When it comes to Brexit, is the City a help or a hindrance?

We should ask what kind of financial sector we really want. 

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The City of London has always (and not accidentally) baffled outsiders but Brexit has draped a new question over its age-old mystique: is London’s financial sector the UK’s trump card, or its Achilles heel, in negotiations over leaving the EU?

During the EU referendum campaign, the City overwhelmingly backed Remain. It argued that large parts of its franchise depended on being able to sell its services into the Continent. It seemed obvious, therefore, that the City’s access to the single market must be a high-value chip on the EU’s side of the table in the game of Brexit brinkmanship.

Is it? In his most recent intervention, Mark Carney, the governor of the Bank of England, claimed it is the EU that needs the City just as much as the other way round. The City, he pointed out, is “the investment banker to Europe”: half of all equity and debt funding for eurozone companies is raised in London. So, for the EU to cut London off would be an act of mindless self-harm.

The fact is that both claims are true, because the City is not a unitary industry but a shorthand for the nebulous agglomeration of banking, insurance, asset management, legal, accounting and numerous other services that firms based in London (and quite a few in Edinburgh and elsewhere, too) provide to clients all over the world. Brexit will mean very different things for different parts of this diffuse group, and for the individuals, companies and governments that are their customers.

One simple dividing line is between firms that provide financial services to retail customers – the mortgages, bank deposits, investment funds and insurance products sold to individuals – and those whose business is in the wholesale markets: arranging bond or equity issuance for large companies, insuring the insurance companies themselves, or trading in foreign exchange, for example.

The provision of retail financial products is closely regulated by the EU’s Markets in Financial Instruments Directive. This allows British firms to go to other EU member states and seek out clients there without any need for further approval – the so-called passporting system. In practice, the markets for many retail products remain dominated by national players: but in fund management the passport system is indeed in widespread use. Consequently, the fund management part of the City stands to lose from Brexit.

The market for wholesale financial services, however, operates quite differently. When a eurozone business wants to issue debt or equity, or a eurozone insurance company wants to lay off its risks, the client comes directly to London to hire its investment bank or find its syndicate at Lloyd’s. Because the transactions take place in the UK, the City firms involved have no need for an EU passport – any more than they do when they are selling to American or Asian clients. For this part of the City, Brexit matters quite a bit less.

Then there is the infrastructure of the financial system itself: the exchanges on which shares and other financial instruments are traded, and the clearing houses where millions of daily payments are recorded and settled against one another. The City does a lot of this as well.

It differs from either the retail or the wholesale services described above, because it is highly transactional in nature and not intrinsically complicated – and so, in principle, could easily be moved. However, for the same reasons, it is the least profitable part of the sector and the one being transformed most rapidly by automation and digitisation in any case. There would be transitional costs to any relocation – but little net economic benefit to the UK or the EU. Brexit won’t make many winners here either way.

So, there are parts of the City, such as fund managers, that need the single market a lot more than the EU needs them. There are parts, such as investment banks and the wholesale insurance market, on which the EU is quite heavily dependent. And there are still other parts that get neither side very excited, and that the march of technology will probably overtake soon anyway.

Yet there is something perverse about this debate. For beneath it is an unspoken assumption that the City is a lodestone of economic dynamism and a treasure chest of tax revenues and, as such, the grand prize in the Battle of Brexit.

Do we need reminding that, in recent and painful memory, one part of the City – the banking sector – was exposed as something else entirely: a source of catastrophic economic risk and a monumental drag on the public finances, almost single-handedly responsible for the doubling of the UK national debt in the space of seven years?

The irony is even more extreme. For isn’t the financial crisis the event which, more than any other, shattered the public’s trust in our elite and fuelled the anti-establishment rage that led to Brexit? Yet somehow the vampire squid of 2008 has become the golden goose of 2017.

I fear the debate over passports and market access is in this sense, a dangerous distraction from three much more serious facts: that 2008 exposed simple but egregious flaws in the structure of our banking system, for which taxpayers were required to pay; that little has been done to remedy these deficiencies; and that the combination of these first two facts has poisoned public trust in the UK’s financial and political leaders.

With Brexit, and the election of Donald Trump, the establishment’s failure to remove the root causes of the financial crisis has come back to haunt them. It looks as though the eurozone’s turn will be next.

So, rather than comforting ourselves that the EU needs the City, we should be asking ourselves what kind of City it is that the UK really needs.

Felix Martin is a macroeconomist, bond trader and the author of Money: the Unauthorised Biography

This article first appeared in the 09 February 2016 issue of the New Statesman, The May Doctrine