This is the third chapter of a five-part series covering Brexit’s impact on UK financial services. Click here for Part II.
Financial services are crucial to the British economy: altogether, the industry produces annual revenues of approximately £200BN, contributing approximately £60-67BN in taxes per year. The financial services industry also contributes a trade surplus of approximately £58BN to the UK balance of payments annually. Therefore, the effects of Brexit may be felt more broadly than in the direct EU business transactions, according to research by Oliver Wyman as discussed in an earlier article.
Evidence suggests that the UK’s financial services industry’s prosperity is attributable to EU integration and the Single Market. Therefore, the realities of Brexit could lead to significant shrinkage in this industry. Some commentators such as Nicolas Véron believe that this may lead to a negative impact on the national economy and not just the City.
“The jewel in the crown for London is the insurance sector due to the high concentration of talent”. Dr Richard Ward, Former CEO Lloyd’s/ Non-Executive Chairman Brit
As a leading financial centre, the UK has a significant proportion of business generated from EU-related activities as illustrated in Figure 1, according to the research by Oliver Wyman.
In order to estimate the potential impact of Brexit on the UK’s financial services industry and GDP, the range of services and clients are important considerations.
The services as illustrated in Figure 2 include providing specialty insurance for complex risks; trading bonds and equities, hedging interest rate and foreign currency exposures; asset management; providing data and technology services to businesses and consumers; capital raising; clearing and providing the market infrastructure.
The Financial Services Ecosystem
The financial services industry operates in an ecosystem comprising of various financial and related professional services firms. The degree of interdependency within the financial services ecosystem means that the impact of Brexit may extend beyond business transacted directly with EU clients. For example, if a firm loses access to serve EU clients it may also lose the scale to operate profitably in the UK and may, therefore, exit completely. Additionally, an activity operating adjacent to another related activity may relocate if the activity it is co-dependent on happens to leave the UK as supported by the Oliver Wyman research. The impact on financial services is discussed further in the next article.
The benefits of this ecosystem are set out below,
The Short-run Implications
The initial impact of the referendum results appears to be a weaker sterling, a rise in inflation, and increased cost of borrowing. The Oliver Wyman report produced for CityUK, and titled –The impact of the UK’s exit from the EU on the UK-based financial services sector provides a more detailed analysis of the short-run implications on the UK financial services.
“Brexit is using up a lot of senior management oxygen.” Jacob Nell, Chief UK Economist, Morgan Stanley
Data from the FCA published in September 2016 indicated that approximately 5,500 UK firms relied on ‘passporting’ to conduct EU-wide business according to the article by Jill Treanor.
“Passporting is a very efficient way for our customers to access Lloyd’s specialist underwriting expertise. The passporting regime results in minimal reporting and no additional capital requirements under a single regulator.” Hayley Spink, Brexit Programme Director, Lloyd’s of London
Assuming that the UK ends up with reduced access to the single market, the impacts across the various financial services sectors based on the quantum of EU-related business that may be lost are summarised as follows:
The article by Julia Kollewe provided useful insight into how the Specialty Insurance sector may be impacted by Brexit: ‘Unless agreements were reached with individual member states, UK specialty insurers and brokers would not be able to service EU clients’. The entire value chain, including portfolio management, risk management, underwriters and brokers may need to move to an EU entity. Some leaders in the Specialty Insurance sector, including Lloyd’s CEO, are considering cities such as Dublin, Brussels and Frankfurt. This is a key consideration for Lloyd’s as the business could lose up to £800 million of premiums from loss of passporting rights (representing 4% of the business). Although, nearly £3bn could be at risk, as 11% of Lloyd’s premiums comes from continental Europe.
“In the short run the UK economy may be negatively impacted by losing consumers who are big spenders and contributors to the economy.” Nicola Horlick, CEO, Money & Co.
