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29-07-2016 | POINT OF VIEW
Will UK-based Banks Retain Passporting Rights Post-Brexit?

This is the third ‘Point of View’ Brexit briefing from Parker Fitzgerald. Previous articles can be read here:

What would Brexit mean for the UK Banking sector? (February 2016)

Brexit: The short-term and long-term risks for UK based banks and the EU (June 2016)

Over a month on from the UK’s historic decision to leave the EU and the consequences of Brexit are still being digested in the City of London. Faced with the possibility of prolonged uncertainty in the economic and policy environment, the financial services sector faces many risks. For many firms, particularly banks, some of the biggest concerns stem from the lack of certainty over the UK’s continued access to the single market (including the single market for capital and the single digital market) and the potential loss of passporting rights. Indeed, issues around passporting and the ability to make markets, list or trade euro denominated instruments look set to dominate the industry and public policy agenda in the near future.

Under the current passporting regime, many internationally-owned financial firms have established their European headquarters in the UK as a base for offering products and services across the 28 member states of the EU. In addition, large European banks including Deutsche Bank, Commerzbank, BNP Paribas and Société Général, have established a significant presence in the City through establishing UK branches under the passporting regime. Should Brexit negotiations result in the UK leaving the single market and the loss of passporting rights, it would be necessary for firms to consider how business models and group structures would need to change. This is of pressing concern, as current EU legislation (such as CRD IV) does not contemplate a framework for third country access.

Without the current passporting regime or an equivalent arrangement, internationally-owned financial firms operating in London would potentially need an additional EU subsidiary to provide banking services into the EU. At the same time, EU domiciled firms that wish to provide services into the UK would need to establish a UK subsidiary for commercial banking. Some EU banks already operate under business models that do not depend on passporting, for example Santander UK is a subsidiary of the Madrid based bank and fully regulated by the PRA, but most do commercial banking and even trading with full passporting into Europe.

Furthermore, these new entities would have to structure their UK commercial banking and trading in compliance with ring fencing rules set out in the Vickers report for the Independent Banking Commission whose recommendations are now being implemented. The non-ringed fenced bank may well generate a low ROE and further have to comply with group internal TLAC rules. The net effect would be that the subsidiary would have both capital and liquidity trapped in the UK with some potentially strenuous rules on repatriation of dividends and capital. In this scenario, banks would have multiple regulators and would have to have an operating Board for entities either side of the ring fence as well as an overall Group services company for IT, HR, Legal, and Treasury management. The lack of mobility of capital and liquidity alone has significant cost implications not only through the level of capital and liquidity but the marginal costs of trapping this capital and collateral with potentially significant consequences for the profitability and business models of banks.

Whilst neither the exact consequences nor the scale of the impact is fully known, it is likely to result in significant additional costs for banks operating between the UK and the EU. Banks could face substantial cost increases associated with additional capital and liquidity requirements. Such an increase in the cost of doing business in London combined with loss of access to the euro capital market would have a notable impact on London as a financial centre. Some banks are likely to scale back their activities in the UK and, ultimately, some might leave the UK altogether. Employment and economic growth over the short and medium term will be put at risk.

With this in mind, it is more than likely that UK Government negotiations will focus on exploring other ways to preserve access to the single market for UK-based financial institutions without creating additional costs and regulatory burdens associated with subsidiarisation. In this respect, it is important to consider how the UK financial regulatory and supervisory regime currently operates;

As the leading global financial centre, the UK has some of the toughest regulatory and supervisory standards in the world. On this basis, maintaining access to the single market on a principle of ‘equivalency’ of standards is significant. Indeed, the UK regulatory regime has often been accused by its banks of ‘super equivalency’ (ie going above and beyond international agreed standards and gold-plating rules) and the UK has been the driving force behind many elements of European regulations whilst a significant proportion of EU financial services law has been modelled on the UK’s regulatory system. It is unlikely that the UK could substantially deviate from the initiatives that are already finalised or underway. Last week, the new FCA Chief Executive, Andrew Bailey, made clear that he expects “no great bonfire of regulation” post-Brexit.

This principle of equivalence is already well established to the City of London’s benefit. At a prudential level, the PRA already has rules and criteria for supervising international banks operating in the UK, through assessing equivalent financial regulatory standards of the institution’s home regulator. Banks from countries that have regulatory standards which are deemed equivalent (for example, US banks) can operate branches in the UK without any regulation by the PRA. Of course, regardless of branch or sub, all banks operating in the UK are regulated in part by the FCA where they serve UK customers or trade in UK markets. Post Brexit, the Bank of England and PRA would be able to apply the equivalence principle to EU based institutions assuming close cooperation with the European Central Bank (ECB). The relationship between the central banks will therefore be pivotal.

At a broader regulatory and conduct level, the implementation of MiFID II should provide new rules allowing non-EU countries, including the UK, to access the single market if their regulatory set-up is deemed to be of an equivalent standard. Arguably, the main obstacle would be in determining the cross border resolution regime. The Bank of England must be certain that if it allowed Euro institutions to operate without bolstering capital and liquidity that in the event of any failure of these institutors significant bail in (contingent capital at Group level) and TLAC capital layers existed. This, however, should be something that can easily be worked out between the Bank of England and the European Central Bank. Further there is an issue of the Vickers structural reform program that could potentially be bypassed as the entity in question would remain a Euro institution operating in the UK but regulated by the ECB.

