Commentary: UK finance and Europe.

Armstrong, Angus

The UK relationship with the European Union (EU) will be a defining issue for the new government. The EU is undergoing profound changes in the aftermath of the global financial and its sovereign debt crisis. Accordingly, a thorough analysis of the pros and cons of EU membership and the scope for reform is required. Following our assessment of the 'Scottish Question' around the independence debate last year, the 'British Question' is one of our top research priorities.

The EU is the UK's most important economic partner. Over half of exports are sold to the EU, almost 60 per cent of inward foreign direct investment comes from the continent and almost half of all migration is with the EU. However, critics argue that the EU is in relative decline and that membership limits our sovereignty and our ability to compete in new markets. Moreover, the EU cannot be considered to be in a steady state. Assuming no further enlargement, in five years' time 23 out of the 28 EU states will be Euro Area members. A new equilibrium might be an EU with a closer political union and a pooling of fiscal resources that resembles a 'United States of Europe'. An alternative scenario is that at least one country might leave the Euro Area. (1) Either outcome would have important consequences for the UK.

An important part of this debate will be around financial services. This is inevitable given that the UK is effectively host to the Euro Area's wholesale financial markets, the EU's key decision to create a European Banking Union (EBU) and the fundamental differences between the UK and continental European models of financial intermediation. This is especially important to the UK because financial services have long been one of our most successful economic sectors. A House of Lords report suggested that the consequences of the EBU for the UK could be 'momentous'. (2) For non-Euro Area members of the EU the EBU may create either centripetal or centrifugal forces. This commentary raises four questions regarding financial services and the UK's EU membership.

UK financial services and the EU

The UK has been a leading global financial centre for two centuries. British institutions financed development across the Empire, created capital markets for trading companies and government debt and famously financed South America's railroads in the late nineteenth century. Until the recent global financial crisis the UK had not allowed a bank to fail since 1866 and had a strong reputation for self-policing and upholding high standards of behaviour. (3) There have been a number of official reviews over the past century suggesting that the system may be sub-optimal for the broader economy, but any changes that followed failed to alter the UK's dominance in international finance. (4)

Financial services (particularly banking and insurance) is one of our largest economic sectors. Output accounts for over 8 per cent of total national output and so its success is important for the overall success of the economy. UK exports of financial services as a share of GDP are greater than any other country (excluding city states), the UK has a trade surplus in financial services of 2.5 per cent of GDP and the sector is estimated to contribute up to 11 per cent of total tax revenue. (5) The growth of financial services reflects the role of the UK as an international centre of capital markets. Over 150 foreign banks have branches and almost 100 have subsidiaries in the UK (see box 1 for the distinction between branches and subsidiaries). The UK is also home to four of the thirty Global Systemically Important Banks (GSIBs) and host to two large GSIB subsidiaries from Switzerland. (6)

The UK joined the European Economic Community in 1973, which became one part of the EU in 1993. (7) All members of the European Economic Area are permitted to open branches in other member countries. Since former Bank of England Governor, Mr Eddie George, negotiated UK membership to the euro payments system, the introduction of the euro further strengthened the UK's position. While the UK has a trade deficit with the rest of the EU of 3.7 per cent, trade in financial services is in surplus of 1.3 per cent of GDP. (8) London accounts for 25 per cent of total EU banking assets, 70 per cent of derivative trading, 85 per cent of hedge fund assets under management and 50 per cent of maritime insurance. (9)

Over the past four decades the relative scale of the UK banking system has increased by over four times --standing at 450 per cent of GDP on a residency basis. (10) However, as the past eight years remind us; with financial services, more is not always better. While there is no clear link between size of banking system and fragility, Bush (2014) reports that the fiscal cost of a crisis increases with the size of the banking system. Many of the losses in the UK banks occurred in their overseas operations. It would also be incautious to assume that 'too big to fail' is resolved under the current regulatory proposals. Therefore, the mutual interest between the public and the financial sector is no longer obvious. This is especially the case given our limited fiscal capacity to backstop a sector over four times bigger than output.

