Kim Kaivanto, Department of Economics, Lancaster University

The Brexit penny dropped like a manhole cover. Likely collateral damage includes London-based Euro-clearing operations and financial services reliant upon EU passporting rules. Given the importance of the EU as a market for the City’s financial services, how is it that so many people dropped the ball so comprehensively?

Source: Wright “The Potential Impact of Brexit on European Capital Markets”. New Financial, April 2016.

But rather than casting the City as a victim of Brexit, a second narrative – quite different from the din of emotive chords played during the campaign – is quietly emerging: Brexit as the pivot to prise UK-based financial services away from encroaching EU regulation.

This is not to suggest conspiracy, but that Brexit may also serve as an effective response to recent developments on the international stage.

To the west, the US is bringing online a new bank-safety regime which compels all overseas lenders with at least USD50bn in US assets to create US-based Intermediate Holding Companies that are subject to US banking supervision including liquidity rules, capital rules, and annual stress tests.

The era of the globally integrated mega lender is definitively over.

From the east, the EU has been waging a determined campaign to bring all aspects of London-based Anglo-Saxon finance under more direct regulatory supervision and control, and to wrest as much as possible of the London-based business to capitals within the Euro zone. The range of targets is familiar, ranging from hedge funds and alternative investment management, bankers’ bonus caps and clawbacks, attempts to compel Euro-settlement operations to be geographically located within the Euro Zone, regulations constraining insurance companies’ decision making pertaining to solvency, through to measures designed to bring an end to large-scale corporate tax optimisation (i.e. the Common Consolidated Corporate Tax Base (CCCTB) initiative). So it is not only banking operations that are being targeted by EU regulation, but the full range of financial services for which London is the largest provider this side of the Atlantic, if not globally.

The UK, through the work of its representatives in the European Commission – most recently, in the person of Jonathan Hill, Commissioner for Financial Stability, Financial Services and Capital Markets Union – and through its active engagement in the work of the Economic and Financial Affairs Council (EcoFin), has successfully fought a rearguard action against the encroaching EU regulations.

However, if at some point the insiders to this process realised that in effect ‘the writing is on the wall’, and that it is only a matter of time before the juggernaut of EU regulation succeeds in hobbling the UK financial-services industry, would the UK’s best response be to remain engaged with the rearguard action for as long as possible? Or would the UK’s best response be to seek a reconfiguration of the formal relationship with the EU, if an opportunity to do so arose, as long as the costs of doing so were of a transitional, adjustment-cost variety, rather than of broad-spectrum, irreversible annihilation within the sector?

On the face of it, the latter appears most prudent, even from the standpoint of Henry Kissinger’s adage, ‘Whatever must happen ultimately should happen immediately.’ Furthermore, there are indications that the costs involved may indeed be of the transitional, adjustment-cost variety.

The notion of a globally integrated lending balance sheet has already been precluded. Segmentation of lending operations by regulatory region is in fact happening regardless. In terms of liquidity, capital, and stress-test resilience, all banks operating within the US, both domestic and foreign, will have to do so on the basis of the domestic US balance sheet, rather than gaining strategic advantage on the ground from drawing on a global balance sheet. The same logic applies to banking operations in Europe, regardless of whether the parent company is US-based, UK-based, or EU27-based.

Post-Brexit, the question is to what extent will UK-based banks be able to make use of MiFID II ‘equivalence’ provisions to offer banking services within the EU in lieu of the current passporting arrangements. In seeking to secure the best possible access to EU markets, the British Bankers’ Association (BBA) has adopted a soft, non-confrontational stance, so as to maximise the probability of holding on to as much access to EU markets in Brexit negotiations as possible. Of course, the principal determinants of this outcome are the respective positions adopted by the EU and the leadership of the new Conservative UK government. Given the Conservative Party’s new leadership, prospects for a soft exit have become vanishingly remote, as have the chances for e.g. EEA-based passporting. Post-Brexit, UK financial services firms will in all likelihood have to rely on MiFID II equivalence-based access to EU27 markets, or on sprouting locally compliant EU27-based business units.

With all avenues of retreat blocked, the UK is now precommitted to forging an independent existence distinct from the recent past. In order to make the most of newly acquired freedom, only one narrative lends itself to an optimistic, positive portrayal of current prospects: to make the UK ‘the most open and dynamic economy in the world.’ Whatever post-Brexit notions Leave voters may have had, likely outcomes on specific questions may be usefully divined by testing them for consistency with the objective of enhancing an open and dynamic economy. Free trade across the board, possibly sharing features with already-agreed TTIP terms, seems a likely starting point for negotiators. Will those aspiring to create the world’s most open and dynamic economy seek to continue CAP-style subsidies for domestic agricultural production, bolstered further with import tariffs, as is currently the case? Will they rebuff or embrace opportunities for introducing market forces at all levels, including privatisation? What sort of corporation taxes and personal income taxesare consistent with the objective of creating the world’s most open and dynamic economy? Is the objective of achieving the world’s most open and dynamic economy likely to be enhanced or diminished by externally imposed restrictions on the magnitude of bonuses?

Overall, the open-and-dynamic-economy test bodes well for the future of Anglo-Saxon financial services in the UK. Senior City and BBA figures, being acutely aware of this, have had no reason to weigh in heavily yet, and are quietly biding their time. EU27-dependent business – not all of which relies on passporting, or passporting alone – hangs in the balance, to a degree that only completion of the Brexit process will reveal. However, it is also true that this will be accompanied by renewed freedom to calibrate the regulatory framework in ways that are not inimical to Anglo-Saxon finance– all of which can be accomplished without sacrificing robust mitigation of systemic risk.