In theory, therefore, the regulatory obstacles preventing Single Market access for UK-based financial institutions (and vice versa) can be overcome. That is to say the technical apparatus of equivalence and cross border resolution regimes already exist. In practice, however, the likelihood of a satisfactory outcome will depend on a number of political factors, including the actions of the key political figures throughout the negotiation process and how the competing priorities of the EU institutions and member state governments are managed. In this respect, there are many risks and many unknowns.

    • Clarity of UK Government Policy: Currently there is a lack of clarity on the policy direction of the UK Government. The UK Government’s position to Brexit negotiations is only just beginning to take shape. Perhaps predictably given the domestic politics within the Conservative party, there have been a number of conflicting statements from Ministers with regards to the UK’s future position and relationship with the single market. Two weeks ago, the new Chancellor, Philip Hammond, made a pledge at a BBA event “to ensure access to the single market for our financial services industry” claiming he understands the importance of passporting. These encouraging words, however, have not been strongly echoed by the ‘Three Brexiteers’ Boris Johnson, David Davis and Liam Fox, who now have leading Government roles in driving Brexit negotiations. The recent statements of David Davis as Secretary of State for Exiting the European Union, in particular, have given cause for concern – as he seems focused on cutting regulations and controlling borders rather than expressing support for UK financial services through the maintenance of a robust, EU equivalent regulatory regime. How these priorities are managed will depend on the position and focus of the Prime Minister.

 

    • Clarity of Policy by the EU Leaders: We have yet to see a consensus view among EU institutions and key member states about how they should negotiate with the UK and on whether it should be allowed to maintain single market access. To an extent there is some hostility towards the UK – there is an impatience for the UK to trigger Article 50. There could be overt attempts to weaken the City of London and encourage UK banks and financial companies to relocate inside the Eurozone. Equally there are signs of pragmatism beginning to drive the agenda. France has already softened its tone and last weekend we saw reports that the major EU states are considering providing a special status to the UK enabling the UK to exercise a seven-year migration brake (an offer, incidentally, that is actually more than Cameron originally asked for pre-referendum). Why the change of heart? Domestic political and economic concerns are no doubt focusing minds. Many EU member states share the same concerns about migration and control of national borders, which arguably delivered the Brexit vote. These concerns will have only been heightened by recent incidents in Nice, Germany and Turkey. There is an emerging need to calm tensions. Germany, France, Holland and the Czech Republic all face national elections in 2017 with worries around the rise of populist parties. This raises the spectre of other referenda across the EU, a possibility that is likely to be reinforced in 2017 and beyond should the UK be granted a ‘special status’ deal. There is much for Mrs May and her counterparts across the EU to balance off.

 

    • USA Policy and NATO: A third factor in play is the influence of the USA. President Obama’s ‘back of the queue’ comment in respect of a trade negotiation with the UK seemed designed to support David Cameron’s ‘remain’ campaign. The US has now adopted a different tone particularly in light of fast changing geo-political issues. The US is extremely concerned about the counter revolution in Turkey and sees an urgent need for a strong NATO with the UK and the EU aligned – a fragmented EU would potentially weaken NATO. Concerns about the strength of NATO would be substantially further complicated by the election of the Republican nominee, Donald Trump, whose own policies would effectively distance the US from NATO. Regardless, an integrated EU with the UK involved is the safest and most desirable option for the USA. The recent visit of Secretary of State, John Kerry, was no doubt to pressure the EU to negotiate flexible terms for the UK.

 

  • Financial Instability: A further factor in determining the future relationship between the UK and the EU is the wider concerns of recession triggered by Brexit. The impact is already being felt – the sentiment index is down by 20%, Sterling has hardly recovered and the FTSE 250, as measured in real terms, is much lower than pre-Brexit. Fears around financial stability and the prospect of a global recession will focus minds on both sides of the negotiating table as a protracted and bitter dispute will not help financial markets and the wider economy. With such high stakes, key concessions offered by the EU as well as the Pro-Brexit UK politicians, should in theory be welcomed.

What is clear is that for all banks with UK operations, these factors place significant levels of uncertainty on their business models. While the technical and regulatory obstacles surrounding single market access are relatively straightforward, the political factors are both volatile and complex. Indeed, global and national politics is now more important than ever in determining a desirable outcome. It will therefore be important for UK-based banks to understand the political agenda, its likely consequences and how they can push their own agenda with key decision makers.

The final outcome of the negotiations will be a key determinant of a banks’ strategic decisions over issues such as operating locations, legal entity structures, issuance of contingent (bail-in) capital and it’s long-term customer strategy. Any subsidiarisation in the UK would have to take full account of trapped capital and liquidity and profitability from both ring fenced and the non-ring fenced bank under Vickers.

Ultimately, banks will be driven by cost considerations as they already have anaemic profitability. However, while it remains possible that there could be a mass exodus from London, coupled with significant changes to the UK’s financial services sector, it’s more likely that politicians and regulators will succeed in reaching a good deal; at a time of evolving geo-political risks, it is in their interests to maintain calm and continuity.

Nevertheless, it is prudent for banks to prepare for all possible scenarios and consider the solutions for each. Significantly banks must consider the potential impact of subsidiarisation and how it will result in higher capital requirements and TLAC capital layers. The potential cost of this to the sector runs into billions and could be crippling if banks are not prepared.

 

[1] Supervisory Statement | SS10/14 Supervising international banks: The Prudential Regulation Authority’s approach to branch supervision (2014)




For more information contact:

COLIN LAWRENCE
Dr. Colin Lawrence
Head of Strategy & Research
Email: clawrence@pfg.uk.com
Phone: +44 (0)207 100 7575

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