With the UK’s Brexit negotiations underway, this Q&A guide to the issues looks at what the results of discussions will mean for asset finance.
Click on each query to view a specific answer, or scroll down to read through the full article.
- What will be the main implications of Brexit for asset finance?
- How is the UK economic outlook affected by Brexit so far?
- How does the exchange rate affect customers in the UK leasing market?
- How will Brexit affect the UK's trading relationship with the EU27?
- What are the alternatives to the Customs Union and does this have direct implications for asset finance?
- What would be the implications for trade in goods if the UK does not remain in the Customs Union?
- How could financial services be affected by the UK's exclusion from the European Single Market?
- How does the ‘passporting’ issue affect asset finance?
- To what extent could migrations of activity for passporting purposes threaten London's ‘critical mass’ as a financial centre?
- Aside from passporting effects, what other Single Market aspects of Brexit affect financial services?
- Is the Euro clearance issue directly relevant to asset finance, or just another aspect of the ‘critical mass’ Brexit threat to London's financial markets?
- How long will the Brexit negotiations take?
- What are the prospects of the UK obtaining acceptable terms in the Brexit negotiations?
- Will the deal have to be ratified by all national parliaments in the EU27?
- What will happen to the future of all the UK legislation adopted over the years under EU requirements?
It could be said that there are broadly three ways in which the industry will be affected. Firstly, for UK-based financial groups undertaking equipment leasing business in other parts of the European Single Market, and more particularly for their parent banks, there could be licensing implications affecting their ability to continue operating as at present.
Secondly, all lessors (and lessees in some sectors) currently benefit in many ways from the vibrancy of UK financial markets and institutions centred in London.
Again because of Single Market licensing issues, there is some potential threat of parts of the London financial infrastructure being forced to migrate to alternative centres within the remaining EU countries (the EU27).
Much more important than either of these issues is the general impact of Brexit on the UK's international trade and hence its overall economic performance; and in consequence the prospects for the national market in equipment finance.
The ultimate impact will depend in large part on what alternative arrangements can be negotiated for the relationship between the UK and the EU27.
There is a wide variation in assessments of the possibilities in that respect and of the economic effects of possible outcomes.
It would be fair to say that since the referendum the majority view among economic forecasters is that the long run impact of Brexit is likely to be negative for the UK.
The possible scale of such an effect is subject to a great deal of uncertainty. Some expect that UK gross domestic product (GDP) could be as much as 3% lower than it would have been had the UK remained in the EU, by the time any transitional Brexit arrangements have run their course. Some also suggest that after that the long-run growth potential of GDP might be reduced by up to 0.25% per year.
However, all of this is highly speculative. The UK economy in general continued to perform quite strongly, measured by either historical or international standards, for at least the first six months after the referendum on leaving the EU, helped by some easing of monetary policy.
The main initial impact of the Brexit vote, reflecting financial market expectations of long-run negative consequences, was a sharp fall in the sterling exchange rate against other currencies. For most of the period since the referendum in June 2016, the pound has traded within the range of 10-15% below its level a year ago.
Generally, a lower exchange rate will help UK manufacturers most directly exposed to international competition in either the home or export markets for their products. However, because of the effect on import costs it will be negative for final consumers, and for businesses with a high proportion of suppliers, rather than customers, who are outside the UK.
The critical factors to be negotiated with the EU27 relate to:
• the Customs Union, governing ‘visible trade’ (i.e. imports and exports of goods) within the present EU; and
• the Single Market, affecting the freedom to trade services across borders, and mutual recognition of some regulatory licences, throughout the European Economic Area (EEA) which includes a few non-EU European countries.
The UK will be seeking to negotiate alternative arrangements, comparable with those presently available to some European countries outside the EU or the EEA, to minimize disturbance to mutual trade.
It will be important for all asset finance customers directly involved in international trade, especially many of those in manufacturing or agriculture.
