Nicolas Véron

Brexit and Finance: Brace for No Impact

This text was published last week by Milan-based think tank ISPI on the occasion of its Forum on Multilateralism. 

Updates: the same text was just republished by Bruegel (October 14) and by PIIE (Oct. 15). 

Amid the daily high drama of Brexit, it is easy to lose track of the structural shifts, or lack thereof, that may be associated with the UK’s possible departure from the European Union. One of them, and not the least, is the potential impact on the European and global financial system. London is currently the undisputed financial hub of Europe of the broader region encompassing the Middle East and Africa; together with New York, it is one of the two still-leading financial centers worldwide, despite the ongoing rise of Asia and especially China. How does an event as momentous as Brexit interfere with this critical regional and global role of the United Kingdom?

The answer so far is: not much, and looking forward, probably not much more. Massive as the political shock of Brexit is, the European and global financial systems are intriguingly resilient to it.

To understand why, it is necessary to go beyond the in/out dichotomy that dominates the Brexit debate, and to understand at a more granular level what changes or doesn’t at different points of the different scenarios. Seen through the lens of the financial sector, the complex arborescence of possible UK futures boils down to two relatively simple observations.

First, the really decisive choice for the UK, from a financial-sector standpoint, is not whether or not to leave the European Union, but whether or not to leave its Internal (or single) market. The single market is closely associated with the EU construct and is defined by compliance by EU law, but its boundaries are broader than the Union’s. For example, Norway is in the single market without being an EU member state, and the same would be true of the UK during the transition period defined by the Withdrawal Agreement endorsed almost a year ago by Theresa May’s government. While being or not in the Union makes a major difference for UK officials who will no longer sit at the EU policymaking table if the UK leaves, it makes little differences to financial firms as long as single market membership is preserved, with the regulatory “passports” that come with it. So far, beyond responding to specific requests from supervisory authorities, most financial firms have appear to act on the baseline assumption that the UK is staying in the single market over their business planning horizon, and have correspondingly not made major changes to their operations even as they have sought new licenses to operate in the European Union outside of the UK.

Second, leaving the European single market would be severely detrimental to the UK as a regional and global financial hub. The loss of passporting rights would mean, to summarize a complex arrays of different situations, that the UK will no longer be the best place in its time zone to conduct financial business. In the benchmarking with the best competing locations within the post-Brexit European Union, the comparative advantages of the UK, significant as they are in matters such as language, culture, and the legal environment, would not be enough to offset the disadvantage of not being in the single market. As a consequence, new investment would be overwhelmingly directed elsewhere than to the UK, and there would most likely also be some direct transfers of activity from London to other European locations – in contrast to what has happened so far.

As a consequence, it appears highly likely that the UK will remain in the single market, even if it ends up leaving the European Union. The 2016 referendum was about leaving the EU, not the single market. Leaving the single market is too much pain for too little gain. And if the UK stays in the single market, its financial sector can and probably will keep its leading position regionally and globally.

If however, by an improbable twist of political dynamics, the UK does leave the European single market – a “hard Brexit” as the expression tends to be used – then the consequences may be dire for the UK, but will not be disruptive from a European let alone global perspective. Summarizing again a lot, this is because the core of the City of London is a set of firms that are not structurally dependent on the UK: most are international arms of firms headquartered in the United States, or in Asia, or indeed in Continental Europe. For these firms, if London loses its edge, relocating elsewhere will be annoying and costly but by no means impossible. And one can be confident that European and other authorities will do what is needed to facilitate an orderly transition, because they have no interest in financial instability.

There are a number of challenges in today’s world which could turn out to be transformative for the global financial system. Brexit is not one of them.

Questions on financial services policy for Valdis Dombrovskis

This blog post was published on Monday by Bruegel, ahead of the European Parliament's hearing of Executive Vice-President-designate of the European Commission Valdis Dombrovskis scheduled for October 8. 

Update (october 7): a near identical version was published by the Peterson Institute. 

Completing the banking union is the dominant task in the financial services area for the next five years. In the short term, the Commission should affirm its leadership by pushing for the creation of a credible EU anti-money laundering supervisory agency.

Mr Dombrovskis’s designated portfolio as “Executive Vice-President for an economy that works for people” covers a wide array of issues, including economic and monetary affairs and trade which are covered in separate blog posts in this series, as well as jobs and cohesion policies. Nevertheless, the allocation of supporting services gives him direct and sole authority over DG FISMA (the European Commission’s Directorate-General for Financial Services, Financial Services and Capital Markets Union), and his mission letter from President-elect Ursula von der Leyen confirms that this area has a special status within his portfolio.

This post, echoing the memo on the same scope that was recently published by Bruegel, is thus focused on financial services policy. In this area, Mr Dombrovskis can hit the ground running, as he took it over from Commissioner Jonathan Hill in 2016 following the latter’s resignation.

