On June 23, Britain voted by a margin of 52 to 48 percent to leave the European Union (EU). Much ink has already been spilled on the policy implications of that vote and, indeed, its long-run consequences may prove quite profound. When it comes to financial regulation, however, it is difficult to see any significant changes emerging in the short- to medium-term. There are a couple of fundamental reasons for this.
The first stems from the fact that the British financial sector is desperate to maintain its current access to the European Economic Area (EEA), also known as the “single market.” As things stand, a process known as “passporting” allows British financial firms to do business throughout the single market, whether on a cross-border basis or by establishing branches, without having to get separate regulatory approval in every jurisdiction. This arrangement is important to the industry and — given that financial services produce 8 percent of the UK’s output — the British government is likely to make its continuation after Brexit a priority.
But how can they bring that about? The most straightforward path is for Britain to leave the EU, but remain a member of the EEA. This approach, often referred to as the “Norway option,” would see Britain exit the EU’s centralized political institutions, while still participating fully in its “four freedoms” — that is, the free movement of goods, services, capital, and people. There is much to commend such a settlement, as I’ve written before. But if it did come to pass, Britain’s financial sector would clearly be subject to EU rules in much the same way as it is now.
There’s also a political problem with EEA membership: namely, it wouldn’t allow the British government to pursue its stated aim of controlling immigration from the EU. That suggests that the obvious alternative — a bilateral, post-Brexit trade treaty — might be the more likely outcome of Britain’s eventual withdrawal. Such a treaty could, theoretically, protect the British financial sector’s passporting rights. However, the quid pro quo for market access of that sort would undoubtedly be regulatory equivalence — that is, the European Commission would have to deem British regulation equivalent to EU rules before any passporting could take place. The handful of existing EU directives that provide “third country” financial firms access to the single market work in precisely this way. Ultimately, then, there are unlikely to be any major reforms to British financial regulation so long as the British financial services industry maintains access to the single market.
What if the Brexit negotiations do not result in single market access for British financial firms? This is by no means an improbable outcome: the UK will have to give something up if it wants to restrict EU immigration, and EU negotiators may consider financial services trade the best area in which to extract their pound of flesh (not least because Paris, Amsterdam, and Frankfurt are ready to capture any business that Britain loses). In those circumstances, the British government might just consider a program of regulatory reform, designed to make the City of London more competitive against light-touch financial centers like Hong Kong and Singapore.
But I wouldn’t count on that, because it’s not just the desire for continued single market access that suggests British financial regulation is unlikely to change much after Brexit. In fact, one of the most important — and perhaps least remarked upon — developments in post-crisis financial regulation is that it increasingly starts at the global level. Take the EU’s Capital Requirements Directive IV (CRD IV), which sets out prudential rules for banks, building societies, and investment firms: prima facie, that’s EU legislation, which the UK might no longer be bound by after Brexit; in reality, though, CRD IV mostly implements the Basel III agreement, which means the essence of that directive would continue to apply to Britain whatever happens at the EU level. And CRD IV is just the tip of the iceberg: from insurance to accounting standards, more and more financial regulation is coming from global institutions.*
Britain, moreover, has been an enthusiastic participant in the globalization of financial regulation—so much so that Mark Carney, the governor of the Bank of England (and Britain’s de facto chief financial regulator), is also the chairman of the G20’s Financial Stability Board, which coordinates the regulatory work of national authorities and international standard-setting bodies. As a House of Lords report on the post-crisis EU financial regulatory framework put it, “it is likely that the UK would have implemented the vast bulk of the financial sector regulatory framework had it acted unilaterally, not least because it was closely engaged in the development of the international standards from which much EU legislation derives.” None of this bodes well for those hoping Brexit will lead to liberalization.
There is, however, a larger point to be made here, and that’s that it isn’t at all clear globalized financial regulation is a good thing. There’s nothing wrong with regulators sharing best practices, of course, and still less to object to in efforts to eliminate regulatory barriers to trade. Nevertheless, the global harmonization of financial regulation may actually pose a threat to financial stability, since it tends to impose a single view of risk on financial firms around the world, and therefore encourages herding around particular investments and business strategies. If the regulators’ view of risk turns out to be wrong (let’s imagine that globally-agreed rules encourage banks to invest in, say, mortgage-backed derivatives, or Greek sovereign debt), you may end up with a systemic, global crisis on your hands—precisely the opposite of what regulatory harmonizers set out to achieve. Financial regulators would do better, I think, to let a thousand flowers bloom — both domestically, and internationally.
Sadly, I wouldn’t bank on Brexit doing anything to advance that point of view.
*Chapter 16 of “Flexcit: A plan for leaving the European Union” offers a helpful analysis of the extent to which EU financial regulation has international origins. This report, originally authored by Richard A. E. North, is also where I discovered the quote from the House of Lords European Union Committee that I have reproduced and linked to above.