Brexit countdown: Deal or no deal?
Yesterday, UK Prime Minister Boris Johnson and European Commission President Jean-Claude Juncker, announced that they reached a new Brexit deal. It replaces the controversial “Irish backstop,” which would have committed the UK to a customs union until it reaches an agreement for keeping an open border on the island of Ireland, with an effective customs and regulatory border in the Irish Sea - between Northern Ireland and the rest of the UK. It also commits the UK to a future trading relationship with the EU based on a free trade agreement rather than close regulatory alignment, giving greater freedom for the UK to seek independent trade policies with other countries and for regulations to diverge. There would be a transition period until December 31, 2020 for the UK to negotiate a free trade agreement.
EU leaders endorsed the deal at the EU Council Summit on Thursday and Parliament will vote on it during a special session on Saturday. While the Conservative Party’s traditional ally, the Northern Ireland Democratic Unionist Party (DUP), has explained that they will vote against it, several members of the opposition Labour Party have stated they are likely to support the deal despite its leaders calling for the party to oppose it. The European Parliament will also need to ratify the deal. If the UK Parliament does not pass the deal on Saturday, Johnson is required by law to request an extension to the October 31 Brexit deadline.
The end is nigh one way or the other - but the road ahead remains unclear. If Johnson can pass his deal tomorrow, it is only the first step in the long Brexit process - negotiation of the future trade agreement between the EU and UK will then begin. Considering the difficulties the UK has had reaching agreements both internally and with its European counterparts over the last several years, any possibility - from relatively close alignment with the EU to a “hard Brexit-style” minimal agreement - remains an option. An election seems to be on the horizon if Johnson cannot pass the deal, but his changes to the Irish backstop have lost him the support of the DUP and their 10 votes in what could be an election won or lost by single digits.
What trade war? China opening FS could be big win for US banks
China’s State Council released a series of documents this week providing details into its plans to lift limitations on foreign ownership in its financial services sector and relax certain regulations for foreign firms. Notably, the reforms will allow foreign firms to engage in RMB-denominated transactions rather than transact through local correspondent banks. They will also ease capital requirements and remove restrictions on permitted activity for foreign firms as well as eliminate requirements that insurance companies must be “engaged in the business of insurance” for 30 years and establish a representative office in China for two years prior to entering the Chinese market. Alongside the State Council’s release, the China Securities Regulatory Commission (CSRC) provided a timeline for lifting restrictions on foreign ownership of fund management companies (April 1, 2020) and securities companies (December 1, 2020). There is no firm timeline for the removal of limitations on foreign ownership of banks, insurers and other financial firms, although previous communications have set targets for 2022.
The State Council’s reform plans and CSRC’s restriction removal timeline follow a series of recent actions that the Chinese government has taken to open up its financial markets after it explained that it would do so at the November 2017 Sino-US summit. Following the summit, the CSRC raised the cap on foreign ownership of securities and fund management companies from 49 percent to 51 percent.
The US-China relationship has been tumultuous over the past several years - with headlines focusing on the trade war - so whether these plans materialize remains uncertain, but if they do it will usher in the first new wave of foreign investment since China joined the WTO in 2001. US banks, which have never exceeded three percent of market share, will be excited about the opportunity to tap into China’s rapidly growing financial services sector. They should, however, expect to face a number of obstacles and challenges. For example, China has not indicated that it will grant any equivalency decisions or tailor any requirements for foreign firms. As a result, they will therefore be subject to the same regulations - including licensing and examinations - as Chinese firms and most are largely unprepared to comply with the significantly different Chinese regulatory environment. In addition, foreign firms will need to develop business strategies and train staff to suit the Chinese market - which is easier said than done. Over time, the likely increase in foreign entrants will allow for more competitiveness, which could drive the Chinese banks to become more innovative and customer-centric and have the added benefit of providing them with a bigger pool of locally trained talent to aid their eventual integration into the global market.
LIBOR transition: FASB comment letters are in
The comment letter period ended last week for the Financial Accounting Standards Board’s (FASB’s) Exposure Draft (ED), which proposes optional relief for certain contract and hedge relationship modifications related to the LIBOR transition. Specifically, it includes optional expedients for accounting analyses related to cash instrument, lease and derivative modifications. It also provides exceptions to hedge accounting guidance that would have potentially required dedesignation of a hedging relationship and resulted in impacts to earnings if critical terms were to be changed due to reference rate reform.
