Brexit and the City

Take the City out of Europe and there won’t be much left of its current global luster, warn London-based bankers and financiers.

LONDON — It’s a strange world when you can’t trust a conservative UK government to defend the global interests of the City of London.

And that’s why the financial industry isn’t bothering to wait for talks between Prime Minister David Cameron and his European partners to state clearly on which side it will stand on a referendum on the UK’s European Union membership: a resounding, unqualified “yes” for staying in, whatever the outcome of London’s attempt to reform the way Europe works.

The arguments all center around one overwhelming reality: In the last decades, London has become a global financial center, rivaling Wall Street — but it could only do so because it is first and foremost Europe’s financial capital.

Take the City out of Europe, and there won’t be much left of its current global luster, warn London-based bankers, asset and fund managers and insurers.

“Brexit” supporters say the fears are overblown, and there might be a way for London-as-financial-center to prosper outside the EU. But the overwhelming feeling among business circles, across all industrial sectors, is that it would severely hit the British economy.

“Of course the EU needs to reform, but even right now, the benefits of membership for the UK hugely outweigh the disadvantages,” says Andy Bagnall, campaigns director at the Confederation of British Industry, the UK’s employers federation. Sir Mike Rake, the CBI president, recently made a speech asking UK businessmen to enter the fray by “being crystal clear that membership is in [the] national interest.”

This week, Moody’s, the ratings agency, became the latest institution to warn that leaving the EU would isolate the UK economy from trade and growth opportunities, put pressure on the pound sterling and perhaps lead to a downgrade of the country’s sovereign debt.

Fears of the Brexit risk are even more vivid in finance, the one sector where the UK is the undisputed European leader — and which would have the most to lose if London decided to split. In a report published in March, Open Europe, the London-based think tank, noted that leaving the EU would have the most severe consequences for the UK financial services industry. More than 40 percent of the City’s business is with the rest of the EU, generating a £16 billion (€22 billion) annual trade surplus in financial services.

For London financiers, the nightmare scenario goes like this. First, the City loses its easy access to the European market. Then, with active encouragement from other, hostile European capitals, part of the financial industry relocates to the continent. “A lot of activities will repatriate to Paris or Frankfurt,” says the chief operating officer of a major French bank with important business in London. “I’d say mostly Paris,” he quips. “I don’t think bankers are eager to go live in Frankfurt.”

Losing access to Europe’s single market will become automatic if the UK leaves. It can then either opt for a “third country” status and renegotiate all its existing arrangements and treaties with the EU, or try to remain within the single market — like Norway — but without any say on its rules and regulations. In other words: London will be either cut off, or powerless.

That explains why some major banks such as HSBC or Deutsche Bank have already indicated that they might switch operations from London in case of an EU exit. For both banks, there would be other reasons for the move — and neither one might end up actually relocating to the continent. Asia will be HSBC’s natural destination, and Deutsche may be tempted by New York.

The worries aren’t exclusively those of European banks. U.S. institutions have long seen London as the entry point to the rest of Europe and would look elsewhere to conduct their continental business. In the last couple of years, banks such as J.P. Morgan or Goldman Sachs have warned about the possibility of Brexit. European banks would leave London “in very short order” if it ever happened, Goldman Sachs International co-chief executive Michael Sherwood famously warned in September, 2013.

The exodus would be a natural for all the European banks that domiciled most of their wholesale activities (i.e., lending and borrowing between financial institutions themselves) in London over the last 20 years. Prompted by lighter regulations and a friendly tax system, Italian, German or French banks made London their second headquarters in all but name. They would have little reasons to remain if the UK wasn’t part of the same economic space.

The risk of relocation is acute in finance, but industrial companies fear Brexit as well. Their business with the continent would be severely hit if the UK sits outside the single market. And their exports to the rest of the world would also take a beating, as London will have to renegotiate the dozen trade treaties the EU has signed over the years with other countries.

But it’s hard and cumbersome to move a British car-parts factory or pharmaceutical production line to Spain or Italy. Finance types, on the other hand, can move anywhere in the world overnight. It only takes a one-way Eurostar ticket for a banker to relocate.

A major financial exodus would come at a high fiscal cost for the UK government. It gets about 11.5 percent of its tax revenue from the financial services industry. According to a recent PwC report, the sector paid an estimated £66 billion (€89 billion) in to total taxes in the fiscal year 2013-3014. Almost half of this was made up of the income tax paid by the 1 million-plus employees working in finance.

No wonder that nearly half (49 percent) of City professionals polled earlier this year by the Center for the Study of Financial Innovation would “definitely” vote no to Brexit, while another 24 percent are “likely” to vote the same way. That’s nearly three out of four bankers, traders of fund managers eager to remain within the EU.

Younger financiers are even more Europhile than their elders – which is consistent with all other polls on the matter: Eighty percent in the 18-30 age group would favor remaining within the EU. And according to the CSFI study, the City is strictly driven by its own interests here: It wants to remain in the EU even though “it doesn’t like Brussels, fears European regulation and is worried about the political drift of the EU.”

For the City, there would be bitter irony in Brexit, after the UK’s huge contribution to the creation of a European financial single market. No EU financial regulation has ever been adopted against the opposition of London, and most bear the influence of the light-touch regulation school that dominated the pre-crisis years. The liberalization pursued since then has expanded even further the opportunities offered to City players. Richard Metcalfe, the director or regulatory affairs at the Investment Association, which represents asset managers, mentions for example the possibility to “market funds throughout the EU, with a high level of safety and economies of scale.”

The City has even benefited from a seismic shift it wasn’t a part of: the creation of the euro. The monetary union has created a single-currency financial market whose capital is London — even though it chose to opt out. The City has prospered outside the eurozone — but largely thanks to the eurozone.

Finally, the UK might leave just as the EU is embarking on a reform that would offer even more opportunities for London’s financiers: the capital markets union, designed to break down remaining national barriers to the free flow of capital and allow seamless financing of the economy throughout the EU. The reform falls under the jurisdiction of UK European Commissioner Jonathan Hill, who has started the job in earnest.

You can still find a minority of hardcore Euroskeptics in the City of London. They argue that London could not only survive, but even prosper as an off-shore center, geared towards the needs of global — as opposed to strictly European — financial markets. The UK, so the theory goes, would revert to its light-touch regulation model, break free from the cumbersome Brussels bureaucracy and better cater to the needs of emerging economies from Asia to the Middle East.

The argument pays scant regard to the fact that if anything, UK regulations of banks or the financial sector have been as strict as in the rest of Europe, if not stricter, in the last five years. Unsurprisingly the City of London has lost in popularity since the 2007-2008, so any government would think twice before it wants to restore it to its former unregulated glory.

Then there’s the question of the EU’s possible reaction. “There would be active retaliation,” says Leon Cornelissen, chief economist of Robeco, the €200 billion Dutch asset manager. “European governments will resent an overblown financial center at their door and they could really make things difficult for London” through potent regulation or protectionist measures.

For now — precisely because the financial industry is not at its height in popularity at the moment — City lobbies don’t plan to campaign aggressively, and bet that reason will prevail overtime.

“Once tempers cool, they will look at the numbers and get real,” says a London investment banker, talking about British voters and reflecting the general sentiment, or hope, of the City. Meanwhile, in executive suites, contingency plans are drafted in case reason doesn’t prevail. And financiers are already confronted with the clear and immediate risk presented by the Brexit debate: its utter unpredictability.