Andreas Dombret: The possible impact of Brexit on the financial
landscape
Speech by Dr Andreas Dombret, Member of the Executive Board of the Deutsche Bundesbank,
at zeb (consultancy for financial services), London, 24 February 2017.
* * *
1 Introduction
Ladies and gentlemen,
Good morning. I hope that you enjoyed the breakfast buffet. I am sure that what one says about
the quality of breakfast in England is not true here at the new zeb office. Now that you have
started the day energised after a good meal, I want to provide you with some thoughts on a most
topical issue - something else to chew on, so to speak.
I am talking, of course, about Brexit. Even though this is by no means a new issue, and the
element of surprise that it had in June last year has vanished, it still attracts tremendous
attention. After all, it is what made all of us gather here today.
And there are many reasons why Brexit is still attracting so much attention. Among them are the
profound impact it might have on the world we live in, and the intense uncertainty surrounding its
precise effects. This combination of significance and uncertainty makes Brexit a topic well suited
for speculation about what might happen. And if you have followed the topic closely, you have
probably noticed different and even opposing statements on the same question.
But speculation doesn't help. What makes more sense is scenario-based thinking. Today, I will
try to set some things straight - at least regarding the financial sector. The first part of my
remarks will therefore cover the potential impact of the Brexit on the financial sector. In the
second part, I will look at the bigger picture and share with you my expectations for the
negotiations as well as my thoughts on the future of regulation and supervision in the EU and
the UK.
2 The possible impact of the Brexit on the financial landscape
Let's start with the potential impact of the Brexit on the financial landscape. First and foremost,
this means talking about market access. We should not forget that this is a two-way street, and
so I will talk about market access in both directions. But the centre of attention is certainly on
market access for UK based financial institutions to the EU, as this potentially has the largest
impact for banks and other financial institutions. It affects all institutions, both from the UK and
the rest of the world, which currently use London as a hub for their continental European
business.
The debate on market access was transformed in mid-January. Prime Minister May made it clear
that the UK is looking for a clean break from the EU's single market. For the financial industry,
this means that the current model of using London as a gateway to Europe is likely to end. Banks
from third countries need a licensed entity inside the European Economic Area to gain access to
the whole area, known as "passporting". Shortly before the Prime Minister's speech, CityUK
already dropped demands for maintaining access through passports.
Instead, many are now hoping for an equivalence decision to fill the gap left by passporting rights.
If the European Commission deems the regulatory and supervisory regime in the UK to be
equivalent to that in the EU, market access would be partly retained. However, I am rather
sceptical about whether equivalence decisions - may they be likely or not - offer a sound footing
for long-term location decisions of banks. Equivalence is truly different from single market
access.
There are three major drawbacks to equivalence decisions. First, they only cover the wholesale
business of banks. Second, given the fact that banks need time to build up a new entity
elsewhere, an equivalence decision would have to be taken quite soon to actually have a bearing
on the location decisions of banks. Third, equivalence decisions are reversible, so banks would
be forced to adjust to a new environment in the event that supervisory frameworks are no longer
deemed equivalent. These drawbacks lead me to the overall conclusion that equivalence
decisions are not a reliable substitute for passporting.
So it seems that the prospects for EU market access through the UK look rather dim. To ease
the pressure on financial institutions, a transition period could help. It would reduce risks and
increase planning security for banks, which would be economically beneficial. Furthermore, it
could support a smooth relocation process by taking pressure off both supervisors and banks,
for example by making "first mover advantages" less important. This being said, transition
periods would be a politically sensitive topic in the negotiations, and it is unclear how likely such
an agreement might be.
As mentioned earlier, we should not forget about the access of European banks to the UK, which
is also an important issue. For German banks, for example, the UK is the second-most important
foreign market, right after the US. It will be up to the UK Prudential Regulation Authority to decide
under what circumstances European banks can retain access to the UK. Whether the UK would
be prepared to unilaterally grant access for EU financial institutions in order to retain the
attractiveness of London as a financial centre, remains an open question. And let me add that it
is of course not regulation alone that plays a role when European banks decide on opening a
branch or a subsidiary in the UK. It is also a question of what kind of entity their counterparties
and clients want to do business with.