The Long Run Implications
It has been estimated that by 2030, GDP may be between 1.5 per cent and 3.7 per cent lower than if the UK remained in the EU. Real wages are forecasted to fall by between 2.2 per cent and 6.3 per cent, and consumption to fall by between 2.4 per cent and 5.4 per cent, according to the research by the National Institute of Economic and Social Research. Real wages and consumption may decline more than GDP in the long term as a result of trade deterioration and a shift towards savings. However, if interest rates became negative this could lead to more consumption.
“Brexit was not about economic benefits”. Dr. Richard Ward, Former CEO, Lloyd’s, Non-Executive Chairman, Brit
The economic indicators are further discussed in order to estimate the impact of Brexit on the UK economy.
UK GDP Growth
Most estimates suggest that GDP will be negatively impacted and could be materially lower in the long run when the UK leaves the EU. According to economist Richard Portes, leaving the EU may lead to a 1% reduction in GDP in perpetuity. A lower GDP will result in lower public spending.
To some electorates, it initially appears that leaving the EU may improve the UK’s public finances by £8bn a year, assuming that the UK doesn’t agree to an alternative deal that involves contributions to the EU budget, however, the net impact may be negative both in the short and long run due to increased uncertainty, leading to higher costs of trade and possibly reduced FDI. The impact on public finances has been estimated by the National Institute Of Economic and Social Research to be between £20 billion and £40 billion by 2019. Putting this in context, leaving the EU may lead to an additional two years of austerity measures, such as spending cuts and tax rises in order to balance the public finances according to research by the Institute for Fiscal Studies.
“If the long run cost of Brexit is only 3%of GDP as estimated that represents losing only 18 months of growth. The global financial crisis of 2008 led to GDP being over 10% lower, therefore, on relative terms, although not insignificant, 3% is not a disaster.” David Miles CBE, Former member of the MPC
Sterling Exchange Rate
The pound went approximately 20% down against the dollar immediately following the Brexit vote, dropping from around $1.33 to £1 to $1.22. Whist the devaluation is positive for exports; the impact to the UK is a net negative as the UK is a net importer of goods. However, the exchange rate has since recovered to be about 15% lower, which economist David Miles argues that, it is possible the GBP was overvalued given the level of the current account deficit.
“It is possible the GBP was overvalued given the level of the current account deficit and this is perhaps a necessary correction.” David Miles CBE, Former member of the MPC
Foreign Direct Investment (FDI)
As the fourth largest recipient of foreign investment after China, US and Brazil, the UK is seen as the best route to gaining access to the EU according to research by the Centre for Economic Performance at the London School of Economics. Foreign direct investment into the UK appears to have reduced due to the heightened uncertainty following the referendum result and investors typically put a hold on investment plans until there is more clarity.
“Following Brexit some investors worry that the UK may behave like an emerging market economy where the government tightens policies to attract foreign investors after a negative shock”. Jacob Nell, Chief UK Economist, Morgan Stanley
With the UK’s current account deficit (CAD) at its widest since WWII and the widest in the G10 according to research by Morgan Stanley, this is giving rise to the thought among investors about the UK behaving like an emerging market (EM), as the indicators (such as lower levels of domestic savings) point to a high level of dependence on foreign investor appetite for UK risk. The current account deficit, combined with the UK’s perceived overvalued housing market suggests that Brexit may bring significant disruption and poses a risk of a potential UK break up, further discouraging investors.
Weak economic activity and a rise in unemployment due to the uncertainty, and a rise in inflation above the 2% target due to the depreciation of sterling were all expected following the referendum result according to the BoE.
“The weaker sterling resulting in higher inflation could be considered the economic price of Brexit.” David Miles CBE, Former member of the MPC
The key economic indicators have recovered from the lows observed immediately after the referendum result, suggesting that the short-run outlook has been stronger than expected (although investment remains subdued). Although the net effect of the long run impact remains unclear, the overarching perception suggests a negative outlook.
Stay tuned for the fourth chapter of Peace Ani’s overview of Brexit’s impact on UK financial services, published tomorrow.