in a hard Brexit scenario. Thus, to the extent you wish to use any such tools, your cross-border move needs to be fully completed pre-Brexit.

III. Observation 3:  Consequently, this issue can’t wait  

For these reasons, any signals from the Brexit negotiation table capable of having a material impact on the Brexit planning of the banks need to (i) come very soon and to (ii) be close to 100% reliable.

A “nothing is agreed until everything is agreed”-attitude will not entail the desired effect (of, in my example, keeping high levels of banking substance in the UK).

A preferable approach may be to agree, at the beginning of the Art.-50-period, on a grandfathering period. Such period could last e.g. 30 months from the conclusion of the negotiations or the expiry of the two years (plus extension, if any) under Art. 50 TFEU, whatever occurs first. During this period, the current passporting system would continue to apply, to be automatically replaced by the end of this period by whatever will be agreed as the permanent solution in the Brexit negotiations. On this basis, banks could wait for the eventual outcome, and base their decision-making on their certain knowledge of such outcome, rather on their uncertain current predictions.  

 

Johannes Adolff is Partner at Hengeler Mueller.

 

This post is part of the ‘Brexit Negotiations Series’, a series of posts based on contributions at the ‘Negotiating Brexit’ conference that took place in Oxford on 17 March 2017.