9 April 2020

The UK has a winning hand, let’s not be bluffed out of playing it

By Jon Moynihan and Barnabas Reynolds

Coronavirus, the Euro, the EU and Brexit: all are becoming inextricably intertwined.

This can be seen with contagion of a separate sort threatening the EU’s – and thus the world’s – financial order, as the economic impact of Covid-19 bites harder and harder. For the EU and the Euro area, existential questions now arise, as the countries of southern Europe in particular face an unprecedented need for vast sums of money to get through the crisis.

Naturally, the political classes in the EU are less focused now on trade negotiation with the UK. The arguments in recent weeks have been all about whether Germany can afford, and will decide to accept, ’mutualisation’ of new sovereign debt across the EU; or whether, instead, the Germans will continue with their insistence that each EU state must retain sole responsibility for the obligations of their own country’s debt.

Germany’s longstanding refusal to mutualise sovereign EU debt had already meant that many EU states, even before the pandemic, were struggling to fund their deficits; if they are now forced to self-fund their lockdown strategies, it could drive several countries, not least Italy,  over the brink.

Until now, with the City of London operating within the EU’s regulatory framework, the impact on Eurozone banks and on the ability of EU corporations and citizens to access global markets efficiently and cheaply, was lower. But now EU banks must take on the new burden of supporting further EU fund-raising, whether as country bonds or EU- wide ‘Coronabonds’, plus the cost of financing a swathe of nigh-on bankrupt SMEs in each country. The fact that the City is now no longer part of the EU or its regulatory framework means that Eurozone banks in particular will come under much greater scrutiny than before.

The EU has made noises about handicapping the City of London by blocking access to EU markets unless the UK aligns itself closely with the EU’s regulatory approach. But the current situation makes it increasingly clearer that the boot is in fact on the other foot: the assistance of the City of London will be important in supporting eventual economic recovery within the Eurozone. This in turns requires the EU to be cooperative if it is to get that support.

In this negotiating environment, it is key for the UK to understand its own strengths and take proper advantage of three key considerations that EU negotiators will –publicly or privately– be taking into account when it comes to financial services.

The EU’s first consideration will be the list of potential economic and practical problems that would be created for the EU’s banks by a world of multiple subsidiarisation of banks, that could be imposed by the UK on the EU, should the UK decide to go that way.

The second consideration is the unlikelihood of bluff and bluster working in this new environment.

The EU’s third consideration will be of the political pressure that could (indeed should) be brought to bear by the UK.

Let’s look at each of these, in turn.

1, Subsidiarisation, the first consideration, is something that, if avoided, offers an opportunity to create a more rational global banking order. If not avoided, it threatens severe additional costs and inefficiencies to EU banks. Subsidiarisation is currently practised by the US in its relations with European (including British) banks; it requires any bank doing business through a presence in its jurisdiction (say, in New York) to be a fully capitalised, standalone, “ready to IPO” subsidiary of the parent bank.

Through this approach, the US imposes significant inefficiencies and costs on all foreign banks doing physical business in the US. The emergence of the City of London as a non-EU- regulated entity means that were the UK to adopt the US approach, all EU banks that wished to do business through a presence in London would have to have their own, ring-fenced, “IPOable” and thus heavily capitalised, subsidiaries. This in turn would mean that these EU banks would have to live in a world where they would need, in essence, three separate subsidiaries (US, UK and EU).

At the same time, a great prize to be gained from the UK’s prospective financial services negotiations with the US would be an agreement on mutual harmonisation and recognition of the two nations’ financial services regulatory frameworks, so that UK banks would not need any more to have such heavily capitalised subsidiaries in the US –and vice versa for US banks in the UK. That outcome would create a double advantage for UK (and US) banks over EU banks. The need to avoid such a disadvantageous outcome (no subsidiaries for US and UK banks; three subsidiaries for EU banks) should make Brussels eager to do a fair deal with the UK on financial services.

