The month of August may have seemed relatively quiet in the wake of the EU referendum and the commencement of Brexit negotiations may yet be a little while off, but for the financial services sector, there is considerable long term uncertainty.
Following wobbles in the financial markets immediately after the referendum result and the Bank of England’s decision to cut interest rates even further in July, retaining and boosting confidence in the UK’s financial services sector is key. Whilst, the Brexit vote will not change much for the financial services sector in the short term, as most of the existing financial rules stemming from EU legislation are enshrined in UK law, the longer-term consequences are a lot more uncertain and London is at risk of losing its status as the financial hub of Europe.
The end of passporting rights as we know them
A key issue for financial services firms is what impact the Brexit negotiations will have on ‘passporting’ rights, where businesses based in the UK – and regulated by UK authorities – are able to provide financial services anywhere in the EU and in the EEA while only having to follow one set of regulations.
Much will depend on the exit terms negotiated between the UK and the other EU member states. This leaves London-based financial firms in a deep state of uncertainty, given that financial services account for 8 per cent of the UK economy. If the passporting rights allowing them to operate across the EU single market from their home state are revoked, much of the logic behind basing trading operations and so many staff in Britain will be undermined. Equally, EU financial institutions wishing to access British customers may need to establish an office in the UK.
The City of London has already given up hope of full access to the single market, and is instead hoping for a bespoke agreement, leveraging London’s status as a global powerhouse in finance. [Financial Times] The British Bankers’ Association is allegedly pushing for a beefed-up EU-Swiss style relationship for the UK, allowing for some sectors to benefit from access to the single market in return for maintaining a certain level of regulatory equivalence.
However the road to equivalence will not be the same for all. Whereas British wholesalers are hoping for a hassle-free journey thanks to the third-country provisions under the EU legislation on markets in financial instruments (MiFID II and MiFIR) due to apply from January 2018, equivalence will be harder to get for institutions wishing to provide services such as lending, deposit-taking or pretty much any financial service to retail clients.
Given the EU’s insistence that the UK cannot “cherry-pick” aspects of the single market (in particular keeping passporting rights while denying free movement of persons, as demanded by the Leave campaign), the prospects do not look too bright, particularly as any deal must be ratified by both parties. Yet again Switzerland is a good case study here. Two and a half years after Swiss citizens voted to restrict immigration from EU countries, Switzerland’s bid to renegotiate free movement has fallen on deaf ears in the EU. Even those states which seem to have taken a softer stance on the future EU-UK relationship, such as Germany and Luxembourg, agree that passporting rights and free movement of people are inseparable. [Bloomberg, Reuters]
No drastic regulatory change ahead
Depending on the model agreed for post-Brexit interactions with the EU, it may be that the UK has greater freedom to repeal domestic regulations which are based on EU legislation. But what will most likely happen is just a slight divergence in regulatory requirements over time. Even where EU and UK authorities have been clashing for years, London may eventually not diverge much from the EU regulatory framework post Brexit. Just a month after the Brexit vote, the European Commission announced its intention to ease remuneration rules for smaller and less complex credit institutions and investment firms – a move long advocated by London.
Ironically, even plans for an EU financial transaction tax (FTT) may not survive Brexit, as an EU FTT would make it harder for wannabe major financial hubs in Europe, such as Frankfurt and Paris, to attract UK-based companies wishing to relocate elsewhere. After yet another extension of the negotiation deadline over the summer and rising scepticism from Belgium, Slovakia and most recently Germany, EU Ministers have grown weary of the whole procedure. A lack of agreement by October, when the 10 EU countries negotiating over a common FTT are due to meet, could spell the end of the negotiations.
Although much of the financial regulation applying in the UK emanates from Brussels, most of the EU-derived requirements stem from the work of global financial services bodies around the world. The same is true for the fight against tax avoidance, which is led at global level by the OECD. The UK was an early adopter of some of the OECD recommendations on the matter. A recent push from the Commission to endorse EU legislation which goes beyond their scope has gone largely unheeded in the Council, where member states favoured the adoption of EU rules which are more in line with what had been agreed at OECD level.
Slower innovation, faster integration in the EU
The homogeneity of the financial system within the EU will likely be reinforced, supporting the traditional banking sector at the expense of new disruptive financial technology such as FinTech. Financial regulation in the EU will probably become less market friendly without Britain. This will force UK regulators to toughen up too should the new EU-UK relationship imply that British law must be consistent with EU rules.
