How Brexit is set to hurt Europe’s financial systems
Canary Wharf business, financial and shopping district of London, U.K. (Simon Dawson/Bloomberg)
Like many multinational companies, Italian engineering business Brembo relies on London to run its finances. The company, based close to the Alps, makes brakes for Formula One cars and motorbikes and sells them in 70 countries. Hundreds of millions of euros pass through its bank accounts each year – and London is the hub for those flows.
As Britain prepares to leave the European Union, the company says it may now have to shift the center of its banking operations to Frankfurt. If Brexit happens with little provision for London’s financial services, banks, funds and insurers in London will lose their ability to sell many of their services to European companies.
Such upheavals will hurt not just London, say bankers and businessmen, but Europe as well. Financial firms say such shifts will mean the cost of banking for European companies will have to rise, though it is not clear yet who will pick up the bill – the banks or their clients.
“At the end of the day it will not be a problem for Brembo, but for our bank,” said Matteo Tiraboschi, executive vice president of Brembo, in an interview at the company’s headquarters in Bergamo. “We expect to have the same service for the same price.”
Interviews with scores of senior executives from big British and international banks, lawyers, academics, rating agencies and lobbyists outline some of the dangers for companies and consumers from potentially losing access to London’s markets.
The EU needs London’s money, says Mark Carney, governor of the Bank of England. He calls Britain “Europe’s investment banker” and says half of all the debt and equity issued by the EU involves financial institutions in Britain.
Rewiring businesses will be expensive, though estimates vary widely. Investment banks that set up new European outposts to retain access to the EU’s single market may see their EU costs rise by between 8 and 22 per cent, according to one study by Boston Consulting Group. A separate study by JP Morgan estimates that eight big U.S. and European banks face a combined bill of $7.5-billion over the next five years if they have to move capital markets operations out of London as a result of Brexit. Such costs would equate to an average 2 per cent of the banks’ global annual expenses, JP Morgan said.
Banks say most of those extra costs will end up being paid by customers.
“If the cost of production goes up, ultimately a lot of our costs will get passed on to the client base,” said Richard Gnodde, chief executive of the European arm of Goldman Sachs. “As soon as you start to fragment pools of liquidity or fragment capital bases, it becomes less efficient, the costs can go up.”
UK-based financial firms are trying to shift some of their operations to Europe to ensure they can still work for EU clients, but warn such a rearrangement of the region’s financial architecture could threaten economic stability not only in Britain but also in Europe because so much European money flows through London. European countries, particularly France and Germany, don’t share these concerns, viewing Brexit as an opportunity to steal large swathes of business away from Britain and build up their own financial centers.
Britain alone accounts for 5.4 per cent of global stock markets by value, according to Reuters data. Valdis Dombrovskis, the EU financial services chief, said the EU will still account for 15 per cent of global stock markets by value without Britain, and that measures were being taken to strengthen its capital markets. But he added: “Fragmentation is preventing our financial services sector from realizing its full potential.”
Industry figures have similar concerns. Jean-Louis Laurens, a former senior Rothschild banker and now ambassador for the French asset management lobby, told Reuters: “If London is broken into pieces then it is not going to be as efficient. Both Europe and Britain are going to lose from this.”
London is currently home to the world’s largest number of banks and hosts the largest commercial insurance market. About six trillion euros ($6.8-trillion), or 37 per cent, of Europe’s financial assets are managed in the UK capital, almost twice the amount of its nearest rival, Paris. And London dominates Europe’s 5.2 trillion euro investment banking industry.
London’s markets insure French nuclear reactors and Greek ships. German carmakers borrow money for expansion. Dutch pensioners invest their savings.
Britain has the largest foreign exchange market and the second largest derivatives market in the world, accounting for just under 40 per cent of the world’s dealings in those markets, while Paris, London’s nearest EU rival, handles under 5 per cent, according to the Bank for International Settlements.
Each year, euro, yen and dollar trades worth about a combined $869-trillion happen in London – more than in all the euro zone countries combined – according to the City of London Corporation.
Barclays Chairman John McFarlane told Reuters that a bad trade deal between Britain and the EU risks harming the international economy, and that some banks may decide to abandon some lines of business altogether because they will be too expensive.
“Brexit will put a spotlight on the economic attractiveness of activities you are moving,” he said. “Everybody will say, ‘If you move, is it worth it financially?’”
Bankers say a number of areas are likely to be affected when Britain leaves the EU. The first is Europe’s ability to sell sovereign debt. At present, when a country, say Portugal or Greece, needs to sell debt to keep its hospitals or schools running, it will tap the bond markets, arranged by banks primarily in London. London-based firms are currently responsible for trading about 70 per cent of sovereign debt in Europe, according to bankers.
But some banks are already withdrawing from arranging the bond sales because it is unprofitable. In the first quarter of the year five banks stopped being primary dealers in various European country bonds, Reuters reported in January.
The chief executive of one of Britain’s largest banks and one of the largest underwriters of European sovereign debt told Reuters the European Central Bank called him asking him not to abandon selling European debt because of Brexit. “They (EU countries) cannot be shut out from London’s capital markets,” he said. “It’s suicide.”
The ECB declined to comment.
