In 2016–17, HM Revenue and Customs attributed £27.3 billion of tax receipts to the banking sector. The City of London Corporation estimates that the broader financial services industry (including insurance firms, for instance) generated more than £70 billion in tax revenues in 2017, making up 11.0% of the national total.
According to some estimates, a quarter of the financial services sector’s annual revenue comes from business related to the EU. The Institute for Fiscal Studies calculates that EU business is particularly important in banking and investment, with over 40% of UK exports in these areas heading to the continent. Many overseas banks have made the UK their European headquarters because of its access to the EU market.
But the relationship works both ways: London is the world’s leading financial centre, with no European alternative able to match it on efficiency and cost-effectiveness. PricewaterhouseCoopers emphasises that many European businesses rely on the UK to fulfil their financial requirements.
There are four broad models for conducting financial services trade with the EU:
- Passporting: Firms based in EU member states, and non-EU states that are members of the European Economic Area (EEA), can sell their services freely within the bloc under a system known as ‘passporting’.
- World Trade Organization (WTO) terms: States outside the EEA, or ‘third countries’, typically do business with Europe on the terms outlined in the WTO’s General Agreement on Trade in Services (GATS).
- Equivalence: Some third countries receive preferable market access rights regarding certain services, on the basis that their laws and supervisory frameworks are deemed ‘equivalent’ to the EU’s by the European Commission and a committee of experts from member states.
- Free trade agreement (FTA): Other third countries have attempted to cover financial services as part of a broader FTA with the EU. The Comprehensive Economic and Trade Agreement (CETA) between the EU and Canada is the most recent example of this.
EU member states have agreed a body of shared regulatory and supervisory standards relating to financial services. Firms in one member state can apply to their national competent authority for a range of ‘passports’ indicating that they meet these standards in given areas. This allows firms to establish branches elsewhere in the bloc and trade across borders with minimal further scrutiny.
The UK financial services sector currently trades with Europe on this basis. Since the UK plans to leave the Single Market, passporting will no longer be an option after Brexit.
Trading on WTO terms entails significant limitations on cross-border trade compared to passporting, and stricter regulatory requirements and supervisory oversight of the EU branches of UK banks. Both sides are also able to impose measures for ‘prudential reasons’ such as ensuring the stability of the financial system, which can lead to further restrictions.
The UK financial services sector would trade with the EU on these terms in the event that no deal is agreed on the future UK-EU economic relationship.
The European Commission can grant equivalence to a third country if it considers the country’s laws to have the same intent and produce the same outcomes as those of the EU. The Commission can also unilaterally withdraw equivalence should the situation change.
With equivalence comes market access. In financial services, though, this is much narrower than the access offered by passporting. Furthermore, there are different equivalence regimes for different financial services, meaning third countries’ laws have to meet different criteria for different services.
Some financial services, including basic banking services such as lending and deposit-taking, are not covered by existing or incoming equivalence regimes. Trade for these services would revert to WTO terms or need to be negotiated separately in bilateral agreements.
The Chancellor, Philip Hammond, has made it clear that the Government considers the EU’s ‘unilateral’ equivalence framework “wholly inadequate for the scale and complexity of UK-EU financial services trade.”
A number of countries, including South Korea, the Ukraine and Canada, have recently negotiated FTAs with the EU. However, FTAs typically offer few provisions for trade in services. The financial services provisions in CETA, for instance, fall a long way short of passporting, and don’t go far beyond WTO terms.
Nonetheless, since the start of the Article 50 process, the UK Government has intended to cover trade in financial services as part of a comprehensive FTA. The Prime Minister said in her Mansion House speech in March 2018 that this FTA should go beyond any previous agreement.
The Chancellor offered more detail on how the Government envisages UK-EU trade in financial services to work after Brexit in his HSBC speech in March 2018.
He proposed the planned FTA acknowledges, in the first instance, the complete alignment of UK and EU financial services regulations on ‘Day 1’ of Brexit. As a result, no restrictions on market access should be necessary in the immediate aftermath of the UK’s exit from the EU.
