The interconnected nature of London-based financial markets and European Union (EU) businesses has helped the UK achieve relatively steady growth since the global financial crisis.1 Yet with the country due to withdraw from the EU on March 29, 2019, economic growth has slowed and the future of the financial services industry in the City of London remains uncertain.
A key economic sector
In April 2018, the UK House of Commons submitted a briefing that highlighted the importance of the finance sector to the nation's economy, noting that the financial services industry contributed 6.5 percent (GBP 119 billion ) of the UK's total economic output.2 London is an important contributor to the country's total output, with financial service firms based in the capital accounting for half of all activity.3
Europe has traditionally been a major destination for the export of UK services, particularly for financial services. According to the UK's Office for National Statistics, financial services products make the largest contribution to the UK's trade services surplus with the EU, amounting to GBP 18.4 billion in 2016.4 If the UK is to maintain a trade surplus of financial services with the EU, London-based firms must seek to retain access to European markets.
Mixed economic performance forecast
Key insights
- Capital expenditure is forecast to slow as London's access to European financial markets may be difficult post-Brexit
- The UK will now be required to adhere to third-party equivalence rules to access EU financial markets, but it is seeking to negotiate special exceptions
UK financial services have shown unexpected resilience since the 2016 referendum result, but some forecasts suggest that this may now be changing.
According to the Organization for Economic Co-operation and Development (OECD), Britain will face weak economic growth unless it is able to maintain close ties with EU businesses following Brexit.5 The Paris-based think-tank's warning came as it increased the UK's gross domestic product gross domestic product growth forecast for 2018 by 0.2 percentage points to 1.4 percent. This projected growth is slower than Spain with a 2.8 percent forecast, Germany at 2.1 percent, France at 1.9 percent and the Eurozone as a whole with an average of 2.2 percent.
The OECD also reported that the gradual pace of Brexit negotiations might further slow capital expenditure as businesses delay plans further. If greater clarity can be achieved about the future of trading arrangements, businesses may be more inclined to resume capital expenditure, which would lead to stronger economic growth.
Forging a new path
On July 12, 2018, the UK government published a white paper detailing its negotiating position in talks about its future trading relationship with the EU. The paper confirms that the UK will leave the Single Market and will exit the EU's “passporting" regime for financial services, which enables London-based financial services firms to trade freely with the EU.
If greater clarity can be achieved about the future of trading arrangements, businesses may be more inclined to resume capital expenditure
The paper states, “Both the UK and the EU will wish to maintain autonomy of decision- making and the ability to legislate for their own interests. For example, in some cases, the UK will need to be able to impose higher than global standards to manage its financial stability exposure. In other areas, the UK market contains products and business models that are different from those found elsewhere in the EU, and regulation would need to reflect these differences. The decision on whether and on what terms the UK should have access to the EU's markets will be a matter for the EU, and vice versa." 6
The decision has significant consequences for London-based firms. Under the European Market Infrastructure Regulation framework, the UK will now have to adhere to third-party equivalence rules to access EU financial markets, and the process of achieving third-party equivalence could be legally and politically complex. In its white paper, the UK government claims that third-party equivalence rules are insufficient for reciprocal supervisory cooperation, information sharing and crisis procedures, and warns that unless exceptions are made it could result in “unnecessary fragmentation of markets and increased costs to consumers and businesses."7
Exporting financial services
The City of London benefits from being integral to European financial markets, with 35 percent of all EU wholesale financial activities occurring in the UK capital.8 According to the Office for National Statistics, the financial services sector contributed GBP 58.2 billion to London's economy, totalling 14 percent of the city's overall economic output.9 The loss of passporting rights could impact the continued success of London, as firms based in the City will now require external authorization from the European Banking Authority to provide services such as lending, offering UCITS funds and providing payments to the EU.
The UK's negotiating position represents a stark challenge, not just to firms in London but also to firms in Europe that rely on transactions with the UK
The UK's negotiating position represents a stark challenge, not just to firms in London but also to firms in Europe that rely on transactions with the UK. According to professional services firm PwC, more than 8,000 EU firms hold at least one passport that enables them to provide services to UK clients, while 5,500 UK-authorized firms provide services into Europe.10
The loss of passporting into and out of the UK will dramatically reshape the prospects of London's financial services firms. London remains the most important financial services exporter within the EU and it remains to be seen just how much this will change when Brexit occurs. What happens next will depend on the EU's willingness to accommodate Britain's pursuit of an exceptional third-party equivalence deal.