Why a Brexit could ‘kill’ London as a top financial hub

A vote to leave the EU could cost banks billions of dollars, if they lose their key ‘passporting’ rights

Bloomberg

London’s financial city could be hit hard by a Brexit

A U.K. exit from the European Union risks costing the City of London billions of pounds, thousands of workers and its spot as the world’s top financial center.
That’s the message from players in the financial industry ahead of the highly contentious in/out referendum on EU membership this month, and it all centers on one simple process that’s complex to undo: passporting.
The mechanism allows British-based financial institutions such as banks, fund managers and insurers to seamlessly sell their services across the 28 EU nations without having to get regulator approval or set up subsidiaries in each member state.

So what could happen in London’s financial sector, if the passporting right goes down the drain? The Brexit “leave” and “remain” campaigns are still hashing out the issue, but several voices across the City of London are clear.
“It would kill it,” said Stuart Alexander, chief executive at Gemini Investment Management, which is using the mechanism.
“You’d have to go back to the old regime of a U.K. fund management company going into Frankfurt and saying, ‘Please, Mr. Regulator, will you authorize this fund for distribution in your country?’” he said.

Passporting has been extremely popular. U.K. banks use it to expand its customer base in the union. EU firms use it to tap into the international financial markets via London, as a global financial hub.
Plus, non-U.K. and non-EU banks use it as a financial springboard to do business with the entire EU, with the benefit of only having to set up a base in one place. Swiss and U.S. banks, for example, use London for easy access to the European single market.
UBS UBSG, -2.20% UBS, -1.29% Goldman Sachs GS, -1.64% Russia’s Sberbank SBRCY, -2.82% J.P. Morgan JPM, -1.88%  and China’s ICBC 1398, -0.48%  are among several international banks that use passports this way, according to the U.K.’s Financial Conduct Authority.
But that right is likely to disappear if British voters choose a “Brexit” — a departure from the EU — in the June 23 referendum. And given “passporting is of vital importance,” then it will mean a shake-up for the sector, says Nicky Edwards, director of policy and public affairs at TheCityUK, a lobby group for London’s financial services industry.
“Brexit would have a number of potential impacts,” Edwards said. “One is that you have to expect the non-U.K. firms that currently are based here to relocate some or all of their operations to within the single market.”
Read: This stock-market sector will get hit hardest by a Brexit

Cost of a new passport

Totaling up the cost to all those individual companies, the loss of a London passport could mean billions of pounds of outlay on office relocations, staff transfers, added paperwork and new capital requirements.
If financial firms want to continue to do business in the EU after a Brexit, they need to get regulator approval in another member state. To do that, they will need to set up a subsidiary in the new country and comply with local regulations there. Then they can “passport” their services into the rest of the EU, just like they used to do from London.

This is an expensive process, as the “new” regulator state requires a significant amount of cash or assets on the institution’s balance sheet to be properly capitalized. Under EU rules, the minimum share capital for banks and insurers is 5 million euros ($5.58 million), although most local regulators impose much more, according to law firm Hogan Lovells. The EU-wide Basel III rules require banks to keep a capital buffer — cash equivalent to 8% of their total assets.
For funds, the capitalization cost varies. For example, Luxembourg requires such firms to have at least €10 million of capital on the their balance sheets, while Irish rules demand only €300,000, according to Funds Partnership, a recruitment company for the asset management industry.
And for the banks, fund management companies and insurers affected, securing such new authorization from a new regulator could take months, or possibly years.
“People have to think about what their priorities are. Capitalizing banks is a very, very expensive business. So you have to decide how big your presence will be,” said Sharon Lewis, partner at Hogan Lovells.
“I think people will rethink their business,” she said.

“I think it will postpone investments. I think it will cost jobs. I cannot really see anything positive about it”

Sharon Lewis, Hogan Lovells

There are already signs that major financial players are considering ditching London as their key European hub. Frankfurt and Paris have been mentioned as the obvious choices for a replacement European financial powerhouse, but Dublin has also been thrown into the mix, mainly because it has the advantage of being another English-speaking capital.
The potential loss of passporting rights is “absolutely massive” for Hogan Lovells’s clients, Lewis said, with some already expressing concerns about the “costly, time-consuming” process of dealing with it.
“I think it will postpone investments. I think it will cost jobs. I cannot really see anything positive about it,” Lewis said.

