Will New York Gain From a ‘Hard’ Brexit?
Banks may choose to redeploy resources in Asia or the US if they need to find up to $50bn (€42bn) in extra capital to support new European entities after the UK leaves the European Union.
If the negotiations over the UK leaving the EU result in a ‘hard’ Brexit, with UK financial services losing access to the trading bloc, this will fragment the European wholesale banking market and make it significantly less profitable. In a report, One Year On From The Brexit Vote, consultancy Oliver Wyman estimated a hard Brexit will result in the wholesale banking industry needing to find between $30bn and $50bn of extra capital to support new European entities, equivalent to between 15% and 30% of the capital currently committed to the region.
“Given that returns on equity in European wholesale banking are already below hurdle for many players, these new challenges from Brexit will raise difficult questions about the viability of some activities over the medium term,” said Oliver Wyman. “Some banks may even choose to withdraw capacity from the European market as a whole and redeploy to other regions, such as Asia or the US.”
In addition, banks would face increased costs if clearing of euro derivatives contracts is forced to move from London to one of the member states remaining in the EU after Brexit, putting further pressure of profitability.
LCH, the clearing house owned by the London Stock Exchange, clears more than 90% of global cleared interest rate swaps and 98% of all cleared swaps in euros. Mark Carney, governor of the Bank of England, warned in a speech in June that the fragmentation of clearing would lead to higher costs. He gave the example of Japan, where the clearing of yen-denominated swaps by certain Japanese firms must take place onshore, and the price is one to three -3 basis points higher than in offshore markets .
“Such seemingly small price differences translate into significant costs for users given the scale of activity in these markets,” said Carney. “Industry estimates suggest that a single basis point increase in the cost resulting from splitting clearing of interest rate swaps could cost EU firms €22bn per year across all of their business. Those costs would ultimately be passed on to European households and businesses.”
Carney continued that if existing trades of EU firms were trapped at a clearing house that was not recognised by the European Commission, those EU firms would face capital charges as much as ten times higher until they could be moved.
The European Commission has proposed stricter supervision of central counterparties, including more rigorous recognition and supervision of non-EU CCPs which are of key systemic importance for the EU and relevant to financial stability. In addition, the European Central Bank is seeking tougher banking supervision across the Eurozone.
Oliver Wyman said: “This means new requirements for the operations of multi-national banks to demonstrate that they are economically self-sufficient, resolvable, and have strong local control and governance will all likely build over time. It may also mean booking and risk management has to take place locally, raising questions over the use of back-to-back booking models.”
As a result, wholesale banks are likely to need to increase their presence inside the EU over time. Some functions previously centralized in London will have to be duplicated in an EU subsidiary, such as risk, compliance, and finance. Oliver Wyman estimated that such changes could add 2% to 4% to the annual cost base, equivalent to $1bn across the industry.
The consultancy said Frankfurt and Dublin are emerging as the main destinations for potential new sales and trading entities, along with Paris, Luxembourg, and Amsterdam.
Last year, with TheCityUK, Oliver Wyman estimated that a hard Brexit would drive 31,000 to 35,000 jobs out of the UK across all financial services, including between 12,000 and 17,000 in wholesale banking. Now the consultancy has increased its estimate to 35,000 and 40,000 UK job losses just in wholesale banking.
Nicky Morgan, the member of parliament who is the new chair of the Treasury select committee in the UK House of Commons, has written to the Bank of England asking for details of the risks of a hard Brexit.
Last month, a committee in the UK House of Lords also launched an inquiry into how financial regulation and supervision can evolve following Brexit with written evidence to be submitted by 29 September 2017.
Consultancy sees MiFID II, ETFs and Brexit as things to watch.
Negotiating transition arrangements must be a priority.
EU rulemaking powers will be moved to the FCA and Bank of England.
Many contracts mature after the second quarter of 2019, when the UK is scheduled to leave the EU.
Pan-European exchange operator is acquiring the Irish Stock Exchange.