A worrying geopolitical forecast for financial services

The ramifications of a messy Brexit are bad for the UK, bad for the EU and bad for the world.

As the Brexit negotiations become more toxic, the UK talks calmly of breaching international law, and the EU gives every indication of opting for Fortress Europe, we can only fear, in the financial sector, that we are heading for the worst of all possible worlds. Forget about Global Britain, we are in a world of America First, Fortress Europe and the Chinese dominated Asian regional model.

First, the UK. The proposal to breach international law by re-interpreting the EU Withdrawal Agreement places the UK on par with rogue states whose bond cannot be trusted. Those may have rejected more serious aspects of international law, especially on human rights, but there is, in such cases, a line that is crossed and the UK proposes to cross that line. Second, the EU. COVID-19 is a tempting catalyst for protectionism. With soaring unemployment, widening budget deficits, rapid deterioration in corporate balance sheets and the likelihood of material increases in financial sector loan losses, Europe, and indeed much of the rest of the world, is in a bad place. The UK in Europe was always the free market advocate; without the UK, EU weight of opinion may well veer to greater protectionism. And that is contagious in a global sense. And in the financial sector it could have a far greater effect than the current Trump inspired trade wars.

So what scenario is likely in the financial sector if we do not get an agreement on a trade deal? We need to remember that there are no clear rules in the EU around the level of resourcing needed in EU-based financial entities, which are subsidiaries of major banks. The EU will look at people, assets, resources and local empowerment before approving a model. The catch is that, on the banking side, many banks are looking at operating models that leave their EU subsidiary marginally profitable, but very reliant operationally and, especially through back-to-back bookings, very dependent on their parent. The EU regulators are focused on Brexit and UK banks as they will leave the EU and now need (as happens in the USA) a substantive EU-based local presence that will not be a burden on the State in the event of default or similar event. But the UK banks, and in this case, they include the major investment banks be they ultimately US or UK parented, are not the only ones impacted by such moves. The EU is faced with two major challenges in this area.  First, they could be in breach of international law if they treat, without due reason, UK banks differently from other nations’ banks. This may be a driver for taking the UK to Court for breach of its Agreement as it could allow the EU to treat UK banks and their subsidiaries on a unique basis. However, without a judgement by the appropriate courts, such a move may be questionable.  And second, the UK is a major banking presence; enforcing the rules too strictly will result in split capital allocation, less liquidity allocation and reduced credit appetite, or even a review of the value of a presence in one or another of the locations. The last thing the EU wants is, in the current climate, to see a weaker financial flow from the private sector and a greater need for ECB intervention and support.

Many are betting on the UK being granted equivalence which would allow some leeway on the banking side but also in other areas. Clearing looms large in EU thinking and they have, even while the UK was in the EU, yearned to relocate the mass of Euro-based derivative clearing within the Eurozone. There is logic in this, for, despite the major enhancements to clearing house risk controls, there remains ambiguity as to the lender of last resort for a failed clearing. The quantum in question is mind boggling, even though the chances of default are infinitesimal. That is no comfort and we all remember similar, and ultimately catastrophic, assertions around the potential of default in other parts of the financial markets during the last crash.

And it is clear that asset managers could also be hit in any serious fall-out. The post-trade side looks manageable although there remain areas of dependency on parent entities, especially over technology, risk and general management as most major firms operate a globally integrated model. The main challenge could be on the asset management side. There remains a chance that asset management could be required to become an EU-based discipline for UCITS and similar vehicles and that would destroy the operating models of pretty well every multi-locational firm. Once again, the EU would be faced with the challenge of the scope of such a move. It is possible it could be part of action taken in the event of a UK breach of the Withdrawal Agreement, but, if not, it would have a global disruptive effect. It would decimate the Luxembourg and Irish investment industry; and would undoubtedly lead to reciprocal moves all over the world. In effect it could lead to asset management reverting to a local or regional model rather than the very dynamic global one that is currently in operation.

With weeks to go before the final deadline passes, one thing is clear. We have passed the point of no return for an extension of talks. The mood music is not right for an agreement with level playing fields, fisheries and Northern Ireland being the major stumbling blocks. WTO is not an ideal exit strategy for either the UK or the EU for it weakens both at a time when the pillars of their financial and corporate infrastructures are under extreme strain. This is the end game and the ramifications of a messy exit are bad for the UK, bad for the EU and bad for the world.