This is what Brexit could mean for banking

The Brexit vote has undoubtedly created uncertainty and market volatility, with particular uncertainty for London, the EU’s largest financial centre. One issue facing the UK banking sector is the right to conduct cross-border activity in the EU (so-called ‘passporting’) when the UK is no longer an EU member. Another is the impact of Brexit on flexible recruitment in London. A further issue is the possibility that UK regulation moves away from that in the EU. The final question is the effect on bank profitability more widely across Europe.

Passporting

Currently, banks established in the UK – either UK owned or UK subsidiaries of overseas banks – have the right to establish branches or carry out cross-border activity in the rest of the EU and other EEA states (passporting). It is far too early to say if these rights will be maintained as a result of the exit negotiations. If the rights are not maintained, then many banks may have to reassess their European structures if they wish to carry out cross-border activity into the EEA. Before deciding on changes, however, the banks need to consider the extent to which they can utilise existing subsidiaries established in the rest of the EU to achieve their passporting rights. A quick review of a sample of major non-European banks with subsidiaries in London indicates that around three-quarters also have subsidiaries elsewhere in the EU.

In addition, the Markets in Financial Instruments Directive (MiFID) does allow for cross-border access by banks established outside the EU to exchanges, clearing houses, and clearing and settlement systems, and third-country equivalence provisions allow passporting into the EU to deal with professional clients. Third-country equivalence requires an assessment of areas such as authorisation and supervision, rules covering market abuse, and so on.

The questions are therefore much more about access to non-professional customers, and here existing subsidiaries could in many cases be used to provide passporting.

Regulation

One concern that the industry has is that UK regulation could diverge from that of the EU, adding cost and complexity. However, capital regulation of banks is underpinned by the Basel Accords, making it unlikely that the UK would move away from the EU in this area. Of course, over time some differences in application might develop, but in terms of implementation the UK has had a distinct approach. Indeed, changes in the Single Supervisory Mechanism led by the ECB are tending to bring the continent closer to the UK’s approach in areas such as Pillar II, the assessment of risks in the round and adequacy of capital. The UK has also always had a distinctive approach to conducting regulation.

Attractiveness of London as a financial centre

The crucial question going forward will be London’s continuing attractiveness as a financial centre. London’s attractiveness has always centred on language, the size and interconnectedness of the different facets of the financial centre, its cosmopolitan nature and available skills, and labour market flexibility. Labour market flexibility is an important part of the modern UK economy, but access to skilled labour from the rest of the world, including the EU, will need to be maintained. Successive governments will have to consider what makes London attractive as a home for financial activity and how to encourage those aspects. This means continuing to enhance infrastructure, considering taxes, and so on. If London continues to be attractive, then wholesale activity is likely to continue to gravitate to London.

Bank profitability

For the banking sector, the shorter-term implications of Brexit for profitability are perhaps even more front of mind. The very low interest rate environment is likely to persist for longer, with a further cut likely. Uncertainty is knocking on into lower growth and the possibility of a significant slowdown. This will also have an effect on the sector’s profitability not just in the UK but across Europe. Banks are already under pressure from investors to increase the rate of return on equity, and now share prices have fallen significantly. So far, investors have not accepted that better capitalised banks will have lower returns on equity, justified by improved soundness. This increased pressure on profitability will create further impetus for business model change, with banks exiting lines of activity where adequate returns cannot be achieved (EY 2015) and striving to cut costs. In this environment, the further proposed changes to bank capital requirements post Basel III are extremely unhelpful. The UK is already planning to offset them by reducing the much higher Pillar II buffers required in the UK. The continent of Europe does not have this scope because the use of Pillar II has been more limited and the buffers are therefore lower.

References

EY (2015), Rethinking risk management: Bank focus on non-financial risks and accountability, a risk management survey of major financial institutions