It is not easy to get past the rhetoric coming from the US, the EU, and the UK and figure out where economic nationalism agendas and plans for regulatory disarmament (and armament) may take global financial services and markets in the immediate future. Is another financial crisis looming? Will the UK strike a deal with the EU? Will there be a race to the bottom in the EU or the UK? Will US plans for financial services simplification become a reality?
“President Trump has talked many times about how he’d like to support America first and American businesses first, but personally, I am not confident that he’ll be able to achieve the level of change that he might have hoped for,” says John Mongelard, technical manager for risk and regulation in ICAEW’s Financial Services Faculty. When Trump was elected he told the finance industry that he would roll back the regulation that the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act had imposed in the wake of the 2008 financial crisis.
Dodd-Frank did a sweeping rewrite of financial laws that ranged far and wide, from trading of stocks and bonds to how banks are regulated. In February 2017, when Trump signed an executive order directing the US Treasury department to revise and update Dodd-Frank, he explained his action by saying: “There are so many people, friends of mine, that have nice businesses… and the banks won’t let them borrow because of rules and regulations in Dodd-Frank.”
Trump is not alone in his dislike of Dodd-Frank. Many Republican politicians see it as an impediment to economic growth and the party has always criticised what it sees as the act’s huge regulatory overreach. So although Trump’s first year in office has been a crash course on the limitations of presidential executive orders (for all of us), the US House of Representatives passed the Financial CHOICE Act in June 2017 (in a near party line vote) and made Trump’s promised dismantling of Dodd-Frank seem like a real possibility.
OUT WITH THE OLD
CHOICE may not pass through the Senate, with or without change. At the moment it promises to kill or scale back many post-crisis Dodd-Frank reforms, to simplify financial regulatory compliance, curtail regulatory discretion, reduce the independence of the US central bank, the Federal Reserve (Fed) and eliminate bank bailouts. It also proposes capital market reforms, such as requiring lower minimum risk-based capital ratios and minimum leverage ratios of banks.
Diego Zuluaga, financial services research fellow at the Institute of Economic Affairs, a free-market think tank, explains the appeal: “CHOICE promises to free banks from post-crisis prudential regulation if they remain above a 10% leverage ratio. This would give financial institutions a simpler framework in which to manage risks. It is also likely to benefit household and business credit, which is currently being choked by post-crisis product regulation.” Although some banks may not welcome the costs of administering and complying with new regulations.
Janet Yellen, chair of the board of governors of the Fed, has other reasons for favouring the status quo in US financial services regulation. Speaking in August 2017 at an economic policy symposium in Kansas, she said: “The balance of research suggests that the core reforms we have put in place have substantially boosted resilience without unduly limiting credit availability or economic growth.” She also voiced concern that memories may be fading of how costly the financial crisis was and why certain steps were taken in response.
“CHOICE promises to free banks from post-crisis prudential regulation if
they remain above a 10% leverage ratio. This would give financial institutions
a simpler framework in which to manage risks. It is also likely to benefit household and business credit, which is currently being choked by post-crisis product regulation”
AVOIDING FINANCIAL CRISES
“Bankers may now be behaving less recklessly,” says Zuluaga,
“but the incentive to take inordinate risks remains.” To minimise this, professor Richard Werner, director at the Centre for Banking, Finance and Sustainable Development at the University of Southampton, suggests regulating bank credit transactions that do not contribute to the economy. “Banking crises and subsequent negative impact on the economy can be avoided by monitoring and restricting bank credit creation for asset purchases and unproductive bank credit
If another financial crisis does loom over the horizon, Yellen sees the post-crisis tightening of
US financial regulation as some defence. “Our more resilient financial system is better prepared to absorb, rather than amplify, adverse shocks,” she says. Yellen believes that only “modest” adjustments should be made to regulations that are meant to protect the economy from financial panics, such as runs on banks. Whether Trump re-nominates Yellen when her term ends in February 2018 remains to be seen, but she is no longer the front-runner.
If there is a flip-flop on US financial services regulation, this may have global repercussions. “CHOICE will likely lead regulators elsewhere to consider the desirability and feasibility of similar proposals for banks in their own jurisdiction,” suggests Zuluaga. The impact on capital markets activity and credit allocation is harder to predict: “Because the CHOICE Act is a simplifying piece of legislation, it does not necessarily give US banks more of a competitive edge.”
