When stakes are high, a lot gets read into official pronouncements, rebuttals, and even silences. This is certainly the case with British assertions that border controls must be taken as read for any future relationship, and European ripostes that full access to its single market requires free movement of labour. Suddenly, a “hard” Brexit – an abrupt rending of open supply lines and free trade by early 2019 – is more than a theoretical possibility.
While it is tempting to dismiss talk of hard Brexit as posturing, history is replete with bluffs gone wrong. Not surprisingly, the market has reacted to the rhetoric by sending the pound to multi-decade lows.
Nowhere is the sense of a looming cliff greater than in the financial sector. On Brexit day one, all UK-based financial firms – European, British, American and Asian – will lose the “passporting rights” that allow them to conduct business on the Continent already approved by UK regulators.
To continue servicing their clients, these firms would need a dauntingly inefficient and costly series of approvals. Alternatively, they could move to the Continent, but this too would be costly, as the underlying infrastructure for capital market services is in London.
Losing a significant part of its activity would obviously be a big deal for the City. But even if one cared not a whit for well-off financial workers, the damage would extend well beyond the City. Accounting for three-quarters of European capital market activity, London is as much Europe’s financial capital as it is the UK’s political capital. We know from recent bitter experience that financial shocks – higher costs and reduced market access – are far more damaging and extensive than trade and other economic shocks.
The imperative for a properly functioning capital market cannot be exaggerated. With some 80 per cent of corporate financing coming from banks, Europe has no real capital market outside London. The highly bank-dependent system has been unable to deliver the credit needed for recovery and growth in the way that more robust US capital markets have done.
Dismantling the City’s intricate eco-system of professional, technical and legal capabilities, and trying to reassemble it on the Continent as if it were Lego, would set back Europe’s capital market development project by a decade. The last thing a struggling-to-recover Europe needs is a fragmented capital market to sit alongside its fragmented banking system.
Viewed from New York, the failure to rule out a hard Brexit has the surreal feel of opposing sides holding the same hostage, both threatening to tear up the pan-European asset that is the City of London.
What can be done
Ideally, the two sides ought to agree on preserving – indeed growing – the City of London as a European financial centre. This may entail new regulatory arrangements and understandings with the EU, eg along the lines suggested in Bruegel's Continental Partnership or my colleague Reza Moghadam's proposal for UK participation in Banking Union.
But such solutions may be a bridge too far. Negotiations need to reconcile complex issues and entrenched positions. Moreover, the political seductiveness of moving the City to the Continent is not to be underestimated. If London must be cut off from Europe, at least a longer transition period for doing so should be agreed during which existing regulations continue to apply. This is critical since any move to the Continent will take years – many more than the two- year negotiating period contemplated.
Aside from staffing, the new entities will require new or expanded licences, approvals for capital models and resolution plans, and enhanced capital, governance, systems and controls. New links to exchanges, clearing houses and payment systems will need to be forged, and new laws, property rights and taxes factored in.
From the perspective of a global bank, with no national dog in the fight, what is most important is that Brexit negotiations proceed with the clear understanding that London’s financial centre is a European public good as much as a British one.
Whatever the final outcome of the negotiations, the City must not become a bargaining chip in a great game. If that happens, both sides could be losers, and the prize could move somewhere else – perhaps to New York.
Colm Kelleher is president of Morgan Stanley and based in New York. He is an Irish citizen.