Show me the Money: Prospects for United Kingdom and EU cooperation on Financial Services post-Brexit

Draft Guidelines for the second phase of Brexit negotiations were submitted to the European Council on 7 March 2018, for adoption on 23 March.  In them the EU lays down tight limits for negotiation of the UK’s withdrawal agreement and future relations with the Union.  Faced with the UK Government’s insistence that the UK will leave the EU customs union, the Single Market and jurisdiction of the European Court of Justice, the EU refuses to compromise on the “four freedoms” of movement of goods, services, capital and people. It rejects any idea of allowing the UK to “cherry-pick” specially advantageous deals for sectors of particular interest.  The most that the EU offers is negotiation of an orthodox Free Trade Agreement (FTA) which by definition must fall short of the benefits of Single Market membership.

This new stage of negotiations raises in acute form the vital issue for the UK of how services will be treated in a new bilateral relationship.  Services constitute 80% of the UK economy, account for some 40% of UK exports to the other EU member states, and earn the UK a substantial surplus with the EU (£14 billion in 2016) which partially offsets its much larger deficit in bilateral goods trade.  Financial services represent a large chunk of these totals. The March Guidelines accept that services can be included in a future bilateral FTA, subject to the fact that the UK and the Union will no longer share a common regulatory, supervisory, enforcement and judicial framework.  Reciprocal market access and establishment rights for UK and EU service providers would be handled on a case-by-case basis.  By implication the Guidelines rule out specially favourable treatment for UK financial services (which are not specifically mentioned), and it is well-known that some other European financial centres are campaigning hard to attract business away from post-Brexit Britain.

Against this background, and also on March 7, the British Chancellor of the Exchequer Philip Hammond set out ideas for future UK/EU cooperation on regulation of financial services.  In her speech on March 2, UK Prime Minister Theresa May had described in general terms the sort of relationship which the UK wants to have with the EU in future, namely a partnership retaining the positive aspects of the current relationship and which would work for both sides.  Concentrating on financial services, Hammond made the case for maintaining the strongest possible regulatory cooperation in order to avoid the potential risks which Brexit might entail for financial stability; but his positive proposals still did not extend much beyond aspirations.

Mr. Hammond evoked the paradoxical-looking prospect that leaving the Single Market would leave the UK more freedom to cooperate closely with partners, including the EU when it is the mutual interest of the two sides to do so.  He challenged the assertion by some leading EU politicians that financial services cannot be covered within a FTA. The UK financial services hub, he said, is a unique financial ecosystem built on advantages of language, legal system, time zone, culture, networks, appetite for risk and regulatory approach.  It is not just a British asset, but serves business and citizens across the EU and worldwide.  UK financial services manage €1.5 trillion of assets on behalf of EU clients, facilitate around two-thirds of debt and equity capital raised by EU corporates, and handle about three-quarters of European Forex trading and of European trade in interest rate derivatives.

But this powerful system also presents risks to the UK taxpayer, and in the light of experience with the financial crisis ten years ago, the UK’s continuing priority must be consistent improvement of rigorous and robust standards. There was no prospect the UK, after Brexit, would be a haven of low regulatory standards.

Mr. Hammond argued that great progress has been made since 2008 in improving international cooperation on regulation of financial services, strengthening the disciplines on banks and segregating retail banking operations from asset management.  The risk to financial stability nowadays lay not in continuing this cooperation, but in breaking it up.  If the system were to fragment, the most likely beneficiaries would be not in Europe, but in New York, Singapore and Hong Kong.  The EU and the UK together should construct a future partnership on financial services which would protect everyone’s interests.

Arguing for a “bespoke” FTA, Hammond saw no reason why this could not include financial services – all trade agreements including those made by the EU are unique to their participants, and the reality today is that EU and UK economies, including financial services, are deeply interconnected on the basis of regulatory systems which are effectively identical.  Because of the UK’s trade balance with the EU (a substantial surplus in bilateral services trade) no agreement could be “fair and balanced” if it excluded services, in particular financial services.

A new UK/EU partnership should rest on three principles:

• A process for establishing regulatory requirements for UK/EU cross-border trade. This should start from current de facto equivalence of regulation and maintain equivalent regulatory outcomes even if the systems of the two sides later evolve separately. But the huge size of the UK financial services market (roughly 10 times GDP) means that the UK cannot automatically adopt rules made elsewhere.  A structured regulatory dialogue should be put in place to discuss new rules proposed by either side.
• Reciprocal and reliable cooperation arrangements prioritising financial stability. These must cover regulatory supervision and information exchange, and encourage regulators to work together, even though the UK would have withdrawn from EU supervisory agencies and the two sides would not formally participate in each other’s governance processes.
• A durable and reliable legal framework for participants in the market and their business clients. This would be particularly important where, for whatever reasons, the UK and the EU did not maintain equivalent outcomes.  Arrangements would have to be made to allow industry to plan with confidence, including an agreed independent arbitration mechanism.

Importantly, prudential regulations have usually been carved out from FTAs, giving parties greater scope to regulate according to domestic circumstances. Any bespoke FTA between the UK and the EU that goes deeper than existing FTAs would need to include provisions for prudential regulation that square with the stated ambition of retaining separate regulatory and enforcement mechanisms.

Mr. Hammond made a strong case in principle for maintaining the closest possible degree of equivalence and cooperation between the UK and the EU on financial services standards and regulation, essentially keeping and building on the arrangements that currently exist within the EU.  He did not however develop practical ideas for achieving such an outcome, and indications from within the EU, in particular the new negotiating Guidelines and comments from member states such as France, are that it will be extremely hard for the UK to achieve such a degree of regulatory cooperation while it insists on leaving the Single Market.