Banks without passports: The baseline scenarios for the UK banking sector after Brexit

Тhe decision of the British electorate to leave the European Union (EU) will have a profound impact on the financial sector in the UK, which employees 1.1 mm people and generates about 9% of the country`s GDP as well as 11% from the overall tax revenue. One of the most severely affected firms in the financial service sector are very likely to be wholesale and investment banks due to their significantly reliance on a direct access to the single European market of financial services. The concerns of the UK-based banks are thus focused on the critical issue of “passporting” rights , which allow UK-licensed financial institutions to provide financial services directly to customers in other EU Member State. As the prospects for a Norwegian-like “soft” Brexit are weakening, the UK-based financial institutions are very likely to loose the benefit of the EU “passport”, which may deeply impact their business model, market share and balance sheet. In a series of posts I will outline the different scenarios for the UK`s exit from the EU, the associated implications as well as the available mitigating factors or scenarios.

On July 11 2016 the British prime-minister Theresa May re-asserted in her address to the nation that “Brexit means Brexit” and there will be no attempt to stay in the EU. However, not much else is clear about the desired terms or the road map that will eventually lead the UK out of the EU.  The existing EU legislation shed no light on the terms of the future relationship of the leaving Member State with the EU, thus leaving substantial discretion to the parties to the negotiations. In this respect, Article 50 merely envisages that the EU shall negotiate and conclude an agreement with the withdrawing Member State “setting out the arrangements for its withdrawal, taking account of the framework for its future relationship with the Union” (TEU, Article 50, para. 2). In the absence of a clear framework for withdrawal from the EU, most analysts have conceptualized the possible terms of the UK`s exit on the scale between „soft“ to „hard“ Brexit depending on how far apart will the UK and the EU end up at the end of the negotiation period (e.g. Sapir for Bruegel, Oct. 2016; Simon Wells et all for HSBC Global Research, Oct. 2016).  The most commonly discussed scenarios are as follows:

Norwegian or European Economic Area (EEA) model.

Under this model, the UK will leave the EU but will remain part of the larger European Economic Area (“EEA”), which also encompasses Norway, Iceland and Liechtenstein. In this scenario, like Norway, the UK will retain its almost unlimited access to the internal market in most areas, except for fishing and agriculture. Most importantly for the purposes of this paper, UK financial institutions will retain their „passporting” rights, that is, their unlimited access to the European single market of financial services. Brexit tailored according to the Norwegian model should therefore be business as usual for most financial institutions in the UK and is usually considered a „soft” Brexit (e.g. Wells et all for HSBC Global Research, Oct. 2016). However, if it remains part of the EEA the UK would continue to make significant financial contributions to the EU budget, to allow free movement of persons, and to apply EU law in a number of fields, while losing its say in the EU decision-making process. In the area of financial services, the UK will be excluded from participation in the European Supervisory Authorities and will therefore lose its influence over the regulatory decisions and rule-making.

Customs union or World Trade Organization (“WTO”) model

Under this model, the UK would not have any preferential access to the internal market. The EU will be entitled to impose, in line with the WTO regulations, different tariffs and other barriers on the supply of goods and services from the UK. The UK may alternatively or additionally enter into a customs union with the EU, which could waive some or all of the restrictions on the import of goods (but not services) from the UK.

However, from the perspective of the UK financial sector both the WTO the Custom union will do very little, if anything, to facilitate the cross-border provision of services, including financial and professional services by UK firms (including subsidiaries of US companies) into the EU on equal terms with EU member state firms. The UK financial institutions will no longer be entitled to EU „passporting” rights, which would mean separate licensing for UK banks in each EU member state. The UK will no longer take part in the EU financial supervision or rule-making and will not be bound by the EU financial regulation in its internal affairs. In order to gain access to the internal market of financial services, where possible under EU law, the UK will be required to gain a third party „equivalence” status. Therefore, from the perspective of the UK financial institutions both the Customs union and WTO do not differ significantly and would lie in other end of the spectrum of possible scenarios as a „hard” Brexit.

