Time has moved on since the Brexit Referendum on 23rd June 2016 and since Article 50 was invoked on 29th March 2017. The UK will leave the EU in March 2019. It will then enter a transition period, lasting until January 2021. In that period, the UK will continue to be a member of the Single Market and the Customs Union and will continue to abide by the judgements of the European Court of Justice (ECJ).
This much is known. But little else is: enormous uncertainty surrounds the UK’s trading and economic relationships with the EU - its most important trade partner, accounting for 43% of the UK’s trade in goods and services.
This uncertainty is especially marked in the case of financial services. This matters for several reasons. It matters because of the importance of financial services for the UK economy. Financial services account for close to 7% of the UK’s GDP and generates £70bn tax revenue per year, around 11% of total revenue. This is around half of the annual spending on the NHS.
It also matters because of the strategic role of financial services in the UK. Since the “Big Bang” reform of UK financial services in 1986, the City of London has become one of the most dynamic and productive parts of the UK economy. It has achieved this in effect by moving away from the national market; it now operates in a pan-European and global environment.
And finally, it matters because financial services are mobile and footloose. It is quite easy for major institutions to move some of their operations out of the UK and into a Eurozone country, safe under the regulatory umbrellas of the EU and the European Central Bank.
What happens next? This has been left to the negotiations between the UK and the EU that will dominate the next few years, if not longer.
As things stand, there are four options. These have been usefully summarised by the Institute for Government. All four options have difficulties and issues.
First, and closest to current arrangements, is the “passport” whereby states agree a set of common standards on supervision and regulation; with this, financial and other firms based in the UK can trade freely within members of the EU and European Economic Area (EEA). However, this business as usual arrangement is only possible if the UK stays within the Single Market or becomes a member of the EEA. This has been ruled out by the UK Government and the Chancellor has stated that the UK is not seeking to retain the passport post-departure. That said, the current negotiations have been characterised by the UK Government staking out fixed positions, from which it then retreats when put under pressure from the EU side. So, looking through the rhetoric, this option should not yet be discounted. Currently, the option of the UK remaining in the Customs Union is being floated, not least because it offers a possible solution to the problem of the Irish border. Customs Union membership would not be sufficient for retaining the passport.
Second, at the other extreme, is the option of trading under World Trade Organistion (WTO) rules. The outcome here is less clear, but cross-border trade in financial services could well become significantly more difficult and expensive. This option would imply stricter regulatory requirements on the EU branches of UK banks, and both the UK and the EU would be able to impose further restrictions to promote financial stability. Although the details are unclear, this is very much the worst case scenario.
Third, between these extremes is the option of “equivalence”. In this the EU can agree that that the laws and regulations relating to financial services in a “third country” (which is what the UK will become post-Brexit) if it “deems these to have the same intent and produce the same outcomes as those of the EU.” Recognition of equivalence gives access to some, but not all, aspects of financial markets. Equivalence is better than trading under WTO terms, but has significant limitations, from the perspective of the UK Government. First, equivalence is determined unilaterally by the EU, with no input from the third country. Second, it carries the obligation to match any changes in laws and regulations introduced by the EU. Third, and most important, it only provides partial access. In particular, Banking is excluded as it is governed by a different set of regulations to other aspects of financial markets. Access to banking and other forms of deposit-taking would have to be done on WTO terms or covered by a bespoke Free Trade Agreement. The Chancellor has stated that Equivalence is too narrow and restrictive to be appropriate for the UK post-Brexit.
Finally, there is the possibility of a Free Trade Agreement (FTA), negotiated between the UK and the EU. There are precedents for this; the most prominent is the EU-Canadian FTA, but the EU also has FTA agreements with South Korea, The Ukraine and others. Existing FTAs make little provision for financial services, in part because of the difficulties in drafting an agreement in such a complex and connected area; it has often been noted that existing agreements do not provide much beyond a basic WTO when it comes to financial Services. Despite this, a FTA is the preferred option of the UK Government. The Chancellor has argued that the close alignment between financial services in the UK and EU will make an agreement easier than in other cases. This is probably true. But the difficulties in reaching a comprehensive agreement cannot be underestimated.
What does all this mean for UK financial services post-Brexit? In essence, no-one knows. The public debate consists of more-or-less-informed speculation about the various options and detailed explanations of the many difficulties facing the UK in agreeing anything above basic WTO provisions. Beyond that, the debate is dominated by strident partisan statements, mainly on social media.
One thing is clear. The real power in the Brexit negotiations is with the EU. From their perspective, a range of outcomes is possible, depending on how many of their stated red lines the UK chooses to maintain. Politics has always trumped economics in the UK’s stance on Brexit. So it seems unlikely that the UK will abandon enough of its red lines for it to stay in the Single Market or at least join the EEA. As a result, the outlook for UK financial services post-Brexit is gloomy at best.
This blog post is part of the Brexit, Money and work series, a new series of IPR Blogs with a focus on employment and skills, trade and business, industrial strategy, tax and pay that highlights some of the crucial issues policymakers may face in the coming years. Subscribe to the IPR blog to get the latest blog posts, or to keep up to date with our activities, connect with us on Twitter, Facebook or LinkedIn.