Brexit and the Irish economy
[...] The ultimate impact of Brexit on the Irish economy remains uncertain and highly dependent on the terms of the UK's future relationship with the EU. Nonetheless, it is clear that the close relationship between the Irish and UK economies makes Ireland the most exposed to Brexit of all of the EU's remaining Member States, for a number of reasons, including:
First and foremost, the UK's departure from the EU will most likely reduce Irish exporters' access to UK markets and Irish consumers' access to products sourced from the UK. This may take the form of the imposition of tariffs on goods sold into the UK. In what could be considered a worst-case scenario, the UK may revert to trading with Ireland on the basis of world trade organisation rules. Work by the ESRI shows that under these rules some of the highest tariffs would be applied to products from Ireland's most exposed and most employment intensive exporting sectors, with numerous agri-food products possibly facing rates in excess of 30 per cent.
In a less extreme scenario, whereby an extensive free trade agreement is reached between the UK and EU, the reduction in market access should be less severe. If we look at existing free trade agreements between the EU and non-EU countries for example, many of these eliminate tariffs on virtually all goods. However, exceptions are applied and again are particularly prevalent in sectors of most importance to Irish exports such as agri-food.
Furthermore, it must be remembered that tariffs are not the only barriers to trade outside of the Single Market. Non-tariff barriers such as increased administrative and customs' requirements or costs associated with setting up new logistics and trade-processing systems also pose substantial costs to importers and exporters. Many of these existing, extensive free trade agreements between the EU and its trading partners, often referred to as "New Generation" free trade agreements, have also targeted these additional barriers to trade.
Ultimately, when compared with current trading arrangements and the achievements of the Single Market, any Free Trade Agreement could still represent a substantial loss of market access. This would suggest that following Brexit, Irish exporters seeking to continue to trade with their UK clients will face considerable challenges and increased import costs, which could both reduce the range and increase the price of imported goods available to Irish consumers.
One very tangible risk posed to the Irish economy is the potential disruption of the land-bridge to continental Europe that the UK physically provides to Irish trade with the rest of the EU. [...]
The implications of reduced access to the UK market would be further aggravated by any negative economic shock to the UK economy associated with Brexit. A reduction in the incomes of UK households or the profits of UK firms will lead to a reduction in their demand for the goods sold by Irish exporters. Further depreciation in sterling may also make Irish goods less affordable for UK consumers and, relative to goods produced within the UK, less competitive.
Taking these factors into account, our estimates suggest that in the event of no post-Brexit trade agreement being reached, GDP in Ireland might be around three per cent lower after ten years than under a no-Brexit scenario. This figure could be expected to translate into roughly 40,000 fewer jobs, which may occur largely in particular regions and sectors. [...]
Risks to the Irish financial services system
For the Irish banking sector, the potential implications include, amongst others, negative impacts on profitability and asset quality from the expected slowdown in UK and Irish economic growth. In addition, direct credit exposures from lending to the UK retail market are vulnerable to a UK slowdown. The impact of sterling weakness and declining economic growth may also impact the repayment ability of Irish Corporates and SME exporters.
From a structural perspective, the loss of the passport is relatively less concerning from an Irish retail banking perspective vis-à-vis other sectors, as the largest Irish retail banks tend to access the UK market via subsidiaries, which they can continue to do post Brexit and the provision of banking services through passporting to the Irish economy and citizens is relatively small.
However, new businesses entering Ireland as a response to Brexit will mean a significant transformation of the Irish banking landscape, with a material growth in its size and complexity.
The Irish insurance sector has significant international linkages. At the end-2015, over €3 billion of non-life business and over €2.6 billion of life business was written through international channels, either through branches or on a freedom of service basis.
Most of this is written by UK and Gibraltar-based insurance firms. This is perhaps unsurprising given the similarities in legal frameworks and the absence of a language barrier between both jurisdictions. Firms from the UK and Gibraltar accounted for €1.8bn of non-life and €2.5bn of life insurance business.
These interactions between the insurance industry in Ireland and the UK include the sale of insurance products, financial arrangements such as cross border reinsurance, and the use of outsourced service providers.
This cross-border business has been an important channel in improving the provision of insurance to Irish businesses and consumers, some of it quite specialist in nature. The cross-border model works well, in both directions, when provided by firms that are financially resilient, well managed, with a solid business strategy and are knowledgeable about the Irish insurance market.
The potential loss of EU authorisation will affect the ability of UK and Gibraltar-based insurance undertakings to continue performing certain obligations for EU policyholders (and vice versa) and will impact the service continuity of contracts concluded before the UK leaves the EU. Without action, there are risks that UK and Gibraltar-based insurers passporting into Ireland will lose their ability to continue to provide insurance cover, including collecting premiums, making mid-term alterations and negotiating and settling claims on any outstanding insurance contracts - ranging from long-term life insurance policies to annual motor insurance contracts - taken out prior to the UK's departure from the EU.
