How important is "passporting" to the City of London?

Financial services account for nearly 12 per cent of the UK’s GDP and are one of few bright spots in the country’s current account balance with the rest of the EU, given that the sector produces a large and sustained trade surplus year after year (around £20 billion in 2015). It should therefore come as no surprise that the discussion over the future of UK financial services after Brexit has taken centre stage.

Particular attention is being paid to the impact of losing the so-called EU financial services “passport”—which allows UK-headquartered firms to do business across the bloc, either via local branches or on a cross-border basis. Open Europe has taken a forensic look at this issue in a new study published last week, and assessed possible alternative arrangements to ensure that UK financial services can continue thriving after Brexit.

Our analysis concludes that the importance of the passport really depends on the industry. It is relevant in some sectors, but has much less value in others. Put differently, it is exaggerated to claim that the UK’s success as a global financial centre is entirely reliant on the passport—but so is it to suggest that losing it would bear no consequences at all.

Of the main financial services industries, banking would be in for the hardest hit. Around a fifth of the UK banking sector’s annual revenue is estimated to be tied to the EU. For some key banking services (including deposit-taking, lending and payment services), there is currently no alternative to the passport—which explains why many banks have been drawing up contingency plans for a worst-case scenario.

For asset managers, the story is different. The passport works less well for them. A number of barriers remain in place at the national level (supervisory fees charged by local regulators, for instance) which can make it quite hard to market funds across borders—particularly for the smaller players. Furthermore, it is already common practice to keep EU clients’ assets in funds domiciled in another European hub (mostly Dublin or Luxembourg) and then delegate their management to the UK. In theory, this kind of set-up could continue after Brexit—mitigating the impact of losing the passport on UK-based asset managers.

As regards insurance, it is a more globally diversified industry by nature. As such, it makes much less use of the passport. The overwhelming majority of insurers that currently operate across borders do so via separate local subsidiaries—which are not reliant on the passport. The Lloyd’s of London insurance market is an important exception because of its very specific structure, but ultimately only a tiny fraction of its business (around 3-4 per cent of its Gross Written Premium) is thought to depend on the passport.

Add to this the fact that there is not one single passport, but several sector-specific ones built upon a number of separate EU regulations. In other words, the UK is not facing a black-or-white choice—and this is why the Government needs to target its negotiating efforts at retaining or replicating passport-like arrangements in areas where the passport is most valuable and there are no good alternatives available.

Regulatory “equivalence” with the EU is often cited as the most obvious fall-back option for financial services if the UK were to leave the single market. This essentially means the EU would continue to judge UK financial regulations as good as its own after Brexit. By logic, equivalence should be much easier to achieve for the UK than for any other third country—given that it is currently applying the exact same rules as the rest of the EU. However, one major shortcoming of equivalence is that it does not cover the full spectrum of EU financial services regulations. It bestows passport-like rights in some sectors, such as investment banking and re-insurance, but is not available at all in some other areas—wholesale banking being the key one, as I mentioned above.

Therefore, while the Government should indeed seek equivalence where possible, it should also aim to bolster it with bespoke deals where it is not on offer. An agreement to keep the Capital Requirements Directive (CRD IV) passport for wholesale banking in place should be a top priority, given the size and importance of the UK’s banking sector.

This will be a race against time for the Government. The fluid nature of the business means the financial services industry needs maximum clarity on future trade arrangements with the EU as early on as possible in the upcoming Brexit talks. Prolonged uncertainty would prompt some firms to push the button and set their contingency plans into motion. This might involve moving part of their operations out of the UK—or even shutting some business lines down altogether.

However, I believe the UK has good economic arguments to persuade the EU-27 that keeping financial markets open across the Channel would be mutually beneficial. One consequence of fragmenting the UK’s financial ecosystem, for instance, would be to drive up the costs of funding for European consumers, corporates and governments. Furthermore, no-one can be absolutely sure that business moving out of London would necessarily pick Paris or Frankfurt or any other European hub over, say, New York or Singapore to relocate.

In other words, the UK and the EU-27 may well end up in a “lose-lose” situation. Perhaps some EU leaders have political motivations to push for this kind of outcome, but one thing is certain: it would make little sense economically for everyone involved.

Open Europe's new paper, "How the UK's financial services can continue thriving after Brexit, can be found here