The very thought of Brexit may have been unwelcome for many banks based in the UK, but in the wake of June’s referendum result, the months, quarters and likely years of uncertainty the country faces as a ‘divorce settlement’ is negotiated could be a bigger concern altogether. How should financial institutions face the risks of market instability and a large set of unknowns? And could Brexiteers be right that opportunity, too, lurks in the abyss? Sarah Williams reports.
“I’m afraid that this is not such a good day for Europe. At this stage, we cannot fully foresee the consequences, but there’s no doubt that they will be negative on all sides.”
John Cryan, Deutsche Bank’s CEO, was speaking on 24 June, the day after the UK’s historic vote in favour of leaving the EU. While his bank may be well prepared, Cryan continued, “There’s no doubt that the uncertainty created by the referendum results will be a challenge.”
The passing weeks may have given banks longer to digest the news, but they have brought little certainty regarding either the proposed terms or the full implications of the UK’s departure – beyond a commitment by new Prime Minister Theresa May that “Brexit means Brexit”.
Financial institutions must therefore mitigate the inherent risks of such uncertainty, while taking steps to prepare for the – as yet undefined – regulatory changes that the process will engender.
Arguably the pre-eminent issue is the question of the UK’s continued membership of the European single market and the accompanying ability for organisations based there to ‘passport’ financial activities and to access euro-clearing services.
In the case of the UK leaving the single market, many commentators have pointed to the likelihood of some financial segments needing to relocate to an EU member state. Indeed, banks such as Morgan Stanley and HSBC hinted prior to the referendum that some jobs could be moved abroad should the ‘Leave’ camp triumph, although both recently played down the probability (with the former denying the day after the ‘Brexit’ vote that a move of around 2,000 such jobs was already under way).
While wholesale banking activities based in the UK are perhaps particularly vulnerable, for Nicolas Véron, a senior fellow and co-founder of European economics think tank Bruegel, a more holistic view of the industry is advisable.
Reached in Washington DC – where he is a visiting fellow at the Peterson Institute for International Economics – Véron reflects, “London has hugely benefitted from the network effect; it has the advantage of being basically the best place for doing financial business in general terms in its time zone. If that is no longer the case, the network effect could start working against London in terms of activities clustering in a different jurisdiction, namely the EU single market from which it would be now absent.
“And this may actually cut across different market segments and not be something that you have to look at too narrowly segment by segment.”
New markets conditions
For the moment, without confirmation of whether the UK will indeed leave the single market, the cost of transitioning existing jobs elsewhere is likely to be a deterrent against any immediate exodus. However, Véron cautions that in the shade of such uncertainty, London will feel the effects of declining appeal more indirectly.
“I think most big financial firms are still in ‘wait-and-see mode’ in terms of moving actual jobs,” he says. “But when it comes to new investment, they’re probably considering alternative locations as a matter of priority and, over time, this effect could become quite substantial.”
Significant gains could then be up for grabs for the eventual winners of this business, but it is too early to define where these will be. For now, new investment is unlikely to centre in one specific destination, but rather to be distributed in accordance with the specific needs of each company, Véron says.
“There are some places that have most of the ingredients and some places that have few of those ingredients, but I don’t think there is one single place that would win it all; certainly not in the first stage,” he states. “You have to remember that London’s current dominance is something that has built up over time – over two, three decades.”
Some politicians in Europe may of course welcome a potential end to London’s dominance as a financial hub. However, Véron emphasises that the selection of new centres will be driven by business needs rather than any political desire for fairer distribution.
BNP Paribas is one European bank that highlighted the probability that London’s loss could be other markets’ gain. At the same time, the extent to which this benefit is realised also relies upon the EU response to its own new-found freedom from the UK and, consequently, it also faces regulatory uncertainty.
In an article posted on the bank’s website the week following the referendum, BNP Paribas Group chief economist William De Vijlder wrote, “Of particular importance will be the shape of the future UK-EU relationship, and its potential impact on regulation and policy.
“If the UK’s departure leads to greater integration of the remaining EU countries, accompanied by liberal policies, for example, this could benefit the EU economy, enabling it to attract foreign direct investment [FDI] and, potentially, some relocation of financial services from the UK.
“As the UK is one of the bloc’s most non-interventionist economies, however, its withdrawal could leave the EU with a less liberal policy agenda, with negative repercussions for long-term growth.”
Give a little, get a little
It is that ability to pursue a more liberal agenda that pro-Brexit economist Tim Congdon sees as the UK’s major gain. A fellow of UK free-market think tank the Institute of Economic Affairs, Congdon also founded a new Institute of International Monetary Research in association with the University of Buckingham in 2014. He looks unfavourably upon past EU intervention in cases such as Northern Rock and RBS, and has previously argued that “harmful and unsympathetic” EU regulation has stunted the formerly rapid growth of the UK’s financial services industry.
