UK Finance and the EU

It is often said that a camel is a horse designed by committee. Their humps and famous bad tempers are supposed to reflect the inconsistent compromises often made on committees. With financial services the compromises may be less obvious than camels’ humps, but the consequences can be much more serious.

 

The decision of the EC to create a European Banking Union (EBU) in response to the financial and sovereign debt crisis is a transformational event. It crosses the Rubicon of pooling of fiscal resources of member states.[1] While euro zone members are required to join (and non euro zone members are encouraged), the EBU raises important issues for members choosing to remain outside its perimeter. The UK’s in-out referendum is an opportunity to address some of these issues. This blog summarises four inconsistencies discussed in our latest National Institute Economic Review.

 

Assuming no more countries join the EU, by 2020 at least 23 of 28 EU nations will be members of the EBU. This means that there will be two major central banks both carrying out separate monetary policy and banking regulation within a single market in which the free internal movement of capital is a core principle. The ECB will act on behalf of at least 23 members while the Bank of England will act only for the UK. But the counter-weight is that the UK hosts the major share of euro wholesale financial markets.

 

The first issue is the sense of having two sets of financial regulations in one internal market. While the EC has stated that there should be close cooperation, it is clear that there are already substantial differences in regulations. Banks can raise funds on one side of the EBU perimeter and transfer them internally to move funds across borders. Different macro-prudential regulations can also be partly mitigated by cross perimeter flows. It is highly unlikely that sterling would seamlessly adjust, to prevent arbitrage with possible unintended consequences.

 

A second issue relates to different interests in resolving failed banks. The ECB is directly responsible for 130 largest banks in the EBU. Yet some of these banks have systemic operations on both sides of the EBU perimeter.[2] In a resolution process the ECB and Bank would act for different taxpayers with fiscal consequences for the other. Even with legally separate subsidiaries, national interests dominate. It was Lehman’s integrated cash management system that meant that cash could be drawn from its London subsidiary overnight.

 

A third set of issues is around location policy. The Treasury recently won a valuable concession from the ECB that it would supply emergency liquidity to Central Clearing Counterparties trading in euro assets.[3] The perimeter of the EBU can again raise important issues. The swap would leave the UK responsible for any capital loss (so consistent with regulatory responsibility) and the currency risk in making good a shortfall.[4]

 

Fourth, the design of EBU institutions reflects the political reality of delivering monetary union ahead of political union. The ECB was created as a monetary institution without regulatory powers and therefore awarded a high degree of independence. But by shoehorning financial regulation into Article 127(6) of the Treaty on Monetary Union, ultimately fiscal decisions can be taken with surprisingly little political accountability.

 

This matters because the solution to some of these issues is for the UK to join the EBU.[5] The UK would benefit from sharing the contingent fiscal risk of a banking sector over four and a half times GDP with other member states. But unless the UK joins the euro zone, it cannot join the ECB’s Governing Council. This would imply passing regulatory responsibility for this vast contingent liability to an institution beyond its permitted control.

 

At present the EU integrated financial market looks more like a camel than a horse. But there are sensible answers to these issues. The question is whether negotiators can find a coherent way to accommodate two major central banks in one integrated capital market.

 

[1] While the funds for the Single Resolution Mechanism will technically come from banks the governments are their backstops in a systemic crisis.  

[2] Six of the EU Globally Systemically Important Banks operate from the UK (two are Swiss subsidiaries).

[3] The UK won an appeal at the European Court of Justice on the grounds of competencies and not on the ECB’s point of principle.

[4] Swaps between central banks have a checkered past, e.g. the Bank of England and Bundesbank currency swap in 1992.  

[5] It appears increasingly likely that Denmark, the second opt-out country, will join the EBU.

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