“Brexit may have a greater impact on the financial services sector than on any other area of the economy,” wrote EY, the consulting company, in a report on the preparations of the financial institutions for Brexit.
“It affects all institutions, both from the UK and the rest of the world, which currently use London as a hub for their continental European business. Financial institutions need to systematically think through what effects Brexit could have on each of their areas of operations,” said Andreas Dombert, a member of the Management Board of the Deutsche Bundesbank, during a meeting with financiers in London.
For the financial sector Brexit means that London will no longer be a hub for banks wishing to do business in Europe. That is because they will lose the possibility of “passporting” their services. They will have to apply for a license in the member states of the EU. The British banks will find themselves in a similar situation.
What is hidden in the vaults of the Gringotts Wizarding Bank
The total assets of banks operating in London amount to EUR10.2 trillion, of which EUR5.2 trillion accounts for wholesale banking, and EUR5 trillion accounts for retail banking. “About 90 per cent of the total EU turnover of the largest US and Swiss investment banks, and about an equal share of their EU staff, is located in the UK,” Uuriintuya Batsaikhan, Robert Kalcik and Dirk Schoenmaker estimate in a report of the Bruegel Institute.
The 20 largest investment banks in the world (mainly American, British, Swiss and Eurozone ones) operating in the City of London represent approx. 80 per cent of the European investment banking market. It involves the financing of mergers and acquisitions, the organization of the issuance of shares and debt, and huge syndicated loans.
The London foreign exchange market is responsible for 43 per cent of all spot foreign exchange transactions for the euro. When it comes to foreign exchange derivatives, London has a 37 per cent share and is the largest market for the EUR, USD and JPY. The situation is similar in case of interest rate derivatives – two-thirds of global transactions are concluded in London, including 75 per cent of transactions for the EUR and 95 per cent of transactions for the GBP.
A report of the consulting company Oliver Wyman prepared for TheCityUK, an organization of British financiers, indicates that out of approximately GBP200bn of revenues of the entire British financial sector in 2015 (slightly more than half of which was attributed to the banks) about a quarter came from customers from the European continent. This includes not only wholesale banking, but also retail banking services. Similar estimates are presented by the latest report of the London School of Economics.
André Sapir, Dirk Schoenmaker and Nicolas Véron from the Bruegel Institute wrote that the obligations of the customers from the 27 member states of the European Union amount to EUR1.8 trillion, or 35 per cent of the EUR5.2 trillion of assets located in London’s wholesale banking sector. This represents approx. 17 per cent of the total assets of banks in the City of London. They believe it is highly likely that when Britain begins its exit from Europe, these funds will flow to the Continent.
Where to move London?
The process of Britain’s departure from the European Union could take years, and there could even be no Brexit at all, so far several global banks have already made declarations of their intention to move their operations to the Continent in the near future for the customers in the EU-27.
According to the latest findings of the EY Brexit Tracker more than a quarter of the 222 UK financial services firms have announced that they are moving some staff or part of their operations out of the UK as a result of Brexit. Whilst firms voicing such intentions remain in the minority, the figures represent an uptick of circa 50 per cent from four months ago.
21 of the 47 investment banks (45 per cent) monitored by EY said they are actively moving some staff or part of their operations out of the UK, or that they are reviewing their domicile as a result of Brexit. 10 of the 47 investment banks (21 per cent) have changed their public stance on staffing and operations since the beginning of the year and are now stating that some roles or operations will be moved. Still almost a third (15 of the 47) of investment banks have not made a public pronouncement on Brexit.
The US bank JPMorgan Chase confirmed that is moving its new back office operations center, probably to Warsaw, as well as up to 1,000 bankers that are going to be relocated to Dublin, Frankfurt and Luxembourg. Also Standard Chartered informed its shareholders that it was in talks with regulators in Frankfurt about setting up a new subsidiary in Germany. Deutsche Bank has said up to 4,000 jobs from its UK workforce of 9,000 could be moved to Frankfurt and other locations in the EU.
Morgan Stanley is looking for office space for 300 employees in Dublin or in Frankfurt. The British HSBC intends to move approx. 1,000 people to Paris, where it already has large operations. Citi has declared it will move 900 employees to Dublin. Frankfurt, Dublin, Paris and Amsterdam are cities most frequently mentioned as those that will take over most of the operations from London.
So far there are no signs of a mass exodus – these declarations cover approx. one-quarter of the 10,000 jobs that could disappear from London-based banks according to estimates of the Bruegel Institute. The City of London employs close to 140,000 people in such jobs, and the entire financial sector along with ancillary positions employs over 700,000 people.
The mayors of many cities, and even heads of governments are wondering how to attract bankers, how to lower taxes for them, and what red carpets to roll out before them. They are not aware of the fact that the sum of the losses could be greater than the profits.
The consequences of losing the financial passport
The banks from the City may lose the most, and if they delay decisions until the situation becomes clearer they could lose customers and revenues. Regardless of whether the divorce happens or not, and whether it will be a soft or a hard one, an assessment of the benefits and losses associated with moving has already started – from an evaluation of the strategies, as well as management, business, operational and structural models. The basic assumption is that the United Kingdom will leave the European Union.
