The financial sector might not be everyone’s favourite part of the UK economy, but it is nonetheless very important: it is a huge contributor to the Treasury’s tax take, contributor to GDP and employs a large number of people, particularly in the City of London.
As with many other sectors, though, it is very exposed to the risks associated with a no deal Brexit.
Currently, the EU-wide system of passporting system enables firms authorised in one member state to operate anywhere in the single market without needing further regulatory approval.
After Brexit, the UK will no longer have access to this system, and will instead move into an arrangement based on ‘regulatory equivalence’: if the European Commission judges a country’s regulatory regime to match that of the EU in intent and outcome, it may then grant market access.
However, equivalence has two key weaknesses from the UK’s perspective. First, it is not as extensive as passporting, and large parts of financial services business, such as banking and deposit-taking, or selling investment products to retail consumers are out of scope.
Second, the European Commission can revoke its judgement of equivalence at only 30 days’ notice.
Although the UK’s regulatory regime will be part of the EU’s right up until the moment of Brexit, and remain identical to it the following morning, the possibility of a quick revocation still poses a significant worry for firms, especially if future governments chose to draw the UK’s regime away from the EU’s (or, for that matter, chose not to implement any future changes required by the EU).
The irony is that thus far the UK has been very successful in shaping EU regulation in the way that it wants, because it represents such a large part of European financial services (particular in investment banking and trading). Brexit means it will lose that ability to influence future EU regulation.
For these reasons, Theresa May’s deal aims for ‘structured regulatory dialogue’, with the Political Declaration stating that equivalence discussions should start as soon as possible after Brexit, and that they should be concluded by June 2020.
Furthermore, to overcome the problem of revocation at short notice, there is a proposal to wrap regulatory equivalence in an institutional framework facilitating long-term cooperation.
Should one or other party seek to diverge, these structures would allow for the process to be managed in a careful and transparent manner, and – hopefully – for areas of business not caught in the divergence to remain unaffected.
The structures would be established over the course of the implementation period – running from Brexit day to the end of 2020 – during which passporting would also continue to apply, giving firms time to adapt their business models and legal entity structures.
For financial services, then, a ‘no-deal Brexit’ describes the scenario where there is no implementation period, and so no opportunity to put these structures in place. We can make two sets of comments relating to what might arise in this situation.
First, there is the impact for UK financial services firms. As we have seen, market access for trading under equivalence is limited to certain services and certain types of client, and so firms wishing to maintain their current levels of activity will need to establish an off-shoot, with the appropriate regulatory authorisation, in the remaining EU27.
Many are in the process of doing so. Bank of America is spending $400m moving employees and operations to Dublin and Paris; some banks are able to use existing EU entities to expand operations such as UBS in Frankfurt; and Barclays and HSBC are set to become the biggest banks by assets in Dublin.
But this is a lengthy and complex task which they might have hoped to complete during the implementation period.
If that window never opens because the UK and the EU fail to reach an agreement, then we can expect a rapid acceleration in their efforts, and where business lines are deemed no longer viable (because markets cannot be accessed and new European hubs cannot be established in time) we can expect job losses.
Frankfurt, Dublin, Paris and Amsterdam have all been successful in attracting UK banks and investment firms.
Second is the broader impact on the UK’s regulatory regime. This is where things get even trickier.
Financial firms and markets are heavily regulated and supervised, and as we can recall from the events of almost a decade ago, problems arise when regulators are not aware of the precise workings of foreign firms operating on their patch – or, indeed, not clear on who is meant to be looking at what, or what is the impact of being the lender of last resort.
The financial markets of the EU and the UK are highly interconnected, with firms from one side of the channel selling services to clients on the other, and trading extensively with one another and with entities inside their own groups.
In this light, both UK and EU regulators will take time to scrutinise changes to firms’ locations, or business practices; likewise, each will demand that management, capital and liquidity are kept in their own jurisdiction for the entities that they oversee.
What this means for Brexit is that detailed burden-sharing arrangements, framed in memoranda of understanding, must be compiled between UK and EU regulators, clarifying who is going to supervise the Frankfurt office of a British firm as it sells services to clients across the EU, for example.
Once the UK is no longer inside the EU regulatory framework, such memoranda will need to provide an equivalent regulatory structure to allow, for example, the recovery (or winding up) of a failing entity in the remaining EU when its parent is in post-Brexit UK.
An implementation period would give UK and EU regulators just under two years to put these arrangements in place. Were it not to materialise, there is a very real danger that risk could build up in a pocket of this interconnected financial system.
In a commendable spirit of diligence and preparedness, UK regulators are taking various steps to mitigate the risks of a breakdown in regulatory cover, and in the legal framework.
A ‘Temporary Permissions Regime’ is being established at the moment, which will allow EU firms currently operating in London the chance to apply for fast-tracked and strictly time-bound access to UK markets if the implementation period never happens and passporting suddenly disappears on Brexit day.
EU regulators have not yet followed suit.
Similarly, UK regulators are using special statutory instruments to onshore, and if necessary update or amend, the EU’s rulebook for financial markets. The European Union (Withdrawal) Act 2018 will roll EU law onto the domestic statute book (with the legal status of ‘retained EU law’) and a similar exercise will be required at the more detailed level of specific technical standards and rules. This means that in the event of a ‘no-deal Brexit’, the domestic regulatory regime will be ready to take effect immediately.
By Dr John-Paul Salter, researcher at The UK in a Changing Europe and teaching fellow in Public Policy & Management at University College London