The Brexit result has provided the UK regulator for financial services with the challenge of navigating a tightrope, between diverging away or remaining aligned with EU regulation. It is likely that improving UK financial regulation, by diverging from EU legislation, will have some negative economic consequences, if only in the short-term.
The decision of the UK to leave the European Union is reversing 47 years of economic integration from the Single Market. By leaving the EU, legislation governing the City of London’s financial hub has been placed once again in the hands of the UK regulator. Thus, enabling them to rectify certain regulations and directives that previously hindered the efficiency of financial operations, and can now increase the competitiveness and attractiveness of the City.
Initially, the removal of the “passporting rights” lost the City its previous full access to the European Market. Consequently by 2021, 440 firms in the financial industry moved part of their operations to the Continent. Out of the 440 firms, 135 have relocated to Dublin, Paris 102, Luxembourg 93, Frankfurt 62, and Amsterdam with 48. Consequently, a total of 7,600 financial service jobs left the City. Equivalently, as firms leave, so will their capital. An estimated £900bn, representing 10 per cent of the UK banking system, and more than £100bn in assets and funds from insurance firms and assets is expected to be reallocated to the EU.
Financial services are also crucial for the UK exports, amounting to £79 billion in 2018. The loss of influence from reallocation has weakened the City’s position, jeopardising its £26 billion trade surplus in financial services with the EU.
However, although the EU may see an increase in its provision of financial services, the victory is a “hollow” one. The City has far greater economies of scale than any other current European financial hub. As firms previously concentrated their operations in the City, reallocation across Europe will ultimately lower firms’ efficiency.
Although the short-run outlook looks bleak, hope is not lost. One of the benefits of leaving the Single Market is the possibility of de-regulating UK’s financial markets. The close collaboration between the regulator and the financial markets will allow for a more responsive regulatory system, compared to the bureaucratic system of the EU. Furthermore, the UK will no longer have to abide by legislation that it opposes.
An example is the Alternative Investment Fund Manager Directive (AiFMD), proposed by the European Commission in 2009. The aim of the directive was to respond to the 2008 financial crisis by “establishing a harmonised regulatory framework for managers of investment funds”. Its impact was extensive and far-reaching, particularly concentrating on Hedge Funds and private equity, who heavily criticised the directive.
A 2012 Deloitte research survey concluded that, 72 per cent of respondents viewed AIFMD as a threat to their business and 68 per cent suggested that the AiFMD would reduce Europe’s competitiveness. The Directive would also potentially put more than 100,000 jobs at risk, costing the economy €21.5bn. The legislation is an example of many in which the UK’s regulation can now diverge in order to increase its competitiveness and attractiveness.
However, it is important that the regulator does not entail a complete divergence. Just like walking on a tightrope, if there is too much weight on one side and the walker will fall off. For the City to maintain access to the EU markets, it will be required to meet the “equivalence requirement”, meaning that the UK regulatory system must be considered “equivalent to EU standards”. In addition, a high degree of coherence in regulation will provide predictability and consistency for firms, which for the financial industry translates to a healthy high functioning economy.
Moreover, competition over certain financial sectors may result in de-regulation by both the UK and EU. An example is the euro-denominated derivative market. In 2019, the UK cleared, on average, 80 per cent of all OTC derivatives positions, demonstrating that the operations are ingrained within the City. Thus, actions through de-regulation, such as the EU attempting to gain a share of that market or the UK attempting to stay competitive, may lead to a slippery slope of racing to the bottom through a trade war. Using IRSG Report on Global Regulatory Coherence within Financial Services, a divergence of financial regulation through de-regularisation increases the volatility of economic cycles and can lead to crises like the 2008 Financial Crisis.
On reflection, the success of maintaining the City’s global position as an international hub will crucially depend on the correct legislation being implemented. The UK regulator must act promptly to alter the current weakening of the City’s position post Brexit. Thus, they must take a step forward along that tightrope and continue their arduous task of walking between the fine line of coherence with previous EU regulation and new divergent UK regulation.