The City of London is strong enough to go it alone post-Brexit

By: Professor David Blake, a member of Economists for Free Trade and is a Professor of Economics at the Cass Business School.

Whenever the ‘merits’ of aligning UK regulations with those of the EU after Brexit are discussed, the fate of the financial services sector features prominently.

I recently gave evidence to the House of Commons International Trade Select Committee on the economic effects of trade policy, alongside my Economists for Free Trade colleague Patrick Minford. As written evidence, I submitted ‘Brexit and the City’ which considers various options.

The main choice is between equivalence and mutual recognition – and this would cover both the services themselves and the qualifications of those providing services. However,

in the absence of an agreed solution with the EU, there is growing support for World Financial Centre model, where the City ‘goes it alone’.

I discussed the following seven different possible models with the Committee.

Enhanced equivalence model (proposed by Barney Reynolds from Shearman & Sterling)

A ‘third-country equivalence regime’ is permissible under the EU’s MiFID II legislation which came into force in January 2018. This covers the entirety of investment businesses, including banks doing their investment business. Barney Reynolds proposes an ‘enhanced equivalence’ model, under which regulations are accepted as being sufficiently similar, but without actually being identical.

There would be two key issues to resolve during the Brexit negotiations: the EU and UK agree to treat each other fairly in assessing rules as being equivalent; and they would agree terms on which equivalence can be withdrawn without political interference.

Enhanced equivalence would allow the UK to: remove the most unnecessarily onerous requirements of EU legislation (while maintaining equivalence determinations); move away from the EU’s process-focused approach to one based on outcomes; re-draft laws in common law style, which would bring with it far greater legal certainty by removing the so-called ‘purposive’ method of interpretation; and move away from poor European Court of Justice decision making in the financial services context, given that ECJ reasoning is insufficiently focused on fact-based analysis to provide the clarity that the common law brings.

The EU has negotiated equivalence-based arrangements with the US for the most systemically risky portion of the market, clearing houses. Further, the EU is committed to free capital movement through the Maastricht Treaty and the European Central Bank has signed up to the Bank for International Settlements rules on creating a level playing field for all providers of financial services.

The UK also supports these objectives. In December 2017, the Bank of England’s Prudential Regulatory Authority proposed permitting EU banks to convert to third-country branches in the UK.

A leaked draft of an annex to the EU’s Guidelines for negotiating a future trading relationship with the UK suggests the EU might be willing to offer ‘improved equivalence mechanisms’ to cover financial services.

Mutual recognition (including professional standards)

‘Mutual recognition’ through ‘mutual market accesses’ achieves a similar result as enhanced equivalence. However, it assumes that financial services regulation and supervision in the UK and EU would remain sufficiently aligned in the future – and this would be jointly monitored by a Forum for Regulatory Alignment.

Many in the City prefer this model. However, Lord Kerr, the former British Ambassador to the EU who drafted Article 50, didn’t see it working all, believing instead that only the equivalence option will be offered on the grounds that “the City needed to prepare for a deal that would ultimately hurt London’s standing as a global financial centre”.

Dual regulatory regime (Channel Islands model)

Jersey, as one of the Channel Islands, is not formally in either the UK or the EU. It has much lighter regulation than the EU, but offers an equivalent regulatory regime for firms that want to access the single market.

If the UK adopted a dual regulatory system, it would operate as follows: EU equivalence – UK companies providing wholesale investment would only need to set up branches rather than subsidiaries to do this; UK and the rest of the world – the UK would establish a regulatory framework that is best suited for UK companies operating outside the EU.

Special hybrid (Swiss insurance model)

A bilateral arrangement that was better than equivalence but different from a passport (which is the current arrangement). It would be similar to the EU-Swiss deal on insurance.

Establish a fully capitalised subsidiary (Swiss banking model)

In this model, firms operate through subsidiaries. Such firms also use distribution or servicing hubs within the EU, such as Luxembourg or Dublin. However, this model is very expensive, since each subsidiary has to be separately capitalised and there are strictly limited opportunities to use capital more efficiently by netting and diversifying risks across different subsidiaries.

Multi-layered approach (Country-by-country model)

The Association of Investment Companies (which only conducts business in a subset of EU member states) supports a multi-layered approach to fund regulation once the UK leaves the EU. European rules would only be imposed if the funds were marketed within the EU.

The World Financial Centre model (Barney Reynolds)

Barney Reynolds recognises that the enhanced equivalence might not be acceptable to EU, so the “UK should be ready to adopt the ‘go it alone’ World Financial Centre model…and design a more attractive regulatory framework, freed of the EU’s restrictive policy and process-driven approach, based on global standards”.

The UK can continue doing business in the EU even without single market access via passporting or an enhanced equivalence regime, by making maximum use of

international law protections: making use of ‘reverse solicitation exemptions’ or ‘overseas persons exemptions’ which allow financial institutions to provide certain cross-border services to a wholesale client without being registered or authorised in that client’s member state, so long as the services are provided on the initiative of the client; making use of existing EU laws that allowed cross-border dealings — ‘including multiple on-the-ground visits’ — without a local branch or licence; and making use of human rights legislation – the European Convention on Human Rights and the EU’s own Charter of Fundamental Rights – that protects property rights under contracts between UK and EU27 businesses that exist prior to Brexit.

Earlier this month, the Institute of Economic Affairs issued a report on the financial services regulations that would be needed to support the World Financial Centre model. The report argues that financial services regulations must: not restrict growth in financial services, not encourage regulatory arbitrage, not prevent sections of the economy from accessing capital or other financial products, help to develop safe but competitive markets, and facilitate the growth of new and small businesses.

With these aims in mind, the report proposes to form an alliance with other major financial markets, such as Switzerland, Hong Kong and Singapore to enable further and deeper integration opportunities. A UK regime of multilateral mutual recognition would allow the UK to strengthen its involvement in global regulation formation and dispute resolution.

Freed from burdensome and costly EU regulations – equivalent to 2-3 per cent of the financial sector’s annual costs – Economists for Free Trade have estimated that the City would grow by £20bn over the next ten years under this model.

What’s the most likely outcome?

It is clear that the EU is not prepared for a tailor-made bilateral deal with the UK, so the only realistic options for a solution that both sides will accept are enhanced equivalence or mutual recognition.

However, in the absence of an agreement, the City is more than capable of ‘going it alone’ – as it has done successfully for most of its history.

The sky will not fall in as we leave the EU. Our energetic, enterprising financial hub – unshackled from restrictive EU regulation – will continue to inspire admiration as well as bring in business from across the world.

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