Although growth in financial services has been subdued following the referendum, the sector is still an important component of the UK’s economy, contributing 6.9% of the UK’s GDP in 2019. The tax revenue from finance is particularly important – making up 11.5% of the total employment tax take in the UK.
However, the sector remains concentrated in London and the South East of England. This distinctive economic geography does not sit easily with the Chancellor’s aim to ‘level up’ economic performance in northern England and the Midlands.
The trade negotiations for financial services in 2020 will therefore provide an early illustration of the trade-offs between domestic policy concerns and the negotiation of a new trading relationship with the EU, the choice between regulatory autonomy in a critical area of the economy and maintaining high quality access to EU markets.
Following the referendum, preparations focused on the possibility of a no deal Brexit, particularly in terms of protecting financial system stability in both the UK and the EU. Contingency planning, led by the Bank of England, ensured that, by September 2019, UK banks held enough capital to continue serving UK households and firms in a disorderly ‘no deal, no transition’ Brexit scenario.
These preparations were necessary because the current size and shape of the UK’s financial services sector has been determined to a large extent by its relationship with the EU. The liberalisation of cross border trade in financial services paved the way for ‘passporting’ arrangements between EU member states.
Passporting means that a financial services firm authorised to undertake activity by the regulator of one EU member state can apply for a passport that allows it to conduct the same business throughout the EU without the need for further authorisation.
Using passporting arrangements, it is estimated that 67% of UK financial services (not including insurance) supplied to the EU are delivered cross border from a UK base. As a result, London has developed into the EU’s leading financial centre.
The possibility of passporting continuing after Brexit appeared to end in January 2017 when the then Prime Minister, Theresa May, ruled out continued single market access after Brexit. Following this, representatives of the City of London lobbied for a model whereby the EU and the UK would accept each other’s divergent regulatory regimes – so-called ‘mutual recognition’.
However, this was not acceptable to the EU. There were also differing views within the government regarding whether the UK should become a rule taker – agreeing to follow EU rules over which it had no say – in such a key sector where EU ambitions were known to depart from what UK regulators wanted.
The Political Declaration agreed by Johnson in October means that current passporting arrangements will cease at the end of the transition period – currently the end of December 2020. From then, the UK’s relationship with the EU in financial services will be based on equivalence arrangements. Under these, the EU permits foreign financial firms market access if it believes that their home country’s regulatory arrangements are equivalent to, or closely aligned with, those of the EU.
There are three potential problems with this. First, the Political Declaration sets an ambitious timetable to complete equivalence assessments before the end of June 2020. Equivalence decisions can be taken rapidly but some have taken several years to conclude.
Second, there are 40 areas in which equivalence needs to be assessed and it has not been granted in all areas to any country to date. However, because the UK is a member state, logic suggests its regulatory arrangements will satisfy the assessors.
Third, equivalence can be revoked by the EU with 30 days’ notice. Consequently, reliance on equivalence will not end uncertainty about the relationship between the UK and the EU. Any hint that the UK was about to diverge from the EU regime could lead to revoking the equivalence assessment.
It is hard to assess what the impact of relying on equivalence arrangements will be. Not least, this is because the financial services sector is diverse. It includes not only multinational investment banks but also domestically focused insurance companies and a range of growing challenger banks in fintech. Each of these relies on exports to the rest of the EU to different extents.
Those parts of the financial services sector which are more reliant on trade with the EU have begun to relocate activities to other EU countries in order to maintain single market access. Investment banks have moved staff and assets to Frankfurt and Paris in particular.
Asset management firms have more typically relocated parts of their operations to Dublin. Institutions that facilitate cross-border transactions, known as financial market infrastructures, have concentrated their early relocations in Amsterdam.
However, parts of the financial services sector that are less exposed to EU-UK transactions or hope to benefit from UK divergence, such as hedge funds, have seen new office openings in London since the referendum.
These relocations provide early indications as to how financial firms will protect their interests during the transition period, gradually transforming the sectoral focus and size of the UK’s financial services sector as they do so.
However, they raise important questions about how the financial services sector will contribute to the renewed focus on regional economic development in the UK after Brexit.
Any contraction in financial services activity would result in lower tax revenue, reducing the domestic funds available to support investment elsewhere in the country.
It also risks contributing to a ‘levelling down’ of the economy as financial services growth is negatively impacted most significantly in London and the South East, rather than the ‘levelling up’ aspirations of the government.