by Dhruv Patel OBE
Our deeply interconnected global financial system has many benefits. It keeps transaction costs low, profiting consumers, and it supports efficient allocation of capital, contributing to economic growth. A legitimate aim of Governments can therefore be to remove blockages from the plumbing of this interconnectedness, by allowing financial services companies to operate across borders as easily as possible.
In the UK’s current position, as a member of the EU, its financial services industry benefits from the passporting regime. This allows financial services companies to operate freely across national borders within the EEA without any additional regulatory barriers.
EU Directives set the regulatory requirements and standards, and all countries within the EEA are required to implement them. The system flows with complete freedom.
Outside of a single regulatory framework with a common rulebook such as the EEA, countries often rely on the free trade agreement concept of mutual recognition. This is where two independent jurisdictions agree to accept each other’s rules as achieving the same outcomes, even if the specific provisions and implementation in each location differs. However, a comprehensive deal on mutual recognition covering financial services has never been reached in any free trade agreement.
As Sam Lowe of the Centre for European Reform has recently pointed out in his June bulletin on Brexit, TTIP and the City of London, even the informal proposals from the EU during the fifth round of the (now dead) TTIP negotiations with the US, which both British Chancellor Philip Hammond and Prime Minister Theresa May have cited as the closest the EU has got to doing a serious trade deal on financial services with a third country, offered only a muddied and undefined mutual “reliance” proposal with delayed implementation, not the clear, comprehensive and immediate agreement that Britain would need.
More vitally, the UK Government has given up on any hope of achieving a mutual recognition deal with the EU after Brexit and the transition period. The EU has always said that its four fundamental freedoms (free movement of goods, services, people and capital) are inseparable. And with the UK unable to accept free movement of people it is inconceivable that the EU would allow Britain to cherry pick free movement of financial services. This takes both passporting and mutual recognition off the table. The UK Government’s July Brexit white paper accepts this and instead proposes an enhanced (or expanded) version of equivalence.
Equivalence allows for financial services providers from outside the EU to sell into the EU if where it is agreed that their home regulators will enforce the equivalent standards required of EU providers. Unlike two-way mutual recognition, in this situation the EU sets the rules and the outside country takes them.
However, Catherine McGuiness, the City of London Corporation’s Policy Chairman, commented following publication of the white paper that “equivalence in its current form is not fit for purpose… [it] would put up unnecessary trade barriers and runs the risk of fragmentation of financial markets, increasing costs and reducing choice for consumers.”
The first serious exploration of the equivalence option for UK-EU financial services post Brexit was published by thinktank Politeia in July 2017. In it, report author Barnabas Reynolds, Shearman and Sterling’s Head of Financial Regulations, acknowledges that it will require enhancements to form an effective basis for relations post Brexit. Notably, equivalence does not cover all the areas of financial services which are currently covered by the passporting regime. And also, the current EU powers that allow equivalence determinations to be revoked with only 30-days notice – not enough time for businesses to have the certainty required to offer services based on them – need to be curtailed.
UK trade negotiators do have some leverage in negotiating enhancements to equivalence. In July, they told their counterparts in Brussels, that about 7,000 European-based investment funds which rely on British clients for their cash and profits, would not be allowed to continue offering their services to those clients after Brexit, if no deal on financial services was reached. The likely ultimate outcome,if a deal is reached, now being agreement from the EU for an extension of the current 30-day notice period,as part of an enhanced equivalence arrangement.
An equivalence based deal would also allow the UK the opportunity to maintain two side-by-side regulatory regimes in some areas of financial services. An EU equivalent one to be used by firms wishing to operate in EEA markets, and a more lightly regulated regime for domestic financial services providers operating in the UK only. This light touch domestic only regime could encourage innovation and new start-ups, particularly in the fintech space, where Britain are now the world leaders according to KPMG’s latest pulse of fintech report. These start-ups need not be burdened with the costs of complying with EU red tape and regulations if and while they chose not to sell their products into the EU.
But there are other possibilities.
In September 2016, Morgan Stanley’s Vice Chairman for Sovereigns and Official institutions and former Director of the European Department at the IMF, Reza Moghadam, proposed in an opinion piece for the FT that “the UK should consider joining the EU’s banking union (membership of which is open to countries that are not part of the eurozone), even as it withdraws from the bloc”. So far, no non-eurozone country has entered into the“close co-operation agreement” that banking union requires, but it is being actively pursued by Bulgaria, and under consideration by Denmark and Sweden. It would provide a single prudential regime and surely lead to mutual rights of establishment for banks. It has so far been dismissed by policy makers because it would mean more rule taking – inconsistent with taking back control– but, in reality, it goes no further than proposals in other areas such as Chemicals, Medicines, Space and Aviation Safety where UK Government has suggested Britain would join the relevant EU agencies.
Another idea, if Britain is to fulfil the free trading, Singapore type, vision proposed by arch Tory Brexiteers, might be unilateral recognition. Here the UK could regard other countries’ regulatory regimes to be significantly secure and reliable so as to allow their firms to offer services in the UK. UK regulators could allow EU regulated and domiciled banks to establish branches (rather than subsidiaries) in the UK with minimal red tape, and without requiring the same in return. Or UK regulators could recognise European investment funds as being well regulated enough not to pose any risk to UK consumers (disregarding the threats that politicians have already made). As there are now very few deposit taking institutions domiciled in the UK and operating in Europe using the passporting regime who have not already established a subsidiary in the remaining 27, and as the vast majority of new UCITS funds are established in Luxemburg or Ireland (even if the fund managers are based in the UK), the impact on British firms would be minimal.Indeed, such unilateral action proposals have been included, on a time limited basis, in the UK Government’s approach on financial services if there’s no Brexit deal.
Ideas such as these, which will help prevent clogging of the global financial system, need to be actively considered by policy makers now, in order to secure Britain’s position at its centre post Brexit. According to PwC’s most recent Total tax contribution of UK financial services report, the financial services sector contributes an outsized 11% of UK tax receipts, and so a strong City of London will result in a strong Britain. That’s something all Brits want whichever way they voted.
Dhruv Patel OBE
Politician (Elected Member of the City of London Corporation), ‘Name’ at Lloyd’s of London insurance market, Businessman and Investor. You can follow him on Twitter: @dhrvptl.