The effects of Brexit may not be felt immediately, but it spells the end of the City as we know it. The last 15 years will go down as London’s golden age and be sorely missed, writes Nicolas Véron.
Nicolas Véron is a senior fellow at Bruegel in Brussels and a visiting fellow at the Peterson Institute for International Economics in Washington DC.
This article was first published by Prospect Magazine.
“Brexit frees us to build a truly global Britain,” enthused Boris Johnson in his Telegraph column immediately after being appointed Foreign Secretary. If anything presently embodies the vision of “Global Britain,” it is the City of London, that marvel of a world-leading, cosmopolitan, ferociously competitive and efficient financial centre that serves as a powerhouse for the entire UK economy. But just as the City owes much of its current awe-inspiring prosperity to European integration, the brutal realities of Brexit will make it shrink, not thrive.
The reason, in a nutshell, is that the European Union’s single market has always been much more than a free trade zone. From its very inception as the 1950s European Coal and Steel Community, the EU has been about removing “behind-the-border” barriers to business and creating a single economic space regulated by supranational authorities. (This is why EU-level competition policy is so central to the whole project.) Deep economic integration goes hand-in-hand with supranational administrative capacity, especially in economic sectors that require intrusive public oversight, such as regulated services and especially finance. As Dani Rodrik, the Harvard economist, put it in his 2011 book The Globalisation Paradox, “Markets are most developed and most effective in generating wealth when they are backed by solid governmental institutions.” The EU project, for all its twists and turns, can largely be summarised as applying this insight to a continent-sized region. The fact that the single market vision is still far from fulfilled, especially in services sectors, does not invalidate the logic of deep integration.
Until now, the City has benefited disproportionately from the EU single market. London achieved its current dominant position in international finance in three phases: a head start in the 1970s with the development of international currency markets, a sharpened competitive edge in the 1980s thanks to the deregulatory “big bang” of the Thatcher era, and in the 1990s and 2000s, a centralisation of most of Europe’s wholesale financial activity thanks to the aggressive dismantling of national barriers by EU legislation on investment services, financial instruments, fund management, accounting standards, market infrastructure, and much more. Crucially, the structure of the EU single market allowed non-EU financial firms, including financial behemoths in the United States, to conduct most or all of their European business from a single location – London – allowing for significant cost savings. On most measures of wholesale financial activity, London’s share of the EU financial market rose sharply after the early 1990s, typically to three-quarters or more, while the other contenders such as Frankfurt or Milan or Paris all shrank to single-digit percentages.
These benefits, of course, might be preserved if the UK stays inside the European single market. But the more we explore possible scenarios, the clearer it becomes that “Brexit means Brexit”, not only from the European Union, but also from its single market. This is only partly about free movement of people, the issue that tends to dominate English debates. Even assuming all sorts of emergency brakes on foreign workers, UK membership of the European Economic Area (EEA) would provide the exact opposite of the “Leave” campaign slogan of “take back control.” On almost all non-tax issues of financial regulation, and many more in other sectors, the UK would have to submit to EU diktats in the preparation of which it would have no voice, an essentially unacceptable position for a sovereignty-focused post-Brexit government. It is no coincidence that all EEA members are nations whose independence is rather recent (1806 or 1866 for Liechtenstein, 1905 for Norway, 1944 for Iceland) and who make comparatively less of a fuss about national superiority. In other terms, and quite independently from the EU’s tactical choices and psychological stance in any exit negotiations, there is (to paraphrase George Osborne) a remorseless logic that will lead the UK to leave the single market as it leaves the EU, at best with a few years’ additional delay. Only a reversal of the entire Brexit process could prevent this from happening, but would certainly require a second referendum and for the moment appears improbable.
In sum, by far the most likely scenario for the City’s future post-Brexit is one in which there might be access to the single market, but from outside, as is currently the case for jurisdictions such as the US, Canada or Japan. In some market segments, EU regulations and bilateral agreements may allow for equivalent status, but not in all areas and presumably not forever. One may call this scenario “Switzerland-minus”. Switzerland is not a member of the EEA and has its own sovereign framework for financial regulation. It has agreements with the EU that grant its firms some access to the single market. But this stops well short of single market membership. Not coincidentally, much of the large Swiss banks’ services to EU clients are provided through their London affiliates, rather than directly from Zurich.
The impact on the City from being outside of the single market is inevitably a matter of speculation, given the complete absence of precedents. The optimistic view is that only a limited share of the City’s business, perhaps somewhere between 15 and 25% of its activities, will need to remain inside the single market and thus will move outside the UK, with the rest unaffected by Brexit. It would be a significant blow, but far from a fatal one. This view, however, downplays the risk-management and cost advantages of keeping all parts of a business in one single entity. In the current system, the UK affiliates of large international financial firms internalise a vast array of transactions, exposures, and market segments, which would be split if a significant subset had to move to a separate jurisdiction. For at least some of these firms, it might be preferable to move the bulk of the business, rather than suffer the consequences of fragmentation. If so, the financial services that move onto the continent may drag a much larger volume of activities along. The network effect, which has been the City’s best friend in the past 20 to 30 years, could become its most implacable enemy.
