The United Kingdom's approaching departure from the European Union in March 2019 has raised concerns about how the split will affect London's bustling, heavily influential financial sector. The British government is currently focused on two negotiation topics: making sure that trade in goods remains unaffected by Brexit and ensuring that the border between Northern Ireland and the Republic of Ireland remains open. The European Union has offered the United Kingdom a comprehensive free trade agreement similar to the one it recently signed with Canada. However, both proposals focus primarily on goods, leaving companies in all service sectors — and especially the financial sector — with open questions about Brexit's impact.
The United Kingdom's departure from the European Union will have a direct impact on the Continent's financial sector, as companies in both spaces adapt to the new reality. The result will probably be greater fragmentation, because London will continue to be an important financial hub while other centers in Europe will grow stronger.
London is currently Europe's financial capital. But after Brexit, many of the thousands of financial services companies operating in the city will need to find new ways to continue serving their customers within the European Union. Many of these companies are already intending to partly relocate their operations to the European mainland, sparking questions about what will become of London and what city might take its place of prominence in the financial industry. London has too much infrastructure and know-how to completely lose its role as a financial center, but the business dispersion that will come after Brexit will provide opportunities for other cities, creating a European financial system more scattered and fragmented than it has been in decades.
Bye-Bye Passporting Rights
The services sector accounts for roughly 80 percent of the British economy. More than 40 percent of British exports to the European Union are services, and the country has a trade surplus with the bloc in this area (It has a trade deficit in goods). The United Kingdom's financial sector is particularly important, representing almost 7 percent of the country's gross domestic product and more than 3 percent of all jobs. About 40 percent of UK banking and investment services exports go to the European Union.
Companies in the United Kingdom's financial services sector currently have "passporting rights," which allow them to sell their services — such as investment banking, asset management and insurance — in the EU single market without needing to ask for authorization in each member state. The British government's decision to leave the single market means that companies in the country will lose these rights and that the United Kingdom will have to negotiate new agreements to preserve their access to the bloc. The European Union already has these kinds of agreements with countries such as the United States, Japan and Singapore through a mechanism known as "equivalence," according to which Brussels grants market access to banks and insurers from countries where the national rules are in line with those of the European Union. But equivalence excludes some important activities, such as commercial loans. More importantly, equivalence agreements are periodically reviewed, which means that Brussels has the right to unilaterally end them.
The United Kingdom would prefer a permanent deal covering the financial services sector, so it doesn't have to worry about its equivalence rights potentially being revoked. But the European Union is not in a rush to make concessions to London, and some countries such as France and Germany are even making plans to attract the companies and activities that will leave the United Kingdom. A no-deal Brexit would make a permanent agreement on financial services even less likely.
In the probable case that the United Kingdom loses its passporting rights, not all financial companies would be affected the same way. Companies with a domestic focus would probably not face any dramatic changes in their status, but firms that use the United Kingdom as a hub to access EU markets would have to move some of their operations and staff to the mainland to continue selling their products in the single market.
The Race to Replace London
On Oct. 10, UK financial services minister John Glen said that about 5,000 financial services jobs will have moved to the mainland by March. For its part, the City of London Corporation predicted that about 12,000 UK financial sector jobs could be lost to the mainland by early 2019.
Indeed, since the Brexit referendum, several companies have already announced plans to move some of their staff from London. For example, HSBC said it would move about 1,000 jobs to Paris; USB said it would transfer a similar number of workers to Frankfurt; and Barclays said it would relocate about 150 jobs to Dublin. Other firms announced a multi-city strategy; JPMorgan said it would move staff to Dublin, Frankfurt and Luxembourg, while Goldman Sachs announced that its EU-related operations will be handled between Frankfurt and Paris. In some cases, the decisions involved a transfer of activities without a relocation of staff. For example, Deutsche Bank said in July that it would move almost half of its euro clearing business (an intermediation service between firms that trade financial instruments) to Frankfurt but said nothing about jobs.
These announcements indicate that companies in the British financial sector are not leaving the United Kingdom altogether. Moreover, the jobs and activities leaving London are not all moving to one single EU city, but to several locations, typically based on where various companies already have a significant presence.
Frankfurt is one of the main contenders to attract financial sector companies relocating from London, because it is home to the European Central Bank and the Bundesbank, as well as Deutsche Bank and Commerzbank, two of the biggest banks in Europe. Frankfurt is also attractive for companies that want to keep close contact with EU regulators, because it is home to the union's Single Supervisory Mechanism, the European Systemic Risk Board and the European Insurance and Occupational Pensions Authority. Moreover, Frankfurt's location at the heart of Germany allows formidable land connections with the rest of the Continent, and it operates one of the busiest airports in Europe. However, Germany also has strict labor laws and high taxes, and Frankfurt is a relatively small city that does not offer the same leisure and cultural options that bankers and their families in London would be used to.
