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A nation must think before it acts.
British Prime Minister Theresa May triggered the two-year countdown to Brexit—the United Kingdom’s departure from the 28-member European Union (EU)—in late March 2017. Since the June 2016 referendum, there has been a steady drum beat of analysis about the impact of the referendum’s result on economies, markets, and politics—some of it backed by hard data, some pure conjecture about what is, after all, an unprecedented event. There are myriad problems to solve over the next two years, from the status of expats to what to do about the border between Ireland and Northern Ireland. In many ways, Brexit can be seen as a backward step, a turning away from international cooperation, pulling up the symbolic drawbridge and retreating into a “Little England” mentality. It is certainly easy to outline the likely negative consequences, not least in light of the political confusion within Britain caused by the outcome of the June 8 general election. However, in one respect, Brexit might actually have a positive impact, namely in the development of capital markets in the EU-27.
Many commentators are throwing out numbers about the negative impact of Brexit on GDP growth and income across Europe. The Center for Economic Performance has concluded that every EU member will lose income after Brexit, but that the loss for the UK will be about twice the loss for the remaining 27 members combined. However, a lot depends (as ever when economics is involved) on what data you look at, as well as on what deals and Euro-fudge the politicians come up with in the coming months. Most assume that the hit will be worse for the UK than for the EU-27, given the probable loss of preferential trade access to the EU markets. Around half of the UK’s merchandise trade is with the EU; Brexit implies higher tariff and non-tariff barriers to that trade. The impact of the loss of free trade with the UK on the EU-27 is harder to quantify, but some data suggests a disproportionately high negative impact on Germany, Belgium, and Ireland. Not all EU exports to the UK will stop, of course, and the size of the hit depends on the actual terms of the Brexit deal. In the event of a “hard” Brexit, i.e., the UK leaves the single market altogether, everyone will be affected by the sharp increase in direct and indirect trade barriers (long lines of lorries waiting to clear customs at Dover; no automatic reciprocal standards recognition; etc.).
The economic effects of Brexit extend far beyond trade. What might be the impact on productivity among the EU-27 from losing free trade access to the large UK market? Without delving into the minutiae of this particular economic debate, the idea is that the more places you trade with, the higher the productivity of your exporters. So “losing” some part of trade with the UK could have long-term negative impacts on productivity across the EU. And what about foreign direct investment (FDI)? The UK is the largest recipient of FDI among the EU-28 averaging, according to UNCTAD data, $56 billion a year in 2010-2014 period, with just under half of this amount coming from EU partners. Some 72% of investors cite access to the European single market as important to the UK’s attractiveness to FDI. Will some of this cash instead go to others in the EU-27, or will it be “lost” to Europe altogether?
There will certainly be an impact on the EU budget. The accountants are still calculating the numbers, but as one of the largest contributors to the EU budget, the loss of UK membership will hurt. Either other countries will have to make up the difference (unlikely to be popular), or they will have to agree to spending cuts (politically tricky). Britain’s total contribution to the €145 billion EU budget in 2015 was €18 billion, the third-largest contribution after Germany (€24 billion) and France (€19 billion), and ahead of Italy (€14 billion). The absence of the UK’s contribution will leave a sizable gap to fill.
One of the thorniest issues to untangle, of course, will be the status of migrants. Just how this issue will unfold is anyone’s guess. Many expats from, say, Poland may have set up near-permanent homes in the UK, while those from Romania may be more intent on sending money back home for a couple of years. Again, much depends on the deal cut by the politicians, but Romania and Bulgaria will certainly see a negative hit to their migrant labor workforce. Will they go elsewhere within the EU?
There may be some winners as a result of Brexit. The relocation of a couple of EU agencies from the UK to the continent will presumably be a bit of a boost to the cities where they end up; other governments certainly think so. In late April 2017, the French government officially made its bid to house the European Banking Authority, noting that Paris hosts four of the eight largest banks in the EU-27. Frankfurt is also vying for the agency, noting it is already home to the European Central Bank (ECB), its Single Supervisory Mechanism, and the European Insurance and Occupational Pensions Authority. Many cities in the EU-27 have put in a bid to house the European Medicines Agency and its 900 scientists and European-wide medicines regulation.
