Why the City is wrong to oppose the Brexit White Paper

The City establishment is up in arms, and it’s not a pretty sight. Inga Beale, boss of Lloyd’s of London, was firing off like a modern day Joan of Arc with her claims this week that the latest Brexit proposal for financial services with the EU will trigger more firms leaving the UK.

Beale – who is herself leaving the insurance market – said the deal would speed up Lloyd’s own plans to set up a Brussels subsidiary. Others would soon follow, she warned.

At the the City of London Corporation, which governs London’s financial district, policy chairman Catherine McGuinness was even more scathing of the Brexit White Paper, describing it as a real blow for the UK’s financial and related professional services sector.

Ex-Treasury minister, Mark Hoban, now head of the International Regulatory Statutory Group, which had put together the City’s proposal to the Treasury, is also said to be fuming. Over at TheCityUK, one of the Square Mile’s lobbying groups, Miles Celic, added his two pennies worth when he described the plan as “regrettable and frustrating” while Huw Evans, director-general of the Association of British Insurers, said the ‘insurance industry is too important to be a rule taker.’

So what has got the City’s elite so hot under the collar? Are all these hot shots – who happen to be Remainers to a man and woman – right? How has Theresa May managed to infuriate business leaders in financial services – most of whom like her want to achieve the possible closest EU relationships?

And how has the PM managed to swing a double-whammy –  alienating the Brexiteers by agreeing to stay in much of the single market for goods but also annoyed the City’s staunch Remainers by ensuring they are not rule-takers? Quite a feat.

How did we get to such a paradoxical situation? It’s complicated. And, to be fair to those criticising the deal, much of the argument comes down to technical jargon which many – even in the City – don’t appear to fully understand. Or they have been wilfully and woefully misled.

The starting point is that the latest Brexit proposal for financial services has stunned so many because the government has given up on pushing for binding mutual recognition – a concept which the City had hoped would align rules in both markets by allowing banks and fund managers equal access to the EU markets and vice versa. A version of this was pushed by the City’s main lobbying group – the IRSG – which argued that a new concept of ‘divergence’ should be provided for, and that any ‘material differences’ between UK and EU law avoided.

Indeed, much of the City establishment had hoped binding mutual recognition would be the basis of the deal, one they thought they had won when the Chancellor, Philip Hammond, supported it only three weeks ago, referring to equivalence as a land grab in which the EU could have the final say on access.

But behind the scenes there’s been a tug of war between the Treasury and the Bank of England, against the backdrop of what the UK Government thought the EU might be prepared to accept. The Bank has been arguing with the Chancellor for months that any solution must avoid leading to the UK being a rule-taker from the EU in financial services.

As pragmatic as ever, the Bank’s concern was that not only would rule-taking be a nonsense for the City as one of the world’s leading global financial centres but it was also dangerous because of systemic risk. The Old Lady won.

Which is why the Brexit paper now proposes an agreement between the UK and the EU based on what is known as enhancements to the EU’s existing concept of equivalence.

In a nutshell, this would allow the UK financial services in the future to adopt a beefed-up version of a system already used by certain non-EU countries, including the US, Japan and China, whereby if these third party countries achieve similar outcomes to certain EU rules they obtain access to the bloc. This means that the rules are equivalent to each other in some areas, a system that has been operating for decades.

This sounds eminently sensible, particularly as the City is a global market, doing more trade with the rest of the world than with Europe. Indeed, 80% of the City’s business is either domestic or wholesale.

So why are Lloyd’s, the Corporation and others so upset by this new form of wording?

Legal expert, Barney Reynolds,  head of the London financial advisory practice at US law firm, Shearman & Stirling, has been arguing for this form of enhanced equivalence as the preferred option ever since the referendum. His paper, A Template for Enhanced Equivalence, was published last year and has been closely studied by both Treasury and the Bank.

It can be found here.

Reynolds argues there are advantages to using the equivalence concept as the starting point because it is in use by the EU already in its dealings with the US, Mexico and Singapore. As he says: “In the form in which it exists now, it does not bring with it any attempt at EU control of UK law or policy, or restrictions on the UK’s need to be competitive, any more than the EU seeks to control those matters for the US or other sovereigns. It merely seeks to measure the similarity of the UK’s regime to that of the EU in the respects that matter.”

He goes on to show this approach requires equivalent outcomes to be achieved and these outcomes are higher level than the minutiae of detailed regulation. In other words, one where there is mutual recognition for mutual access.This approach also works well because it fits with the lead that the UK takes in setting and complying with international standards in financial services regulation, to which the outcomes should sensibly look.

But Reynolds also identifies shortcomings in the existing EU definition – which is why both sides will have to come up with new details in new legislation and there would have to be a third party independent resolution system to adjudicate on procedural matters at the very least – which the Brexit paper does propose.

At the heart of “enhanced equivalence”, however, is the ability by other parties to diverge from, or change rules, they found to be adverse to themselves. So if the UK decided it no longer agreed with EU outcomes on insurance it could decide to exit the access arrangement for that area, whilst continuing the others, and forge an entirely different path for insurers. The White Paper does not adopt one aspect of Reynolds’ proposals, which is for an independent court to oversee both parties’ application of equivalence. Instead it seeks to achieve certainty by relying on the procedures Reynolds laid out in order to underpin predictability.

So why are so many of the City’s bigwigs so upset? Well, Reynolds believes they have misunderstood the nature of enhanced equivalence, and that if it is implemented correctly by both parties, it will inevitably lead to mutual recognition for mutual access anyway. Which is what everyone wants. It’s how you get there that is the crucial test, and getting there without being a rule-taker.

Even so Reynolds has some reservations about the proposals which have yet to be fully fleshed out, and would like to see more precision along the lines he mapped out in detail in his template.

He reckons the City can get the model that works for the UK and EU with four caveats. They are if all the gaps are filled in within existing equivalence regimes, that equivalence is defined by reference to sufficiently high level outcomes, if it is sufficiently binding procedurally, and if the approach is forced to be technical and apolitical.

Indeed, the Brexit paper acknowledges this, saying that existing frameworks for equivalence would need to be expanded “to reflect the fact that equivalence as it exists today is not sufficient in scope for the breadth of the interconnectedness of UK-EU financial services provision”.

Government sources are trying to play down any disputes, saying this new “reciprocal recognition of equivalence” is a happy medium achieving mutual recognition through enhanced equivalence.

Reynolds is too polite to say so but you do have to wonder if some of these City figures in meltdown fully understand the government’s proposal? If they did, why would the City Corporation and CityUK say equivalence is not fit for purpose?

It’s a system that the EU already operates and one which – with enhancements built into a new bilateral treaty- would mean that both the UK and the EU can adapt their rules with those of the global markets here in the UK and the smaller, more domestic markets of the EU-27. It’s a win win.

What’s not to like? The opposite would be rule-taking by the UK from the EU, or micro-management by some oversight committee, both of which would be destined to fail but also create systemic risk.

What the EU has to say about such a clean-cut and neat proposal is another matter entirely. The French and Germans are not crazy about the idea because they fear it gives the UK an advantage. Which gives the City even more reason to fight for it, once they come to their senses.