Can the City survive Brexit?
The biggest international financial centre in the world faces its toughest test
?THE WORLD has a handful of great commercial hubs. Silicon Valley dominates technology. For electronics, head to Shenzhen. The home of luxury is Paris and the capital of outsourcing is Bangalore, in India. One of the mightiest clusters of all is London, which hosts the globe’s largest international financial centre. Within a square mile on the Thames, a multinational firm can sell $5bn of shares in 20 minutes, or a European startup can raise seed finance from Asian pensioners. You can insure container ships or a pop star’s vocal cords. Companies can hedge the risk that a factory anywhere on the planet will face a volatile currency or hurricanes and a rising sea level a decade from now.
This metropolis of money, known as the City, generates ￡120bn ($152bn) of output a year—as much as Germany’s car industry. Because it allocates capital and distributes risk at a vast scale, its influence is global. But now, with a “no-deal” conclusion looking increasingly likely after a change of leader of the Conservative Party, Brexit threatens to rupture Britain’s financial links with the European Union. If Labour wins the next election under Jeremy Corbyn, Britain will also end up with its most left-wing government since 1945, one that is deeply hostile to capital and markets. Either outcome would make the EU poorer and damage London’s position. Together, they could change the workings of the global financial system.
London’s prowess is something to behold. It hosts 37% of the world’s currency dealing and 18% of cross-border lending. It is a hub for derivatives, asset management, insurance and investment banks. Relations with Europe are particularly intimate. The City generates a quarter of its income from the continent, and Europe gets a quarter of its financial services from London, often the most sophisticated ones. French or Italian firms go to London to meet investors or organise a takeover. When the European Central Bank buys bonds as part of its monetary policy, the sellers are very often asset managers and banks domiciled in Britain. Some 90% of European interest-rate swaps are cleared through the City’s plumbing.
The City’s history is long but serpentine. In 1873 Walter Bagehot,?The Economist’s then-editor, wrote of its “natural pre-eminence”. In fact decades of decline lay ahead. A revival began in the 1960s when the offshore market for dollar lending boomed. Another lift came with the stockmarket deregulation of Big Bang in 1986 and again after 2000 when London became a centre for trading the euro and emerging markets. Even the financial crisis of 2008 did not do much damage to the City’s standing abroad. Today the magic formula has many parts: openness to people and capital, the time zone, proximity to subsea data cables, and posh schools. But, above all, it relies on stable politics and regulation, close ties to America and seamless ones to Europe. Brexit and Mr Corbyn threaten this formula in three ways.
The first is by ripping up the legal framework, as the EU cancels the “passports” that let City firms operate across the continent. Activity may move in search of certainty. The second is by the remaining 27 EU members adopting an industrial policy that uses regulation to compel financial firms to move to the euro zone. As Amsterdam, Frankfurt and Paris jostle for business, this fight is turning ugly. And the last is from within Britain—if a Corbyn government takes the country back decades, with nationalisation at below-market prices, a financial-transactions tax, a tough line on mergers and acquisitions and possibly even capital controls. If a Labour government also attacks private schools and second homes, London’s giant pools of capital will disappear faster than a trader’s cocktail.
Given the sums at stake—London hosts $20trn of bank assets and securities—you might expect a grand bargain between the EU and its financial hub. Some chance. Britain has spurned the option of staying in the single market. A bespoke deal for financial services is not on the table because the EU is loth to grant special favours to a departing country. It is as if New York and Wall Street were divorcing America without any agreement. Thanks to temporary licences, the risk of a financial crisis on Brexit day is slim. But these arrangements will not last long—the deal over derivatives, say, expires next year.
Behind the stand-off is a deep divide. The City could keep free access to the EU if it agreed to be regulated by it. But Britain rightly fears handing control of its largest industry to the bloc, particularly if the EU’s unspoken goal is to shrink London. Europe’s motives blend principle and greed. It wants to supervise its own financial system, but also to grab jobs and tax revenues from London. In the long run the most likely set-up is “equivalence”, in which firms receive recognition from Europe. The catch is that, as Switzerland is discovering, this can be withdrawn at any time, leading to a state of permanent instability. That threat will lead to a drift of activity and people into the euro zone as EU authorities win full sovereignty over the euro zone’s capital markets.
This sounds good for the EU, but it is likely to be a pyrrhic victory. The continent’s financial system is balkanised and dominated by sluggish banks. New business will be spread across several cities, fragmenting activity further. Europe’s heavy-handed regulation may prompt non-EU business to stay away. Ultimately the costs of a less efficient financial system are likely to outweigh the extra income from capturing business from London. The annual bill for every 0.1 percentage-point increase in euro-zone firms’ cost of funding amounts to €32bn, or 0.3% of GDP.
And what of the City? It has a chance of prospering. Its links with America remain tight. It will have to try to keep Europe close, too, while increasing its non-EU international business from today’s share of 25-30%, and developing new strengths in fintech and green finance. The biggest danger is that it has lost the battle of ideas at home. Many Britons, not just Mr Corbyn, resent the City’s post-crisis bail-out—no matter that British banks have since tripled their capital buffers, and thus pose little threat to taxpayers. Even Margaret Thatcher, who oversaw Big Bang in the 1980s, disliked flash bankers. But Britons cannot ignore the ￡65bn, or 3% of GDP, of annual tax that the City pays towards hospitals and schools. For a country that is losing friends fast, having a global, sophisticated industry is a blessing, not a curse.