Chris Middleton explains the size of the challenge – or is it opportunity? facing the UK financial services and RegTech sectors this year.

2019 will be a landmark year for the UK, not least for the banking and financial services sector that is so critically important to the economy. Services contribute 80 percent of UK GDP, according to 2018 government figures, with financial services alone adding £119 billion in economic value – 6.5 percent of the country’s total output.

The UK has the leading share of trading in several international financial markets, such as cross-border bank lending (16 percent), international insurance premium income (29 percent), and foreign exchange trading (37 percent). It is also a global leader in professional services and is widely acknowledged as a FinTech and RegTech powerhouse.

But can it sustain those positions once it quits the EU?

Trade surplus

According to the government, exports of UK financial services were worth over £61 billion in 2016, while imports totaled £11 billion, a surplus of more than £50 billion – down from £63 billion in the previous year.

However, 44 percent of the UK’s healthy financial services exports (roughly £27 billion) were to the EU. So with the clock ticking towards Brexit, the impact of leaving the single market can only be significant. Indeed, it may be highly damaging to the sector in simple economic terms.

Elsewhere, there is complexity. The degree of interlinkage between the City and EU economies is substantial, and highly intricate in terms of legislation and regulation.

While both the government and the banking sector are working towards sustaining ‘business as usual’ for UK customers (buoyed by banks’ increased capital requirements since the 2008-09 crash), the wider impact of Brexit on this critical sector is unlikely to be positive.

Regulatory backlash?

According to pro-capital markets think tank New Financial, Brexit could trigger a regulatory backlash within the EU against any elements of the single market and capital markets union that are seen to play to the UK’s advantage, such as the location of euro-denominated clearing.

Whichever form Brexit takes, the UK will lose influence over the future direction of EU regulations that it will still have to implement, adds the organisation. And in order to retain access to the single market, the UK must retain an equivalent regulatory framework, calling into question one of the stated reasons for leaving the union in the first place.

While this regime would be equivalent on day one, changes to EU legislation over time may lead to costly regulatory divergence and leave the UK chasing Europe’s tail indefinitely, barking (no doubt) but unable to bite.

The government acknowledged the organisation’s findings in an August 2018 impact assessment, but suggested they were overly negative – without contradicting the points it raised.

Moreover, there is “little certainty over what will happen next and a gulf between what the industry wanted at the start of the process and what it looks as though it will now achieve is quite wide”.

Again, that quote doesn’t come from a Remain-supporting commentator, but from the same Parliament report on the impact of Brexit on financial services, underscoring the gulf between political aims and business reality.

Threats of mass exodus

Many London-based institutions have set up European arms and transferred both staff and functions abroad, to ensure continuity of services to European clients, added the government in its August assessment. That said, the report suggested there was – at that time – little sign of a mass exodus of firms or capital from the City.

However, this month, EY (formerly Ernst & Young) claimed that financial services firms are preparing to move £800 billion – over $1 trillion – of assets out of the UK to Europe as part of their Brexit contingency plans.

According to EY financial services’ Brexit Tracker, 20 companies have so far announced plans to transfer assets, including cash, stock, and bond holdings, out of the City this quarter.

By the end of March, the numbers could be far higher, suggested EY, as most firms have yet to reveal their plans. To date, 36 percent of the 222 UK financial services firms tracked by the company have already said they are relocating staff and/or operations to the continent, or are considering doing so. That figure jumps to 56 percent for banks, investment banks, and brokerage firms.

In total, EY estimates that some 7,000 jobs could be relocated from London to the EU in the near future. If true, this could leave the City struggling to retain its allure for finance professionals and those in associated services, including technology.

Of course, in these narrative-driven times, there should be a degree of scepticism about such claims until they can be backed up with hard evidence.

The tax problem

There could be indirect impacts on the economy, too, from any genuine erosion of confidence and opportunity in the City.

According to the government, financial services companies contributed £27.3 billion in direct taxes to the Exchequer in 2016. In 2018, PwC estimates that the UK’s banking sector alone contributed a total £36.7 billion to HMRC, including employee taxes. That’s equivalent to 5.4 percent of all taxes raised in the UK.

