Disconnection of the City and Multipolarisation of Eurozone Financial Markets (European Financial System by 2022)

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(Selected article from the Bulletin GEAB 121 / Jan 2018)

“Brexit means Brexit”[1]. For Theresa May, soft Brexit does not exist: an exit from the European Union necessarily means an exit from the European single market. Brexit therefore means hard Brexit for the British government. Within our GEAB bulletin no 103, we have already stated the possibility that the City might find itself “on the outskirts of the European continent”[2] by 2020. Along with the negotiation terms, comes the first move induced by the difficult, but inevitable, divorce. And as in any divorce case, the two partners have to share the house furniture. In case of Brexit, the financial companies move their headquarters, assets and jobs to the continent[3].

On the European side, Michel Barnier, the European Chief Negotiator for the UK’s exiting, said that “there could be no special agreement for the City”[4]. Since no other trade agreement with a third country currently covers financial services, the European Commission plans to avoid at any cost a possible à la carte agreement for the UK for fear of a domino effect[5]. Indeed, for Brussels this would endanger the very functioning of the Union by attracting the wrath of countries complying with European directives.

Now more than ever, our team’s anticipations are valid. To set up the independence of the Eurozone, the Europeans seem ready to free themselves from London, even if this means they will leave some feathers behind.

Brexit or no Brexit, London will see its access to the single market restricted and the United Kingdom will be perceived as an unstable continent for investors. Currently we anticipate a gradual disconnection between the City and the single market during and after the post-Brexit transition period, as well as a multipolarisation of the financial services in the Eurozone by 2022.

A financial ecosystem losing its raw materials 

 fig11Fig. 1 – UK net trade position in different European service market sectors (2014). Source: Capital Market

In 2016, the City was still the world’s leading financial centre, an accomplished financial ecosystem hosting the European Banking Authority, meaning 74% of the EU’s stock exchanges with the rest of the world and 40% of the global trading denominated in euro.

The financial sector is therefore vital for the United Kingdom. It represents 8% of GDP, 12% of public income[6] and around 3.5% of its labour.

However, a hard Brexit would represent the loss of the “financial passport[7]” which allows the actors of the City direct access to the single market. This loss is problematic because all the trade in services between the City and the EU is based on this authorisation. Mrs May’s government estimates that 5,000 British companies use it on the continent and 8,000 European companies use it to trade with the City[8].

In the absence of this passport, the country will have to negotiate an equivalence scheme to maintain the presence of British companies in the single market. According to Ivan Rodgers, former UK permanent representative to the EU, these equivalences are “rather capricious, political and incomplete[9]“. The economic compatibility and the rationality of agents will not condition the creation of such equivalence schemes. On the contrary, the economic actors are confronted here with the politicisation of the negotiations and the desire of the European Commission to punish the City by isolating it from the single market.

Interest and repatriation of systemic clearing houses 

The City would move from a free full access to the single market to a limited and incomplete one. Banks and insurance companies are not the only companies threatened by Brexit. The departure of the United Kingdom also raised the issue of clearing houses[10] in euro and their repatriation to the continent.

These institutions were given a central role in the derivatives market in 2009 following the decision of the G20 leaders to make their use mandatory. They thus became particularly strategic for the knowledge of the market they are actually providing.

On June 13, 2017[11], the European Commission made a proposal for the reform of the Eurozone’s clearing system. This paper insists on the need to “adjust to the rules” in order to better deal with the departure of the “biggest financial centre of the EU”. Therefore, European legislators are already preparing for the management of a post-Brexit European finance.

The idea is not to sharply exclude the city’s clearing houses, but to create two levels instead: those which are systemically important for the EU (known as level 2) and those which aren’t. The latter will continue to comply with current standards. On the other hand, the level 2-clearing houses will have to meet new requirements. The Commission reserves the right to repatriate those considered as the most important[12]. This distinction allows to avoid the City’s brutal stripping (which would be as detrimental to the EU as to London), but at the same time losing a precious sector for the stability of the Eurozone.

