Not so equivalent after all: Cutting off the City of London would be a disaster for the eurozone

A leading City lawyer claims that Britain’s departure from the EU exposes such great systemic risks at the heart of the eurozone that it could trigger another global financial crisis.

In a dynamite new report, Barney Reynolds of US law firm, Shearman & Sterling, lifts the lid on what he calls hidden systemic flaws in the EU’s financial system which are currently mitigated by the role played by the UK’s financial markets.

The report, Managing Euro Risk: Saving Investors from Systemic Risk, and published by the Politea think tank, claims that as a member of the European Union and a global financial hub, the UK’s supervision of much of the EU banking system has protected the world’s financial markets from significant oversights in EU law. As a host of the global financial market, the UK has been performing a supervisory function, one that has shielded the world economy from risk by counteracting EU assumptions that eurozone debt is sovereign.

But Reynolds, who is head of the Shearman’s financial regulatory practice, adds: “EU financial regulations conceal financial risk which is dangerous to the world economy. This is because the eurozone system has misleadingly treated member-state debt as sovereign for years, despite no one country having sovereign control over its currency.”

Until now, he says the UK has played a vital role in mitigating this eurozone risk. But this protection will not automatically continue on the current basis after Brexit, unless the two parties can put their heads together and agree a mutually beneficial trade deal on financial services, such as Enhanced Equivalence, which is now the preferred outcome for the government. “Failure to foster a deal could lead to disaster for the eurozone.”

Reynolds is the brains behind the concept of “enhanced equivalence” and has been campaigning for years that it’s the best solution for both parties because it is relatively straightforward, and has the merit of being adaptable as regulations change. Under enhanced equivalence, the EU would allow UK financial businesses to trade in the EU under UK law, so long as UK regulations meet international standards and outcomes.

Reynolds told Reaction: “This acknowledgement of the role the UK plays in eurozone debt is a game-changer for the dynamics of how the government negotiates with the EU. It re-boots discussions onto the right footing by identifying the key role the UK plays for the EU and the terms on which it does so.”

“It shows how extraordinary Michel Barnier’s demands for a level playing field and for the UK to apply EU laws like state-aid actually are, since the EU is running the Eurozone at the risk of investors all over the world, which is far from operating on a level playing field.”

Reynolds adds the problem arises because EU financial regulations misrepresent the risk levels of Eurozone debt. Despite the inability of Eurozone member states individually to issue their own currency, EU regulatory institutions still register their debt as “sovereign”.

He points out that with debt treated this way, as less risky than it actually is, a small spark in a minor bank could set off a meltdown of the global financial system. This would work in ways similar to the 2007-8 financial crisis that arose because central banks globally had under-appreciated the (much smaller) systemic risk arising from Californian sub-prime mortgages.

EU law and regulation, he says, provides a false picture of financial risk. This is further masked by “perilous accounting practices.” That’s why failure to foster UK-EU co-operation could precipitate another global financial crisis. If it were to be operated entirely under EU jurisdiction, eurozone financial risk would be magnified. “It would lack the mitigating role of London as a global financial centre and would be lacking proper EU management of the risk.”

If the 19 eurozone countries were to try and build a similarly robust system to that comparable today with the City of London, albeit on a smaller scale reflecting the domestic rather than global nature of the eurozone’s markets, this could take decades and billions of euros.

However, he claims an Enhanced Equivalence agreement would allow the UK to continue to protect the global financial system from the inherent problems of Eurozone debt on similar terms to now.

“Enabling the UK to continue its mitigating role should be at the forefront of negotiators’ concerns. Under Enhanced Equivalence, involving mutual UK-EU recognition of either party’s laws and financial standards, UK financial businesses could continue to service EU27 customers and businesses cross-border from London under UK law, minimising friction, undercapitalisation and disruption to regulation.”

What’s more, Reynolds argues that without Enhanced Equivalence, many of these services would cease to exist in their current form, adding exposure, trapping newly acquired capital and collateral in EU27 entities and magnifying the Eurozone’s financial risk.

Not everyone supports equivalence as the best outcome for the UK. A recent report by New Financial, the capital markets think tank, argues that while equivalence would reduce the disruption to the financial services industry and its customers from Brexit, it is a poor substitute for passporting. It would limit the UK’s room for manoeuvre in diverging from EU rules in future and can be unilaterally withdrawn at short notice.

However, Reynolds’ model involves enhancing existing EU equivalence laws, filling in the gaps, rendering them predictable and reliable, and ensuring equivalence is granted when high level internationally-defined outcomes are achieved, principally by reference to the international Basel Rules.

He says: “My proposal builds on existing EU laws, already in use for recognising financial businesses operating from around the world. It ensures neither side is a rule-taker from the other, and would leave the UK free to craft its rules and supervise businesses here in a safe manner, and at the same time to continue to mitigate Eurozone risk.”