Banks, insurers, businesses and European Union (EU) agencies based in the UK are accelerating their moves to assure full access in the EU, the world’s largest financial-economic area. Their theoretical deadline is Friday, March 19, 2019, when Britain will be out of the EU according to EU Treaty rules, but practical hurdles make the real deadline mid-2018. The exodus of Brexit-generated refugees is also growing more urgent because the Tory government has failed to clarify its Brexit negotiating strategy during the 14 months since the fateful referendum. This policy vacuum is forcing companies to plan for the worst-case scenario – “hard Brexit.” Moreover, organizing legal subsidiary or branch status to assure integration in the EU is time-consuming and complex despite the blandishments offered by EU member states wooing UK-based corporations that need EU access. Most of the remaining 27 EU countries want to attract the new employment, investment and influence these companies represent with tax, regulatory and other enticements that are sometimes in competition with each other – as well as EU-wide policies.
A very tight schedule is forcing financial institutions based in London’s “The City” to accelerate efforts to assure an EU operating base that is fully compliant with EU and European Central Bank (ECB) regulations and will give them “passporting” (as explained below) rights to operate in all the other EU countries. HSBC Bank PLC has opted for Paris as its EU base. Citigroup, Morgan Stanley and Standard Chartered will use Frankfurt for their base. Germany’s largest bank, Deutsche Bank announced it will expand operations in Frankfurt but and, in late July, signed a 25-year lease for a new headquarters building for its London branch, confirming that it will continue to be a major presence in London. Deutsche Bank warned, however, that it might have to convert the London branch to a subsidiary depending on final Brexit conditions.
The Bank of America and Barclays announced Dublin will be their principal EU base. UBS AG, Standard Chartered PLC and Goldman Sachs Group Inc. have announced they may move staff and operations from London. ING, the Dutch bank, said that a “hard Brexit” divorce could force it to move some UK staff and operations. MUFG, the Japanese bank, chose Amsterdam for its EU base. Other Japanese banks, including Nomura, Daiwa and Sumitomo Mitsui Financial announced that they will make Frankfurt their EU base.
Since 2000, many global financial trading entities, including the latest digital platforms, made The City their base because of “passporting” access to the other 27 EU states. (Passporting allows firms legally established in one EU country to carry on their business with their personnel in other EU countries without further complications. Brexit would likely end such passporting for UK-based firms which did not have a subsidiary in one of the other 27 EU countries.) Now many of them face a closing window of opportunity to set up EU-based operations to retain the same passporting privileges. KPMG warned that next month, September 2017, is the last chance for requesting EU trading, banking and insurance licenses. It noted that the European Securities and Markets Authority (ESMA) threatens to block “letterbox” operations in which companies run shell operations in the EU, directing business from their London base. To date, Market Axess, one of the world’s largest bond trading platforms; Tradeweb, the New York-based fixed income and derivatives over-the-counter trader owned by Thomson Reuters and 11 of the biggest U.S. investment banks, all chose Amsterdam as their EU base.
Two key EU agencies based in the UK, the European Medicines Agency (EMA) and the European Banking Authority (EBA), must leave before Brexit and are being wooed by most EU member states. The agencies are not, however, part of the Brexit negotiations between the UK and EU. Given their critical importance and need to continue operating smoothly after the UK-EU divorce in March 2019, the transition process has been remarkably swift. Applications to host the EMA (received from 19 cities) and EBA (eight) were submitted to the European Commission (EC) by July 31.[1]
The EC is now assessing those offers with criteria proposed early this year by EC President Jean-Claude Juncker and European Council President Donald Tusk, and approved by EU-27 heads of government. The EC will publish its opinion on Sept. 30 and the EU Council will consider the EC recommendation and alternatives in October. A final decision will be made by EU ministers in November. Smooth functioning of the EBA is particularly important because it conducts the stress tests of European banks and is empowered to overrule national regulators who fail to properly regulate their banks. The EBA is also charged with preventing regulatory arbitrage and ensuring banks to compete fairly in the EU.
The private sector’s need to establish fully fledged legal entities in the EU well before 2019 is given more urgency by warnings from, ironically, British authorities. Finance, in particular, must act quickly, since the massive financial positions and operations of firms in The City are systemically important to the global financial system. These are likely to be directly impacted by post-Brexit UK-EU differences in regulation and supervision of banking and insurance. Brexit-induced changes in foreign exchange and interest rates will also directly affect trillions of sterling, dollar and euro-denominated assets, derivatives and transactions.
