Discussions this week concerning the future of the UK’s financial services sector focus attention on an important conundrum the government faces as it develops its negotiating strategy in Brexit trade negotiations: namely, how to balance the need for access to the EU’s market with a desire to ‘take back control’ by implementing new, British rules.
In this case, the issue rests on the framework for regulating financial services, and thus for the continued access to EU markets for UK firms.
The EU’s system of passporting enables firms authorised in one member state to operate anywhere in the single market without needing further regulatory approval.
The UK only has access to this system for the duration of the transition period, currently expected to last until the end of 2020. The next arrangement will most likely be based on regulatory equivalence.
This is ‘passporting lite’: a country’s financial firms can be granted limited access to the EU’s market if the Commission judges the country’s regulatory regime to match that of the EU.
The range of services covered is nowhere near as extensive, and large parts of financial services business, such as banking and deposit-taking, or selling investment products to retail consumers, are not covered.
Furthermore, the Commission can revoke its judgement of equivalence at 30 days’ notice. Indeed, last summer it cut back the access granted to firms from Singapore, Brazil, Canada, Argentina and Australia.
The UK government has long sought to encourage the EU to improve this system. For example, back in January 2018 the European Union Committee explored possible alternatives and suggested ‘enhanced equivalence’, under which assessments would be based on outcomes, such as financial stability, rather than rules.
Later that year Theresa May’s White Paper looked to wrap equivalence in a set of institutions which would make it harder for the Commission to unilaterally – and suddenly – withdraw access. This didn’t go down well with the EU, but the White Paper came to naught anyway.
It was reported on Monday that the UK Government would seek ‘permanent equivalence’, shifting the entire issue into a chapter of the future free trade agreement (FTA).
Again, the idea is to lock the EU into an arrangement loosely based on regulatory equivalence, but to do so in the structures of a new legal context – an FTA, rather than the existing corpus of EU law governing financial services.
Failing that, the unreleased briefing paper shown in an unverified photo reported in the Financial Times sets out two possible ‘landing zones’: one is essentially the proposal from 2018 (equivalence plus memoranda of understanding and joint cooperation on rule changes), and the other, a ‘time limited’ FTA chapter (which clearly doesn’t deliver the kind of long-term certainty firms need).
British exceptionalism, or EU intransigence?
So while the term ‘permanent equivalence’ is new, debates about different possible meanings of equivalence are not.
For several years now, the government has been trying to leverage the UK’s ‘special status’ into special treatment from the EU: first, as a former member state (and so different from, say, Australia); and second, as the home of a major global financial centre.
The first of these might lead to the expectation that the granting of equivalence will be straight forward. After all, until very recently, the UK’s regulatory regime was part of the EU’s, and so the criteria for an equivalence judgement are arguably already met.
The second, though, conflicts with this, and this is where the problems lie.
London is, without a doubt, a vitally important financial centre for European businesses, reflecting its wider position as a leading international financial centre: more than half of debt and equity capital raising for EU firms was routed through the City between 2012 and 2018. This status is echoed in a certain exceptionalism present in the arguments of British politicians and policymakers.
Sir Jon Cunliffe, a deputy governor of the Bank of England, recently told an audience in Berlin that “[t[he UK cannot outsource regulation and supervision of the world’s leading complex financial system to another jurisdiction.”
The same sentiment was expressed by the (now former) Chancellor, Sajid Javid, in CityAM, when he wrote that ‘… there will be differences, not least because as a global financial centre the UK needs to keep pace with and drive international standards.’
The implication is clear: the City of London is, and will be, a more complex and distinctive beast to regulate than the EU’s relatively undeveloped financial system.
As such, the UK cannot afford to be shackled to a regulatory regime potentially unable to keep up with developments in a whole suite of financial markets and products.
In that sense, the UK has to be able to diverge from the letter of the EU’s rules, not out of spite, but because it has a genuine need to adapt to conditions and innovations in the global marketplace.
Not surprisingly, the EU remains unimpressed by these calls for regulatory divergence based on the exceptionalism of the City of London.
Indeed, shortly after the photos from Downing Street appeared, its opposition to a bespoke equivalence regime being devised with the UK was made clear in comments made by the EU’s chief Brexit negotiator Michel Barnier – who stated that open-ended financial services equivalence was not an option.
However, this is not mere intransigence: just as the UK has a valid argument to make about hosting a complex financial system and needing the ability to regulate it appropriately, so the EU is legitimately concerned about the integrity of its single market programme and the consistency of its treatment of non-members.
Furthermore, the EU is – justifiably – nervous about the City of London undercutting its own integrated financial sector, which it is trying to develop through the banking and capital markets unions.
Overall, the tensions evident here show how quickly a technical issue like ‘regulatory alignment’ becomes politicised, as claims for flexibility on the one hand and continued regulatory oversight on the other brush up against one another.
Whatever happens with the eventual agreement, though, there are domestic implications: the UK financial services sector itself is changing (witness the significant growth in fintech and green finance), and the question of how to enrol the sector more effectively in addressing persistent regional differences in growth and productivity within the UK remains unanswered.
These issues are likely to be tackled in the Treasury White Paper on the future of the UK financial sector due this spring.
In the meantime, unresolved questions surrounding equivalence mean that the future size and shape of the UK’s financial services sector, its political influence and its relationship to the rest of the economy – as different sectors are prioritised (or not) in the 2020 trade negotiations – remains uncertain.