For the City of London membership of the European Union is a double-edged sword. Here the Bruges Group explains how this important industry can thrive after Britain leaves the EU.
30th November 2016
Coming with EU membership is, for what it is worth, full access to the single market in services. Whilst this market is far from complete; being part of it, also known as the European Economic Area, is one of the ways Britain can have full unencumbered and automatic access for the sale of services into the EU. This right, that does not require setting up a subsidiary in the EEA nor the need to gain authorisation from each single market state, is known as passporting.
The ability of British based financial institutions to trade with countries on the continent is clearly a great benefit to the economy. At the same time, the EU’s reticence at making trade agreements, an exclusive EU competence, with emerging markets around the world that include access to their services markets is holding the UK back. EU membership has meant that Britain could not make agreements that allowed our great strength, the services industry, to fully engage with other markets around the world. Instead of looking at the enormous opportunities that Brexit presents, the debate so far has focused on the risks of losing access to the EU’s single market.
Prior to the Brexit referendum, the government sought to claim that the EU’s services market could of particular benefit to the British economy. The government argued that if the EU completes the Single Market in services – opening-up all member states to competition – the UK’s economic output could be boosted by as much as 7%.[i] The completion of the single market in services always was a very big if. Indeed, it is illusory. Many EU states have still have not properly implemented the EU’s services directive and are unlikely to do so. Keeping in place restrictive practices and barriers to entry.
That said, the services industry is still an especially important part of the UK’s economic links with the EU. In 2011 the UK's trade in goods with the EU was in deficit by around £43 billion; however, trade in services was in surplus by £16 billion. This reduced the overall deficit to approximately £28 billion.[ii]
The UK’s entire financial services sector, which supports the resulting and even larger international business services, is however threatened by the UK’s membership of the EU. These businesses sell their services much further afield than the continent, yet inside the European Union they will still be subject to the whims of EU laws proposed by the Commission and agreed by qualified majority vote without the UK having a veto.
EU regulators, the European Banking Authority, the European Insurance and Occupational Pensions Authority and the European Securities Authority have been established to regulate the industry across the EU. Some in the EU do not look kindly upon this very Anglo-Saxon industry. Under the European Systemic Risk Council and the European System of Financial Supervisors control, enforcing the writ of the European Commission, the City of London may have faced its biggest test. These new bodies have the power to close a financial institution. The EU bureaucracy has already began interfering in UK financial affairs.
Research by the economist Professor Tim Congdon CBE has concluded that this threatens the UK’s position as a world leader in international business services. These businesses are highly mobile and can easily relocate to more welcoming climates; taking their tax revenue and employment with them.
Research published by the Bruges Group found that ‘in the fourth quarter of 2013 business services accounted for 1,517,000 jobs in London, which was 28% of all London employment. (Their proportion in UK employment as a whole was 15.7%.)
‘These businesses are based primarily in or around the capital. London-based international business services (i.e., both financial and non- financial services) employ about 5% of the UK’s working population and produce perhaps 8% - 10% of its national output, with most of that output exported. Continued growth of these activities at above the growth rate of output as a whole would be positive for the UK’s average living standards.’
Since the 1960s financial services in Britain enjoyed stellar growth. It was the most dynamic part of the British economy. This has now ended, and Professor Congdon sees EU interference as being partly to blame. He argues that the EU’s regulatory structure is less efficient than Britain’s previous national system and the EU’s rules are in effect anti-growth. The 40 years of rapid expansion is now at an end, with some responsibility resting with the EU.
If Britain is to remain a prosperous nation, the UK must follow a path that will both protect businesses from the harmful effects of EU regulators whilst preserving full access to the EU’s single market. What can be done to achieve this?
There is the example of the Swiss, like Britain they have a strong financial services industry. Although they have a series of free trade agreements in goods these do not cover the export of services.
Swiss-based companies do not have the right to sell their services to the EU unless they establish a subsidiary inside the European Economic Area. This is not an insurmountable problem but should be avoided. Multi-national companies, by definition, can and do establish themselves in different jurisdictions. However, small and medium-sized enterprises will find creating subsidiaries burdensome. Restricting opportunities to tap into the EU’s internal market.
The Swiss experience is that rules that would deprive British financial service firms from operating inside the remaining EEA can be sidestepped. A Swiss report found that 'Though extremely cumbersome this does give them full access to the EU market.'[iii] However, if the subsidiaries are based in the EU they will be subject to the same heavy handed bureaucracies.
The UK can leave the EU, freeing businesses from the European Commission’s quangos, and keep full access to the Single Market. This can be achieved by Britain rejoining the successful and non-authoritarian European Free Trade Association (EFTA) and thus remain a member of the European Economic Area (EEA), also known as the Single Market.
