The UK leads Europe’s financial services industry but, as Brexit looms, there is uncertainty as to how the sector will operate once the UK leaves the bloc. So, how will UK financial services cope with Brexit?
The Brexit drums continue to get louder as the March 2019 deadline draws nearer, but the tune has remained largely the same and many questions remain unanswered. The few agreements that have been made so far are also reliant on the UK and the EU striking a wider deal on their future relationship. A guiding ‘principle’ of the Brexit negotiations published by the EU clearly states that ‘nothing is agreed until everything is agreed’, adding ‘individual items cannot be settled separately’.
The idea of the trade between the UK and the EU remaining as ‘frictionless’ as it is now, as laid out in Prime Minister Theresa May’s Chequers plan, has all but died, but if there is one industry epitomising the need for the UK and the EU to maintain the current close relationship then it is the financial services industry. A ‘clean Brexit’ (a complete break from the EU) could shut off car manufacturers from their supply chains, cripple airlines’ ability to fly, or bring ports like Dover to a standstill – but none of that is relevant if the financial system underpinning it all can’t function.
After more than 40 years of harmonisation, the UK and the EU are inextricably interlinked in so many ways. This is particularly true when it comes to their money. The UK has had a hard time finding ammunition against the 27 other EU members, that together, have industries and markets that often outsize and outdo the UK on its own. But it does have one silver bullet: its dominant role in Europe’s financial services – the banks, asset managers, insurers, fintech firms and so on.
The fact that Brexit means the EU will lose the financial hub that is London is quite often forgotten. Thereby ignoring the fact that no matter how quickly cities like Frankfurt and Paris woo UK banks and financial services looking for a home in Europe, they will struggle to catch up with London.
With so much still up in the air and time running out, we take a look at how Brexit could impact UK financial services, as well as the possible outcomes that could be on the horizon.
How do UK financial services currently operate in the EU?
The UK government has been open in saying the majority of UK financial services legislation derives from the EU and that the current market is ‘highly integrated’. The EU’s common rulebook and standards apply to the market and it is governed by EU regulatory bodies.
All members of the European Economic Area (EEA), including the UK, can access each other’s markets using their ‘passporting rights’ without the need to ask European regulators.
The core regulation underpinning EU financial services and passporting is the Markets in Financial Instruments Directive (MiFID II), which has reinforced protection for investors and strengthened banking systems following the last financial crisis. This covers investment banking, derivatives trading, underwriting services, client order execution and sell services between member states. The Capital Requirements Directive, which facilitates deposit-taking, lending and securities trading, also partly overlaps MiFID II.
Although the UK has its own regulatory bodies, such as the Financial Conduct Authority(FCA), much of the country’s financial services are regulated at an EU level, mostly through the European Securities and Markets Authority (ESMA) which oversees the likes of credit rating agencies and trade repositories.
How is Brexit likely to impact UK financial services?
The only certainty of Brexit is that, whatever the outcome, change is coming. The trade relationship between the UK and the EU will not be the same after the transition/implementation period (however long that ends up being) comes to an end and Brexit kicks in. The implications for the UK go further afield than Europe, as most of its trade (including financial services) with around 60 non-EU countries is conducted through deals with the EU that will no longer exist once the UK leaves the EU. One of the major benefits of Brexit is the UK’s ability to go out on its own and strike deals with the rest of the world but the immediate job will be replacing the ones the UK will lose because of Brexit, and this is why there is a strong argument that the UK needs to be free to begin negotiating with other countries during the transition period to avoid trade with non-EU nations from collapsing on departure.
The EU has set the bar high for the rest of the world: non-EU countries that want any preferential treatment outside of the World Trade Organisation (WTO) rules have to meet the bloc’s standards, whether it’s on immigration, movement of goods or meeting European standards. The UK has been at the forefront of this. For example, the country led EU regulation such as the Retail Distribution Review implemented in 2013 to improve transparency within the investment industry and the introduction of tougher stress tests for banks in 2014 following the financial crisis. From a regulatory standpoint, it is likely that UK financial services will seek to continue to set if not exceed European standards after Brexit.
