Written By: Diana Bailey – Corporate Finance
The United Kingdom’s Prime Minister Theresa May’s government has raised the possibility of a so-called “hard Brexit”, which prioritises immigration control over membership in the European single market. Banks and other financial firms now understand that they are facing an automatic loss of the City of London’s EU (European Union) financial passport.
This passport is a right for companies within the European Economic Area (EEA) to sell their products and services within the bloc. It is an obligation when talking about collection of deposits, derivatives trading, issuance of credits and bonds, portfolio management, payment services, insurance brokerage and mortgage lending. The European passport is not necessary for European foreign-exchange markets because foreign exchange is an unregulated activity. Without this financial passport accessible anymore from London, the financial industry will have to establish subsidiaries in European countries to reobtain it.
Another option could exist between UK financial firms and Europe with the request to obtain an agreement based upon “equivalence” in regulation. This enables companies outside of the EU to benefit from privileged or targeted access to a market. To do this, the European Commission must first recognize that the rules in Britain are as stringent as or equivalent to its own. Among the first such deals was a 1990s arrangement between the UK and the United States covering mutual access to derivatives markets.
After all, in the aftermath of Brexit, British rules will still be the same as those of the EU member states. But equivalences have the disadvantage of being a privilege not a right, which can be withdrawn unilaterally by the Commission. In addition, “equivalences” do not cover all activities, such as the collection of deposits and cross-border loans.
Specific UK-EU agreements are still possible, and negotiations are, of course, ongoing.
If the UK financial industry has to find a way out, so does the European financial industry.
The stake for non-UK but European financial industries and their countries is also rather high, as they have built in the City many hubs for their derivatives, stocks and money-market activities. And, last but not least, euro-clearing activity is located mostly in London clearinghouses. Eighty percent of European OTC (over-the-counter) interest-derivatives transactions, essential to the financing of the economy, are traded and cleared in London. In the City, the main player in this type of asset is the LCH.Clearnet Group, regulated by the British Competition and Markets Authority and the Bank of England, not by the European Central Bank (ECB).
UK and European financial firms are trying to target an optimized organization, where they will not face redundant costs in overheads, possibly centralizing back-offices maintained in London or externalising only some parts of their activities in Europe. Failing this, the organizational evolution created over the past 20 years will have to be rebuilt.
However, both the ECB and the FCA are warning that they will not be indulgent.
The ECB has made clear that it will grant licences only to well-capitalised and well-managed banks. It will not accept empty-shell companies in Europe, and it will carefully check that new entities have adequate local risk management, sufficient local staff and operational independence. The ECB has also indicated that it will use phase-in periods to make sure that lenders comply with European rules, which may take up to two years to pass through.
On the other side of the Channel, UK regulators are also going in this strict direction. Andrew Bailey, CEO of the Financial Conduct Authority (FCA), said there is a “potential world” in which trading arms seek to move the minimum amount of activity that would satisfy a regulator, while still keeping the UK “hub” intact. A reminder that European banks have their hub in London as well. Mr Bailey told reporters that the FCA will make sure that transaction-booking models are transparent and backed by sound risk management.
Will politics burst the financial industry?
The financial-organization model is not the only one that is going to be shaken. The European Union is still a conglomeration of countries with somewhat different regulations, and each country is competing in this sphere to attract business to its soil. This is obvious when witnessing major cities—Dublin, Frankfurt, Luxembourg, Brussels and Paris—competing to attract financial activities:.
Already, Frankfurt and Dublin are in the news:
- Frankfurt is a natural option, given a very well-established financial ecosystem featuring Deutsche Bank, the European Central Bank and BaFin (Federal Financial Supervisory Authority).
- Dublin shares similar laws and regulations with the UK and is the only other English-speaking country in the EU so would naturally make sense for ease of transition in terms of relocating staff and operations.
The EU’s securities watchdog declared that it would issue guidance and possible curbs to stop a “race to the bottom” among national watchdogs in the EU to lure banking business from London because of Brexit.
Hopefully regulators will take all of this seriously, or we could well see a totally broken European landscape after Brexit—not good when facing US and Chinese competitors.