So, what do we know? Britain has voted for Brexit. The Prime Minister has announced his intention to resign. Markets are now experiencing extremely high levels of volatility, with sharp falls in Sterling (the lowest level in 30 years), banking stocks and now a downgrade in the UK’s credit rating. The ripple effect on the world and especially Europe is significant; European stock markets and major bank stocks fell with good reason over the past few days. The major casualties being Italian and French bank stocks, whilst the Dax and German Bank stocks also fell sharply.
The assurances given by Chancellor George Osborne and Bank of England Governor Mark Carney have a bitter twist of dramatic irony since it was they who warned us of the perils of Brexit back in May. We know as a fact that Central Banks are slowly running out of monetary options (following eight years of bail out, and unprecedented quantitative easing) in a time of a gigantic liquidity trap. There are genuine fears that a prolonged period of economic and political instability will cause a deep UK and global recession – as the systemic impact of the turmoil threatens the entire interdependent world. Indeed, many of these impacts were anticipated by Parker Fitzgerald back in February here.
The short-term transitional risks
The transitional risks, involving a deteriorating economy and a higher risk premia associated with an uncertain political and economic landscape are significant. Of course banks’ core tier 1 capital positions are roughly 10 times higher than at the time of the 2008 global financial crisis, but while banks can certainly absorb shocks, their business models might not be sustainable – with interest rates already close to zero, net interest income anaemic and trading income negligible. In addition to the potential relocation and regulatory change ahead (see below), banks face a vulnerable macro environment, where it is not clear how they will transition to a new steady state which exhibits sustainable profitability. This is true for banks both in the UK and for Europe.
The reaction of the past few days demonstrates that financial markets loathe uncertainty and markets are currently presented with two uncertainties – the future ‘steady state’ of the UK outside the EU and the processes by which it would get there. The length and nature of this uncertainty is dependent on political events:
The new UK Prime Minister and Government: David Cameron said that a new Prime Minister would be required to carry out negotiations with the EU. The Conservative 1922 Committee has stated that a new leader will be in place by 2 September. This leadership election has two stages, in which MPs first narrow the field down to two candidates and then Party members decide between them. Likely candidates include Theresa May, Michael Gove and Andrea Leadsom. The leadership contest itself is likely to set the tone for the withdrawal negotiations and the priorities for a post-Brexit partnership with the EU. Meanwhile, the leader of the Opposition, Jeremy Corbyn, faces a leadership crisis after the poor outcome for Labour in the referendum. At this point in time the vote for Brexit has literally eviscerated the leadership of the country in government and opposition.
The timing of invoking Article 50 by the UK Government: The formal mechanism of leaving the EU is set out in Article 50 of the EU’s Lisbon Treaty. This Article, triggered by the new Prime Minister, provides for a two-year period for the UK to conclude its withdrawal and negotiate a framework for its future relationship with the Union. This new arrangement must be agreed by the European Council through a ‘qualified majority’ (the UK and 20 of the 27 others), and approved by the European Parliament. The leaders of the Leave Campaign (Boris Johnson and Michael Gove) have indicated that there would be no rush for the UK Government to trigger Article 50 and it could set its own pace. Although this is contested by Brussels (who are demanding that the UK trigger Article 50 immediately) it is indeed the member state which invokes Article 50. In any event given the dismantling of the current government and opposition, this will further postpone any triggering of Article 50.
Nature of negotiations: An atmosphere of volatility and fear is likely to influence proceedings. From an EU perspective, there would be fears of ‘contagion’ (i.e. that other member states would also want to leave the EU if the UK receives too good a deal) and therefore an incentive to ‘punish’ the UK for leaving. This is mitigated by a softer touch from Mrs Merkel, sensitive to Germany’s huge trade surplus with the UK. There will be further political recriminations from a UK perspective too, with the Scottish National Party already threatening a second independence referendum, as well as concerns about the future of Northern Ireland.
Key considerations for financial services
Brexit, in whatever form, will fundamentally reshape the UK financial services industry. The City of London is the largest financial centre in the European Union (EU), attracting a wide range of global banks and other financial services providers. Whilst many foreign institutions have UK presences to participate in the UK financial market, a large number of non-EU financial institutions also use the UK as a hub to access clients and markets across the EU. Many EU firms also maintain branch presences in London. However, the extent of the impacts will depend on the arrangements put in place during the transitional period after triggering Article 50 while negotiations take place between the UK and the remainder of the EU, and how far those negotiations preserve access for UK firms to EU clients.
Since 1999, the EU has successively launched a number of regulatory initiatives aimed at ensuring an integration of EU financial markets and the removal of legal barriers which hindered the provision of cross-border financial services activity across Europe. These initiatives set out to create a harmonised framework of regulation and technical standards for firms within the EU and include Directives such as the Capital Requirements Directive (2009/138/EC), Markets in Financial Instruments Directive (2004/39/EC), Payment Services Directive (2007/64/EC) and Undertaking Collective Investment Scheme Directive (85/611/EEC).
