From folly to fragmentation

THE bleeding stopped on the third day: sterling steadied and stockmarkets perked up on June 28th, after two sessions of carnage (see article). By then Britain’s vote on June 23rd to leave the European Union had taken a heavy toll (see chart). The shares of Lloyds and the Royal Bank of Scotland, Britain’s biggest domestically oriented banks, were down by around 30% and those of Barclays by slightly more. Continental institutions were clobbered too: BNP Paribas, Deutsche Bank and Santander all lost 20%-plus and Italy’s beleaguered UniCredit 30%-odd. American banks with big operations in London also suffered, though not as much. Nor was the damage confined to banks: American insurers copped double-digit losses and Invesco, a big asset manager, shed 22%. A merger of the London Stock Exchange and Deutsche Börse, its German rival, looks likely to collapse.

Markets are worried that growth will slow in Britain and the euro zone, pulling interest rates and bond yields even lower. That would squeeze banks’ margins, and insurers’ and fund managers’ prospective returns—all thin already. Beyond the immediate turmoil is a longer-term concern: what harm might Brexit do to London as a financial centre?

According to TheCityUK, a trade body, London boasts 250 foreign banks and 200 foreign law firms. Finance and ancillary trades employ 730,000—perhaps surprisingly, more than in 2007-08, when the financial crisis struck. An abundance of clever people—adept in English law as much as in finance—draws in banks, fund managers and so forth; the wealth of employers, in turn, attracts more workers.

Brexit threatens this happy balance. Britain has not only become politically unstable, with no government or opposition worthy of the name; it also no longer affords the regulatory predictability that investors crave. How the City fares depends on how, and how soon, order is restored.

The main worry is that financial firms will no longer be able to serve the whole EU from London when Britain leaves, perhaps two years after the formal start of exit talks. Companies from one EU country have “passports” to do business in the other 27, with no need for local branches or subsidiaries. Thus equipped, banks from both outside and inside the EU have made London their second home. Goldman Sachs, for example, has 6,000 of its 6,500 European staff there, against just 200 in Frankfurt. Insurance is more localised, but passporting still matters to some, such as America’s MetLife, which saw its share price fall by 17% in the two days after the vote. London’s asset managers sell mutual funds (UCITS, in Eurojargon) across the whole union; they managed more than €1 trillion ($1.1 trillion) last year.

A deal that preserves passporting is imaginable, even though no non-member of the EU enjoys full rights at present. In theory, Norway (to some, the most promising model for Britain) has unfettered access to the EU’s single market, although most of the EU’s post-crisis regulation has yet to be incorporated into its deal. But access to the single market requires freedom of movement, which Brexiteers reject. And Norway has no say in setting the EU’s rules.

Without a Norway-like deal, some wonder whether MIFID 2, a directive that comes into force in 2018 and that allows non-EU members to enjoy some access to the single market, might open a back door to Europe. But the surest way to serve the EU would be to do so from other places. Asset managers would no longer be able to sell UCITS from London. One, M&G, has been planning to replicate funds in Dublin, and will move some staff; another, Columbia Threadneedle, is applying to expand in Luxembourg. Some banks may have to acquire new licences elsewhere, which takes months. It would mean shifting some people. And European regulators would surely want entities on their patch to have their own capital. No bank has yet said it will move anyone, but these are early days. Before the vote HSBC said it could transfer 1,000 of its London staff to Paris and JPMorgan Chase warned that up to 4,000 of its 16,000 jobs in Britain could go. Morgan Stanley has denied a report that it is already working on moving 2,000 investment bankers to Dublin and Frankfurt.

A second concern is that London could lose its status as the main centre for clearing trades in euro-denominated securities. Around 70% of trading in euro interest-rate swaps takes place in London, four times the share of France and Germany, even though London is outside the euro zone. LCH, part of the London Stock Exchange, clears the lion’s share. The European Central Bank has long wanted clearing in its currency to take place on its turf, in case it ever needs to provide liquidity to a clearing-house in a hurry. Last year the British government won a case at the European Court, thwarting a four-year attempt by the ECB to bring euro-clearing home.

The ECB has a currency-swap agreement with the Bank of England, to provide liquidity if needed. But it would surely prefer direct oversight. If it tried again, a post-Brexit Britain would no longer have recourse to the European Court. A promise of non-discrimination against EU countries outside the euro zone, negotiated by David Cameron, Britain’s prime minister, before he called the referendum, will be null. It is “unlikely”, writes Angus Armstrong of the National Institute of Economic and Social Research, a think-tank, “that a major central bank would permit a swap line to support such a volume of transactions to take place offshore”.

Another worry is whether London can hang on to its lead in new areas of activity, such as fintech. No one knows what will happen, says Marta Krupinska of Azimo, an online money-transfer service used mainly by migrant workers. But she points to three possible problems: restricted access to the EU market; an inability to look abroad for talent (three-quarters of Azimo’s London staff are non-Britons); and the feeling that Brexit will make Britain a less attractive place to work. “A place perceived as not welcoming and insular will not attract the right talent.”

Britain’s efforts to make itself a hub for trading in Chinese assets are also in question. London has been the European focal point for China’s plans to internationalise its currency. But reports from China say it may now shift more toward other European cities. The link between the Shanghai and London stock exchanges, announced when China’s president visited London last year, is also likely to be delayed, though officials say it will still go ahead.

Undaunted Brexiteers promise an energising cull of regulation. Some hedge funds hope to see the end of the Alternative Investment Fund Managers Directive, which they regard as costly and bureaucratic. Freed from red tape, some fund managers hope to tap fast-growing sources of wealth in Asia, or recall the growth in European issuance of dollar bonds in the 1970s, which bypassed American regulation. But most of London, if it wants EU clients, will have to play by the EU’s rules. And lifting the cap on bankers’ bonuses—another European imposition—may be popular in the City, but much less so among British voters.

Meanwhile, other cities are hoping to gain from Brexit. The French have long had their eye on euro-clearing, and are pressing their case anew. François Hollande, France’s president, has already said that it must leave London. “I’m very anglophile and very sad for Britain,” says Valérie Pécresse, president of the greater Paris region, “but I absolutely want as many jobs as possible to move to Paris.” Hubertus Väth of Frankfurt Main Finance, which promotes the local financial centre, reports plenty of interest from property brokers. He thinks Frankfurt could take some derivatives-trading business and regulatory activity from London. One European banker recalls that long before the vote a senior Irish politician tried to persuade him to move business to Dublin, using Mr Cameron’s promise of a referendum as an argument.

The City is not about to crumble. Other centres lack its scale and sheer concentration of expertise. But some business will go elsewhere and Europe’s financial industry will become more fragmented and less efficient. The Brexit shock may already have reduced London’s allure. The longer the political and regulatory vacuum lasts, the more harm it will do.