So not only may banks’ tax contributions fall as a direct result of the UK leaving the EU –  as banks shift operations to Germany and elsewhere – many are also using Brexit to campaign for lower tax rates, due to the risks of a disruptive or no-deal outcome, according to the FT.

So one way or another, financial services companies’ tax contributions to the UK could fall significantly, either as a direct result of Brexit, or of post-Brexit sweeteners to the industry. With banks’ own financial barrel leaking, they would have every incentive to bend the government over it to maximise their profits.

‘Reg’ challenges

The government acknowledges that there could be other problems, too. If UK firms lose their EEA ‘passport’ they would no longer be able to provide services outside the UK.

For example, in the absence of regulatory change within the EU itself, EEA clients would no longer be able to use the services of UK-based investment banks, and those banks may be unable to service existing cross-border contracts.

Again, this isn’t scare-mongering from a Remain-supporting analyst, but commentary published in the government’s own impact assessment last year.

Meanwhile banking itself is changing, at least in the UK. The new year has already seen one major change to the sector, with a clear division between retail and high-risk investment banking finally appearing a decade on from the financial crash.

From 1 January, UK banks holding more than £25 billion in deposits have to ringfence their retail operations from their investment banking arms – changes that directly affect behemoths such as Barclays, HSBC, Royal Bank of Scotland, Lloyds Banking Group, and Santander.

While the move is welcomed by many – not least a public that has endured a decade of austerity policies in the wake of multibillion-pound sector bailouts – the regulatory shift has yet to be mirrored in the US and the EU, creating a further gulf between the UK and its allies at an already challenging time.

“Ringfencing is the second biggest piece of post-crisis regulation to hit the UK banking industry – it comes second only to MIFID II and supersedes Brexit in cost, complexity and resource, ” said Jon Holt, head of financial services at KPMG in the FT. That doesn’t sound like an endorsement.

Opportunity or challenge?

So what of RegTech in this context? Among other things, RegTech aims to help organisations automate and streamline processes, reduce risk, increase transparency, efficiency, and agility, cut costs, and be more resilient against cyber threats and fraud.

But while the UK’s regulatory and political upheaval may create opportunities for RegTech specialists to help their clients navigate through this increasingly challenging and complex sector, the big picture is far from encouraging – and that’s according to the government’s own research, backed by commentators in financial services.

The reason is simple: RegTech is a heat-seeking market. As is fintech, and despite the advent of open banking a year ago, the UK banking sector remains stubbornly untransformed by reams of nimble startups. Only four new banking licences were issued in 2018 – compared with 12 in 2017, according to the Financial Conduct Authority.

In the real world, UK banking is still easily dominated by the same giants that have had to ringfence their retail and investment arms, while the digital payment infrastructure remains largely in the control of companies like Visa and Mastercard, who will snap up challengers and startups.

The bottom line

But the underlying problem is this. One of the key drivers for the boom in RegTech and fintech companies in the UK has been the country’s global importance as a financial centre, one that offers a bridge between Europe, the US, and the rest of the world. The UK’s status as the world’s sixth largest economy (after tech hotspot California) is largely built on that bridge – and overwhelmingly on services.

With that long-term future now in doubt – no credible assessment says the bridge isn’t smouldering, if not actually in flames – it stands to reason that the epicentre of the supporting technology sector, and of innovative startups, may also shift outside the UK.

Put another way, why would it stay in the UK rather than follow the money to Germany, China, India, the US, Singapore, or Dubai? An outflow of a trillion dollars is no incentive to remain, if the claimed scale of that capital and personnel outflow is genuine.

But even if stories of a banking exodus turn out to be little more than a useful lever for banks to pull – in order to persuade the government to lower their taxes, for example – there is little evidence that financial services companies believe that Brexit is a good idea (unless they’ve gambled on the outcome).

Let’s hope the government has the common sense to step back from the ideological brinkmanship of some within its ranks and properly assess the threat of lasting economic damage, as the UK hurtles towards a possible no-deal, or a delayed Brexit outcome.

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