Introduction
In June 2016, the world was taken by surprise when the United Kingdom (UK) voted to leave the European Union (EU). Observers considered this vote an “unusual” one because many people thought of the UK as a progressive economy that stands for economic integration and European progression. Therefore, the choice to leave the EU economic bloc contradicted this view. Since then, the process of exiting the EU has proved to be long and complex (Deloitte, 2017). Based on the protracted nature of the “Brexit” vote, many people have not understood the full impact of the move. This paper seeks to fill this research gap by providing a focused understanding of the effects of “Brexit” on the country’s financial sector. Although the scope of this report is sector-wide, there is a deliberate attempt to explain the impact of the UK’s impending exit from the EU, relative to the international aspects of its financial operations. Here, the scope of the analysis is centered on understanding the threats and opportunities of the move and the models of economic relations between the UK and the EU. However, first, it is essential to review the theories of economic integration in the EU.
Theories of Economic Integration
Neofuctionalism
The neofunctionalism theory was deemed a popular theoretical basis for understanding economic integration in the 1950s and 1960s (Tanja, 2013). In 1958, Ernst Haas used it to explain why the European Union formed an economic bloc in a book titled, “The Uniting of Europe” (Moravcsik, 2013). The theory focused on explaining how cooperation among countries could lead to economic gains and political integration (Kahler, 2013; Papa, 2013). Functional integration is one idea that was proposed by the theory’s proponents when they said that economic convergence leads to other forms of cooperation (Kahler, 2013; Papa, 2013). For example, they argued that the free movement of goods and services often led to the growth of money markets through the formation of a common currency – Euro (CIVITAS Institute for the Study of Civil Society, 2017). The theory also posits that political integration is a by-product of economic convergence because supranational players often want to safeguard their interests when countries merge their economic values (Pradhan, Dasgupta, & Bele, 2013). Based on these tenets of the neofunctionalism theory, its proponents view the European process of integration as sustainable. They also argue that it would culminate in the creation of one political unit that would probably be based in Brussels (CIVITAS Institute for the Study of Civil Society, 2017).
Intergovernmentalism
The theory of intergovernmentalism evaluates the roles of independent governments in the integration process. While some people fear that governments may become obsolete in an integrated system, this theory proposes that their role cannot be obliterated because they are the legal custodians of the integration process in the first place (Bickerton, Hodson, & Puetter, 2015). Proponents of the theory argue that faster integration is achieved when nation-states have converging national interests, while slower integration is evident when the interests of the same units diverge (Bickerton et al., 2015).
The intergovernmentalism theory is partly supported by the fact that the European Union primarily operates on the premise that member states need to contribute a specified sum of money to make the entity operate well. For example, in 2013, the UK contributed 14.55 million Euros to the union’s budget (The Statistics Portal, 2018). At the same time, Germany contributed 26.11 million Euros to the same fund (The Statistics Portal, 2018). These statistics reveal that nation-states are the primary players in the formation of the EU. Therefore, their contribution is pivotal to its operations.
Liberal Intergovernmentalism
Liberal intergovernmentalism is another theory explaining the integration of the EU and its financial markets. It proposes that nation-states have selfish interests during the integration process and they are free to negotiate with other entities to create win-win situations for all parties (Puetter, 2014). Package deals and side payments are considered by-products of the negotiation process, but the common understanding among nation-states, which are considered the main players in the integration process, is that they will stick to their end of the deal. The liberal intergovernmnetalism theory differs from others highlighted in this paper because it does not consider supranational institutions as important players in the integration process. The theory has been applied in negotiations between the EU member states and its international partners. In events where third parties do not feel that the regulatory framework provided by the EU aligns with their interests, they choose not to engage in further negotiations. For example, in 2015, the US refused to include its financial services in its economic trade agreement with the EU because it believed that doing so would complicate its regulatory framework (CIVITAS Institute for the Study of Civil Society, 2017). This example shows that liberal intergoverntalism is applicable to the EU’s operations because it defines how countries create package deals for their markets when negotiating with others.
Institutionalism
The theory of institutionalism is deemed a new area of theoretical investigation in economic integration. Unlike the liberal inter-governmentalism and intergovernmentalism theories, it considers institutions as the main actors in the integration process, and not nation-states. Proponents of this view say integration could be best fostered when all players follow a predetermined framework of institutional rules (CIVITAS Institute for the Study of Civil Society, 2017). Three types of institutionalism define this theory. The first one is the rational choice institutionalism, which advocates for the adherence to a strict set of institutional rules. The second one is sociological institutionalism, which requires players to adhere to a set of norms or values of operation. The last one is historical intuitionalism, which encourages countries to follow the vision of the EU founders in their operational plans. The active involvement of big financial institutions in promoting cohesion among EU member states and those of the European Economic Area (EEA) have supported the institutionalism theory. For example, since 1998, the European Investment Bank has provided more than 150 million Euros in grants and interest rebates on loans to achieve the same goal (Europa, 2016).
Models of Economic Relations between the UK and the EU
Swiss bi-lateral Model
Some economic experts have proposed that the UK could adopt a similar model to the Swiss bilateral agreement with the EU in the post-“Brexit” era (Brexit Financial, 2017). The model stipulates that the UK would have to adopt specific EU laws to access the single market. However, the problem with this model is that the EU has given the Swiss preconditions for implementing the agreement. Some of them involve contributing to the EU and being part of the Schengen membership plan. The UK is unwilling to accept such conditions because it was the main premise of the “Brexit” vote. Additionally, the EU has expressed its unwillingness to allow other countries to adopt the Swiss bi-lateral model because it is in the process of renegotiating it.
