It is too narrow a lens through which to view the advantages enjoyed by our financial services companiesby George Magnus / September 25, 2016 / Leave a comment
It is not surprising that the City is a central issue in the Brexit discussion. It’s a pretty important part of the economy. Financial services in general account for about 12 per cent of GDP, run a £72 billion balance of payments surplus and raise about £66 billion in tax revenues. Inside the City, there is a handful of well-known Brexit supporters amid a predominantly pro-EU, pro-Single Market consensus. Outside it, opinion is divided also between those who think it important to preserve the operating environment for the City, and those don’t mind at all if the industry shrinks and becomes less important. The most surprising view though is the idea that Brexit is an opportunity for the UK financial services industry to thrive, regardless. This was the main message of a piece in The Times last week by Ed Conway, who comments on economics and finance for Sky News, under the heading “Resilient City will take Brexit in its stride.” This falls under the same category of headings as “Global warming good for summer holidays.” So what’s this all about?
No one knows where the Brexit referendum result is leading us, least of all Her Majesty’s Government, which has yet to articulate a strategy, let alone a workable one. There is no precedent for leaving the EU, no template, and no clarity about how to restructure an array of complex political and economic relationships, including those relating to the City.
The optimistic view is that the City has survived two world wars, the Great Depression and more, and Brexit is just another, maybe smaller, challenge. Conway’s focus is specifically on the issue of “passporting,” or the right enjoyed by banks, insurance companies and asset managers based in one EU member state, to provide services in all other member states without having to set up separately capitalised, funded and regulated subsidiaries in each country. Out of the Single Market, companies would lose that right, and face higher costs, higher demands for capital at a time when they are under significant regulatory pressure to do so anyway, and greater fragmentation in their businesses. Or, they would back away and the industry will shrink, creating higher costs and dislocations for everyone else.
To be fair to Conway, his editorial headline writers may have exaggerated his point because he concedes that Brexit has made us focus on “piddling policies” like passporting instead of much bigger issues relating to financial stability, trade, investment and so on. I’m not sure it is true that passporting has stolen the limelight as suggested but even so, the assertion that losing passports will be no disaster is surely bravado.
He and others argue that “equivalence,” or EU-approved rules governing the access of non-EU companies to specific parts of the financial services market, will nullify the removal of passports and that the EU is considering passport rights for Canada, Switzerland and Japan. Yet, this is to over-state considerably.
Access to the EU market under equivalence is piecemeal, selective, not really applicable to insurance companies and mutual fund companies, and in any event subject to the approval of the EU and removable at its sole discretion. There wouldn’t be much taking back control here.
On the contrary. To get an idea of the significance of passports, consider the Financial Conduct Authority’s (FCA) recent revelation that 5,476 UK based firms hold 336,421 passports. The latter is the product of the number of firms, activities and countries in which those activities occur. Further, the Financial Times recently reported that senior executives and consultants reckon that about 20 per cent of investment banking and capital market (IBCM) revenues in the UK—or £9 billion—are at risk from losing passport rights. In addition, it quoted the consultants, Oliver Wyman, as saying that over half of IBCM revenues generated in London are traceable to European clients outside the UK, and that 80 per cent of IBCM activity in the rest of the EU is managed and executed in the UK.
Passporting alone then is too narrow a lens through which to consider the advantages enjoyed by UK financial services companies. It is important in its own right, but it is also a key part of what makes UK, EU and non-EU companies want to be in London and offer the array of services to clients in Europe that they do. For so many companies, London is also a European or regional headquarters, used to derive economies of scale and lower costs from other activities including risk management, loans and deposit-taking, foreign exchange, fixed income and financial derivatives trading, and clearing and settlement (or the managing of accounts of trading parties, arrangement of accounts for transfers of money and securities, and ultimately, the transfers themselves). Simply put, if passporting rights were lost and companies had to apply case-by-case, and country-by-country to conduct business, their activities would become fragmented, less efficient and more expensive. Companies would have strong incentives to relocate.
Moreover, it doesn’t take much imagination to expect the European Central Bank to want all euro-denominated transactions to be cleared and settled by financial institutions registered in an EU country. Last year the ECB lost a legal case to require clearing and settlement of some derivatives transactions to be conducted by banks in the eurozone. The UK won the case because of its EU membership. It is highly improbable that any subsequent pitch for clearing and settlement to be done in the EU will fail. To the extent it involves all euro-denominated transactions, London’s loss will be all the greater, and banks in the UK are already looking at where they might go and how many jobs they will take with them.
So how should we think about the outlook for the City if no satisfactory arrangement is possible that allows financial firms to carry on, more or less, as now?
Looking on the positive side, it certainly wouldn’t mean that London would become a financial museum. London’s favourable global time zone, English language, the favourable perceptions of and widespread recourse to English law, the concentration of highly rated law and accounting firms, and the benign influence of the Bank of England’s regulatory authority would continue to enhance its status. EU financial firms may also lobby for a mutual passporting deal since, as the FCA also reported, there are over 8,000 (mostly smaller) such firms holding 23,532 UK passports. Moreover, China didn’t chose London to be its principal non-Asian financial centre for trading RMB on a whim; some global companies would still choose to use the UK, and by implication London-based financial services, as a European base for foreign direct investment; and you can bet your devalued pound that City ingenuity will look for ways of trying to compensate for the costs of Brexit, and associated loss of business.
Yet, if you look at how the UK financial services industry developed, you get an entirely different sense of what is at stake, and it’s a lot bigger than passporting. The City has always been about internationalised and open markets from the creation of euro-dollar financial markets to global currency trading, Big Bang, and importantly the centralisation of international wholesale financing, spurred not least by the development of the EU, itself. It would most likely cope with the kind of financial balkanisation that Brexit would entail, but so would New York, Singapore, and Dubai that have had more practice. Moreover, other EU financial centres such as Dublin, Amsterdam and Luxembourg, if not Paris and Frankfurt, would doubtless benefit from any relocation and restructuring away from London, with the bonus, of course, of picking up large chunks of euro business, from which UK banks might be excluded.
It would be nice to believe that Brexit, or a hard Brexit we should say, will spur the City towards new creativity and inventiveness. But belief belongs in your preferred place of worship, not in the hard-headed world of politics, economics and finance. UK financial services prosper because of being in the EU, and the advantages they enjoy will not be replicated outside. You can welcome the diminution of UK finance if you think this will make the economy safer and more balanced, or you can fear it as another catalyst of relative economic decline. What you can’t do is say “Rule Britannia, the City will thrive anyway.”