The €1.8 billion value of business written inwards by UK and Gibraltar-based firms for non-life lines of business is significant. Approximately, €17 billion of non-life business is written domestically and internationally by firms regulated by the Central Bank. The larger firms typically have activated plans to obtain licences in the EU27. However, there are some providers, often offering relatively niche products or serving niche markets, where the cost of setting up and running a new EU subsidiary may be prohibitive. In addition to the contract continuity risk, there are clear risks of reduced competition and a reduction in customer choice.
In fund management, UK fund managers could lose the right to manage Irish authorised funds under the passporting regime. Such funds could also lose the power to delegate investment management and risk management functions to UK authorised entities.
Brexit is also going to impact on how financial institutions interact with each other. New regulations brought in since the crisis have sought to increase transparency and reduce risks in the securities and derivatives markets. The effect of this is that more firms are required to clear and settle their securities and derivatives with Central Counterparties (CCPs) and Central Securities Depositories (CSDs).
However, much of this essential financial market infrastructure, including as it relates to Ireland, is currently located in the UK. For example, the London Clearing House (LCH) is one of the world's largest CCPs. LCH dominates the clearing of over-the-counter interest rate swaps, with over 95 per cent of the market, and regularly clears in excess of $1 trillion notional per day.
If UK CCPs are not recognised under EU regulations after Brexit, firms engaging in, for example, interest-rate swap transactions would be unable to clear them in the UK. This issue is compounded by the lack of sufficient substitute capacity elsewhere. This will affect any EU firm that is using interest-rate swaps to mitigate the risk of interest-rate changes, elevating financial stability risks and, again, potentially reducing consumer choices.
A similar risk of loss of market access arises in relation to the settlement of equity securities traded on the Irish Stock Exchange. These are currently settled in the UK's Central Securities Depository. After Brexit, the UK CSD may lose its right to passport its services into Ireland, with a direct impact on the settlement of Irish equity securities.
Brexit impact on financial services firms
For existing firms, we consider Brexit as part of our ongoing supervisory approach. As I have described already, my vision for the Irish financial services sector is that it is well managed, well regulated and sustainably serves the needs of the economy and its consumers over the long term. In this context, when the Central Bank assesses the firms we regulate, we are essentially looking at four objectives from a prudential supervision perspective. Regulated firms should:
Have sufficient financial resources, including under a plausible but severe stress.
Have sustainable business models.
Be well governed, with appropriate cultures, effective risk management and control arrangements in place.
Be able to recover if they get into difficulty, and if they cannot, they should be resolvable in an orderly manner without significant externalities or taxpayer costs.
Brexit has the potential to affect each of these, and all financial services firms should be evaluating the impact of Brexit on these aspects of their business. From a regulatory and supervisory perspective, a primary concern is to ensure that regulated firms that have business models with direct or indirect exposures to the UK economy address and plan appropriately for the potential negative impacts of Brexit.
Therefore, we expect regulated firms across all sectors to consider, plan and adapt to the potential implications for their business models and revenue streams. It is the responsibility of firms' boards to assess the potential impact of Brexit on their firm and to plan accordingly. This should include early engagement with the Central Bank and relevant UK authorities as appropriate.
New or materially changing entities
In terms of new entities or business lines, we have been working for some time with a range of firms who have recognised that they need to relocate some of their activities in order to continue to access the EU market after Brexit.
Once again there are asymmetries here. Brexit is an imposed and undesired cost for businesses. There is the potential cost of setting up a new business in a different location, seeking authorisation, finding premises, relocating staff and so on. Perhaps more importantly for some firms there are ongoing costs and frictions associated with reorganising business lines, funding flows, booking models, and so on. It is understandable that firms want to minimise these costs and frictions.
But our gatekeeping role is hugely important in mitigating financial stability risks and protecting market integrity and customers in Ireland and across Europe. So, it is imperative that any new business authorised here as a result of Brexit meets the high standards that are expected of any such firm authorised in the EU - consistent with them effectively being, in many cases, an EU head office responsible for business undertaken in multiple jurisdictions. They need to organise themselves so that when they are up and running their business will truly be run from here, be clearly governed by EU norms and standards, and be set up to meet our robust, analytical, intensive and outcomes-focused supervisory expectations.
Good practices have involved firms who have looked very carefully at the legislative and business constraints, identified a credible new working model and put in place a strong team to deliver that. The process is typically more effective and efficient when we are dealing with the CEO and the Board of the entity that will be running the new business, rather than a project team from a global group.
The Central Bank of Ireland has been working on Brexit-related issues since before the 2016 referendum. We have been conducting our own analysis of the impacts, and engaging with firms on a continual basis to ensure that they are preparing appropriately. In short, it is one of our highest priorities and involves teams working across every area of the Central Bank.
In terms of new authorisations, there is considerable challenge for us in terms of the large volume of applications being processed over a relatively short period of time. Consistent with the challenges outlined by the UK authorities as recently as this week, the unprecedented level of authorisation activity is necessitating the Central Bank to make hard choices. We have increased headcount, recruited heavily and re-allocated senior and experienced resources from other important tasks to ensure that we deliver effectively, efficiently, predictably and in a timely fashion. We are also having to now de-prioritise and defer other less critical work to accommodate our work on Brexit.
