Could a “Hard Brexit” Dim London’s Financial Influence?

Scenario #1

It’s the middle of the day in the “City”, but London’s financial district is eerily quiet. The financial behemoths that once reared above London’s skyline, have relocated to Dublin, Frankfurt, and other cities on the continent. What was once the financial capital of the world is now a ghost town – a desolate museum of London’s forgotten place in the global financial system. Welcome to post hard Brexit London, where trading floors and boardrooms have gone quiet, and the bustle and traffic on its cobblestoned streets have disappeared.     

Scenario #2

Introducing London, where there never seems to be any dearth of capital. Even as large financial companies continue to move to greener pastures in the EU, London has prevailed by reinventing itself as a global hub for money laundering. Smaller firms set up shop in the city to avoid the scrutiny of European regulators, washing billions, and investing into London’s thriving real estate market.       

Scenario #3

Brexit hits the City hard, but London carries on, unfazed. Good governance, a sophisticated regulatory environment, decades of experience in global finance, and the entrepreneurial zeal of Londoners continue to drive investment and capital into the city. Despite post hard Brexit setbacks, London still remains the financial capital of the world.

Which of these three scenarios seems like a plausible outcome of a hard Brexit? Many prognosticators argue that a hard Brexit is a highly unlikely outcome. In early March, analysts at JPMorgan and Pantheon Macroeconomics put the likelihood of a no deal Brexit at 10 to 15 percent.

After the UK Parliament voted for a Brexit delay last week, the date for the Brexit agreement seems likely to be postponed to June 30, 2019, pending various approvals. Fundamentally, however, the three Brexit options remain the same: A deal (soft Brexit), no deal (hard Brexit) or, the third outcome: No Brexit, where Brexit is abandoned altogether and the UK continues to stay within the EU.

This post, however, will consider the aftermath of a hard Brexit, in the unlikely event that it occurs. Earlier in the post, we laid out three different scenarios in the event of a hard Brexit. Let’s examine the regulatory  and other factors at play.

The inevitable slowdown

In the event of a hard Brexit, Britain would revert to commercial rules that govern members of the World Trade Organization (WTO), established in 1995. While that does provide a baseline for trade, and an attendant dispute settlement process, the favorable trade and tariff policies with countries within the EU, and with those countries that have deals with the EU, will no longer apply to Britain. This means that UK exports will face tariffs that Britain is currently exempt from; additionally, the UK would also have to deal with the costs of paperwork when exporting to the EU.

Imports into the UK could also face increased tariffs and controls, unless it decides to drop these. However, under WTO rules, it would have to do so for all WTO members, which could result in exporters dumping their goods into the country, and cutting into UK businesses.

Already, the uncertainty around Brexit has caused a slowdown in the British economy. The Bank of England (BOE) predicts first quarter growth at an anemic 0.2 percent, as investment contracts. This is the lowest growth rate in a decade and is predicted to be the lowest in Europe in 2019.

If a hard Brexit does occur, the numbers will be much worse; according to a BOE analysis published in November, inflation could accelerate beyond two percent, unemployment could rise to 7.5 percent and housing prices could fall by 30 percent; the British Pound could drop by nine percent.

However, BOE Governor Mark Carney states the UK is better prepared, “There has been progress in preparedness and that reduces the level of the economic shock … To be absolutely clear, we still expect that there would be a material economic shock. Half of the businesses are straight up reporting to us that they’re not prepared for a no-deal Brexit.”

The EU passporting system

The UK’s Financial Conduct Authority (FCA) states, “The European Union (Withdrawal) Act 2018 will convert existing direct EU legislation into UK law on exit day, and preserve existing UK laws which implement EU obligations.”

Consider the EU passporting system for banks and financial services companies. These rules allow an authorized firm in the European Economic Area (EEA) to provide services in the EEA’s member states with minimal additional requirements. Each passport covers a different financial service area. With a passport, a bank that is incorporated in any state within the EEA can open multiple branches in other EEA states or launch the specific financial services, delineated in the passport, across the EEA, without having to take the bureaucratic and costlier route of setting up legal subsidiaries in member states.

According to UK Finance, the leading trade association for the UK banking sector, “these passports are the foundation of the EU single market for financial services.”

For each of the nine passports covering different financial services, there are specific regulatoury requirements.

Should a hard Brexit take place, UK-based financial institutions will face additional requirements as Britain would be a “third-country”. Granted, the EU may consider the third-country’s regulatory regime as acceptable. However, this would only apply for some financial services; additionally, the regulatory equivalency is limited in scope, and is considered uncertain and less secure by many.

To avert such a situation, the UK could try to negotiate its way back into the EEA; however, there are serious political considerations and membership obligations, which would make this difficult to accomplish.

Data adequacy

In the Digital Age, data is of paramount importance; currently, data can be transferred freely between member states of the European Economic Area (EEA). However, with a hard Brexit, the UK becomes a third country, and would require an “adequacy decision” to gain access to European data.

CEO of the Direct Marketing Association (DMA), Chris Combemale, states, “…without an adequacy agreement in place, UK businesses and other organizations would need to find an alternative route to retain the free flow of data with the EU.” While the UK does have the GDPR in effect, according to UK-based thinktank, The Institute for Government, “there is no guarantee the UK will be awarded an adequacy decision.”

Outright catastrophe or business as usual?

Having considered the aforementioned factors, let’s reexamine the plausibility of the three scenarios outlined earlier.

#Scenario 1

This outright doomsday scenario has little basis in fact, although there are some experts suggesting the collapse of UK’s financial clout. Since the implementation of Margaret Thatcher’s Big Bang reforms in 1986, the UK has become the locus of the global financial system. Even as capital and personnel trickle out of the UK, experts agree that it would take years for any European city to develop a financial ecosystem that can rival London’s.

#Scenario 2

Some experts do see money laundering becoming a problem in the event of a hard Brexit; the UK’s National Crime Agency predicts that money-laundering opportunities will increase. The argument is based on the fact that Anti-Money Laundering (AML) is best fought by international cooperation – a hard Brexit would weaken cross-border communication, regulation synchronization and enforcement. Also, a shrinking UK economy would require a shift in priorities: The government would have to focus on improving national growth, leaving scarce resources to undertake effective AML measures.

Having said that, any gaps in AML cooperation would certainly be of concern to the UK government, which has been particularly strong on cracking down on money laundering in comparison to other countries. In fact, if a socialist government were to come to power, it would likely take an even more aggressive approach in combating money laundering. To ensure that progress continues, it’s vital that effective cross-border AML processes be a priority if a hard Brexit were to occur.

#Scenario 3

It’s important to acknowledge that the UK has seen worse, both politically and economically. But London has continued to attract more capital, and nurture brilliant talent. In the eighties, Britain’s awakening from its post-war slumber created enormous wealth, and turned London into the epicenter of global finance. If history is any indication, the City’s strong foundations – including the English language, English law, a huge pool of human capital and an open, international outlook – will likely see it through the crisis. Indeed, in London, it will always be “business as usual.”