Several major cities across the EU27 (the EU28 minus the UK) are eagerly looking at the financial sector in the City of London. Some are even putting together incentive packages to lure business away from London after Brexit.
The potential benefits are numerous: high-quality jobs in financial services, expansion of ancillary services such as legal support and consultancy, better access to finance for corporates, higher tax revenues for the government, and prestige for the city and country. All in all, capturing some of London’s financial activity could give a boost to the (local) economy.
However, hosting a major financial centre also comes with significant risks and responsibilities. Most importantly, the country’s authorities are responsible for the supervision and stability of the incoming financial players and markets.
Banks and other financial firms currently based in London will of course want to keep on doing business with clients across the EU. If there is any major loss of passporting rights, they will have to set up a separately licensed subsidiary to do this, or upgrade one of their existing entities in the EU27.
This fully-fledged subsidiary can replace the London entity’s passport for EU27 clients. Early estimates suggest that the EU27-focused activities can amount to 30 percent of overall financial activities in the City. This relocation will be inevitable if London exits the single market – an outcome that is looking increasingly likely.
The first step for a city on the receiving end of a relocation would be to grant authorisation to the (new) subsidiary. The local prudential supervisor will do this in tandem with the ECB, the banking supervisor in the Single Supervisory Mechanism, if the new banking entity is based in the Eurozone and its assets exceed € 30 billion. Because these banks are carrying out financial market activities, they will also need a licence from the local financial markets authority (for example, the Autorité des Marchés Financiers in Paris).
Do the local supervisors have sufficient resources to process a surge of authorisation requests in a timely fashion? And do these supervisors have the right level of expertise on investment banking and trading activities? Perhaps not. Until now, the European supervisory expertise in these areas has been more or less pooled in the UK, within the UK Prudential Regulatory Authority (which is part of the Bank of England) and the UK Financial Conduct Authority.
The next step is to supervise these new players and markets in their work. Again, do the local supervisors have the resources and the skills to do so? Unfortunately, fraud and miss-selling are not uncommon in the financial sector and do also happen in wholesale financial markets (remember Libor, forex fixing, miss-selling of CoCos to retail clients, and others).
The Irish central bank governor, Philip Lane, has rightly warned against a regulatory race to the bottom. While the ECB plays a leading role on the prudential side, the European Securities and Markets Authority (ESMA) has only a coordinating and advisory role. The final responsibility rests with the national authorities for securities markets.
The final step is crisis management. The key players in the forex, securities and derivatives trading are the large banks. Who picks up the pieces if any of these large banks gets into trouble? The national central bank would be responsible for potential Emergency Liquidity Assistance (ELA) if and when needed.
Next, the national government forms the fiscal backstop. Of course, new bail-in rules will reduce the size and likelihood of public support, but the potential bail-out costs are not zero. Are the hopeful incoming countries aware of these responsibilities and exposures?
At the strategic level, the EU27 might want to think about the design of a vibrant financial system to serve the financing needs of their corporates, governments and households after Brexit. Should the financial system and related architecture remain predominantly national, or should we consider a more integrated financial system?
In the former case, fragmentation might lead to a lack of liquidity in the dispersed markets and subsequently to higher funding costs for corporates. In the latter case, a more integrated financial architecture might help preserve the benefits of integrated markets with central clearing (which allows participants to net margins and collateral across currencies and products).
We advocate three institutional changes to support such an integrated financial architecture. First, the banking rule-making body, the European Banking Authority (EBA), should be relocated from London to a capital in the EU27.
To prevent staff defections and a loss of expertise, we suggest a rapid informal EU27 decision along the lines of “should the UK leave the European Union, the EBA will relocate to [insert city name]”. This can be done without awaiting either confirmation of Brexit or the broader debate about post-Brexit EBA reform.
Second, the Banking Union needs to be completed to ensure effective prudential supervision and crisis management (including the fiscal backstop) at the euro-area level.
Finally, the Capital Markets Union should be upgraded with a central role for ESMA to ensure effective conduct supervision.
We thus advocate a tightly integrated EU27 financial architecture, so that financials can relocate to various cities without that being a problem. An interesting example is the United States with an integrated regulatory structure and financial sector, while financial market activities take place in New York and Chicago.