We are also active internationally to ensure that the risk of divergence between EU jurisdictions in how they handle relocations from the UK is mitigated. In order to address the concern of regulatory divergences and the risk of regulator arbitrage between EU member States, we have long been engaging closely with the European Central Bank, across the Single Supervisory Mechanism (SSM) and the European Supervisory Authorities to agree European-wide approaches to the key policy and supervisory issues, stances and decisions that have arisen from Brexit. For example, we worked very closely and very actively as part of the SSM to develop a set of guidelines on this matter.
The ECB's stance is reflected in comments by Sabine Lautenschläger of the ECB's Executive Board when she stated that "the euro entity should not be an empty shell where the credit risk stays in the euro area, and all of the market risks are booked and governed and managed outside of the euro area"
The result is that much of the heat is now gone out of the regulatory arbitrage issue, although we will continue to work hard to maintain consistent approaches as new issues arise and the work on key issues develops and deepens.
As I mentioned at the start, all of this work takes place in a period of uncertainty, and it can appear that the sands are continually shifting beneath us. This is reflected by the announcement in March of an agreed transition period. On the one hand, the knowledge of a 'transition period' does provide a measure of comfort to both regulators and market participants.
On the other hand, as the transition phase only comes into effect if there is a withdrawal agreement, and the EU27 does not have the same legislative backstop as the UK. Therefore, we still must know what we are going to do in the event of a hard Brexit in March 2019. We still expect firms to continue to prepare for all plausible contingencies, including the eventuality that the transition period is not finally agreed on account of the overall uncertainty of the negotiations. Taking a conservative, prudential approach, we cannot exclude such a scenario - even as we welcome the progress on a political level.
Existing firms who are doing their contingency planning well for Brexit have already clearly defined a realistic worst-case scenario. They have worked out what they will do in such a worst-case scenario and they have figured out what the trigger events are for their worst-case scenario contingency plan to be put into operation. They already know who within their firm will have the lead in implementing that plan. Their boards have already seen and approved those plans.
Not every firm is in that situation. We are saying to boards and chief executives - you need to mandate your staff to think through the plausible scenario of a hard Brexit. You need to be costing it and you need to be putting timelines on it now. You need to encourage your risk managers to be realistic about that worst-case scenario and not make optimistic assumptions about what Governments and legislators might do to solve your problems for you.
That said, we recognise the realities and complexities of the situation. It is also important (as I outlined earlier) that Ireland and the EU continues to have an outward facing financial system, which facilitates global financial flows and retains connectivity with the UK. So, when I talk about pragmatism in this context what do I mean?
A fundamental principle of authorisation and supervision is that a regulated entity must have the governance and control arrangements in place that are commensurate with the nature, scale and complexity of its business from the point of authorisation. It must also have the necessary resources (human, operational and financial) to support the business on, what could be referred to, as Day 1 of authorisation. This is not negotiable.
However, many Brexit-related changes and applications involve transfers of existing business lines, new licences and growth plans. So Day 1 may not be the destination, it may be a staging post on the path towards the time - let's refer to this as Day 2 - when the full post-Brexit business arrangements of the firm are operational.
In the event that the proposed transitional arrangements are ratified, this transfer and growth may take place over an extended period. So, we are open to understanding, on a case-by-case basis, both existing and applicant firms' plans for navigating the paths between their Day 1 and Day 2 arrangements. Importantly, these plans need to be clearly articulated, credible and reflect the uncertainty associated with Brexit. In other words, we may hope that we have time post-March 2019, but firms need to be able to credibly demonstrate they can accelerate their journey from Day 1 to Day 2 should the transitional arrangements not be ratified.
And again, there are asymmetries here. What may be appropriate for a firm passporting into the UK may not work for a firm passporting from the UK into the EU, simply because of the different backstops that are in place. [...]
The impact of Brexit on the regulatory framework
[...] As such, a risk of material divergence between the EU and UK regulatory frameworks is one which must occupy some time as part of wider Brexit preparations. Divergence in the future might be problematic for the following reasons.
Firstly, access to EU markets for financial services is based on the concept of equivalence, or the idea that the firms seeking access to the Single Market from outside the EU have broadly comparable regulatory requirements as those present in the EU. This seeks to ensure a level playing field for EU and non-EU firms; maintain high prudential standards and investor protection outcomes; and ensure financial stability aims are met by applying stringent standards to the riskiest firms operating in the EU, regardless of where their home country is. [...]
Secondly, on a more practical level, following the UK's departure from the EU there will be a loss of experience and expertise when UK regulators are no longer sitting at the table. Whilst this might sound like a relatively minor issue given the other challenges Brexit presents, as a regulator I believe it is something that we need to be mindful of, particularly in Ireland. Whether it is because or despite of the long history between Ireland and the UK, our regulatory philosophies, approaches and thinking are usually aligned. [...]
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