The E.U. expects…but what? With Brexit negotiations stalled, the finance sector must prepare for all eventualities | Wolters Kluwer Financial Services
  • Insights

  • The E.U. expects…but what? With Brexit negotiations stalled, the finance sector must prepare for all eventualities

    By Selwyn Parker

    Published January 05, 2017

    The timing of Brexit could hardly be worse for the UK finance sector’s compliance function.

    The legal challenge to UK’s departure has stalled progress over negotiations about what deal will eventually be struck, leaving firms in limbo. The country’s banks are immersed in the minutiae of ring-fencing, a transformative process with a deadline roughly contiguous with Britain’s exit from the EU.

    On top of all this it’s unlikely firms across the entire financial spectrum will learn exactly how they can operate across the Channel until the final months of what’s certain to be a highly charged and politicised several years of negotiations. (Negotiators say it’s highly unlikely that Brexit can be done within the two-year statutory deadline.)

    For a sector whose 24/7 preoccupation is to eliminate as much uncertainty as possible, it’s an unhappy scenario. As Sam Woods, the new chief executive of the Prudential Regulation Authority, put it recently, the timing is unfortunate. “The implementation process [of ring-fencing] coincides with a period of heightened uncertainty before the UK – and therefore the banking system – adjusts to a new relationship with the European Union,” he said in September. “I won’t pretend this is a perfectly happy coincidence: in an ideal world we would not restructure our banking system and extricate ourselves from the EU at the same time.”

    Full steam ahead

    Yet what can firms do? Despite the complications created by Brexit, the Bank of England is going on with its own reforms – “full steam ahead,” as Woods said. And that’s probably what firms should do, whatever corner of the financial sector they occupy. If a firm wants – or needs – to be in Europe, it should plan on that basis. And, despite the uncertainty over the actual date UK kisses goodbye to the EU, there’s a lot to be going on with.

    First, it should be taken for granted that UK regulation across the financial spectrum will continue to match or exceed European standards. In short, no bonfire of all those rules. And it’s unlikely firms with any ambitions in Europe would want the rule book ripped up anyway.

    Considering that UK firms, for example, have spent years embedding MiFID I and, imminently, MiFID II, the last thing they’d want is to waste all that time and money. Whether a firm wants to be in Europe or just the UK, MiFID II will be the gold standard, as indeed it’s becoming in the Asia-Pacific and Middle East.

    Also, it’s UK’s regulators who have been leading the way in the reform of the rule book and that’s not going to change. “Firms must continue to abide by their obligations under UK law, including those derived from EU law and continue with implementation plans for legislation that is still to come into effect,” the Financial Conduct Authority underlined after the Brexit vote. “Consumers rights and protections, including any derived from EU legislation, are unaffected by the result of the referendum and will remain unchanged unless and until the Government changes the applicable legislation."

    So the rule book is here to stay.

    Third country

    But let’s assume there’s a “hard Brexit” and Britain effectively becomes a third country from the EU’s perspective. This would mean asset management firms, for example, must find their own way back into the EU by making individual arrangements. Here the options are strictly defined. As European law firm Field Fisher explained in a recent briefing, under MiFID’s Article 42, a firm could only provide services “at the exclusive initiative of the client in an EU member state”.

    Few firms would find this a satisfactory situation.

    The second – and slightly better solution – would be to establish a physical branch in one of the member states, assuming that country’s regulator approves, and acquire a local licence. Several hurdles would have to be cleared including guarantees of adequate capital, compliance with anti-money laundering rules and membership of a recognised investor compensation scheme. None of these should prove difficult but, as Field Fisher pointed out, because other member states would have to agree, “[this] would not be an automatic route.”

    And it could be an uphill one. As the chief executive of the International Underwriting Association, Dave Matcham, said recently: “It is essential to maintain a level playing field so that insurers can operate across the continent without the need for local licences.” 