Most non-EU European countries have free-trade agreements (FTAs) with the EU. Trade between themselves and the EU is free of tariffs and most non-tariff barriers (NTBs) such as import quotas. Yet they do not necessarily adopt the the EU's common external tariff (CET) on imports from third countries and may have their own trade agreements with some such countries.
Those countries are outside the Customs Union. Goods traded between them and EU countries have to pass through customs checks to confirm whether they qualify for tariff-free access in the light of the country of origin of those goods or (in the case of some manufactures) of major components.
Turkey is the only non-EU country presently within the EU Customs Union for most purposes. Trade in agricultural produce is, however, excluded from that arrangement.
The present UK government's negotiating aims in this respect are not entirely clear. Prime Minister Theresa May has said that she may aim to retain “some elements of the Customs Union”. However, other Ministers have looked forward to the future negotiation of UK bilateral trade agreements with third countries, which does not appear compatible with full membership of the Customs Union.
In the absence of any different agreement, the UK's visible trade with the EU27 would revert to World Trade Organisation (WTO) rules, comparable with Europe's existing trade with most ‘third countries’. UK exports to the EU27 would face the common external tariff (CET).
The UK would set its own rules for external tariffs and non-tariff barriers (NTBs) on imports, which in this case would apply to the EU27 as well as third countries. For this purpose, retaining the CET would be the default position for tariffs on industrial products, although unilateral UK moves towards free trade would be a possibility.
On most industrial products CET rates are very low, usually no more than 2%. However, for motor vehicles they are significantly higher at around 10%. The possibility of traded goods having to pass through customs checks between the UK and the EU27 is widely seen as potentially much more disruptive to the supply chain in many manufacturing sectors than the tariff rates themselves.
All the EU institutions have insisted that the UK could not remain in the Single Market, like EEA countries, without accepting continued free movement of labour. Since concerns about the recent high level of immigration were assumed to be a critical factor in the Brexit vote, the UK government is not seeking to keep the country fully within the Single Market.
Alternative arrangements that might be sought by the UK could include a degree of mutual recognition of comparable regulatory rules and licensing systems outside of the Single Market rules, under ‘equivalence’ procedures. Switzerland, which belongs to neither the EU nor the EEA, has an extensive agreement with the EU covering mutual recognition of licences, with consequent ‘freedom of establishment’, in some financial sectors. This does not include banking, though it covers insurance.
In narrower sectors there are certain bilateral arrangements with major jurisdictions outside Europe such as the US. These can cover institutional freedom of establishment. They may also include ‘safe harbour’ rules for large ticket financial transactions with cross-border elements, where the local regulations in the respective jurisdictions (if these are harmonized within the EU) are similar if not identical.
Passporting refers to the ability of a business of a certain type, with activities subject to licensing and other types of regulation, to operate in all EU countries on the strength of a single licence granted by its home state. There are of course two distinct roles for licensing and regulation, either or both of which could be relevant to passporting for some businesses:
• prudential regulation (of a firm's capital adequacy etc); and
• the regulation of business conduct, e.g. of a lender or lessor in relation to its customers or their guarantors etc.
For various reasons, passporting appears to be of limited application to business-to-business (B2B) transactions like equipment leasing. It has rather more direct relevance to consumer credit, including non-business car finance, which of course often concerns the same finance companies as equipment leasing. To the extent that it might force the migration from the UK to within the EU27 of other financial services activities, it is also conceivable that the passporting issue could erode to some extent the critical mass of London financial market activity, with adverse implications for lease funding.
With a few exceptions (including for certain transactions in France) B2B equipment leasing does not require prudential regulation in EU27 countries, nor indeed elsewhere in the world. However, most leasing business throughout Europe is written by banking sector lessors; and banks are subject to prudential regulation, which will include capital requirements to cover any leasing exposures within a banking group.
For business conduct purposes, few if any EU27 countries regulate equipment leasing business to the extent of requiring licences to be held by lessors. By contrast, in consumer credit EU Directives require extensive regulation including licences.