Financial Exodus

fig22Fig. 2 – Migration of wholesale market shares (leading to an equivalent relocation of the financial markets).

Certain financial corporations started to make arrangements and leave the UK territory aiming to preserve their access to the European financial market. According to some Ernst and Young estimates, 59 of the 222 City-based companies have already started moving staff or operations out of the City whilst 22 investment banks expressed their intentions to do the same[13].

All in all, the British losses could be up to 1,800 billion euro, 10,000 finance jobs and 20,000 positions related to professional services according to the Bruegel think tank[14]. Specialists are still divided on the total number of relocated jobs.

Once a company decides to invest in its relocation, there is no turning back. For the moment, financial companies are protecting themselves by shifting a minimum of activity to the Eurozone. In doing so, they protect themselves from the no deal risk. But this does not prevent them from “virtually” moving their activities, knowing financial activities nowadays is mostly virtual… an extra reason why relocations are not so visible yet.

Transition time is needed

In 2016 already, the growth of foreign investment in the British financial sector was 5% lower than in 2015. France and Germany, on the other hand, enjoyed a 25% and respectively 18% increase over the same period of time[15].

The slide of the activity towards the continent is currently happening. However, it is not in the EU’s interest that the City abruptly stops being the main European financial centre. That is why, at the risk of seeing some financial activities escape, a transition time is needed to form a European financial ecosystem able to survive the hyper-competition of Wall Street and Asian financial markets.

This transition will therefore serve both British interests and European restructuring into a multipolar ecosystem[16]. In the framework of Brexit negotiations, besides the conflict between the Commission and the United Kingdom, there is visible competition between the European cities likely to host the financial activities, as private interests are preferring competition to complementarity.

Financial multipolarisation on the European continent… or else?

Paris, Luxembourg, Dublin and Frankfurt are directly competing to welcome the Exiles of the City of London. For now, Frankfurt is apparently the most attractive actor, hosting the Citigroup, Goldman Sachs, Morgan Stanley, Standard Chatered and the Japanese Nomura Holdings, among others[17].

 fig33Fig.3 – Relocation Intentions of City bankers (28/09/2017). Source: Bloomberg.

Deutsche Bank will also move to the city already hosting the ECB.  Along with it, 300 billion euro of the balance sheet, and probably hundreds of banking jobs, will migrate from the United Kingdom to Germany[18]. In the case of Morgan Stanley, who chose the same destination by the way, we are speaking of 200 jobs threatened within the City[19].

Paris is not far behind this, with the arrival of the HSBC and its 1,000 employees[20], making the City of lights host of the largest number of post-Brexit jobs. The recent announcement of the relocation of the European Banking Authority from London to Paris is undoubtedly in favour of the French capital, a trend we started to anticipate as early as 2016[21].

Dublin also announced that contracts were signed with a dozen companies, each seeking offices with capacity of 10 to 500 employees[22]. Among them, Barclays would transfer nearly 150 jobs to the Irish capital city[23].

Luxembourg market should also boast about having attracted 10 companies, mainly business service-oriented, including the North American AIG[24]. Europe would therefore move from a complete financial hub, the City, to a multipolarised system within the Eurozone perimeter.

However, the strategy adopted by the companies is foresight-oriented and not meant to take the form of the final exodus. Assuming that Brexit can still be cancelled and soft Brexit is still achievable, the financial lobbies have not yet used all their cards, especially since they still rely on a rejection of the final agreement by the population and / or the British Parliament. This rejection would logically lead to a no deal action or an extension of horse-trading for soft Brexit. London financiers are therefore probably counting on a second referendum, so desired by some[25].

fig44Figure 4 – Hard Brexit, an estimation of costs. Source: Rabobank.

