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The good news
The good news is that Brexit will reduce systemic risk, primarily via two channels.
Taking Britain out of Europe leaves both financial systems weaker and less efficient, but all the wasted effort and barriers to trade will also make it less likely that both financial systems fail at the same time and, so long as the barriers are not too high, will also help to maintain diversity within both systems. While fragmentation is undesirable from an efficiency point of view, systemic risk is decreased.
The bad news
Brexit might also cause systemic problems if, despite all the fears, planning and precautions, at some stage during the process some new fear suddenly arises or confidence in the ability to offset or hedge some risk suddenly disappears. If this comes as enough of a surprise and is pervasive enough it could conceivably result in a systemic crisis if earlier fears had been directed towards the wrong targets.
Two areas appear to be of concern, legal ‘plumbing’ and equivalence. We do not think either is likely to cause problems, but systemic risk is about unlikely but serious events.
Could some boring, totally mundane function such as settlement or rehypothecation have its post-Brexit legal status questioned? Obviously, there is a well-established basis for these functions in Europe, another in the US, and 40 years ago there were the appropriate laws in the UK as well. But when the acquis is nationalised – transplanted whole into British law – is there any potential that something will be broken in the move?
Brexit will almost certainly reveal new problems within well-established contractual relationships, just as the Lehman insolvency lead to some aspects of the International Swaps and Derivatives Association being construed in court in a way many parties had not expected. The real question is whether any problems will be of sufficient magnitude to cause a systemic event.
It is reassuring that the rules will be applied by regulators whose intent is to make things work as before. Courts are sensible – the intent of nationalising the acquis is not to change things and courts will be strongly influenced by this. Provided that sufficient time is available, sensible solutions can be found.
Set against this, no burden of proof is required for uncertainty to explode into a crisis. All we need is a credible question being raised about the legal basis of some activity and we might see all market participants prudently and immediately stop carrying out the affected activity until sufficient reassurance can be provided.
Such jumps in expectations and behaviour have been at the heart of many systemic crises, including in 2008, when the fear that further insolvencies might follow AIG and Lehman was sufficient to shut down lending to finance-sector counterparties until adequate reassurances were given that no more banks would fail. Unfortunately, legal timescales are long, so if the legal ‘plumbing’ does threaten to fail, the UK and EU governments may need to find some way to underwrite the affected activity until the ‘leak’ can be fixed.
Another potential avenue for systemic crisis is equivalence – the treatment of foreign institutions and regulations as functionally equivalent to domestic institutions and regulations. As long as Britain is a member of the EU, financial institutions can safely assume that rules in one country apply in all member states. It is not possible to have a special set of rules for a subset of countries. If a financial institution complies with British regulations, it complies everywhere in the EU.
When Britain leaves, this permanence is gone, replaced by equivalence agreements. The EU can choose to recognise compliance with British rules as being equivalent to complying with European rules, and vice versa. However, by its very nature, such agreements are transient. Equivalence could in principle be revoked with a few months' notice.
If financial institutions operate on the assumption of permanent equivalence and equivalence is revoked or found to have a hidden weakness that is only exposed in a time of stress, or even if market participants only fear such an eventuality, then financial institutions could find themselves in unexpected difficulties.
The need to avoid excessive reliance on equivalence is fundamentally at odds with the desire to make the concept useful, and so there is potential for problems, even though all involved are highly aware of the issue. We expect both European and British authorities to handle termination of equivalence agreements with considerable care.
Conclusion
Systemic crises happen when we suddenly question our existing assumptions for how the world works and don’t like the answer. We might get there with Brexit, perhaps via ‘plumbing’ or equivalence.
However, on balance Brexit seems unlikely to increase systemic risk. It is a very visible problem which is likely to increase uncertainties, fragmentation, frictional costs and mistrust. All of these are both stabilising and systemic risk reducing, however costly they are in other economic terms.
Among all the competing commercial, national and regional interests in the Brexit negotiations, financial stability and systemic risk appear to us to be relatively unimportant.