Loan Market Association (LMA)– Written evidence (FTS0025)

The Loan Market Association[1] welcomes this opportunity to respond to the EU Services Sub-Committee's inquiry into the future of UK-EU relations on trade in services.

1. Scope of LMA feedback

We have not aimed to provide comments on every aspect of the EU Services Sub-Committee's inquiry but, instead, have commented only on those issues we consider most relevant to the syndicated loan markets in Europe. Our comments address the inquiry’s questions about the impact of the UK-EU Trade and Cooperation Agreement (“TCA”) on the financial services sector and about what form the forthcoming dialogue to establish structured regulatory cooperation on financial services should take. In particular, we consider the impact of the TCA’s lack of provisions to replicate the passporting regime and the absence of any decisions relating to equivalence regimes. We strongly urge the UK to work with the European Commission to smooth the path to obtaining equivalence decisions.

2. Executive Summary

A summary of our key comments and recommendations is provided below. For a more detailed explanation of these recommendations, please refer to Annex 1 (Detailed Submissions).

In terms of the TCA's impact on the loan market and regarding the forthcoming UK-EU Memorandum of Association (“MoU”), there are three key groups of issues which need to be addressed. The first arises in relation to licensing, and the ability of UK financial institutions to lend out to the EU and to support UK subsidiaries trading in the EU, in respect of both existing business (i.e. arrangements in place at the time of the end of the transition period) and future business. The second arises in relation to the loans themselves and ensuring their continuing validity, effectiveness and enforceability. Thirdly, there exists additional EU regulation which could affect the decision to lend or the lending process more broadly. Their impact is such that, even if lending itself is permitted in a particular jurisdiction, other contributing factors could lead to such lending becoming impractical or even impossible. This is particularly likely in the context of syndicated lending, where other ancillary banking products and services are often provided as part of a financing “package”.

1. Licensing and cross-border services

• The TCA does not make any provision for UK based lenders to continue to provide the cross-border financial services into the EU which were covered by the Capital Requirements Directive (“CRD”) prior to the end of the transition period. As a result, regulation of these activities is now governed by the national law of each EU Member State.
• Within the EU, regulation of loan market activities – both as to who can be a lender and who can own a participation – varies significantly from one Member State to another. In France, for example, only banks who are locally authorised or passported may engage in this type of business.
• The loss of EU passporting rights by UK lenders, and the TCA's lack of provisions to mitigate this loss, will negatively affect the ability of UK financial institutions to lend out to the EU27. Such restrictions, which could hinder or even prevent lending from the UK to the EU, may also mean that UK institutions struggle to support their subsidiaries trading in the EU.
• Although EU lenders will not be legally affected by the loss of passporting rights or the lack of mitigating provisions in the TCA, the UK is still a net beneficiary of EU loan funding, and a reduction in UK lending to the EU may lead to a reduction in the UK's market share. 

• Collateralised Loan Obligations (“CLOs”) require recognition under the Markets in Financial Instruments Directive (“MiFID”) in order for EU investors to invest in them. The loss of authorisation under MiFID by a UK firm as a result of Brexit has the potential to affect both legacy transactions and future lending business. The TCA does not mitigate this risk.

2. Choice of jurisdiction clauses and enforceability of judgments

• Following the end of the Brexit transition period, the UK no longer has access to a complete and fully effective legal framework for the approval and enforcement of its judgments in the EU. The UK’s accession to the Hague Convention only gives effect to exclusive jurisdiction clauses (and provides for enforcement of the resulting judgment).
• It is no longer possible for the UK to accede to the Lugano Convention, which would have allowed enforcement of an English judgment in the EU.
• This could leave lenders and borrowers facing a certain degree of uncertainty regarding the impact of the UK's departure from the EU on their rights against each other.