Or look at it this way: the City has thrived in recent decades because it was the best place to do financial business in its part of the world, which the financial set refers to as Europe, the Middle East and Africa (EMEA). Post-Brexit, the loss of single market membership will become a clear disadvantage in comparison to EMEA financial centres inside the EU, which the City’s other comparative advantages may not offset. British firms such as, say, Barclays or Aviva may endeavour to keep as much of their business as possible in the home country. But non-domestic ones, whether from America, Asia, or the EU itself, will have no sentimental or otherwise non-bottom-line-related reasons to linger in London if there are better business conditions elsewhere. A number of places will surely jostle to eat the City’s lunch, including Amsterdam, Brussels, Dublin, Edinburgh (if Scotland has serious prospects of staying in the EU), Frankfurt, Luxembourg, Madrid, Milan, Paris, Stockholm, Vienna, and probably others as well. Given the enormous opportunity, these cities and their respective countries will compete hard to burnish their existing credentials and remedy some of their handicaps in terms of attractiveness for financial service activities. It may be that neither of the two most often cited contenders, Frankfurt and Paris, will be winners in this contest, because of unchangeable rigidities such as onerous labour regulations. But there are enough places in the EU with top marks in cultural vibrancy, physical infrastructure, English proficiency, independent judiciary, and other key factors, so that it is likely that at least one and possibly even several (in a first phase) will emerge good enough to become, as London has been so far, the best place to do financial business in EMEA.
Attitudes of regulators may further tip the balance. In the EU, national and euro-area authorities have been effectively prevented from discriminating against UK-based firms thanks to the single market framework and its forceful enforcement by the European Commission and European Court of Justice. Such protections will erode when the UK leaves. Perhaps less evidently, the US authorities’ stance may change as well. In recent decades, American federal regulators have tended to be rather accommodative in their relations with their British counterparts, since operations from the UK provided US firms access to the vast EU market. When this beachhead function disappears, one may expect them to become more demanding in terms of UK regulatory standards as they are with smaller offshore places – seeing no particular advantage in having US firms conduct activities from London rather than from New York, Boston or Chicago. Similar incentives may apply in other non-EU jurisdictions.
To be sure, London is set to remain the largest financial centre in EMEA for the foreseeable future. It is currently so dominant that it will presumably take a very long time for any of its regional competitors to surpass it. There are also factors that will make it burdensome for some activities to move elsewhere, such as the depth of case law from English courts that can’t be easily replicated. But that will be little comfort. For the reasons exposed above, the City is likely to decline in absolute size, and even more so in relative terms as global financial activity can be expected to keep expanding. The EU will probably pursue further cross-border integration, perhaps implementing its project of a Capital Markets Union alongside the ongoing reshaping of the euro-area banking landscape under the policy framework known as Banking Union. Meanwhile, financial activity will probably keep growing at a rapid clip in Asia. Over the long term, at least one major financial centre may emerge inside the EU, and at least one also in Asia, that would grow enough to eventually outrank London. Given the likely continued strength of New York, the City would then drop to fourth place globally, if not lower. The future of London outside of the EU single market may resemble the present situation of Tokyo in Asia: a highly developed financial centre with respected institutions, but too insular to maintain itself in the truly global leadership league.
What can the British (or, if Scotland secedes, English) government do to improve the City’s prospects against this grim future? Two different paths may be pursued, and it is possible that both will be tried at different times, or perhaps even simultaneously, in the years to come. The first strategy, which may be labelled “near-remain,” is to stay as close as possible to the single market, by emulating most EU rules and maintaining close cooperation between UK financial authorities (such as the Bank of England and Financial Conduct Authority) and their counterparts in the EU. The second strategy is “going it alone,” enhancing the difference between the UK and its larger neighbour and boosting the City’s competitive edge on at least some market segments through more favourable tax and regulatory treatment, as most off-shore financial centres do. But these two strategies are largely incompatible with each other. Furthermore, none of them is exactly a winning one: “near-remain” will never be as good as being in the single market in terms of mainstream EU financial business; “going alone” implies focusing on a limited number of niche segments and losing the one-stop-shop position that the City currently enjoys—not to mention possible retaliation from the EU and others in case the stance becomes overly aggressive. Different firms in the City, and different factions within government, can be expected to advocate either strategy. If, as may be the case, UK policy shifts from one to the other and then back, it will fail to reap the full benefit of either.
All this is bleak news, not just for the City but for the national economy. London’s financial sector is a huge generator of tax receipts for the government: according to the City of London Corporation, in the year to March 2015, the City paid £66.5bn in tax, equivalent to almost two-thirds of the national education budget. It also provided revenue and profits for innumerable non-financial businesses, not to mention easier access to capital for many UK companies. For all the anger directed at fat-cat financiers, their mass emigration will do the nation no good. The market reaction has been rather muted so far, but this may only be because the harsh reality of Brexit has not fully surfaced yet. Reliable data about the “Leave” vote’s impact on investment or capital outflows will not be available until this autumn. Moreover, the international financial media, being largely headquartered in London, have various incentives to focus on the bright side. The London-based financial community, which normally acts as a ruthlessly unemotional processor of information, may also be biased in its initial judgment, not least because so many of its members have themselves voted in the referendum. The rest of the world, including non-European investors, is critically dependent on these two clusters of sources – London-based international media, and City analysts – for their own assessments. On this particular issue, then, global information channels may be viewed as temporarily impaired. But this gap cannot last forever
Recognising the high probability of the City hollowing out as a consequence of Brexit is not about “talking down” the UK economy, but rather acknowledging an impending tragedy. The future described here is terrible news not just for London and England, but for Europe as a whole. No prediction is ventured here about the pace of decline, which, among many other things, will be highly dependent on the occurrence of financial crises. But its reality appears inexorable, and only secondarily dependent on the specific political motivations of policymakers in London, Brussels, Berlin, Washington and elsewhere in the years ahead.
The golden age of London in the 2000s and early 2010s a place of blatant excesses but where everything seemed possible, that made Paris and even New York or San Francisco feel provincial, a de facto capital of the world, may be wistfully remembered as a fleeting wonder. It will be sorely missed by many.