2, Whether to try to conduct the negotiations in an atmosphere of gaming, rather than in an atmosphere of careful respect and acknowledgement of the true strengths of either side in financial services, will be Brussels’ (or, in truth, Germany’s) second consideration.

The balance of power here has taken a different turn as a result of the coronavirus crisis. The EU (supported in the UK by their Remainer cheerleaders) has to date asserted that its member states will take business away from the City as a punishment for Brexit. The fact that Frankfurt, Paris, Amsterdam have already been trying to do that for years, with little success even since the referendum, shows how weak this bluff is.

The impact of coronavirus makes it increasingly implausible for the EU to attempt this approach — at such a perilous time the EU would be foolish to risk any weakening of the important links between its large banks and the City of London. The EU’s national banks now need to prop up the multiple failing small and large companies in their home countries, as lockdowns wreak havoc on national economies; and they need London to help prop up the tricky finesse whereby EU country eurobonds, under current rules, are held on an EU bank’s books at zero capital requirement —citing the dubious (increasingly seen as bogus) claim that these bonds are sovereign, and therefore carry no risk.

It should therefore take very little effort on the UK’s side, assuming we possess even a vestige of intestinal fortitude, to persuade Brussels to abandon any bluffing attempt to force the City of London into accepting improper or onerous conditions in these trade talks.

3. The final consideration is political issues. The EU has to decide how much it is prepared to risk here. Can it, should it try to, persuade the UK to drop plans for simultaneous trade discussions with the US this year? Were the EU to pull that off, they would have eliminated the considerable competitive pressure imposed on them by such talks.

For the UK, on the other hand, it is essential to maintain the competitive tension created by holding simultaneous talks. Competitive tension is, as all negotiators know, crucial for ensuring that the other side behaves realistically —so that a good deal for both sides is achieved. So long as the talks with the US are run realistically in parallel with the EU talks, the UK can, because of the competitive tension the talks create, achieve great deals with both. Were the UK to abandon simultaneous talks, the most likely result will be a good deal with neither party. The fact that EU talks started up again, however tentatively, this week is worrying – we must hope similar talks with the US will be on the agenda once the Prime Minister returns.

Making competitive tension work, by ensuring parallel trade talks, in turn means that the overall strategies for each trade deal – and this applies nowhere more so than in financial services – need to be run at the highest level. Decisions must not be the province of any one department, but part of an integrated approach across sectors, and across these two trade negotiations, with coordination being run at a high committee level, reporting directly to the Prime Minister. Neither our Brussels negotiators, nor our US ones, nor any single department, should have the power to commit the UK to anything in one set of trade talks that could damage the other; this applies above all in financial services.

Looking back, future generations will see this as the moment either when the UK took centre stage in a global reform of the financial services sector, or where we threw away our clear negotiating leverage and surrendered our most valuable economic enterprise, the City of London, to the EU project. Remember that this is a project that, while it indeed has significant economic power, has an enormous underlying monetary weakness (the Euro); very little global financial expertise; and a growing need for the City’s capabilities as the world enters an unclear future of high national debts, increasing nationalism, and insecure institutions.

As we have been told this week, the trade talks (the EU ones, at least) are starting up again. Meantime, the EU funding crunch gathers pace, threatening at least a Eurozone-wide crisis, at worst a global one. At this time, the UK has the choice; it can speak quiet but clear and firm words to the EU to establish a current and future basis for cooperation, both sides agreeing for the UK to proceed unhindered on an independent path, but supporting the EU in its hour of need; or it can choose to continue on a path of prostration that will be bad for both sides.

It’s up to us which of these two paths the UK takes. The stakes are high, but all that’s needed is for the UK to be resolute, and understand that we hold the winning hand — so long as we are not bluffed out of playing it.

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Jon Moynihan is Chairman of Ipex Capital, the Technology-focused Venture Capital company.

Barnabas Reynolds is a partner at law firm Shearman & Sterling, and the author of 'A Blueprint for Brexit: The Future of Global Financial Services and Markets in the UK'.

Columns are the author's own opinion and do not necessarily reflect the views of CapX.