Box I: Branches versus subsidiaries

Foreign banks operating in London can do so as a branch or
subsidiary. A branch is simply an office of the foreign bank
operating in London. Capital typically flows freely between the
branch and its foreign parent bank, and the branch typically
maintains no separate capital of its own. It is regulated primarily
by the regulator where the bank is incorporated (the 'home'
regulator), although its 'host' regulator, in this case the
Prudential Regulation Authority (PRA) and Financial Conduct
Authority (FCA), may impose restrictions on the types of activities
it may undertake and the services it may offer to UK based clients.
A subsidiary is a separately registered bank incorporated in
London, but which is wholly or partly owned by the foreign bank.
Because it is registered in London, its primary regulators are the
PRA and the FCA, and it must meet UK prudential requirements
independently of its parent, although it may use the support of its
parent to do so. Branch structures may pose greater risks for
financial stability. Capital can easily flow between branches and
their parent meaning that financial shocks are easily transmitted
across borders. On the other hand, branches may be more efficient
than subsidiaries, leading to a tension between the preferences of
supervisors and those of banking groups.

Towards European Banking Union

Flaws in the design of the single currency system were dramatically exposed by the financial crisis. The lack of political union when the single currency was introduced meant that the European Central Bank (ECB) had no fiscal backstop, no financial supervisory role and therefore no capacity to provide emergency liquidity assistance if necessary. (11) The absence of this essentially fiscal function, but conducted by a central bank, created a fragile Euro Area banking system with a doom loop between governments and their banking systems. Governments bailed out failing banks by issuing public debt, which led to higher interest rates which further damaged the distressed banks, thereby requiring an even greater bailout. (12) The IMF (2013) estimates that in 2008-12 the cost of recapitalisation and asset management reached 4.6 per cent of EU GDP and, including guarantees, 13 per cent of EU GDP. (13)

In 2012 the EU Heads of State and Government agreed to create the EBU, which they claim will complete the economic and monetary union. Article 127(6) of the Maastricht Treaty is interpreted such that the ECB can take on specific supervisory tasks without Treaty change on the unanimous decision of the European Council. The IMF (2013) notes that this is an expansive interpretation of the Treaty, creating some litigation risk as a financial institution could bring a case before the European Court of Justice (ECJ). Membership of the EBU is obligatory for Euro Area members and non-Euro Area countries may choose to join. While non-Euro Area members can be represented on the ECB's Supervisory Board, ultimate regulatory authority lies with the Governing Council of the ECB (which consists of permanent staff and Euro Area representatives). This raises governance issues and the UK and Swedish governments have made clear that they will not participate in the EBU.

EBU has three elements. The foundation is a single regulatory rulebook covering all financial institutions (including 8,300 banks) in the EU. These rules cover capital requirements, protection of depositors and prevention and management of bank failures. Members who do not join the EBU can add domestic regulatory powers to the rulebook which functions as a regulatory minimum across the EU. A Single Supervisory Mechanism (SSM) assigns the ECB as the central prudential supervisor of financial institutions in the EBU. The ECB directly supervises the largest 120 EBU significant banking groups, while national supervisors monitor the remaining institutions. The Single Resolution Mechanism (SRM) resolves distressed banking groups covered by the SSM with ultimate access to the Single Resolution Fund (SRF) financed by the EU's banking sector.

Is financial sovereignty achievable?

The way that governments responded to the financial crisis showed that relying on 'mutual recognition of national interests' is too optimistic. Therefore, a first question is whether UK financial sovereignty is consistent with the emerging EU governance structure? National governments resorted to resolving institutions on national boundaries. For example, Icelandic banks gave preference to domestic depositors, Fortis was divided and resolved along national boundaries and TARP was only available to US headquartered banks. When national governments or unions consider only their own interests, and not the possible spillovers on other nations, this can lead to suboptimal outcomes. In a highly integrated financial system, decisions in a nation or union can undermine sovereignty elsewhere.

[FIGURE 1 OMITTED]

Schoenmaker (2009) generalised this problem into a trilemma where only two of three outcomes can be achieved (see figure 1). This is an extension of the classical trilemma of Mundell-Fleming. (14) In this context, consider an extreme case of a systemic financial event, where several financial institutions are affected at the same time. The decision of one country to resolve an international institution (say, Lehman Brothers) may well have financial stability or fiscal consequences for other countries. Unless these consequences are taken into account then the decision may be sub-optimal. The more integrated the financial system, the more that financial sovereignty and, in extreme cases fiscal sovereignty, is shared (all else equal).

The SRM and SRF can be interpreted as resolving this trilemma by pooling financial resources, or sharing sovereignty. In the event of a bank resolution shareholders and other (pre-determined) liability holders will have their assets written-down while the bank is a going concern. In the event of further losses, and after national support, the SRF will be available to EBU members. The idea is that the fiscal backstop is not national taxpayers so breaking the 'doom loop'. Buiter and Raubin (2010) nicely describe this as compensating for the loss of financial independence (by no longer having a national currency) to mitigate sovereign risk. The solution allows banks to remain closely integrated while the common resolution fund avoids the feedback to the sovereign by limiting national sovereignty.