As the memo makes clear, the reform agenda is dominated by the unfinished banking union, whose completion is highlighted by Ms von der Leyen both in her political guidelines and in Mr Dombrovskis’s mission letter. Mr Dombrovskis should not aim at upgrading the current halfway house of banking union to an incrementally better halfway house, but at genuinely finishing the job – i.e. breaking the notorious vicious circle between banks and sovereigns, which in 2011-2012 has been correctly identified by policymakers as the true engine of the euro crisis. This is a difficult task that will require a lot of dedication: if it is not granted clear priority, it will fail. Fortunately, it is far from impossible: completing the banking union (which means not eliminating all structural differences among member states in terms of banking services, but only decorrelating banking credit from sovereign credit) can be achieving without treaty change, and without any major steps towards fiscal union.

In comparison, the “capital markets union” (CMU) is a valuable vision, but should not be a diversion from the main task of banking union. A true CMU can only be viewed as a very long-term project, and cannot really start as long as banking union remains unfinished.

An exception to this order of priorities, however, could and should be made for the fight against money laundering, given the issue’s recent salience and its resonance with Ms von der Leyen’s ambition of a “geopolitical Commission”. This makes a strong case for an early initiative. Thus the following questions.

1. Will you create a credible EU Anti-Money Laundering (AML) supervisory capability?

The current AML supervisory system in the EU is failing for structural reasons, as the Commission’s own analysis has compellingly established. The time is not for another incremental attempt at tweaking the existing system, as was done a year ago, but at a structural solution. The priority is the architecture for AML supervision, namely making sure that banks and other obliged entities have the right systems in place and operate them properly. The creation of a European AML Supervisory Authority is the simplest and most compelling answer to this challenge and should be undertaken without delay.

2. What is your strategy to complete the banking union?

Even as the Juncker Commission has not achieved major legislative steps towards a more complete banking union, there has been progress in the past five years. The initial banking union package of Single Supervisory Mechanism (SSM) and Single Resolution Mechanism (SRM) has entered into force, with early successes and failures that help to better identify the missing bits. There has also been a lot of debate that has brought further analytical clarity. The agenda can thus be distilled around three sub-questions.

2.1 How will you address the challenge of concentrated sovereign exposures?

The home bias in banks’ sovereign exposures is a well-known problem, but in recent years there has been a reluctance to tackle it head-on as the euro-area-specific challenge it is. If “domestic” banks can still be persuaded by governments to grant them preferential credit, there can be no political consensus on further euro-area-wide risk-sharing. To lift this roadblock, the Commission may consider the introduction of sovereign concentration charges. By specifically targeting sovereign concentration risk, these address the bank-sovereign vicious circle while avoiding the difficulties associated with an explicit regulatory recognition of sovereign credit risk, an issue that unlike the home bias is not specific to the euro area.

2.2 How will you build a credible European-level safety net, so that national public guarantees on banks can be effectively dismantled?

One lesson of the Great Financial Crisis is the necessity of a public safety net for the banking system. This should be kept to the minimum necessary, and set the right incentives. For the banking union to be completed, it needs to exist at the European (essentially, euro-area) level. That entails a genuine European Deposit Insurance Scheme – i.e. one that does not in any way make the insurance of deposits up to €100,000 conditional on national decisions – but also instruments to manage systemic crises, such as liquidity guarantees for sound banks. Correspondingly, the regime for non-viable banks, which includes the resolution framework but also national bank insolvency proceedings and the state aid control regime, must be reformed holistically to become more consistent and predictable.

2.3 How does the reformed framework remove the current disincentives against cross-border banking integration?

The persistence of a national mandate for deposit insurance and bank crisis management is the key reason why banks are prevented by regulators from adopting a seamless banking-union-wide management of their capital and liquidity.

3. Will you reform the governance and funding of ESMA?

The European Securities and Markets Authority (ESMA) is positioned to become the catalyst of CMU, but it was not initially designed to be a credible supervisor of financial markets and entities such as financial infrastructures, a role it is playing increasingly and should play even more in the future. Building on the experiences of the SSM and SRM, its governance and funding must be comprehensively reformed so that it becomes a genuine independent agency to oversee Europe’s capital markets. By contrast, reforms of the sister agencies EBA (European Banking Authority) and EIOPA (European Insurance and Occupational Pensions Authority) are less urgent.

4. Will you honour the EU’s commitments to global financial standards?

In line with the vision of the “geopolitical commission”, the EU should bolster its leadership as the “guardian of multilateralism”, again quoting from Ms von der Leyen. It should fully adopt the Basel accord on banking regulation, including its latest developments, and phase out the remaining “carve-outs” from its adoption of International Financial Reporting Standards. It should also streamline its representation in international bodies such as the Financial Stability Board and the Basel Committee, reflecting the institutional changes generated by the pooling of bank supervisory policymaking within the SSM.