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How Brexit could benefit the City and the EU

March 28, 2017

Mark wrote the following article which appeared in today’s Daily Telegraph.

Not long after the referendum, DExEU Ministers asked the City’s leading lights to set out on two sides of A4 what they most wanted from Brexit negotiations. I am told what followed was hour upon hour of pained debate as London’s masters of finance thrashed out their priorities without reaching any consensus.

The collection of policy ‘must haves’ that was eventually settled upon before Christmas, including the demand to retain the apparently essential EU banking passport, has since been whittled down as it has become ever clearer that our planned withdrawal from the single market makes certain demands unachievable. The passport for one requires the UK to remain signed up to the authority of EU supranational bodies and would likely involve substantial continued payment into the EU’s budget. Unsurprisingly this has quickly fallen by the wayside.

What had become apparent to the Square Mile and what has fast crystallised in the government’s own mind, is that the ‘City’ as a catch-all term for the financial and professional services industry actually disguises myriad sectors and sub-sectors, each with wildly differing levels of interaction with EU markets. Some City firms are undoubtedly worried about the impact of Brexit on their existing business model and have already or will soon be moving a number of staff onto the continent to hedge their bets in the event of an unfavourable deal. Others are unfazed or worry less about regulatory fallout than their ability to retain and recruit talented EU nationals.

So how can the UK secure a deal that best satisfies the conflicting interests within the financial and professional services industry and prepares the City to compete in – and ideally dominate – an increasingly aggressive global marketplace?

Insofar as there is now an agreed City opinion, it is that the UK government should push for an enhanced equivalence deal with the EU on financial services that delivers mutual market access through the recognition of one another’s regulatory systems. There is already an established EU process in place for third countries (i.e. those nations outside the EU) to obtain equivalence status in a host of different areas that we might use as the basis of our own agreement. The US and Singapore, to name but two, already have equivalence for clearing houses for instance, and may be able to achieve it for investment business once that concept is introduced in January 2018. In theory, it should be much more straightforward for the UK to obtain a broader equivalence deal since our current regulatory regime already complies with EU rules and any existing EU financial services regulation would be copied onto the UK statute books via the forthcoming Great Repeal Bill. This would allow us to retain sovereignty, not interfere with the EU’s four fundamental freedoms and require no joint oversight body, keeping us in line with the broad principles the Prime Minister set out in her Lancaster House speech.

An ‘enhanced equivalence’ deal would go further to address the opacity and patchiness of current provisions. Our goal ought to be to plug gaps in the existing third-country equivalence regime by outlining clear benchmarks on how those jurisdictions can obtain equivalence status and building a new procedural framework that would allow equivalence to be established, maintained or withdrawn for different areas of financial services business, alongside cooperation on data sharing and potentially some kind of arbitration mechanism separate to the European Court of Justice. This would serve to inject commercial and legal certainty into any new regime by depoliticising equivalence determinations.

While it would be unwise to rely on logic and self-interest prevailing during the forthcoming negotiation with the EU, it should not be difficult to frame an enhanced equivalence deal as in the interests of the remaining member states. Given the increasingly divergent needs of Eurozone and non-Eurozone members, a fissure over financial regulation was bound to have opened up even if we had voted Remain. It should be easy to argue that Brexit helps to resolve that inherent tension between the City and Eurozone members, who now require much tighter financial cooperation with one another if the single currency is to live to fight another day and will be freer to pursue it post-Brexit.

Enhanced equivalence would ensure that the City can continue to operate as a capital market within the EU time zone to rival New York, providing services and liquidity to European businesses and financial institutions at a time when the Eurozone in particular can ill afford the shock that would come from cutting itself off from the City’s cash and expertise. In expanding that equivalence regime to non-EU members, the EU would turns its back on fragmentation and instead open its markets to greater global investment, decreasing costs and making the EU27 more attractive places in which to do business. Plus it would make life easier for EU banks with branches in the UK, who could continue to operate here without needing to subsidiarise.