It may be an oversimplification to presume that strong regulation has a negative impact on the competitiveness of financial services. Mongelard does not anticipate a race to the bottom on UK regulation, not least because many of the reforms the UK has introduced in response to past financial crises appear to have played in its favour: “The UK has wonderful rules. People like London and the stability and safety that having our reforms – and plenty of good people to execute them – brings.”
The UK’s past role in financial services regulation in the EU could be a strength post-Brexit. “The vast majority of the legislation that has allegedly been imposed on us, we drafted, and it sits well with our standards and laws,” says Mongelard. The Bank of England’s Prudential Regulation Authority (PRA) and the Financial Conduct Authority (FCA) have warned against a post-Brexit bonfire of regulation, as this would threaten financial stability. Either way, the regulatory roles of the PRA and the FCA will almost inevitably become more demanding and costly.
Some in the finance sector see benefits in a break from Brussels’ rules: the insurers Legal & General and the Prudential have criticised Solvency II during appearances before the Treasury Select Committee. However, broadly speaking, deregulation would make it more difficult for financial services to maintain access to the EU market after Britain leaves.
As the UK government has indicated that it does not intend to pursue an approach that relies on the continuation of passporting, many see “third country equivalence” rights as a way forward.
Passporting allows free movement of financial services within the EU, to member states plus European Economic Area (EEA) countries Iceland, Liechtenstein and Norway. Service providers can operate directly from their home country or branches in other member states that do not require their authorisation; there is no need to open a local subsidiary, a separate legal entity subject to host-country licensing that has to meet capital requirements on a solo basis.
Broadly speaking, any non-EEA country may ask for “equivalence” treatment by the EU. During the rollout of Solvency II, some third countries have been granted equivalence on a provisional
or temporary basis, while discussions continue between their representatives and those of the EU about reciprocal recognition of each other’s regime. However, equivalence is not available for
the provision of all financial services and it can only be requested where it is explicitly provided for in EU legislation, where equivalence provisions vary.
Passporting allows free movement of financial services within the EU, to member states plus European Economic Area (EEA) countries Iceland, Liechtenstein and Norway. Service providers can operate directly from their home country or branches in other member states that do not require their authorisation; there is no need to open a local subsidiary
“UK financial services companies may set up an operation in the EU now and hope for equivalence post-Brexit,” says Mongelard. From a logical, legalistic perspective achieving post-Brexit equivalence may seem like a reasonable expectation. After all, the UK is effectively equivalent today, but, as Mongelard adds: “It does not take account of emotions. EU folk may not want to be seen as being too soft on the UK.” Some companies may plan to keep their main entity in the UK and set up a subsidiary
in the EU, initially, but at some stage the reverse may begin to seem more appealing.
BRASS PLATES IN EU LAND
The EU is trying to discourage a race to the bottom among its 27 members. “It doesn’t want brass plates in EU land. It does not want UK firms to move into the weakest EU regime,” says Mongelard. The EU is pushing for consistency across the EU 27 in financial services – just as it has started to put its foot down over competition in national tax rates. Ireland, Luxembourg, the Netherlands plus Apple, Fiat Chrysler Automobiles and Starbucks are among those to be affected by sizeable European Commission demands to pay back taxes.
In March 2017, the European Securities and Markets Authority (ESMA) issued an opinion advising the EU 27 to be consistent on authorisation, supervision and enforcement related to the relocation of entities, activities and functions from the UK, covering all legislation referred to in the ESMA Regulation. As Steven Maijoor, ESMA chairman, explained: “Firms need to be subject to the same standards of authorisation and ongoing supervision across the EU27 in order to avoid competition on regulatory and supervisory practices between member states.”
Since the triggering of Article 50, financial brands have developed contingency plans and started to put these into action. “Financial services companies are looking to make sure they can continue to conduct business across the EU, while retaining a strong base in London and they are starting to select potential European locations,” says Omar Ali, financial services leader at EY UK. Its “Brexit tracker” for financial services sees Frankfurt, Dublin and Luxembourg all coming out on top among the 200-plus larger UK financial services companies it tracks.
Only time will tell if one financial centre emerges as a compelling alternative to London or which country will eventually benefit most from Brexit or the push for consistency across the EU 27.
Ali says: “The operational changes highlight a real risk to European businesses and the wider economy, as the fragmentation of European financial services could increase costs and limit the breadth and depth of finance options for European corporates.” A country that advocates economic nationalism and regulatory disarmament may yet become the biggest winner.