3. Ancillary regulatory issues

• Exposure to UK entities: Following the end of the transition period, exposures to UK firms may only be treated as exposures to "institutions" under the Capital Requirements Regulation ("CRR"), if the UK's requirements, as a third country, are deemed equivalent to those applied in the EU. The Government should encourage the European Commission to take all necessary steps to ensure that EU27 entities continue to treat UK exposures as European Economic Area ("EEA") exposures, to avoid increased capital requirements which do not reflect any increase in risk (for example, by amending Implementing Decision (EU) 2016/2358 to extend it to cover UK institutions and other UK entities).
• Use of UK credit ratings: The European Securities and Markets Authority ("ESMA") has confirmed that it considers the UK’s legal and supervisory framework for credit rating agencies to meet the standards required for endorsement by an EU27 credit rating agency. However, the final decision on endorsement will still lie with EU credit ratings agencies. This is not a comprehensive long-term solution in the same way that an equivalence decision would have been. The Government must urge the Commission to adopt a decision on the equivalence of the UK’s regulation of credit rating agencies under the Credit Risk Agency Regulation (“CRA”).
• Use of UK benchmarks: HM Treasury's (“HMT”) decision of equivalence regarding EEA benchmark administrators came into effect on 1 January 2021. However, an equivalence determination from the EU Commission is still pending, meaning that UK benchmark administrators still need to seek recognition or endorsement of their benchmarks before these can be used. This could affect firms’ ability to hedge exposures under wholesale loans using OTC derivatives and reduce the appetite of EU27 supervised entities to enter into loans referencing UK benchmarks. The Government must urge the Commission to assess equivalence as soon as possible in relation to the UK’s regulation of benchmarks so that UK benchmarks can be included on ESMA’s list of permitted benchmarks and used by EU27 entities.
• GDPR and data transfer: The transfer of data between the parties to a syndicated loan arrangement, as for other financial services, is a vital aspect of achieving a seamless cross-border service. The Government must ensure that a long-term data adequacy agreement is reached as part of the framework for regulatory cooperation to ensure that data transfers between the UK and the EU27 can continue without restriction beyond the six-month bridging period granted by the TCA.

3. Supporting information

Further supporting information in relation to this response can be found in each of the following Annexes:

• Annex 1 (Detailed Submissions)
• Annex 2 (Volume of Lending between the UK and the EU27)

ANNEX 1

Detailed Submissions

1. LICENSING

We have outlined below three key areas which are particularly affected by the loss of passporting rights and the fact that the TCA does nothing to mitigate this.

1. New business

On 1 January 2021, many banks incorporated and authorised in the UK lost their benefit of a passport to provide cross-border services covered by the CRD from the UK into the EU27, which includes lending. The TCA does not mitigate this loss, as it provides no access for UK financial services firms to the Single Market.

The CRD leaves the regulation of cross-border services by non-EU banks to the national law of each Member State. A significant number of Member States have strict rules requiring entities providing deposit-taking, credit, payment and foreign exchange services to either obtain a local license or hold passport rights. Since the TCA provides no replacement to the passporting regime, UK-based banks will be prevented from seeking new business from local customers, in some cases including existing customers. The same issues apply to CLOs, investment firms, debt funds and insurance companies providing cross-border services into the EU27. Such restrictions may also mean that UK institutions struggle to support their subsidiaries trading in the EU.

The CRD’s requirements are relevant to fully drawn loans. The TCA does not address whether a fully drawn loan agreement, entered into legitimately by a UK-based bank under the CRD passport would continue to be enforceable when the CRD passport is no longer available. The requirements also apply to undrawn or partially drawn facilities. Neither does the TCA address whether a further extension of credit by a UK-based bank under a revolving credit facility would be permitted. The consequence of breaching the EU27 licensing requirements can be a civil or a criminal offence, leading to regulatory sanctions and affecting the enforceability of loan agreements.

EU lenders will not be legally affected by the loss of passporting rights or the lack of mitigating provisions in the TCA. This is because, in the UK, loans are not regulated products (i.e. a person may be a lender without any particular regulatory requirements). However, as demonstrated in Annex 2 (Volume of Lending between the UK and the EU27), the UK is a net beneficiary of EU loan funding. If, for example, the percentage of syndicated loan volumes that the UK contributes to a particular EU27 country were reduced as a result of the loss of UK passporting rights, the banks of that Member State may have to compensate for the difference, which may in turn lead to a withdrawal of financing and a subsequent reduction in the UK's market share. 

Lending to Europe is a profitable source of UK business for the UK loan market. Excluding UK-based entities from continued access to EU borrowers may hurt the UK's market share unnecessarily.

