Executive Summary: A technical regulatory capital/resolution proposal from the European Systemic Risk Board holds major implications for negotiations regarding the UK's exit from the European Union.
The Discovery Process
Today's aggregate momentum activity showed banking in the lead for the first time in weeks:
To a certain extent, this was not exactly a surprise. Eurogroup finance ministers met yesterday in Europe. At the end of the week, deputies for the G20 Finance Ministers and Central Bank Governors will meet. Banking and financial stability traditionally generate more activity around the edges of those sessions. With trade war rhetoric and Brexit rhetoric muted at present, seeing banking at relatively high activity rates was expected. Seeing systemic risk issues generating high activity rates in the detail view also was not surprising.
After all, yesterday's Eurogroup meeting featured an agenda and decisions focused on making additional incremental progress towards long-standing goals of increasing cross-border economic integration inside the euroarea and fostering a larger international role for the EUR.
Neither of these goals can be achieved unless and until policymakers can find a way to share the financial burden of resolving financial institutions in Europe without contravening the Maastricht Treaty's prohibitions against "fiscal transfers." EU and EuroArea policymakers have spent the last ten years making the case that cross-border funds collected from private institutions through deposit insurance systems and certain elements of the regulatory capital framework do not contravene the Maastricht Treaty because the funds in question are not taxpayer funds. They may be pooled at the EU level, but their origin is from private banks (leaving aside temporarily the issue of state-owned or state-controlled banks).
So when a new set of proposals issued by the European Systemic Risk Board regarding how cross-border bank resolution should operate rose to the surface this morning, it was worth a deeper dive. Our technology accelerates discovery and insight formation, but it is still necessary to read.
Consider this detail from the proposals.
The technical language may be about regulatory capital, but the practical impact falls squarely in the Brexit universe even though the UK and its exit from the EU is never once mentioned.
Connecting the Dots -- MREL and Brexit
In fairness, one must be an expert in both banking regulation and the geopolitics of Brexit to connect the dots. Specifically:
1. One significant trigger for Brexit back in 2010 (see the history HERE), was that UK policymakers did not want to be responsible for funding banking resolution or rescues from outside the UK. These refusals applied equally to Lehman Brothers as to any number of banks caught up in the EuroArea sovereign bond crisis.
2. One significant rallying cry for Brexit later was that many people in the UK did not want to be subject to or bound by judicial decisions taken by courts outside the UK.
3. One significant strategic priority for EU policymakers is to increase reliance on capital markets located in the EU (principally Frankfurt, Paris, Milan). The shift over time would decrease reliance on policymakers based in London even as it would deepen local capital markets and, ultimately, increase international reliance on the EUR for securities market issues.
With these puzzle pieces in play, read the quote again. The proposal on the table in Europe, in plain English, is that the only way that certain securities can be recognized as part of the regulatory capital cushion is if those securities are (i) issued under EU law, (ii) issued in other countries that would expressly permit EU resolution authorities to change their value in a resolution situation; OR (iii) issued with contractual clauses that provide that authorization to EU authorities without regard to local (non-EU) law.
Option (iii) above potentially provides an elegant way for financial market participants to side-step the otherwise irreconcilable positions by policymakers in London and Brussels regarding whose laws should govern. Market participants are being provided with the opportunity to decide for themselves which laws should govern their contracts.
By creating a contractual escape clause from political posturing, the proposal potentially provides policymakers with an opportunity to think expansively about alternatives to the divisive equivalence determinations currently used to guide market access. The proposal effectively prioritizes capital market interoperability over scoring political points.
But there is a catch -- failing to re-write existing AT1 and Tier 2 capital instruments means that European banks will not be permitted to include these items in their capital market structures. Lawyers across Europe will celebrate, particularly since most financial instruments currently need to be re-written in order to implement the massive shift away from LIBOR-based pricing towards pricing based on alternative benchmarks in local markets.
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