Aside from all these potential boons, however, there is one area in which the British voters may inadvertently have given a long-term boost to the rest of the EU: the development of capital markets across the Union. Here, there are three particular issues to consider: the revival of the Capital Markets Union project; the potential shift of banking operations out of London; and the possible relocation of euro clearing.
The Capital Markets Union (CMU) is a European Commission project to create deeper and more integrated capital markets across the EU. Launched two years ago as part of the Commission’s Investment Plan for Europe, the project is intended to give companies access to more sources of finance at a lower cost, and ultimately to make the financial system more resilient. In particular, the CMU aims to give businesses access to sources of funding beyond the traditional continental reliance on bank loans. This reliance has been problematic for the EU’s banks, leaving them not only heavily exposed to the health of regional business, but also at risk of policy lending impacting their portfolios. It has certainly been a financing constraint for many companies. The CMU would also lessen dependence on London’s capital markets—a hitherto unspoken aim of the project that is now becoming more overt.
The CMU project had begun to flag before last year’s referendum. However, on May 17, 2017, Reuters reported on a Commission draft document on CMU that mentioned talks of updating the project and noted that London has traditionally pooled liquidity and provided risk management services for the rest of the EU. The draft concludes that Brexit means that a “deep re-engineering” of the financial system is necessary. On June 8, 2017, the Commission duly announced that the CMU would be “rebooted” and vowed to create “an integrated capital market in the European Union by 2019.” The next step may come in the third quarter of 2017 when the Commission is expected to propose ways to strengthen the powers of the EU’s European Securities and Markets Authority (something Britain had long opposed) in order to make CMU more effective.
Whatever the final details of the proposals for CMU, it is rapidly becoming clear that the Commission is not likely to accommodate Prime Minister May’s vision of negotiating a trade agreement that includes financial services. Instead, the Commission appears intent on using the disruption of Brexit to galvanize the CMU.
It is also likely that Brexit will lead many of the large financial institutions currently based in London to shift some portion of their operations to locations within the EU, such as Frankfurt, Dublin, Paris, or the Netherlands, in order to ensure they retain access to the single market. Just how significant the total move of personnel might be, and how much the move will boost the receiving cities, remains to be seen. Some news headlines have claimed the large global banks are planning to move about 9,000 jobs within the next two years, but estimates of total finance-related job losses vary from 4,000 to 232,000. Some 13 institutions have so far stated publicly that they plan to bulk up their European operations, with Frankfurt and Dublin as the front runners. For now, it seems that the largest banks are taking a two-step approach, starting with some initial relocations to make sure all the licenses, technology, and infrastructure are in place to accommodate what could be a more sizable move in a year or two. A JPMorgan Chase spokesperson said that the bank plans to relocate “hundreds” of London employees to its offices in Dublin, Frankfurt, and Luxembourg: “We are going to use the three banks we already have in Europe as the anchor for our operations. . . . [We] will have to move hundreds of people in the short term to be ready for Day One . . . and then we will look at the longer-term numbers.”
Just how many staff end up moving depends on the details of the Brexit negotiations. The heart of the issue is the concept of “passporting.” With an EU passport, a bank can operate throughout the Union, but be regulated by just one country. Without passporting rights, a London-based branch loses the right to operate in the EU—hence the scramble to set preliminary operations elsewhere ahead of Brexit. A related issue is whether the Bank of England (BoE) will demand that European banks convert their branches into subsidiaries. To date, the BoE has allowed the European banks to operate in the UK as branches, which requires lower capital requirements than full subsidiaries and can be regulated by their home authorities. But the BoE has recently warned the banks to be ready to set up full subsidiaries and to submit to BoE regulation, if the Brexit negotiations do not allow some form of reciprocity to be maintained. BoE Governor Carney has called for the UK and EU to make a deal to recognize each other’s rules post-Brexit, to at least maintain some form of reciprocity even if full passporting does not happen. But this form of reciprocal regulation has never before been agreed on such a large scale.
The BoE is most concerned about large investment banking operations, which carry a lot of risk and large balance sheets. It’s not just the American banks that are looking to move to maintain access to the EU market; several European banks base the bulk of their investment banking activities, such as sales and trading, in London. Without reciprocity, the UK’s Prudential Regulatory Authority would become the overseer of, say, Deutsche Bank London post-Brexit, and as a subsidiary, the institution would be required to boost its capital significantly in order to support its business in the UK. The loss of reciprocity and the requirement to convert branches to subsidiaries could mean some €40 billion in extra capital would have to be raised across the big EU banks. It’s not surprising, therefore, that many banks reportedly are privately warning that this development would hasten their exit from London. The BoE has given financial institutions until July 14, 2017 to set out their post-Brexit plans. Many are likely to assume the worst and plan for more large-scale moves, not wanting to suddenly be wrong-footed if reciprocity does not happen. And once such a plan is committed to paper, it is much more likely to be implemented.
