Question

Discuss the potential impact on financial markets, especially FX markets, of the United Kingdom’s exit from the EU.

Answer 1

The UK’s exit from the EU1 and the new relationship with the EU are critical issues for the UK-based financial services sector, and for the wider economy it serves. To inform the UK Government’s approach to the UK’s exit from the EU negotiations TheCityUK commissioned Oliver Wyman to develop a comprehensive fact-base on the size of the sector and the potential impact of the UK’s exit from the EU.

The UK-based financial services sector is a significant contributor to the UK economy. The sector annually earns approximately £190-205BN in revenues, contributes £120-125BN in Gross Value Added (GVA)2, and, together with the 1.1 million people working in financial services up and down the country, generates an estimated £60-67BN of taxes each year. It contributes a trade surplus of approximately £58BN to the UK’s balance of payments.

The UK-based financial services sector, together with the related professional services sector, has developed over many years into an interdependent and interconnected ecosystem comprising a large variety of firms providing world-class services, products and advice. This ecosystem brings significant benefits to financial institutions and to the corporations and households they serve.

Because of the interconnectedness of the activities and firms within this ecosystem, the effects of the UK’s exit from the EU could be felt more widely than simply in business transacted directly with EU clients

analysis suggests that, at one end of the spectrum, an exit from the EU that puts the UK outside the European Economic Area (EEA), but otherwise delivers passporting and equivalence and allows access to the Single Market on terms similar to those that UK-based firms currently have, will cause some disruption to the current delivery model, but only a modest reduction in UK-based activity. We estimate that revenues from EU-related activity would decline by ~£2BN (~2% of total international and wholesale business), that 3-4,000 jobs could be at risk, and that tax revenues would fall by less than £0.5BN per annum.

At the other end of the spectrum, in a scenario that sees the UK move to a third country4 status with the EU without any regulatory equivalence, the impact could be more significant. Severe restrictions could be placed on the EU-related business that can be transacted by UK-based firms. In this lowest access scenario, where the UK’s relationship with the EU rests largely on World Trade Organisation (WTO) obligations, 40-50% of EU-related activity (approximately £18-20BN in revenue) and up to an estimated 31-35,000 jobs could be at risk, along with approximately £3-5BN of tax revenues per annum.

In this scenario, the impact on the sector would be greater than the loss of direct EU-related business. For example, the knock-on impact on the ecosystem could result in the loss from the UK of activities that operate alongside those parts of the business that leave, the shifting of entire business units, or the closure of lines of business due to increased costs. An estimated further £14-18BN of revenue, 34-40,000 jobs and ~£5BN in tax revenue per annum might be at risk.

This is not a “zero sum game” within the EU. Organisations will not shift activities and employment on a one-for-one basis out of the UK to the EU. For some institutions, the cost of relocation and the ongoing inefficiencies associated with a more fragmented environment could cause them to close or scale back parts of their business. Others, particularly those with parents located outside of the EU, could move businesses back to their home country, reducing their overall footprint in Europe.

There are likely to be opportunities arising from new networks of trade and investment agreements, that the UK will negotiate with its partners, and nurturing of growth areas in the sector (for example, FinTech), boosting jobs, taxes and the trade surplus delivered by the sector. Recent work by TheCityUK highlights a number of medium to long term opportunities for the UK, including the creation of Sharia-compliant central bank liquidity facilities, coordinated support for emerging markets wealth management, supporting masala bond trading and issuance, green finance and FinTech.

A number of assumptions underpin the analysis outlined above, including the continuation of international norms in areas such as portfolio delegation, UK equivalence agreements with non-EU regulators6, continuation of agreements over issues such as data, Know Your Customer (KYC) and Anti-Money Laundering (AML) and continued access to skilled talent7 from the EU, and non-EU nations. If these assumptions do not hold, then the impact on the sector could be yet larger, particularly over the medium to long term (the next five years and beyond).

While it is impossible at this stage to predict what the UK’s new relationship with the EU will be, the final outcome is likely to fall somewhere between these two ends of the spectrum.

Settling the new general legal relationship between the UK and the EU and formulating more specific financial services regulations are complex tasks and will take time. Failure to build sufficient transition arrangements, at both the end point of the negotiation of Article 50 and the implementation date of the new regulatory framework, could result in threats to growth, competiveness and financial stability as financial services firms need to change their operating models in order to continue to do business in a compliant way. Certainty on the transitional period is therefore needed as soon as possible.

EU businesses have an interest in retaining access to the UK as an international financial centre, not only for the services provided directly but also as a conduit for global investment into the EU. The best outcome would recognise these dynamics and deliver mutually beneficial results for the UK, the EU and the rest of the world.

CONCLUSION

analysis suggests that the impact of the UK’s exit from the EU on the financial services sector will vary dramatically with how much access to the EU is retained. In a high access scenario the disruption could be negligible. In a low access scenario the impact is likely to be much larger, and any resulting wider impact to the ecosystem could magnify losses.

A high access scenario, with a clear and sensible transition period, is likely to minimise disruption to the sector, benefiting customers who have come to rely on the UK as a uniquely skilled and connected centre for financial services. These customers come not just from the UK but also from the EU and around the world. It would also enable the UK to maximise the potential growth opportunities that could arise from the UK’s exit from the EU (such as FinTech) as well as the continuation of the UK as a centre of regulatory excellence. For related professional services the following components will be especially important: access to talent, reciprocal rights around data, and equivalence of UK regulation.

analysis suggests that including the following five features in the future agreement between the UK and EU would lead to the highest levels of employment and tax revenues in the UK, and would deliver the highest service levels to consumers, be they from the UK or the EU.