Pressing need to act to mitigate risk of no deal, says financial policy committee

The Bank of England has issued its strongest warning yet to the EU that its lack of adequate planning for Brexit has created growing risks for almost £70tn of complex financial contracts.

Threadneedle Street said the bloc had made only limited progress to protect the financial system and time was running out, with little more than six months before the UK is due to leave the EU.

Stressing the urgency of the situation in a statement from its financial policy committee, the Bank said: “In the limited time remaining, it is not possible for companies on their own to mitigate fully the risks of disruption to cross-border financial services.”

Brexit anxiety for businesses 'at highest since referendum' Read more

Without action, the contracts governing the financial derivatives – currently sold across the UK-EU border by banks to companies looking to protect themselves from movements in interest rates and changes in global markets – could be rendered illegal the moment Britain leaves, it warned.

EU firms have about £69tn of outstanding derivatives contracts that are handled through a process known as “clearing” in the UK, while as much as £41tn mature after Britain exits the EU in March 2019.

In a corner of the finance industry worth more than three times the overall value of the EU economy, the process of clearing derivatives involves banks organising their trades through a central third-party organisation – known as a clearing house – which takes on the risk of either party defaulting.

Clearing has become increasingly important since the financial crisis as the EU introduced rules forcing banks to trade greater volumes via clearing houses, with the idea of improving transparency and to avoid the confusion of banks going bust with complex webs of contracts with multiple parties – as was the case in 2008.

EU-authorised clearing houses must handle EU banks’ trades, but UK organisations such as the London Stock Exchange’s LCH handle the bulk of business and could fall outside the rules in the event of a hard Brexit. As much as 90% of EU firms’ interest rate swaps – one of the most common types of financial derivative – are cleared in the UK.

The UK has already taken action to arrange temporary permissions to grant EU banks access to the British market, although parliament has yet to pass the legislation with just months to go before Brexit. The Bank has previously issued warnings to the EU, but there is a growing sense of urgency.

Threadneedle Street warned the EU had shown little willingness to reciprocate the UK plan with potentially damaging consequences for financial sector risk, adding: “The need for authorities to complete mitigating actions is now pressing.”

The game of brinksmanship between the UK and the EU could be seen as a potential way for Brussels to grab more financial services industry activity away from the City of London to European financial centres such as Frankfurt and Paris.

Clearing houses need three months’ notice from banks before they relocate business to another institution, which means failure by the EU to announce any contingency plan by Christmas could force banks to begin relocations.

While that might appear tempting for Brussels, there are fears the EU is ill-prepared to manage the huge influx of derivatives business. Very few contracts have moved in the two years since the Brexit vote, despite repeated warnings over the risks.

Senior bankers have warned that relocating derivatives contracts is akin to handling “nuclear waste”, while British officials believe there is too little time for banks to act given the scale of the challenge.

Sign up to the daily Business Today email or follow Guardian Business on Twitter at @BusinessDesk

The Bank sounded the alarm over other emerging risks to the UK financial system besides Brexit, including rapid growth of leveraged lending to high-risk companies, in a worrying parallel to the US sub-prime market before the 2008 crash.

It also said it would announce the results of its annual banking industry stress tests on 5 December, which would include an economic scenario worse than Brexit. The Bank said it continued to judge that the UK banking system would be strong enough to serve households and businesses through a disorderly cliff-edge Brexit.