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Countries and companies alike have long turned to English law when raising money on international bond markets, in an attempt to reassure investors that disputes would be settled in a neutral venue known for relatively quick and predictable outcomes.
On top of this trusted legal framework is the great patchwork of regulation the EU introduced after the financial crisis, aimed at making banks more resilient to shocks and to prevent taxpayers’ being put at risk when they do collapse.
Where investors are getting jittery is in the area of bank capital bonds, which has helped financial institutions bolster their balance sheets since the crisis. Regulators give varying degrees of credit to such debt because they can be written down to absorb losses when a lender runs into trouble. But as a bank’s failure is almost always intensely political, investors in these risky securities have generally eschewed buying debt written under local law out of fear from domestic interference. Instead, English law has been favoured.
That posed no problem for continental European banks when the UK was part of the EU. And even in the wake of the vote for Brexit in 2016 many were sanguine about potential disruption, particularly because the Bank of England was a driving force behind much of the thinking that shaped the EU’s bank recovery and resolution directive (BRRD).
But now the UK’s impending exit next year is becoming increasingly messy, fund managers that buy riskier additional tier 1 (AT1) and tier 2 bonds are worried that European bank debt issued under English law may no longer comply with the EU regulation.
While investors in some bonds could potentially extract fees from banks that need to make contractual tweaks, clauses in the documentation of other deals could let banks swap English law for local law — whether bondholders like it or not.
“It’s a really big issue as a relatively large proportion of AT1s have been issued under English law,” said Filippo Alloatti, a senior credit analyst at Hermes Investment Management. “With a French bank you might be happy to switch to French law, but I think a lot of people would struggle with local law for Italian and especially Portuguese bonds.”
Nomura’s capital solutions team estimates that approximately €120bn of AT1 and tier 2 bonds from European non-UK banks are governed by English law.
While many believe the regulatory fixes to address Brexit should be straightforward, if no compromise is reached this debt is at risk of no longer complying with the EU’s “minimum requirement for own funds and eligible liabilities” (MREL) regulation. [...]
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