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Brexit endangers London’s status as a financial hub

The UK’s competitive edge in financial services is substantial and would be difficult to dislodge. But Brexit could damage London’s attractiveness as

Publishing date
10 March 2016

London’s strength as a global financial centre is impressive. The British capital has a share of nearly 50% in certain segments of global financial markets. Table 1 shows that the UK hosts  48.9% of the world’s interest rate over-the-counter (OTC) derivatives turnover and 40.9% of foreign exchange (FX) turnover. The UK is also one of the main players in the US equities trades, with 20% of the global market. By contrast, other European countries play only a comparatively small role in global markets: France hosts 7.3% of interest rate OTC derivatives, and 2.8% of FX turnovers. In terms of European markets, the UK and Germany each have a share of more than 20% in the issuance of securitisation. The share of investment fund assets in Europe is 24% for the UK, compared to 22% in France and 17% in Germany.

In general, the UK has been accumulating  substantial surpluses in trade of financial services over the last 15 years. Looking at the geographical distribution of UK financial service export in 2013, we see that 30% was with the European Union, while 70% was with the rest of the world. .

Recent research has found that the synchronisation of business cycles between the UK and the euro area has increased since the end of the 1990s. Campos and Macchiarelli have recently argued that this probably increases the costs of a potential UK exit from the EU. In a recent paper, we found that the UK credit cycle - measured here as the filtered growth of real bank credit to the private sector - has also become significantly more aligned with the credit cycle of the euro area, particularly since the end of the 1990s (figure 2). This suggests that EU-UK financial linkages have become tighter, although it does not tell us who would suffer the most from the financial consequences of Brexit. We should therefore look more in depth at specific aspects of UK-EU financial integration.

International integration of the banking sector

Turning to cross-border banking, table 2 shows that the banking sector of the euro area consists of 83% domestic banks, 14% banks from other EU countries, and only 3% from third countries. The rate of cross-border integration in the entire EU banking sector is even higher. 16 % of total bank assets are owned by banks based in other EU countries, and 9 % by banks from the rest of the world. By contrast, the UK seems to be a special case.  It is the only EU country with more claims from banks in the rest of the world (32 %) than from banks headquartered in the rest of the EU (17 %).

This can be explained through the role of major US and Swiss (investment) banks, which use their London offices as a springboard to conduct business across the EU. Indeed, when asked about the importance of EU membership for financial service businesses located in the UK, 49% of high-level professionals from “The City” cited access to EU customers and 46% cited the single regulatory framework for financial services as very important for their own business (see Ipsos Mori poll, 2013). The former is guaranteed through the role of UK authorities in ‘passporting’ banking and other financial services. Currently any firm headquartered in the UK can apply for a passport from the UK regulators to do business in the whole of the European Economic Area. The latter is granted through the European Court of Justice, which is in charge of enforcing single market rules.  84% of respondents said that the best option for the overall competitiveness of the UK as a financial center would be to remain a member of the EU.

Foreign direct investment in the UK

Beyond financial services, many European firms invest in the UK in a variety of sectors. When looking at the inward stock of Foreign Direct Investment (FDI), the EU is the biggest FDI investor in the UK, with nearly 500 bn GBP invested in 2014, as opposed to 253 bn GBP invested by the US (figure 3). The FDI investment of European firms is spread across different sectors (figure 4), in 2014 most notably retail and wholesale trade (83.2 bn), mining (67.5 bn), IT (48.7 bn) and financial services (47.5 bn).

In this context, 415 members of the Confederation of British Industry (CBI) in  a survey conducted by YouGov in 2013 also valued the financial aspects of EU membership: 52% of respondents said that the ability to invest in other EU states without restrictions had a positive or very positive impact on their business; 42% said that the ability of their company to attract inward investment from companies based in the EU would be negatively affected by the UK leaving the EU and 32% said that their company’s ability to attract investment from companies based in non-EU countries would be reduced. A sizable 75% of respondents expected that Brexit would have a negative impact on the level of FDI.

Brexit uncertainty

If Brexit happens, the advantages of EU membership that businesses appear to consider the most significant could be at risk. The UK’s passporting capacity in financial service might have to be re-negotiated. The UK’s adherence to a single rulebook would also be called into question, as exiting the EU would mean exiting the jurisdiction of the  European Court of Justice. However, much would depend on the exact form of EU-UK relationship that was built after Brexit. The UK could opt for a Norwegian-style agreement, and join the European Economic Area (EEA) with full access to the single market. It would then fall under the jurisdiction of the EFTA Court of Justice, which enforces European laws in countries which are part of the EEA, but outside the EU.This would mean adopting regulations and standards without much influence on their development, an awkward situation for the EEA’s preeminent financial centre. Another alternative would be free trade agreements or bilateral agreements, which could guarantee access to the single market in selected sectors while preserving independence in others.

However, the outcome of any negotiations for single market access or shared regulation is uncertain. This uncertainty alone could prove destabilising. Even if a new deal were eventually reached, the confusion surrounding the negotiations would have negative consequences for European firms operating in the UK and might endanger FDI flows to the UK. The attractiveness of London as a global financial hub and springboard to Europe might also suffer.

 

About the authors

  • Silvia Merler

    Silvia Merler, an Italian citizen, is the Head of ESG and Policy Research at Algebris Investments.

    She joined Bruegel as Affiliate Fellow at Bruegel in August 2013. Her main research interests include international macro and financial economics, central banking and EU institutions and policy making.

    Before joining Bruegel, she worked as Economic Analyst in DG Economic and Financial Affairs of the European Commission (ECFIN). There she focused on macro-financial stability as well as financial assistance and stability mechanisms, in particular on the European Stability Mechanism (ESM), providing supportive analysis for the policy negotiations.

    Between May 2011 and August 2012, she worked as Research Assistant to Jean Pisani-Ferry, then-director of Bruegel. During 2009 and 2010, while a student, she collaborated to research projects of Bocconi University and the Italian ENI Enrico Mattei Foundation (FEEM). During this period she was involved in the MICRODYN project, working on a cross-country and cross-sectors analysis of productivity developments with firm level data, and on the POLINARES project (“Policy for Natural Resources”).

    Born in 1986, she holds a MSc in Economics and Social Sciences at Bocconi University in Milan and graduated in 2011 with a thesis on Current Account Imbalances within the Euro Area. She obtained a BA in Economics and Social Sciences from the same university in 2008, with a thesis on Ukraine and Moldova in the European Neighbourhood Policy.

  • Pia Hüttl

    Pia Hüttl is an Austrian citizen and joined Bruegel as an Affiliate Fellow in 2015. Her research interests include macroeconomics, financial economics and monetary policy as well as European political economy.

    Prior to this, Pia worked as Research Assistant for Bruegel, and as a Trainee in the Monetary Policy Division of the European Central Bank. Also, she worked as a Blue Book Stagiaire in the Monetary policy, Exchange rate policy of the euro area, ERM II and Euro adoption Unit in DG Ecfin of the European Commission.

    She holds a Bachelor's degree in European Economics and a Master's degree in International Economics from the University of Rome Tor Vergata. She also obtained a Master's degree in European Political Economy from the London School of Economics, with a thesis on Current Account imbalances in the Euro area and the role of financial integration.

    Pia is currently pursuing a PhD in Economics at the Humboldt University in Berlin.

    She is fluent in German, Italian and English, and has good notions of French.

    Declaration of interests 2015

    Declaration of interests 2016

    Declaration of interests 2017

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