Deutsche Bundesbank, Member of the Executive Board
Ministry of Economy and Finance, France, Director General of Treasury
Santander UK, Chairman
1. Potential impact and implications of Brexit for the EU
An official noted that one should be modest when evaluating the impact of Brexit. Before the British referendum, there were many very negative assumptions and forecasts about what the impact of a ‘Leave’ vote would be, but in the very short term, there has been no real impact. The UK economy is doing well, and the resistance of financial markets has been very good. However, Brexit will ultimately have an impact on growth, probably more so in the UK than in Europe; the current forecasts are a loss in UK GDP growth of around 1%, and a quarter of that in the EU.
Another official stated that a financial centre the size of London is clearly important for the European economy. If Brexit hampers European banks and corporates from accessing London based financial services, this will affect funding conditions for Europe as a whole. For the German banking sector for example, the United Kingdom is the most important financial market in Europe, and second only to the United States in the world. The total exposure of German banks against UK domiciled debtors is around €320 billion, constituting a fifth of what is being lent across borders by German banks, which is very significant.
Taking into account all economic sectors, Germany has total claims against the United Kingdom of more than €1 trillion, the bulk of which is accounted for by financial derivatives and short term deposits held with UK banks. Conversely, Germany has liabilities against the United Kingdom of €1.2 trillion from the same sources, and all of this will be impacted by any change in the EU-UK relationship. Traditional banking services (e.g. loans, deposits…) should be relatively easy to substitute for, but complex banking services conducted in the City (e.g. derivatives clearing) will be much more complicated to replace because such risks are more difficult to transfer.
An industry representative stated that, while it is important to focus on the challenges posed by Brexit, it should also be recognised that it presents an opportunity for Europe to create a much deeper capital market, particularly if the Capital Markets Union (CMU) can be accelerated. The UK will have to accept that there are going to be changes, and there will be movement of jobs from the UK and into all of the major European capitals.
An official added that, however, Brexit is not good news: it will take up a great deal of time and negotiation, and will be the focus of a large amount of attention, as has been demonstrated by the discussions that have taken place thus far.
2. Priorities and possible outcome of the EU – UK negotiations
2.1. Priorities and appropriate conditions for the EU-UK negotiations in the financial area
An official considered that although it is unlikely that Brexit will be a positive change, all involved should do their best to limit the negative impacts. Europe and the UK are about to enter into a period of negotiation; on both sides, there has been a good start. The degree of convergence and solidarity observed among EU Member States, which have been very disciplined about not entering into bilateral negotiations before Article 50 has been launched, is very positive. There is a shared view among the EU’s 27 member states about the objectives and the consequences of Brexit. Both sides now understand that the UK will no longer be in the single market anymore. Europe needs to find an arrangement with the UK that will preserve the unity and integrity of the EU, and its capacity to decide in an autonomous way, the official believed, while also maintaining a very close relationship with the UK.
Another official emphasized the importance of maintaining a close cooperation and close ties between the British and European economies, and of preserving a level playing field with a single rulebook. The Bundesbank has always worked very closely with the Bank of England PRA, and will continue to do so following Brexit in order to mitigate risks. The official expected that the Single Supervisory Mechanism will remain applicable, as well. The four freedoms of the European Union are however not divisible, and no third country should receive a better deal than any single EU Member State.
The two biggest mistakes that could be made regarding the Brexit negotiations the official emphasized would be for the EU27 to consider penalising the UK for its decision to leave, and for the UK to believe that it can ‘cherry pick’ and force the EU27 into a position that they cannot agree to. The negotiations should be conducted in a pragmatic and constructive manner.
The first official agreed that ensuring a level playing field between the different players is essential. If there are different regulations and full market access, a competiveness gap will open up.
Another concern is financial stability, the official emphasized: the EU needs to have the ability to ensure its own financial stability, which is strongly related to government and national sovereignty. Very fundamental financial functions located in the UK will be outside the EU, and therefore outside the scope of the EU’s regulation and supervision. Some agreement will need to be struck regarding supervision, but the first step is deciding how regulation and convergence are to be dealt with. The current equivalence regime used in different EU legislations is a potential tool, but this will need to be reviewed, enlarged and refined to be effective in the context of the UK.
An industry representative stated that it is not necessary to discuss every issue related to financial services during the negotiations. Capital markets are the most important – about 80% of EU27 capital market activity takes place in, and is conducted through, London – but retail insurance, retail banking, and some aspects of commercial banking are less important. London is one of only two universal, global financial ecosystems in the world, and provides a depth of liquidity and a cost of capital that must not be jeopardised, particularly in the context of a crucial turning point in the European economy. Fragmentation will lead to costs, both for financial firms and for the real economy. There is also a need to prevent perverse impacts of increasing costs for investment banks at a time when they are struggling to meet their hurdle rates of return because it would be a shame if the gains of Brexit were realised by New York, rather than Europe.