The UK’s success in the FinTech sector is also reliant to a large extent on the EU, with many start-up companies boosted by investment supplied through the European Investment Fund. Without this, investors could turn their focus on other leading FinTech centres within the EU.
Whereas Jonathan Hill (former Commissioner for financial services, a British national who resigned after the referendum) thought Brexit would be a lose-lose situation for both the UK and the EU, others believe the European Commission’s plan to build a Capital Markets Union (CMU) will be better off without the biggest capital market in Europe. Former EU official Paul N. Goldschmidt, for example, reportedly said that “Brexit eliminates the need to consider and cater for the UK’s well-developed sterling market. It creates the opportunity to align the architecture of CMU on that of the Banking Union – a euro-denominated capital market centred on the Eurozone and open to third EU countries to join”. [Politico] Valdis Dombrovskis, Commission Vice President for the eurozone who has inherited Hill’s financial dossiers (and Hill’s staffers Lee Foulger and Mette Toftdal Grolleman), is pretty much on the same page.
Brexit may pave the way for faster integration in the EU financial sector and taxation policies. With Brexit, the plan for an EU consolidated common corporate tax base (CCCTB) – to be re-launched this autumn – is losing one of its most outspoken opponents. The same goes for the upcoming negotiations over new measures to enhance transparency for beneficial ownership of offshore trusts, which had been repeatedly opposed by the UK.
Hill’s predecessor to lead Brexit negotiations
The roll-out of Brexit negotiations is a necessary consideration for financial service providers. Commission President Jean-Claude Juncker has appointed Michel Barnier, former French Minister, as chief Brexit negotiator. In his previous role as Commissioner for financial services, Barnier oversaw the introduction of some 40 laws aimed to tighten up regulation in the sector, and clashed repeatedly with the UK over the proposed EU-level cap on bankers’ bonuses.
In Brussels, Barnier is seen as someone who understands the value of compromise over conflict. In London, his appointment was seen as a provocation. On the other hand, Barnier has many ties with the financial industry. Over his time as Commissioner, he even successfully sided with the UK when the European Central Bank wanted to repatriate all euro-clearing operations to the eurozone. One UK cabinet Minister said Barnier’s appointment was a “clever move”, giving the Commission a direct line to the next French government (likely to be from Barnier’s Republican party). [The Guardian]
Undoubtedly, with Brexit, France is gaining influence, not only in the European Council but also in other bodies. In order to lighten Commission Vice President Valdis Dombrovskis’s workload upon Hill’s resignation, Pierre Moscovici (Commissioner for economic and financial affairs) has been handed more responsibility in euro-related matters and global negotiations. The Frenchman is reportedly now leading the Commission’s economic rescue program for Greece, and has also become the Commission’s representative in talks with the IMF, G7, and G20 countries.
The View from the US
The Brexit vote initially shocked US markets and has upended the long-term business plans of many US-based banks, asset managers and service providers to the financial industry. Large banks such as JP Morgan, which have had established bases in London for many years, are taking a wait-and-see approach before implementing any contingency plans that were drawn up prior to the vote. That said, the prospect of the UK losing its automatic ability to sell financial services to the continent has sent a shudder throughout a banking industry that has been beleaguered in recent years by regulations and declines in trading revenues.
While many US institutions are hopeful that the new UK government will be able to negotiate its “passporting” ability to maintain some measure of continuity, most recognise it is not a likely scenario.
Many have resisted entreaties by the UK Treasury to issue statements of confidence in the long-term future of London as a global banking center – and instead have chosen to remain silent or issue tepid statements of support for their UK operations.
Given the strong rebound in US markets over the past few weeks, it has become clear that investors feel that the economic impact of Brexit will be somewhat less dire than initially feared. Many US businesses outside the financial sector that deal regularly with the UK see Brexit as a potential net positive, with British businesses looking to strengthen their ties with their closest ally.
Still, the uncertainty presented by Brexit negotiations, the fact that long-term business models have been thrown into doubt, and the expensive prospect of moving operations from familiar grounds are weighing heavily on the future of the US financial industry.
Events will determine how broad and deep the impact of Brexit will be on the US financial industry and whether its strong ties to London will remain. Given this volatile fact pattern, we are advising that US financial firms communicate their contingency plans clearly – while stressing that seamless continuity is a key goal.