Let me summarise the prospects for market access, at least from my point of view. Continued
passporting rights are rather unlikely, and an equivalence decision would be a somewhat
imperfect substitute. A transition period could ease some of the pressure, but it clearly is a
sensitive issue.
Could a free trade agreement be the solution? According to their Brexit white paper,
the UK government will strive for an ambitious free trade agreement with the EU as a long-term
solution. But regardless of the fact that negotiating comprehensive free trade agreements is an
arduous and time-consuming task, financial services are an especially tricky area. So far,
the EU has never fully integrated finance in its free trade agreements with third countries.
Where does this lead us? So far, while acknowledging and accepting the divorce, policymakers
are trying to find ways to hold the UK and EU economic areas and jurisdictions together. And
they will continue trying so. The reason is that most of us are convinced that harmonised rules
eliminate unnecessary frictions and act as a powerful catalyst for business across national
borders - for the real economy as well as the financial sector. However, looking at the facts that
I've just laid out we also have to acknowledge that it is at least questionable whether this
undertaking will be easily achieved. Financial institutions should take into consideration that, in
the end, there might well be two separate jurisdictions in which they operate, and that these
jurisdictions might diverge over time - or instantly, once the divorce has gone through.
3 Whether and where to move
As a consequence, many banks are now considering moving some of their activities to the EU.
First, let me say that I expect London to remain an eminent global financial centre. Nevertheless,
I also expect a number of UK-based market participants to move at least some business units in
order to hedge against all possible outcomes of the negotiations.
The question that is causing some excitement is: Where will banks go? As a supervisor, my
main concern is that banks are supervised according to standards that are both high and
consistent. This is best ensured within the SSM area. This also means that I will not promote any
particular financial centre. That said, I am open to dialogue with financial institutions in assessing
the conditions for moving business units to Germany. And I go as far as to say that - in many
respects - these conditions are attractive.
Numerous major market participants have already contacted the German Federal Financial
Supervisory Authority BaFin and Bundesbank. We respond to such requests pragmatically. That
is, we provide financial institutions with quick and reliable guidance and aid a smooth transition if
one of them decides to move business units to the continent. Three weeks ago, BaFin has
hosted a workshop for representatives of foreign banks covering all questions surrounding Brexit.
And just this Wednesday, Bundesbank has launched a website on the topic, providing
information as well as contact details for banks assessing to move part of their business to
Germany.
Of course, we also emphasise the requirements for establishing a licensed entity there. For
example, this means that we will not accept any empty shells or "letterbox companies" where the
business effectively continues to be done out of London. For critical functions such as
management, controlling and compliance, qualified personnel need to be present at the
nonUK EU subsidiary at all times. And I urge banks not to spend their time inventing strategies to
circumvent these requirements. This includes seemingly creative solutions such as
"fly-anddrive" banking, where bankers fly in daily from London, or "dual hatting", where transactions are
booked on the EU subsidiary but in fact executed in London.
To summarise: As important as outsourcing strategies will understandably be when banks
restructure their business to adjust to the new environment, it has its limits, and we expect any
branch or subsidiary to retain chief responsibility for its business.
4 What to expect, and how to prepare
I trust that the vast majority of financial institutions are aware of the many question marks
hanging over market access, and that they are assessing their implications. But they should not
focus solely on the obvious. Financial institutions need to systematically think through what
effects Brexit could have on each of their areas of operations. For example, banks should check
what Brexit might mean for covenants, or how it could affect the handling of margin calls.
I said earlier that scenario-based thinking is called for. However, assessing the likelihood of
different scenarios is not an easy task by any means. Brexit negotiations will be highly political,
and the political debate is already becoming extremely tense. If policymakers on both sides agree
on one thing, it's that arranging the divorce between the UK and the EU is going to be very hard.
European Commission President Juncker expects the negotiations to be "very, very, very
difficult", and UK's Brexit Secretary Davis predicts they will become the "most
complicated" negotiations of all time.
While as a central banker I don't tend to use such dramatic words, the two gentlemen do have a
point. European leaders see the bloc as being in an existential crisis and have made it clear that
the future unity of the EU 27 is the highest priority, which includes the inseparability of the four
freedoms. The UK, on the other hand, aims at regaining control of law-making, the public budget
and immigration. With these priorities, the UK government wants to do justice to Brexit voters.
