Analysis of The Economic Consequences of Brexit

In this assignment I will be considering what Brexit is and what impact it has had on financial services as well as financial institutions. This will be followed up by some recommendation on how the Bank of England and the Financial Conduct Authority should/ are preparing on the impending exit of the EU.

On the 23rd June 2016 a referendum was held where 51.9% of the British public voted to ‘Leave’ the European Union, the name give for this movement was Brexit combining Britain and exit. The UK are now scheduled to leave on the 29th March 2019, this was instigated when the UK initiated Article 50 of the Lisbon Treaty. The European Union was created in an effort to stop the war between neighboring countries. The six founding countries are Belgium, Netherlands, France, Germany, Italy and Luxemburg and in the 1950s they all signed a deal stating that they will pool coal and steel resources, as of this 2017 the EU has 28 members.

There are 4 Key institutions that work together to run the EU, which are:

• European Commission - The European commission proposes and enforces, laws, manages EU policies and delegates EU funding
• European Parliament - European Parliament is invoked in the creation of legislation, supervision as well as budgeting.
• Council of the European Union - The Council of the European Union will negotiate and adopt EU laws alongside European commission and the European Parliament
• Court of Justice - The Court of Justice will preside over all cases brought before them and is used when national courts are unsure over a ruling and require clarification over the details.

Why did the majority of the British public vote to leave the European Union? Income, age and education were the key figures in deciding which way the vote ended up. The voters who were on income of less £1200 per annum had 66% in favor of the exit from the EU. The majority of the over 65s also voted to leave the EU. Over 78% of the no qualification in education voted for leave.

Being aligned with the EU has led to access to skilled workers as well as a free passport to sell products and services across the single market. It has been well documented that through this partnership the net benefit has been 4-5 % additional GDP which will equate to £62to 78 billion per year.

Main body

Ever since joining the EU in 1978 the UK’s GDP has risen at an exponential rate as you can see from Figure 1. As you can see there are two periods of substantial growth in 1970 and in 1972. 1970 was close to after the entrance of the UK to the EU and the reason why there was an increase in 1992 was due the EU opening its single market in goods. The financial services sector amounts to 8 per cent of the UK economy this shows any impact on the sector will correlate to a n impact on the UK economy.

The Financial Conduct Authority (FCA) was created on the 1st April 2013 where they took over control from the financial services authority. They are the conduct regulator for over 56000 financial service firms and financial markets in the UK. For consumers to receive a fair deal it is up to the FCA to keep the financial markets honest fair and effective. They have 3 key objectives protect consumers, financial markets and competition. It is an independent public body that is funded by the firms that they are regulating by charging the fees.

Due to Brexit, the UK’s passporting rights will be affected massively. A financial services passport was created to allow the UK firms access to the financial markets inside the EU and European economic area (EEA). The EEA includes all of the EU countries as well as Iceland, Liechtenstein and Norway which allows them access to the EU’s single market. Currently, as the UK is still inside the EU, it allows any UK business to provide their financial services inside the EU whilst being regulated by the UK authorities. Being apart from this would lead to reduced costs for business as there would not be a need to set up large headquarters in different countries as well as there would not be a requirement to comply with the different regulation that each country would understandably have. Losing the ability to provide services to the EU would mean that the UK would miss out a market of 500 million consumers and 22 million+ businesses.

However, some businesses maybe be able to retain existing European clients if the UK loses it financial passporting rights, but it depends of what and where the services provide. The UK could remain in the single market if they were to join the EEA however by join this it would mean that the UK would have to allow the free movement and rulings from the European court of Justice but the prime minister of the UK Theresa May is strongly against this, so it would be highly unlikely. Without the EEA any UK based banks would require an additional license from the host supervisor in an EEA member state in order to offer any services. There is also another option in which the City of London can operate on its own with a more lenient regulatory environment which hedge funds and bankers will appreciate due to previous EU imposed regulations on any bonus payments.