Canadian or Free Trade Agreement (FTA) Model

In a search for a „softer” alternative to a WTO model, UK might seek to negotiate a FTA with the EU, which primary benefit is that it generally covers both goods and services. In this respect, some observers turn to the recently negotiated Comprehensive Economic and Trade Agreement (“CETA”) between the EU and Canada, which is one of the most comprehensive FTAs concluded by the EU so far (Scarpetta and Booth for Bruegel, Jun. 2016). Therefore, it can serve as a benchmark of how far the UK can reach under this model to secure a liberal regime for its economy, and its financial services sector. Similarly, to most other FTAs, CETA contains a number of market access restrictions when it comes to financial services. In principle, CETA allows trade in financial services between the EU and Canada under all the four ‘modes’ envisaged by the WTO’s General Agreement on Trade in Services (“GATS”): cross-border supply, consumption abroad, commercial presence, and presence of natural persons. However, the agreement establishes that “a Party may impose terms, conditions, and procedures for the authorization of the establishment and expansion of a commercial presence” (CETA, Art. 13.6, para. 3a). Under CETA, the EU is not required to allow Canadian companies to “do business or solicit in its territory” (CETA, Art. 13.7, para. 6). This essentially means Canadian firms that want to either sell their services to European customers on a cross-border basis or establish a commercial presence in the EU need to comply with EU rules. In other words, CETA does not appear to get Canadian companies much further than the position that could be achieved under the „equivalence” regime of the EU financial regulations (Leblond, 2016).

Swiss or Individual Agreements model

The UK may choose to re-negotiate its relations with the EU in a manners similar to Switzerland, which has entered into 120 different bilateral agreements that govern different aspects of its relationship with the EU (rather than simply gain access to the internal market as a whole as in the case of Norway). This scenario has a particular appeal for the UK. The national interests of the EU Member States differ significantly in the various areas, which may allow the UK to achieve a better bargaining position and eventually a better deal with the EU.

The example of Switzerland is unique in a number of ways. Firstly, the Swiss model is unique in the context of its conception as it was supposed to facilitate a smooth accession of the country to the EU. A Swiss accession never took place and the EU is currently in the process of re-considering its relationship with Switzerland. Secondly, Switzerland itself, at a referendum in 1992, voted not to join the EEA, which meant that it could not gain a direct access the internal market and had to go through painstaking process of negotiating separately all aspects of its access to the internal market. Thirdly, the UK should pay special consideration to the Swiss example because, similarly to the UK, Switzerland managed to sustain a large banking and financial sector while staying out of the EU. In a way, the UK has headed to a position that Switzerland has taken for years.

However, the Swiss models provides for mixed conclusions at best. Despite the large number of negotiated treaties, Switzerland has not managed to achieve a privileged treatment from the EU with respect to its financial sector. The Swiss banks have no general access to the single EU market of financial services and do not benefit from the EU „passporting” rights: Swiss banks had to establish subsidiaries and obtain a licence from a EU/EEA Member State in order to benefit from a EU „passport“. Moreover, in the absence of a general access to the EU market, Switzerland had to ensure a third party „equivalence” status. Therefore, the Swiss government and the Swiss Financial Market Supervisory Authority FINMA (“FINMA”) had to ensure that any proposed domestic financial services legislation would be compliant and consistent with EU law thus largely mirroring the EU regulation in its domestic legislation. As a result, Switzerland is more of „a rule taker, rather than a rule maker“ (Davis Polk, Lex et Brexit, Issue 6).  Finally, some commentators raise concerns whether the UK will be able to secure equally comprehensive deal with the EU within the limited two-year period under Article 50 given that it took 24 years for the Switzerland to negotiate the whole set of 120 individual agreements.

Based on the above, the prospects for a “soft” Brexit seem rather slim. Unless the UK chooses a Norwegian model, the UK-based financial institutions are very likely to lose their general access to the internal market as well as the benefit of their “passporting” rights. However, it will require significant contributions to the EU budget as well as a number of concession on behalf of the UK, for example in the area of migration policy. In view of the recent statements by the British PM Theresa May that the UK has „voted to leave the EU and become a fully-independent, sovereign country” as well as that it is not leaving the EU „only to return to the jurisdiction of the European Court of Justice“, a Norwegian scenario seems less and less likely.

Atanas Sabev is an LL.M. candidate at Harvard Law School (class of 2017) and a Senior Consultant at PwC. This is part one of three posts about the consequences of Brexit on the European financial single market. 

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