2. Existing business – Direct loan investment

In jurisdictions where authorisation is required to lend or acquire loans, there is still uncertainty as to what the effect is of a lender ceasing to be authorised during the life of the loan. The TCA does little to provide any clarity on this subject. There remains a risk that, where a UK-entity loses its passport rights, the loan itself may be legally vulnerable or subject to repayment and/or restructuring.

Many UK-based banks and investment firms have established branches in the EU27 using their passport rights under CRD and the Markets in Financial Instruments Directive ("MiFID"). There is no harmonised EU regime for the treatment of EU branches of non-EU banks and investment firms. Member States may choose to authorise these branches but must not treat them more favourably than branches of EU firms. This could mean that, unless legislative action is taken, banks would be required to cease business in those branches unless and until they are relicensed under the relevant Member State’s domestic regime.

3. Existing business – CLO investment

Investors in loan assets often invest in pools of loans. These pools generally contain a credit support element and are therefore classified as securitisations. They are referred to in the market as CLOs.

The Capital Requirements Regulation (“CRR”) requires that EU investors only invest in CLOs where there is a minimum risk retention by a MiFID-authorised sponsor, originator or original lender of the assets (known as the “skin in the game” requirement). Where a UK firm ceases to be MiFID-authorised as a result of Brexit, EU investors would arguably be required to divest themselves of their interest in the CLO. The TCA does not mitigate this risk. Given the volume of CLO investment held by EU investors, such a wholesale divestment has the potential to create unnecessary systemic risk.

2. CHOICE OF JURISDICTION CLAUSES AND ENFORCABILITY OF JUDGMENTS

A large proportion of syndicated loans in the European market are governed by English law. These loans are therefore generally transferred under English law because market participants have come to rely on English law as a common vernacular for loan transactions. Any disturbance of this regime would create significant commercial problems both for borrowers and for lenders. Therefore, preservation of the recognition of English law and English jurisdiction is crucial.

From 1 January 2021, Rome I and Brussels I Regulations ceased to apply in or to the UK. This does not materially affect the UK’s position on choice of law. The UK has brought the Rome I Regulation into its domestic law, which requires EU Member States to give effect to parties’ choice of law regardless of whether or not it is the law of an EU Member State.

However, there is an issue regarding the fact that UK judgments will not automatically be recognised under the TCA. If this is not addressed in the UK-EU framework for regulatory cooperation, that would leave English judgments in the same position as that of, for example, New York judgments, whose enforceability in a Member State depends on the domestic law in that Member State. The UK’s accession to the Hague Convention in September 2020 only gave effect to exclusive jurisdiction clauses (and provides for enforcement of a resulting judgment). The UK did not accede to the Lugano Convention before the end of the transition period, meaning that it is now too late for the convention to re-enter into force. Acceding to the convention would have largely replicated the existing regime for enforcement of UK judgments in the EU and ensured a higher degree of continuity.

3. ANCILLIARY REGULATORY ISSUES

Lending in respect of a syndicated loan arrangement does not exist in isolation. Rather, it is often part of a wider “financing package” consisting of numerous other financial products and services. This “package” may be offered on the same terms to all or certain other entities within the wider borrower group (and across different jurisdictions).

This raises two potential issues: firstly, even if the act of lending, acquiring or selling a loan is appropriately authorised, the ancillary products and services may not be; secondly, even if all products and services are appropriately authorised in the principal borrower’s jurisdiction, it may be the case that they cannot be offered to some of its subsidiaries within the borrower group.

The following ancillary issues should be addressed as part of the upcoming dialogue between the UK and EU, with the solutions recorded in the MoU establishing structured regulatory cooperation on financial services.

1. Exposure to UK entities

Under the CRR, exposures to third-country investment firms and credit institutions may be treated as exposures to “institutions” (and thereby benefit from preferential regulatory capital treatment) only if the third country applied prudential and supervisory requirements that are at least equivalent to those applied in the EU.

The TCA provides no such equivalence determination, meaning that EU-regulated institutions cannot risk weight exposures to UK institutions and other UK entities arising from lending activity in the same way that they might have done before the transition period. Unless there is mutual recognition of regulatory regimes, this will ultimately increase capital requirements in respect of existing and future cross-border contracts and could generate unnecessary systemic risk.