The British government makes no efforts whatsoever to maintain a financial activity on its territory. In Theresa May’s 78-page report, White Paper on Brexit, only one page is dedicated to financial services[26]. The City seems to have lost all confidence in Whitehall, as illustrated by the recent statement of Goldman Sachs’ CEO in Frankfurt, designating it as “a beautiful city in which he would spend much more time in the future[27].

Should we be optimistic about the development of a multipolar system of European finance?

At first glance, sliding from one centre to multiple poles is problematic. Cities compete with each other and do not show any sign of cooperation. It is hard to see Frankfurt agree on sharing a financial hegemony it already holds at the monetary level thanks to the ECB. But it might soon not have the choice… The last German elections tarnish the image of the country previously known as the European superpower. On the opposite side, Emmanuel Macron’s election made France more attractive for the financial sector. The image of this former Rothschild member strengthens the investors’ confidence in Paris. It is in this context that the French government abolished the 20% tax on high wages and is planning new tax measures to welcome more companies from January on[28].

Luxembourg and Dublin, tax havens in the heart of Europe, are also well positioned to complete the triumvirate of tomorrow’s global finance: Wall Street, Singapore and the Eurozone. Beyond the struggles to drain the investors of the City, the EU must be ready for post-Brexit times and think thoroughly of its duty to set up a sustainable multipolar system. The context of reforms of the Eurozone and its democratisation can be truly a chance, if implemented by good actors, and not by players “by default” (European Commission), and on condition that the citizens don’t miss the opportunity. Representatives of competing cities need to realise that Eurozone is not an economic island in the middle of nowhere, but a system which makes sense within the global financial system where it is responsible for assuming its role and its image as a leader in the world of the 21st century.

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[1]    Source: The Independant, 11/08/2016
[2]    Source: City of London, 2020: A small financial platform on the outskirts of the European continent, GEAB, 15/03/2016
[3]    Source: The Disunited Kingdom: the end of the United Kingdom as we know it… and its reinvention, GEAB, 15/05/2015
[4]    Source: The Guardian, 18/12/ 2017
[5]      Source: GEAB n°119, 15/11/2017
[6]    Source: Dhingra, Swati, Ottaviano, Gianmarco, Sampson, Thomas Reenen, John Van, « The impact of Brexit on foreign investment in the UK », Centre for Economic Performance, London School of Economics, 04/2016
[7]    The term “financial passport” refers to the fact that authorisation from a single market member country is required to obtain the right to trade with all member countries. Source: BBC, 25/06/2016
[8]    Source: Business Insider, 19/12/2017
[9]    Source: « EU-UK relations in preparation for Brexit », European Scrutiny Committee, House of Commons, 01/02/2017, p. 12
[10]  Created to prevent the risk of crises after 2008, a clearing house is an intermediary for the purchase of over-the-counter derivatives. Clearing houses are meant to avoid financial sector arrears known as counterparty risks. They help to reduce losses for the seller and trade the exchange with the buyer.
[11]  Source: Press release of the European Commission, 13/07/2017 and other connected links.
[12]  Source: Bourse Direct, 20/12/2017
[13]  Source: The Economist, 06/07/2017
[14]  Source: BusinessInsider, 08/02/2017
[15]  Source: Le Figaro, 01/01/2017
[16]  Source: Le Monde, 13/12/2017
[17]  Source: Bloomberg, 23/06/2017
[18]  Source: Bloomberg, 24/07/2017
[19]  Source: The Guardian, 19/07/2017
[20]  Source: Europe 1, 24/06/2017
[21]  Source: GEAB, 2016
[22]  Source: The Guardian, 29/06/2017
[23]  Source: The Guardian, 14/07/2017
[24]  Source: Paperjam, 27/12/2017
[25]  Including Nigel Farage, but for totally different reasons. Source: BBC, 11/01/2017
[26]  Grant, Charles, « Mrs May’s emerging deal on Brexit », Center for European Reform, 02/2017
[27]  Source: Twitter account of Lloys Blankfein, CEO of Goldman Sachs, 19/10/2017
[28]  Source: Les Echos, 28/12/2017