No Quick Fix to City of London’s Brexit Conundrum
Posted by hkarner - 30. September 2016
Source: The Wall Street Journal By SIMON NIXON
Some argue EU rules provide a way for London-based banks to keep their access
to Europe, but the reality is more complicated, Simon Nixon writes
The City of London generates an estimated £60 billion in U.K. tax revenues annually.
As the debate over how to carry out Brexit intensifies, the City of London finds itself in the firing line. To some hard-line Brexiters, repeated warnings from bankers about the costs of quitting the European single market and losing passporting rights—which allow U.K.-based firms to sell financial services anywhere in the European Union—smack of special pleading. Passporting is a red herring, they say, because the U.K. would qualify as an “equivalent” regulatory regime under EU rules, allowing most financial-services activity to carry on as before. City warnings of imminent doom often turn out to be wrong, not least over Brexit itself. The City will be fine because it is always fine.
The City, though, hasn’t always been the global financial hub it is today. In the decades after World War II, London was a backwater, a largely domestic capital market, dominated by domestic firms and presided over by an old-money elite sustained by fat, fixed commissions, elaborate barriers to entry and rampant insider trading.What restored London’s global fortunes was a combination of the Thatcher-government overhauls, which removed capital controls, eliminated restrictive practices and opened the City to foreign competition, and the creation of the EU single market. It was the advent of passporting in the early 1990s that enabled London to suck in the bulk of Europe’s wholesale financial-services jobs, and its related tax revenues.
Similarly, the argument that passporting is now irrelevant rests on shaky legal foundations. Market access based on regulatory equivalence is only available for some asset management and trading activities; retail and commercial lending are excluded. Meanwhile, the key piece of EU law—the Markets in Financial Instruments Directive—won’t come into force until 2018. Its equivalence provisions have never been used before and equivalence decisions in any case lie in the sole hands of the European Commission, leaving the process susceptible to political pressures.
Besides, banks are unlikely to rely on equivalence for long-term business planning. The difference between a passport and equivalence is similar to the difference between offering someone citizenship or a temporary right to remain, notes Simon Gleeson, a partner at Clifford Chance. One allows a person to build a life in a country; the other encourages them to seek long-term security elsewhere.
The risk for firms is that a regulatory regime might not stay equivalent for very long, given the dynamic nature of financial market regulation. At the very least a mechanism would be needed to ensure that the regulatory frameworks of both sides evolved in tandem. That could be difficult for the U.K., notes Karel Lannoo of the Centre for European Policy Studies. For example, would the EU make equivalence conditional on the U.K. abiding by EU rules on banker bonuses? And what if the EU decided to tighten those rules further? Would the U.K. follow?
Most firms are more likely to restructure their European operations to create separate EU subsidiaries rather than rely on equivalence, Moody’s Investors Service said in a report last week. How much would this cost Britain? The government is frantically trying to work this out by mapping the entire financial-services ecosystem.
But clear answers are elusive. Pan-European banks don’t collect information on revenues and costs by passport. However, a strict legal analysis suggests the disruption is potentially huge: The standard regulatory test to determine where a financial service is traded is to look where the person soliciting the trade is based. In the most extreme scenario, banks could be obliged to transfer all EU customer-facing staff to EU-based subsidiaries—and those subsidiaries would need to be separately capitalized, funded and managed.
Ultimately, banks will base their decisions on what makes commercial sense. A big consideration will be whether creating new ringfenced EU subsidiaries generates any extra capital requirements. That is possible given that banks will need approval from the European Central Bank to use the risk-based models they currently use to keep their capital requirements down.
After all, Brexit is taking place as bank business models have never been under greater pressure. The current turmoil surrounding Deutsche Bank partly reflects market skepticism over its long-term ability to generate an economic return on capital. In this environment, banks may respond to any additional Brexit-related pressure on returns by simply withdrawing capital from European markets.
Of course, this would hurt the wider European economy as much as the U.K., prompting some Brexiters to argue that this should convince an economically rational EU to strike a generous deal that preserves the current arrangements. But a European might respond that it is up to the U.K. to propose a solution that gives the EU sufficient influence and control over the City of London to justify continuing the passporting regime.
After all, the political pressures on the U.K. are surely higher. The EU generates an estimated 25% of U.K. financial services revenues, and the City generates an estimated £60 billion in U.K. tax revenues, according to KPMG, which suggests the U.K. could be facing a £15 billion budgetary black hole—and that excludes any impact on sectors reliant on City spending. That would confront the government with some unpalatable political choices—possibly more unpalatable than disappointing hard-line Brexiters.