Faced with the possibility of a “hard Brexit” with no financial passporting equivalent or transition period, financial service firms are now urgently preparing for business continuity ahead of March '19. Given the compressed timeframe, resources are being fully utilized to get firms over the line in time- however the fastest route to Brexit readiness may not lead to the most optimal solution from a long-term cost or efficiency perspective.
While replicating the existing operational and business setup in the new EU entity is a quick way to guarantee timely, minimal compliance, there will undoubtedly be duplication in resources and technological infrastructure. Additionally, scarce capital and funding resources will be absorbed in underpinning a duplicative legal entity structure. This increase in cost is merely for the benefit of preserving existing revenue levels, rather than capturing incremental revenue. Consequently, the distortion of the cost-income ratio is unsustainable in the medium to short term.
While it is critical to aim for Brexit readiness ahead of Mar’19, Firms should be planning a Day 1 “flux state” to ensure they are ready in time while simultaneously considering their transition to the Day 2 “end state” that will return their cost-income ratios to normal as quickly as possible.
Key areas for Day 2 consideration
1. Market access
Ahead of Mar’19, the fastest route to ensure full financial market infrastructure access, is to simply duplicate various exchange, CCP, broker, agent, dealer, and custodian memberships and relationships in the new EU entity. While this guarantees full access to service the firm and its clients, there is likely to be an increase in the cost of the operation, both from the membership fees and additional resourcing required to maintain them. Firms should consider long term optimisation of complex multi-market access arrangements via legal entity rationalisation and phasing clients into a single entity where possible. Additionally, firms should rationalise their product and service offerings and client base, by prioritising those items that support simplification in legal entity structure.
2. Booking model
Back-to-back booking models are the quickest route to market, with the least disruptions to people and process. It is possible that regulators could mandate changes to these booking models and enforce the establishment of risk management practices for every entity, deeming such booking models sub-optimal. Additionally, the back to back models create additional balance sheets between entities and therefore attraction additional capital charges.
For the Day 2 state, firms will need to consider eliminating the back-to-back model in favour of a localised entity specific risk management model. This will be a toss-up between decreasing capital charges and increasing operating cost. Alternatively, a legal entity rationalisation in favour of the EU entity, will allow centralised risk management.
3. Client migration
The Day 1 readiness approach, involves moving all EU clients to the new EU entity, without time for much consideration around the cost/benefit impact. Firms risk migrating low revenue generating clients, or clients that are not feasible when running the dual/multi location model.
For Day2, firms will need to undergo a client rationalisation exercise, to understand which clients are not achieving the required rate of return, from both a revenue and bottom line profitability perspective
4. EU/UK regulatory bifurcation
Firms are currently preparing each entity to remain compliant with all known EU and UK regulations.
However, these changes should be implemented keeping potential full-bifurcation of regulations in mind which support quick roll-backs. Failure to consider this possibility could mean firms will have limited time to adapt to bi-furcated requirements and be left non-compliant.
5. People and location strategy
To prepare for the Brexit ‘Day 1’ deadline, firms are increasing their resources within all new entities to support core activities for repapered clients.
This will result in duplication of responsibilities and take firms away from resourcing strategies around centres of excellence or common governance fora.
Headcount increases will need to be reassessed after the impact of client migrations and regulatory requirements are clear This should include an assessment of the location strategy of resources, and determine how best to leverage optimization techniques like centers of excellence, low cost location and robotic process automation.
To support new entities, firms are either implementing tactical technology changes or are extending/replicating existing technology platforms to absorb incremental requirements. This Day 1 model promotes a replication of current technological deficiencies and tactical “band-aids”. In some extreme circumstances, firms have had to abandon strategic technology initiatives that don’t fit into the hard Brexit timeline.
Ahead of Day 2, firms will need to assess post Brexit architecture for inefficiencies, duplications and redundancies. Remediation should be planned to avoid decreasing business performance or ability to meet regulatory and operational requirements.
The Day 1 state will impose an additional capital burden, and excess collateral will be required is to ensure that new EU entities can fund capital to underpin trading and regulatory obligations. Firms could, due to limited time, resort to sub-optimal cross-entity capital management.
Post day 1, capital optimisation analysis will be needed to maximise the efficient use of firm inventory pools across entities.
Day 1 ‘Readiness’ does come with some unavoidable costs, however with timely Day 2 planning, the duration of that cost could be quickly remediated. Firms that are fastest to eliminate the duplicative cost of being Brexit ready, will achieve normality of cost income ratio quicker and therefore be at a comparative advantage to peers.
To find out how Capco can help prepare UK and EU organisations to approach Brexit Day 2 Challenges please get in touch.