Tuesday, July 19, 2016

Brexit and its Impact on the Financial services Industry

In the past few articles we have covered many different aspects of the Brexit Impact on UK and its economy. London is considered one of the international financial hubs and hence this Brexit is going to have profound impact on the financial services industry of the country. 

First, we start off by looking at the economic contribution of Britain’s financial services exports to the European Union. Then we assess how a new policy regime might negatively impact on these exports post-Brexit. Lastly, we will also talk about how this exit could benefit the prospects for British exports.

The Importance of Financial Services to UK’s GDP 

Accurate statistics for recent years Financial Services Exports by the UK are not available on the internet. As of 2013/14 exports of Financial Services contributed about 1% of the British GDP. 1% may sound small but if we take Britain’s 2013 GDP, it works out to about 25 Billion USD. Again this is just the number from 2013 and with the growth in the Financial Services industry in the UK, this number could potentially be much higher. 

Brexit – A Threat to the Financial Services Sector?

The single biggest risk that multinational firms would foresee as a consequence of the Brexit is the “Passporting Rights”. In layman terms, a US Bank could just obtain license to operate in the UK and on account of UK’s EU Membership, they could operate in many different EU Nations without actually having to set up a subsidiary company there. Get the idea? 

With the type of infrastructure and political stability that the UK has long boasted, most multinational banks, insurance cos and financial cos set up branches in the UK and offered their services to the EU nations. 

Of course, things could be as simple as the foreign banks set up a subsidiary company in another EU nation and then continue their operations in the UK. But, this is just wishful thinking. It is quite possible that the UK is going to lose a lot of its financial services business. Experts predict that the exports of financial services to the EU could fall by as much as 50%

To avoid this, the United Kingdom could preserve its single market access and passporting rights if it remained in the European Economic Area. But, as we discussed in prior articles, this may not be a favorable outcome for the voters who chose Brexit, as Britain would have to adopt all European Union financial rules & regulations. In fact, as a consequence of not being an actual member of EU, they would even lose their ability to block any new regulations that could potentially damage them. 

Of course, even being a member of the EU, the UK does not have full control over the financial regulations set up by the EU. For example, in 2013, the EU wanted to bring a regulation that would introduce an upper cap on banker’s bonuses which the UK was very much opposed to. Still, the new regulation was passed because the other EU nations wanted it. I could throw in a couple of more examples where the UK was either successful or unsuccessful with regards to new financial regulations brought in by the EU but that wouldn't serve the purpose. The point here is, being a EU member the UK would have a say in new financial regulations that are being considered. By being just a member of the economic area, the UK is going to lose this ability. 

Worst case scenario, the EU could deliberately try to undermine the UK to win business for other EU members like Germany or France. 

If Britain did not want to stay in the European Economic Area, it could still negotiate bilateral trade agreements with the European Union, as Switzerland has done. But Swiss banks do not have direct passporting rights and so operate their European investment banking businesses through subsidiaries in London. Considering the fact that the UK is leaving the EU, chances of their negotiating a deal as good as the Swiss did is highly unlikely. With this Brexit, there is a high chance that those banks would want to relocate to another nation that offers the flexibility to offer services to the EU nationals.

To make matters worse, the EU is coming up with a new financial regulation in Jan 2017 which will force all non-European Economic Area providers of financial services to have equivalent levels of regulation in their home country before they can do business across the EU. This new directive is called “Markets in Financial Instruments Directive II”

So, Britain’s financial services exports to the European Union would most probably be hit hard by Brexit. 

Does Brexit Present Any Opportunities to UK? 

There is a decent chance that London will continue to prosper even after the UK leaves the EU. London was a longtime financial hub even before the EU came into being. The city comes with it advantages, including a strong legal system, English language, a convenient time zone that is perfectly placed with working hours that overlap with both Asia and New York, a large pool of skilled labor and a ton of expertise in support services like accounting. 

As we saw in the previous section, it looks very possible that exports to the EU will suffer but, these losses could get offset in the long-term by the greater opportunities to boost trade ties with non-EU countries. This Brexit would free the United Kingdom from the limitations of the EU’s Common Commercial Policy, which prevents EU members from negotiating bilateral trade deals by themselves with other countries. 

This potential for growth in trade with countries outside Europe applies to all exports but is perhaps more pertinent for financial services. As you can see from the pie chart below, the EU Accounts for the biggest chunk of the UK’s financial services exports. However, the chances of growth in Asian markets like India & China as well as ability to expand their exports to USA or Canada could be vital for UK in the long run. Of course, this is under the assumption that they can negotiate favorable trade deals with non-EU nations which is highly likely. 

Some Last Words: 

A short term threat but a potential long term opportunity
At the outset, the Financial Services industry is going to have a big speed bum right away post Brexit and will probably be the biggest impacted sector. Even in a best case outcome in which passporting rights get preserved, the UK would still lose influence over the single market rules. The UK and London in particular will be hurt in the short term but it will not be a disaster. 

As you saw in the previous section, London’s competitive advantage existed long before the EU was formed and with flexibility to negotiate deals with non-EU nations by themselves, this Brexit could pay dividends to the financial services sector in the long run. 

Yes, there is a chance that the UK may no longer be the financial hub of Europe. Post Brexit, foreign firms may begin to reconsider their position and potentially relocate to EU states such as France or Germany in order to maintain their market share and avoid higher costs of operation should the Euro Zone insist that Euro denominated transactions be moved out of London. This potential shift of capital flows and investments from the UK to other parts of Europe may also tempt some companies, possibly including financial institutions to relocate out of the UK so as to seek better opportunities. 
On the upside, the Brexit would free the financial sector from EUs complicated regulatory restrictions. However, this may not translate to financial deregulation as it will be unlikely that the UK government will stray far from their EU counterparts in order to preserve financial competitiveness and stability. 
All in all, it will be a short term threat but has the potential to become a long term opportunity for the UK.

Disclaimer: All views presented in this article are those of the Author and are not endorsed by anyone. While every effort has been made to ensure that the data quoted and used in this article is reliable, there is no guarantee that it is correct, and the Author accepts no liability whatsoever in respect of any errors or omissions. This article is only economic research and is not intended to constitute investment advice, nor to solicit dealing in securities or investments.

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