As part of the process of a Guild Apprentice becoming a Guildman, each is required to write an essay on an aspect of the City of London or of the Guild which may be of interest to members. Below is that from Apprentice James Jalali-Farhani.

What Challenges Could Brexit Pose to London’s Financial Dominance?

Brexit has begun. With Article 50 triggered and exit negotiation rounds well under way, the dangers of leaving the European single market to be faced by the Europe’s largest financial centre have been becoming evermore clear. This essay will try to assess the threat of Brexit to London’s current financial dominance by firstly understanding the current passporting rights setup, which are determined by the UK’s access to the single market. In the event that the UK fully exits the single market and becomes a “third country”, I then explore alternative solutions to be debated at the negotiating table that could serve as some palatable passporting-replacements, as well as factors that would mitigate the losses.


London’s unchallenged financial dominance has been majorly buttressed by its access to the EU’s passporting scheme – which enables all authorised financial institutions in the UK to trade freely in any other EU or EEA state with very minimal additional authorisation. Two important features of passporting have empowered the City to become the de facto location of most leading financial institution’s European HQ. Firstly, it has enabled banks and financial services firms to sell products and services from the UK across borders to any other EU market on the same basis as if they were present in the market of sale. This allows businesses across the EU to buy financial services directly from the UK. Secondly, passporting enables UK based banks to establish branches in other EU states on preferential terms, where national authorities are generally required to treat branches of banks from other EU states as if they were locally authorised. This has permitted UK-based banks to establish networks of branches in financial centres across the EU, and many banks from other EU states to establish operations in the City of London. Crucially, both these features mean that any ‘passported’ UK banks will thus operate across the EU efficiently, without duplication and at a low cost. [1]


However, in the event of the UK losing its membership in the single market upon a ‘hard’ Brexit, the passporting frameworks will no longer cover London-based firms. Hence, in principle, it would see UK-based banks lose their ability to sell products and services directly to customers in other EU states, and would cause the branches of UK-based banks in the rest of the EU to revert to the status of ‘foreign’ bank branches. Under current ruling, these ‘third country’ firms could instead apply for a license in each country to maintain similar rights, but this is a highly toilsome task leading to duplication and substantial additional cost. Emerging as the foremost concern for Brexit among the financial sector, leading firms have been preparing to replace their passporting access by moving key operations to the continental EU cities such as Frankfurt, Paris, Dublin, Luxembourg, Amsterdam and so on. Already Oliver Wyman predicts to that 40,000 jobs will leave the UK unless a ‘softer’ Brexit deal is reached. [2] Hence City lobbyists are eager to ensure that the UK government takes on their concerns with utmost priority at the negotiating table.


With the UK’s exit negotiations underway, there is still considerable debate over whether the UK should truly have a ‘hard’ Brexit and leave the single market altogether by exiting existing memberships of both the EEA (European Economic Area) and the EFTA (European Free Trade Association) further to the EU. Despite delivering the key advantage for the financial services sector of maintaining passporting rights, continued access to the single market would almost certainly force the UK to accept the principles of free movement of goods, services, capital, and workers in exchange – controversially going against the key anti-immigration promise of the Leave campaign, which is presently reinforced by David Davis’ commitment to the red lines for fully restrictive EU immigration policies. However, pressure is now mounting from pro-passporting City lobbyists on the basis of reports such as Oliver Wyman one above, as well as from influential academics calling on the government to base the new UK-EU relationship on the ‘Norway’ model as the best way forward, recommending continued access to the single market through a UK-specific form of the EEA membership in order to salvage economic prosperity from the inevitable costs of Brexit. Hence it is highly possible that passporting rights could be retained if a more ‘pragmatic’ Brexit were to be agreed. That might have been unthinkable had Theresa May increased her power base — and continued her push for a hard Brexit — with a triumphant general election result. But her weaker position and the greater influence of more conciliatory pro-Europeans both within her party and on the opposition Labour benches gives a greater chance that passporting rights may ultimately be prioritised. Perhaps public opinion could develop to the extent that the true costs of a ‘hard’ Brexit come to be fully digested, such that a softer stance on free immigration develops – a critical point described by economists as where prosperity would triumph over politics.[3]


In these negotiations, the EU must walk a fine line: if it is too soft on the United Kingdom, a host of other countries will want to renegotiate their positions in the EU, but if it is too harsh, it will further alienate anti-EU voters. However, since freedom of immigration has always been a key cornerstone of the single market’s philosophy, it is unlikely that the UK’s single market membership will be maintained unless concessions on immigration are made by the Conservative government. In the event that Davis refuses to back down on his immigration red line then, at least in its current form, passporting is off the agenda. There currently exist no complete replacements for passporting rights, with schemes such as the aforementioned licensing having duplication and substantial costs, or ‘equivalence’ grants by the EU only permitting operations in fewer areas, covers fewer services and is inherently less secure (the most acute concern being that the grant can be unilaterally removed if the two regulatory regimes diverge with notice of only 30 days). [4] As a result, they cannot be relied upon to allow non-EU banks to meet all their customers’ needs in the EU.