The EU doesn’t have any immediate concerns about UK products and services once they are no longer tied to European regulation but the bloc is worried the UK will eventually adopt its own regulations and systems that diverge from its own, possibly creating barriers to one another’s markets. May conceded her Chequers plan could see the UK and the EU go down different regulatory or legal paths and admitted ‘that this would have consequences’. After Brexit, the UK could boost financial services by lowering capital requirements, easing taxes or loosening labour laws – all changes that could begin to test the relationship with Europe’s financial centres. Some argue UK financial services, not as geographically limited as goods, can instead focus on building new relations with the other financial hubs around the world such as Hong Kong and Singapore.
For now, and until the final outcome of Brexit is known, the focus for UK financial services has to be on the severe risks they face: such as the threat of being shut off from Europe and having to jump (and pay the price of) higher barriers in order to keep business going as usual, or how it will affect cross-border investment and impact the country’s lucrative exports of financial services to the EU? And that is only the start of a long list of concerns for the industry to ponder.
For now, a transition deal is an immediate priority because the near-term shock is likely to be unpleasant without one. Falling off such a cliff edge would undoubtedly hit UK growth and have a knock-on effect on confidence. That could culminate in slower lending activity that could trickle down to companies’ earnings.
How important is financial services to the UK economy?
Financial services contributed £119 billion to the UK economy in 2017, representing 6.5% of the country’s total economic output. The industry’s output peaked in 2008, the year when the financial crash began to unravel, and in the following year financial services represented 9% of the UK economy.
Financial services is also a major contributor to the public purse. The sector paid £27.4 billion in tax during the 2016/2017 financial year, 4.8% of the country’s total tax receipts and the highest contribution on record.
The industry directly employs more than 1.1 million people, accounting for 3.2% of the UK’s entire workforce. The number of people employed in financial services had fallen for four consecutive years before rising in 2016, and then again in 2017 to its highest level since 2012. Still, the proportion of jobs within the wider economy has fallen from 3.8% in 2008.
Is the UK’s financial services sector really concentrated in London?
Conversations about financial services is often centred on London, and rightly so. Half of the financial services sector’s value is concentrated in the city, with the rest spread thinly out across the UK. The industry in Scotland, once the most prominent banking destination in the world, contributes over seven times less than London, and Northern Ireland’s role barely registers.
UK financial services economic output by region
|Economic output (£, billions)||% of potential output||% of UK financial services|
|East of England||5||3%||4%|
Brexit and trade in financial services: UK plays outsized role in EU
Financial services is one of the UK’s biggest exports to the rest of the world and represent almost 10% of the country’s total exports to both the world and the EU.
The value of financial services imported by the UK, from both the EU and other nations, has held steady over the last decade, dipping to £10.6 billion in 2016 from £12.1 billion in 2007, while the value of UK exports worldwide has soared 40% to £61.4 billion from £43.9 billion. This has seen the UK’s trade balance in financial services consistently deliver a healthy surplus that has grown 40% over the last nine years. Particularly exceptional growth has been seen since 2014, with the surplus rising almost 50% in just two years to breach the £50 billion mark for the first time in 2016.
The UK is an unrivalled world leader in areas such as insurance and dwarfs its European counterparts in almost every way when it comes to financial services: UK cross-border bank lending is greater than that of Germany and France combined, and the size of the latter’s hedge fund assets is 18 times smaller than the UK’s.
The ties between financial services over both sides of the English Channel is evident: the EU is the biggest single market for UK exports and the country imports more financial services from EU states than anywhere else. Exports of financial services to the EU has (not consistently) risen over the last five years, but so has the proportion of imports from EU countries.
UK exports of financial services dominated by investment banking
The UK’s overall trade deficit (taking all services and goods into account) is already running over £40 billion annually but, according to Deutsche Bank, this would be 40% larger if the huge contribution the UK makes to European investment banking was excluded. That figure is more poignant considering some reports suggest UK exports of financial services to the EU after Brexit could more than halve in the worst case scenario.
