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Western EuropeSeptember 1 2016

How Switzerland's financial sector copes outside the EU single market

Switzerland’s rise as a European financial centre has followed an unorthodox path. Danielle Myles looks at the various ways its banks access the EU market, why the model is under threat, and how the Swiss plans to exploit Brexit.
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Stefan Hoffmann has worked in Swiss banking for nearly 30 years. Now head of Europe at the Swiss Bankers Association (SBA), he has witnessed the evolution of the country’s complicated relationship with the EU. Describing its viability in supporting Switzerland as a financial hub, Mr Hoffmann needs just one word: “Endangered.”

Brexit has thrown the so-called ‘Swiss model’ firmly into the spotlight, but when it comes to banking, there is confusion over what that model actually entails. Switzerland’s relationship with the EU is governed by more than 120 sector-specific bilateral accords. Financial services are a notable omission. Attempts to negotiate a financial services agreement (FSA) giving access to the single market stretch back to the early 1990s but have faced significant resistance from Brussels.

Cut off

There is reluctance to extend a key benefit of EU membership to a country that is not actually a member. More importantly, the EU is unhappy with the bilateral agreement approach, particularly because it means continually renegotiating updates to Swiss rules. “They set up these accords because the elite was pushing for Switzerland to join the EU to have full market access, but as that possibility has drifted away, the European Commission [EC] and other member states are getting increasingly fed up with this cumbersome system of regulatory download,” says John Springford, a senior research fellow at the Centre for European Reform.

Today, an FSA seems further away than ever. The EC is preoccupied with Brexit talks, and by early next year the Swiss government is obliged to implement the results of a 2014 referendum by imposing quotas on EU immigration, which conflicts with one of its bilateral agreements.

In lieu of an FSA, Swiss banks and their overseers have follwed four routes into the single market: passporting from an EU subsidiary, equivalence recognition, cross-border services and reverse solicitation. So far this patchwork approach has been successful, but as Mr Hoffmann warns, it has become precarious. EU reforms and the global clampdown on bank secrecy are chipping away at Swiss banks’ ability to serve foreign individuals, the lifeblood of its wealth management sector. Government initiatives to improve single market access have seen some success. But exploring banks’ four routes to the EU reveals the imperfections of the Swiss set-up.

Passporting rights

Just like their US and Japanese counterparts, the biggest Swiss banks have branches and subsidiaries throughout the EU from which they use passporting rights to conduct much of their single market business. Private banks such as Pictet, Julius Baer and Vontobel have offices in countries such as Germany and Luxembourg, but London is the location of choice. According to figures from the UK Treasury, 26.4% of European investment in UK financial services during 2014 came from Switzerland. As expected, Credit Suisse and UBS have the biggest operations, and this is reflected in the numbers. By revenue they are among the world’s top 10 investment banks (according to Statista), yet investment banking accounts for just 2% of the Swiss banking sector’s revenues (see chart).

Offshoring large amounts of business clashes with the SBA’s objective of maintaining jobs and value creation in Switzerland. But René Weber, head of the markets division in the State Secretariat for International Financial Matters (SIF), lays no blame.

“We have tried to facilitate cross-border business to the extent we can, but there are limits to what we can do,” he says. “So we realise banks are optimising their rights to operate in different ways. Of course we don’t suggest where they should seek to do business.”  

Equivalence recognition

The principal way the SIF is improving EU access is through third-country equivalence recognition under the Alternative Investment Fund Managers Directive (AIFMD), the second iteration of the Markets in Financial Instruments Directive (MiFID II) and the European Market Infrastructure Regulation (EMIR). Drafting Swiss rules that correspond to these EU instruments increases the chances of the European Securities and Markets Authority (ESMA) and the EC recognising them as equivalent and permitting Swiss firms to offer the relevant services in the EU.

Swiss banking gross revenues (2013)

Equivalence is not easy to achieve, however. It must be initiated by the EC or a member state, and there is no appeals process or fixed timeline, meaning ESMA and the EC have full control regarding if and when they make a decision. And if a determination is granted, that is not necessarily the end of the story. “The disadvantage is in the possible evolution of EU legislation. If it changes, the question of equivalency will be put on the table,” says Pascal Gentinetta, head of public policy at Julius Baer.

