An investment bankers’ guide to Brexit

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Based on conversations with bankers, lawyers and consultants, here is a guide to post-Brexit investment banking.

What is at stake?
For years, international investment banks have chosen London for their European home in part because Britain’s membership of the EU allows them to do business across the entire bloc. The main fear about Brexit is loss of access to the EU’s single market for goods and services, otherwise known as “passporting”.

What’s that?
Passporting allows financial companies with subsidiaries in the EU to sell services or set up branches in each of the bloc’s members with minimal regulatory hassle. Confusingly, there isn’t one passport. Instead there are nine different European directives linked to passporting. Each one covers a different slice of financial activity, ranging from insurance to asset management and trading.

What are investment banks doing?
Most are working on a worst-case assumption that the UK financial system gets frozen out of the EU. This requires them to create an entity in the EU to deal with customers there. Lenders are going through their businesses line by line to work out which jobs have to be done where. Banks are also calculating profit margins on each product to see if it is worth continuing to provide it to EU clients. For cost reasons banks are looking at scaling up in European cities where they already have banking licenses and basic infrastructure.

So how could investment banks restructure?
The aim is to continue serving important European clients, while moving as few roles and as little capital as possible out of their existing UK operations. This won’t be easy. Investment banks are broadly looking at four models:

The introductory model. Banks keep most of their traders and compliance teams in the UK. Sales teams in the EU “introduce” clients to the UK entity. This is the dream model for banks as it wouldn’t require a vast reshuffle of their activities or trapping a pool of capital in the EU. Lawyers say EU local regulators probably wouldn’t sign off on this model because it doesn’t give them enough oversight of the banks.

The European branch. In the 1990s, before the creation of the European common currency, banks had a series of licenses with different European countries. These could be re-activated. Instead of building fully capitalised subsidiaries, banks would “branch” from the UK or US into specific countries where they already have licenses. Unlike a subsidiary, which is essentially a local bank, a branch functions as an outpost of the home office. The upside: they don’t have to trap capital in EU subsidiaries. The downside: banks could only do business where they have a branch, so they wouldn’t be able to access clients across the entire EU. Each country would need its own branch. This could work for smaller banks. But the EU is already discussing rules that would force big banks to create holding companies – not just outposts – inside the bloc.

The back-to-back model. This requires banks to build a compliance team and put a few traders into an EU entity. Deals would be booked in the EU and then flipped over to a bigger entity in the UK or even New York. The advantage of this model is that, because the risk is taken out of the EU entity, it probably wouldn’t have to hold as much capital. It also requires less infrastructure build out. Again, it would require regulators to be comfortable with the set up.

The full blown bank. If all else fails, there’s this. Lenders re-create a “mini-me” version of their UK investment bank in the EU. This would require substantial capital, trading infrastructure, compliance and top management to be in place in whatever country is chosen. This would be the most costly outcome for banks and given that investment-bank profit margins are less fat than they once were, some banks might decide it isn’t worth it to preserve the business. Regulators are likely to be most comfortable with this model.

What jobs are affected?
Most bankers say they don’t yet really know. There isn’t an EU wide definition of what counts as doing cross-border business with a non-EU country. So it depends on which European country a bank bases itself in.

Banks broadly think the following… Those very likely to move: Sales staff who do business with clients based in the EU. That covers a big swathe of products including the buying and selling of shares and derivatives, the ability to offer loans, and provision of services like custody and clearing.

Further along the chain the picture gets fuzzier. Regulators could demand on site compliance teams, and back-office and legal support to process those deals. They could also ask that key risk takers, such as traders, be present, along with senior managers. Business considerations will also come into play. Banks, for instance, may want to keep their trading and sales teams physically together even if regulators don’t require it.

Unlikely to move: Merger advice, for instance, could be provided from outside the EU, because it isn’t considered selling of a financial product. Other “ancillary” services such as accounting or investment research could also be done in a post-EU Britain.

The uncertainty is reflected in consultants’ estimates of the impact of Brexit. Oliver Wyman, for instance, sees anything from 3,000 to 35,000 roles leaving London.

London is a pretty big financial prize. Is the rest of the EU keen to claim it?
Cities like Frankfurt, Paris and Dublin certainly want a piece. All would welcome at least some of London’s finance business. But national politicians and regulators might not be so keen. With big investment banks come big investment-bank balance sheets. Countries such as Ireland, which went deep into debt to fund bank bailouts during the eurozone crisis, could be wary of taking on the risk.

Is a big, painful shakeup certain?
No. There are a few ways it could be avoided. The most straightforward would be for the UK to strike a fresh treaty with the EU that retains access for its banks to the single market. European leaders have made plain that such an arrangement is only palatable if Britain continues to allow their citizens to work and travel in the UK. Since many Brexit proponents are keen to tighten borders, the politics of this option look difficult to square. But everything is a negotiation.

One option is for Britain to join the European Economic Area, a larger group that comprises the EU plus Iceland, Liechtenstein and Norway. Those extra countries abide by some but not all EU rules, and have access to some but not all of the passporting rights. This seems unlikely: EEA countries also have obligations to permit foreign workers to come.

Another option: On paper, at least, rules coming into force in 2018 permit non-EU companies to access the single market if their countries have adequate regulatory regimes. EU authorities would have to decide to grant this “equivalence” status to the UK – and it only applies to some of the things banks do. What’s more, the EU authorities could withdraw equivalence at their discretion. That makes it hard to form a business plan around.

If all else fails, European clients could come to London. Some corporations might simply choose to continue doing business with London-based banks. They could do that if their own financing arms were based in the UK. That might be appealing to big companies keen to dip into London’s massive capital markets. But it likely isn’t an option for most smaller companies.

What happens next?
Bankers are hoping this all takes years to play out. Brexit negotiations are due to start by the end of March, but that might slip pending legal challenges to Brexit in the UK. The two-year negotiations could be followed by a transition period, lasting several more years, allowing banks to reorganise their operations. Banks will continue to work on contingency plans, speeding them up if it looks as if things won’t go in their favour. If jobs must move, it will likely be in drips.

That said, big banks don’t turn on dimes. They’ll need the path to be laid out with some certainty years in advance – these decisions can’t be made on the eve of Brexit. And for now, uncertainty reigns.

Write to Max Colchester at max.colchester@wsj.com

This article was published by The Wall Street Journal

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