According to surveys, the voters put the economy only in third place after sovereignty and
immigration when making their decision.
So while economic policy will of course be an important topic during negotiations, we should not
count on economic sanity being the main guiding principle. And that means we also have to
factor in the possibility that the UK will leave the bloc in 2019 without an exit package, let alone
the sweeping trade accord it is seeking. The fact that this scenario would most probably hurt
economic activity considerably on both sides of the Channel will not necessarily prevent it from
happening.
5 Regulation and supervision
Ladies and gentlemen, I have laid out my thoughts on the effects of Brexit on the financial world
and have shared my views on what mechanisms will steer negotiations. I want to dedicate the
remainder of my remarks to regulation and supervision in the light of Brexit.
My main message here is that we must avoid a regulatory race to the bottom at all costs. Given
how the Brexit debate developed early this year, this warning is not at all an empty one. A
financial centre strategy comprised, among other ingredients, of very low corporate taxes and lax
regulation has already been mentioned in the UK as a fall back option for London. And in January,
Chancellor of the Exchequer Philip Hammond made it clear that the UK would "do whatever [it
has] to do" to regain competitiveness.
Regulation and supervision in the UK have been both highly professional and stability-oriented in
the past. I strongly hope that supervisors here will be able to keep up this good work and turn a
blind eye to demands for deregulation and lax supervision. The current regulatory and
supervisory standards we have set together are an important lesson from the financial crisis and
it would be a mistake to roll them back. I am convinced that in the long run, well-capitalised and
strictly supervised financial systems are the most successful ones.
To be clear, my call to refrain from using regulation or supervision for the sake of increasing
one's competitiveness is equally addressed to the EU. There might be a certain temptation to
use Brexit as a chance to strengthen financial centres across the rest of Europe, for example by
offering discounts with respect to licensing procedures. This is not a route we should take, and I
am confident that the strong role and far-reaching competences of the SSM, including the ECB's
responsibility in licensing, will forestall such ideas becoming reality.
While I am serious about my warning of lax rules and supervision, I am cautiously optimistic that
we can prevent this scenario from materialising. And this is because I know my colleagues in
London very well, and I know that they share my views on this issue. Our cooperation with
the UK Prudential Regulation Authority has been exemplary in the past, and we will invest all our
efforts in continuing this partnership in the future.
Now, more than ever, we should also harness our relationship to work together closely during
Brexit. Information sharing needs to be an important part of this. For example, when European
authorities examine the risk models of banks wishing to establish a subsidiary on the continent,
we would benefit from knowing what the PRA found in their previous assessment. This includes
at what time the PRA last examined the model, under what assumptions, and to what verdict it
came. Conversely, we are open to sharing all necessary information that the PRA might need to
process applications by EU banks to operate in the UK.
The guiding principle of our cooperation should be to ensure a smooth transition to a post-Brexit
world. As supervisors with the necessary distance from political haggling, we can make a
substantial contribution by providing pragmatic and efficient solutions. In parallel, I believe that
European and UK supervisors should fathom out how we can put our future cooperation on a
more formal footing.
6 Closing remarks
Ladies and gentlemen, let me summarize. The financial landscape will change, and we cannot
know how. While I have outlined some things to expect and some not to expect, uncertainty will
persist for quite some time. The task for financial institutions is to deal with the uncertainty
surrounding Brexit as efficiently as possible.
As regards the course of the negotiations, we should bear in mind that economic rationale might
not be the main guiding principle - and will certainly not be the only one. This means that
companies have to factor in the possibility that the final deal will not prioritise the economy - or
that, in a negative scenario, both sides might not agree on any deal at all.
But whatever happens in terms of our future relations, it is vital to remember that lax financial
rules have often paved the route to failure. The outcome became painfully apparent in the
financial crisis that erupted just under a decade ago, and its costs are still being felt. None of us
wants to see such events again any time soon. And preserving the progress we have made in
increasing the resilience of financial institutions is the only way to ensure this.
Thank you for your attention.