Why are people in London less friendly?

Brexit and Britain's special role in the EU

Christian Odendahl

Dr. Christian Odendahl is chief economist at the Center for European Reform, a think tank financed by large German, British and American companies with a focus on European and transatlantic issues and based in London.

The City of London is central to the UK and international finance. How will Brexit affect London's position? Christian Odendahl on winners and losers of Brexit.

City of London License: cc by-sa / 2.0 / de (Flickr / Bo & Ko)

One of the largest industries in Great Britain is the financial sector, which is often simply called "the City" - after the traditional location of British banks, the Old Town district of London. In 2014 insurance and financial services contributed eight percent to UK value added (around half of which came from London), and the financial sector was estimated to be 11.5 percent of all government revenue. [1] London is also the most important financial center for Europe, for example around 80 percent of all European hedge fund assets are managed from here. [2] London is even a leader on a global scale, with 41 percent of all currency transactions worldwide, according to estimates by the interest group TheCityUK, in London. [3]

There are many reasons for this outstanding importance. The geographical location and time zone between Asia and America help, as you can access both markets from London. For a long time, London was the center of the British Empire and home to the then reserve currency, the British pound, before it was replaced by the dollar. Added to this was the political stability, the long tradition of the British legal system and the relatively friendly regulation compared to the rest of Europe. The fact that Britain is populated by English speakers also helped.

The European Union (EU) and, paradoxically, the euro (which Great Britain has not introduced) have also strengthened London as a financial center. The EU enables the free movement of capital across borders as well as the free trade of goods and increasingly also of services. The latter, however, are often strictly regulated: whoever is allowed to be a doctor, lawyer or bank is subject to strict guidelines. Over the years, the EU has made it easier and easier for banks to operate across national borders: EU countries, for example, recognize the banking licenses of other countries - banks receive a so-called "EU passport".

The euro has also made it easier for London financial services providers to grow. Suddenly there were no longer 19 different currencies, which the local banks may have specialized in, but one currency for most of Europe. This allowed the financial center of London to grow further and became the center of trade in financial products in euros, especially between banks.

How would Brexit affect London's position? The answer depends very much on what would come after Brexit. Because it is by no means clear at the moment what the arrangement between Great Britain and the EU would look like. From the possible scenarios we can pick out two examples in order to recognize the possible consequences.

The first would be the Norwegian option, in which the UK would leave the EU but remain a member of the European Economic Area (EEA). That would mean that little would change for most companies; they would continue to have full access to the EU market. In principle, this also applies to banks, but the EEA states have to implement EU regulations for this, which has been a problem since the financial crisis. For example, the EEA states are finding it difficult to accept the newly created EU-wide financial regulators - which would not be easier with Great Britain in the EEA. And here lies the main problem with this Norway scenario. Great Britain would no longer have any influence on future EU policy, including the banking sector - Norway receives EU decisions by fax. In addition, the UK, like Norway, would have to continue to co-finance the EU budget and accept the free movement of workers, two things that those in favor of leaving are strictly opposed to. Politically, the Norway option would be an untenable situation for Great Britain.

The second option would be some kind of free trade agreement between the UK and the EU, similar to the one recently concluded between the EU and Canada. The problem would be that financial services are usually excluded from such arrangements, as they require strong regulatory harmonization. In addition, the EU will be very keen to link, at least in part, EU funding and free movement of workers with free access to the EU financial market, which the British will find difficult to accept.

Even Switzerland, which has concluded many sectoral agreements with the EU that the EU has to co-finance and accepts EU immigration, does not have full access to the EU market in the financial sector. Swiss banks therefore have to overcome some regulatory hurdles before they can operate in the EU market. As a consequence, most Swiss banks serve the European market through their branches in London.

After a British exit from the EU, access to the European financial market would be more difficult. The extent to which this would affect the city would depend on whether the difficult access outweighs the advantages of the city as a financial location to such an extent that banks and other financial service providers set up their European business elsewhere - in Amsterdam, Dublin, Frankfurt or Paris.

For business among banks, London will remain important due to its size and international network. The areas that serve European customers will want to relocate at least part of their business to an EU country in order not to have to go the more complicated route across the EU's external borders. This is especially true for banks from non-European countries: if they were to serve European customers from London, they would have to navigate a jungle of three different regulations and authorities - those of their home country, the British and the European. Some US banks such as JP Morgan and Citibank recently announced internally to their employees that parts of their business would have to be relocated to the EU. [4]

The so-called clearing houses are a special case. They are central offices for securities transactions and not only allow lower costs, but also less risk and more anonymity for buyers and sellers. They play a central role in the financial market, and their position was even strengthened by the tightening of regulation after the crisis. In times of crisis, however, clearing houses are potentially vulnerable and could shake the financial system as a result. The most important clearing houses for euro trading are based in London. The European Central Bank (ECB) has a legitimate interest in regulating and monitoring these clearing houses. Their attempt to force these clearing houses to relocate to the euro area, however, failed at the European Court of Justice due to a lawsuit brought by the British. After a Brexit, however, this path would be open to the euro zone again, so that this part of London's financial infrastructure would probably migrate.

One of the big problems for the UK economy will be the transition period. Not only will the Europeans negotiate hard, if only for self-protection - which can take a long time. The period of uncertainty will hinder investment, including in the banking and financial sectors. It remains to be seen whether banks wait for the outcome of the negotiations or secure themselves beforehand with a reorganization.

Would there also be any beneficiaries of Brexit in the continental European financial sector? According to a survey of 55 experts from business and politics (the author himself was one of the respondents), Frankfurt would be the main beneficiary. The city is a good choice, as the ECB, the central bank and the banking supervisor of the euro area, is already based here. However, only a few in Hesse or Frankfurt say it out loud, because most of them hope that the British will remain in the EU: the political and economic damage of a Brexit for the EU would be great and the most experienced country in the field of financial regulation and international financial markets would deal with it located outside the EU - potentially to the detriment of the European financial industry. But Paris and Dublin, which is very successful with international companies, could justifiably raise hopes, just like Amsterdam, of profiting as a financial center.

Brexit proponents argue against it that the financial center London could also be one of the winners: Free of EU regulation, the city could open itself even better to the world. However, that is unlikely. On the one hand, a great deal of regulation of the financial market is agreed internationally (e.g. in "Basel", as the Basel Committee on Banking Supervision is often shortened). Great Britain would also not be able to free itself from this in the event of a Brexit. On the other hand, British regulation will inevitably have to be based on EU regulations in order to be able to participate at least partially in the European market. Finally, since the crisis, British regulation has by no means been less strict, but rather more stringent than that of the euro zone, as banks in London like to complain. [5] An example is how much of their own money banks have to put into investments (i.e. how much equity they have to be financed with); Great Britain is demanding more here than most EU countries.

History gives little clue as to what would happen if Britain left the EU. The consequences for the financial sector are also difficult to predict. But the access of the London banks to the common EU market is likely to be made more difficult. A shallower regulation for the city is also hardly to be expected after a Brexit. The financial center of London would be one of the losers in Brexit.