An emerging solution that now appears likely to be taken to the negotiating table is ‘mutual access’, as proposed in a detailed legal document prepared by law firm Hogan Lovells. Billed as the blueprint for the world’s first ever substantial free trade agreement in financial service, the report makes clear: “A bespoke mutual access deal, providing something as close as possible to passporting, is the optimal solution.” [5] Mark Hoban, who heads the International Regulatory Strategy Group (a City of London lobby group) has publicized the framework, proposing that the UK and EU could agree to reciprocal market access in financial and professional services as part of its new relationship post-Brexit. The model would be based on mutual recognition of each other’s regulatory and supervisory regimes, with the intention to enable firms based in the UK to continue trading services across the EU and vice versa. Despite appearing practically identical to passporting, this framework has importantly provided accurate starting points to evaluate the fundamental criteria for guiding this setup, which is a key step to beginning realistic negotiations that would facilitate the continuation of the unprecedentedly integrated UK-EU relationship.


Promisingly, mutual recognition of each other’s regulatory and supervisory regimes does appear possible. Capital regulation of banks is underpinned by the Basel Accords, making it unlikely that the UK would move away from the EU in this area. Of course, over time some differences in application might develop, but in terms of implementation and execution, the UK has had a distinct approach. Indeed, changes in the Single Supervisory Mechanism led by the ECB are tending to bring the continent closer to the UK’s approach in areas such as Pillar II, the assessment of risks in the round and adequacy of capital. [6] Hence we can expect a healthy degree of appeal for the ‘mutual access’ approach from both sides of the negotiating table, providing signs of hope that the City may continue to retain its status as a fellow European financial centre.


Positively, recent developments in negotiations indicate a movement towards some common ground as Michel Barnier, the EU’s hardline chief negotiator has also recognised there will need to be EU “special vigilance on financial stability risk” going into the talks. As Bank of England governor Mark Carney has pointed out, the EU relies on the UK for three-quarters of its hedging activities, three-quarters of its foreign exchange, half its lending and half its securities transactions. Hence an extended ‘transition period’ may very well be welcomed by both sides, allowing more time to better hammer out an agreement that suits the requirements of both parties.


We must also highlight that the broader attraction of the City may also mitigate the said factors swaying financial companies to make any major relocation decisions. So far there appears to still be a strong appetite for participating in London as, despite a narrower lead than in previous years, the UK’s financial services were still able to retain its title as Europe’s most attractive location for international investment. The sector attracted 99 foreign direct investment (FDI) projects in 2016, the highest level since 2006 and an increase of 5 per cent on the previous year, a study by EY shows, [7] reflecting a continued confidence in the substantial synergies to be gained by conducting business in London.


The passporting losses may also not be as detrimental for all financial services companies in reality. Before deciding on changes, the banks need to consider the extent to which they can utilise existing subsidiaries established in the rest of the EU to achieve their passporting rights. A quick review of a sample of major non-European banks with subsidiaries in London indicates that around three-quarters also have subsidiaries elsewhere in the EU, thus requiring only minimal structural changes of such banks in the event that passporting is no longer available in the UK – no matter what other deal that may be negotiated.


Besides securing a sufficient passporting-replacement agreement, a central question going forward then will be London’s continuing attractiveness as a financial centre. London’s attractiveness has always centred on language, the size, and interconnectedness of the different facets of the financial centre and complimentary services, its cosmopolitan nature and available skills, and labour market flexibility. Labour market flexibility is an important part of the modern UK economy, but access to skilled labour from the rest of the world, including the EU, will need to be maintained. Successive governments will have to consider what makes London attractive as a home for financial activity and how to encourage those aspects. This means continuing to enhance infrastructure, considering taxes, and so on. With net EU migration levels into the City already falling, as well as London’s profitable Euro clearinghouse business under the threat of being taken out into other European capitals, it is imperative that the government enact the proposed policies swiftly and significantly. If London continues to be attractive, then wholesale activity is likely to continue to gravitate to London.


To conclude, the importance of the rights from passporting in the City will ultimately be weighed up against other political factors, most critically immigration. In the case of ‘third country’ status upon exit from the European single market, these could be enhanced in a range of ways if the UK and the EU are ready to be ambitious and innovative in agreeing on mutually acceptable terms. Undoubtedly there has already been contingency planning to move certain areas of operations and personnel away from London to continental European financial centres by numerous financial institutions, sometimes regardless of the negotiations’ results. However, it is likely that London’s comparative advantage as a result of its broader attractiveness in addition to the potential ‘mutual access’ deal should be able to stem any greater outflows – ensuring the pervasive willingness to maintain businesses and investments in the UK that has led the City to its preeminent status of today is kept ever-present.


[1] BQB #1

[2] Oliver Wyman: The Impact of UK’s Exit

[3] Swati Dhingra: Salvaging Brexit

[4] BQB #4

[5] Hogan Lovells: Mutual Recognition – A basis for market access after Brexit

[6] Patricia Jackson: This is what Brexit could mean for banking

[7] EY: UK Attractiveness for Financial Services Investors


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