Additionally, the directives that have been put in place since 1999 create a single market by enabling financial services firms authorised in one Member State (their home state) to carry on business in any other Member State (a host state) without the need for a separate host state authorisation either by establishing a local branch or on a cross-border basis – this is referred to as the ‘passport’. In some areas, EU legislation also provides a framework within which non-EU firms may access the EU single market. This is generally restricted to wholesale business and depends on the non-EU regulatory regime being assessed as equivalent to the EU regime. In addition, there usually has to be some form of co-operation agreement in place between the relevant authorities in the non-EU country and the EU.
Since the financial crisis, there has been a marked increase in the desire to coordinate financial services regulation at a global level which has been driven, in part, by the G20 nations. As a result, in addition to developing the passport system, recent EU initiatives have focused on implementing the work of organisations such as the Financial Stability Board (FSB) or the Basel Committee on Banking Supervision (BCBS) in key areas such as resolution, prudential requirements and centralised clearing in the derivatives world. Any analysis of the impact of Brexit in the area of financial services has to consider the ramifications for global initiatives as well as the future interactions and arrangements between the UK and the EU.
The Post-Brexit trading and regulatory framework: Formulating Scenarios
So what will the longer term steady state look like? Here are options available for the new status of the UK under Brexit:
1. ‘No change’: There is still a possibility that the referendum is challenged by Parliament or by a future government following a snap general election (much less likely given the Fixed Term Parliaments Act 2011, but not impossible), meaning that Brexit does not happen (although this does appear unlikely) through triggering Article 50.
2. The UK to become member of the EEA (with EFTA membership) : This is the so-called ‘Norwegian Model’. In this case the UK will have access to the single market but not be part of any decision making. The issue here is that the UK would be dictated to on all policy issues thus essentially relinquishing its democratic rights to formulate its own regulatory policies. It is an all or nothing policy fit for countries like Norway, although it appears to contradict the sentiment of ‘taking back control’ that was a key referendum pledge of the Leave campaign. Still from a business model perspective, banks would have the ability to passport.
3. Become part of the European Free Trade Association (EFTA) without the EEA: This model would definitely be a credible alternative. Following Switzerland, the UK can negotiate bilateral agreements and ‘cherry pick’ which areas of the single market it would opt in and which it would opt out. In areas where it has not negotiated bilateral agreements, it must demonstrate ‘equivalency’; the UK regulatory system, unlike emerging market regulators, is highly sophisticated and has often been accused by its banks of super equivalency. It furthermore operates under global standards thus this would not be a barrier, but it will lack any explicit decision making on EU policy. This model may also raise questions over the UK’s ability to negotiate passporting rights with the EU, which may result in some banks leaving the UK.
4. A third party or WTO model: This will make the UK fully democratic in all areas of regulation, tariffs and taxation as well as full control of its borders (addressing political issues over freedom of movement and immigration). However, this model would not provide bilateral agreements with the EU, the regulatory regime would have to demonstrate equivalency again. Again, this raises serious questions over the UK’s ability to negotiate passporting rights.
5. The ‘Soft Landing’ of Associate Membership: (A hybrid Model for the entire EU) There is a chance Article 50 might never be triggered, it is rumoured that Germany would offer (and have to influence the other 26 countries) the UK the status of ‘Associate Membership’. It is not clear exactly what the full details of this structure would look like, but it may get closer to what David Cameron actually attempted to negotiate for in the first place. This is based on a strategic analysis by the German Finance Ministry, which seeks to realize two goals; the first being that Germany wants to ensure that it continues to trade with the UK (where it exports over €130 billion) but also it wants to ward off the essential collapse of the EU. To do this, the EU could implement a structure of two types of entities in the single market.
The first is full membership which moves much closer to fiscal integration thus avoiding a Greek-style tragedy, where only a few countries would be eligible. A second tier of “associate members” would also be formed, which would participate in the “common market” and realise all the benefits of economies of scale and customs union but stop short of being part of the Eurozone and fiscal integration or further political union. Such a model could be negotiated in two phases – firstly enabling the UK access to the single market in the first phase to occur way before Article 50 is triggered, thus the UK would still be treated as an EU member with some special status.
A second phase would be the same deal for all other member states; they could elect to be a full member or an associate member. Essentially this solution would kill two birds with one stone and could get the backing of all major institutions, including the BIS, the FSB, the IMF and the world bank.
We think this is the best solution for both the EU and UK enabling full political integration for Members (probably Northern Europe) and Associate Membership for Southern European countries and of course the UK.
Even if this is not on the table in Merkel’s definition of “Associate Membership” international institutions plus new UK leadership should attempt to influence Brussels to move in this stable direction. It would provide greater stability of the Euro, it would facilitate the ambitions of most European countries and avoid a Greek crisis.
