Despite the long list of problems resulting from the 2007/08 crisis, the financial sector remains an important part of the UK economy. It employs around 1.2 million people, constitutes a large part of the country’s exports, and contributed around £72bn to the Treasury’s coffers in 2016-17.
Since before the referendum, various commentators and industry leaders have stressed the challenges to the sector posed by Brexit. However, only recently has any clarity emerged.
This is not because the underlying issues have changed, but because the government finally seems to have settled on a position about the UK’s future membership of the single market and customs union.
There are three interconnected issues to consider. First, there is the question of continued market access after Brexit. The EU-wide market in financial services rests on a common regulatory framework and the system of ‘passporting’.
Once a firm has obtained authorisation in any member state, it is able to conduct business in all others without needing further authorisation.
British financial firms such as banks, insurance companies and securities dealers currently use this system to sell services to clients in the EU. Furthermore, many firms from ‘third countries’, including the US, Japan, South Africa, Switzerland and China, have made London the base for their EU operations.
However, passporting rights are only available to firms domiciled in an EU or EEA member state. As Theresa May made clear in her recent speech, the UK intends to leave the first and not join the second.
As a result, all firms based in London will lose their automatic access to EU markets and will need to establish a new presence somewhere in the EU to continue offering their services to European clients.
One possible solution could emerge from a post-Brexit trade deal with the EU, which could, in theory, contain financial services provisions. In practice, though, this is highly unlikely: such agreements rarely cover services in great depth, and anyway the EU has long opposed a sector-by-sector deal.
Alternatively, there is an existing legal mechanism which could facilitate market access. The EU can judge the regulatory regimes of third countries as equivalent to its own, and allow their firms access to European markets.
The US, Australia, Canada, Switzerland and Bermuda have already been granted this status for certain areas of business. Since on Brexit day the UK and EU’s regimes will be perfectly aligned, the decision on equivalence ought to be straightforward.
But the key difficulty is that equivalence is nowhere near as uniform as passporting: it does not cover the full range of services currently sold by UK-based firms into the EU, nor the full range of clients.
Most troubling for the City, and also for the Treasury, is the fact that banking services could not be offered under an equivalence regime.
The second issue concerns the trajectory of regulatory policy in the two jurisdictions. Whether access is granted as part of a free trade agreement, or under existing legislation (which is more likely), its long-term future rests on the continued judgement – on the part of the EU – that the two regimes remain equivalent.
Were the UK to decide to significantly diverge from the EU, the Commission could revoke access at only 30 days’ notice. In recent years, London has argued strongly against certain regulatory changes that were favoured by the rest of the EU—such as a cap on bonuses paid to bankers—which indicates that regulatory preferences are likely to diverge.
Providing a stable model to enable long-term access for UK-based firms to European markets, then, will place significant pressure on British regulators and politicians to keep as closely aligned as possible with the EU’s regulatory regime. This may well become politically difficult to sustain with time.
Third, even putting aside policy convergence, considerable effort will be needed to foster cooperation between the two at the institutional level. British regulators are currently represented in the many venues in which EU financial policy is made: in the working groups under the Commission and Council, and in the technical committees convened by the European Banking Authority.
This will end with Brexit, but it will be in neither side’s interests for the UK to be frozen out altogether. Thus, new channels of communication will need to be established to protect the otherwise potentially fragile status of the two sides’ regulatory equivalence.
This will have to extend far beyond policy and take in cooperation over supervision: as firms shift their operations around the EU to make use of whatever licencing arrangements are available to them, the resulting complexity in their structures will start to pose systemic risk, which both British and European regulators will want to monitor closely. Both currently have experience in cooperating over the supervision of cross-border firms, but this will become more delicate after Brexit.
Clearly, then, much remains to be done if British financial services firms, and foreign firms based in London, are to continue to enjoy anything like the current levels of access. New access provisions will need to be negotiated, which in turn will rely on a delicate judgement of the continued alignment of regulatory policy.
The catch is that all this will require considerable clarity on the part of the British government on its priorities, and for it to embrace a difficult set of trade-offs: either alignment and market access, or divergence, sovereignty and a rough ride for the financial sector.
By Jean Paul Salter, researcher at The UK in a Changing Europe. This piece originally featured in our Article 50 one year on report.