The trilemma suggests that because the UK is outside the EBU and relies on its own fiscal resources, then maintaining a large integrated cross-border financial system may not be compatible with financial stability. It is unclear how the interests of EBU nations and EU nations outside the EBU will be aligned. This is particularly important for the UK because six of the EU's thirty GSIBs operate as legal institutions in the UK. Decisions can be taken within the EBU with regard to a GSIB subsidiary or branch in an EBU member state, which could have fiscal consequences for the UK and hence the loss of national financial sovereignty.

Schoenmaker and Siegmann (2013) carry out an intriguing exercise of estimating the possible costs and benefits of pooling resolution costs across EU members. They find that the benefits of risk sharing are greatest for the UK. In fact, joining the EBU would be one solution to Chancellor Osborne's 'British dilemma'. (15) However, even if the UK joined the EBU it cannot be represented on the ECB Governing Council as long as it remains outside the Euro Area. We doubt the UK would hand such a degree of fiscal sovereignty to an institution it could not ultimately influence.

Unless the UK has a fundamental change of position with regard to the euro, solving the EBU governance issues is required if the trilemma is to be resolved. The default outcome is that the business models of cross-border banks become balkanised, requiring individually capitalised subsidiaries regulated by host nations. This reduces the degree of financial integration and increases the cost of cross-border intermediation. Outside the EU the trilemma would be solved by significantly reduced cross-border integration with less influence on financial regulation policy decisions.

Is national regulation plausible?

A similar coordination problem arises if national policies (figure 1) are interpreted as domestic financial regulations. To what extent is the domain of national financial regulation limited in a country with large cross-border capital flows in order to be consistent with financial stability? Capital and liquidity can easily be transferred across branches in a banking group to exploit regulatory differences. Unless spillovers are taken into account cross-border flows may exploit regulatory differences and the outcome may be sub-optimal.

Prior to the crisis there was little sign of 'mutual recognition' of the potential consequences of significant capital inflows associated with current account imbalances. The divergence in regulation between the UK and Euro Area members, from capital and leverage ratios to tax and conduct, suggests a significant divergence from 'maximum harmonisation' previously heralded for a single market. The Bank of England has already indicated that it intends to have higher prudential requirements than the EU. The issue is whether being heavily financially integrated limits the scope for different regulatory policy.

The most difficult regulatory domain may be macro-prudential policy. This is supposed to mitigate systemic risk across the financial system and over economic and financial cycles (such as the credit cycle). Cross-border flows are notoriously pro-cyclical suggesting coordination is desirable. The EU has established the European Systemic Risk Board (ESRB) responsible for monitoring and preventing systemic risk arising across the union. The ESRB has no direct control over policy and issues recommendations to member states which must either 'comply or explain'. Implementation is left to national regulators but the ECB has the authority to implement new macro-prudential regulations across EBU members.

An important layer of protection for the UK from the ECB and EBU dominated ESRB is the European Banking Authority (EBA) located in London. (16) This is responsible for implementing the single rulebook on banking applicable to all 28 members of the EU and the efficient and orderly functioning of the banking sector. To protect the interests of non-EBU countries from Euro Area regulations, decisions at the EBA are decided by a 'double majority' voting system. This is a 'qualified majority' of EU members and a 'simple majority' of Euro Area and non-Euro Area countries. However, the EBA can only request that the ECB follows its decision but cannot require it to do so.

A possible solution is that an independent monetary policy with a floating currency can create enough degrees of freedom to manage differences in regulation. Yet Rey (2013) observes that even with a flexible currency the size of and cyclicality of cross-border capital means that the scope for independent monetary policy is limited. The degree to which cross-border capital markets are correlated even with separate currencies suggests the coordination problem remains. The alternative is that cross-border institutions shift from branches and towards subsidiaries. This is consistent with the host regulator being able to resolve and regulate the institution and avoid some of the regulatory coordination problems. (17) Again this may add to the cost of intermediation.

There is also a question over how long the EBA can be an effective form of defence for the UK. Assuming no further enlargement, and those who are committed to join the euro do so on schedule, by 2020 23 of the 28 nations will be Euro Area members. This would essentially come down to the ECB and the Bank of England as the dominant institutions but with very different membership support. This implies the 'double majority' voting system increasingly serves the UK. The question is whether within the EU this can be sustained. Outside the EU the UK would have no vote. The UK's largest bank, HSBC, has recently cited uncertainty over the UK's position with regard to the EU as one reason for its review of location.

