The Spectre of Brexit Haunts London’s Financial Sector

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The potential of Brexit risks dealing a critical blow to London’s financial sector. In the worst-case scenario, the loss of passporting rights could trigger an exodus towards Paris or Frankfurt from which the City will never recover.

The spectre of Brexit looms gravely over Britain’s financial sector. London’s access to the EU’s single market is a cornerstone of its claim to the title of financial capital of the world. Without it, its financial sector could shrivel to a shadow of its former self. In written testimony to the English Parliament, Goldman Sachs International wrote

New York and London are pre-eminent financial centres because they sit within two of the largest financial markets in the world, the United States and Europe.

New York City can afford to focus its gaze inwards. The City of London, on the other hand, can hardly afford to damage its access to the single market.

The Financial World Fears the Consequences of Loss of EU Membership

A firm established in any European Economic Area (EEA) country can offer cross-border services or open branches in other EEA economy. ‘Passporting’ is the term used to describe the exercise of these rights. Given the size of the EU’s financial market, the right to passport out of London contributes greatly to its appeal as a global financial center.

If Britain was to leave the EU, some analysts predict financial firms located in Britain would lose their right to the passport. An important fall in financial exports would invariably ensue. The EU accounts for 41% of Britain’s exports of financial services. In 2013, this amounted to £19.4bn (imports were £3.3bn). Capital Economics estimates that in the short-run these could fall by as much as £10bn, or roughly half.

If one considers the risk that banks move all their international operations inside the EU, it is the UK’s near-£60bn surplus in financial exports that is at stake. This risk is not benign: according to a survey by CityUK, 37% of financial service companies say they are likely to relocate staff if the UK were to leave the EU.

Source: Office for National Statistics, HM Treasury annual report 2015
Source: Office for National Statistics, HM Treasury annual report 2015

Gauging the Long-Term Impacts of Brexit

To forecast the long-term impact of Brexit, one first has to predict what agreement the EU and Britain might come to. Norway and Switzerland are indicative of what this could look like. Neither is an EU member, but both enjoy special relationships with the EU.

As a member of the European Economic Area (EEA), Norway enjoys unfettered access to the single market, including full passporting rights. However, by belonging to the EEA but not the EU, it is subject to EU regulations but has no formal influence over them. Since the main impetus behind Brexit is the prospect of recovering British sovereignty from Brussels, this scenario is highly unlikely.

Switzerland enjoys access to the single market via a number of bilateral agreements. It is not a member of the EEA, and as such does not have passporting rights. That is why most large Swiss banks manage their European businesses out of London-based subsidiaries. It is not clear how much presence they would maintain if London ceased being an entry point for EU markets.

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Whatever status it chooses to aim for, Britain will find itself in a weak bargaining position upon leaving the EU. At least in terms of financial service exports, the current relationship is heavily tilted in Britain’s favour, implying the EU has no desire to maintain the status quo. The EU will also be trying to establish a discouraging precedent, at least in areas where reciprocity would hurt least.

A report by Open Europe considers finance the major export industry that is least likely to retain its access to the single market following Brexit. To make matters worse still, the European Union is already in the process of erecting further barriers for non-EU members. The new “Markets in Financial Instruments Directive II” is set to be implemented in January 2017.

Source: Open Europe
Source: Open Europe

The presence of Swiss banks lining the shores of the Thames is indicative of the value of passporting rights. Of course, London’s competitive advantage is not limited to its access to the single market. Some of its natural strengths are near-inviolable. These include English as the national language and a convenient time zone.

Nonetheless, its appeal is vulnerable. It is an attractive place to do business in large part because it possesses a deep pool of talent and a critical mass of auxiliary services, including law and accountancy. In finance, these external economies of scale matter.

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If Brexit squeezes Swiss, American and Asian banks out of London and into Paris or Frankfurt, the ensuing loss of support services and local talent could push other institutions to relocate their operations to those cities. Such a doomsday scenario is unlikely; moving headquarters is costly stuff. Still, one is forced to question whether Brexit is worth taking that risk.

Is There a Silver Lining?

Some have been quick to state that Brexit may not be all bad for Britain’s financial sector and that leaving the EU could, in fact, be good for the industry in the long-run.

Freed from the shackles of the EU, Britain would be able to strike commercial deals with other countries, most notably China. This could be valuable, given that exports to China and Hong Kong accounted for only 2% of the whole in 2013. Being forced to look outwards could shake the City into a meaningful pivot to Asia. The 2014 opening of a London Renminbi clearinghouse, however, indicates this may already be taking place.

Source: Woodford Investment Management
Source: Woodford Investment Management

Leaving the EU would also give Britain more control over its borders. With the ability to be more selective, Britain could attract more skilled workers, thereby increasing the size of the talent pool valued by the financial sector.

The loss of passporting rights for financial service firms represents one of the largest costs of Brexit. In addition to shrinking the trade surplus in financial services Britain currently enjoys, it could lead to the departure of a number of banks from London.

Because finance is an industry with strong external economies of scale, one low-probability scenario is that this will trigger an exodus from which London’s financial sector never recovers. On the other hand, the upsides are that Britain would be free to direct its attention to the East without needing to defer to EU bodies and that it could increase the size of its financial talent pool through stronger control of its immigration flows.

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