A second area that may suffer is the selling of derivatives for companies to buy protection against swings in the U.S. dollar or spikes in the price of oil. Bankers say rivals to London will offer a smaller array of products and at a higher cost because there will be fewer banks offering these services.
A third area likely to be affected is the clearing of derivatives denominated in euros, an activity that London dominates. EU policymakers want such clearing, which ensures the safe completion of a trade, to be shifted to the euro zone after Brexit. Financiers say that would bump up trading costs for continental customers that deal in a variety of currencies because they will have to route trades through multiple clearing houses, requiring them to post more collateral to back those trades.
The Futures Industry Association, a global derivatives industry body, says forcing a shift in euro clearing would increase the amount of cash needed to back trades by about $80-billion. German clearing house Eurex, which stands to gain from a shift, said the increase would be a far more modest $3-billion to $9-billion.
The global head of foreign exchange markets at one of the world’s largest banks said if the amount of cash required to back trades went up as much as $80-billion – nearly a doubling of the current amount – then “it’s going to stop the market.”
While bankers say it is hard to estimate how much extra it will cost a European company to borrow without direct access to London’s markets, the Association for Financial Markets in Europe said in a report early this month that European customers are being overly optimistic if they think lenders will pick up the bill.
The report said for companies similar in size to Brembo “any increase in the cost of debt funding and derivatives would therefore have a material impact on the business, making it less competitive.”
Brembo’s Tiraboschi disagreed. “As far as Brembo is concerned, we do not have indications for a growth in financing costs linked to Brexit,” he said.
Last autumn, the British government set about persuading Europe of the risks the EU faces if London’s position as a financial center is damaged. A research paper by Ernst & Young surveying major corporates, including Volkswagen and Airbus, found that companies across Europe were worried about the cost of funding rising. The paper, which was commissioned by the City of London Corporation, a municipal body that runs the financial district, was sent to policymakers across the EU.
The British government predicted that European companies would tell their respective governments they face higher costs and potential disruption, putting pressure on politicians to take this into account during Brexit negotiations.
In a speech in late June, British finance minister Philip Hammond said Europe will only hurt its own economy if it undermines London’s status as a global finance hub. “Fragmentation of financial services would result in poorer quality, higher priced products for everyone concerned,” he said.
But Jeremy Browne, the City of London Corporation’s special envoy for Europe, who has visited 26 EU countries over the past year, said many companies and politicians are willing to accept higher prices in return for sticking to EU principles and not giving London any special exemptions.
“They are not getting down on one knee begging their governments to be nice to Britain,” Browne said.
With formal divorce talks now triggered, the EU is wasting no time in regrouping to try to replicate Britain’s financial services on euro zone soil, egged on by the powerful European Central Bank (ECB). In 2015, the EU launched a “capital markets union” project to improve the way companies can raise funds from stocks, bonds and other securities. That project is now being given more priority, the European Commission said in early June.
The ECB says that a “new equilibrium” may be beneficial in the long term to euro zone banks looking to take advantage of business opportunities created by Brexit – while an increase in financing costs is likely to be only “modest” in the near term.
Christian Noyer, a former central bank governor of France, is now wooing financial firms to relocate to France. He told Reuters that if European banks had time to adapt “they will do exactly the same job” as London does now. “I don’t believe for a minute it will be detrimental,” he said.
At least eight European cities are vying for financial firms to set up entities in Europe, hoping to attract their highly-paid employees. The French government has been the most aggressive, dangling the promise of tax breaks and flexible labor laws to complement the French capital’s cultural charms.
The chief financial officer at one of Europe’s biggest banks said he sat through a recent presentation by French officials highlighting the restaurants and nightlife in Paris. “It was all very Moulin Rouge,” he said.
A senior German lobbying official, who recently held meetings with the German government, said there is a feeling that Britain is failing to understand that the European project comes first. “British politicians think they are in a position whereby the EU 27 will say, ‘OK, there are lots of problems for the EU so we will agree on a trade deal as otherwise the EU will be faced with turmoil as well.’ They just don’t get it,” he said.
Bankers are skeptical about Europe’s efforts to replicate London. They say continental Europe is too leery of Anglo-Saxon free-market capitalism – which many politicians and economists blamed for the 2008 to 2009 global financial crisis.
London’s dominance as a financial center has been built up over decades and would be very hard to replicate, especially with any speed, given the global talent pool, the widespread use of the UK legal system and the vast amount of money that is managed through London, say executives.
The head of European operations at a large U.S. investment bank said that if Europe ever managed to reform its labor laws, develop its capital markets and attract a global workforce, then it would mark the decline of London as a financial center. But Europe may miss this opportunity, he said, because of infighting between EU countries and no clear plan for where jobs and assets will end up.
Discord between the euro zone’s three largest countries – Germany, France and Italy – initially stalled the ECB’s efforts to come up with a way to force euro clearing out of London and put it under its watch, three sources told Reuters in May.
Europe “will end up with a hodgepodge of financial centers,” the U.S. executive said. This is “a humongous risk,” he said. “If Europe becomes so unattractive, we just won’t be as big in Europe as we are today. Europe won’t win.”
Instead, some bankers predict the big gainer could be New York, 3,500 miles away. They say it is the only place that can replicate London’s depth of markets and expertise.