Speaking to Future Banking a few weeks after the referendum, he reflects: “Regulation will again be under the British authorities’ control in the extreme, but of course still constrained by at least two things: one, we belong to the Bank for International Settlements (BIS) and the G20. The BIS is the effective policeman for banking systems in the main advanced countries – and that hasn’t changed. The second thing is that the exact basis of the UK’s withdrawal from the EU isn’t established yet.”
While the terms of the UK’s access to the single market are yet to be confirmed, and Congdon acknowledges that a wish to remain within it would require banking regulations to conform to EU standards, several other matters are now clarified for the better, in his view.
“It’s clear, for example, that were the financial transaction tax [EU FTT] ever to go ahead inside the EU, it wouldn’t affect us [the UK], which is good. And also things like the restriction on bankers’ bonuses, which certainly affected HSBC, again won’t apply.”
Congdon believes that one of the UK finance industry’s biggest winners from the potential softening of regulation will be investment funds.
“The areas that really have suffered from EU regulation in the past few years have been hedge funds and small fund-management businesses. The Alternative Investment Fund Managers Directive [AIFMD], an EU regulation incorporated into UK law in 2013, has altered their arrangements, the proof of ownership of securities. Obviously, the UK had its own arrangements for this for many decades and the AIFMD put those on to a French model, which increased the cost of hedge funds and fund management businesses.”
He adds: “This is now history, mercifully, and the AIFMD was part of the reason why in the hedge fund world there was a lot of opposition to the EU and support for Brexit; so they benefit straight away.”
For Congdon, the issue concerning passporting has also been exaggerated, and he is sceptical that any major movement of people will be implemented as a result.
“What you see across the EU is that non-EU nations such as the US, Japan and others have banking operations where they want to have them, on reciprocal bases that are nothing to do with EU membership. And if they can have that, there’s no reason why the UK shouldn’t have the same when we’re outside the EU. ”
Keep it clear
Likewise, with regard to euro clearing, he emphasises that euro-denominated assets are bought and sold between non-banking organisations in non-EU locations, such as New York, Singapore and Tokyo, and he believes that the only potential problem could be clearing between banks.
“Banks clear usually in a settlement balance at a central bank, and so the ECB’s attitude could be important,” Congdon says. “But the US Federal Reserve for example has allowed dollar clearing to occur in locations outside the US. So why should the ECB be any different? And if they do not allow London to continue, fine, but frankly that’s protectionist and inward-looking.”
For Véron, the ECB’s stance should indeed be a cause for concern with regard to London’s future. Writing for Bruegel before the referendum, on 6 June, he highlighted the protection that the EU framework has in fact provided London against what he called “regulatory fiat”, with, for example, the European Court of Justice in 2015 rejecting the ECB’s location policy that would have required euro-denominated operations to be shifted over to the eurozone.
In the light of the referendum result, does he therefore see a direct order by the ECB for services to move as imminent?
“Not immediately,” Véron says. “There are many things that will happen, and this is probably not the first, but I think it participates in the general equation that if you want legal predictability – even assuming the ECB does nothing in the next two years, it might do something along those lines later on – it’s much better to have your operation in the EU outside of England, than in England.”
It’s a problem he sees as extending to business more widely, beyond the banking sector.
“I’ll be blunt; at this point, given the huge uncertainty affecting the UK in the next few months and quarters, international businesses will not find the UK an attractive location for investments.
“Once this uncertainty has lifted, and that will probably take several quarters at least, then it depends on what the landscape is like when the dust settles.”
For Congdon, meanwhile, it’s a busy road ahead for UK-based banks and businesses, but certainly not a cause for panic.
“What this means for the long run, I hope, is that we look to the wider world, including the wider English-speaking world, for increased cooperation and increased trade,” he says. “The truth is that, in the 21st century, the importance of the EU in the world economy is going to diminish very substantially.
“So I think when we look back 25 years from now we’ll say ‘what a good thing it was done like that’.”
What the future really holds for the UK and Europe more widely is hard to divine at present. Some shifts in favour of the EU seem inevitable – the EBA announcing a planned move from London, for example, with Paris or Frankfurt the most likely successors.
But efforts to ‘stand by’ London are also under way, as heads from Standard Chartered, Goldman Sachs and Bank of America Merrill Lynch among others joined the UK Treasury in a pledge to protect the city. Announced 7 July, the signatories undertook to “help London retain its position as the leading international financial centre”.
The degree to which this is achievable remains to be seen. For now, as Véron urges, banks and businesses located in the UK must base their decisions upon “as clear-sighted, unemotional and unsentimental an analysis of the UK position as possible”.