By Barbara Casu
This article discusses the key implications of Brexit for the UK financial services industry, looking at the differences between: membership vs. access; passporting rights vs. equivalence principle; customs union vs. free trade agreement. While negotiations have yet to start, the attractiveness of London as the European finance capital has started to lose some of its shine as banks announce relocation plans.
Even though Article 50 has yet to be officially triggered by the UK government, the decision to leave the European Union (EU) seems to have gathered momentum, as the UK parliament has supported the government’s European Union Bill, by 498 votes to 114 on February 1, 2017.
Article 50 of the Treaty on European Union (the Treaty of Lisbon) is a part of EU law that sets out the process by which member states may withdraw from the EU. While the notification is expected to take place by the end of March 2017, the British Prime Minister, Theresa May, has clarified – to a certain extent – the UK’s negotiating position. This position has become known as “Hard Brexit”, given that it seems likely to entail not only exit from the EU but also exit from the EU Single Market and, possibly, from the EU Customs Union (EUCU). The direction of travel seems a little clearer than it was in the immediate aftermath of the referendum on June 23, 2016; however the hopes of the UK financial industry to retain passporting rights seem to have been dashed. What are the implications of a “Hard Brexit” for the UK financial industry?
The European Union, the Single Market and the Customs Union
The European Union was formally established in 1993 by the Maastricht Treaty; although its history dates back to the post World War II period. The current constitutional basis of the EU is the Lisbon Treaty, which came into force in 2009. Membership of the EU has grown through a number of enlargements to the current 28 countries. Nowadays, it is the largest integrated economic area in the world, accounting for more than 20% of the world’s GDP.1
The signing of the Maastricht Treaty also marked the official start of the EU Single Market project, which led to the establishment of the single currency, the euro, and of the European Central Bank (ECB) in 1999. The Single Market refers to the EU as one territory, without any internal borders or other regulatory obstacles to the free movement of goods and services. It accounts for around 500 million consumers and 21 million small and medium-sized enterprises (SMEs). The free movement of goods is one of the four freedoms of the Single Market. The other three fundamental freedoms are: the freedom of movement for workers; the right of establishment and freedom to provide services and the free movement of capital. The Single Market requires acceptance of all four freedoms, as this is necessary to obtain a level playing field. In this respect, the Single Market goes beyond a free trade area and, as a consequence, the benefits of membership go beyond those of access to the Single Market. Arguably, most countries in the world have access to the EU as an export destination; however membership of the Single Market also reduces “non-tariff” barriers in a way that no existing trade deal, customs union or free trade area does. The benefits of EU membership are large and substantially outweigh the costs. A recent study estimates, on a country-by-country basis, the benefits from joining the EU in terms of economic growth and productivity. Using a methodology known as SCM (synthetic counterfactuals method) the authors provide an estimate of what would have been the per capita GDP if a given country had not become a member of the EU. They suggest substantial and permanent benefits, concluding that the positive pay-offs of EU membership are clearly above the direct costs.2
It is now likely that the UK will seek a type of free trade agreement (FTA) with the EU. While FTA might mean better access to the Single Market relative to a situation with no FTA, such a deal will be difficult to achieve, it will be enormously time-consuming and will not replicate the kind of access currently enjoyed by membership.
Financial services are key beneficiaries of Single Market membership; for the UK this is particularly important as financial services account for 8 percent of the value created in the UK economy, 7 percent of tax receipts from earnings and corporate profits, and 65 percent of the UK’s service trade surplus.3
Membership of the Single Market enables financial institutions established in any EU country – either EU owned or EU subsidiaries of foreign banks – to establish branches or carry out cross-border activity in the rest of the EU and in the European Economic Area (EEA) countries. The single banking licence (or passport), first introduced by the Second Banking Co-ordination Directive in 1989, is now enshrined in the Capital Requirement directive IV (CRD IV). A number of studies have identified the importance of passporting rights and related benefits, suggesting that the UK financial sector would be disproportionately damaged outside of the Single Market, its output potentially some 7% lower in 2030.4 Passporting rights reduce the need to set up local subsidiaries as separate legal entities, thereby reducing the costs involved with applying for a banking licence or authorisation or meeting local regulations.
It is expected that the UK government will seek a bespoke deal for its financial services industry. However, it must be stressed that access to the Single Market for financial services firms from outside of the EEA is unprecedented and none of the existing deals the EU currently has with third countries provide passporting rights. For example, Switzerland’s bilateral agreements with the EU do not cover financial services and Swiss banks have had to establish subsidiaries in the EU.
In addition to leaving the EU and the Single Market, a “Hard Brexit” would also imply leaving the Customs Union. The EU Customs Union came into force in 1992; since then no customs duties are levied on goods travelling within the internal borders between the member states. In addition, unlike a free trade area, members of the Customs Union impose a common external tariff on all goods entering the EU. This implies that the EU negotiates as a single entity in international trade deals. While the latter is often seen as a constraint on British freedom to negotiate trade agreements with third countries on its own terms, it is important to note that the benefits of a Custom Unions cannot not be replicated by a free trade agreement.