The financial sector after the transition period - will it get a meaningful equivalence?

The first of the newly scheduled weekly talks between the UK and EU teams on a trade deal by the end of the transition period (31^st December 2020) finished early last week, sending warning signals to those hoping for some breakthrough. Time is running out. Prime Minister Johnson has rejected the possibility for an extension of the negotiating period into 2021 and Brussels has said talks and the text of any deal which has the status of a legally binding international treaty have to be completed no later than October to allow all 27 EU governments and the European Parliament to examine and sign off on the new agreement. London has also indicated that it wants a deal by the end of September. Given the summer’s holidays and parliamentary recess this allows very little time indeed to produce anything substantial.

The spectre of a no deal scenario has thus been raised again. There are suggestions that any negative impact if no agreement is reached impact can be dwarfed by the enormity of the Covid recession and that therefore the UK government is relaxed about the possibility of “no deal.” But the truth is that the Brexit impact will be long lasting and will affect productivity and growth for decades to come. And most firms across all sectors are simply not prepared nor are they able to bear the extra costs.

We know that on the trade front the main stumbling blocks remain fisheries; level playing field, i.e. the ability of the UK to depart from EU competition and state aid rules, and adjudication for disputes where the UK does not want the ECJ involvement under any deal they may strike with the EU. The markets are pricing no deal quite highly. But much else outside the strict confines of the FTA negotiations remains unresolved too – and crucially what the trading regime will be on financial services.[1]

This week’s talks are nevertheless resuming. But what happens during them, and the tone of the communiques/joint conferences afterwards, will be crucial in calming down nerves. For the sector the lack of progress so far has been a major disappointment. The deadline for reaching an agreement by 30^th June was passed with no solution in sight. True, the big financial firms have taken steps already to cover themselves by transferring funds and operations elsewhere in the EU and will continue to do. But it has not been cheap. And coming on top of the coronavirus uncertainty it has not been helpful either for forward planning. And crucial questions remain.

The cold truth is that the financial sector still doesn’t attract the type of sympathy from the public or the media attention that other sectors do. The memory of the financial crisis and the sector’s role in that remains in memories ten years on and the institutions – and their regulators – continue to be blamed for the austerity years that followed. In some areas, such as investment banking, the sector has done well during the crisis, so “why should we worry” remains one possible response from the public.

Yet during the pandemic financial services were considered – and are – a key sector of the economy as the various loan schemes had to be administered through them. Many of the high street banks are likely to suffer losses as a result and are setting funds aside. And we have seen some of the newer entrants finding life much more difficult during the pandemic. In addition, some 1.1 million people work directly in the financial sector in the UK and a further 1m or so are employed in sectors that provide related services to the financial sector. Services are the one part of the economy that has a surplus on our external trade, amounting to some £40b – City estimates suggest that some £20b of that is with the EU. The sector contributed some £130 billion to the UK economy, equivalent to 6.9% of GDP in 2018 [2] . Latest City of London estimates suggest that the sector paid some £75.5b of tax to the Exchequer in 2019[3]. London accounts for about half of overall output of the sector but there are particular concentrations of activity across many cities in the UK. Brexit has been a real challenge and the uncertainty cannot help.

So what lies ahead? It has long been clear that as a third country vis-à-vis the EU the best that the UK can hope is to move from ‘mutual recognition’ – having in effect a ‘passport’ for its firms to operate anywhere in the EU and which is the preserve of EU or EEA members – to ‘equivalence’, which requires the UK regulation to be of an acceptable or ‘equivalent’ standard to that in the EU. The UK can ask for equivalence but the decision to grant it, for how long, as well as the decision to withdraw equivalence remains entirely an EU prerogative.

While talks resume, what has put the cat among the pigeons was a speech by Michel Barnier, the EU’s chief negotiator last week[4], that accused the UK of trying to sabotage the EU’s clear position in this area. He made clear that ‘the EU would only grant equivalence in those areas where it is clearly in the interest of the EU, of our financial stability , our investors and our consumers.” It looks, from the tone of frustration in the speech, that progress may be hampered by the UK still thinking they have the upper hand in this area.

In that they may be wrong. It is true that the City is important for the EU and its companies as a whole, and it has played a major role in assisting the financing of its growth and prosperity. But there is little doubt that the integrity of the totality of EU rules are uppermost in Barnier’s mind. And the UK may have underestimated the EU’s response to Covid which has made the region even more intent than ever to get its institutions to be fit for purpose. EU leaders are saying they want to push ahead with completing the banking union and a capital markets union to rival eventually what the City can do .

The result has been a raising of the temperature in the City of London with the sector gathering voices to express the need for an early resolution of the issue. The Investment Association, which looks after UK funds which face the risk of being frozen out of the European markets if no agreement is reached, has made its concerns very clear[5]. The Association for Financial Markets in Europe has come out all guns blazing urging for an agreement on equivalence as otherwise direct access by UK firms in the future will be restricted, as will EU investors wishing to use London’s financial services[6]. It also highlighted the difficulty of coping with any additional disruption if no agreement is reached given the problems already being faced because of the pandemic. The Association for Financial Markets in Europe has declared that “Covid-19 has the potential to disrupt Brexit planning including impacting client readiness as well as potentially affecting the ability of firms to relocate staff to other jurisdictions”. The concerns extend to EU investors’ ability to continue using clearing houses in the UK and also having to ensure two way access in stocks and derivative trading if disruption is to be avoided.

British politicians tend to offer their own visions of Brexit with the former chancellor, Sajid Javid, having first raised the prospect of achieving ‘super equivalence’. But no-one in Europe is picking up on this. After Barnier’s comments last week , Pierre Gramegna, the Luxembourg Finance Minister, this week expressed concerns about the inconsistency of the UK position which, while insisting on its right to be a sovereign nation with 100% decision making on its regulatory environment post transition is at the same time hoping for an agreement on stable access rights that would give it “appropriate consultation and structured processes” before any equivalence provisions that the EU applies to third countries for some 40 financial sector areas are withdrawn from either side[7].

The Swiss have already seen the loss of equivalence as the EU withdrew existing equivalence regulations for Swiss bourses in protest at Swiss foot-dragging in concluding a deal on an overarching framework agreement for Swiss-EU relations instead of dozens of sectoral bi-lateral agreements. The decision to award equivalence or withdraw it is entirely in the hands of the EU Commission.

If the UK continues to insist all the fault lies with the EU side instead of finding a common sense compromise, the chances of London-based financial services firms from banking to insurance or investment funds operating in Europe as they do today are close to zero. Equivalence may not be the magic wand some claim it can be as there are many forces in EU capitals who would have no problem in seeing the City come off its high horse about its indispensability to the rest of Europe and instead seeing more vigorous financial service sectors develop in European capitals.

Impasse? Possibly. The EU has already backed down by suggesting a compromise on fishing agreements which would change the operation of the Common Fisheries Policy[8] in the direction demanded by Britain. Barnier has also made clear the European Court of Justice would only interpret EU law and would not have a role in British court decisions. In the end, it is a political decision by the prime minister and his closest advisors. How big a rupture does he want? It is clear the lobbying by different economic interest groups has not been effective. The Labour Party is waiting on the sidelines. The decision that will impact massively on the City and all it has grown into ever since the Single European Act (supported by Margaret Thatcher) abolished national protectionisms in Europe 35 years ago is now entirely in the prime minister’s hands and head. Which way will he go? We will soon find out.