The Effect of Brexit on the Banking in Financial Markets

Konstantinos Svintzos, Ding YuPei, Liu MengYang

December 2017

Capital Markets Union (CMU) is initiative proposed by the European Commission in 2014 in order to reduce barriers among the countries in the Eurozone, increasing the range of available funding for banking and companies, ensures the post-crisis regulatory framework. The UK is currently a European major international financial center and leads in the quantities of financial services areas. For example, in cross-border bank lending the UK makes up 17 percent international market share, with Germany and France only 9 percent. Hedge fund assets consist of 18 percent market share in the UK compared to 1 percent of France. As a result, the UK dominates the wholesale funding and wholesale financial services and has done so for decades. Additionally, the UK has become the biggest center in the world for trading the Euro and dominates the world's foreign currency trading market; this trend has been accelerated initially with the creation of the EU single market and with the Eurozone from 1999. The UK's membership of the EU affords it access to the world's biggest single market, there are approximately 500 million people from foreign countries who work at banking sector or different firms, which make the GDP in UK growth $ 13 trillion per year from 2003.

The result of the UK referendum on its membership of the EU creates significant influence on the banking and financial service industry. Although the outcome of Brexit is not clear nowadays, it is obvious that only countries that pay into the EU budget, and permit free movement of people from within the EU, currently benefit to any degree form flexible entry into the EU's financial services single market. However, new financial pioneers believe that Europe needs bigger and better capital markets to help drive its recovery and growth, the main current efforts across the EU is to reduce the dependence of the European economy on bank lending. Additionally, the UK has played for many years a significant role in setting global standards for prudential supervision and regulation of banks and other financial services firms, in fact, the Bank of England is the global bodies to make both European legislation and regulation. As a result, after Brexit completely, the Bank of England is nevertheless a major influence on European financial market, in other words, the UK's banking industry will never be the same.

The potential influence on the banking in the event of Brexit

(1) Passporting

Every bank with its headquarters in the UK needs to consider first of all whether the UK still remains the most appropriate and attractive destination, as it was before Brexit. Under the EU passporting rules, Banks and corporations that have authorized and incorporated in one EU state has the right to set up branches or conduct cross-border business the EU without the need for additional local authorization, many of these UK-based banks using passports are branches of EU-owned banks, investment banks or asset management companies obtain advantage of this single market to set up business in the UK and almost them have good profitability.

One-third of all overseas banks operating in the UK are headquartered in the rest of the EU, and more than 70 banks incorporated in the European Economic Area (EEA) use passports to access the UK market and benefit for UK customers. In terms of banks and investment banks in the UK, they are able to operate across the EU under a CRD (Capital Requirements Directive) or prudential passport, which is efficiently single EU-wide banking license. For UK bank, this single point of entry significantly reduces the complexity and cost of their cross-border business. Similarly, Investment banks operate this model under MiFID (Markets in Financial Instruments Directive) passports and are able to trade. Additionally, market to clients across the EU from one location can reduce their funding costs and provide easier market access for the clients. However, in the event of Brexit, banks in the UK may have to set up separately-capitalized subsidiaries inside in the EU, and investment banks should have to set up separate broker-dealers in the EU in order to retain this automatic access. The chief executive of JPMorgan, Kamie Dimon, was quoted in the Financial Times in 2016 warning that Brexit would consist of "massive dislocation" to London's financial center could reverse the economic growth for international banks in London. After the Brexit event, this passport regime will disappear, banking has high barriers to entry and high fixed costs when different branches distribute in the UK and other European countries. Meanwhile, the less liquidity and more frictional costs of trading between the headquarter bank located in the UK and its branches distributed in different countries. HSBC has just announced (in the same month that the UK announced the date of the Referendum) that consider the high cost and fraction operation in non-EU countries, it is inevitable to remain the headquarters in the UK after Brexit, since the bank would need to consider whether it would be the best to locate the relevant operations in a company incorporated in the UK, in a Member State or in a non-EU country, in order to increase profitability and having a stable capital market.

(2) Bank funding and capital

Banks' issuance of securities and the minimum capital requirements are two main change parts after Brexit for the UK. In terms of securities issue, the twin pillars of which are the Prospectus Directive (PD) and the Transparency Directive (TD), which are work together to establish a uniform capital market across the EU and to enable UK banks to access the European capital markets with relative case. Especially for PD can allow banks to use one prospectus to offer securities in multiple jurisdictions across the EU. However after Brexit, any prospectus required an offer in the UK or can trade on a UK market would need to be approved by the UK competent authority, any prospectus required for an offer in another Member State or admission to trading on a market in another Member State would need to be approved outside the UK in the appropriate jurisdictions. As a result, Brexit will push up costs for banks by 4 percent.