Will location policy become competitive?

Financial services are a highly desirable economic sector and there has always been competition between nations to host this business. The Royal Exchange opened in London in 1566 inspired by Sir Thomas Gresham. It was originally called a bourse, designed by a Flemish architect, built by European craftsmen and the traders were mostly from overseas. (18) Assuming the EBU becomes a closer union, will a location policy emerge to attract financial services within the geographical borders of the union? If the UK is within the EU this must comply with the Competition Law and there is a right to appeal to the ECJ.

An interesting recent case is the ECB's Eurosystem Oversight Policy Framework making the case that Clearing Houses with substantial business in euro should be within the Euro Area: "as a matter of principle, infrastructures that settle euro-denominated payment transactions should settle these transactions in central bank money and be legally incorporated in the Euro Area with full managerial and operational control". (19) The UK appealed to the ECJ on several points, and the court upheld that the ECB does not have competence to rule on securities clearing. Note that the ruling did not address the principle about supplying euro liquidity to infrastructure outside the Euro Area. This is yet to be addressed.

The issue raises a number of points for the UK. First, the ruling supports the integrity of the ECJ. This is important given the likely disagreements over regulation (for example, on bonus caps and a financial transaction tax). Second, clearing houses are acknowledged to contain liquidity risk by the ECB. The IMF accepts that they may pose systemic risk if mismanaged. Third, since the ex ante liquidity and solvency risks cannot be easily separated, this issue must be resolved in advance. The immediate solution appears to be swap lines between the Bank of England and the ECB as all EU sovereign debt is zero risk-weighted. However, depending on the size of the exposure there would be currency risk for the UK. (20)

Another potential location issue arises with EC President Juncker's initiative for a Capital Markets Union. It is designed to complement bank lending, particularly for loans to small and medium enterprises, and the EC suggests the market could exceed 300bn [euro] by 2017. An advisory 'hub' is due to be operational by the middle of this year and there are indications that the market will physically exist in an actual location. This is clearly attractive to the UK because English Law is common to capital market instruments, the UK is already host to relatively large equity capital markets and the dominant location of euro interbank markets necessary for hedging risk.

Since much of the justification is to reach a size of market seen in the UK, Switzerland and the US, the EC may either see the UK as the most likely location to achieve their aspiration or prefer a competing location. Whether the UK can compete against the interests of EBU members for new euro capital markets remains to be seen. Outside the EU would limit the UK's ability to influence all administrative but not necessarily economic decisions.

What is the alternative?

The critical issue for UK financial services is the consequences of the creation of the EBU. This creates two dominant central banks with uneven EU member support, resolution powers for significant banks residing with two authorities, and divergent regulation across a financial integrated union. Ferran (2014) has suggested that this may create centripetal or centrifugal forces. (21)

One approach is to seek to resolve these issues through re-negotiation of particular agreements. This requires establishing priorities and possible solutions for member states. For example, the voting rights at the EBA could be along size of financial sector rather than simply national members. Another approach is to consider leaving the EU. This begs a series of questions including what the alternative arrangement would be, what would be the consequences for other countries, what would be the consequences within the UK, whether this is preferable to the status quo, or a re-negotiated EU.

The procedure for exiting the EU is by Article 50. Once notice is served, the dynamics would be difficult to control as the UK would not take part in formal exit negotiations. It may be that the EU would seek an accommodating solution, on the other hand there may be a risk of other departures which the EU may wish to discourage through less accommodation. One of the most important issues is whether UK institutions would continue to have direct access to the euro payments system.

A number of alternative arrangements outside the EU are often suggested. Some arrangements were created for particular circumstances and, while they establish precedence, it is unclear that they could be replicated. For example, Norway is a member of the European Economic Area (EEA) with full market access to the EU and agreements with the rest of the world. But it has no say on any policy or representation in EU institutions, referred to as 'fax diplomacy' or regulation without representation. Switzerland has negotiated a series of bilateral sector level agreements with the EU over many years. This includes free trade in goods but not services (hence why two Swiss GSIBs operate through London). Under both arrangements the UK would have very little influence on EU financial policy, resolution procedures and location policy discussed above.

REFERENCES

Armstrong, A. and McCarthy, D. (2014), 'Scotland's Lender of Last Resort options', NIESR Discussion Paper no. 434.

