17 October 2016

Open Europe has published a new report, ‘How the UK’s financial services sector can continue thriving after Brexit’. The study offers a comprehensive, independent assessment by unpicking the true value of the EU financial services ‘passport’ – the ability to provide services across the EU from a base in London – and considering what alternative arrangements the UK should pursue as part of the upcoming Brexit talks with the EU-27.

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Key conclusions

  • The financial services ‘passport’ is not a single thing. In reality, there are a series of sector-specific passports built upon dozens of financial regulations and principles. In some sectors, the passport is important to the business, but in other sectors it has much less value. The assertion that the success of the City of London is based on full and complete access to the EU single market in financial services is not borne out by our analysis. However, the loss of the passport could be damaging to some sectors if the Government does not negotiate effective alternative arrangements with the EU.
  • The passport works best in banking (wholesale and investment). Around a fifth of the banking sector’s annual revenue is estimated to be tied to the passport. The passport in banking is also a two-way street, with a number of large EU banks making significant proportions of the revenue in London via the passport. Deutsche Bank, for instance, gets 19% of its revenue in the UK.
  • Passporting works less well for asset managers, given that a number of technical barriers remain to marketing funds across the EU (e.g. supervisory and legal fees). Many of the larger funds already choose to operate European subsidiaries, rather than relying on a passport. A large chunk of EU clients’ assets are already kept in funds domiciled in Dublin and Luxembourg, with management delegated to the UK. Based on a recent industry survey by the Investment Association, we conclude that a maximum of around 7% of assets managed in the UK would be under direct threat from the loss of the passport.
  • Insurance is a global industry: 28% of insurance exports went to the EU in 2015, compared to 44% for financial services in general. There is no real single market in insurance in the EU. Up to 87% of insurers operating across borders in the EU do so via subsidiaries rather than branches (reliant on the passport). Lloyd’s of London is an important exception to this. The current regulations allow the pool of underwriters based in London to serve clients across the EU. However, even this only accounts for 11% of the market’s gross written premium, £2.9 billion – with possibly as little as £800 million (3%) directly reliant on the passport.
  • If the current passporting system is lost, there are three broad alternatives: ‘equivalence’, bespoke agreements and local arrangements.
  • In some cases, equivalence can offer access to the single market when a country is judged by the EU to have a broadly equivalent regulatory and supervisory regime. However, it is a partial solution. While some EU regulations offer passport-like rights for third countries (e.g. MiFIR) others offer no equivalence at all (e.g. CRD IV). Granting equivalence is also a political decision, requiring a judgment from the European Commission, and can take several years. That being said, the UK starts from the basis of having the exact same regulations as the EU – something which should make equivalence easier to achieve.
  • Negotiating bespoke deals to keep passports based on certain EU regulations will be necessary where equivalence is not available. There is precedent for this, for example the EU has a bespoke agreement with Switzerland on the provision of direct insurance (not including life insurance) via branches.
  • Where the Government does not succeed in negotiating cross-border access, financial firms will still be able set up local branches and subsidiaries if they wish to continue to provide services in certain member states. However, this may require significant investment in terms of capital, staff and infrastructure and may involve moving some of it from the UK.

Key recommendations

  1. The Government’s primary objective, with regards to financial services, should be to try and keep the CRD IV passport in place to ensure that London can remain a centre of international banking. CRD IV does not allow for equivalence, or meaningful third party access, so this could be achieved through a specific bilateral agreement (similar to the EU-Swiss deal on insurance) or as a specific chapter of a comprehensive UK-EU free trade agreement. There will need to be deep cooperation on the supervision of the banking sector. The UK should pursue equivalence under MiFIR, which would allow many of the investment banking services provided via the passport (including those by foreign firms) to continue.
  1. The UK should seek to ensure that EU-domiciled funds can still be managed from the UK after Brexit. This can be done via so-called ‘delegation’ of portfolio management and may involve firms setting up some additional operations in the EU. Achieving equivalence under MiFIR would also give asset managers a chance to retain passport-like rights for some of the services they offer to professional investors.
  1. The UK should also try and obtain equivalence under Solvency II to help smooth the transition for the insurance industry. A bespoke agreement will be important for Lloyd’s of London. Keeping asset managers, insurers and pension funds on board and invested in the UK will be vital. If they (the buy side) stay, the sell side (banks and other businesses) is also more likely maintain the bulk of their operations in London.
  1. Given the fluid nature of the financial services sector, the Government should aim to offer the industry maximum certainty about the prospects for future market access and possible transitional arrangements as early on as possible. It is essential to avoid a cliff-edge situation and give the industry enough time to adapt to whatever the new reality is. Based on our background conversations, if banks, for instance, were still unclear about what the future holds one year before the UK formally exits the EU, they would be forced to start making decisions – including over whether to shift part of their business elsewhere. Some firms may well start implementing their contingency plans even earlier than that. A transitional agreement to keep the existing reciprocal passport arrangements in place would allow the industry greater time to plan and the UK Government to negotiate alternative arrangements with the EU.
  1. The UK should push for ‘pre-emptive equivalence’ in areas where it seeks it. This would see the process of judging equivalence starting immediately while the UK is still inside the EU and during the Article 50 negotiations. There is some precedent for this under Solvency II – with equivalence being approved before the directive was fully in force.
  1. The UK needs to convince the EU that keeping cross-Channel financial markets open is a mutual interest. Throughout the negotiating process, the UK should make it clear to its European partners that this is not a ‘zero-sum game’ and think creatively about how to ensure that the new trade arrangements benefit EU companies and governments. Fragmenting London’s financial services ecosystem would lead to higher costs for all concerned. Indeed, if business moves out of London, it is far from obvious that it would relocate in the EU. Financial hubs located outside of the EU would be just as, if not more, likely to reap the benefits. Furthermore, if certain business lines no longer look profitable from the UK they might just be discontinued altogether – a deadweight loss for the UK and EU economy and all consumers of financial services.
  1. The UK should offer reciprocal access to its markets to EU firms, and maintain the current access offered to third countries (granted through EU equivalence at the moment). This will mean the UK would create and establish its own equivalence system. The UK should also quickly seek to establish its baseline at the WTO and its commitment to the General Agreement on Trade in Services (GATS).
  1. Domestic reform would help to ensure that London, and the UK more widely, remains an attractive place to for financial services to do business. In particular, the UK Government should consider scrapping the bank levy and the corporation tax surcharge for banks. However, at the very least, it should consider faster reductions in the bank levy rate and slower introductions of the corporation tax surcharge.

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