While a loss of 9,000 jobs would only represent about 2% of the employment in London’s financial sector, the shift of operations to, say, Frankfurt, is likely to develop momentum over time. The German authorities, along with their Irish, French, and Dutch counterparts, are already quietly, yet actively, courting the big banks. Before we look at what such a move might mean for the cities that “win” London’s global financial business, there is one more issue to consider: the concept of clearing.
The G20 has made it mandatory to settle most simple derivatives trades through clearing houses, and London dominates the clearing industry. LCH, the clearing house that is owned by the London Stock Exchange, clears over 50% of all interest-rate swaps across all currencies; around 75% of those in euros are cleared in London. The city currently clears €927 billion worth of euro-denominated transactions each day. The ECB tried previously to force euro-denominated clearing to move out of London; it lost the 2015 court case. But Brexit will likely revive its determination to gain direct control over euro-denominated clearing.
A study by consultancy firm EY (formerly Ernst & Young), commissioned by the London Stock Exchange and published in November 2016, warned that if clearing were forced out of London, 83,000 British jobs could be lost and a further 232,000 affected. London is pushing for “equivalency” whereby European firms would be able to use clearing houses in countries that the European Securities and Markets Authority deems to have equivalent regulations, as it already does with America. Clearing houses require collateral from the counterparties using them, and so are subject to close supervision wherever they operate. Hence, the European Commission is arguing that the systemic importance of the British clearing houses for the euro area may require new and stricter oversight—either supervision by EU regulators or forced relocation. The latter is apparently gaining support among EU policymakers, who could force European banks to use EU-based clearing houses.
On May 4, 2017, the Commission announced that it is looking into new rules for euro-denominated clearing, including the relocation of services away from London. LCH maintains that Brexit should have little impact; after all, the U.S. is fine with the fact that almost all dollar interest rate swaps are cleared in London, so why should the EU insist on relocation? UK Chancellor Philip Hammond has taken the stance that leaving clearing in London benefits everyone and that forcing a move would be disruptive.
At the EU level, however, even such apparently technical decisions carry an overlay of political considerations—and an acrimonious “hard” Brexit will increase the likelihood of a forced relocation in clearing. Such a move may not seem like a big deal in and of itself, but money tends to pool where the services are based, and the clearing industry has become the heart of the global financial services sector in London.
If the loss of passporting rights, the need to capitalize subsidiaries, and/or the forced relocation of euro clearing business lead to more financial sector operations moving from London to elsewhere in the EU, how much might the EU-27 benefit? To answer this question, taking a look at Britain’s own recent experience will provide some clues.
October 1986 saw the launch of a series of financial market reforms in Britain, known as the Big Bang. A sweeping set of changes deregulated the City of London, leading to significant structural changes in the UK’s financial markets and turning London into a financial capital to rival New York. In particular, the change from traditional face-to-face share dealing to electronic trading helped London to outpace its European competitors and become a magnet for international banks. On October 27, 1986, an advertisement in the Financial Times promised a new financial centre, three miles to the east of the City at Canary Wharf, which would “feel like Venice and work like New York.” Although forced into bankruptcy in 1992 as it struggled to find tenants, from the late 1990s, development in Canary Wharf took off. Across the financial services sector, particularly that segment based around international finance, profits, salaries, and bonuses boomed.
Today, the services sector as a whole is the powerhouse of the UK economy, accounting for almost 80% of GDP. According to a recent government research paper, in 2016, financial and insurance services contributed £124.2 billion in gross value added (GVA) to the UK economy, accounting for 7.2% of the UK’s total GVA. London accounted for 51% of the total financial and insurance sector GVA in the UK in 2015. Across the entire country, there are over one million jobs in the financial and insurance sector (3.1% of all UK jobs). The UK had a surplus of over £60 billion on trade in the financial and insurance sectors in 2016. Finally, in fiscal year 2015-16, the banking sector alone contributed £24.4 billion to UK tax receipts in corporation tax, income tax, national insurance, and through the bank levy.