As for the capital requirement, the wholesale banks in the UK would need to find $30bn-$50bn extra capital to support their new European operations, it is estimated an increase of 15 to 30 percent, and the branch of the bank's annual cost would rise by $1bn. Mr Austen, the chief for the HSBC said that "any time you split a portfolio up whether it be credit portfolio or a trading book portfolio, you will lose benefits of diversification that allow you to reduce the capital you hold against it". As a result, if the UK left the EU but did not implement an equivalent capital regime, the banking in the UK could be at a disadvantage when obtaining credit from other EU banking sector, as the cost of such credit would be likely to increase.

The challenge and supervision of the banking in the event of Brexit

In the below part, we discuss the influence of the Brexit on the banking from passport and capital part aspect. The negative effects are obvious to the banking that from another country. Therefore, the banking that already operates the business in the UK for many years face challenges that how to steady their headquarters in the UK. Also, the banking that is planning to expand the business in the UK are confronted with an obstacle and high cost to participate the UK bank industry.

From one side, the EU domiciled bank face the end of EU pass porting. UK subsidiaries of non-EU banking groups from large trading partners could face the greatest disruption to their business models. It is the challenge for them to negotiate with the EU banking supervision to find the proper way to continue the business in the UK. Also, the bank model is no longer suitable for UK subsidiaries of non-EU banking groups. They could face the greatest disruption to their business model. PRA head Sam Woods has recently asked CEOs to ensure that they are preparing for a wide range of scenarios including ‘the most adverse potential outcomes'. The ECB has asked Euro area banks to perform similar Brexit scenario planning.

On the other side, EU banks face the risk of exclusion from London's capital markets. Many UK branches are used by the larger Eurozone banks to conduct significant fundraising for themselves and clients. It is also the challenge for EU to increase extra capital to maintain current levels of activity if they required full EU subsidiaries. As we all know, the liquidity and solvency is the essential part of the bank sector. Brexit is a big challenge for the EU central bank that whether prepares enough capital to response the crisis. The capital requirement is settled by the Basel Capital Accords and implementation in EU through the Capital Requirements Regulation. Once the UK leaves the EU, still following the Basel Capital Accords or not for the UK bank need to considerate.

Not only the EU banks face the challenge after Brexit, but also the supervision needs to modify the regulation. Creating new European securities supervision would be a huge operational challenge. It could take several years to design, establish, staff and launch such a body. Nor is there an obvious capital markets hub within the EU bank that could host it within a legal, accounting and governance ecosystem to match London. Furthermore, there will be a major challenge for the SSM and national authorities to ensure that sufficient resources and expertise are in the right place to provide timely delivery of license and model approvals and maintain or supervise rigorous, common standards for wholesale markets business. Eventually, the plan that banks will implement depend heavily on the requirements set by regulators and supervisors, adding a dependency and additional source of variability to the process.

The Future of European Financial Market

The degree of integration of international financial markets has significantly accelerated in recent decades, particularly since the second half of the 1990s. Growing financial integration across borders is a potential source of benefits, notably due to enhanced opportunities for international risk sharing. Indeed, financial globalization may provide countries with instruments to hedge against idiosyncratic shocks in order to yield significant welfare gains. Large financial markets with lots of trading activity provide more liquidity for market participants than thinner markets with few available securities and thus trading opportunities. The U.S. financial system is generally considered to be the best in the world.

The European Union, with its single banking market and currency, has created a significant common basis among the countries to facilitate saving, investment borrowing and lending. The stock, bond and derivative markets replace all smaller less liquid products that previously were available mostly on a country basis.

Furthermore, the Euro likely increases the attractiveness of financial markets to the rest of the world. Within the EU, the Euro eliminates the exchange rates and make the credit allocation process more competitive and efficient in a long term.

However, the last events of Brexit have afflicted the confidence with the other financial markets leading to inner crisis. Therefore, while some researchers often point out that the integration of the banking system into one entity has only advantages, there is no doubt that we live in a world in which advances in technology combined with regulatory and institutional changes have led the financial markets and institutions becoming more interrelated across borders than ever before.


References

  • Skan, J. and Shaugnessy H (2016). Brexit: the potential impact on the UK’s banking industry. Accenture
  • Bank of England, Monry and credit, Arbuthnot Banking Group, 15 August 2016
  • Ruth, Lea (2016). The potential impact of Brexit on European Capital Markets Capgemini Consulting
  • UK institute for employment studies (2016). The UK economy continues to progress and the Bank shifts into neutral
  • European Central Bank (2016). What will it meant for banking and the financial services industry?
  • Carey, M., Prowse, S. and Udell, G (1993). The economics of the private placement Market.

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