Brexit creates new opportunities and new risks for the British and EU financial markets. If policymakers react optimally, both could benefit. However, a more likely outcome is a fall in the quality of financial regulations, more inefficiency, more protectionism, and less protection. Systemic risk could increase, with a systemic vicious feedback loop a possibility.
By Jon Danielsson, Robert Macrae and Jean-Pierre Zigrand*
The UK vote on Thursday to leave the European Union will have widespread consequences for financial markets, creating both opportunities and problems. Much depends on how policymakers and market participants react, and there will be much to learn about the resiliency of financial markets and their regulation.
There is of course the potential for Brexit to increase financial stability. Heterogeneity of financial markets and economic systems increases financial stability, as discussed here on Vox in 2013 (Danielsson 2013). It makes financial shocks less likely to amplify into a systemic crisis, with the visible risk resulting from heterogeneous systems damping the growth of endogenous risk and the many minor fault lines helping to prevent system-wide fractures.
With the UK leaving the integrated European financial markets and its uniform regulatory structure, it could increase heterogeneity and efficiency of the financial markets on a global scale by making the British regulatory system more different from the European.
However, this may be optimistic. ‘Leave’ campaigners trumpeted Britain’s ability to design its own regulatory system as a major benefit of Brexit. But this has probably been exaggerated because most participants will need to trade in Europe and so will in effect be bound by both sets of rules, and because to some extent European regulations already reflect the UK’s approach due to London’s importance in European cross-border financial trade.
Markets are reflecting a substantial shock, and their initial reaction indicates both weak sterling and UK asset markets overall. The depreciation of sterling may well lead to inflation, particularly if the fall is sustained because insularity makes the pound less attractive to non-UK entities.
Does that matter from a systemic point of view? It is tempting to say no – that markets are merely doing their job of discounting news, good or bad, and that the system will adapt and move on. However, it is not that clear-cut and, while unlikely, the probability of a consequent systemic crisis is certainly not zero.
The stability of the British financial system and its rather fragile economic growth are dependent on the near-zero interest rates to the extent of this being an addiction.
The government is highly indebted; pension funds are underfunded; and the financial system has limited willingness to fund the small businesses likely to generate economic growth. All this at a time when loan books are underpinned by real estate that has all been valued on the basis of a very depressed yield curve.
Under these circumstances it is not hard to imagine a bond buyers’ strike echoing that of the ‘Gnomes of Zurich’ who in the 1960s declined to entrust their assets to the UK. Given the very high sensitivity of bond values to inflation, as we will discuss in a forthcoming VoxEU column, a vicious feedback loop could ensue between a falling sterling, rising inflation, increasing yields, and falling bond prices. This could happen slowly over many years, or very quickly indeed if current bond holders are assuming they can insure their portfolios by selling as prices fall.
What options would the Bank of England have in this scenario? Fund banks on ever-more generous terms, in the Chinese model, to maintain nominal real estate valuations and accept the resulting inflation? Or refuse, triggering a collapse in real estate and widespread bankruptcies, followed by rather similar largesse spread among the survivors?
European policymakers have disliked three things about Britain’s financial sector: its objection to many European regulatory initiatives such as Mifid II, FTT, and bonus regulations; its insistence on remaining outside of the euro; and its size. If the sector were small the other issues could be ignored, but it is not.
All of that will change, leaving Europe free to design the regulation it wants.
It seems obvious it will do so with an eye to competition from the City of London and will seek to enhance the roles of Frankfurt and Paris in European finance. It easily do so by crafting regulations that force certain activities to move to Europe and this temptation may prove hard to resist.
If EU strategies were to attract UK-based financial business that lead to different and larger risk-taking under the watch of regulators who have had insufficient time to develop the appropriate expertise, then systemic risk may increase.
Those contracts would not be written under UK law and would not have been tested or have the legal certainty they currently have. Finally, if the trading of those new securities and their clearing move out of the UK to the EU, CCP arrangements change, which may lead to new risks. Meanwhile, the transmission network of shocks changes also in unknown ways.
Furthermore, without a passporting-type arrangement, Brexit would curtail the sharing of financial information on a European level (e.g. Emir), making it impossible to construct a picture of Europe-wide risk exposures taken by financial institutions.
