UK says Brexit could hit banks' stock of 'risk free' EU debt

By Huw Jones

LONDON (Reuters) - Britain could force European Union banks operating in London to start holding capital against inventory of riskier EU government bonds in the case of a 'no-deal' Brexit.

At part of preparations for Britain's departure from European Union next March, the finance ministry has published a "statutory instrument" or 'SI' to help transfer EU rules like financial regulation into national law to avoid a legal void on the first day of Brexit.

Banks in the EU don't have to hold capital against holdings of their own government's bonds, a rule known as zero risk weight, as such domestic debt is considered "risk free".

The government said in its SI published on Tuesday that if Britain leaves the bloc with no transition deal next March, the EU would automatically become a "third country".

This means that the zero risk weight rule would no longer apply to EU banks in Britain.

"Therefore, this SI will remove preferential treatment for EU27 exposures," the document said.

The SI acknowledges that the same change would be made by the EU when regulating British banks operating in the bloc after Brexit.

The finance ministry said it plans to put the SI to parliament in the autumn.

"The intention of this SI is not to make policy changes, other than to reflect the UK's new position outside the EU, and to smooth the transition to this position," the finance ministry said.

The zero risk weight rule is based on a global standard from the Basel Committee of banking supervisors.

It became discredited when a sharp deterioration in Greek, Irish, Portuguese and Spanish government bonds during the euro zone debt crisis showed that such debt can be risky and feed a "doom loop" to drag down lenders.

Efforts to change the rule at the global level have dragged on as the issue is seen as politically sensitive in the euro zone, where introducing capital charges could prompt lenders to ditch the bonds of governments with lower credit ratings to minimise capital requirements.

(Reporting by Huw Jones, Graphic by Danilo Masoni; Editing by Toby Chopra)