London occupies a central role in the European financial system. Brexit will therefore generate significant risks and opportunities for the financial system of the remaining members of the European Union (EU-27). To successfully manage the resulting shifts, the EU-27 needs to adapt its financial regulatory structure. And with Britain’s departure from the EU single market nearly certain to occur before mid-2019, the EU-27 should not wait.
The main risks relate to the supervision of wholesale activities of financial firms and capital markets. Many wholesale market activities will need to be relocated from the United Kingdom to the EU-27 so that financial firms can keep serving local customers within the single market. To address these risks, European leaders should reinforce the European Securities and Markets Authority (ESMA) with significant additional resources and expanded responsibilities.
Market disruption is not the main risk for the EU-27’s single market. Most market participants have enough time to prepare for the worst-case scenario that there is still no agreement on “B-day” in early 2019. Rather, the main risk is market fragmentation along national lines with the loss of the London hub. Such fragmentation could result in less effective market supervision than is currently achieved by the UK authorities, a higher likelihood of misconduct and systemic disturbances, and a more onerous cost of funding for EU-27 corporates and households.
Fortunately, and thanks to wide-ranging reforms introduced during the past years of crisis, the EU-27 is much better equipped to face these challenges than it would have been a decade ago. All euro-area banks are now supervised on the prudential side by the European Central Bank (ECB), directly for the larger ones and indirectly for the smaller ones. This minimises the possibilities of regulatory arbitrage and of a concentration of systemic risk in a given country.
However, the ECB has no jurisdiction on important arenas of market activity and regulation. These include securities firms (also known as broker-dealers), asset managers and financial infrastructure such as central counterparties (CCPs, also known as clearing houses). The ECB also does not cover the conduct-of-business oversight of banks themselves.
ESMA was created in 2011 to help foster “supervisory convergence” and mitigate the vast existing differences of approaches, experience, and effectiveness between individual member states’ national authorities (such as BaFin in Germany, AMF in France, and Consob in Italy). ESMA also has some direct supervisory authority, but only over comparatively tiny market segments, namely credit rating agencies and trade repositories. ESMA has built up a decent track record, but its current mandate is not sufficient to integrate EU-27 capital markets and ensure high standards of compliance with EU regulations.
The obvious solution is to enhance ESMA's responsibilities, especially over those wholesale market segments which are currently concentrated in London and which require uniform, high quality supervision. We recommended expanded responsibilities that include
- authorisation of significant investment intermediaries (for example banks and securities firms) under the EU Markets in Financial Instruments Directive and Regulation (MiFID/MiFIR);
- registration, supervision, and resolution of CCPs, at least those that serve international clients and have a potentially systemic importance from an EU perspective;
- supervision of audit firms and the enforcement of International Financial Reporting Standards.
In parallel, the governance and funding of ESMA should be overhauled to better suit an enhanced scope of authority. Its current supervisory board, in which only representatives from national authorities have a vote, should be reformed to include an executive board of, say, five or six full-time members vetted by the European Parliament, as is the case with the ECB and the recently created Single Resolution Board. And in line with international best practices, ESMA’s funding should rely on a small levy on capital markets activity under scrutiny from the European Parliament, instead of the current political bargaining through the general EU budget.
Moreover, ESMA should be the single EU-27 point of contact for all interaction with third-country (non-EU) authorities. It should represent the EU-27 securities regulatory community in international supervisory colleges wherever relevant, and in international standard-setting bodies such as the International Organization of Securities Commissions and the Financial Stability Board. It should also, importantly, be given oversight authority over non-EU financial infrastructure that is systemically important for the European Union, similar to what already exists in the United States. This would allow flexibility in handling the financial stability challenges linked to the location of derivatives transactions, especially those denominated in euros, without having to force a costly relocation of their clearing in the euro area in the short term.
These reforms are significant but can all be achieved within the current treaty framework and without having to wait for the actual UK exit. They would all take the form of Internal Market legislation approved by a qualified majority vote. In fact, the United Kingdom can be expected to favour them all, for the same reasons it supported the inception of banking union in 2012–14: It is in the interest of the United Kingdom to have a well-regulated, well-supervised EU-27 financial system as its neighbor, for economic growth and financial stability reasons.
There is no compelling counterargument against financial market policy integration, especially now that the early achievements of banking union, including a broadly strong and effective European banking supervision led by the ECB, have provided a “proof of concept.” Significantly, the influential German Council of Economic Advisors (Sachverständigenrat) indicated in its latest annual report that “organising the supervision of banks, insurance companies and financial markets at [the] European level is the right approach.” The European Commission will review its signature policy of capital markets union in June: This should offer the perfect opportunity to announce the reinforcement of ESMA along the lines suggested above.
Other initiatives are also needed to make the best of Brexit for the EU-27 financial system. In particular, banking union is still an unfinished project that will need strengthening in order to better share the risks and benefits of the forthcoming relocation of financial activity from London. The distracting project of a European Financial Transaction Tax should be either reframed as a stamp duty on securities transactions or abandoned altogether.
Most importantly, leaders should make it clear that the inevitable competition among European financial centers to attract business from London should not be based on financial regulatory competition, but on other, non-regulatory factors such as infrastructure, skills, quality of life, as well as labour and tax legislation within the boundaries set by EU law. A swift move towards a stronger, more authoritative ESMA would be the best way to cement this vision.