Brexit’s implication on EU-UK Financial ServicesTrade
Since the UK unexpectedly decided to leave the EU in 2016, there has been evidence of reduced trading relations between the two regions. An estimated 5,000 firms exited from exporting relations with the EU. This slump is the result of heightened uncertainty in trade policy post-Brexit. Firms decided to defer investments and chose not to enter into new markets and exit existing ones. After four years of negotiations, the Brexit deal was resolved. Northern Ireland retained many of the EU rules but for the rest of the UK free movement to the EU has come to an end. The Brexit deal specified details on the movement of goods between borders and fishing rights however the Brexit document spanning 1,200 pages covered very little detail on the future of the financial services industry. The financial services industry was conspicuously absent in the Brexit deal despite being a significant contributor to the UK economy (6.9% of total economic output and 3.2% of jobs contributed by this industry). The regulatory changes brought on by Brexit has implications for EU-UK financial services trade.
Key Changes Brought on by Brexit
On 31st December 2020, EU laws ceased to be applicable in the UK. To access the EU Single Market, banks and financial services firms rely on ‘passporting rights’ that allowed them to provide services to any member state of the European Economic Area (EEA) with minimal new authorisation. This passporting right is not available for firms based in countries outside the EEA. The finalisation of the Brexit deal at the end of 2020 meant the UK had to give up its passporting rights. The UK now qualifies as a third country regime. A host of new regulatory barriers to cross-border banking are now applicable. However, the EU offers UK some degree of access to the integrated EEA market by way of ‘equivalence’. Equivalence plays an important role in financial services trade with the EU. It is an agreement between the two parties that their financial institutions have a sufficiently similar level of regulation, frameworks and safeguards. For example, in November 2020 the UK has extended equivalence to EU insurers and credit rating agencies allowing for significant cross-border trading. Equivalence offers some access to the Single Market post-Brexit however, it is not the same as passporting.
The New System of Equivalence
For starters, equivalence is inherently unsecure. So far, the EU has offered equivalence to the UK only in areas limited to Irish securities (for 6 months) and clearing derivates (for 18 months). The UK is pushing for a wider deal but currently enjoys less access to the Single Market than counterparts in New York and Singapore. The UK has allowed EU firms to operate for three years according to the Pre-Brexit regulations while they await UK authorisation. The EU hasn’t extended the same benefit and UK firms in the EU face uncertainty as they await authorisation. Additionally, equivalence benefits can be withdrawn with a 30-day’s notice proving the equivalence system to be far more uncertain than the old passporting arrangement.
Secondly, the equivalence system is much narrower and onerous compared to passporting. Many banking services cannot be provided at all by the new equivalence system. Core banking services such as lending, deposit-taking and corporate banking are not included under equivalence. Limited investment services can be offered by UK-based banks to the EEA under the new system. Additionally, UK-based banks cannot offer payment services such as credit card and e-money to their EU clients. This means that banks would require outposts in the EU member states to continue serving their clients.
Finally, the new system places the UK at a commercial disadvantage. UK-based banks in the EU would now be classified as ‘foreign banks’. This has restrictive implications as a host of new prudential requirements would be applied. EU-based customers would be restricted to contract with UK-based banks. At the same time, UK-based banks would be restricted to serve their EU customers unless they become authorised inside the EU. This may lead to increased costs and inefficiencies as UK-based banks would have to duplicate functions over several member states to qualify for authorisation and serve client simultaneously.
What lies ahead?
Brexit is expected to make the UK a less open economy and one that is much less integrated with the European Union. To mitigate this risk, the UK has adopted a lenient or an outcomes-based approach to equivalence, meaning that activities would be considered to be equivalent if they achieve similar outcomes even if some regulations are not met. This approach is adopted in a bid to promote London as the financial centre. EU, on the other hand, has been prioritising the development of its own financial centres. They have been trying to replicate financial services capabilities that have historically been the strengths of London. Post-Brexit saw financial centres such as Paris, Frankfurt and Dublin gaining importance as business was shifted away from London. Big banks such as Bank of America Corp and JPMorgan Chase & Co shifted staff and money to cities such as Paris and Frankfurt in order to continue doing business with the EU. Since Brexit, 7,500 jobs have left the UK as banks plan to make local hires in the EU. If this trend continues then London could see it’s significance as the financial hub in Europe diminishing.