The doubts and risks mostly concern the degree to which the British and the Continental legal orders will eventually drift apart. “On the assumption that the majority of regulations governing Financial Institutions will remain largely unchanged under any option, the key questions for many FIs will revolve around the ease of future access to the EU Single Market. This will be dependent upon the outcome of treaty negotiations, and crucially upon passporting rules, and the degree of reciprocal recognition of regulatory equivalence ,” writes EY.
The most important thing for financial institutions is the principle of the single passport. It enables companies that obtained authorization for the provision of services in one member state to offer them in other member states, without separate permissions. In this way, non-EU banks established in London could operate throughout the EU territory. This is also how Polish banks are operating abroad – Alior in Romania, mBank in the Czech Republic, and in Slovakia and PKO BP in Germany and in the Czech Republic.
When it comes to the license for banking activities, the situation varies slightly in individual countries, because the European law introduces certain minimal requirements, which can be tightened by the local authorities. In Poland, for example, a two-stage license is required in order to set up and to conduct banking activity. This is an example of relatively high requirements.
Equivalence doesn’t always mean equivalence
If the United Kingdom ceases to be a part of the European Economic Area, institutions from third countries, such as the United States and Japan, will lose the European “passport”. But they will not be the only ones. The United Kingdom itself will become “a third country” and British banks will find themselves in the exact same situation.
Provided that the principles of supervision over financial institutions are consistent with the European law, there is a possibility that the EU will recognize the equivalence of the supervisory policies of the United Kingdom. This would simplify the access to the EU market, but is not synonymous with “passporting”. In contrast to the single passport, it does not entail automatic access to the market. EY calculated that Swiss banks have to obtain approx. 20 different equivalence agreements in each and every country in which they wish to conduct operations.
“Equivalence is truly different from single market access (…) equivalence decisions are not a reliable substitute for passporting,” said Andreas Dombert.
The decisions on equivalence only apply to the wholesale operations of banks, rather than retail banking operations. For banks to have quick and continuous market access, such decisions would have to be taken immediately, and no one is able to guarantee that. Additionally, changes in the law could cause the decisions on equivalence to be reversed, and this would put the operations of the banks in a very difficult position.
The declarations of the European supervisors point to a transitional period following the divorce. This would alleviate the risk for the “laggards” and would reduce the time pressure. However, the transitional period depends on the negotiations, so it’s difficult to accept the risk of their possible result. Finally, the British Prime Minister says that she would like to conclude a free trade agreement with the European Union, which could introduce rules similar to “passporting”, applying in both directions. However, negotiations of such a treaty could take years. It is better therefore not to take such risks and to set up a separate company on the Continent.
London may be replaced with fragmentation
The issue of institutions moving out of London could be solved by the European Commission’s announced requirement for banks from third countries to establish a single company consolidating all their operations in the European Union. The company, of course, would be subjected to the European Single Supervisory Mechanism (SSM) at the European Central Bank (ECB). This entails much more than just an important structural change.
The creation of such a company will require the banks to find physical headquarters, as well as a proper organizational infrastructure, management, controlling, accounting, auditing, back office and compliance departments. This also concerns capital, the cost of which would be incurred by the non-European parent institutions. The EU regulators do not want these banks to be shell companies. The creation of such companies does not guarantee, however, that their activities on the Continent will be as effective as in London.
Contracts concluded in the financial hub of London include merger-financing transactions, huge international syndicated loans, issues of debt securities, not to mention offers on the capital market, foreign exchange market and the derivatives market. Almost all of these contracts are concluded on the basis of the British common law. But if London is no longer used for the conclusion of such transactions, will they still be concluded on the basis of the British common law? And will possible disputes be settled by the British courts?
The report of the Bruegel Institute predicts that trading activity will continue to be subjected to agreements concluded in accordance with British common law. But will this also be the case, for example, with the issuance of bonds of an Italian company, organized by a French bank and placed on the stock exchange in Frankfurt? One way to get out of this situation would be a European contract law. But such legislation still hasn’t been written.
The ECB presented a proposal for such an approach a few years ago in its opinion on the project of the Capital Markets Union. European law would apply in parallel to the national legal systems. The parties could apply either the national law, or the European law. This would be the basis for the conclusion of contracts, settlement of disputes and the recovery of debts. This is a serious alternative, because if the current contracts based on the British common law are over time replaced with contracts based on 27 different national legal systems, the fragmentation of the common market will only deepen.
And fragmentation is a problem where the EU stands to lose the most if it fails to effectively counteract such tendencies. The report of the Bruegel Institute warns against fragmentation, as its consequences could include higher costs of obtaining financing by both economic operators and households. If the operations of banks from London moved to individual member states and were separated by their national borders, the cost of raising capital would increase by 5-10 basis points, or EUR6-12bn per year across the EU, which represents 0.05-0.1 of its GDP. Replacing London is becoming a very big challenge. Neither Paris nor Frankfurt will be able to meet this challenge on their own.