With so many unknowns, it is somewhat difficult to make an informed assessment as to what Brexit would mean for the UK economy and its financial services industry. One of the key challenges is that few people can agree what it would look like. Even among advocates of the UK leaving the EU, there is a lack of agreement as to what it would mean in terms of future trading relationships and the UK’s openness to the world.
Some campaigners for Brexit argue that the UK could negotiate a generous exit from the EU, which would lower the regulatory burden without diminishing trade access for UK businesses and the financial services sector. This, of course, would be an attractive scenario, yet its likelihood is questionable.
The nature and tone of the post-referendum negotiations with the EU will be crucial and will most likely be conducted under an atmosphere of volatility, fear and mistrust. From an EU perspective, there would be fears of ‘contagion’ (ie 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. Yet there will also be other market and political fears that may focus minds into providing the UK with an acceptable deal.
Despite these uncertainties, we can consider the likely areas of impact of Brexit on UK financial services, which include (1) the short term transitional risks and likely market volatility, (2) questions over the UK’s continued access to the single market, (3) issues over the application or reversal of EU regulations and (4) long term consequences in the context of the continued globalisation and digitalisation of the financial services industry.
1. Transitional risks and market volatility: Brexit presents two uncertainties – the future ‘steady state’ of the UK outside the EU and the processes by which it would get there. The UK has two years of EU membership after the referendum and during this time the UK government will be focused on agreeing new trading relationships (this could, for example, involve joining the European Economic Area or forming a series of bilateral deals).
Regardless of what the new Brexit ‘steady state’ would look like, there will be a period of heightened market uncertainty during these transition arrangements. This uncertainty will impact on the UK financial sector and is likely to result in price volatility in the markets. Foreign exchange markets would be particularly volatile, with some analysts predicting sharp falls in Sterling.
2. Continued access to the single market: This is likely to be one of the biggest concerns for financial services and particularly for the banking sector. The UK financial sector has become heavily interconnected with the rest of the EU, particularly since the 1990s. If Brexit leads to a loss of access to the single market, or its fragmentation, then it could result in a lack of liquidity or increased costs. If the UK does not get access to the single market on terms which it desires, then the UK could lose its ‘prowess’ in, for example, trading in euro denominated instruments. Many internationally-owned financial firms have chosen to establish their European headquarters in UK, as an EU member state, as a base for offering services more broadly in Europe, under a regime known as ‘passporting’.
One of the major fears from Brexit is that Britain would be unable to negotiate the same passporting rights after exiting the EU, which may result in some banks leaving the UK. Brexit may also affect current UK-EU processes to achieve further market integration in financial services. Lord Hill, Financial Services Commissioner, is leading efforts for the proposed EU Capital Markets Union, which is intended to lead to greater diversification of borrowing and saving opportunities across member states. These benefits may not be realised in the event of Brexit.
3. Application of EU regulations: A significant amount of legislation and regulation impacting on UK financial services derives from Brussels. The design and application of EU regulations is often seen as burdensome for many in the City, who would prefer a lighter regulatory regime. There have been many complaints within the industry, for example, about aspects of recent EU legislation, including the latest Capital Requirements Directive (CRD IV) and the delayed MiFID II.
Those favouring Brexit would argue that UK authorities could remove undesirable parts of these regulations as well as ensure that future EU regulations need not apply to UK. Unpicking existing regulations could potentially be costly and it is questionable as to whether having two different regulatory regimes across the UK and EU is desirable. In many cases, it is better to have ‘second best’ rules which apply across the market than it is to have ‘first choice’ regulations that only apply to the UK. A significant divergence in regulatory regimes between the UK and EU would increase costs for many in the industry.
4. Long term future of London as a global financial centre: A final question concerns whether Brexit would harm London’s role as a global financial centre in the long term, particularly within the context of the continued globalisation and digitalisation of the financial services industry. Financial regulations are increasingly global in nature, with issues such as capital requirements and the recovery and resolution plans (RRPs) requiring globally applied standards. In addition, the digitalisation of banking and trading will ensure that cross-border transactions are easier to conduct than ever.
As the major global financial centre, London stands to be a beneficiary of these processes, it retains all the key fundamentals it has to be attractive destination for global finance (firms will still favour English speaking population, English-style legal system and the first-class regulatory, accounting and legal infrastructure that the City undoubtedly has). It is questionable however, whether Brexit – and any resulting impact in terms of fragmentation in the market or regulatory regimes – would be beneficial. Globalisation of the industry will require less local fragmentation. It will be important, therefore, that the UK does not diverge significantly from EU standards and remains open and consistent with international markets and regulatory standards.