Almost three-quarters of the UK’s global financial services exports and one-third of that sent to the EU relates to investment banking, dominated by London’s role in the derivatives market (acting as the European hub alongside New York, which dominates across the Atlantic). European trade in foreign exchange and interest rates, for example, is heavily concentrated in London, which quickly became the logical destination for forex traders after euro was introduced in 1999. The UK is the biggest venue to trade the euro in the world and overall the country handles more than double the amount of foreign exchange (forex) than its closest rival — the US. In addition, while the US has become the central hub for interest rate derivatives the UK still accounts for almost four out of every ten trades.
Foreign banks make up almost half of the UK banking system by holding 49% of all bank assets in the country: an unrivalled figure compared to less than 20% in the US, 14% in Germany, below 10% in France and just 4% in Japan.
The EU needs London’s financial flair but not forever
London’s financial centre is unlikely to crash overnight in the event of a no-deal scenario and its size and importance will have pushed it high up on the negotiation agenda. But this is also the EU’s best and only chance, if it chooses to take it, to deliver a blow to UK financial services in an effort to steal the market. Both France and Germany, the two leading nations of the EU, have openly vied for business from UK-based banks and financial services companies in the hope of moving the industry back to Europe after Brexit.
Possible outcomes for UK financial services in Europe after Brexit
Almost all possibilities remain on the table even at this late stage of negotiations, causing uncertainty for the financial services sector. A deal is arguably more vital for financial services than any other, but also one of the most difficult. Talks about a custom union are moot as it only includes goods and not services and while other countries with prominent financial industries such as Switzerland enjoy relatively unfettered access to Europe without being a member of the EU, the ‘off-the-shelf’ models being considered are not ideal. This is why there are calls that a bespoke trade deal is needed for financial services and the UK as a whole.
Possible post-Brexit trade models
- European Economic Area (EEA): The foundation of the transnational internal market across all EU members plus three non-EU nations: Iceland, Liechtenstein and Norway (this is often referred to as the ‘Norway model’). EEA members enjoy full access to the single market but are obliged to contribute to the EU budgets and subscribe to EU laws, including the free movement of people.
- European Free Trade Association (EFTA): This facilitates free trade between Iceland, Liechtenstein, Norway and Switzerland (which is not part of the EEA, hence why this is referred to as the ‘Switzerland model’). EFTA members have the choice of becoming EEA members, which would be the most straightforward way for the UK to retain access post-Brexit. But Switzerland, which did not take that option, had to strike numerous free-trade agreements to cover particular sectors (rather than all trade) and pay to gain access to the single market. However, while it is largely free of European law (although not regulation) it does have to allow the free movement of people. EFTA has also struck deals with other nations including Canada and Mexico.
- Comprehensive Economic and Trade Agreement (CETA): More commonly referred to as the ‘Canada’ option, this has given the North American nation preferential access to the single market with fewer obligations to those non-EU members of the EEA. However, it mostly covers goods and again doesn’t fully accommodate the needs of UK financial services that would struggle to maintain crucial passporting rights.
- WTO: The WTO sets global rules for trade that are used when there are no agreements or deals in place between the nations involved. This would require the UK to adopt a ‘most-favoured nation’ model that would require both the EU and the UK to trade on the same terms as they do everyone else – if access to each other’s markets remains open, that is. There are advocates of this unilateral free trade policy that have used it to virtually drop all import and export tariffs as a way of opening themselves up to trade and investment. While often referred to as the ‘no deal’ option or ‘hard Brexit’, there is reason to think this option could be of benefit to financial services considering Singapore and Hong Kong – the two financial hubs of the east – have both adopted this approach and seen their respective financial systems flourish. However, this would mean dropping tariffs across the board, which would severely hurt other UK industries such as agriculture and manufacturing.
- Bilateral free trade agreement: Although a bespoke deal would be best for the industry, help facilitate smooth trade post-Brexit and overcome political hurdles such as ending contributions to the EU budget, the UK would have to handle the fact it would no longer be able to steer EU regulation or policy that could still influence UK financial services firms.
The UK government has a huge task on its hands as it tries to strike the best deal for business and the economy without compromising on the Brexit ‘promises’ that form the closest thing to a mandate that May and her negotiating team has. For example, staying a member of the EEA would largely maintain much of the access the sector enjoys today but it would mean the UK would have to allow the free-movement of people, contribute to the EU budget and, although it wouldn’t fall directly under the ruling of the European Court of Justice (ECJ), it will still fall within its oversight. That would go against the commitments made to limit immigration, escape European courts and to stop contributing sums into EU coffers.