Influencing the future direction of regulatory policy making
A significant proportion of EU financial services law has been modelled on the UK, such as large parts of the EU market abuse regime and the framework arising from MiFID. As part of the EU, the UK has been able to use its expertise to influence the development of the EU financial services framework. To the extent the post-Brexit model that is adopted prevents the UK from being able to continue to exercise this influence on applicable new EU measures and initiatives to which its firms are subject when conducting business across the EU, this may have a detrimental impact on the UK’s financial services industry to the extent UK firms were subject to those rules. This would be similar to the position that Norway, for example, currently faces.
Furthermore, the work of the BCBS and FSB has shaped the direction of global thinking on prudential requirements and resolution regimes and such thinking has been encapsulated within EU directives and regulations. Given the UK’s commitment to global reform in the financial services industry, it is difficult to see how the UK could substantially deviate from the initiatives that are already finalised or underway. Even if this is the case though, divergences in drafting, interpretation and application are likely to develop over time where the UK is required to adopt national laws in order to meet international commitments rather than continuing to conform with the EU requirements. Such divergences would exacerbate the regulatory compliance burden facing financial services institutions and would likely be a key consideration for firms when deciding whether to conduct business here.
What could this mean for your organisation?
For purely UK-focused firms – both UK entities and UK branches of foreign entities, we do not anticipate material impacts. For firms which use the passport, the key issue will be whether that system continues. If the passport lapses, it would be necessary to consider how business model and group structures would need to change. This is of particular concern in the context of banking activities because CRDIV does not contemplate a framework for third country access. The need for an EU subsidiary that could provide banking services into the remainder of Europe under the passport system would become fundamentally important in this scenario. For EU firms that wish to provide banking services into the UK, it would be necessary to consider establishing a UK subsidiary.
With respect to the derivative market, given its size and importance to the capital markets sector, the idea that the authorities would seek to deregulate that market is untenable. The global reforms that have taken place or are in the process of being finalised within key jurisdictions mean that the UK would continue to apply mandatory clearing, minimum margin requirements and reporting to a centralised trade repository whether it was in the EU or not. The primary open question is how the UK might seek to do that.
In terms of Market Infrastructure, given how fundamentally important the financial market infrastructure is to the operation of the UK capital markets, it is assumed that the UK Government would focus efforts on ensuring that EU firms continue to be given access possibly through the adoption of other measure e.g. grandfathering. If Brexit means that the benefits of MiFID and EMIR described above are no longer available, firms operating UK based trading venues or clearing or settlement systems would need to consider how they can continue to service EU-based firms or link up with EU-based market infrastructure.
What to do now
Of course, none of these outcomes and suggested impacts are guaranteed; the transition and timeline could be uncertain and the final steady state may involve a combination of the above models.
Understanding the strategic and operational impacts of each scenario will be key to determining the on-going viability of operating models and will also be a key input into strategic decision over issues such as operating locations, legal entity structures and long-term customer strategy.
To facilitate this, firms should mobilise an EU disengagement programme under stewardship of either the Chief Executive or Chief Operating Officer. The programme should be positioned as the key authority on all related Brexit issues, managing recommendations to both the board and planned interactions with key industry and political lobbying groups (e.g. BBA, TheCityUK).
Naturally, understanding the potential economic impacts will need to take priority and we anticipate the Bank of England (BoE) and the European Central Bank (ECB) will conduct a series of ad-hoc quantitative impact assessments and stress tests to determine how ongoing volatility in financial markets and macroeconomic fallout will impact balance sheets and create potential vulnerabilities in operating models.
Another key focus of the programme should be to formulate a comprehensive communications plan and communication filter for customers, employees and external stakeholders e.g. investors, to keep them informed of major impacts, as they are identified as well as any potential planned changes in operating strategy.
We would also recommend the establishment of a design authority to quickly assess any proposed changes in the operating model on key systems and processes, in addition to, how Brexit may impact major in-flight programmes and their objectives. In doing so it is crucial that the Design Authority is empowered to initiate strategic projects to ensure all necessary change is delivered within the 2-year transition window.
Finally, in the transition to a post-Brexit trading and operating environment, Banks will need to determine how their enterprise risk management frameworks will need to be adapted to support new business models and an emerging new regulatory architecture. The core fundamentals of many regulatory projects may need to be revisited (particularly those relating to structural reform, ring-fencing and resolutions and recovery programmes) which is likely to add additional levels of re-work and complexity to an already complicated landscape.
How Parker Fitzgerald can help
In direct response to the decision for the UK to leave the EU, Parker Fitzgerald has launched a new practice comprising of over 100 technical experts, economists, former regulators and industry specialists who can provide clients with thorough analysis, strategic advice and execution support as developments unfold over the coming weeks and months. Additionally, we have designed a bespoke assessment framework and programme template for UK and international banks to help guide implementation effort at each stage of the EU disengagement process.
For a confidential discussion on how we can help you understand the impacts of Brexit and plan for EU disengagement please contact: