12 March 2021

Breugel's Veron: Financial services: The Brexit dust begins to settle

The phase of greatest Brexit-related uncertainty for the European financial sector ended on 1 January. Although too early to discern more than the broadest contours of the future landscape, it is increasingly apparent that London will be less dominant than before.

The Brexit story has entered a new phase. The United Kingdom’s exit from the European single market on 1 January was orderly in the financial sector, despite significant shifts of liquidity in shares and derivatives, and unlike the shift in trade for goods. In contrast to the past five years of radical uncertainty, the near-future policy framework is now fairly predictable, with the EU and UK taking separate regulatory paths. The resulting financial ‘decoupling’ has left the City of London on the back foot, whereas the prospects for EU financial services will depend greatly on whether EU policy supports further financial market integration. The structural consequences of this new state of affairs will take years to unfold.

As with the Year 2000 problem, the orderliness of the transition was not to be taken for granted. That it went smoothly was down to a number of factors. First, financial firms on both sides of the Channel (and of the Irish Sea) worked hard and were able to pre-empt most of the operational challenges. Second, despite all the recurring high-stakes drama between the UK government and the European Commission, the technical cooperation between the authorities actually in charge of financial stability, primarily the Bank of England and the European Central Bank (ECB), appears to have run smoothly.

Third, the aptly designed phasing of the Brexit discussions helped reduce uncertainty. The Brexit Withdrawal Agreement ensured that the UK government would meet its financial obligations to the European Union, avoiding a scenario that would have been akin to selective default. It also kept the UK in the single market beyond the country’s formal exit from the European Union. The decision by the UK not to extend that transition period allowed for six months of effective preparation from July, ahead of the exit from the single market. The fraught final stages at the end of 2020 of the talks on the Trade and Co-operation Agreement (TCA) mattered comparatively little for financial services, since trade agreements typically barely cover them. By one count, the TCA that was eventually approved (albeit still unratified on the EU side) contains only six pages relevant for the financial sector, or less than 0.5%  of 1259 pages.

Pause for breath

Now, the new legal environment is unlikely to change much any time soon. Contrary to occasional portrayals in the UK, there is no ongoing bilateral negotiation on financial services, except for a non-binding memorandum of understanding expected before the end of March. The UK is now a third country and consequently UK-registered financial firms have lost the right, or passport, to seamlessly offer their services anywhere in the EU single market. They now have no better access to that market than their peers in other third countries such as Japan, Singapore, or the United States.

In some (though far from all) segments of the financial sector, firms from these other third countries currently have better single market access than British ones. This is because these market segments are covered by a category known in EU law as equivalence decisions, by which the European Commission allows direct service provision by firms in the third country whose regulatory framework of the market segment it deems ‘equivalent’. Equivalence decisions are at the Commission’s discretion. Unlike the single market passport, equivalence is a privilege not a right, and can also be revoked at short notice. So far the Commission has not granted the UK any such segment-specific equivalence, except in a time-limited manner for securities depositories until mid-2021 and clearing services until mid-2022. For the moment the Commission appears to lean against making the latter permanent, but it is too early to be sure.

In most other market segments, it appears improbable that the Commission will grant equivalence to the UK in the foreseeable future. Although this may appear counterintuitive, since almost all current UK regulations stem from the existing EU body of law, the expectation is the UK authorities will diverge as they (not least the Bank of England) have declined to make commitments to the contrary.

Moreover, it would be understandable for the Commission to aim at reducing the EU’s dependence on the City of London. There has been no comparable dependence on an offshore financial centre anywhere in recent financial history. Keeping that level of dependence would entail financial stability risk, because in some crisis scenarios, the aims of UK authorities would not necessarily be aligned with EU aims. Think of the Icelandic crisis of 2008, when Reykjavik protected the failing banks’ domestic depositors but not foreign ones. An aim to reduce that concentrated risk is therefore defensible, even if – as appears to have happened with derivatives – some of the activity migrates to the United States or other third countries as a consequence.