Consumer credit licences are nevertheless not themselves within the category of licences covered by passporting under Single Market rules. However, consumer credit lenders are again generally within banking groups. Where a credit company is regulated as a bank in any EU country, it can transact business throughout the EU on the strength of its banking licence. So potentially, passporting could be a relevant Brexit issue for consumer lenders regulated as banks in the UK.
On the other hand, for credit and leasing business, pan-European or multi-country operations are usually undertaken through separate local subsidiary companies in each state, rather than on the “branch basis” without the use of local incorporation. Where substantial consumer credit business is undertaken by national subsidiary companies of a UK-based bank within the EU27, it seems likely that (even if a credit licence is not held in every country) at least one company within the EU27 will either hold a banking licence already, or be in a position to obtain one without major disruption to its business model.
Where UK-based groups in any regulated sector require new local licences because of Brexit, they will need to have substantial local operations in the country where the licence is sought. A ‘brass plate’ centre would not be sufficient. For banks and insurers, for whom prudential regulation is important, a local subsidiary seeking a licence would need the required level of capitalization on a ‘solo’ basis.
The good news for the UK is that no single financial centre in the EU27 presently looks like coming close to matching London's scale. Any migratory moves will be divided among several destinations. Some banks are considering moving certain operations to either Frankfurt or Paris. The two largest national securities markets in the EU27 are in those cities, and they consequently host significant investment banking activity.
However, various types of non-bank UK financial services players affected by the passporting issue – particularly insurers and investment fund management firms – appear to be more interested in other west European financial centres, principally Luxembourg, Dublin or Amsterdam.
One significant issue concerns the clearing of over-the-counter (OTC) financial derivative contracts through central counterparties (CCPs). OTC derivatives are those swaps, options and futures that are executed for clients by investment banks, as opposed to those quoted on public capital markets.
Following the international financial crisis of 2008, major jurisdictions including the EU and the US mandated that OTC derivatives executed by banks under their regulatory supervision (or that of individual member states in Europe's case) should where possible be cleared by these banks through CCPs, which were thereby brought into being as creatures of regulation.
The purpose of requiring clearance was to ensure stability on financial markets by guarding against default on delivery of a derivative order by any bank providing the contract. The clearing process is undertaken by the CCPs through matching sales against purchases on the same types of transactions, which can only be done by CCPs with major market shares and large transaction pools, and/or by requiring collateral from providers which of course affects cost margins on the contracts.
The largest CCP player in Europe is the London Clearing House (LCH), a subsidiary of the London Stock Exchange. Before the Brexit complication appeared, the European Central Bank (ECB) – having taken over regulation of the major Euro zone banks in 2014 under the Single Supervisory Mechanism (SSM) – attempted to require those banks to clear their derivatives within the Euro zone, and thus not through London. However, the European Court of Justice (ECJ) upheld a legal challenge against any restriction.
In the circumstances of Brexit, there is no doubt that, in legal terms, EU institutions could eventually require Euro derivatives executed within the EU27 to be cleared within those countries. The European Commission will be publishing a document later this month with some proposals for the post-Brexit regime on Euro clearing.
Some analysts suggest that the negative consequences of a restrictive resolution of this question could be as serious for the Euro zone as for the UK. The Euro is an international ‘reserve currency’; and consequently a large proportion of Euro derivative contracts requiring clearance are not executed in the Euro zone, or anywhere else within the EU27.
Therefore, any move to force a split in the Euro clearance pool presently handled in London by LCH could hit liquidity in that market, and make all Euro derivative contracts rather more costly. The EU already permits Euro derivatives executed in Europe to be cleared in the US under an ‘equivalence’ regime. So, any market share losses that might be suffered by London could benefit New York rather than any EU27 centre.
Among the underlying over-the-counter derivative contracts, one variety in particular – interest rate swaps – play a part in equipment leasing and lease funding. Lessors widely use swaps to offer fixed rate leasing deals over much longer terms compared to their funding facilities which roll over at variable rates. On some large ticket deals, lessees may also use such swaps to hedge their exposures to interest rates, especially where variable lease rates are based on a benchmark rate like LIBOR or Euribor.