    Equivalence

    The preferred option presents as the “equivalence” principle. Basically this means that, if UK is recognised as having regulations that satisfy those of the EU (which it undoubtedly does), firms could operate in Europe without the necessity of opening a branch there. In fact this would not be too dissimilar from the present situation.

    This wouldn’t be a done deal either though. The equivalence issue promises to be a highly political matter and it’s safe to say that rival firms in, say, France would lobby hard against a favourable outcome for the dominant City-based wealth management industry.

    At this stage equivalence seems to be the City’s preferred option. It’s why British Banking Association chief executive, Anthony Browne, has expressed his hope that there is not a bonfire of regulation because a conflagration might put equivalence at risk.

    The stakes here are high. Andrew Tyrie, chairman of the Parliamentary Commission on Banking, has put the number of “passports” held by UK-based firms at 13,500. And that, as Tyrie says, means “the business put at risk [by Brexit] could be significant.”

    And because passports – effectively, the right to operate – go both ways, thousands of firms are on the hook on both sides of the Channel. For instance, consultants Deloitte estimates 2,250 UK firms hold at least one outbound passport under MiFID while 988 hold an inbound one. In the insurance sector dominated by Solvency II, the corresponding numbers are 220 outbound and 726 inbound. 

    Parallel firms

    And finally, there’s always the option of establishing a parallel operation in Europe that would be to all intents and purposes an EU firm. Of all the strategies, this offers the most certainty.

    The one-off costs would however be heavy in terms of real estate, compliance, technology and everything else – some sources estimate at around £50,000 the expense of shifting just one employee to Europe. On the other side of the ledger though, provided there’s enough business in Europe to justify the move, there may be gains in the long run.

     “[We believe] locating the right parts of your business in the right place at the right time can reduce operating costs by as much as 60 per cent,” claims Christopher Burke, chief executive of Brickendon, the UK-based consultancy specialising in the financial sector.

    Another Brexit-caused compliance issue arises from the regulatory timetable. Many banks offer services within the EU under the immensely complicated Capital Requirements Directive, which probably won’t become operational until after Britain has signed out of the EU. Such core banking activities as deposit-taking, lending and payments depend on an institution obtaining the CRD IV passport. Yet this won’t be resolved for a long time, leaving many institutions up in the air.

    Less bulky regulation

    There’s a bright side to Brexit. If the banking industry hopes that leaving the EU will deliver a reprieve from Brussels’ sometimes heavy-handed and counterproductive regulation that has tied them in knots for nearly a decade, they just might get it. Although they can’t expect a bonfire because British and European regulators share the same principles, there’s a move within the Bank of England to rationalise the burden of that has been imposed on the City. As FCA chairman John Griffith-Jones said back in June, there’s a need for better regulation rather than “bulkier regulation.”

    Encouragingly, American regulators are thinking along the same lines. As the US Federal Reserve’s Governor Daniel Tarullo, America’s regulator-in-chief, remarked in an important speech in early December, there’s an argument for “rationalisation measures”, especially in the case of smaller banks for whom compliance costs are high.

     “I would raise the threshold for enhanced prudential standards from its current $50 billion level, perhaps to $100 billion,” he said, surely raising cheers of approval right across the American banking spectrum. “And I would entirely exempt community banks – by which I mean those with less than $10 billion in assets – from some regulations, such as the Volcker Rule and the incentive compensation rule.”

    His argument is based on the law of unintended consequences. Governor Tarullo believes the benefits of enhanced regulation are outweighed by “the disproportionate costs of exams, audits and reporting.”

    Thus he suggests it may be better simply to streamline the number of rules that apply to these small banks and to reduce the number of compliance hoops they must jump through. “There is no question, in my mind at least, that regulations can become excessively complicated,” he argues, probably causing consternation in the corridors of the European Securities and Markets Association (ESMA) that has never seen a regulation it didn’t like.