The procedure also varies from instrument to instrument. “These equivalence processes aren’t uniform. The EC itself has struggled with that,” says Mr Weber. “But regulatory processes in the EU are, of course, a negotiated process with each and every directive going through the European Council and European Parliament. This has led to very differentiated approaches from A to Z. It’s not always a predictable process to pass through as a third country.”

Switzerland is awaiting equivalence sign-off for AIFMD (which would allow fund managers to market to EU professional investors) and EMIR (which would facilitate cross-border clearing). The MiFID II process will not start for some time, but it is likely to disappoint. The directive covers banking and investment products and services. It is clear that an equivalence determination would give access to institutional investors and corporates, but some private banks had hoped it would also extend to high-net-worth (HNW) individuals. The growing consensus, however, is that HNW will be captured by the broadly defined ‘retail’ exclusion.

“The exact meaning of the directive is not undisputed,” says Mr Hoffmann. “But we understand that retail clients are defined under MiFID II irrespective of assets under management. In fact, retail clients are defined as all clients who are not professional clients or eligible counterparties. You can be very wealthy and still be considered retail. So it’s very hard to have another interpretation. That poses a very big problem for the internationally oriented Swiss banks doing a lot of business in international wealth management for private clients.”

Cross-border services

Swiss banks can still access the EU the old-fashioned way: by following the relevant member state’s rules. Before concepts such as passporting and equivalence came about, this was the primary route for cross-border banking. But it has become more hazardous since 2000 when national regulators tightened enforcement. A lack of an EU framework linking national regimes also means they differ in two ways.

First, the process of becoming locally licensed. Some regulators simply require compliance with national consumer protection rules, while others demand the use of a local intermediary or a local office, which leads to labour and tax considerations. Second, there is the question of what triggers the need for local authorisation in the first place. In some countries this is simply picking up the phone or emailing a potential client, while in others it is offering an existing client a new product or signing a contract. 

Among Switzerland’s key EU markets, Germany and Luxembourg are the easiest to access, while Austria is quite liberal and Italy a little less so. Belgium is very restrictive, and France notoriously difficult. For Swiss bankers to know what they can do in any given country is a tricky and often time-consuming task. Compliance departments consult hefty cross-border manuals to ensure they do not violate local rules. It is understood that the Swiss Financial Market Supervisory Authority (Finma) encourages smaller banks to limit themselves to a handful of foreign markets, to maximise the possibility of them being fully compliant. Finma declined to comment on this point.

The SIF and Finma, with the help of the SBA, have set about negotiating supervisory co-operation agreements with financial watchdogs in key markets to ease cross-border access. Known as freistellungsverfahren, they essentially exempt banks from local licensing requirements provided certain requirements are met. The first was agreed with BaFin, Germany's financial regulatory authority, in 2008, but was of limited use as Swiss banks were still required to use a German intermediary. A revised version, which took years to negotiate, was released in 2015 but has yet to be used.

Is the single market a misnomer? 

It is among the most popular benefits of EU membership, but whether the single market for financial services delivers what its name suggests is subject to growing scrutiny. On paper, a branch or subsidiary licensed and supervised by a member state regulator can sell services across the bloc without the need for further authorisation. But the reality is different, as Swiss firms passporting from EU offices have found.

“What we hear from them is that the single market is not always as single as it seems. It is fragmented, as national supervisors would still like to keep control and know what is going on,” says René Weber, head of the markets division in the State Secretariat for International Financial Matters. While some go as far as requiring locally licensed operations, others place conditions on inbound passporting from more liberal markets. For example, investment products registered with Germany’s financial regulator BaFin have needed tweaks before being sold in Italy.

“As I’ve experienced several times, it’s not a case of getting a stamp and then being free to market your products around the EU. Some local regulators and governments are still in favour of imposing certain local rules,” says Homburger partner René Bösch. “I’ve seen discussions where people say it doesn’t make sense to passport into country X as the cost-benefit analysis is negative.”

