Financial services are a very important sector of the UK’s economy, accounting for between 7-12% of GDP, 11% of gross tax receipts, and 7-12% of employment.  In a recent paper, prepared for the Oxford Review of Economic Policy / British Academy conference on Brexit in December, I reflect on the likely consequences of Brexit for this sector.

While banking represents both the largest component of UK financial services and the largest share of intra-EU revenues, the UK’s banking sector is less important to the EU27 than its financial market activity. The European Commission’s ambitious Capital Markets Union reform programme is intended to spur the growth of capital markets throughout the EU. This is motivated by concern that the EU’s financial system is excessively dependent on banks, which is thought to have an adverse impact on the financing of innovation, and to render the system very dependent on the stability of large financial institutions.

A ‘soft’ Brexit, whereby the UK leaves the EU but remains in the single market, would be a lower-risk option for the City than other Brexit options, because it would enable UK financial services firms to continue to rely on regulatory passporting rights. However, soft Brexit would require one of the parties to soften their current stance on free movement, which seems unlikely.

Under a ‘hard’ Brexit scenario, where the UK leaves the single market, much depends on the scope and operation of third country ‘equivalence’ regimes applied by the EU to determine whether financial services firms authorised in the UK would need also to be authorised in EU states. There are important sectoral differences in the scope of these frameworks. In particular, there is no equivalence regime for banking, which as we have seen is the largest single component of the UK’s financial services exports to the UK. This would mean UK banks would need to conduct EU business through subsidiaries located in the EU27. Overseas banks that had subsidiaries in the UK simply to gain access to the EU would likely relocate.

In contrast, various equivalence regimes are or will be applicable to wholesale financial markets and associated services. Despite suggestions of politicisation, there would be a clear mutual interest in continued connectivity. However, there is a more prosaic—but no less serious—problem. It typically takes the Commission at least two years to make a determination that a third country’s regulatory regime is equivalent to the relevant EU rules. Unless the Commission can be persuaded to begin work on UK equivalence assessments almost immediately, so as to have a determination in place by the time the UK’s Article 50 negotiating period ends, there is a risk of a disastrous hiatus. And in the medium term, the same equivalence regimes might in principle also be applied to the US, meaning US firms would then be able to compete directly with UK firms, rather than locating subsidiaries in London.

The best outcome for the UK, absent breaking the deadlock on free movement, would be for a negotiated agreement on financial services that offers something more than the patchwork of equivalence provisions discussed above. The UK would want such an agreement to (i) provide a more enduring foundation for access by its firms than a unilateral equivalence determination by the Commission; (ii) to cover, in addition to wholesale markets, in order of priority, payment services, banking activity, and wholesale insurance. A transition arrangement so as to avoid running out of time for an equivalence determination is also highly desirable. But how far the UK gets towards these goals in its negotiations will likely depend at least in part on its outside option—that is, hard Brexit. And the foregoing suggests this does not place the UK in a particularly strong position, at least as respects financial services.

John Armour is Hogan Lovells Professor of Law and Finance at Oxford University and a Fellow of the European Corporate Governance Institute.