As expected, plans are now being actioned by banks in London based on the assumption of a hard Brexit. Quite simply, irrespective of the form that Brexit will eventually take, the time lag to safe implementation of an operational restructuring militates for advance planning and firms cannot risk waiting for any last-minute resolution. So, Paris, Dublin, Luxembourg, Amsterdam and Frankfurt battle for migrating UK-based activities. Unsurprisingly, the biggest driver for selection of an EU based location is existing infrastructure and management depth in that location for the many with a pan EU presence, although some of the soft inducements made, irrespective of the strictures of ESMA to avoid regulatory arbitrage, no doubt will sway a few who have multiple options.
The reality is that the biggest winner in the process will not be the EU locations but the rest of the world and, in particular, the US. And, although some of the movement out of London to the USA is going to be triggered by Brexit, the main drivers are going to be other fundamental changes. These are a perceived sea change in the US regulatory and fiscal environment, at a time of increasing UK political risk, and the likely re-engineering of processes that will be driven by new technological developments. Indeed, it could be argued that some of the migrations, which will undoubtedly be labelled BREXIT related, are totally unrelated to that event but use Brexit as a useful cover for their true purpose given the political, economic and social ramifications of such moves.
The best proof of the US environmental change can be gauged from a remarkably underreported review of bank regulation by US Treasury Secretary, Steve Mnuchin. Interestingly enough the scope of the changes proposed in US regulation are far more limited than would have been expected from Donald Trump’s evisceration of the over regulation of US markets. But they are significant. There is a wish to re-invigorate the US repo market where activity has shrunk one-fifth since 2012 quite simply by removing the safest assets, such as central bank deposits and cash, out of leverage ratio calculations. The review also looks to expand the range of assets that can be used as collateral for liquidity. Importantly it advocates more flexibility in market making and expresses concern at the thinness of markets, the balance sheet inspired shrinkage of bank lending and the market dependence on listed and unlisted corporate loans.
So how does this impact Europe? Quite simply Europe is heading in the opposite direction. A bad debt mountain, equal to the GDP of Spain, petrifies European Central Bankers and they urge ever smaller and safer balance sheets whilst lamenting the lack of market liquidity especially for SME’s. Regulation, in general, in the EU remains onerous, with variations by country remaining in the detail of many EU wide regulations and, in substance, in the hallowed fields of national interest especially around taxation and KYC. And we must not forget that the US did not adopt the strict asset safety rules of AIFMD and UCIT regulations and the EU’s crazy abandonment of any concept of originating investor caveat emptor. The US is also proposing stress testing banks on a biannual basis, an event that has been criticised as overkill, but one that is a sound counterbalance to the relaxation of controls proposed. In short, the indicated US moves could improve bank profitability, free up bank capital, encourage greater market activity and maintain a fairer balance than in Europe between investor and supplier risk.
But how will this impact the securities services business? One has to recognise that US regulation is a template regarded by many outside the US. Thus, we can expect similar approaches from the Asia Pacific region, which may be the second big gainer from Brexit related or inspired corporate structural changes.
A US or global bank looking at its European footprint in 2017 will change its custody operations around the edges as a result of Brexit. More importantly, the potential move to regulatory sanity in the US, the maintenance of the flexible labour code, allied to likely changes in the US tax code, militates for the migration of core support functions to the US. London and Europe are expensive places to do business with the risk of, or existing, inflexible labour laws. As US banks, in particular, look at their UK based European operational hubs, I am sure Brexit will be attributed as the cause for migration of a substantial portion of such activities to other centres in much more user friendly and cost-effective locations. As markets move to longer trading days and automation extends its reach through artificial intelligence and robotics, consolidation within a flexible labour market is incredibly attractive. Who is going to move discretionary activity from the liberal UK market environment to the claustrophobic regulation of much of the rest of the EU as, post Brexit, they assess the optimal structure of their truncated EU/UK operational activities with their two pools of identical costs?
There are downside risks as well. One assumes Steve Mnuchin will survive despite the dysfunctionality of the Trump administration, although nothing is certain. One assumes that tax reform will gain greater traction in Congress, although there are some who will worry about the risk of offsetting revenue loss through lower taxes with only hoped for increases from economic activity. But we can be certain that, in the future, the US, and in all likelihood, Asia Pacific, will be easier and more attractive zones for financial market activity.
For the UK, the question must be whether, post Brexit, it aligns itself to the progressives or stays in the safe haven of financial over regulation. Nothing can be certain given the fragility of the government’s majority in parliament. And the threat of Corbyn socio-economics with its Tobin taxes, bank levies, greater employee rights and higher corporate tax is a stimulant that may well be the tipping point for many, including the regional mega-hubs of securities operations, to desert the City of London.