In April 2017, the Bank of England’s Prudential Regulation Authority (PRA) required banks and insurers operating in the UK to set out contingency plans, including a scenario in which Britain quits the EU without market access to the EU and no transition period, a “hard Brexit.” Having reviewed those contingency plans, the PRA summarized its concerns to the British Treasury and made them public in early August. The Financial Times editorialized (Aug. 9, 2017) that The City is running out of time since it takes well over a year to establish an EU-authorized subsidiary or branch.[2] Moreover, finding office space, hiring senior staff, and ensuring IT and compliance systems are compatible with both British and EU norms is equally time consuming.
The PRA warned that the UK and EU financial services sector could be disrupted if post-Brexit transition is not managed well. Banks’ open positions on trillions of sterling, dollar or euro-denominated derivatives positions would have to be transferred to EU clearing houses. Hard Brexit could lead to entirely separate UK and EU fixed income markets requiring duplication of resources and regulation. Another PRA concern is a possible UK economic downturn or sterling instability, either of which could stress UK financial institutions’ capital adequacy which, because of the UK’s light-touch regulatory approach, is significantly less than that of U.S. banks. Systemic financial risk could also be more difficult to detect and prevent if supervision and regulation of financial institutions in the UK and EU are less integrated than they are today.
Tougher UK regulation of financial institutions is another incentive for London financiers to move to the EU. The Financial Conduct Authority (FCA), Britain’s financial regulator, announced in late July a proposal to tighten the “Senior Managers Regime” (SMR) and Certification Regime, which began in March 2016, and extend it to all financial services, including investment managers, insurers and trading firms in the UK.[3] The FCA said it wants to protect consumers, strengthen market integrity and to hold financial companies to high standards. As of next year, all UK-based financial services staff will be subject to individual conduct rules; and senior managers will be held individually responsible for their firm’s actions. Companies will also need to certify staff for their fitness, skill and propriety at least once a year. EU regulations start to look rather lenient by comparison.
Bank of England Governor Mark Carney added to the pressure in early August when he warned that Brexit uncertainty was cutting investment in the UK and weakening economic growth prospects. The BoE expects capital investment to be 20% lower in 2020 than it did before the Brexit referendum. The central bank also expects real GDP growth to remain below 2% a year to 2020.
On the EU side, the European Parliament (EP) plans to toughen supervision of clearing of euro-denominated transactions in London after Brexit. In September, the EP will consider proposals to require UK clearing houses, which today handle the vast preponderance of euro-denominated derivatives contracts, to comply with EU rules and accept EU supervision. Clearing of euro-denominated transactions is one of The City’s most profitable businesses. [4] The volatility of FX rates since the Brexit referendum, plus the Federal Reserve’s and ECB’s transition from post-crisis quantitative easing to more conventional (i.e. tighter) monetary conditions, makes multi-currency trading more problematic for ECB and Bank of England regulators.
The European Commission (EC) and the Banque de France argue that the European Securities and Markets Authority (ESMA), based in Paris; and the ECB be responsible for assessing the systemic risk of non-EU clearing systems, including those in London after Brexit. Those deemed to be too risky would have to submit to EU regulation. If clearing houses refused, they would lose the regulatory authorization required to do business in the EU. British politicians are resisting the proposed extension of EU supervision to UK finance. Deutsche Borse’s Eurex and the London Stock Exchange’s London Clearing House are today key parts of the international financial system since they today cooperate closely as the clearing intermediaries between EU and UK counterparties and manage the risk involved. If they were supervised/regulated separately by the UK and EU, systemic risks could be less visible.
The ECB is also pressuring UK financial institutions to regularize their EU status. Sabine Lautenschlager, vice chairwoman of the ECB’s Single Supervisory Mechanism (SSM), warned in May that time is running short for EU authorities to process and approve new banking license applications from UK-based banks, the first step for any bank wanting to do business in the Euro area. Joint approval is required by the national supervisor of the EU country concerned; and the ECB, which makes the final decision to grant the license. The process, which includes vetting senior staff and client information, usually takes six-to- twelve months leaving little time before the 2019 deadline. She noted that the ECB directly supervises 126 of Europe’s largest banking groups which account for 82% of the euro area’s banking assets. Some 40 UK banking groups now operate in the EU market, she added.
“Mifid II” is an even more immediate challenge to UK-based banks. The EU’s second “Markets in Financial Instruments Directive” goes into effect on Jan. 1, 2018 and aims to increase transparency and reduce conflicts of interests between investment fund managers and financial institutions providing them research.[5] Mifid II will allow fund managers to continue paying for research from investment banks and brokerages but will require them to price each research service they receive and show how such research contributes to investment decisions.
