With information on Brexit still sketchy, the City of London should push for an interim arrangement with the EU. Otherwise there is a risk that continued uncertainty will cause financial institutions to pull out.

Howard Davies

It is evident that when prime minister Theresa May took office, the UK government did not have a Brexit strategy: there was no cunning plan in a Downing Street drawer that she could take out and use. The cupboard was bare.

Her predecessor David Cameron has been criticised for that oversight. He did not even leave the euro-equivalent of Liam Byrne’s note in 2010 to his successor as chief secretary, “I’m afraid there is no money.”

That criticism is understandable, but a little unfair. With a Cabinet campaigning on both sides of the referendum it is hard to imagine that a Brexit strategy would have remained secret for a nano-second. It would have become a central part of the debate, which clearly Mr Cameron wanted to avoid.

On the side of the Leavers, there was little more than a vestigial argument on offer: 'they', the 27 other EU countries, run a large trade surplus with us, so why would they not want to agree a free-trade deal? This – along with some footling agreements on funding pensions for British Eurocrats (who anyway should have known better than to go to work in Brussels) offset by a share of the European Commission’s wine cellar – would ensure that a mutually satisfactory arrangement would be rapidly reached.

Where next for the City?

We all know people who embarked on 'amicable' divorce settlements based on similar arguments. Curiously, most of them ended up in court, complaining bitterly to their friends about the unreasonable behaviour of their erstwhile other half. Some particular element of the inheritance became the focal point of the dispute – a country cottage, a painting, or perhaps a dog.

In this case, the City is finding itself in that uncomfortable position. The underlying reason is clear. The continuing 27 do indeed run a big surplus with the UK in the trade of physical goods, but the UK runs a big (though not quite as big) surplus with them in services – and particularly financial services.

Furthermore, while the default option on trade in goods – some kind of World Trade Organization regime – is theoretically available, there is nothing comparable to fall back on in the finance arena.

European financial markets are intricately intertwined. Firms operate from London across the EU, using a variety of passporting arrangements, with little regard for national borders. And many financiers live an itinerant life, with a family in South Kensington, and weeks spent earning frequent flyer miles and having loud conversations on mobile phones in airport lounges. Preserving the lifestyle of the embarrassingly wealthy does not seem likely to be the top priority for the UK's Brexit negotiators.

Avoiding a shift

But, unfortunately, the problem needs to be addressed. Because otherwise we may be drifting towards a major shift of activity out of London, which Porsche dealers and nightclub owners, but more importantly the Treasury, will come to regret.

The financial services industry provides about 12% of all tax revenues –pre-crisis it was more – at a time when the public finances are under severe pressure, as the Autumn Statement showed. The City employs huge numbers of people, including some among the now-famous JAMs – families who are 'just about managing'.

The problem is easy to describe, but difficult to resolve. Unless the UK signs up to the four freedoms it cannot expect to preserve full single market access for financial firms based in London, and agreeing freedom of movement seems politically inconceivable.

If they cannot serve the whole of the EU from a London base, then some firms will move their operations and staff to other centres, albeit reluctantly. Some have argued that there is a 'brass plate' option: just open a poste restante address in Luxembourg and carry on as before. But firms need a firm legal base, and will not take chances; host regulators will ask for evidence of something more substantial than a plate.

All the right skills

So what can be done? The UK is not without cards to play. London is home to the major trading operations of all EU banks, and they do not wish to move them. It also has a deep labour market. If you walk down Lombard Street and shout that you need a risk manager with substantial experience of the Three Lines of Defence Model as it applies to equity derivative trading, you will not get to London Bridge without finding several business cards pressed into your hand. In Frankfurt you might get all the way to the airport without finding a candidate.

London also raises more than half of the new capital sought by large EU firms. The UK's regulators oversee most clearing and settlement activities, in the euro and other currencies. Any serious disruption to these markets would carry risks for financial intermediation and financial stability across the continent.

It is also evident that other governments are nervous about the consequences of a sharp break in these market mechanisms. In the long run, they might like to attract some of the business to their financial centres; but in two years’ time, from one week to the next? The risks are immense. The necessary regulatory capacity is just not there, not to mention the shortage of office buildings and housing.

Rushing not an option

So the UK should first be arguing for a transitional arrangement, lasting a few years, not months. That would preserve existing markets for a while, and allow firms to make rational decisions on business location based on a clear analysis of what must in future be done inside the eurozone, and what can remain outside it. There are those who see this as the thin end of a Remainer’s wedge. I believe that is wrong, and that a transitional regime should be seen as part of an exit strategy, not an alternative.

It would allow regulators to work out an appropriate set of collaborative arrangements, which may allow some activities to remain under UK regulation, with EU regulators relying on their work. UK regulators are well respected across the continent, perhaps better appreciated than they are at home. And in some areas of the capital and commodity markets they have a near-monopoly of expertise.

Durable market access arrangements could then be put in place. We have not needed them before, but we would have a strong case to argue that, immediately on departure, the UK is by definition operating a regime that is equivalent to those elsewhere in the 27, having hitherto scrupulously implemented EU regulation.

In those areas where the UK chooses to diverge in the future, and there will be some, we can manage the disengagement on a case-by-case basis. Complex negotiations are required, involving member states, the European Commission and the European Parliament. A rushed job is more or less inconceivable.

Resolving disputes

There are some difficulties in this kind of approach, certainly. Perhaps the knottiest issue is the question of dispute resolution. At the moment, regulatory disputes ultimately find their way to the European Court of Justice (ECJ). There are very few, of course, and on the whole financial firms have been happy to have the ECJ in the background. It was the court, for example, that prevented the European Central Bank from insisting that euro clearing must take place within the eurozone.

The ECJ is not, to put it mildly, the Brexiteers’ favourite institution. But would keeping it in place for a limited range of purposes, for a transitional period, be an inconceivable outcome, if it helped to underpin the integrity of European financial markets at a delicate time? In the longer run, an alternative will be needed. In fact, the little-known European Free Trade Assocation (EFTA) Court is available for use in disputes involving EU and EFTA members.

In the longer run, there will be some rebalancing of financial activity in Europe. London’s dominance in recent years has been remarkable, and Brexit is causing many firms to ask whether they want all their eggs in a British basket. A number will soon announce some shifts of activity to other centres, to hedge their bets in the face of continued uncertainty.

Some of those moves may not be hugely disruptive. Some will now happen whatever Brexit deal is done. But firms are making bigger contingency plans with reluctance, and may not trigger them if they see a possibility of a sensible, planned separation deal, rather than a messy divorce. That should be the government’s objective, and it will find some support for it on the other side of the English Channel.

Sir Howard Davies is the chairman of RBS, a former chairman of the Financial Services Authority and a former deputy governor of the Bank of England.  

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