BRUSSELS (Reuters) - Euro zone banks that have issued bonds under English law may face capital shortfalls after Britain leaves the EU, regulators in the currency bloc said as they encourage banks to switch to continental law for future contracts.

Anti-Brexit demonstrators wave EU and Union flags outside the Houses of Parliament in London, Britain, January 30, 2018. REUTERS/Toby Melville

The corporate bond market is one of several sectors in which a tectonic shift away from English law may occur if Britain and the European Union failed to mutually recognize their financial rules after Brexit.

Lawyers and investors say the huge London-based derivatives and corporate loan markets might face the same fate, potentially causing significant job losses.

There are at least 100 billion euros ($123 billion) of outstanding bonds issued by euro zone banks under English law, the Single Resolution Board banking watchdog said on Thursday, citing conservative estimates.

This represents roughly 10 percent of the total amount of buffers the bloc’s banks have to raise under EU rules that require them to hold loss-absorption capital, known as Minimum Requirement for own funds and Eligible Liabilities (MREL).

But the debt issued under English law may no longer be recognized as a buffer after March 2019 when Britain is scheduled to leave the EU.

“Banks must plan for any possible outcome in the ongoing (Brexit) negotiations and we are closely monitoring their plans,” SRB’s chair Elke Koenig told a news conference.

“One topic will be the question of how to deal with bonds issued by euro area banks under UK law. These will become third country issues and might no longer be eligible for MREL.”

If no agreement were found on mutual acceptance of bonds to be written down or converted in case of a bank failure, euro zone banks will have to issue new bonds to cover likely capital gaps.

The problem is spread across the 19-country bloc and concerns mostly larger banks. The SRB cited banks in Italy, Germany, France and Finland as being exposed to the issue, without naming specific lenders.

WIDER IMPLICATIONS

Given the legal uncertainty, banks are being advised to shift to laws of EU countries when they sign new bond contracts. This would be “the most logical answer”, Koenig told reporters in Brussels.

The European Banking Authority, another watchdog, issued a similar recommendation in October, “given the enhanced legal certainty this would entail”.

Regulators face this problem for all bank debt issued under foreign jurisdictions that, in the absence of mutual recognition agreements, may not allow it to be wiped out to rescue a bank.

But with Brexit the headache would be exponentially bigger because a larger part of European banks’ debt is currently issued under English law.

The problem is not limited to the corporate bond market either.

The global derivatives industry has begun work on fundamental changes to cope with a hard Brexit by allowing any disputes involving trillions of euros of swaps contracts to be resolved under French and Irish law.

The market for large syndicated loans could also be affected by the change, Etienne Dessy, a lawyer at Linklaters said, adding that discussions are already under way in the industry to change the standard contract from English law to the law of an EU country.

This could represent a significant blow to London’s legal industry, he said.