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DatabankOctober 1 2013

Can London survive outside the EU?

The UK's relationship with the EU has rarely been harmonious, but in recent years the heavy-handed regulations and onerous taxes perceived to be emanating from Brussels have seen this marriage teeter perilously close to divorce. A referendum could be called in the UK in 2017 regarding its EU membership, but how would the country – and London in particular – look should the vote call for a permanent separation?
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Can London survive outside the EU?

The UK’s Conservative Party has said that, if elected, it will launch a referendum on whether the country should stay or leave the EU, which it joined 40 years ago. The vote would take place by 2017. The UK, argue Eurosceptics within the country, is fed up with layers of heavy regulation coming from Brussels and with its wider-reaching influence on policies that jar with the UK's pro-market and pragmatic ways.

In the years since the crisis hit, the UK’s economy has struggled, which, as is the case in many other European countries, has fuelled nationalistic sentiment, playing into the hands of the right-wing UK Independence Party, which strongly opposes the UK's membership of the EU.

The 'pro' camp defends the UK's membership of the EU and the privileged position it holds within it, pointing to London's role as a sophisticated gateway to European businesses and euro-denominated transactions.

The debate rages

The debate has generated much noise at home, and has seen some big international names wade in. US president Barack Obama has emphasised the merits of the EU membership, while Japan recently highlighted that its firms are attracted to the UK because it offers an entry point to Europe.

Tony Blair, the UK’s prime minister between 1997 and 2007, is passionate in his defence of the UK's EU membership. “Our position within the EU is absolutely central to our position in the world,” he wrote in August in the Evening Standard newspaper. “The idea that we would form equal relationships with new powers such as China and India with an identity separate from the EU is so unrealistic that is risible to anyone who has seen how big power politics works.”

Furthermore, 19 leading figures from the world of business, finance and politics published a letter in The Independent newspaper stating that “the economic case to stay in the EU is overwhelming” and that “to Britain, membership is estimated to be worth between £31bn [$49.32bn] and £92bn per year in income gains, or between £1200 to £3500 for every household.” The authors, who wrote in a personal capacity, include Lloyd’s chairman Sir Win Bischoff, Virgin Group founder Sir Richard Branson, WPP chief executive Sir Martin Sorrell, Eurostar chief executive Nicolas Petrovic, and Rothschild vice-chairman Sir Anthony Salz.

A substantial percentage of foreign direct investment coming to the UK is believed to take place because of its EU membership. “Research we did last year says that four out of 10 foreign direct investments in the UK are made on the basis of the UK being a member of the single [European] market,” says Chris Cummings, chief executive of financial sector organisation TheCityUK. “This is of substantial importance to businesses around the world that want access to a market of 500 million people.” According to data from greenfield investment monitor fDi Markets, a total of $41.18bn was invested in the UK last year, with London’s financial sector attracting $1.06bn.

Despite such high-profile and notable figures campaigning for the UK to stay in the EU, there is still a widespread feeling within the country that it is being stifled by expensive and burdensome rules and regulations coming out of Brussels. While London has undoubtedly benefited in many ways from the UK's EU membership, it is also a major global financial centre, and while the EU is perceived by many to be an over-reaching bureaucratic machine, London has established a reputation for having sensible financial regulation backed by powerful capital markets.

A marriage made in hell?

The EU undoubtedly has its idiosyncrasies. Founded in 1958, it is now formed of 28 countries but only 17 of these have been able or willing to join its currency, the euro. Single market principles apply to all countries but European institutions constantly need to deal with ambiguity generated by operating in different currencies and the lack of a common plan for all members to eventually join the euro (it is inconceivable that the UK will adopt the euro even if it votes to remain in the EU). Furthermore, EU policy-makers are not elected through a democratic process, and its powers had to stretch beyond their original mandate during the financial crisis. This required a great deal of legal manoeuvring and a change of gear regarding how fast fiscal union – a prerequisite for true banking union – would have to be achieved.

A 'Brexit' – as the possible exit of the UK from the EU has been branded – would help to simplify the EU structure and may speed up its consolidation. “Europe would gain something [if the UK left] – the possibility to streamline its institutional structure by merging the eurozone with the EU,” says Nicolas Veron, an economist at Brussels-based think tank Bruegel who is currently based in Washington, DC, as visiting fellow at the Peterson Institute for International Economics. “At the current juncture, this duality creates difficulty. It should not be over emphasised, but it is a problem,” he adds.