Much of the same goes for the EFTA model, but this approach would be useless for financial services anyway because the EU’s arrangement with Switzerland – the only country with access to the single market through EFTA – doesn’t include the banking or financial services sectors.
The WTO model (or no deal) would likely require UK banks to incur the costs of setting up EU subsidiaries to retain access to the single market, where other issues such as securing talent could arise. Elke Konig, the head of the eurozone’s Single Resolution Board tasked with winding down failed banks, said in October that banks cannot look to move using ‘letterbox’ relocations and that actual operations and staff would have to move from the UK to the EU post-Brexit.
How would a no-deal Brexit impact UK banks and financial services?
The UK government has always insisted a no deal scenario has to be left on the table so it can negotiate effectively with the EU, and this has led it to publish a swathe of guidelines to help various sectors prepare for a no-deal Brexit, including financial services.
As would be expected with no deal, the UK government has stated it would have to fall back on WTO rules and would therefore be classed a ‘third nation’ (a country outside the EEA). The UK would take the same attitude to EU financial services but has said it is willing to ‘diverge from this approach’ to keep business running as smoothly as possible. However, the EU’s willingness to do this has not been as great.
The UK intends to introduce a Temporary Permissions Regime if no deal can be reached that would allow EU banks and financial firms to continue using their existing passporting rights to continue serving the UK market for up to three years after the exit, with similar access to be given to other firms like electronic money and payment institutions. As far as the UK is concerned, EU financial services will have the same operational access to the country that they enjoy now (stating measures will also be used to keep clearing houses going and protect existing insurance contracts). While no formal agreement is in place this is the UK’s attempt to use ‘equivalence rules’ to keep access to the EU without being legally bound to it. Consider equivalence to be a mutual recognition of one another’s standards. This is where the UK aims to at least meet European regulation and standards to remove any concerns about trade in the future (the EU’s negotiations with the US has been largely based on equivalence). However, these open arms have not been reciprocated by the EU.
The EU’s financial services chief Valdis Dombrovskis said in August that the UK wouldn’t be offered ‘super equivalence’ and that the UK would have to undergo the same assessments as any other country: ‘sector by sector and legislation by legislation’. While there is little argument over the UK’s ability to meet European standards the debate seems to be around the EU’s willingness to grant equivalence rights to the UK.
A survey released by Ernst & Young (EY) in June revealed more than a third of 222 large banks, insurers, asset managers and other other financial services firms based in the UK were considering or had confirmed plans to move operations and staff to the EU post-Brexit, with over 50 having already confirmed their European city of choice. If this has a severe impact on UK jobs in the sector then the effect would be more widespread because, despite London accounting for half of the UK’s industry, over two-thirds of all those employed in the sector are based outside the city.
How could Brexit impact clearing houses?
Since then, Dombrovskis has rolled out a warmer welcome by making a pledge to let EU companies continue using UK clearing houses for euro-denominated contracts after Brexit. However, this temporary measure would only kick in should a ‘no-withdrawal’ deal be reached.
London’s clearing houses, dominated by the London Stock Exchange’s (LSE’s) LCH Group, conduct the majority of Europe’s swaps business and, according to the Bank of England(BoE), £38 trillion worth of deals could be impacted by Brexit including euro-denominated interest rate contracts – 90% of which are currently traded in the EU through the UK. Other major UK clearing houses include the London Metal Exchange and ICE Clear Europe.
This area is the perfect example of how the EU understands the immediate need for the UK’s financial system after Brexit but doesn’t want to rely on it long term. The EU has already tried to poach euro-denominated derivatives and other trading from the UK, arguing as far back as 2011 that this should be conducted inside the EU. But the UK successfully defended itself against such a move in court. However, the UK will no longer be part of the treaty it used as the basis of its argument (the Treaty on Functioning of the European Union [TFEU]) after Brexit, which could reignite debate about the subject.
There are a few possibilities for clearing houses after Brexit. The first is using equivalence rules to allow UK-EU institutions to maintain close ties. The second is for the EU to supervise UK financial firms, and the third is moving clearing services out of the UK and into the EU. That last point, if not an immediate priority, will certainly play a part in the EU’s longer-term view of future relations with the UK.
In July this year, Deutsche Bank said after Brexit the most likely among the options on the table is the relocation of euro clearing to the euro area. But the German bank also highlights the most important aspect is the possible relocation of the collateral that banks have to put up in order to manage risk if the EU insists it can’t be held in the UK any longer.
How could Brexit impact capital markets?
The dominant role of the UK in the EU financial system means European capital markets will be severely weakened after Brexit but the bloc has already setup the Capital Markets Union (CMU) to help unify financial markets across remaining EU member states after the UK – and London – leaves. This is another area for the pair to butt heads as EU states prepare to harmonise their financial markets while the UK tries to break free but retain access. New reforms under the CMU have been mooted since 2015 but nothing is expected to be enacted until 2019 at the earliest.
Problem is, the EU itself has struggled to agree where its new financial centre should be after Brexit and instead member states have focused on their own countries with Ireland and the Netherlands, alongside Germany and France, also competing to win post-Brexit business from UK firms. All have had some success: at least 25 foreign banks currently based in the UK have opted to move operations to Frankfurt including Goldman Sachs, Citigroup, JPMorgan and Barclays, while Paris has attracted at least eight with another 15 opting to move to either Dublin, Amsterdam or Luxembourg. This suggests that Europe’s financial centre could quickly go from being heavily concentrated to highly fragmented. EU capital markets are already relatively small in relation to its economy once the UK’s contribution is stripped out and this type of fragmentation will not help build a hub capable of rivalling London nor harmonise the industry in Europe.
How have banks and financial services responded to Brexit so far?
The choice of European cities on offer has torn apart many banks and financial services firms that are currently operating in the single market through bases established in the UK. Royal Bank of Scotland has warned the government, still its biggest shareholder after the 2008 crash, of ‘sleepwalking’ into a no-deal Brexit and set aside £2 billion to help small businesses deal with the fallout. But it’s not just UK firms that face issues. European firms like Deutsche Bank, Societe Generale, UniCredit and BNP Paribas are also affected and concerned about how markets will operate without UK infrastructure.
Australia’s banking firms in the UK have also started to shift, with the Commonwealth Bank of Australia moving to Amsterdam, asset manager Macquarie to Dublin and Westpac reportedly eyeing Frankfurt. There is a similar lack of consensus among US firms, with Bank of America moving executives to Paris while investment bank Stifel Financial has gone one step further by buying German bank Mainfirst as part of its Brexit preparations.
Meanwhile, Handlesbanken recently became the first major European lender to secure a new UK banking licence, with others expected to follow.
Conclusion: future of UK financial services still highly uncertain post-Brexit
The perceived lack of preparation among financial services firms for a no-deal Brexit may be justified but the industry is still hoping a deal can be ironed out that removes the need for costly preparations.
The UK government is rightly leaving every option on the table: this is not just a negotiation about future trade relations but the start of a new era whereby both will look to shake one another’s financial stability for their own benefit. The UK wants to use the weight of London to its advantage in securing a wider trade deal but the EU doesn’t want the UK or its banking system to benefit from single market access any longer than necessary. Although there are many logical reasons for the EU to embrace UK financial services after Brexit, it is ultimately not in the bloc’s interest to give the industry or country a deal that incentivises leaving the union.
The balance between striking favourable trade terms and delivering the key promises made during the Brexit referendum campaign around issues like limiting immigration or escaping European courts is difficult enough, but the political divisions in the Conservative (but also the opposing Labour party) government has prompted both Standard & Poor’s and Fitch to warn of the dangers posed by disruption from Brexit and the attached possibilities of a change in party leadership or a general election. The Bank of England has also raised the pressure on the government after governor Mark Carney said earlier this month there would be ‘little’ the central bank could do to help ease a disorderly exit from the EU.
The future of financial services in both the UK and Europe remains as uncertain today as it did when the results of the referendum were announced. A lot is still left to be decided and nothing is agreed until everything is agreed. For the industry it is a case of trying to prepare for every possible scenario.