Giving Brexit a spin
Daniel Mayer examines the complex intricacies of the fundamental review of the trading book.
The UK financial services industry as a whole has benefitted from EU membership. Continental markets have been opened to UK competition and US and Asian financial institutions have invested heavily in the UK as a gateway to Europe.
What impact the UK’s break with the EU will have on UK financial services will depend on what happens in three distinct but interconnected areas: the UK’s future relationship with the EU; the UK’s future relationship with the rest of the world and the UK’s own domestic policy choices.
Where are we now?
Free trade is difficult to achieve for services of any kind, but it is especially problematic for financial services because consumer protection and prudential concerns are particularly acute. The EU’s success in establishing a functioning single European market in financial services is therefore remarkable. At the heart of this is the “passporting” system – the right of a firm, incorporated and licensed in one member state, to carry on business in all other member states without the need for separate local licences. Passporting is available not only to UK-headquartered institutions, but also to subsidiaries of non-EU groups – which is why many US banks, for example, use EU subsidiaries (typically based in the UK) for their EU business.
Passporting is available in all the main financial services sectors, including banking, securities and derivatives businesses (including investment management) and insurance. The same concept of host state recognition of a home state licence also extends to other areas, such as retail investment funds and prospectuses.
This system has been accompanied by increasing harmonisation of national regulatory regimes to ensure a level playing field for competition, establish acceptable standards and facilitate cross-border business. More recently the push for a “single European rulebook” has seen regulatory uniformity, rather than mere harmonisation, being required in many areas.
As a member of the EU, the UK benefits from the EU’s trade agreements with the rest of the world, but it is not able to make its own trade deals. Although the EU’s agreements have not achieved a lot for financial services, the UK has maintained a high degree of openness to firms based in the rest of the world on a unilateral basis, and its EU membership has not proved much of a constraint on this. The Economists for Brexit group argue that London’s position as the main financial centre in Europe is assured whether the UK is in or out of the EU.
What could Brexit change?
Access to the EU market:
UK firms would still have passporting rights if the UK stayed in the European economic area (EEA) or agreed a comparable association arrangement with the EU. However it is unlikely that the UK will agree to full freedom of movement, which is necessary for unfettered access to the single market, given that immigration was a big issue for the Brexit campaign. Alternatively, the UK and EU might negotiate a less comprehensive free trade agreement that nevertheless provided for some measure of market access for financial services. But this would not be easy – negotiations on the EU/US TTIP deal are struggling with exactly this problem. If there is no such arrangement, rights to access the EU market could be limited and precarious. Some use might be made of EU “equivalence” provisions that allow market access to non-EU firms that are subject to a home state regulatory regime equivalent to the EU’s. A wide range of inter-professional investment business could potentially be conducted on this basis from 2018 when the MiFID 2 package comes into force. But there are good reasons to be cautious. “Equivalence” is determined unilaterally by EU institutions and wider political considerations inevitably have some influence. Any equivalence decision could be revoked if UK and EU regulation were subsequently to diverge, perhaps because of a change in the political climate within the EU.
The UK’s relationship with the rest of the world:
The UK’s traditional openness to foreign financial institutions is likely to be maintained post-Brexit. It is possible that the UK could liberalise further over time, perhaps as part of wider free trade agreements, but prudential concerns will make this difficult. The UK was reminded during the financial crisis of the problems of dealing with the failure of financial institutions headquartered elsewhere. But the bigger question here is whether the UK is going to retain easy access to EU markets – if it does not, it will become a less attractive place for foreign institutions to set up subsidiaries.
UK domestic regulation:
Andrew Bailey, the head of the FCA, has said that he expects “no great bonfire of regulation” following Brexit. The UK would want a lot of the EU rules in its own regulatory regime anyway – in fact, the UK has been instrumental in shaping much of the EU rulebook. If the UK remains in the EEA (or there is a comparable association agreement) it will in any event be obliged to continue to implement EU financial services legislation in full. If UK firms are going to rely on “equivalence” instead, as discussed above, they will need UK regulation to remain at least broadly in step with the EU. Similar factors are important in other areas. The EU will not permit social dumping by allowing the UK unrestricted access to the single market if it is able to apply more flexible employment laws than member capital and liquidity requirements for banks and other matters relevant to financial stability. For example, the Basel III standards for bank capital and liquidity have been incorporated into EU law in the form of the Capital Requirements Directive and Regulation, and the FSB’s Key Attributes of Effective Resolution Regimes have been incorporated into the EU’s Bank Resolution and Recovery Directive. But even outside the EU, these international standards will continue to apply to the UK whatever form the future UK/EU relationship may take.
What to do in the interim?
Financial institutions need to plan for the future while these issues remain in flux. UK entities with substantial business in the rest of the EU are potentially most at risk of adverse outcomes. Some will be content to take a wait-and-see approach for the moment. But others may want to make contingency plans now to ensure business continuity post-Brexit, particularly where solutions entail potentially lengthy operational or regulatory lead times. Structural changes may be a part of this in some cases, possibly involving the establishment of new legal entities in other EU countries or changes in where staff are located and trades booked.
The EU is unlikely to have a problem in principle with allowing the establishment of new EU subsidiaries, or with giving them a regulatory licence (which would also enable them to passport into other EU countries). However, a host of regulatory issues typically needs to be worked through, including capital and liquidity requirements, and wider issues of recovery and resolution planning and prudential supervision at entity and group levels.
On the plus side, the current state of uncertainty means there is time for firms to influence the political choices that now have to be made. The importance of financial services to the UK gives the industry a significant voice to argue for solutions that are both in its own and the national interest.