The UK vote yesterday to leave the European Union will have widespread consequences for financial markets, creating both opportunities and problems.
Brexit may increase global financial stability since heterogeneous financial markets and economic systems increase financial stability (as was discussed here on Vox in 2013; see Danielsson 2013), provided the British regulatory system ends up being sufficiently different from the European system.
However, the gain may be rather small. While ‘Leave’ campaigners trumpeted Britain’s ability to design its own regulatory system post-Brexit, most market participants will still need to trade in Europe and so will in effect be bound by both sets of rules.
Instead, a more likely outcome is that both financial systems end up becoming less efficient and more unstable.
The markets are reflecting a substantial shock, where their initial reaction indicates weakness for sterling and global asset markets. Not surprisingly, some of the largest losses are at banks.
But do these market gyrations matter from a systemic point of view? It is tempting to say ‘no’ – that markets are merely doing their job of discounting news, good or bad, and that the system will adapt and move on. However, it is not all that clear-cut and, while unlikely, the probability of a consequent systemic crisis is certainly not zero.
The stability of the British financial system and its rather fragile economic growth are dependent on the near-zero interest rates to the extent of this being an addiction.
The government is highly indebted; pension funds are underfunded; and the financial system has demonstrated limited willingness to fund the small businesses likely to generate economic growth. All this at a time when loan books are underpinned by real estate valued on the basis of a very depressed yield curve.
It is not hard to imagine a bond buyers’ strike echoing that of the ‘Gnomes of Zurich’, who in the 1960s declined to entrust their assets to the UK. Given the very high sensitivity of bond values to inflation, as is discussed on Vox in Csullag et al. (2016), a vicious feedback loop could ensue with sterling falling, inflation rising, yields increasing and bond prices falling.
If that happens, bond prices might fall slowly, over many years, or very quickly indeed if current bond holders are assuming they can insure their portfolios by selling as prices fall. The latter outcome could well turn into a systemic financial crisis.
What options would the Bank of England have? It could seek to maintain nominal asset prices, especially in real estate, by pumping liquidity into the financial markets, thereby funding banks on ever-more generous terms (the Chinese model). Along the way, it accepts the risk of higher future inflation. Or the Bank could refuse, triggering a collapse in real estate and widespread bankruptcies, though this would likely be followed by the Bank using large amount of money to support the survivors.
European policymakers dislike three things about Britain’s financial sector: its objections to many European regulatory initiatives such as Mifid II, FTT, and bonus regulations; its insistence on remaining outside of the euro; and its size.
All of this will change, leaving Europe free to design the regulation it wants.
It will do so with an eye to reducing the competition from the City of London, seeking to enhance the roles of Frankfurt and Paris in European finance. It is easy to do so by crafting regulations that encourage activities to move to Europe, and this temptation may prove hard to resist.
There are several reasons why that might increase systemic risk both in Europe and the UK. The new kinds of risk taking would happen under the watch of regulators who have had insufficient time to develop the appropriate expertise; the new contracts required would not be written under UK law and would not have been tested or have the legal certainty they currently have; or Brexit might curtail the sharing of financial information at the European level (e.g. Emir), making it much harder to construct a picture of Europe-wide risk exposures.
There is also a risk that the European financial system will be less able to play its role of efficiently allocating resources from savers to companies. Clearly the Capital Markets Union, for example, will lose a key advocate.
The homogeneity of the financial system within Europe will likely be increased, supporting the traditional banking sector at the expense of new disruptive financial technology. The UK, supported by smaller like-minded countries, has been a major proponent of a more liberal and diverse financial system in which banks’ overwhelming dominance can be reduced.
The end result seems likely to be a more highly regulated and inefficient European financial market, freed from the discipline imposed by competition and relying on protectionism to maintain barriers to entry. This does not bode well for European savers or for entrepreneurs.
Britain and Europe have fundamentally different approaches to regulation. British regulation is based on common law, assumes that regulations should be applied only where a clear need has been demonstrated, and relies to a substantial extent on transparency and self-regulation. The European approach, by contrast, is based on civil law and assumes that as much conduct as possible should be regulated in a prescriptive way.
The greater flexibility of the British approach has played a key role in London becoming the dominant cross-border financial centre with Europe.
Many British voters have a strikingly negative image of European regulation as over-prescriptive and impractical, but the record is in fact rather more mixed. British policymakers have successfully opposed some areas of regulation that appeared excessive, for instance within Mifid II, but have also been largely responsible for regulations that appear to create new systemic risk where it did not exist before, such as the Solvency II insurance regulations.
If UK policymakers are able to reach an agreement with the EU that allows continued access to the single market that somehow does not require the British exporters to stick to EU rules – a rather unlikely outcome – they might be able to craft a lightweight and nimble regulatory structure, allowing the British financial sector to continue to prosper with the European passport and be even more successful in winning over new markets.
A more likely looking outcome, though, is that policymakers achieve very little.
The legislative and regulatory workload required to shift the entire legal basis of financial regulation from Brussels back to London is immense, so for many years, regulators will have to run to keep still.
Given the level of thoughtfulness of the arguments advanced prior to the referendum, it seems unlikely that the pro-Brexit camp (or anyone else) has spent much time preparing for this phase, so an extended period of confusion appears unavoidable. And, even when this workload subsides, obeying EU regulations will be the likely price of access to the European markets, and so for all but the purely domestic entities (which tend to be small) the landscape will change little.
At the same time, Britain will lose any ability to influence European regulations from the moment it invokes Article 50. It may well be that the best the UK can hope for is an EEA-type arrangement, where it is allowed access to the European markets, at the expense of having to adopt European regulations without the ability to influence them, as discussed by Dhingra and Sampson (2016).
If the UK does lose some of its financial sector to Europe, its dependence on finance will be reduced. While coming at substantial economic cost, this also has the potential to increase the resilience of the British economy, reducing UK systemic risk or at least shifting it over to Europe.
In theory, the Brexit vote yesterday creates an opportunity for both the UK and the European Union to improve the resiliency, efficiency and quality of service of their financial markets. Unfortunately, it is more likely to induce regulatory paralysis due simply to the vast workload that has been created.
Europe, with its most liberal large country gone, is likely to sharply increase its regulatory intensity, with the focus on politics and protectionism rather than efficiency, resulting in a more costly, more homogenous, and consequently less safe financial system.
The likely scenario is for UK regulation to become more onerous, with many participants under dual regulation from both the UK and the EU, with the UK having lost the ability to influence European regulation in a constructive manner. Along the way, the City of London might see a substantial erosion of its major international finance centre status.
In a worst-case scenario, a vicious systemic feedback loop for the UK could ensue.
Authors’ note: We thank the Economic and Social Research Council (UK). Grant number ES/K002309/1.
Csullag, B. J. Danielsson and R. Macrae (2016), "Why it doesn't make sense to hold bonds", VoxEU.org, 27 June.
Danielsson, J. (2013), “Towards a more procyclical financial system”, 6 March.
Dhingra, S. and T. Sampson (2016), "Life after Brexit: The UK’s options outside the EU", VoxEU.org, 4 March.