In its current form, the ED provides relief only where modifications are clearly related to reference rate reform. While respondents were generally in favor of the proposal, some cited operational difficulties in attributing all contract amendments to reference rate reform. They asked for further clarity on the application of the relief, with some requesting the use of a rebuttable presumption that all contract modifications are related to reference rate reform.
Various stakeholders also provided detailed comments asking for additional clarifications such as transition relief for float-to-float cross currency swaps or the extent of relief provided for net investment hedge strategies. Several comment letters noted that the majority of the hedge accounting relief seems to be predicated on an entity adopting the new hedge accounting standard (ASU 2017-12), which many non-public business entities may not have yet adopted. Some stakeholders also explained that the potential for the FASB to add additional quantitative disclosures would be unduly burdensome, explaining that information highlighted in the MD&A section of SEC filings provides adequate information on reference rate reform impacts.
The ED limits the window in which financial statement preparers could take advantage of this relief to the end of 2022. Several comment letters urged the FASB to reconsider the end date for the proposed temporary relief given the uncertainty of when replacement rates for various IBOR currencies around the globe will be operational.
The comment letters to the ED reflect the widely anticipated support for relief from some of the operational burdens and financial reporting impacts of reference rate reform - with a few notable areas of pushback. In terms of what might change, it is unlikely that the FASB will allow for broader application of the relief - for example, the rebuttable presumption regarding contract modifications - as doing so could make it susceptible to abuse and mask the financial statement impact of amendments unrelated to reference rate reform under the guise of LIBOR transition. Therefore, institutions will likely need to thoughtfully analyze their transactions in order to apply the relief. With uncertainty around global IBOR transition plans, entities should not count on an extension of the provided relief window and should ensure that their transition plans will fall within it.
Kraninger on the Hill
This week, CFPB Director Kathy Kraninger delivered her second semiannual report to the Senate Banking Committee (SBC) and House Financial Services Committee (HSFC). There were a number of questions in both hearings concerning the CFPB’s controversial governance structure - a single director that can only be removed for cause. Republicans have challenged this structure since the bureau’s inception, arguing that it violates the constitution by giving the director too much unchecked power. A legal challenge to its constitutionality has been winding through the courts for the last two years, and the bureau recently requested that the Supreme Court review decisions by appellate courts rejecting the challenge. In response to questions, Kraninger confirmed that she believes the CFPB’s structure is unconstitutional after not taking a position in her confirmation hearing. The Supreme Court is expected to rule on the case next week.
Democrats on both committees took issue with Kraninger’s position on the constitutionality issue as well as her stewardship of the CFPB, including her proposed revisions to the payday lending rule and what they view as weakened enforcement and limited restitution for consumers. There was also significant focus from SBC Democrats on the CFPB’s stymied efforts to review a high volume of rejections in a program meant to forgive student loans of public servants. The Department of Education blocked CFPB examiners’ access to student loan servicers’ data last year and Kraninger said she is working with the department to obtain the necessary data, but Democrats expressed dismay that she was not pursuing the issue more aggressively.
Once again, Kraninger was calmly defensive of her actions as CFPB director in the face of combative questioning. She offered neutral statements of dedication to fulfilling the bureau’s statutory responsibility but made clear that she will not change enforcement decisions in response to external - or internal - dissent. The outcome of next week’s Supreme Court review will provide more insight on how long Kraninger may be able to retain unilateral control of the CFPB. If the Supreme Court rules that the president can fire the director at will and if the Democrats win next year’s Presidential election, Kraninger would almost certainly be removed. Otherwise, she could remain in her position until her term expires on December 2023 and further alter the course of the bureau well into a new administration.
On our radar
These notable developments hit our radar this week:
- FSB warns of looming risks. On Wednesday, the Financial Stability Board (FSB) published its 2019 report on the implementation and effects of the G20 financial regulatory reforms. In addition, on Sunday, FSB Chair Randal Quarles sent a letter to the G20 finance ministers and central bank governors outlining a number of evolving risks he and the FSB are monitoring. Both the report and the letter covered leveraged lending, the rise of nonbank intermediation, increased activity by large technology companies in the financial services sector, cyber risk and resilience, and the challenges posed by global stablecoins.
- Comments on CAMELS. Today, the Fed and FDIC requested comment on their use of the Uniform Financial Institutions Rating System, also known as the CAMELS rating system, specifically asking about the consistency of ratings and their use in enforcement actions and applications.