. @BarristersHorse and others requested an explanatory thread following a tweet I posted yesterday regarding one of the key components of financial services prudential regulation, were the EU not to grant full Equivalence to the UK on an ongoing basis. 1/

The key point is that this is the single strongest negotiating card the UK holds. Either Cameron, May or Johnson never understood it, or were too timid to play it. Now is the moment. 2/

Remainers have repeatedly asserted that the balance of economic power lies with the EU and that it is perfectly reasonable for the EU to exercise that economic power in pursuit of its negotiating objectives. I’m sure they will be consistent in supporting the UK doing the same. 3/

In late 2018, in advance of a potential No Deal in March 2019, @hmtreasury introduced a Statutory Instrument (SI) under the EU (Withdrawal) Act 2018. The provisions under the SI are in place. Links to underlying documents are available (Paras 7.12 and 7.13 of the SI). 4/

The SI in question relates to the capital requirements for banks, insurance companies and large financial institutions based in the UK. Such firms are required to hold capital to underpin and mitigate the risks associated with their business. 5/

The level of capital, and provisions relating to its calculation and quantum, are captured under CRDIV and Capital Requirements Regulation (CRR). The SI relates to the amended CRR were the UK to leave the EU without a Deal and without full Equivalence for financial services. 6/

As an EU member, 2 key provisions relate to the application of CRR for investment firms:
1/ Regulators ‘look through’ branches up to the parent when calculating CRR; and
2/ EU government bonds carry a zero risk weighting for meeting capital requirements. 7/

This makes it easier/cheaper for firms to undertake cross border business. Many EU27 Institutions operate in the UK under a branch structure so minimising capital requirements under CRR. Many of these institutions have of course been financially very vulnerable since 2008/09. 8/

Were the UK not to be granted full Equivalence, it would remove the twin provisions of CRR and EU27 firms would need to fully capitalise UK entities. And EU27 govt bonds (which represent a significant part of the capital base) would face a charge, AKA a ‘haircut’ in value. 9/

At a stroke this would significantly increase capital requirements for EU27 firms and potentially render some insolvent. In addition to being used for capital, firms also use EU27 government bonds to underpin large derivatives exposures, both bilateral and centrally cleared. 10/

These large derivatives exposures are housed in UK and the same haircut to values would be applied to the value of the collateral. Any other approach would be illogical. This would likely be an unbearable financial burden for many already weak EU27 financial institutions. 11/

Changing these capital rules not only strengthen the UK’s negotiating hand but also necessarily reflect the true risk profile of many EU states. Only in the mind of a central banker can the credit profile of Italy and Germany be regarded as equivalent! 12/

So, time for UK to play its strongest negotiating card: remove zero sovereign risk weighting from EU27 government bonds for capital and collateral purposes and require all EU27 firms in UK to be fully capitalised - removing beneficial effects of look through to the parent. 13/

Also, end the zero risk weighting of EU27 government bonds for capital purposes and apply the same haircuts to the government bonds used for collateral purposes, collateralising huge derivatives exposures both in UK CCPs and for bilateral OTC derivatives exposures. 14/

Note: what I have laid out in this thread is NOT speculative, it is what is provided for in the SI. Furthermore it applies a far more realistic risk assessment to Eurozone issuers. The only question is how large a haircut to apply to each of the EU27 sovereign issuers. 15/

Deconstructing the Eurozone should be a UK policy objective. It is the fundamental flaw at the heart of the ‘Project’ and has led directly to lower growth and higher unemployment, punishing savers and the poorest and most vulnerable in society. 16/

This triple whammy would strike at the very heart of the Eurozone. Applying a 50% haircut to the value of Italian and French bonds might help concentrate minds. As Merkel and Barnier like to say, leaving EU has ‘consequences’. So too does a lack of Equivalence. Tick tock.
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