EU Financial Services Sector Post Brexit

Reclaiming the dominate EU Financial Center/Finanzplatz Frankfurt

With the UK abandoning the EU and its role as the domicile of dominate European Financial Center, it is time to systematically reform and restructure the (1) EU capital market, (2) EU securities, derivatives (trading, settlement, clearing and custody) business, EU insurance and asset management sector (including Hedge Funds, Private Equity and Real Estate) with a view to expand - at the expense of the UK - these industries - within the EU - and create a stronger, more stable and regionally diverse financial market business infrastructure in Frankfurt, Paris, Amsterdam and Vienna as well as in smaller continental European cities.

Why now?

There has been no more significant event than Brexit in European financial markets since Big Bang under Margaret Thatcher. Significant changes in market convention, capital rules, regulation and market entry standards over time produced the modern, dynamic City of London with an American flavor in Canary Wharf.

With the UK's withdraw from the EU, the vast amount of EU law and regulations (European directives) - governing the European investment banking, capital market, securities and derivatives business as well as the asset management and insurance sectors - will cease to exist in London. It is completely unclear what regime UK legislators will put in place of this modern and vast body of EU regulatory law. There could easily be a longer period of uncertainty and chaos in the City of London. The UK will automatically revert to its domestic, disjointed regulatory framework, which was created after the failed Financial Services Authority (FSA) was abolished in 2013. 

Numerous failed attempts - to set standards and enforce laws in the UK financial services industry - clearly demonstrate the need for the EU to regulate its own markets. Case in point is particularly lax insider trading enforcement in the past. The recapitalization of Morgan Grenfell Group - after the total failure of its compliance department in Morgan Grenfell Asset Management, the fourth largest manager of UK pension fund assets during the Peter Young Affair - resulted in a USD 1 billion loss for Deutsche Bank AG. The London centered Libor scandal, misselling of financial products to retail banking clients and the Maxwell pension fund scandal are further specific examples.

Do EU citizens want the UK to dictate the future of regulation and standards in the European financial services industry and thus to a certain extent influence/control the safety of their savings? I certainly don't think so!

What should the EU Commission do?

The EU should further improve the regulatory framework for the financial services industry and its efficiency and create market driven incentives to pull components of the business back to Frankfurt and Paris and other smaller financial centers on the continent. 

Under the leadership of the European Central Bank (ECB) in Frankfurt, financial services industry regulation should be bundled. This including the: (1) European Banking Authority (EBA), (2) European Securities and Markets Authority (ESMA) and (3) European Insurance and Occupational Pensions Authority (EIOPA).

Why should EU savings to be managed in a non-EU regulated UK environment? EU capital/savings should be managed inside the EU and channeled to finance EU firms, startups and infrastructure with the resulting employment benefits, tax revenue and regulatory control residing within the domestic market.

Market driven incentives could include improved taxation policy, occupational training programs, elimination of red tape and assistance with business relocation.

Concrete next steps?

1. EUR Clearing must be under the direct supervision of the ECB as well as the entire financial services industry. The clearing houses, senior management and workers must reside within the EU with regional central banks and market regulators overseeing the heart of the system and circulation of capital within the EU capital market.
2. The FX market should gravitate to the largest trading block in Europe, and this is clearly the EU. This segment of the global capital market is the last of the wild west and it must be tamed. There have been more scandals and failures here than in any other area of the global capital market over the years. The EU should create a best standards regulatory framework for the FX industry. There is a substantial lack of transparency and real systemic risk embedded in this market. Unregulated market participants are beyond the reach of central banks and other regulators. There are no capital standards, registration requirements or market safety mechanisms in place.
3. The backbone of the City of London is in reality the integrated US investment banks and their asset management subsidiaries. The EU should facilitate the relocation of all their EU related business activity to EU financial centers, bringing additional employment, knowhow, and tax revenue to the continent. A massive pull on lawyers, tax advisors and many other service providers will ensue as they follow their clients. These high wage jobs would be highly beneficial to the employment, revenue, tax and knowledge base of the EU. English as the language of business no longer protects London from EU competition as in the past. The internal language of major market participants is already English around the globe, and especially in Europe.
4. The EU should encourage its own investment banks to repatriate their London based operations, which service EU clients and provide EU products and services. This would further strengthen the EU financial service industry by improving scale, profitability, quality and lowering systemic risk. The EU should reverse its policy of forcing investment research out of the integrated investment banking model. This is fools gold and only weakens EU investment banks. Additionally, it is time to force EU banks to clean up their balance sheet and restore real confidence in their long-term viability. Deutsche Bank AG with its massive derivatives exposure is case in point.
5. The EU insurance industry, in particular the life sector, should be restructured and recapitalized at this venture. Poor life insurance / retirement savings product design and an extended period of low interest rates have gutted the capital base of many EU life insurers. It is time for consolidation, recapitalization and if needed liquidation of some market participants. We need to restore financial health and public faith in the insurance sector.
6. The EU pension crisis should also be addressed. EU firms should be forced to cover their unfunded pension liabilities, encouraged over time to move to defined benefit pension plan. National government unfunded "pay as you go" social security systems should be tied off and future benefits offered in a real capital account based system. The current unfunded government social security and civil servant pension plans throughout Europe are large enough to consume the entire theoretical EU treasury in future. What about fairness to the younger generation? A retirement system based upon real capital would be a boon to the EU capital market, help create new companies and employment opportunities. The additional tax revenue is sorely needed.
7. The EU should encourage Chinese banks, asset managers and insurance companies to domicile their non-domestic operations in the EU. There is still tremendous potential to expand trade with Asia, and China is key to this effort. There is great scope for related trade finance, securities issuance, trading and clearance in Chinese securities in the EU capital market.

What would remain in the UK/London in this scenario?

1. UK domestic retail, commercial and investment banking.
2. UK domestic securities, derivatives trading and clearing.
3. UK domestic M&A and private equity business.

The stand-alone UK economy simply does not have the size, depth, capital or tax base to serve as the backbone/backdrop of the EU's capital market post Brexit. The Bank of England can not replace the European Central Bank as the lender of last resort and lead regulator. These dreams are over, relegated to the dust bin of history. The britisch empire is not going to reappear after Brexit.

What could gravitate to NYC?

1. International, non-domestic USD securities, derivatives trading, clearing and settlement and custody business.
2. International M&A, Private Equity and Hedge Fund business.

End result?

The EU capital market and financial service industry would be on par with the US/NYC in terms of size, liquidity, sophistication and product expertise. Reforms would create a strong and vibrint EU investment banking, asset management, insurance and retirement savings/pension fund industry. The potential for increased employment, prosperity and massive reduction in systemic risk within the EU is massive.

With Brexit, UK has challenged the EU to further reform, restructure and retool the EU financial services sector, and the EU Commission should have the vision to grasp this once in a life time opportunity to take back control of the EU's financial markets.

Rondal Eric Powell

Rondal Eric Powell Consulting, Frankfurt, Germany

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