The European Commission should be encouraged to take all necessary steps to ensure that EU27 entities can continue to treat UK exposures as EEA exposures, to avoid increased capital requirements which do not reflect any increase in risk (for example, by extending Implementing Decision (EU) 2016/2358 to cover UK institutions and other UK entities).

2. Use of UK credit ratings

EU27 institutions cannot use UK credit ratings (or third country credit ratings endorsed in the UK) for capital purposes unless these are endorsed by an EU27 credit rating agency or are certified in the EU under the CRA. ESMA confirmed in a statement in October 2020 that it considers the UK’s legal and supervisory framework for credit rating agencies to meet the standards required for endorsement by an EU27 credit rating agency.

However, endorsement requires an EU credit ratings agency to be willing to endorse the credit ratings issued by a UK-based agency from the same group. The final decision on endorsement therefore lies with EU credit ratings agencies and is not a comprehensive long-term solution in the same way that an equivalence decision would have been.

In November 2020, HMT gave a determination of equivalence regarding EEA credit rating agencies registered with ESMA. This came into effect on 1 January 2021 and means that, if an EEA credit ratings agency registered with ESMA is certified by the FCA, UK firms may use its credit ratings. However, an equivalence decision from the European Commission in respect of the UK has not yet been given.

As part of the intended dialogue to establish financial services regulatory cooperation, the Government must urge the Commission to adopt a decision on the equivalence of the UK’s regulation of credit rating agencies under the CRA.

3. Use of UK benchmarks

On 1 January 2021, the EU Benchmarks Regulation ("EU BMR") transition period ended. On the same date, the EU BMR became part of the UK's retained EU law and was amended to operate exclusively in the UK ("UK BMR"). The UK BMR provides for a transitional period until 31 December 2022, during which time UK supervised entities may use third country benchmarks (including EEA benchmarks).

However, as a result of the EU BMR transition period ending, UK benchmark administrators will need to apply to the relevant EU27 competent authority for recognition of their benchmark, or else to find an EU27 entity who would endorse their benchmark for use by EU27 entities. This restriction could affect firms’ ability to hedge exposures under wholesale loans using OTC derivatives. It may also adversely affect the appetite of EU27 supervised entities to enter into loans referencing UK benchmarks.

If UK benchmarks were included in ESMA’s list of permitted benchmarks, then this would allow EU27 supervised entities to resume using these benchmarks. This would require the Commission to adopt a decision of equivalence under EU BMR. HMT's decision of equivalence relating to EEA benchmark administrators was given in November 2020 and came into effect on 1 January 2021. However, an equivalence determination from the EU Commission regarding the UK is still pending.

The Government must urge the Commission to determine equivalence as soon as possible in relation to the UK’s regulation of benchmarks so that UK benchmarks can be included on ESMA’s list of permitted benchmarks and used by EU27 entities. We urge the UK Government to open a dialogue with the Commission to begin this process now and for ESMA and the FCA to put in place the necessary arrangements.

4. GDPR and data transfer

The transfer of data between the parties to a syndicated loan arrangement, as for other financial services, is a vital aspect of achieving a seamless cross-border service. From 1 January 2021, the UK, as a third country, ceased to be part of the EU “safe data” zone under GDPR. The TCA provides a temporary grace period of six months, during which time the UK will be deemed to have an “adequate” data protection framework in place. However, this relief is temporary, and the absence of a more permanent data adequacy determination from the EU will make any transfer of data between the EU27 and the UK more complex.

A long-term UK-EU data adequacy agreement is necessary to ensure that data transfers between the UK and the EU27 can continue without restriction beyond this six-month bridging period. We would therefore strongly urge that the Government should begin adequacy discussions as soon as possible.

ANNEX 2

Volume of Lending between the UK and the EU27

In 2020, UK lenders provided €43 billion in syndicated loan financing to borrowers located within the top seven EU27 countries, increasing to a total of €50.3 billion across all EU27 countries.[2]

In the Netherlands, for example, UK lenders financed 18% (€7.4 billion) of total syndicated loan volumes. UK lenders also contributed 13%, 13%, 8%, and 10% of syndicated loan volumes to borrowers located in France, Germany, Belgium and Italy, respectively. [3]

Looking at the reverse position, €55.9 billion (36.7%) of UK syndicated loan credit was provided by EU27 institutions during the same period.[4]

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