The Austrian school economist Böhm-Bawerk once conclusively demonstrated that the economic law always in the end triumphs over the political law. Politics can try to delay the hour of truth at rising cost in terms of money and human welfare, but in the end the forces of markets and shortage of resources prevail. One should have this in mind when thinking about the landscape of financial services in a post-Brexit Europe: It is about relative shortages, comparative advantages and long term strengths.
Based on the political will of the EU-commission and the majority of the rest-of-EU 27 heads of state the negotiations have been heading into a trap that can best be described as a prisoner’s dilemma. While the UK tries to achieve a deal focusing on free trade along the lines of the CETA deal the EU has signed with Canada, the negotiating team around Mr. Barnier aims for a fiscal compensation in the range of 100 BN before being ready to talk about free trade. These incompatible claims make a no deal scenario possible if not likely. However, the result will be largely independent of the outcome though.
In a world of cyberspace...
Financial Services deal in essence with a transformation of two things: Risk and Information. These transformation processes are closely linked, as risk transformation effectively is the output of information processes. The result of any risk related process is then the allocation of risk and its coverage by risk taking capacity, e.g. equity capital. This simple reductionist view of things allow us to try to predict what will happen to the components of the financial industry, if and which migrations of people, functions, capital and legal entities will take place or not.
And the results look strikingly different from the prophecies of doom and gloom for London. The reason is the way information transformation takes place nowadays, which is effectively in highly integrated chains of location independent processing steps embedded on computers or in the language of modern digitization: In the world of cyberspace, non-local cloud computing, accessible from anywhere on the globe, easily disaggregated at any interface of the process as data are shuffled back and forth to produce decision relevant throughput or output. At the same time we already do have a global capital market allowing to do the same to risk itself, using well established derivative products.
So, when both risk and therefore capital allocation as well as information are non-local already, what will determine any movement of human resources in the scale that the pundits of media, regulation and politics seem to anticipate? It is quite simple: It is the customers attracting a certain service level. Insofar as this is something that does not change with Brexit at all, I conclude that most of the actual movement of a limited amount of people to Frankfurt has more to do with a Brexit-triggered review of customer service strategies than with Brexit itself.
Let us take a look at the key sub-industries of financial services: Commercial banking, investment banking / corporate banking and capital markets, primary and re-insurance, asset management and clearing.
(Almost) nothing will happen...
Actually I predict almost nothing will happen with regards to commercial banking as this part of the industry is not integrated at all in Europe to date despite several banking groups doing business in more than one member country. It is more than 95% business within the countries and less than 5% cross border, mainly in the form of payment services which will stay integrated via SWIFT anyways.
In investment banking we have to separate the transactional M&A and issuance business from the capital markets trading business.
In the former proximity to the client is a key success factor. Is that new pre- or post-Brexit? No, it is not. What we are currently observing in terms of moving some staff to Frankfurt by some investment banks has insofar more to do with them taking a close look at the global distribution of clients and staff and aligning those more closely. In other words: Anglo-Saxon banks want to and will strengthen their market position in continental Europe, especially in Germany because they view it as an opportunity as the market continues to recover from the low of recent years.
With regards to capital markets trading also some of the client related business might move while the bulk of prop-trading is non-local and will stay wherever it currently is. There might even be some movement back to London because shifting people between hubs is expensive and the bill could be reduced by balancing movement of people in areas unaffected.
Primary insurance is an altogether national business, even in many cases regional business. It will probably consolidate, which is a long term trend resulting from competition, cost pressure and low asset management returns resulting from the zero-interest environment in the Euro-zone; but that will not trigger any cross border movement of people. Re-insurance on the other side is a fully global business. In terms of market share it is being dominated by players in German-speaking Europe, namely Munich-Re and Swiss-Re. The participants in this market are by and large subject to identical rules of regulation, accounting, transparency and risk cycles. 80% of their business is conducted on two large conferences and not subject to any cross border restrictions because that would be an absurdity given the nature of re-insurance itself. As they play in a global market they have been doing so without utilizing any element of the European common market and insofar nothing will change really.
Asset management has gone through a remarkable transformation in recent years which has catapulted a small number of US firms, especially Blackrock and Vanguard , to the top end of players. These dominating forces have fully understood how to disaggregate the information and transaction processes defining their businesses. That is why they are strategically so successful. They are already in every market locally present where they want to be in terms of securities handling, clearing, custody and settlement. Their distribution model has always been independent of the structures of the common market, because it is either based on local cooperation, institutional clients or on web-based direct access. Next to nothing will change here except if the big players decide they want to strengthen market penetration in the EU-27.
…except (maybe) for clearing
That leaves us with clearing. This is the one part that the Euro-zone regulators, the SSM and the EU-Commission will try to claw back from London. Presumed insufficiency of regulatory oversight in the UK as compared to the nimble continental bureaucracies and local matching of systemic risks with capital allocation serve as arguments to demand this. This, at least in theory, could affect a substantial number of jobs in the City of London, the estimates going anywhere from 50.000 to 85.000. In that number though lies the crux of the matter: To wag the dog will not work. This is a matter of available talent. A few comparisons will demonstrate why. While Frankfurt, the biggest financial center in continental Europe has – depending on estimates – 50.000 to 60.000 people working in the sector, the number in the City of London is over 650.000. Just force-moving clearing to any location in Europe simply will not work as there is not enough talent around to do the job. In trade economics a situation like this is called comparative advantage and does not only apply to trade in goods, but also to trade in services.
That does not mean that in the medium term the EU-27 will never be able to establish a working clearing infrastructure, but it will take time, more time than is available to the parties to settle their divorce and trading disputes. And cutting off continental banks from London based Euro-clearing will hardly be an option. So the participants will have to find some accommodation and agreement for the future, whatever the hard words and demands have been up to then.
A talent game
So where does this all lead? We will probably see the movement of 10.000 – 15.000 jobs from London to the continent, the bulk of this going to Frankfurt, which will expand its dominance over EU-finance. 10.000 is a lot for Frankfurt, but it is not the bloodletting doomsayers predict for London. It is more like the size of the measurement error of the number of people working in the city.
Amsterdam, Paris, Dublin and Brussels have already lost the race from what can be said observing relocation decisions of the last 12 months. Frankfurt offers proximity to the relevant regulatory institutions, the ECB and the most stable legal and national regulatory environment as represented by the Bundesbank and the BaFin. Transparency of rules turned out to be more relevant and attractive to decision makers than the promise of tax holidays or other subsidies. Dublin might regain some lost ground once the fixed income issuance market gets going again, but given the interest rate policy of the ECB it is difficult to predict when that could really happen.
The limited movement to the continent comes at a price for EU-players: The expanding dominance of Anglo-Saxon players in investment banking in their own home market. Is that something bad? No, it is not. It comes with a healthy dose of knowledge infusion that the lagging local players were not able to generate themselves, which in turn shows the sheer dominance of the sector rooted in a much longer tradition of global trade, free markets, low regulation environment and international reach that has created the City of London we see today: Faster, cheaper, better, nimbler and more innovative than all of its near abroad competitors.
In the end this will be a talent game. Talent needs to be grown and nurtured over generations to create the uniqueness of London`s financial acumen. As the UK moves towards more international openness while the EU is stumbling down the road of more bureaucracy, regulation and state control the gap will widen, not close.