And a Brexit may not be as catastrophic for the UK as many critics are claiming. After all, similar fears pervaded the UK when the euro was introduced throughout many of Europe's major countries – the concern was that the decision to stay out of the new currency would badly impact on the UK, and particularly on London's future as the dominant European financial hub. In the end, the UK turned the situation to its advantage in some ways, as the eurozone crisis engulfed other EU members and, anecdotally, investments came to London to escape greater taxation elsewhere.

“I was heavily involved in the euro debate when it took place in the UK at the end of the 1990s; at that time it was widely said that if Britain did not join the euro, London would not retain its status as Europe’s major financial centre,” says Gerard Lyons, the economist appointed by London’s mayor, Boris Johnson, to conduct research into the pros and cons of a UK exit. “Of course we now know that despite not joining the euro, London did very well indeed. But I think that the relationship between London and Europe needs to evolve.”

The City and the union

Indeed, there are parts of London’s financial centre that would breathe a sigh of relief if they could escape from Brussels’ regulatory grip. Recently introduced EU rules such as the limit on bank employee bonuses to twice the amount of basic salary and the proposed financial transaction tax, a levy that may apply to stocks, bonds, derivatives, repurchase agreements and securities lending, have met with widespread unpopularity within the City. This exasperation was heightened when it was leaked that the EU’s legal service has indicated that the transaction tax is “not compatible” with existing laws. The European Commission said in mid-September that it will continue to work on the proposal.

It is not just the outcome but also the way the EU approaches policy that causes angst among certain sections of the UK's financial community. Helena Morrissey, chief executive of Newton Investment Management, says that, based on her experience, the legislative process at European level is “disappointing and disturbing”. Ms Morrissey had been dealing with EU authorities about the best way to get more women represented in boardrooms across the country.

Escaping from the heavy-handed EU lawmakers may indeed create an interesting regulatory arbitrage. The boom of London's stock exchange and capital markets more generally was a direct consequence of tougher regulation introduced elsewhere, namely the US.

London’s ‘light touch’ regulatory environment, brought in in the mid-1980s under former prime minister Margaret Thatcher, became particularly appealing with the introduction of the Sarbanes-Oxley reforms in the US in 2002, which were created in the wake of the Enron scandal and which demanded higher reporting requirements that firms complained were both expensive and bureaucratic. Companies wishing to list in the US could simply avoid these requirements by floating their shares in London.

According to data from Thomson Reuters, in 2000 US exchanges captured more than half of the world’s initial public offerings (IPOs), something they had done for the previous 10 years. In 2007, however – when global IPOs reached their peak, with a total value of $313.6bn – the percentage in the US was a meagre 18%. London, on the other hand, had gained ground, from 10% of the IPO total in 2000 to 16% in 2007.

“The rise of London was [originally fuelled by those looking to] escape from the regulation of New York,” says James Carrick, an economist at fund manager Legal & General. “Your immediate reaction is to say that London outside of the EU will lose lots of business and trade done with the continent, but allowing the UK to escape any burden of regulation such as the financial transaction tax could [generate] an increase in London's market share.”

New game, new rules

However, there is a counterargument to this, and wider liquidity issues to take into account, as well as the role that London plays in Europe – and the one it plays as one of the world’s leading hubs for international finance.

London is a key centre for euro-denominated settlements of share, derivative and bond transactions, and hosts more clearing houses than any other European city. Tensions already exist between the UK and the European Central Bank (ECB), which in 2011 issued a policy specifying that clearing houses should be relocated to a eurozone country when more then 5% of their business is euro-denominated. The UK has launched a lawsuit against the ECB, as it believes this policy is in breach of the single market. The UK’s defence on this issue would disappear if it left the EU and the single market.

Furthermore, a Brexit would mean that liquidity in the euro will become an even larger issue for both clearing houses and banks in London holding euro-denominated assets. In extreme scenarios, as the financial crisis proved, counterparties may struggle to supply liquidity while central banks, as the lenders of last resort, would need to support their constituents first. Being outside the single market would isolate London further from the eurozone central bank.

“In the future, can we be sure that, in stressed circumstances, the ECB would be happy to provide unconditional euro liquidity to firms or clearing houses based in London regulated by a body that has nothing to do with the ECB?” asks Ludovic de Montille, chairman of BNP Paribas’s UK operations. He also notes that, historically, London built its wealth on capital markets, starting with the offshore dollar and then other currencies, mostly the euro, but that capital markets are unable to provide that liquidity when turbulence is extreme and confidence vanishes, as the financial crisis showed.