2.2. Outcome that should be aimed for
An industry representative considered that the goal that needs to be worked towards is a free trade agreement, possibly narrower for financial services. The speaker however noted that achieving this would be quite unprecedented in trade history. It indeed takes seven years on average to negotiate a trade agreement, a length of time that will be compounded by the current focus on political priorities at the expense of economic priorities. What is needed is a solution that balances political, economic and market considerations but that is not happening at the moment. A challenge moreover is that politicians usually prefer to wait to act until the negative impacts become clearer if there is a cost associated with acting; the Brexit negotiation process is therefore ‘putting politics in a race against time’, which is not a comfortable position.
The advantage though is the starting point in this case, since there is total convergence between the UK and the EU regulations, the industry speaker claimed. Regulation is key: it is imperative that any deal is based on mutual recognition, and contains a deep and formalised regulatory cooperation agreement. This agreement will need to reassure the EU regarding its ability to supervise and have oversight over systemically significant service providers, as well as reassuring the UK that it can manage the risks of a systemically important sector in its own economy. The speaker noted that the industry is comfortable with this concept, as they are used to having multiple supervisors and regulators. Any Brexit deal will need to be based on international rules and regulations, and uphold the importance of the international organisations, the industry representative added. It is important to remember the role that regulatory arbitrage played in the financial crisis and that should be avoided.
The present level of integration between the UK and Europe is such that a de merger of markets on the scale envisioned is also unprecedented. The outstanding notional value of euro interest rate swaps cleared in London is €77 trillion for example; splitting this would potentially lead to deep instabilities. In the area of insurance, London writes €12 to €15 billion worth of corporate specialist reinsurance and insurance policies for EU27 clients, and London’s international investment banks have a balance sheet of €2 trillion. These are very high amounts. Without an agreement, there would be a need to “safely disentangle and rebuild” activities in EU27 with a sufficient depth of liquidity and of risk capital, with adequate infrastructure, supervisory capability and governance, while retaining the ability to service clients. The choice, therefore, is between an unprecedented, complex, and politically fraught agreement, or an unprecedented, complex, and expensive de merger; which is a choice between two ‘seemingly-impossible outcomes’ and between the positively impossible and the negatively impossible.
An official emphasized that the UK’s decision to leave the EU will inevitably bring fragmentation over time. The easy solution would have been for the UK to move towards an EEA type arrangement. This would mean the country becoming a rule taker, but that is the only way to ensure that the same regulations and rulebook are followed over time. However, since this is not an option, it will be very difficult for the UK to leave the EU and at the same time commit to following all EU regulations, which would involve abiding by the European Commission’s rules and the possible decisions of the European Court of Justice. This is possible in theory but very difficult politically.
The official emphasized that the UK becoming a third country will inevitably change the EU-UK relationship, and there is no precedent for this kind of redefinition; although the EU has a free trade agreement with many countries, these agreements are not of the same nature as the agreement that will need to be struck with the UK. The UK and the EU are starting from the same basis, with identical regulations and organisation, but the UK wants to take back its sovereignty, which means that the UK and the EU may move in different directions. Introducing some degree of sovereignty regarding regulation necessarily leads to fragmentation. This will need to be addressed and adjusted to, which will require all involved to be ‘very imaginative’.
Another issue is that it will also be difficult for the EU to maintain systemic infrastructure in a third country with potentially different regulation and supervision. Although an agreement might be reached regarding supervision, this will give rise to important issues of sovereignty, with political authorities wanting assurance that they can ensure financial stability in their area. The financial crisis has made it clear that financial stability is ultimately a national responsibility, and therefore it is very difficult to have one’s financial stability depend on other authorities.
3. The need for a transition period and its feasibility
An industry representative emphasised that two types of transition are necessary: the first is related to the fact that there may not be a new deal on the day of exit regarding the terms of the relationship, and that a bridging period will therefore be necessary. Secondly, after the terms of exit are known, financial industry players will need to deal with operational issues, including licences, regulatory approvals, IT systems, and repapering clients; this will take a long time, and it is therefore essential that this should begin early in the process. The most positive signal that the industry representative has seen is acceptance, at least in the EU, that it is natural for major items of legislation to come with a transition and implementation period. The UK Government has accepted this too, the speaker believed.
An official stressed that it is difficult to define the transition period while not knowing what the direction of the agreement will be. It seems therefore logical to take the attitude that the transition period can only be discussed once there is more clarity about the future of the EU UK relationship. As the dynamic of the negotiations is not known, it is very important that all parties should prepare for the possibility that negotiations may be unsuccessful, even if this is not the desired outcome.
The industry speaker replied that it would not be helpful to announce that there is going to be a transitional period very close to the date of Brexit since as one approaches the cliff-edge, disruption becomes more likely.