Another way in which the UK could retain their passporting rights would be through Equivalence. This concept is primarily used in cross border trading. Currently only some of the EU’s financial legislation accepts it as a principle. The advantage of using equivalence would be that it doesn’t force both countries to match each other rules and regulations. If the standards are similar enough then it is acceptable for a firm from one country to offer their financial services to another country as long as the consumer is protected, which is why the UK could use this as a method to continue their access to the single market without accepting the EU’s laws and guidelines. However, in 30 days the declaration of equivalence can be cancelled which is an issue especially for financial institution as it means most investors will be discouraged from long term investing as it can be revoked so easily. A detailed agreement is a requirement as any confrontations about rules can be easily solved.

The UK should be negotiating certain areas that require passport rights as there are a small number of alternatives. A EU-Switzerland deal is already in place in terms of direct insurance not including life insurance via branches. As there is a precedent it means that UK and the EU could create another bespoke agreement but for passporting rights for banks.

The BOE believe that lending to businesses could start to reduce after Brexit as firms within the EU are not preparing enough to continue operation in the UK. Companies within the EEA amount to 10% of lending to UK businesses and post Brexit authorization would be necessary in order to continue.

The PRA have an idea on what they need in order to allow EU banks to continue to operate in the UK more easily after Brexit. This revolves around letting the EU Lenders to operate branches instead of subsidiaries inside Britain. Most European lenders operate in the UK through branches due to current EU regulations as it allows for a cost-effective way of transferring services around the European Union. The difference between a branch and a subsidiary is in a branch a lender bank will be able to recover their money back to their business in the event of a crisis. With subsidiaries it makes the banks adhere to harsher rules on capital buffers it also makes them generate a new version of the banks but as a UK Company.

By keeping the Financial system open to any of the EU’s foreign firms it will help increase both the UK’s and EU’s economy. Essentially the PRA are will assess a firm’s activities and whether or not it is systemic. To do this, it will monitor this factor: size, larger than a £15 billion in total assets as well its connection to the UK’s Financial Market. They developed a very complicated chart showcasing the new approach as you can see in the figure 2. Essentially depending on the sector analysis will occur in a step by step manner to authorize its operations in the UK.

Brexit has also caused the Bank of England to raise their interest rates, the last time was a decade ago, most economists predict two further interest rate increases by the end of 2020. IT has dented the UK economy as the sterling exchange rate went from 1.47 before the Brexit vote to 1.21 on the 1st of January 2015. The Bank of England also predicts that business investment will decrease by 25% in 2018 which would damage any growth. Business investment is very important as it will increase the rate of economic growth. Less investment will mean there would be less expenditure on capital spending, this could include buying new offices and machinery.

The UK imports more than its exports and due to Brexit, where there is a weaker pound it has caused trade to be increased by £400 million and £300 million in exports and imports respectively. However, there is a chance of trade costs to increase as it depends on the agreement that is create a free to trade one or a World Trade organization (WTO) one where a they would be increase administrative costs such as VAT as well as non-tariff barriers to trade which are health, safety and environmental standards. A free trade agreement would be the most likely occurrence if a soft Brexit was to occur leading to goods and services trade on a tariff-fee basis.

Conclusion

There are two ways the UK can exit the EU a soft or a hard way. A soft Brexit would entail leaving the EU whilst maintaining all existing agreements as close as possible, it would also mean that the UK will relinquish their seat in the European Council. Financial firms would be allowed to keep their passporting rights as well as having them headquarter based in the UK. They would have to be a part of the EEA as mentioned previously. On the other hand, a hard Brexit would completely give up the single market in leaving the EU. It would force the UK to make new trade deals as well as applying its own law upon it state, this would mean they would follow the WTO rules in terms of trade. The EU wouldn’t be the only thing would be left as the UK would have to leave the customs union which would lead to more check on goods passing through any ports and airports.

In my opinion the Bank of England should prepare for either a soft or a hard Brexit then they would be preparing for both sides of the spectrum. Capital should be stock pilled for public services such as the NHS, so it is protected. Another investment the BOE could invests in any technological based businesses located in the UK that can guarantee a constant stream of money. Also, if it is possible, significant investment into Scottish based businesses as the UK doesn’t break up after Brexit which would obviously destroy wages in England.