London is the financial hub of Europe, providing corporate and investment banking services to the European Union’s 28 member states and well beyond. In a scenario in which the United Kingdom leaves the EU single market by the spring of 2019, UK-based financial firms would lose their passports to do direct business with EU27 clients. Brexit would thus lead to a partial migration of financial services activities from London to the EU27 (EU minus UK¹) so that financial firms can continue to serve their customers there. Some activities might also be relocated to other jurisdictions, primarily the United States (New York)². The next section discusses the orders of magnitude involved for wholesale banking, a crucial market segment. It should be noted that our estimates throughout this paper are for the purposes of illustration and debate, and not intended as forecasts.
The short-term and longer-term risks and opportunities involved in this shift make it essential for the EU27 to adopt clear policy positions on some key issues. In the short term, an abrupt departure of financial firms from London could cause disruption to financial markets and to the financing of the EU27 economy. Section 3 analyses the structural risk that the ensuing fragmentation of trading activity might result in increased costs and reduced access to capital for companies. There is also the related risk of a regulatory race to the bottom among EU27 countries, leading to misconduct, loss of market integrity and possibly financial instability.
On the upside, Brexit is also an opportunity to build more integrated and vibrant capital markets in the EU27 that would better serve all its member economies, improve risk sharing to withstand local shocks and make the EU27 an attractive place to do global financial business. This would speed up the rebalancing from a primarily bank-based to a relatively more market-based financial system, which is a central objective of the EU’s Capital Markets Union (CMU) policy³.
To address these risks and opportunities, we review three key areas relevant for policy (section 4). The first is directly linked to the finding that intra-EU27 financial market fragmentation is likely to lead to higher borrowing costs. To avert this, a single set of rules (or single rulebook) is necessary but not sufficient. Consistent supervision and enforcement are also needed, and would be best achieved by a reformed European Securities and Markets Authority (ESMA) playing an enhanced role as the single European capital markets supervisor. ESMA should operate in a hub-and-spoke model with national capital market authorities, similarly to EU competition policy enforcement and euro-area banking supervision.
Second, financial stability requires the euro area’s unfinished banking union to be further strengthened to generate the desired incentives for banks and national authorities. We recommend that further risk-sharing should go hand-in-hand with additional harmonisation initiatives and the limitation of banks’ holdings of individual countries’ sovereign bonds.
Third, the future European capital markets framework should adequately take into account cross-jurisdictional interdependencies inside the EU27 – especially while not all member states are part of the banking union, let alone the euro area – and in relation to third countries, including the UK, the United States and other jurisdictions such as Switzerland. The next few years may also call for renewed emphasis on the EU’s strategic interests in joint global initiatives in the area of financial regulation, given the likelihood of a less multilateral approach from the United States.
In parallel, EU27 countries should also work on quality of infrastructure, the skills base, English-language proficiency and tax and labour laws within the limits set by the EU framework (eg state aid control and fundamental rights) in order to foster efficient and vibrant markets. The competition between EU27 countries to attract financial activity and jobs can be broadly aligned with European interests if EU-level arrangements prevent a financial regulatory race to the bottom.