This marks a drastic difference with Paris, which promotes itself as a city with incomparable cultural and entertainment options for bankers and their families, on top of being the capital of the second-largest economy in Europe and having a robust financial sector. In recent weeks, the French government has announced corporate and personal tax incentives for banks relocating from London and is planning to open new international schools for bankers' children. But companies are worried about France's high tax rates, restrictive labor laws, limited use of English, frequent strikes, and a tradition of governments that are not particularly enthusiastic about the banking industry.
Dublin has also attracted some activities leaving London in recent months. Its allure is based on its close cultural, legal and economic ties with the United Kingdom and the United States, which would make the transition easy for staff relocating from London. Dublin offers low corporate taxes for foreign companies and a flexible labor market. However, Ireland's financial sector is small and the city lacks the expertise and networking possibilities offered by larger centers. Connected to this is the fact that Ireland is far from the core countries of the EU single market. A shortage of housing and rising rents are also pressing issues in the city.
Amsterdam is taking a different approach, as it is interested in attracting specific financial sectors such as clearing, financial technology and high-frequency trading. The Netherlands is a powerhouse in the world of electronic trading, which is only going to increase in importance over the coming decades. But the country shares some of France's attitudes toward the world of high finance. In 2015, the Netherlands introduced a 20 percent cap on bank bonuses — a fifth of the cap set by the European Union. The Dutch government recently said this regulation could become more flexible, possibly in order to encourage more UK banks to consider relocation.
There are other contenders as well. Some companies are moving to the city of Luxembourg, which offers favorable tax treatments for foreign corporations and is the main investment fund center in Europe and the second largest in the world after the United States. Italy's financial capital, Milan, is currently trying to get a share of London's asset management industry, while Berlin has shown interest in attracting start-up companies. Madrid, meanwhile, has announced renewed interest in a project to build a new financial district with several skyscrapers and hundreds of new offices.
A More Fragmented Landscape
A Brexit without a comprehensive agreement on financial services would hit the United Kingdom's economy fairly hard. Companies that move some of their activities to the European Union and scale down their UK operations will almost certainly reduce the country's economic activity. In a recent report, professional services company PricewaterhouseCoopers estimated a gross value-added impact of -1.3 percent (some $30 billion) per year in the United Kingdom until 2030. At the same time, it will be harder for the United Kingdom's financial sector to attract skilled labor from the European Union because workers from the bloc will probably need a visa.
Although it will take a hit, London will still remain an important financial center, because of its connections to the rest of the non-European world and the concentration of expertise. For activities like insurance and pensions, for example, most UK exports go to non-EU countries such as the United States. Leaving the European Union will also give Britain the chance to reduce regulations and lower taxes to attract businesses.
For companies in the UK financial sector, Brexit will lead to higher costs, at least in the short term, because they will have to spend money to relocate their workers and operations. The branches of non-UK banks operating in the United Kingdom will probably have to undergo the costly process of becoming subsidiaries (separate legal entities from a parent company). Firms could also face a duplication in their corporate costs because of the separation of their EU- and non-EU operations.
Over on the mainland, cities such as Paris, Frankfurt, Dublin and Amsterdam could see an increase in economic activity caused by company relocations. But Europe's financial sector would also become more fragmented, since London would not be "replaced" by a single EU city but by multiple competing hubs. This dispersion will come with a loss of efficiency; after all, there are benefits to the agglomeration of financial services activities in a single hub such as London, a city that offers a distinct combination of services, supply chains, infrastructure and skilled labor, which the European Union will struggle to replicate.
The prospect of a Balkanization of the European financial sector will lead to renewed calls by EU institutions to move ahead with the Capital Markets Union (CMU), a plan to deepen the integration of financial markets in the bloc. The goals of the CMU are to give EU companies and households more choices of funding at lower costs and to improve cross-border investment. But implementing a CMU requires a degree of legal and fiscal harmonization that the European Union has so far proved unable to achieve. (This is partly because CMU initiatives touch on issues that are delicate for member states, such as pension funds and business insolvency legislation.) In August, the EU Commission admitted that it may not achieve its goal of completing the CMU by late 2019.
In the coming months, EU governments will have to decide whether to cooperate to reduce the inefficiencies created by Brexit or, more likely, to continue competing for the spoils of London's inevitable demotion as a financial hub. For companies and households across the European Union, this means adapting to a new reality where financial services are more fragmented, efficiency is reduced and costs are higher.