#BREXIT -- How It Started

Here we are on October 10, with no Brexit deal in sight. Many view the flurry of high level meetings with optimism that a last-minute deal can be found. But as this BCC story today indicates, the European view of the latest UK proposals is far from supportive.


As the clock ticks down to the Brexit deadline this month, many rightly continue to ask “how did we get here?”


The answer is that the Brexit situation has its roots in the Eurozone financial crisis nearly a decade ago. The inflection point was the EU summit in December 2011.


Before migration issues, xenophobia, unicorns, Russian Internet trolls, extremist politicians, trade policy, Northern Ireland, the Withdrawal Agreement, the BackStop, indicative votes, and the customs union dominated the Brexit dynamic, British and EU leaders were locked in opposition regarding governance and sovereignty issues with respect to who exercises what kind of regulation over the euro and the financial system in which the euro trades.


This post tells the story of how and why the EU and the UK are hurtling headlong towards divorce. The craziness that surrounded the referendum result and its aftermath have obscured the deep substantive divisions that were on display in December 2011.

At the time, I was advising large hedge funds and providing macrotrend projection for them. I watched these developments unfold in real time. It was obvious then that the positions being taken would generate dramatic geopolitical shifts.


Scene 1: Prologue


At the time of the December 2011 EU summit in Brussels, the global financial crisis had morphed into a Euro area sovereign debt crisis.


Large banks and sovereign governments across Europe teetered under the weight of non-performing loans and other economic woes. By the time it was all over, five countries (Portugal, Ireland, Spain, Greece, and Cyprus) received bailout packages from the IMF and hastily created European institutions (the EFSF — which morphed into the ESM, the EFSM, and new oversight entities under the umbrella of the ECB). The EU’s common currency survived, but there were days when that outcome was in doubt.


Multiple new treaties were negotiated, signed, ratified, and implemented among Euro area governments at lightening speed. The European Central Bank and EU-level financial regulators acquired significant new authority. The European Commission found itself often sidelined as Euro area governments reclaimed considerable decision-making authority they had previously delegated to Brussels.

While the EuroArea fire brigade was struggling to save the EU, a newly elected British prime minister entered the fray. He collided with a Euro area leadership struggling to save Europe’s common currency, economies, and banking systems. It wasn’t pretty.


As European leaders scrambled to save the euro, they found unity by resisting British policy priorities. Major media outlets (the Economist, the Financial Times, The Telegraph, Euractiv) provided the play-by-play through leaked documents and official statements.

Deep disagreements drove the dramatic discord.


Scene Two: Fiscal Union Dramas


Faced with multiple, simultaneous potential bank and sovereign bond defaults, the Euro area needed a mechanism to funnel financial support to hard-hit economies. but they had a problem. The Maastricht Treaty expressly prohibited “fiscal transfers” within the euro area.


“Fiscal transfers” refers to transmission of taxypayer funds from one sovereign EU Member State to another sovereign EU Member State for the purpose of covering budget deficits, social payments, and bond payment obligations. The idea was to create incentives for all members of the EuroArea to be fiscally responsible (and, implicitly, to follow Germany’s lead in delivering balanced budgets).


If fiscal transfers were illegal, then Member States would know they could not expect their EuroArea sovereign partners to bail them out. Specific economic policy targets (the “Maastricht Criteria” and the “Stability and Growth Pact”) were spelled out in the treaty, creating supposedly binding limits on fiscal policy targets and performance within EuroArea members. The European Commission was empowered to exercise oversight of national fiscal policies.

Obviously, the system failed to operate as hoped.


Heading into the December 2011 summit, leaks to Euractiv indicated that then-EU Council President Herman Van Rompuy would propose a technical solution that would address the fiscal union straight-jacket problem. The idea was ambitious and, in the middle of a major economic meltdown,in retrospect it was unrealistic. He sought constitutional amendments within at least EuroArea Member States (if not all EU Member States). The constitutional amendments would embed the Maastricht economic policy targets into national constitutions rather than seek treaty changes.


In order for that approach to succeed, a unanimous vote was needed at the December 2011 EU summit from all EU Member States. The EU’s need for unanimity seems to have encouraged the UK to negotiate a hard bargain in exchange for delivering political support to the eurozone. At this stage, it is fair to say that at the very least the UK over-played its hand. Less charitable interpretations are possible.


Scene Two: Financial Regulation Dramas

By December 2011, the financial crisis was in its third year. The United States economy had bottomed, finally, but not rebounded. European economies were mostly still in a downward spiral. Weakness in the banking sector (which constitutes roughly 80% of the financial system in Europe) was morphing quickly into a sovereign debt and massive economic problem.


Crisis-driven financial regulation initiatives were in full swing. Policy makers globally had agreed to increase bank capital requirements. Parallel initiatives sought to expand the regulatory perimeter and tighten regulation of central counterparties, SIFIs (systemically important financial institutions), credit rating agencies, significant non-bank financial institutions (like asset managers, including insurance companies), and derivatives markets.


Unlike continental European economies, the UK financial system is dominated by capital markets rather than commercial banks. Financial markets are also the single largest economic sector contributing to the UK’s GDP. This makes financial regulation a strategic, national interest. Traditionally, policymakers both in London and Washington have sought to promote competitive advantages for their markets by issuing regulatory standards exceed global minimum standards.


UK policymakers continued that tradition during the crisis and post-crisis period by seeking to impose “gold plating” requirements on top of those international standards. They maintained that that London as a global financial capital required more stringent standards in certain areas in order to avoid the troubles on display in the Euro area. European policymakers on the continent, unable to increase regulatory capital and other requirements on their ailing banking systems, sought to limit the ability of UK policymakers to exceed international minimum standards.


In addition, continental policy makers led by France sought to impose a “financial transactions tax” on securities markets transactions. Finally, regulators globally were trying to define a framework for cross-border bank resolution. As the Lehman Brothers and AIG situations had illustrated, resolving large, complex, cross-border financial firms can create fiscal policy issues. During 2011, policymakers were still struggling to define a global framework for allocating bailout and/or resolution costs across sovereign borders.


As of October 2019, no agreed international standards exist regarding cross-border resolution. A Single Resolution Board, funded by bank contributions rather than government fiscal resources, was created in Europe to manage cross-border bank closures. The UK is not a member.<