We are going to hear a lot about passporting in the next few years.
The City will make preserving the financial services passport a key aim of its post referendum lobbying. It is less clear who will make the opposite case that the passport creates unnecessary risks to the economy.
The question of whether passporting will form part of Britain’s future relationship with Europe is rising on the political agenda. To answer it we need to know firstly what passporting is, secondly why the City is in favour, next why passporting is risky and finally how real the risks are.
If a bank or other financial business wants to operate in the UK then it has two options:
Firstly it can establish a UK subsidiary licenced and supervised by the Bank of England and other UK regulators. It will need to meet UK capital requirements and liquidity rules. In the event of difficulty the UK authorities would agree the steps to take.
The alternative is passporting. A firm licenced and supervised in an EU or EEA state can open a branch in the UK under the passporting arrangements.
The branch would not have its own capital. It would remain the responsibility of its home state to ensure that it operated safely and to guarantee that in the event of a collapse the deposits would be protected.
UK regulators would have limited rights of supervision and if there were concerns they could only raise them with the home country regulator.
London’s financial firms strongly support passporting. It allows UK banks to conduct business without the need to create subsidiaries. They can deal with one regulator rather than several and instead of allocating capital to each subsidiary, capital requirements can be met at the European level.
The consultants BCG recently calculated that European banks would need an additional £30 – 40 billion in capital to continue to operate in Britain without passporting. Banks have a substantial incentive to retain the passport.
There is a tension in banking between holding more capital, which makes banks safer, and reducing capital which makes banks more “profitable”. Banks’ preferred metric for profitability is return on equity (ROE) which is the net profit divided by (equity) capital. A bank with the same profit but more capital would show a lower ROE.
In 2009 the most urgent political issue was how to reform the financial sector so that it could perform its role without endangering the economy as a whole. The Financial Services Authority produced a major report on what needed to be done following the crisis. The Turner Review called for reform of the EU rules:
These current arrangements, combining branch passporting rights, home country supervision, and purely national deposit insurance, are not a sound basis for the future regulation and supervision of European cross-border retail banks.
The report offered a menu of reforms for discussion some meaning “more Europe” others “less Europe”, but expected a mix of stronger national powers and more EU coordination. It expressed a preference for:
The reinforcement of host country supervisory powers over liquidity, and the right of host country supervisors to demand subsidiarisation and to impose adequate capital requirements and restrictions on local business activity.
The Turner Review’s recommendations for more Europe have not been implemented; in particular its proposal for a European deposit protection scheme has been rejected in the European Council. Passporting remains essentially unreformed.
The risks of passporting would matter less if European banks were stable and well capitalised. The results of the ‘stress tests’ released by the European Banking Authority on Friday show that they are not.
The stress tests fingered Italy’s Monte Paschi di Sienna as Europe’s most problematic bank. The world’s oldest operating bank has already been bailed out twice. In recent months the rescue of Italian banks has been the focus of a stand-off between Matteo Renzi’s government and the European Commission.
The Italian government wants to use public funds to recapitalise Monte Paschi and other troubled banks. The European Commission has been blocking the rescue citing state-aid rules and insisting that bond holders take a loss.
This is a problem for Italy as its banks have been allowed to sell bonds to their customers as if they were savings products.
Banks in Ireland, Germany and Britain have also been identified as vulnerable by the stress tests. The tests themselves have been criticised. They did not give pass or fail marks and covered only the largest institutions.
Greek, Cypriot and Portuguese banks were too small to be included. Yet their banks face chronic weaknesses. Over 40 per cent of the loans on the books of banks in Greece and Cyprus are classed as non-performing.
If Britain was staying in the EU, we would be calling for the reform of passporting along the lines of the Turner Review.
Once we leave, the British government will not have a say in banking regulation in the European Economic Area. We will be faced with a binary choice; either passporting as advocated by the City or protecting the customers of overseas banks by requiring them to create subsidiaries subject to UK regulation.
Whatever the difficulties of immigration, the free movement of people, unlike the free movement of capital, does not risk crashing the economy.
Jos Gallacher represents Labour International on the National Policy Forum of the Labour Party.
See also: We’re still grieving for Europe – big decisions should be avoided