Aligning the UK with EFTA will at a stroke free Britain’s financial services industry from control by: -
- The EBA (European Banking Authority)
- European Insurance and Occupational Pensions Authority
- European Systemic Risk Board
- European Securities and Markets Authority (ESMA)
- Community Programme for Financial Reporting and Auditing
EFTA/EEA nations not only enjoy freedom from EU financial oversight, they also have the benefit of being able to run their economies as they see fit. They are free from EU debt risks and are not subject to European Union tax law, an area which the EU law is steadily expanding into. The City of London will also free from an EU Financial Transaction Tax. As a member of EFTA, Britain will also be able to veto the regulations that threaten pay within the financial services sector, such as; ‘Recommendation on remuneration the financial sector 32009H0384’.
Remaining in the single market, popular with the City and many that in the referendum supported remain, is becoming increasingly unpalatable to many leavers; even people at the top of the British government which once lauded the single market. The Lichtenstein model, one of restricting immigration whilst having full access to the single market, first outlined by the Bruges Group in 2013 has not settled the matter.
There is however a new hope. This is driven by mutual self interest.
According to Mark Carney, the Governor of the Bank of England;
“Banks located in the UK supply over half of debt and equity issuance by continental firms, and account for over three-quarters of foreign exchange and derivatives activity in the EU.”[iv]
Quite clearly, businesses in the EU need the City of London. However, despite this powerful incentive for the EU to keep in place Britain’s passporting rights there are still procedures that must be followed. It could be granted through the withdrawal agreement that would in theory emerge from the Article 50 negotiations. That is presuming that any agreement does not become regarded as one that needs the approval of all EU member states Parliaments, as an Association Agreement would so require.
There are still ways to resolve this issue. If the UK follows the same regulatory framework as businesses in the EU, then the European Commission can grant what is known as equivalence. This should not be too difficult for the UK. Presently, Britain follows the same regulations as the rest of the EU. What is more, according to a report by the House of Lords the UK would have implemented 41 of 42 EU financial services regulations even if Britain was not an EU member. The exception was the Alternative Investment Fund Managers Directive (AIFMD). This is not surprising, the genesis of many of these rules comes from global bodies. For instance, the WTO, OECD, IMF, the Bank if International Settlements, and the Financial Stability Board. Indeed, Mark Carney is the Chairman of this body and guides the development if its regulations. Through his international role, the Governor of the Bank of England, has been developing global rules on financial services, putting Britain firmly at the top table.
The EU rules that can grant financial firms based in the UK access derive from Article 46(1) of the The Markets in Financial Instruments (MiFIR). It grants non-EEA based firms the right to provide investment services in the single market without the need to establish a subsidiary in the EEA and without the provider being under the control of an EU member states national regulator.
To have this special passport, according to DLA Piper, there are a number of requirements:
(i) the firm is authorised in its home country and subject to supervision and enforcement by the relevant regulator (eg by the Financial Conduct Authority)
(ii) a positive equivalence determination from the European Securities and Markets Authority (ESMA) that the legal and supervisory arrangement of the third country have equivalent effect to the prudential and business conduct requirements under MiFID II
(iii) cooperation arrangements between ESMA and the third country authority specifying the exchange of information mechanism, the prompting notification for breaches and the coordination of supervisory activities, and
(iv) registration with ESMA (which is dependent on the above having occurred).[v]
Access for non-EEA alternative investment fund managers is also granted by Article 35, 39 to 41 of the AIFM directive; as long as they are operating under an equivalent jurisdiction. This again is subject to the ESMA.
This route may however prove to be a lengthy process, requiring registration and there is no guarantee that the politics of Europe will be easily obliging to a post-Brexit Britain.
There is however another way that the City’s interests can be protected. The World Trade Organisation, through its General Agreement on Trade in Services,[vi] is seeking to create international agreements that will dramatically open-up access to service industries.[vii] [viii] What is more, the EU is fully engaged with these negotiations. In time, an independent UK should be able to take advantage of WTO proposals for a streamlined “single window” through which businesses can trade their services across national boundaries.
The City of London brings capital to this country financing wealth creation as well as pubic services throughout the land. It attracts skills and other business supporting the wider British economy. Yet, the EU restricts the opportunities open to the City. At the same time, leaving does present challenges. The solutions, however, just like the opportunities, are global.
The UK’s financial services industry has a global role and should not be hemmed into little declining Europe. The City of London should not be afraid to make the switch. Not only do great prospects await it, there is the real likelihood that Britain’s financial services industry will, through the many routes open to it, be able to keep its access to the EU’s single market.
[i] Department for Business Innovation and Skills, BIS Economics Paper No. 11, The economic consequences for the UK and the EU of completing the Single Market, February 2011, page vi
[iii] Centre for Swiss Politics, University of Kent, Switzerland’s Approach to EU Engagement: A Financial Services Perspective, City of London, April 2013, page 4