Buiter, W. and Rahbari, E. (2010), 'Greece and the fiscal crisis in the Euro zone', CEPR Policy Insight 51.

Bush, O. (2014), 'Why is the UK banking system so big and is that a problem?', Bank of England Quarterly Bulletin.

Davies, G. (2002), A History of Money, University of Wales Press.

ECB (2011), European Oversight Policy Framework.

Ferran, E. (2014), 'European Banking Union and the EU Single Financial Market: more differentiation, integraiton or disintegration', mimeo.

Folkerts-Landau, D. and Garber, P.M. (1992), 'The European Central Bank: a bank or a monetary policy rule?', NBER working Paper No. 4016.

House of Lords European Committee, 2012, European Banking Union: Key issues and challenges, The Stationary Office Limited.

IMF (2013), 'A Banking Union for the Euro Area', Staff discussion Nate 13/01.

London Economics (2014), 'The importance of wholesale financial services to the EU economy 2014', Special Interest Paper, City of London Corporation.

PwC (2014), Total Tax Contribution of UK Financial Services, 7th Edition, Research Report, City of London Corporation.

Rey, H. (2013), 'Dilemma not trilemma: the global financial cycle and monetary policy independence', Jackson Hole Symposium, August.

Schoenmaker, D, (2009), 'The financial trilemma', Working Paper, SSRN #1340395.

Schoenmaker, D. and Siegmann, A.H. (2013), 'Efficiency gains of a European Banking Union', Duisenberg School of Finance-Tinbergen Institute Discussion Paper, TI 13-26/DSF 51.

NOTES

(1) There is no procedure for a country to leave the Euro Area. The country in question would become a member of the EU outside the Euro Area but without a Treaty opt-out clause and therefore of unclear constitutional status.

(2) House of Lords (2012) p. 5.

(3) Overend and Gurney failed in 1866. However it is important to note that other British banks would have failed without the intervention by the authorities (e.g., National Westminster Bank in the 1970s). This willingness to support institutions may have contributed to the growth of the City.

(4) For example, see the Macmillan Committee (1929) on Finance and Industry.

(5) This estimate is from PwC (2014) and includes all taxes such as VAT, income taxes paid, tax on interest income etc. It is therefore a maximum total amount.

(6) HSBC, Royal Bank of Scotland, Barclays, Standard Chartered, UBS and Credit Suisse.

(7) The UK joined the European Economic Community in 1973 and negotiated four areas of opt-outs from the Maastricht Treaty which created the economic and monetary union: Schengen area, EMU, Charter of Fundamental Rights and Freedom, Security and Justice (with opt-in clauses).

(8) All trade data are from the ONS and for 2013.

(9) Figures from The City UK (2014).

(10) See Bush (2014) for a discussion of how banking systems can be measured on ownership (UK owned banks including subsidiaries and branches) or residency (UK banks and foreign bank subsidiaries and branches located in the UK). On the former measure the banking system is 350 per cent of GDP and on the latter measure 450 per cent of GDP.

(11) See Folkerts-Landau and Garber (1992), for an early study of the unusual nature of the ECB's mandate.

(12) In many countries it was the size of the banking systems which had such a dramatic impact on government finances. The IMF (2013) points to a second feedback loop from sovereign debt distress due to fiscal indiscipline to the banking system and then back to the sovereign.

(13) See IMF (2013). The guarantees are between 2008 and 2010 only.

(14) The classical trilemma states that only two of a triple of capital mobility, a fixed exchange rate independent monetary policy can be maintained.

(15) The British Dilemma was coined when the Vickers Commission was established. How can the UK enjoy the benefits of a large financial system when this implies a large contingent liability on the state?

(16) The European System for Financial Supervision consists of: the European Securities and Markets Authorities (ESMA), the

European Banking Authority (EBA) and the European Insurance and Occupational Pensions Authority (EIOPA). The system also comprises the European Systemic Risk Board (ESRB) as well as the Joint Committee of the European Supervisory Authorities and the national supervisory authorities.

(17) This is similar to the Single Point of Entry versus Multiple Point of Entry approaches to resolution. The latter is more consistent with a fragmented banking system and minimises coordination problems.

(18) See Davies (2002).

(19) ECB (2011) p. 10.

(20) The Bank of England had swap agreements with European central banks in the 1992 ERM crisis and a deterioration in the mark to market value eventually led to the loss of sterling.

(21) Ferran (2014), p. I.

Angus Armstrong, NIESR and Centre for Macroeconomics. E-mail: [email protected].