Regulatory headwinds

The financial crisis not only revived nationalistic spirits among the UK's political backbenchers and taxpayers, it also created serious issues for regulators and central banks. The development of the capital markets gave lenders an alternative to central bank funds and access to liquidity. Indeed, under the extreme circumstances of the past few years, wholesale funding broke down. A Brexit, however, would not help this situation. Indeed, it would encourage a further fragmentation of capital markets as liquidity would need to be dealt with more within national borders.

UK regulators would have greater incentives to impose stringent subsidiarisation rules if the country were to withdraw its EU membership. This means that foreign banks would need to operate as subsidiaries and be regulated as a local bank, obeying higher capital and liquidity requirements. The rationale is to prevent a government bail-out in case of failure, but these rules have been bitterly contested.

Last year, in a letter to the UK Treasury, a number of major Chinese banks complained that “rigorously demanding” liquidity rules had prompted them to transfer business and even the management of their European operations out of London – despite the fact that London had been marketing itself as a key centre for renminbi settlements. China Construction Bank, ICBC, Bank of Communications and Agricultural Bank of China wanted to open branches in London but were only permitted to open subsidiaries, while Bank of China and ICBC had been allowed to operate as branches in Luxembourg, which “will be used to build up a network of European branches that would almost certainly have previously been run out of London”, according to the letter.

Diminishing advantage?

“If the UK exited, it is likely that the UK regulators would request the subsidiarisation of all EU banks in London, and the eurozone would probably do the same for foreign banks,” says Mr de Montille. “The City of London would still be [relevant] of course, but all major institutions would have to review their strategy. International banks are [in London], mainly because this is an international centre; for American banks this is their window to the eurozone and the Middle East. If the UK exited, the advantages of European passporting would disappear; institutions would have to manage their euro business from within the eurozone. Banks based in London would be seen as foreign banks from the perspective of the eurozone.”

Michael Sherwood and Richard Gnodde, co-chief executives of Goldman Sachs International, wrote in the Evening Standard in September that 85% of the bank’s European staff are employed in London, despite only 35% of client revenues coming from the city. But they warned that a Brexit could mean leaving the bank’s trading desk in London and distributing sales teams across continental Europe, so it could passport into each of the other 27 member countries. They said that other firms would follow suit and a new leading financial centre would develop over time.

In a world where capital markets may be more fragmented, proximity to central banks and the liquidity they can provide may indeed become increasingly relevant. “You don’t need to be a genius to realise that if we see this type of capital markets fragmentation, it is the location where central banks are based that will become attractive for liquidity reasons,” says Mr de Montille. “The issue with the City weakening is not that another financial centre would emerge, it would just be a net value destruction for Europe as a whole, and an additional competitiveness gap with the rest of the world.”  

A loss of influence?

Although EU regulation may frustrate both sides of the divide – pro and anti EU – many European membership supporters suggest that rather than quitting, the UK should seek to exert a bigger influence on Brussels. Norway, which has been cited as a possible model for the UK's relations with Europe, is outside of the EU but has negotiated access to the single market. However, it has no seat at the meetings where EU decisions are taken. Having no influence on such processes would be particularly difficult for the UK and London, as they would still partially feel the effects of EU rules.

Uncertainty over a possible exit is already eating into the negotiation powers of the UK, as Sharon Bowles, a Liberal Democrat politician and member of the European Parliament, notes. Others agree.

“No doubt the UK has lost leverage in European discussions, in financial regulation most obviously,” says Bruegel's Mr Veron. “Take what has happened with bonuses and compensation in the Capital Requirement Directive IV; it was not the first time these ideas had been floated in European parliament [but in the past they had] been successfully fought back by coalitions that included the UK. It suggests that something has changed. My simplistic take is that this is the sort of thing that the UK used to be able to veto, and now it no longer is.”

It is impossible to call the outcome of the UK's referendum, should it take place. A number of opinion polls, including one by the London-based Chartered Institute for Securities and Investment, seem to indicate that if it were to be taken today, the ‘stay-in’ vote would prevail by a small margin. However the country's sentiments could very much change between now and 2017.

By then, financial centres in markets such as China or Brazil may be able to attract significantly larger shares of the world’s business. By 2020, each of the BRIC countries' economies – Brazil, Russia, India and China – will have overtaken the UK's, according to the International Monetary Fund. By 2030, Mexico and Indonesia will have overtaken the UK too. By the time of the referendum, the UK and London may be concerned with bigger issues than simply putting up with European bureaucrats.

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Silvia Pavoni is editor in chief of The Banker. Silvia also serves as an advisory board member for the Women of the Future Programme and for the European Risk Management Council, and is part of the London council of non-profit WILL, Women in Leadership in Latin America. In 2019, she was awarded an honorary fellowship by City University of London.
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