Regulation and the Problems: Passporting & Equivalence

Philip Mokuolu -

There are variety of implications that Brexit will have, but in this article, I will be focusing on Passporting and Equivalence. If the UK leaves the EU single market, which seems highly likely, how will banks (and other financial institutions) continue providing services to European Economic Area (EEA) customers? How will they actively sell products and services to EEA customers? Financial institutions will have to use other strategies to maintain their European presence. If you want to have a better understanding of the consequences for banks, the strategies they could use to overcome this and the limitations behind each strategy, keep reading.

Passporting

Passporting is the ability of a firm registered in the EEA to provide services (and trade freely) in any other EEA state, without needing additional authorisation in each country [2]. This allows firms to use their passporting rights to provide cross-border services and open other offices elsewhere in the EEA. This concept is valuable to financial institutions because it eliminates a lot of red tape (excessive regulation) associated with gaining authorisation in a variety of countries, making the process above less costly for banks. There are 9 different passports that each cover a different type of financial service, for example, Corporate Banking and Asset Management [1]. Each passport is embedded within a specific EU Directive that states the basic rules for that given activity. The main passports are as follows:

  • Corporate Banking services: Fourth Capital Requirements Directive (CRD) necessary to provide advisory services or deposit services
  • Market services: Markets in Financial Instruments Directive (MiFID) is essential
  • Asset Management services: Alternative Investment Fund Managers Directives (AIFMD)
  • Private Banking services: Combination of CRD and MiFID to assist a customer in arranging a line of credit
  • Payments services: Payments Services Directives (PSD)

What happens when the UK leaves the EU single market? Practically, this would see UK-based banks lose their ability to sell products and services to EEA customers in EEA states. This would make expanding and providing cross-border services costlier. How would banks work against this? In an attempt to combat this, UK-based banks could:

  • Negotiate for licenses in each EEA state
  • Use aspects of Directives where being an EEA member is not necessary

However, there are limitations to both of these strategies. Negotiating for licenses in each EEA state will prove to be complex and costly, most likely resulting in unfavourable licenses. That is, most EEA states would place restrictions on the bank’s ability to serve EU customers and customers’ ability to contract with these banks. This is because most EEA states would demand that the bank became authorised inside the EU, reducing the red tape for them as they would not have to negotiate unique licenses for every UK-based bank. Trying to utilise aspects of Directives will prove to be difficult because, this framework has not yet been activated for non-EEA countries.

The last strategy UK-based banks could use to provide cross-border services, is the strategy of Equivalence.

Equivalence

Equivalence is a legal concept that has emerged over the past 30 years. This concept states that cross-border trading can occur between different states if they agree that their standards of regulation and supervision are similar [3]. This does not require both states to mirror each other’s rules and legislation. Therefore, theoretically, the UK could use this concept to retain access to the EU single market without having to abide by its laws. This would allow UK-based banks to continue to provide cross-border services, whilst keeping costs low, and EU customers to continue contracting with UK-based banks. Looking further forward, this concept may facilitate the use of the UK as a base for exporting financial services to the EU [1].

However, once again, the UK could face resistance going down this route. Regimes around this concept are very limited, restricting the variety of banking services non-EU based firms can offer. In addition to this, an agreement of equivalence between two states can be easily withdrawn if one of the states decides that their regulatory regimes are no long similar. This creates uncertainty for banks and discourages them from making long-term investment plans. If banks are restricted to think short-term, how can EEA clients confidently rely on them? Although the UK will not have to mirror EU rules and legislation, there will be some loss of regulatory freedom, as the regulatory regimes between the EU and UK must sufficiently align.

Prediction

What method listed above, if any, do you think the UK will take when they leave the EU single market (which seems highly likely)? Personally, I believe that UK will use their reputation as one of the best (and biggest) exporters of services to negotiate favourable trade deals with other states (not in the EU), whilst leveraging its reputation to negotiate a unique trade deal with the EU. This will hopefully allow banks to continue providing cross-border services with minor increase in costs. What’s your opinion?

[1] UKfinance [2] Investopedia[3] The Financial Times