But even the most ardent Brexiteer would have to admit that the lack of clarity on the government’s negotiating stance makes it more likely that companies will choose to relocate some of their pan-European operations to the continent. That prospect came into sharper focus last week after the City of London Corporation (CLC) delivered an updated 'red' rating in its corporate risk register, an increase from the 'amber' rating from October last year. It means the CLC believes the likelihood of a post-Brexit trade deal between the UK and EU 27 has diminished, hardly surprising given that EU trade negotiator Michel Barnier has already ruled out any special deals for the industry.
Financial services account for about 12 per cent of the UK’s economic output and pay more tax than any other industry, so the stakes couldn’t be higher. But it could be argued that City insiders may be more perturbed about the seeming state of flux on the UK negotiating front, rather than any practical implications of a Brexit ‘no-deal’ – above all, businesses abhor uncertainty.
Take the issue of ‘passporting' rights, the protocols that allow banks and other financial services firms authorised in any EU or EEA state to trade freely in other countries in the blocs with minimal authorisation. Many fear an overnight withdrawal of privileged status would hit City institutions hard, but EU legislation provides for a “third country” category, which allows non-EU-based firms to offer certain services into the EU if their domestic regulatory regime is accepted by the EU as being “equivalent” to EU standards.
It’s worth remembering that a high (and increasing) proportion of financial, accounting and banking rules are set by global regulators, while in some areas it’s accepted that UK regulatory standards are more stringent than those set by the EU, so any immediate impact may be relatively modest. Some have even suggested that companies could simply set up a 'brass plate subsidiary' in the EU to process business essentially undertaken in the UK, while a report published last September by Moody’s Investor Services states “the third country equivalence provisions contained within the incoming Mifid II EU directive may provide firms with an alternative means of accessing the single market”.
However, the designation of “equivalence” is solely at the diktat of the EU commissioners and can be withdrawn at a month’s notice, so given the trading bloc’s intransigence in the negotiations thus far, it’s understandable that some City analysts feel this arrangement would prove unworkable over the long haul. Following the UK’s decision to exit the EU, we might have hoped that political dogma would have given way to commercial expediency, but there’s little sign of that happening. Perhaps the looming €12.5bn hole in the organisations’ budget will have the desired effect, particularly if that restricts the ability of the EU to quell its increasingly rebellious members in Eastern Europe through economic subsidies.
With all this in mind, it’s worth considering how much risk has already been priced into UK financial services, specifically the banks. We know that valuations for blue-chip companies with large foreign interests have done much better than shares in UK-focused businesses since the Brexit vote and the subsequent devaluation of sterling. But the investment case for the UK's domestic banks is compelling compared with those of their counterparts on the continent based on implied cost of equity. But we also know that other risk factors, including the introduction of the Mifid II strictures and growing non-bank competition, especially from 'fintech' companies, have also weighed on valuations. Yet the relative outperformance of banks on the continent seems curious given the extent of non-performing loans for a significant number of banks in the euro area, to say nothing of the degree of support provided by European Central Bank (ECB) monetary policy measures.