Bespoke Free Trade Model
One option the UK has expressed a willingness to pursue is the bespoke free trade agreement. Currently, experts are examining new free trade agreements that the UK could pursue, including the Canadian model, to establish which elements of the negotiations they could include in the UK. If the bespoke framework is successfully adopted, it would mean that the UK’s financial service sector would have limited access to the EU single market (Pritchett, 2015). This option would not only affect the financial service sector but also other service-oriented businesses as well. Two advantages will suffice for the UK. First, there would be no need to accept the free movement of people. Secondly, there would be no need to make financial contributions to the EU. The free trade model would also allow the UK to renegotiate financial service deals with other non-EU countries without any ramifications on its financial operations.
World Trade Organisation (WTO) Model
The WTO model has been highlighted as the last resort for the UK if all other frameworks highlighted above fail to work. This model simply means that the country would trade with the EU-27 states and the EEA under WTO rules. Under this framework, the UK would trade with its partners as a “third country.” Using the same model, there would be no preferential trade agreement between the EU and the UK because the common rules binding their interactions would primarily be based on WTO principles (Rumford, 2014).
Opportunities and Threats of “Brexit”
Threats
Possible Loss of “Passporting” Rights
The possible loss of “passporting” rights may affect the operations of the UK financial service sector because it may trigger the need for institutions to review their business models. As the Grant Thornton UK (2017) points out, financial institutions would have to evaluate which markets they want to venture into and the cost ceilings that they may need to establish while doing so. Several operational considerations emerge if there is a loss of “passporting” rights. For example, there are risks of regulatory non-compliance, the imposition of additional prudential agreements, and the disruption of company operations already set up to exploit the cordial relationship between the EU and the UK. Similarly, companies that offer financial services may have to make decisions regarding whether to set up operations in the EU to continue enjoying the benefits of moving freely within the region, or remain in the UK and comply with its requirements of operating in the EU. Alternatively, financial firms operating in the EU may have to set up operations in Britain and operate as “third country” firms. All of these options have significant capital and operational cost implications for the UK financial service sector.
Increase in Cost of Doing Business
UK’s exit from the EU has led to a downgrade of the country’s credit rating (Parker, 2017). This outcome affects the borrowing costs of money loaned to traders in this market. Investments and financial structuring decisions are also possible tenets of the financial markets that are likely to be affected by the same downgrade. Grant Thornton UK (2017) adds that capital and funding management processes are also likely to be influenced in the same manner. Furthermore, redemption rates could increase because of a change in investor perception of the strength of the UK financial services. Additionally, investors could have a heightened sensitivity to possible issues that could emerge in documenting financial transactions between the UK and EU member states (Sharma, 2014). They are also likely to be concerned about the regulatory compliance frameworks affecting their financial operations. For example, hedge funds and investment management firms may rebalance their portfolios to align with new product descriptions. Offer documents may also be reviewed, but there needs to be a greater reassessment of financial business transactions, which could possibly lead to an increase in the cost of doing business.
Fluctuating Interest Rates and Currency Volatility
The exit of the UK from the EU could cause instability in the financial markets due to fluctuating interest rates and currency volatility. These areas of financial market operations are likely to have a knock-on effect on liquidity funding and capital management structures. UK regulators have already expressed their concerns regarding such outcomes and businesses have realized that they must revamp their risk management strategies to address these concerns (Parker, 2017).
Opportunities
Entry Point for Long-term Investments
There is little doubt among investors that the impending UK exit from the EU comes with many unknowns. Markets are still struggling to make sense of the kind of risks they face and for how long they would last. However, the uncertainty that characterizes the markets is a good entry point for long-term investors to trade because they adopt a protracted view of the markets without necessarily canvassing through the volatility of financial operations (Brooks, 2017).
Legal Financial Robustness
Proponents of the “Brexit” vote often advocated for the UK’s exit from the EU because they felt that the country’s financial services were tied to the fortunes of the EU member states. It was increasingly difficult for UK regulators to protect the country’s financial markets from impending crises because of capital adequacy requirements and financial transaction taxes associated with EU legislation (Leadsom, 2017). The exit from the EU would bring more legal robustness in the UK financial sector because regulators would not be tied to EU laws and would finally have the opportunity to work towards advancing the interests of the UK financial sector.
Taking back Control
The UK financial sector employs more than 2 million people (Taylor Wessing LLP, 2017). Their fate was tied to that of EU member countries. As such, the UK has lacked the opportunity to control its destiny; instead, it has been looking up to other markets to shore up its interests. The exit from the EU will help it to gain back control of its financial markets and encourage the country to re-establish new relationships with its EU partners. This opportunity makes sense to the UK financial service sector because it has always been internationally focused, as opposed to European-oriented.
Conclusion
This paper shows that the UK’s impending exit from the EU comes with multiple threats and opportunities for its financial service sector. The theories of neofunctionalism, liberal intergovernmentalism, intergovernmentalism, and institutionalism highlight the role of nation-states and financial institutions as the main players in the EU financial sector. Their actions in the post-“Brexit” era would have to be framed within different models of trade, including (but not limited to) the Swiss bi-lateral, WTO, and bespoke free trade models. Based on these operational frameworks, the impact of the UK’s exit from the EU is likely to be dominated by discussions about regulatory compliance, access to financial markets, interest rate fluctuations, and currency volatility. All these issues would be pivoted on the need for the UK to take control of its financial sector and to enhance its international influence in the industry, as opposed to shoring its influence in regional markets.
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