Conversely, the economic case for the European Union to keep pooling its liquidity in London is made harder to support by the Union’s own vast size. In addition, mercantilist impulses to gain activity from London unquestionably play a role, even though they generally do not make economic sense. Altogether, there is no compelling policy incentive at this juncture for the European Commission to move towards more equivalence decisions. If it does, it will most probably be for high-level political motives that are not apparent right now.

Differentiated decoupling

The likely trend in the near future, then, is of EU-UK financial decoupling, albeit highly differentiated across market segments which respond to different dynamics and patterns of interests. The corresponding regulatory competition may become a ‘race to the bottom’ or ‘to the top’, depending on particular circumstances, keeping in mind that such labels are somewhat more judgmental in financial regulation than in, say, tax competition. As a point of comparison, the European Union is more demanding than the United States on some aspects of financial regulation, for example curbs on bankers’ remuneration, but less in others, for example aspects of securities law enforcement or capital requirements for banks. Similarly, differences between the EU and the UK will probably not follow a uniform pattern. In such an environment, it is implausible that UK financial regulatory decisions, no matter how agile, could offset the negative impact of the loss of single market passport on the bilateral financial relationship.

As a result, the medium-term outlook for the City of London appears unpromising, even though the COVID-19 disruption blurs all the signals. Until end-2020, thanks to the magic of the European single market, the City was an onshore financial centre for the entire single market, and a competitive offshore centre for the rest of the world. Now, the City is an onshore centre only for the UK, and has become offshore for the rest of the European Union. That implies a different, in all likelihood less powerful, set of synergies across financial activities.

Relevant quantitative data is still hard to come by, but what is available is consistent with a bleak view. Job offerings in British finance, as tracked by consultancy Morgan McKinley, have followed an alarming downward course since the 2016 Brexit referendum. Meanwhile, relevant licensing agencies on the EU side, primarily the European Central Bank (as bank supervisor) and national securities regulators coordinated by the European Securities and Markets Authority, are gradually tightening their requirements for key personnel to reside mainly on EU territory rather than in the UK. As crisply summarised by Financial Times columnist Simon Kuper, many financial firms’ Brexit policy until this year was to “sit tight and do nothing until post-Brexit arrangements for finance forced [their] hand.” That phase has ended. Firms that drag their feet face regulatory disruption, as happened to broker TP ICAP in late January. Such tussles between regulators and regulated entities, rather than between the European Commission and the UK government, are where most of the financial-sector Brexit action is likely to be in 2021. They typically happen behind closed doors, and the regulators typically hold most of the cards.

For all the talk of “Big Bang 2.0 or whatever”, then, the UK’s comparative advantage as the best location for financial business in the European time zone is unlikely to recover to its pre-Brexit level. The negative macroeconomic impact for the UK could turn out to be moderate thanks to offsetting effects, such as a cheaper currency and less onerous real estate costs in London, which may generate greater economic activity, especially in non-financial services sectors. A specific concern is the financing of the UK government, which has been significantly dependent on financial sector-related tax revenue in recent years.

As for the 27 remaining EU countries, as a whole they are gaining financial activity as a consequence of Brexit. How much and where exactly is not yet quite clear. As predicted, the leading contenders for the relocation of international (non-EU) firms appear to be, in alphabetical order, Amsterdam, Dublin, Frankfurt, Luxembourg and Paris, with respective specialisations in the imperfectly integrated EU single market – eg Dublin and Luxembourg in asset management, Frankfurt in investment banking, and Amsterdam in trading. But for future EU financial services competitiveness and stability, much will depend on further market integration, the pace of which remains hard to predict. The European banking union is still only half-built in the absence of a consistent framework for bank crisis management and deposit insurance; and the grand EU rhetoric on “capital markets union” has yielded little actual policy reform since its start in 2014. Though a proactive approach would be preferable, any next steps towards market integration may be prompted by events, such as the still-unfolding Wirecard scandal.

Bruegel

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