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Why is the financial services sector important?

The financial services sector employs more than 1 million people and accounted for over 7% of the value created in the UK economy in the second quarter of 2017.

In 2016-17, HM Revenue and Customs attributed £27.3 billion of tax receipts to the banking sector. The City of London Corporation estimates that the broader financial services industry (including insurance firms, for instance) generated more than £70 billion in tax revenues in 2016, making up 11.5% of the national total.

Does the financial services sector rely on the EU?

According to some estimates, a quarter of the financial services sector’s annual revenue comes from business related to the EU. The Institute for Fiscal Studies calculates that EU business is particularly important in banking and investment, with over 40% of UK exports in these areas heading to the continent. Many overseas banks have made the UK it’s European headquarters because of its access to the EU market.

But the relationship works both ways: London is the world’s leading financial centre, with no European alternative able to match it on efficiency and cost-effectiveness. PwC emphasises that many European businesses rely on the UK to fulfil their financial requirements.

What are the options for trade in financial services with the EU?

There are four broad models for conducting financial services trade with the EU:

  • Passporting: Firms based in EU member states, and non-EU states that are members of the European Economic Area (EEA), can sell their services freely within the bloc under a system known as ‘passporting’.
  • World Trade Organization (WTO) terms: States outside the EEA, or ‘third countries’, typically do business with Europe on the terms outlined in the WTO’s General Agreement on Trade in Services (GATS).
  • Equivalence: Some third countries receive preferable market access rights regarding certain services, on the basis that their laws and supervisory frameworks are deemed ‘equivalent’ to the EU’s by the European Commission and a committee of experts from member states.
  • Free trade agreement (FTA): Other third countries have attempted to cover financial services as part of a broader FTA with the EU. The Comprehensive Economic and Trade Agreement (CETA) between the EU and Canada is the most recent example of this.

How does ‘passporting’ work?

EU member states have agreed a body of shared regulatory and supervisory standards relating to financial services. Firms in one member state can apply to their national competent authority for a range of ‘passports’ indicating that they meet these standards in given areas, allowing them to establish branches elsewhere in the bloc and trade across borders with minimal further scrutiny. The UK financial services sector currently trades with Europe on this basis.

How does trade on WTO terms compare?

Trading on WTO terms entails significant limitations on cross-border trade compared to passporting, and stricter regulatory requirements and supervisory oversight of the EU branches of UK banks. Both sides are also able to impose measures for ‘prudential reasons’ such as ensuring the stability of the financial system, which can lead to further restrictions.

The UK financial services sector would trade with the EU on these terms in the event of ‘no deal’ on Brexit. The Bank of England has ordered firms to plan for this scenario. The Chief Executive of the Financial Conduct Authority expects firms to act on these contingency plans and start moving staff and operations out of the UK by the end of the year – unless a transition deal is agreed before then.

What is ‘equivalence’, and how does it work?

‘Equivalence’ is based on an assessment of how far the laws of a third country have the same intent and outcomes as the EU.

The House of Lords EU Committee’s report on financial services discusses the ways in which relying on equivalence determinations could prove problematic in practice:

  1. Equivalence is not negotiated, but requested from the European Commission – and the UK cannot technically apply until it has left the EU.
  2. Equivalence, once granted, can be withdrawn by the Commission.
  3. While the equivalence process is relatively untested, previous decisions have taken many years and been sensitive to political changes.

Some financial services – including basic banking services, such as lending and deposit-taking – are not covered by existing or incoming equivalence regimes. Trade for these services would revert to WTO terms or need to be negotiated separately in bilateral agreements.

For services covered by equivalence, market access rights are much narrower than those under the passport system.

Switzerland has been granted equivalence in some areas, but many Swiss firms still choose to conduct their European business from bases in EU member states for better access to the internal market.

How would an FTA covering financial services work?

A number of countries, including South Korea, the Ukraine and Canada, have recently negotiated FTAs with the EU. However, FTAs typically offer few provisions for trade in services. The financial services provisions in CETA, for instance, fall a long way short of passporting.

The UK’s unprecedented position of starting negotiations with the same regulations as the EU, and the high degree of interdependence between the two parties, mean that an agreement offering greater access to the financial services market than previous FTAs might be possible. However, the European Council emphasises in its guidelines for the Brexit negotiations that no sector-by-sector membership of the Single Market will be allowed post-Brexit, so some restrictions on trade in financial services should be expected.

The extent of access will likely be determined by how far the UK decides to diverge from EU regulations in the future. Establishing new arrangements for managing changes to rules on either side may prove crucial.

What is the Government’s position on financial services?

The Government’s Brexit May white paper expresses a desire for “the freest possible trade in financial services between the UK and EU member states.” More specifically, the Prime Minister’s Article 50 letter envisages financial services being covered by a comprehensive FTA.

The Prime Minister was adamant in her Florence speech that the UK should push for a more ambitious, bespoke agreement. She also echoed calls from the financial industry for a transitional arrangement to be decided on before the end of the year, during which existing arrangements would be maintained.

The Brexit Secretary David Davis has said that there will be regulatory divergence from the EU on financial services after Brexit, to secure a long-term competitive advantage for the UK.

However, the Chancellor Philip Hammond stressed the importance of regulatory co-operation. Both the Governor of the Bank of England and the Chief Executive of the FCA support this and see the UK and EU maintaining equivalent arrangements as a way of preserving free trade and open markets.

The Chancellor has also reassured financial services firms that they will continue to have access to global talent after Brexit, amid concerns that immigration restrictions could make it difficult to satisfy the industry’s demand for high-skilled labour.

What impact will Brexit have on the UK’s financial services trade with the rest of the world?

It is not only the relationship between the UK and the EU that will change after Brexit. By leaving the EU, the UK will no longer be party to trade arrangements between the EU and third countries around the world. FTAs with the likes of Singapore and South Korea will need to be re-established, and the recognition of other third country regimes in EU regulation will require replication in UK law.

The UK can also attempt to go beyond the market access rights provided under these EU arrangements, as well as pursue new FTAs with other partners.

The IfG would like to thank Elisa Kerr, legal expert and former senior director at Barclays for her help.

Update date: 
Wednesday, October 18, 2017 – 11:00

Original source – The Institute for Government

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