While a concern for the EU, these cracks in the single market may have influenced Switzerland’s attempts to export more financial services directly. “There has not been a huge wave of financial businesses leaving Switzerland despite the fact we are not in the EU,” says Mr Weber.

“We have been working with several banks on this but the requirements are very tough. It more or less expands German law into Switzerland,” says Marc Raggenbass of Deloitte in Zurich. “Swiss banks would indirectly have to comply with the MiFID II standards if they want this privilege, which could become very costly from a compliance perspective. So after a strategic assessment, they decided not to go forward.”

Nevertheless, there is a freistellungsverfahren arrangement with Austria and talks are under way with Italy and France. Neighbouring countries have been prioritised for a reason. “There are, for example, people working in Geneva who live in France, but have a salary paid into a Swiss bank. Very practical issues such as what services that bank can provide to that client across borders are things that we would like to solve in a more tangible way,” says Mr Weber, adding that SIF is very open to speaking with other countries. 

Reverse solicitation

Swiss banks can sidestep EU and member state rules completely if the customer simply comes to them. The long-standing, Europe-wide principle of ‘passive freedom of services’ essentially means that if a Swiss bank does not proactively solicit business overseas but is approached by an EU individual, corporate or institutional investor, it can do business as if the client were Swiss.

It may sound unworkable, but in private banking this has become a well-trodden path into the EU, as HNW individuals and families often refer their friends and relatives. But for Swiss bankers it is a slippery slope that is heavily scrutinised.

“Within a few hours you can be in, for example, France or Italy. And a trip for personal reasons can easily be combined with lunch or a football match with a client. In that situation, where’s the distinction between a social meeting and talking about investments?” queries Homburger partner René Bösch. “It’s a very fine line between allowed and prohibited behaviour. In theory it’s a concept that sounds OK, but it’s difficult to assure and monitor compliance over it.”

It is also not considered a viable business strategy in the long term. “You need to work actively in the market to serve existing and prospective clients. If you are limited to reverse solicitation, you will lose over time, and you will end up having a minority position,” says Mr Hoffmann. It has become even less feasible since Switzerland signed up to global standards on the automatic exchange of information. Starting 2018, Swiss banks must disclose foreign clients’ holdings to their home tax authorities.

Secrecy has been key to Switzerland’s growth into the world’s biggest wealth management centre. With that competitive advantage gone, private banks can no longer rely on clients seeking them out. Ironically, the problem is exacerbated by the strong Swiss franc. “Passive market access is not sufficient,” says Mr Gentinetta at Julius Baer. “Swiss banks acting in the private banking and asset management sectors who want to keep production in Switzerland now have an interest in getting better active market access.”

Leveraging Brexit

What links these four paths to the EU is the prioritisation of consumer protection – even for HNWs – and a more liberal approach to corporates and institutional investors. This means that of the 275 banks in Switzerland, the ones crying out for better EU access are those reliant on wealth management. Retail banking is domestically focused, while investment and corporate banking – even if exported directly from Switzerland – are likely to be tolerated. Clients’ sophistication and influence mean the rule of caveat emptor prevails. “I don’t think the industry would stand for regulators or politicians preventing them access to the largest players. You can’t tell a big French company that they can only use certain banks,” says one industry veteran.

The threats to cross-border private banking, which generates one-third of the sector’s revenues, places a premium on EU access. The Swiss government’s obligation to renegotiate its EU migration policy by February 2017 gives it little bargaining power. But the UK’s exit talks, despite potentially taking years, do. Both countries want the same thing – less migration and strong market access – and the SBA will suggest to Swiss negotiators how to benefit from any UK gains.

“Any agreement with the EU should possibly contain review clauses, specifically with regards to the future UK relationship,” says Mr Hoffmann. “Preferential treatment of the UK by the EU would, according to our judgement, contradict World Trade Organisation most-favoured-nation rules, unless it happens within a regional trade agreement. So in that sense, if the UK gets a good deal with the EU, third countries – including Switzerland – could profit from it as well.” The UK may be inspecting the Swiss model, but the Swiss, it seems, are already thinking about the UK’s.

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Read more about:  Regulations , Western Europe , Switzerland