The U.K.’s Big Brexit Test: Holding On to London’s Financial Crown
Posted by hkarner - 20. Juli 2016
Source: The Wall Street Journal by Simon Nixon
Much of the success of Britain’s giant financial services industry is relatively recent and owes a lot to the U.K.’s EU membership, Simon Nixon writes
The political crisis that engulfed the U.K. after its decision to quit the European Union in last month’s referendum may have come to a remarkably swift conclusion. But the political challenges facing new Prime Minister Theresa May are awesome. She must now fashion a new foreign, commercial, security, scientific and agricultural strategy for the country that meets the high expectations of those who voted for Brexit and her own promise upon taking office to “make a success of it.”
One of her biggest challenges is to find a Brexit deal that preserves the success of the U.K.’s giant financial services industry, which is so central to the country’s economic fortunes. Much of this success is relatively recent and has owed much to the U.K.’s membership in the EU. For several decades after World War I, the City of London was primarily a domestic capital market. Its modern revival only began in the late 1960s with the creation of the Eurobond market, which recycled offshore U.S. dollars, and the Thatcher reforms of the 1980s, which swept away restrictive practices, abolished exchange controls and exposed domestic firms to foreign competition.But what really transformed the City was the creation of the EU single market and, subsequently, the euro. This turned London into Europe’s financial center, home to vast new pan-European markets for equity, bonds and derivative-based hedging products. Thanks to the EU’s commitment to the freedom of movement of capital, services and people, financial-services providers from all over the world could use London as a hub to serve customers across the entire continent.
Today, the U.K. is home to 78% of European foreign-exchange trading, 74% of interest-rate derivatives trading, 85% of hedge fund assets under management and 35% of all EU wholesale financial services, according to TheCityUK, a London-based trade body. The U.K. in 2014 had a £72 billion ($95 billion) trade surplus with the rest of the world in financial services, of which £18.5 billion was with the EU. There are 489 foreign banks registered in London, of which 183 are from the EU.
How much of this success is at risk from Brexit? Certainly, some sectors should be unaffected, including those focused on the domestic and non-EU markets and activities such as insurance, where there is only limited cross-border activity. Some sectors such as hedge funds may consider Brexit a benefit if it allows them to escape what they consider to be unnecessary and costly EU regulation.
The bigger questions surround the future of cross-border banking services: Will EU supervisors allow banks to continue to maintain systemically important businesses and assets offshore in London operating under potentially different regulatory rules?
For many banks, the ideal Brexit outcome is a deal that maintains as much as possible the status quo by keeping the U.K. in the EU single market.
But this seems unlikely since it would require the U.K. to accept EU rules without having any say over them—at a time when financial regulation is constantly evolving. What banks fear is that EU supervisors will revoke the “passport” that allows U.K.-based firms to offer financial services directly to EU customers and insist instead that all banks wishing to do business in the EU maintain separately capitalized and funded onshore subsidiaries under their supervision.
This doesn’t mean that London would cease to be Europe’s financial center. EU regulators would likely insist that new EU subsidiaries are more than mere brass-plate operations and that banks install sufficiently senior locally based management, operational infrastructure and assets. That could include a requirement that EU-based banks clear EU-denominated trades via onshore clearing houses.
But there is no reason why the bulk of traders wouldn’t continue to operate out of London, not least because many traders like living there. As one veteran City adviser puts it, “no banker would willingly relocate to any city where he wouldn’t be happy to spend the weekend.”
Even so, there are three risks to the long-term prospects of the U.K.’s financial-services industry. First, establishing new EU-based subsidiaries would impose substantial costs on the industry when its profitability is already weak. That could cause banks to accelerate existing plans to cut costs, including by transferring back-office and administrative jobs offshore to cheaper locations, including Eastern Europe. That would hit wider U.K. financial-services jobs and revenues. Second, and conversely, the cost of establishing separately capitalized, UK-only subsidiaries could push up the cost of financial services in the U.K., which would have an impact on the wider economy.
Finally, a British exit from the EU risks setting in reverse the network effect that has until now been such a crucial factor in London’s success. Once firms were forced to unbundle some activities currently located in London, others might follow. European banks in particular might choose to relocate more than just management and operational functions, especially if a post-Brexit U.K. made it harder for EU citizens to work in the U.K. Over time, the U.K. could find itself losing market share to other financial centers—and the lucrative tax revenues that flow from it.
How Mrs. May squares this circle is unclear. But the success of Brexit may depend on it.