The case needs to be made firmly that failing to secure a deal on financial services by the EU would be an act of self-harm. While EU financial centres will doubtlessly be getting a greater share of Euro-denominated business going forward, this will not outweigh the greater economic damage done to those beneficiaries should a needlessly punitive approach be taken to the City of London. Simply put, if the City is undermined its business is as likely to leave Europe altogether than go to Paris, Frankfurt or Dublin.

However this argument hints at the bigger danger lurking in this debate. Even though we would retain sovereignty under an enhanced equivalence deal, such a pact would necessarily limit the UK’s freedom and flexibility on financial services regulation since we would have to cleave closely to the EU’s rules in order to retain our equivalence status. In doing so, the UK’s ability to react to Brexit and the changing marketplace in a more profound, responsive and dynamic manner risks being undermined.

While we can attempt to take political risk out of equivalence judgements through the procedural framework I have described, this will take time to negotiate and establish. In the meantime, President Trump has signalled his desire to unleash Wall Street from some of the restrictive provisions of the Dodd-Frank Act, such as the Volcker Rule on speculative investments, and will be lowering corporate tax rates in a bid to repatriate the vast sums of US cash currently held abroad. Should negotiations in Brussels become painful and protracted, it may soon be the City itself that tires of the idea of enhanced equivalence as it becomes ever clearer that the real action is to be had in competing more aggressively with a motoring New York. After all, over the next decade to fifteen years, ninety per cent of global economic growth is expected to be generated outside Europe.

To avoid this scenario, we need to come up with a regulatory solution that retains as much access as possible to the EU for those City firms that require it, while giving maximum flexibility to the three-quarters of the international and wholesale banking business unrelated to the EU to compete with rival financial centres. This can be achieved if we cease viewing regulation in binary terms and instead offer UK-based firms a menu of options – a concept not quite as radical as it sounds. The foundations of this idea can already be found in the operation of certain EU laws, such as the Markets in Financial Instruments Directive (MiFID), where you have MiFID and non-MiFID firms (those which choose to opt into or out of the EU law that harmonises regulation for investment services). Why not extend this principle by allowing financial services businesses an opt-in to specific parts of the EU market where the UK has negotiated an equivalence deal while leaving UK domestic and non-EU business to be regulated as we please? Firms looking to access Europe and other jurisdictions from one UK entity would then need either to adhere to the rules of whichever market demands higher regulatory standards or set up two separate UK entities – one for European business, one for rest of the world activity.

It seems reasonable that only EU-facing business which is material should be subject to EU-equivalent regulations. At the same time, however, we should encourage the EU to define equivalence against outcomes required by international standards rather than through line-by-line comparisons of one another’s legislation. The UK, for instance, could commit to meeting, as a minimum, relevant regulatory standards put forward by bodies like the Basel Committee on Banking Supervision. This would help entrench work already underway towards a robust, internationally-recognised set of common banking standards. A more harmonised global approach would also help identify and deter future crises, deal with the rise of banking technology in a more orderly way and help realign banking to the needs of the everyday consumer and business.

The EU must be encouraged to view the upcoming negotiation not as a zero sum game but as an opportunity to improve existing arrangements in such a way that existing tensions can be removed, allowing the Eurozone to proceed with integration while London thrives in its natural role as a bridge to the rest of the world, offering European firms continued access to deep, liquid markets and expertise.

Meanwhile international banks need to be reassured that the UK government has a plan. Since last June, much City energy has been expended on working out how it retains current business, even though few investment banks have been making much money from their EU interests. Far less thought has been applied to determining how ideally we should like financial services to develop in the emerging international landscape. The UK government must now help progress the debate by outlining a broad direction of travel for financial services. We must use equivalence and third country recognition as the basis for a transitional solution. Then alongside the design of a non-binary regulatory system that caters to the differing needs of City businesses, we should reintroduce the requirement for our domestic regulators to consider the UK’s international competitive position – subject to protecting the taxpayer and economy from systemic risk – and implement a slate of pro-growth policies. We should also seek a parallel financial services regulatory deal as part of any trade pact with the United States.

We are living in an unfrozen moment. It is time to seize the initiative in financial services by shaping this opportunity into a system that works better for us all – remaining EU nations, international firms and the UK economy alike.