    Britain’s insurance sector, for one, has been less than happy with some aspects of the mighty Solvency II regime and, reflecting the views of Governor Tarullo on banking, Andrew Tyrie’s committee is taking a hard look at it. Indeed Solvency II has been named as one body of regulation where UK could use Brexit as a way of getting back some control from ESMA-driven rules. 

    Laundry list

    The stakes are high here too, so high that London’s insurance market has drawn up its laundry list for Brexit. Understandably, the City wants to hold on to its number one spot as the world’s largest global centre for commercial and specialty risk. Thus the International Underwriting Association has identified four priorities for negotiators to bear in mind over the next few years. Taken together, they probably reflect what the entire financial sector would want.

    First, the maintenance of existing freedoms with the current passport and branch regimes preserved under an equivalence deal. Second, the continued application of English law contracts and other long-standing legal arrangements with European parties.

    Third would be a fair, consistent and transparent tax regime.

    And fourth, regulators in UK and the EU should put the infrastructure in place to cope with a predicted avalanche of licence applications as firms rush to open offices so they can provide services for customers that have been stranded by Brexit.

    In short the insurance sector, like the rest of the financial industry, wants business to go on pretty much as usual. And the City’s umbrella insurance body, the powerful London Market Group, is lobbying government hard.

    Whatever solutions are devised during 2017, one thing’s certain: Brexit will mean a divergence between UK and EU regulation, the extent of which will only become clearer in the coming years. And, as consultants Deloitte argue in a crystal-ball exercise, supervisors will want to be certain that the financial sector is equipped to cope with that divergence: “As the UK government begins exit negotiations with the EU, supervisors will closely monitor how firms are preparing to deal with an extended period of uncertainty and the unpredictability of Brexit’s eventual outcome.”

    Uncertainty and unpredictability are the right words. If the deal over the position of Britain’s financial sector outside the EU is not signed off for another three or four years, it means firms could be left high and dry when the terms are finally known.

    That’s why consultants are urging them to be ready to act or they may get buried in the rush.

    And in other news…France gets serious about corruption 

    France’s brand-new anti-corruption laws require companies to install an entirely new compliance function designed to mitigate wrongdoing in what lawyers say is a legal revolution with far-reaching implications for commercial behaviour.

    Tasked with preventing and identifying any corrupt practices, this new compliance desk will answer to the Agence France Anti-corruption, a government agency that will for the first time have the power to conduct investigations, work with whistle-blowers and issue fines and other sanctions. Fines could run as high as 30 percent of a company’s annual turnover and up to €200,000 for individuals.

    The law will also apply to foreign companies that do business in France and its territories.

    According to French law firms, the requirement for an in-house, anti-corruption compliance unit represents a legal revolution that draws in part from UK’s Bribery Act. All companies with at least 500 employees and an annual turnover of €100m will now have to establish such a unit. The government body, which reports to the Minister of Justice, will monitor how effectively companies manage their corruption-fighting compliance. As in the UK and USA, the findings of an investigation will be made public.

    Government lobbyists will also be drawn into the laws which create a national register of lobbyists who must disclose their clients and interests.

    Also for the first time, whistle-blowers are given freedom and protection. If whistle-blowers’ information has been helpful to the national anti-corruption agency, they will be eligible for free legal assistance. They cannot be dismissed or discriminated against in any way – and certainly not identified. If, say, a company officer reveals the name of a whistle-blower, they may be imprisoned for up to two years or fined up to €30,000.

    However there’s no provision for whistle-blowers to receive financial rewards, as they do in America.

    Adopted in November, the laws apply from May 2017.

    About the author: Selwyn Parker is an author of books on finance and business topics, a specialist in financial history, and regular contributor to newspapers and magazines. Based in Spain, France and the UK, he focuses mainly on European developments. His latest book, The Great Crash, is a new history of the Great Depression that among other things explains the rise of regulation in the form of the SEC and related authorities. Selwyn is a regular contributor to Wolters Kluwer Financial Services.



  • Please take a moment and tell us what you think of our content.