London had been a vibrant international city before 1986, and financial services were already a growing segment of the economy—but there is little doubt that the push to attract international financial services has been a major boost to the economy and in particular to the now-thriving area of Canary Wharf. In this area to the east of the traditional City, global banks have their European headquarters in gleaming high rise towers; a massive underground shopping mall caters to workers and visitors alike; and the staff that spill out into the area’s bars and restaurants every evening hail from all corners of the EU, indeed of the globe. Ten or fifteen years from now, will Frankfurt—or Dublin, or Amsterdam—be home to the new Canary Wharf?
As former British PM Harold Wilson purportedly said in 1964, “a week is a long time in politics.” This statement is particularly apt for the European Union, where (for now) 28 countries each have their own domestic political priorities and timetables. Nevertheless, at the time of writing, it is notable how unified the EU-27 are over one issue: they are all singularly annoyed at the UK. How long that unity lasts once Brexit negotiations get to the nitty gritty of details remains to be seen, and a new round of uncertainty has been added to the negotiating process thanks to Britain’s June 8 general election. Rather than boosting the number of seats that her Conservative Party holds in the House of Commons, PM May’s decision to call an election unexpectedly led to fewer seats, resulting in a hung parliament (i.e., no single party commands a majority of the House). Such self-inflicted confusion is unlikely to engender much lasting sympathy from the rest of Europe, adding to Britain’s political and diplomatic isolation going forward. With almost all of the EU-27 guaranteed to lose out in some way from Brexit, it would not be a surprise if the 27 stay unified in their desire to rake the UK over the coals.
Meanwhile, a new mood of Europhilia seems to be building across the continent in something of a backlash to the wave of nationalism that marked the Brexit vote. Overtly pro-European politicians have seen success in Austria, the Netherlands, and most notably, in France. Recently elected French President Emmanuel Macron, a former banker, is actively courting the finance and technology industries to France, wooing French expats, British-based banks, and American scientists as he looks to reform the French economy and give the Euro-project a major shot of adrenaline. His energy is helping to cement the narrative of a forward-looking EU with Brexit as an annoying detail. This wave of euphoria dovetails nicely with the approach of Commission President Jean-Claude Juncker who seems, along with his chief of staff Martin Selmayr, to be trying to build a consensus view on the continent that Brexit is first and foremost a British problem and less of a worry for Berlin, Lisbon, or Tallinn.
Macron has outlined an ambitious agenda for EU reform: he wants intra-Eurozone transfers and investment; funds from a common budget, administered by a beefed-up parliament; and new institutions like a finance ministry. His party, La République En Marche (Republic on the Move), now dominates the 577 seat National Assembly with a very firm majority of 350 seats following elections in June 2017. If the newly elected Deputies can maintain party cohesion, Macron could make progress on his reformist agenda at home, and at the EU level, although low voter turnout in the parliamentary elections may undermine his ability to claim a mandate for reform.
Above all, Macron’s European vision will depend on support from the other EU powerhouse, Germany, where Chancellor Angela Merkel looks set to claim another victory in the upcoming general election in September 2017. Her center-right political supporters would likely baulk at ambitious proposals for fiscal transfers within the Eurozone, and some of the EU-27—particularly in Eastern Europe—may not be thrilled at the return of a Union dominated by the Franco-German “engine.” However, after over a decade in power, Merkel may be looking to cement what will likely be her final term in office with some overtly pro-EU reforms.
So, how might all this play out? If President Macron can keep his new government together; if Chancellor Merkel wins one final mandate; if the CMU is revived at the same time that major financial institutions and their investment capital start to relocate to the Union; and if the narrative of a chaotic and suffering Britain against a unified and forward-looking EU is maintained—then we may indeed be seeing the advent of a Europe resurgent. That’s a lot of ifs; but even without political momentum from France and Germany, or with a “soft” Brexit that maintains much of the UK’s preferential trade access, the EU is likely moving toward a new era of capital markets development, with positive implications not just for financial services, but for the Union’s economy as a whole.
 Center for Economic Performance, Brexit Analysis No. 2, https://cep.lse.ac.uk (March 2016)
 House of Commons, Financial Services: Contribution to the UK Economy, Briefing paper number 6193 (31 March 2017)