The UK's relationship with the European Union (EU) will be a defining issue for the next government. Financial services are one of the UK's largest and most important economic sectors and will be central to the economics of this 'British Question'.

The EU cannot be considered to be in a 'steady state'; it is undergoing profound changes such as with the creation of a European Banking Union (sometimes described as Maastricht 2.0). By 2020 23 of the 28 EU members are likely to be part of the Banking Union. EU financial markets will be dominated by two major central banks: the Bank of England and European Central Bank. The former will act for one EU member and the latter for 23 EU members. This may create either a centripetal or centrifugal force.

New analysis by Dr Angus Armstrong, Director of Macroeconomics at NIESR, raises four broad issues around financial services which must be resolved when considering the best strategy for the UK in light of these changes to the EU. These are whether UK financial sovereignty is consistent with the emerging EU governance structure; to what extent the domain of UK financial regulation is limited by, in particular, macro-prudential regulation in the Banking Union; whether a competitive location policy is emerging to keep institutions within the Banking Union boundary; and finally, what alternative arrangements are plausible?

First, nations resolve financial institutions along national boundaries to limit taxpayers' cost. Yet the decision of one country (say, over Lehman) may have financial stability and fiscal consequences for others. Unless these are taken into account, decision may be sub-optimal. The more integrated the financial system, the more that financial and fiscal sovereignty is shared. Nations in the Banking Union will share (some) resolution costs, yet it is unclear how their interests will be aligned with EU nations outside of the union. This is particularly important for the UK because 6 of the EU’s 15 GSIBs operate as legal institutions in the UK.

Second, significant differences in financial regulations in the UK and Banking Union nations are a marked divergence from ‘maximum harmonisation’. Capital and liquidity can easily be transferred across branches in a banking group to exploit differences. Unless spill-overs are taken into account, cross-border flows may exploit regulatory differences and outcomes may be sub-optimal. This may be particularly challenging for macro-prudential regulation, intended to mitigate risks emerging from credit cycles (among others). Cross-border flows are so large and pro-cyclical having an independent currency may not insulate the UK.

Third, as the Banking Union becomes established, a 'location policy' to attract financial services may well emerge. There has always been competition to host financial services businesses. This may have influenced the ECB decision to state that Clearing Houses with substantial euro business must be within the euro area. So far the European Court of Justice has ruled in favour of the UK, but the core issue of financial stability has not yet been addressed. Another potential location issue arises over location of the new Capital Markets Union. London is an obvious contender as English Law is common in debt assets, the largest capital markets and money markets necessary for hedging already exist.

Finally, what are the alternatives? One option is for the UK to join the Banking Union. But as a non euro area member the UK would not be part of the ruling ECB Governing Council. Another option is to seek reform of the voting powers of existing institutions (e.g. weighed by size of financial system). The two common examples of nations outside of the EU are the Norwegian EEA membership and Switzerland's bilateral trade in goods agreement. Both would leave the UK without influence and reduce cross-border financial integration.

Financial services are one of the UK's largest economic sectors. Output accounts for over 8% of total national output, exports of financial services as a share of GDP are greater than any other country (excluding city states), the UK trade in financial services is surplus of 2.5% of GDP and the sector is estimated to contribute up to 11% of total tax revenues.[1] The growth of financial services reflects the role of the UK as an international centre of capital markets. Over 150 foreign banks have branches and almost 100 foreign banks have subsidiaries in the UK. Therefore, the size of the UK banking system is 450% of GDP (based on residency).

ENDS

Notes for Editors:

This press release is based on an article entitled “UK Finance and Europe”, written by Dr Angus Armstrong, and contained in the National Institute Economic Review No. 232 May 2015. This is a quarterly, peer reviewed, economic and social sciences journal. The full Review is published from midnight on Wednesday 6 May. For a copy of the article, or to organise an interview, please contact Brooke Hollingshead at NIESR press office on b.hollingshead [at] niesr.ac.uk . The article will be available online from Wednesday 6 May 2015. To discuss the article please contact: Angus Armstrong: a.armstrong [at] niesr.ac.uk on 0207 654 1928 or 0796 974 0428

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