Stay or go?

At Goldman Sachs, senior executives have warned publicly about the dangers to the city of London of a Brexit. They said they’d considering shifting the bank’s resources elsewhere in the EU if the exit becomes a reality.
“It is imperative for the U.K. to keep the financial-services industry in the U.K. [...] I don’t know what would replace that industry,” Goldman Sachs’s president Gary Cohn said at the World Economic Forum meeting in Davos in January, early to sound the alarm over Brexit risks.
The U.S. bank has donated £500,000, or about $700,000, to the “Britain Stronger in Europe” campaign. Morgan Stanley MS, -2.61% Citigroup C, -2.78%  and JPMorgan Chase & Co. JPM, -1.88% have also handed over six-figure donations to the “remain” campaign, according to media reports.

Hit to financial services exports

While it’s difficult to exactly quantify the economic benefits of passporting, various organizations have taken a crack at estimating what it would cost to lose the privilege.
“Without passporting rights, it is conceivable that exports of financial services to the European Union could fall by half, or about £10 billion ($14.51 billion),” said the authors of a research report by Capital Economics, commissioned by Woodford Investment Management.

Another report, conducted by PricewaterhouseCoopers for TheCityUK, noted that the U.K.’s status as a global and regional financial hot spot hinges on its having access to the single European market.
It pointed out that in 2014, more than 80% of foreign direct investment into the U.K.’s financial sector came from countries outside the union, highlighting the importance of non-EU investments.
Read: These are the EU countries that would suffer after Brexit, says Fitch
“The ability to access the Single Market is one of the factors in attracting international banking institutions to establish their European headquarters in the U.K.,” the report said.
Because of this, up to 100,000 financial services jobs could be lost in the U.K. if a Brexit goes ahead, according to the report.

GVA = Gross Value Added

Coming out stronger

Some argue, however, that the Brexit fears are overblown. “Leave” campaigners say that quitting the union would free London from the EU’s regulatory restraints and allow the financial services industry to become more competitive.
By leaving the union, the U.K. could, for example, revert the cap on banking bonuses that was introduced after the financial crisis against Britain’s will, said Melanie Debono, an economist at Capital Economics. Removing that cap and letting bonuses run high again could provide a lift to financial activity in London, offsetting some of the negative impacts.
“Passporting rights are not the only thing that’s at stake for the financial services sector,” Debono said.
“We see that the financial services here in the City would flourish in the long run. In the short term, it would be impacted — actually out of all the sectors in the U.K., it’s probably the one that will be most affected — but in the long term, we see it coming out strong,” she added.
Read: 5 arguments in favor of a U.K. ‘Brexit’ from the EU — and 5 against
That view was echoed by more than 100 City executives — including Hargreaves Lansdown HL., -2.76%  founder Peter Hargreaves and CMC Markets CMCX, -1.27%  chief executive Peter Cruddas — who signed a letter backing a Brexit.
They argued EU membership is a threat to London’s prosperity, saying the financial services industry “can thrive and grow” outside the union.

“A bit like a divorce”

What the U.K.’s relationship with the EU would look like after an exit isn’t clear. The process of renegotiating trade deals could take years, and there’s no guarantee Britain’s financial institutions would keep their easy access to the union.
Read: The Swiss franc is your best bet for ‘Brexit’ protection
One option is to strike a bilateral trade agreement with the EU, just as Switzerland does. But there’s one flaw: Swiss banks don’t have passporting rights, and for the most part they operate their European businesses through subsidiaries in London.
According to the Capital Economics report, that’s part of the reason Swiss financial exports have been lower than Britain’s over the past 15 years, despite Switzerland’s success in the financial sphere.

Another possibility is for the U.K. to join the European Economic Area, as Norway has done. While this could help the finance industry preserve its passport privileges, there are still big risks, according to Hogan Lovell’s Lewis. The sector could find itself worse off, vis-à-vis Europe.
“I think the EU will be less cooperative than the Brexit campaign thinks,” she said.
“It’s a bit like a divorce. In some cases, divorces go very well, and there are mutual interests — ‘children’ — involved on either side of the Channel,” she added. “But for Europe, it feels a bit like taking a brick out of a wall, in terms of the whole European Union.”