Banks providing the research will have to identify which services count as research and provide clients with an itemized accounting for the cost of research, execution and other services. Since research is one of The City’s principal services, compliance with Mifid II will be expensive. If UK financial institutions refuse to comply with Mifid II, the EU could block research from The City to EU clients. (The Vanguard Group, second largest asset manager in the U.S., announced in August that it will stop charging clients for research, covering research costs from its own P&L account in order to comply with Mifid II.)
On a practical level, Mifid II’s imminent implementation, 15 months before the Brexit divorce date, means “regulatory equivalence” is an immediate problem for UK-based trading entities since the UK-EU negotiations have yet to enter a substantive phase. Will, for instance, ESMA consider UK dealer-brokers compliant with Mifid II? Moreover, EU capital requirements under Mifid II will be tougher than those of the UK.
Conversely, many of Europe’s (and U.S. and Japanese) largest banks are worried about continued access to The City, still likely to be Europe’s financial hub, after Brexit. Most of them, including those in the European Economic Area (EEA – which includes Norway, Lichtenstein and Iceland[6] ) operate branches in the UK to benefit from Britain’s “light touch” regulatory environment and lower capital requirements. But the Bank of England has warned these institutions that they may be required to establish a UK subsidiary if they wish to continue substantial retail or deposit-based business in the UK.
Similarly, Europe’s leading wealth management institutions want to continue doing business in London, which so many international billionaires find congenial. Credit Suisse, UBS, Pictet and the Société Générale have announced plans to expand operations in London, recognizing that Brexit could make London more attractive to the ultra-wealthy allergic to the EU’s increasingly effective campaign against tax evasion.
Gold, 7500 metric tons of which is stored in London, the world’s largest gold trading center, could also prove problematical after Brexit. Bullion, including the 5100 tons thought to be stored at the Bank of England (including UK gold reserves and those of other central banks), was worth an estimated $300 billion at end-March (according to data recently released by the London Bullion Market Association - LBMA). Because gold is traded over-the-counter there is little regulation and visibility of London gold transactions. After Brexit, however, this light-touch situation might have to change if EU regulators insist on supervising and reporting gold trading in the EU. The LBMA also announced that 32,078 tons of silver, valued at $19 billion, was also stored in London.
Cars made in Britain could, curiously, fall victim to a “hard Brexit” that does not include a customs union. In this case, rules of origin in free trade agreements outside the EU would require that a product contain 50%-to-60% of originating content if it is to benefit from reduced tariffs. But British vehicles include only about 40% of UK-made components, not enough to qualify for reduced tariffs. Thus, “British” carmakers, such as Aston Martin (in fact, owned by Ford, USA, Investment Dar, Kuwait and others), Bentley (owned by Volkswagen in Germany), Jaguar (Tata, India), Land Rover (Tata, India), Lotus (Proton, Malaysia), MG (SAIC, China), Mini (BMW, Germany) and Morgan (Morgan of the UK !), might have to make more components in the UK or negotiate a special customs union with the EU. Noteworthy in this context is France’s PSA Group’s (owner of Peugeot and Citroen) takeover of General Motors’ European makers, Opel and Vauxhall, making PSA Europe’s second largest producer.
European energy is also affected by Brexit. Ireland, which depends on UK energy infrastructure for all of its gas and electricity inflows, has announced that it is exploring a EUR 1 billion electricity link with France and building a EUR 500 million liquefied natural gas (LNG) terminal. The detailed studies by EirGrid, the Irish power grid operator, and its French RTE counterpart, are being funded in part by the European Commission. The 600-kilometer-long “Celtic interconnector” would carry 700 megawatts of electricity from the northwest tip of France to the southern tip of Ireland. The LNG terminal could also be a major entry point for new U.S. LNG exports to northern Europe.
Even British music may fall victim to Brexit. The European Union Baroque Orchestra, based in Yorkshire since 1985, left the UK this summer to take up residence in Antwerp. Acclaimed for its concerts at St. John’s Smith Square in London, the orchestra’s general manager, Emma Wilkinson, explained to The Guardian in February that brilliant young international, including British, musicians are recruited each year and many go on to the world’s top orchestras. A “hard Brexit” would make their frequent travel to Europe far more onerous with two-way visa requirements, EU worker protection contributions, customs problems with equipment and music, and import-export documents for instruments.
The influential European Union Youth Orchestra (EUYO), London-based since 1976, is making contingency plans to move to Europe while awaiting the Brexit negotiations, especially regarding the free movement of people. The Chamber Orchestra of Europe (COE), founded in 1981 and headquartered in London, has been widely praised for its performances with many of the world’s greatest conductors. The Guardian reported the COE does not yet plan to leave the UK. But with 85% of its members living on the continent, the orchestra must keep its options open.
