As Brexit approaches and the international economy marks the tenth anniversary of the collapse of Lehman Brothers, people are thinking about what Brexit will mean for financial stability in relation to the UK economy, London as an international financial centre and the wider international economy. It is important to distinguish UK market access to the Single Market for financial services from issues relating to financial stability. The market access issues that turn on passporting, the rules relating to equivalence and ambitions the UK may have for ‘enhanced’ equivalence, relate to the City of London’s ability to market services, such as insurance and fund management to the EU single market post-Brexit. These questions will influence London’s share of international financial transactions and income, but have little bearing on future financial stability and appropriate regulation of banks and financial markets.
Diminished market access to the EU
The Chequers White paper proposes that post-Brexit the UK will be out of the single market in services. Passporting will no longer be applied to institutions. The overall impact of this is difficult to judge. It is likely that London will lose some financial transactions to the EU. It will have different implications for different financial sectors. Banking, securities trading, commodities trading, fund management, insurance and derivative clearing all will face different rules, challenges and opportunities.
There appears to be an acceptance by many significant international financial institutions that to carry out their present business with EU clients, they will have to establish offices, personnel and commit capital and part of their balance sheets to operations in the remaining EU. Overall this is unlikely to make much difference to London as an international financial centre. Its advantages of agglomeration, an effective yet benign regulator, language, time-zone and reliable mediation and court and legal services will ensure that London retains a huge advantage. The depth and liquidity of its international, money, bond and derivative markets make it the cheapest centre for financial institutions across the world to trade, settle and clear financial transactions. The ECB would like transactions involving euros to be cleared within the eurozone. Yet 75 per cent of euro currency transactions do not originate from parties based in the currency zone.
London’s modern financial markets
London is a successful international financial centre for several reasons that have little to do with ether the domestic UK economy or the UK’s membership of the EU. It can transact business cheaply, reliably, honestly and when something goes wrong there is a framework of law to sort it out. London is open to new and foreign institutions when they want to open up. It is open to people from outside and to new and better ideas of doing things even if they involve a disruption for existing firms.
In short, the modern City of London was built on allowing markets in international currencies to develop. This tolerance of innovation allows for new ways of doing things, such as the international syndicated loan market, the issuing of euro-bonds, the development of the Over the Counter (OTC) derivative market in swaps and the financial futures exchange the Liffe. When the petro-dollar crisis broke following oil crisis in 1973, London was well positioned to be the modern world’s leading financial centre and it has never looked back
If the EU ends passporting and shows an unwelcoming face to international businesses wanting to trade in financial services, as part of a mercantilist reflex to Brexit, it will not be the actions of a self-confident political community that is open to the world at large. Moreover, such a reaction would be inconsistent with the approach of an entity that realistically wants its currency to become a reserve asset that people chose for invoicing.
The rules governing bank capital are set at the Bank for International Settlements
The framework for deciding how much capital a bank should have and how it should define it is set for the major advanced economies by the Basle process at the Bank for International Settlements. The committee on setting these standards – Basle III and leading the future work on a putative Basle IV – is chaired by the Governor of the Swedish Riksbank. In speech at the LSE, Dr Stefan Ingves, the chairman of the Basel Committee for Banking Supervision, made the point that Brexit was in practice neither here nor there in terms of financial stability, because the Basle Accords set the stability rules for all the major countries. How much capital a bank needs is a different and much more difficult question. Today banks have much more capital than ten or twelve years ago, but whether it is ‘enough’ is a hard question. Banks still have much less capital than they were required to have before the early 1970s.
How liquid are trading books?
In an environment where transactions take place off the balance sheets of banks through the process of securitisation, and hedge funds play a greater role within the system which are subject to a less intrusive framework of supervision than banks, the range and depth of trading book liquidity is important. As banks have been obliged to hold more capital they have economised on capitalising less profitable trading books in repo, equity and other securities markets. There is a general recognition that bond and equity markets are less liquid than they were. How much less liquid is not clear. Bank of England economists have noted that banks play a reduced role in providing liquidity in the gilt market, but market practitioners such as investment funds have offered other sources of liquidity.
Central banks are good at pumping money in during a crisis but can they take it out?
Over the last forty-seven years since the collapse of the Bretton Woods system, central banks led by the Federal Reserve Board have dealt with a succession of crises. In general, they have made generous amounts of liquidity available. They were effective at putting cash into the system: in the Mexican crisis, the Asian, Russian and Long Term Capital Management crises in the 1990s, the Tech Wreck in 2000 and in the Great Financial Crisis between 2007 and 2009. Whether they will be as deft at draining it out is less clear, as is the question whether actions taken to remedy an immediate crisis store up future challenges.
Will the Federal Reserve be able to play the role of international lender of last resort again?
In the Great Financial Crisis, the Federal Reserve took on in practice, much of the role of an international central bank and lender of last resort. In a similar way that the Bank of England developed the lender of last resort role in the London money market in the 19th century, which was codified in Walter Bagehot’s book Lombard Street. Whether the Fed will have the scope to do so again is unclear. Legislation passed since 2008 will constrain the Fed’s discretion and in an economy-where the US plays a smaller direct role will potentially blunt its effectiveness even though the dollar is a reserve currency under its control.
The specific financial stability challenges that London has as an international financial centre
London as an international financial centre presents a particular challenge to the Bank of England. Unlike sterling it has no control over the currencies such as the dollar, euro and yen that make up the international financial markets. If things need to be stabilised to prevent an illiquid market leading to a generalised insolvency, it cannot take necessary measures in the way that it can in relation to sterling. In a world where debt is three times national income there are huge flows of liquidity, scope for asset price bubbles that often need to be challenged and it is not clear which institutions have the capacity and resources to manage these flows or the will power to do it.
This blog is based on a speech that Warwick Lightfoot delivered to the conference on Financial Regulations Post-Brexit organised by the London School of Economics on 12 September 2018