Anyone who has recently visited the City will realise that London has become the New York of Europe. With its dazzling and ever-changing skyline, it is apparent for all to see that the British capital is booming, probably more than any other European centre. At the same time, however, there is a risk that the city’s extraordinary transformation will deceive UK citizens into thinking that the growth is endogenous, based on genuine internal strengths, and to overlook its external dimension, above all in a European context. This is especially dangerous in light of the forthcoming British referendum on EU membership.
London’s pre-dominance as a financial centre in the EU is a fairly ‘recent’ phenomenon, and its growth over the last two decades has coincided with the achievement of the single market, which allows for the free movement of capital and the free provision of goods and services throughout the EU. Each country was allowed to develop in its own area of comparative advantage. Germany specialised in manufacturing and cars, London, and also other parts of the UK, specialised in finance and business services. This led to a huge transformation, and those who lived in the City at the end of the 1980s would hardly recognise it today.
Back in the 1960 and 1970s, depending on the indicator used, London was on a par with Paris as a financial centre. London was more international and more market-based, whereas the size of banking assets and its contribution to GDP was higher in France. Financial-sector employment was also similar in both centres until about 20 years ago. London’s big bang, however, in combination with the UK’s labour market reforms, the nationalisations in the Mitterrand’s early years in France and later the single market and the prospect of monetary union changed all this. London managed to adapt quickly to serve as a bridgehead for foreign and, most importantly, US financial institutions’ operations throughout the EU.
Looking at the components of the City as a financial centre today, the single-most important foreign group consists of US-domiciled financial institutions, banks, institutional investors and fund managers, and ratings agents. Their presence in the City is clearly related to the EU passporting rules allowing for the free provision of services all over the EU, a facility that has been further enhanced in recent years. A change in the UK’s position within the EU will rapidly have a negative impact on this freedom, and thus have immediate consequences for US banks. This latter effect will have direct economic implications for the UK, as this group is the most competitive compared to the other components, namely the UK banks, other European banks and other foreign banks.
Moreover, the City plays a pivotal role for US banks in arbitraging between both single markets. The City provides the critical mass and infrastructure for transactions as a global financial centre and as an alternative to US or Asian centres. When the US Commodity Futures Trading Commission (CFTC) introduced rules governing swap execution facilities (SEF) in the US at the end of 2013, euro interest rate swap transactions moved almost overnight to London. It is doubtful that this would remain the case if the City ceased to be an EU financial centre.
From a market development perspective, closer association with Banking Union would provide additional protection for the UK. The UK’s exposure to its banks has grown since the financial crisis as one of the few countries within the EU. The country’s total banking assets are more than five times greater than its GDP, which is more than the double that of the EU average. Choosing to opt into the single supervisory mechanism (SSM), and even more the single resolution board (SRB) and fund (SRF), not to mention the European deposit insurance scheme, would provide the UK with a much larger backstop, and possibly better supervision. But this suggestion is clearly taboo.
A large financial centre like the City requires a large single market and/or requires openness towards other economies. But those voting in the UK referendum may not necessarily be aware of the importance of this interconnectedness and what it means for the UK economy. Large parts of British public opinion, especially when dealing with perceived threats from abroad, seem to prefer isolationism as the best way forward. This stance will be detrimental to the future strength of the City.
Karel Lannoo is chief executive of CEPS. This column was subsequently published by the Wall Street Journal, 26 January 2016.