This regulatory issue is not likely to affect contracts denominated in currencies other than the Euro. Among the asset finance client base in the derivatives markets, it is therefore lessors and lessees within the Euro zone who could be most directly affected, however much London may be impacted as a financial centre.
Article 50 of the EU Lisbon Treaty provides a mechanism for member states to withdraw, two years from the date of giving notice. The UK's Article 50 notice was served in March this year. Although this was nine months after the referendum, it could not have been done very much earlier due to contested litigation within the UK, where the courts ruled that Parliamentary approval was required first. Nor could it have been left much later, without the UK having to have been included in the next European Parliament elections in 2019.
While it therefore seems almost certain that the UK will cease to be a full EU member state in March 2019, nobody expects that all the issues raised by Brexit will have been resolved by then. If the negotiations proceed reasonably well, subsequent transitional periods may be agreed, during which (to a full or substantial extent) the UK might continue to participate in the Single Market and the Customs Union, while remaining subject to ECJ jurisdiction.
From the start, the UK was hampered by the initial absence of any negotiators or other specialists on international trade relations in its public service, since the EU has exclusive jurisdiction over member states' trade with third countries. This gap in expertise is gradually being filled.
The outcome on the key issues depends very much on how either side plays its negotiating position. At present, the risk of a ‘hard Brexit’, with trade reverting to the WTO basis, is still present. This would appear potentially very damaging to both sides, but proportionately more so to the UK.
At times over recent months, it has appeared that some leading figures on the EU27 side have been prepared to accept some disadvantage to their own countries, provided that the outcome is seen to be worse for the UK. In some degree that could have been motivated by a determination to deter any possible moves towards exit in other member states.
Within the past three months, challenges from Euro-sceptic political parties have receded following national elections in two states (the Netherlands and France). Such a challenge remains a possibility in Italy, where elections are due within the next nine months.
An important European Court of Justice ruling recently, arising from a bilateral trade and investment agreement between the EU and Singapore, seems to have clarified the ratification issue on the EU27 side.
It would appear that the major matters requiring agreement (whether on a final or transitional basis), including customs arrangements and those connected with the Single Market, lie within the ‘exclusive competence’ of the EU rather than being shared with all the member states. This means that they would require the agreement of only the inter-governmental European Council (on the ‘wejghted majority’ voting basis) and the European Parliament.
At the same time, some other matters that one or both sides might wish to see agreed might need ratification by all the national parliaments (which in some countries extends also to devolved regional bodies through national laws).
This of course covers a vast range of subjects. Two areas of particular interest to asset finance companies are certain aspects of consumer credit law; and some of the prudential regulations for banks. Generally, the UK government's approach will be to retain all laws as they stand initially, even though Brexit will offer opportunities to change many of them later – either at UK level, or in the devolved legislatures (mainly the Scottish Parliament), depending on the subject.
This standstill effect will itself require new legislation before Brexit takes effect. The transmission mechanism for adopting EU legislative requirements into national law has varied in different cases. Where EU Directives have been implemented through primary Acts of Parliament, or through statutory instruments adopted though powers given by pre-existing primary Acts relevant to the subject, the enactments will remain in force by default following Brexit.
However, other EU-driven enactments have been given effect either by EU regulations having the direct force of law, or by UK statutory instruments that were not enabled by subject-specific primary Acts. In either case, these were adopted into UK law under sweeping enabling powers given by Section 2 of the European Communities Act (ECA) 1972, passed at the time of the UK's accession to Europe.
Section 2 ECA will be repealed with effect from the main operative date of Brexit in 2019 (or possibly from a later date if necessary through any transitional agreement). The repeal legislation will nevertheless provide for ‘legacy’ enactments adopted previously under Section 2 to be kept in place on the standstill basis like the remainder of UK-adopted EU law.
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