The debate over Brexit is focusing on ‘new’ EU-27 banking subsidiaries that will require supervision. However, London’s strength in Euro trading means that financial market supervision could be a greater challenge. There is no single EU financial market supervisor to ensure a level EU-27 playing field – and limited political appetite to address the challenge. In our view, a compromise solution between the EU-27 and UK is the most likely outcome.
The UK’s formal announcement of its intention to leave the EU has opened a two year negotiating period of exceptional complexity. Within the financial industry, the implications for banking supervision are dominating the debate. There is uncertainty over the comparability of UK and EU-27 supervision and resolution rules, both at the point of Brexit and as UK and EU regulations evolve beyond that date. There is also the possibility of a multi-year transition period – though this cannot be taken for granted.
On one side, UK domiciled banks face the end of EU passporting. UK subsidiaries of non-EU banking groups from large trading partners could face the greatest disruption to their business models. PRA head Sam Woods has recently asked CEOs to ensure that they are preparing for a wide range of scenarios including ‘the most adverse potential outcomes’1. The ECB has asked Euro area banks to perform similar Brexit scenario planning.
On the other side, EU-27 banks face the risk of exclusion from London’s capital markets. Many large Eurozone banks use their UK branches to conduct significant fundraising for themselves and clients. If required to set up full UK subsidiaries, maintaining current levels of activity could cost EU domiciled banks over €30bn in additional capital2.
The unifying theme is that altered supervision poses a tangle of operational and political challenges. An aggressive approach to re-domiciling Euro clearing may be politically attractive to EU27 leaders, but would create huge problems for UK and EU-27 banks alike. And yet maintaining the status quo, while appealing to the industry, is not politically feasible.
The debate over the future of banking supervision is gripping. But it is arguably overshadowing an even more complex issue: the post-Brexit supervision of European financial markets.
This problem is of a far greater scale. More than three quarters of all Euro-denominated derivatives, with a daily average notional value of €573bn, are cleared in the UK3. London is also a major centre for Euro-denominated bond trading. Whether or not London manages to continue its dominance after Brexit, it seems inconceivable that EU authorities will allow this economically vital activity to take place outside the reach of the financial stability arm of the ECB, or the ECJ.
Resolving this conundrum could make the challenges of post-Brexit banking supervision look almost simple. Once again, operational and political factors are intimately connected.
To start with, there is no existing European financial market supervisor. ESMA sets common standards, but supervision remains a matter for local authorities such as BaFin or the ACPR. This is in contrast to banking, where the ECB-managed SSM provides an established single supervisor of credit institutions. This lack of centralised oversight creates the danger of a ‘race to the bottom’ as European financial centres compete to lure securities trading business from London. That is something the EU has worked hard to avoid. A recent speech by Sabine Lautenschläger shows that the ECB is alert to the risks of regulatory arbitrage4.
Creating a new European securities supervisor would be a huge operational challenge. To design, establish, staff and launch such a body could take several years. Nor is there an obvious capital markets hub within the EU-27 that could host it within a legal, accounting and governance ecosystem to match London.
Above all, huge political hurdles need to be overcome before a new supervisor could be established. A credible new body would need to be demonstrably free from any national bias, to ensure a level playing field within the EU and between other major jurisdictions. There appears to be limited appetite for the political reforms and EU legal mandate such a securities supervisor would require. The value of a strong, stable banking system is widely understood, and Banking Union has become a key pillar of the European project. In contrast, financial markets are viewed with scepticism by many citizens, politicians and opinion formers.
In short, transferring the supervision of Euro-denominated financial markets activities from the UK to the EU-27 looks nearly impossible within the next two years, and highly challenging even within a post-Brexit transition period. This means that politicians and supervisors face some difficult choices. A pragmatic outcome, such as medium-term joint supervision by the UK and EU authorities, seems likely. This might involve a stronger version of the oversight that the ECB and Federal Reserve already exercise through supervisory colleges. But this sort of compromise will inevitably be complex, expensive and unsatisfactory to many.
To paraphrase Eddie Cantor, “Brexit means having to solve problems on your own which you didn’t have when you were together."
 Contingency planning for the UK’s withdrawal from the European Union, Prudential Regulation Authority, 07.04.17
 European banks face €30bn-€40bn capital bill after Brexit, Financial Times, 15.07.16
 EU prepares rule changes, Financial Times, 15.12.16