Timothy Walker, chief executive and artistic director of the London Philharmonic Orchestra, told The Guardian he fears for the capital’s cultural life. “London has one of the most vibrant creative communities in the world, full of freelance artists, many of whom come from the EU.” If their right to reside here and work through a points system changes, classical music, soundtrack recordings and theater, the vital parts of the city’s arts ecology will be at risk.
With all these pressures on UK-based business and finance, EU members have mounted charm campaigns to attract banks, insurers, companies and the EU agencies. Backed by a solid parliamentary majority, French President Emanuel Macron’s ambitious reforms are a major part of the effort to attract British business to Paris. Labor reforms are already stimulating job creation with more vigorous economic growth and improving business confidence. Further easing of France’s tough hire-and-fire labor code is to be introduced this autumn. New tax breaks for companies and the wealthy are also proposed. Financial assets would be excluded from the ISF “wealth tax”; the current tax of up to 50% on investment income would be cut to a 30% flat tax; and company creation regulations would be simplified. Fiscal policy aims at reducing France’s perennial budget deficit to the EU’s 3% target rate by 2019.
Even more ambitious is Macron’s determination to restore French fiscal and governance credibility with Germany, the Franco-German partnership being even more important as a result of Brexit. Assuming German Chancellor Angela Merkel remains in power after the federal election on Sept. 24, Paris and Berlin are expected to push for more comprehensive fiscal union in the Euro zone as well as banking union, both of which would improve the operating climate for business in the EU. Mrs. Merkel’s government is also considering tax cuts and incentives to spur German economic growth and imports which would stimulate growth elsewhere in Europe.
The Netherlands’ strict 20% cap on bonuses might be a deterrent to London bankers but the Dutch government has informed UK banks that there is an exception to the bonus cap for banks employing 75% or more of their staff outside of Holland.
Politically, the EU looks more attractive to UK-based business, especially since the Conservative government was weakened after the June 8 election. Moreover, the electoral defeats of EU populist parties in France, Italy, Spain and The Netherlands has boosted hopes for rational governance for the next few years. Seventeen consecutive quarters of economic growth in the Euro zone and the ECB’s successful quantitative easing, plus capital inflows from U.S. and other foreign investors, have boosted confidence in the EU and the viability of the euro.
Twenty months before Brexit, the EU looks ever more attractive to business refugees from London, especially on key issues such as regulation of banking, insurance, services and manufacturing; tax rates, labor markets, and portability of pensions and health benefits. Optimists hope Brexit will spur progress toward euro banking union and Franco-German cooperation on fiscal union, two critical aspects for the longevity of the EU and the euro.
J. Paul Horne is an Independent International Market Economist based in Alexandria, VA and Paris where he was chief international economist for Smith Barney for 24 years.
[1] The EMA and EBA are described at: http://www.ema.europa.eu/ema/index.jsp%3Fcurl%3Dpages/about_us/document_listing/document_listing_000426.jsp%26mid%3D ; https://en.wikipedia.org/wiki/European_Medicines_Agency and https://en.wikipedia.org/wiki/European_Banking_Authority.
[2] A European Subsidiary is incorporated in the host EU country in accordance with one of its legal business models. Its capital is fully owned by the foreign parent company, making it a Single Member Company; or controlled by a company in collaboration with minority local partners, a Joint Subsidiary. Both are recognized in all EU countries and have passporting rights. Since a Subsidiary has more credibility with third parties such as banks, service providers, and partners, it is the most popular corporate structure in the EU. A Branch is a more independent entity conducting business in its own name but on behalf of its parent company from which it is not legally separate. A Branch has limited EU passporting rights. More details available at: http://www.openaeuropeancompany.com/the-benefits-of-establishing-a-branch-or-subsidiary-in-europe/.
[3] The SMR is explained at: https://www2.deloitte.com/content/dam/Deloitte/uk/Documents/financial-services/deloitte-uk-senior-manager-regime.pdf.
[4] On Aug. 8, the FT reported that Euronext settled a long dispute with the London Stock Exchange Group (LSEG) which means that Euronext’s equity, commodity and derivatives markets will continue to clear at LCH SA, the London Stock Exchange’s French clearing house. The new clearing arrangement is for the next ten years. Euronext accounts for about half of LCH France’s clearing volume.
[5] The European Securities and Markets Authority’s explanation of Mifid II and Mifir can be found at: https://www.esma.europa.eu/policy-rules/mifid-ii-and-mifir.
[6] The EEA is described at: https://en.wikipedia.org/wiki/European_Economic_Area.