Sources:
https://voxeu.org/article/impact-brexit-uncertainty-uk-exports
https://commonslibrary.parliament.uk/research-briefings/sn06193/
https://ukandeu.ac.uk/wp-content/uploads/2021/01/Brexit-and-Beyond-report-compressed.pdf
https://www.bba.org.uk/wp-content/uploads/2016/12/webversion-BQB-3-1.pdf
https://www.wsj.com/articles/what-does-the-brexit-deal-mean-for-financial-services-11608834027
Figure 1. Economic Impact of a Natural Disaster on Households with Different Asset Positions
Source: Adapted from Carter et al. (2005).
Initially, both households’ asset levels increase, although Household B is still close to the poverty line. When a catastrophic weather event hits, both households’ assets decline immediately due to product damage or recovery cost. Household A can recover more quickly since it retains more productive assets to weather economic difficulties. For a poorer household, such as B, the depletion of assets may push the household below the poverty line.
Constraints to Traditional Weather Insurance
After natural disasters hit, a simple solution is to borrow money to cover the loss. However, many poor households in lower-income countries cannot easily borrow money due to their poor credit history or a lack of collateral. Therefore, savings and insurance may be more obtainable for the poor since they serve as protection before the onset of a loss event. Insurance is a business that depends upon trust. Traditional weather insurance pays indemnities when farmers incur a loss. To pay indemnities to households, the insurance company makes estimates of loss case-by-case. However, there are two major problems associated with traditional weather insurance (and most types of insurance products) are adverse selection and moral hazard. Adverse selection occurs when one party has more information than the other party. For example, farmers living in an area with a higher probability of extreme weather events will be more incentivized to purchase the insurance than those who live in a safer area. Moral hazard refers to the fraudulent behaviors of the insured after purchasing the insurance. For example, farmers may blame the loss of crop failure on weather factors although it is mainly due to careless management practices. It is difficult to tell if a loss is due to a natural or human factor, and the monitoring and administrative cost to control adverse selection and moral hazard problems can be costly. Another constraint of traditional weather insurance is the financing of large losses. For extreme weather events, all insurance buyers within the same geographical area will rush to make claims at the same time. The total claims are very likely to exceed the amount the insurance company can provide. Insurance companies need careful planning to ensure adequate capital is available for potentially huge losses, or sometimes they simply avoid providing weather insurance products. In higher-income countries such as the United States or Canada, their insurance products involve subsidies to mitigate the expense of premiums. However, it is difficult to apply this method to lower-income countries due to their lack of financial capital or poor design of the subsidy scheme to deal with adverse selection and moral hazard problems.
The New Approach—Index Insurance for Weather Risk
Given the insurance companies in lower-income countries typically do not have the financial resource to follow the solution conducted in higher-income countries (e.g. subsidies for weather insurance), index insurance may serve as an alternative for weather risk protection. Index insurance pays out the claim based on values obtained from an index, such as rainfall, temperature, or wind speed, instead of traditional proxies such as farmer’s crop yield. For example, an index insurance contract related to drought risk will make indemnity payments if rainfall does not reach certain levels during a defined period, such as a month or a season. As shown in Table 1 (Skees, 2008), if the rainfall is 100 mm or less, the insurance company begins to make payments, and the maximum payment of $50,000 is made when rainfall is at or below 50 mm for the season. The total accumulated rainfall is measured at a local weather station for the cropping season.
Table 1. Payments Due Under Different Rainfall-Level Scenarios
Source: Adapted from Skees (2008)