There is also a risk that the European financial system will be less able to play its role of efficiently allocating resources from savers to companies. Clearly CMU, for example, will lose a key advocate.
The UK, supported by smaller like-minded countries, has been a major proponent of a more liberal and diverse financial system in which banks’ overwhelming dominance can be reduced. The end result seems likely to be a more highly regulated and inefficient European financial market, freed from the discipline imposed by competition and relying on protectionism to maintain barriers to entry. This does not bode well for European savers or for entrepreneurs, and the fact that asset prices fell across all of Europe is reflective of that fear.
The homogeneity of the European financial system will likely be increased. If combined with more red tape and more protectionism it will lead to higher costs to consumers and also may increase systemic vulnerability.
Britain and Europe have fundamentally different approaches to regulation. British regulation is based on common law, assumes that regulations should be applied only where a clear need has been demonstrated, and relies to a substantial extent on transparency and self-regulation. The European approach, by contrast, is based on civil law and assumes that as much conduct as possible should be regulated in a prescriptive way.
The greater flexibility of the British approach has played a key role in London being the dominant cross-border financial centre within Europe.
Many British voters have a strikingly negative image of European regulation as over-prescriptive and impractical, but the record is in fact rather more mixed. British policymakers have successfully opposed some areas of regulation that appeared excessive, for instance within Mifid II, but have also been largely responsible for regulations that appear to create new systemic risk where it did not exist before, such as the Solvency II insurance regulations.
If the UK policymakers are able to reach an agreement with the EU that allows continued access to the single market that somehow does not require the British exporters to stick to EU rules – a rather unlikely outcome – the hope is that they could craft a lightweight and nimble regulatory structure that would allow the British financial sector to continue to prosper with the European passport and be even more successful in winning over new markets.
A more likely looking outcome, though, is that policymakers achieve very little. The legislative and regulatory workload required to shift the entire legal basis of financial regulation from Brussels back to London is immense, so for many years, regulators will have to run to keep still.
Given the level of thoughtfulness of the arguments advanced prior to the referendum, it seems unlikely that the pro-Brexit camp and its lawyers have spent much time thinking about or preparing for this phase, despite having pushed for Brexit for many years.
Even when this workload subsides, obeying EU regulations will be the likely price of access to the European markets, and so for all but the purely domestic entities (which tend to be small) the landscape will change little.
At the same time, Britain will lose any ability to influence European regulations from the moment it invokes Article 50. It may well be that the best the UK can hope for is an EEA-type arrangement, where it is allowed access to the European markets at the expense of having to adopt European regulations without the ability to influence them.
If the UK does lose some of its financial sector to Europe, that will reduce its dependence on finance. This obviously comes at substantial economic cost, but also has the potential to increase the resilience of the British economy, reducing systemic risk. However, the UK banking system will remain very large compared to the rest of the UK economy. The country’s overwhelming dependence on this single sector suggests the UK will continue have a substantial financial sector risk exposure.
In theory, the Brexit vote Thursday creates an opportunity for the UK to improve the resiliency, efficiency, and the quality of service of its financial markets. Unfortunately, it is more likely to induce regulatory paralysis due simply to the vast workload that has been created, so it is doubtful whether policymakers will be able to take this opportunity.
The likely scenario is for UK regulation to become more onerous, both due to what will effectively be dual regulation from both UK and EU, and also to the UK having to adopt much European regulation without the ability to influence it.
The City of London may also see a substantial erosion of its place as a major international finance centre.
In a worst case scenario, a vicious systemic feedback loop for the UK could ensue.
Europe, with its most liberal large country gone, is likely to sharply increase its regulatory intensity, with the focus on politics and protectionism rather than efficiency, resulting in a more costly, more homogenous and consequently less safe financial system.
*About the authors:
Jon Danielsson, Director of the ESRC funded Systemic Risk Centre, London School of Economics
Jean-Pierre Zigrand, Associate Professor of Finance and Co-Director of the Systemic Risk Centre, LSE
Danielsson, J. (2013), “Towards a more procyclical financial system”, 6 March.