Financial services should be at the heart of trade talks
In my experience, financial services are rarely the focus of heated family discussions, or of so-called water cooler conversations with colleagues and friends.
Instead, we tend to become passionate about individual politicians or teachers, healthcare or utility companies. This is entirely understandable given that those issues affect our everyday lives — or at least are most obviously visible in doing so.
As trade negotiations begin this week to determine the UK’s future relationship with Europe, I would suggest that we should also spare a thought for the fundamental importance of securing a good deal for our financial services.
This is because all our most passionate concerns depend, in some way, on effectively functioning financial services. As we saw from the 2007/8 financial crash, jobs, pensions, and the ability of governments to help society’s most at need all take a massive hit if our underlying fiscal system breaks down. The domino effect can be as alarming as it is swift and exponential.
This alone is reason enough for financial services to take centre stage in the negotiations now underway. However, there is an even bigger issue at stake here; one which until now has been largely invisible.
As I outline in my new paper, Managing Euro Risk: Saving Investors from Systemic Risk, the UK currently plays a key role in protecting the world economy from the inherent, systemic risks associated with Eurozone debt.
The UK acts as a Euro-risk guardian because of its unique dual position as a global hub for financial services, and an EU member. The City of London hosts global financial markets, regulating and supervising much of the EU’s banking system. Our regulators operate under EU law, but they are not subject to EU control in all respects.
Crucially, they are able to use their supervisory discretion to counteract the effects of the EU’s assumptions about Eurozone debt, which we believe significantly underplay risk.
The key to all this, as with much of Brexit, is sovereignty. Under EU regulations, state debt from Eurozone countries, such as Italy and Greece, is registered as sovereign, and therefore risk-free. But these countries don’t have their own currency. They have adopted the euro; and thus their ultimate financial authority is not their own government, but the European Central Bank. As such, any debt cannot be sovereign.
Why does this matter? It matters because a crash caused by unmanaged Eurozone risk could unleash financial and economic carnage, greater in scale than 2007. When the UK leaves the EU’s legal and regulatory framework at the end of this year, these protections will automatically disappear unless we negotiate an agreement.
In truth, the problems go even deeper as perilous and opaque accounting practices further mask systemic problems in the EU.
Nevertheless, there is a relatively simple solution available (should both sides wish to adopt it) called enhanced equivalence. This is an approach that I first suggested a few years ago and which has subsequently been adopted by the UK government as its proposed model for trade in financial services post-Brexit.
An agreement based on an enhanced version of the EU’s existing concept of equivalence would enable the UK to continue to safeguard the world economy, as it has done for the past 40 years.
But why would the EU agree to it? Instinctively, of course, EU negotiators are likely to resist any special treatment for the UK. However, the EU simply cannot manage financial risk on its own. If operated entirely under EU jurisdiction, financial risk would magnify, lacking the mitigating role of London as a global financial centre. This could, in turn, raise the chances of a small spark in a minor bank setting off a global meltdown.
Having created an umbrella of rules and accounting approaches to facilitate the emerging construction of the Euro, EU regulators are conflicted in their supervisory role.
The only prudent, long-term approach is for the UK to continue its mitigating role. An alternative would be for the UK and US, as the world’s global financial hubs, to manage Eurozone risk remotely. This, however, is likely to be far less attractive to the EU as it would almost certainly involve greater levels of bureaucracy across the system — and a potential bypassing of EU financial institutions altogether.
In politics and diplomacy, visibility is, of course, key. It will be images of long queues of lorries at Dover and Calais, empty production lines in factories, and a declining agricultural sector which will spur on both UK and EU negotiators as they begin navigating our future trade relationship.
It is my profound hope that they will also carve out some time to consider the catastrophic effects of financial
meltdown, and the importance of safeguarding against unmitigated risk and systemic financial weaknesses.
Global financial stability — surely — remains vital for all.
Barnabas Reynolds is a partner at Shearman & Sterling and the co-author of Managing Euro Risk: Saving Investors from Systemic Risk, recently published by the think tank Politeia.