How “regulatory equivalence” might help the City post-Brexit

One of the most important issues for the City in the Brexit negotiations concerns “passporting” and “regulatory equivalence”. As matters stand, however, few in the political classes understand these terms or what the important negotiating issues are or are not, and thus are ill-placed to offer the contribution that politics should be able to make to the discussion.

“Passporting” is the term used to refer to the process whereby a UK-authorised financial services firm (e.g. a bank, or an insurer, or an asset management firm) is entitled to offer its services (e.g. offering a loan, or an insurance product, or the management of some assets) in other EU or European Economic Area (EEA) Member States.

There are two forms of passporting. One involves the UK firm setting up a branch in the other Member State (obviously, much less complicated and expensive than setting up a whole new firm or subsidiary there) and doing the actual engagement with customers from that branch. That is called “branch passporting”. The other involves engaging with customers directly from the UK firm. That is called “services passporting”. The technical differences between these options need not concern us much, but it is worth grasping that there are these two basic ways to passport: via a branch; and directly.

Until recently, firms that were not in the EEA (such as US or Chinese companies) had no passporting rights or anything similar. If they wanted to sell their services to firms or consumers in the EU, they had to set up a subsidiary here. That is, however, changing. A number of the EU’s more recent major financial services directives and regulations have introduced the principle that firms can offer their services in the EU, either directly from their home countries or via branches, if their home country regulation is deemed to have “regulatory equivalence” with that in the EU — i.e. deemed by the European Union to have regulation equivalent, in the relevant respects, to the EU’s own rules.

One key thing to grasp about regulatory equivalence, straight away, is that the EU’s existing regulatory equivalence framework does apply to a range of wholesale financial services and financial markets activities that the UK is a very strong global player in, but does not apply to all types of financial services. In particular, deposit-taking and various other retail banking activities have no current equivalence framework, meaning there is no mechanism by which a non-EU-based deposit-taking bank can be deemed to be subject to equivalent regulation to that in the EU and therefore entitled to sell its services to EU customers.

That means that one important dimension of the Brexit negotiations will concern whether UK banks will retain their current deposit-taking and other retail activities passport and, if not, whether there will be some new system of regulatory equivalence introduced for banks.

Where regulatory equivalence exists, it is not entirely straightforward that the EU will grant UK firms that status, even if our regulation is identical to that in the EU. One reason is that regulatory equivalence determinations have been intensely political up to now, with Switzerland in particular being denied regulatory equivalence, in certain areas, precisely because its citizens rejected free movement of persons.

Assuming that difficulty can be overcome, there are further matters for negotiation. But it is important to be clear what is and is not a potential problem here. Under current structures, a regulatory equivalence determination could in principle be withdrawn by the EU at relatively short notice. Financial services firms planning their activities, or even negotiating specific deals, might be nervous about treating the UK as truly equivalent if they thought there were a real risk of equivalence disappearing in a few months. The US and EU deal with this by having structures for regulatory engagement, so they know how future regulation is likely to evolve and notice of any likely withdrawal of regulatory equivalence can be given. The UK and EU would need to set up similar regulatory engagement structures.

In the UK’s case that would probably, most of the time, be more of a theoretical issue than a practical one. UK regulation tends to be “super-equivalent” to the EU’s anyway. In other words, where the UK would like its regulation to differ from that in the EU, it would still qualify as “equivalent” in the relevant dimensions because the differences would make the UK’s rules even stronger than the EU’s. Therefore the concern that the UK might struggle to maintain equivalence is probably usually over-stated.

A broader issue is that some commentators suggest that, if the UK is to maintain regulatory equivalence with EU regulation, that means we will need to match EU regulation that we have not had a vote in designing, so that the UK’s influence would deteriorate. That is confused, in two ways. First, much EU regulation is actually the application, into EU law, of regulation design at global regulatory fora (such as Basel or IOSCO). For example, the key EU regulations for banks’ capital and liquidity, often referred to collectively as the “Fourth Capital Requirements Directive” or “CRD4” are in essence a copy-out into EU rules of the “Basel III” global requirements. The UK would, along with the US, be the most influential members of the global rules-setting bodies and would have our say in the design of the regulations at that stage. If anything, the EU would be implementing rules set by the UK, rather than the other way around.

Second, in financial services the UK is far too big a player within Europe for the EU to design its financial regulation without checking how acceptable it would be to the UK.

There are further issues, particularly about the transition process. But the key takeaways from this piece are as follows. First, regulatory equivalence could, for many of the key wholesale activities that are significant for the UK, provide an alternative to current passporting rules if there is not special deal to retain those rules. Next, regulatory equivalence is not automatic, and up to now equivalence determinations have been highly politicized. Third, there is no current equivalence framework of any form for various retail activities of banks. Fourth, once introduced, it should be fairly straightforward for the UK to maintain. And, lastly, regulatory equivalence would not mean the UK accepting financial services rules set by the EU that it had had no say in designing.