Moving forwards, he suggested a ‘structured regulatory dialogue’. This would involve the UK and EU discussing any new rules proposed by either side, working together to ensure that the outcomes of any regulatory changes are equivalent on both sides of the Channel – with market access maintained accordingly.
The Chancellor was also adamant that the size of the UK financial services market, its importance to the UK economy, and the risks borne by UK tax payers on account of its complexity, meant that the UK could not be an automatic ‘rule taker’. He argued that the UK should be allowed “to deliver an equivalent outcome by different means” in some cases – a proposal akin to, but much more far-reaching than, the EU’s existing equivalence framework.
He added that in certain circumstances the UK “may choose not to maintain equivalent outcomes”. This would entail consequences, likely in the form of reduced market access, which would need to be determined by ‘an independent arbitration mechanism’ and applied “in a predictable way” to offer clarity to business.
The Chancellor has reassured financial services firms that they will continue to have access to global talent after Brexit, amid concerns that immigration restrictions could make it difficult to satisfy the industry’s demand for high-skilled labour. The Brexit Secretary, David Davis, has promised a special travel regime for intra-company transfers, suggesting that those posted elsewhere in the EU for less than three months could be allowed to move freely.
In September 2017, the International Regulatory Strategy Group, a group supported by the City of London Corporation and TheCityUK, published a report setting out their view of the future UK-EU relationship on financial services.
They argue that it is in the interests of the UK and the EU for existing cross-border trade in financial services to continue to sustain jobs and growth across Europe. Like the Chancellor, their report proposes a new relationship to manage changes in the law of each party and calls for close working between the UK and EU on supervision of financial services firms and a robust dispute resolution mechanism.
The European Council’s March 2018 negotiating guidelines make clear that the EU is ready to “work towards a balanced, ambitious and wide-ranging” FTA. However, the guidelines suggest that trade in services should take place “under host state rules”, meaning that UK firms would have to comply with member state regulations and be subject to the greater scrutiny this entails. Trade would also only be “to an extent consistent with the fact that the UK will become a third country”, outside the EU’s legal framework.
There is no explicit reference to trade in financial services in the guidelines. However, the importance of safeguarding financial stability in the EU and respecting the bloc’s regulatory standards and their application is emphasised. This implies that stability cannot be ensured if the EU trades openly with a third country which is not bound by the same legal framework.
This is consistent with previous statements from Michel Barnier, the EU’s Chief Negotiator for Brexit, who said in January 2018 that the UK could not benefit ‘from a system of generalised equivalence of standards’ along the lines proposed by the Chancellor.
The draft version of the withdrawal agreement between the UK and the EU, published in March 2018, reflects political agreement on the terms of a ‘transition period’ after March 2019. Under this agreement, financial services firms in the UK would keep passporting rights until 31 December 2020.
The financial services industry has long been pushing for a transition period. It was hoped that agreement on a ‘standstill’ period immediately after Brexit would give firms more time to determine the likely nature of the future UK-EU relationship before having to enact contingency plans.
However, the Chancellor has said that transition is a “wasting asset”. Some figures in the industry say that by now it has “depreciated almost entirely”. Many banks and financial services firms had to enact plans to minimise the impact of a possible March 2019 ‘no deal’ Brexit months ago. And there is still no certainty: negotiations on the withdrawal agreement are expected to continue until October 2018, and the final version will need to be signed and approved by the European Parliament, the European Council, and the UK Parliament before a transition period is guaranteed.
It is not only the relationship between the UK and the EU that will change after Brexit. By leaving the EU, the UK will no longer be party to trade arrangements between the EU and third countries around the world. EU agreements with third countries, such as its insurance agreements with the US and Switzerland, will need to be re-established, and the recognition of other third country regimes in EU regulation will require replication in UK law.
The UK can also attempt to go beyond the market access rights provided under these EU arrangements, and pursue new FTAs with other partners. Given the UK’s strengths in financial services, it could seek to make these a focus of its new trade deals.
The IfG would like to thank Elisa Kerr, legal expert and former senior director at Barclays for her help.