Brexit: Banks – on the road to somewhere?

Aug 7, 2017 | Articles, Hot Topic - Brexit, Practice - Strategy

If Brexit has done one thing, it is to create yet more uncertainty in the financial sector. Immediately after the referendum, the media was rife with reports that banks were making plans to shift staff and operations from London to EU cities such as Frankfurt and Brussels. Failing to do this and maintaining large operations in London, and therefore outside of the EU, could reportedly render banks unable to properly service their European clients and in turn cause them a considerable loss of income.

More recently, an opposite trend is emerging, with many media reports suggesting that major banks, such as UBS, Credit Suisse and private bank Julius Baer[1], are keen to remain in the UK and are in fact, looking to open regional offices or strengthen their London operations. While the precise nature of the UK’s departure from the EU remains to be seen, Brickendon considers whether the UK may win, as well as lose, some business, and looks at what this means for the recent trend towards organisational and legal entity simplification in the banking sector.

“Simply upping sticks and moving your financial services business to a new location is not as simple or sensible as it sounds,” says Brickendon CEO Christopher Burke. “There are a range of things to consider, such as market access, potential unwinding of complex trading positions, regulatory implications, location of clients and competition for talent.

“While these considerations have always been important, Brexit has now added a new dimension and made the location strategy game even more complex. Getting it right has never been so important to a bank’s success.”

The exact terms of any post-Brexit financial agreement still remain to be seen, but it is widely accepted that the two-way business that takes place under the guise of so-called ‘passporting rights’ will no longer be possible. ‘Passporting’ enables banks based in the EU to automatically operate in the UK through branches which are regulated in their local EU domiciled country, rather than more heavily supervised UK subsidiaries which are regulated by the FCA and PRA. Going forward, banks will be unlikely to be able to service customers in the EU from the UK and vice versa. As a result, they are expected to need operations on both sides of the Channel. For many, this will require the reversal of a key trend of the past decade, namely simplification of the banking structures.

So why is this? For a customer, a bank is a bank whether it’s a physical building, an online system or someone sitting in a call centre in another country. The same cannot be said for the institution itself. The exact form the bank takes, be it a subsidiary or a branch, matters in regulatory terms and defines how it may operate in a particular country. This is even more prevalent now that the UK is leaving the European Union.

A branch is an independent entity that conducts business in its own name, but is not legally separated from its foreign parent. It is subject to local laws governing its parent company, and while a branch can be useful for gaining an understanding of a local market and is more cost-efficient than setting up a subsidiary, it cannot operate as a stand-alone business. By contrast, a subsidiary is an incorporated legal entity which can operate in its own right. A subsidiary will maintain a fully-funded balance-sheet, take responsibility for its own capital and liquidity flows and is regulated in the country in which it is located.

Under the new financial requirements post the financial crises of 2008-09, banks have to ensure they have sufficient access to capital and adequate liquidity to operate in all markets. Looking forward to the Brexit-shaped future, financial institutions which only have branches in either the UK or the EU will need to restructure these operations to run as subsidiaries. This will involve significant transfers of capital, funding and liquidity and will ultimately require the bank to address the increased scrutiny of regulators and legislators that will inevitably accompany such fundamental changes to the operating models and organisational structures.

To consider the impact this will have on the financial sector, let’s take a step back. Historically the globalisation of the banking world has been driven by geographical expansion, accompanied by a proliferation of legal entities and vehicles under banks’ group ‘umbrellas’. For some banks, this increase in organisational complexity was intended, ie. to leverage regulatory or taxation arbitrage; for others, it was simply a consequence of servicing client requirements in relation to new products and geographies. Whatever the reason, by the turn of the millennium many banks had developed highly-complex organisational structures, often covering hundreds of companies and dozens of geographies.

Then came the financial crises of 2008-09 and a rapid reduction in funding and liquidity in the financial markets, which in turn threatened the long-term viability of many large banking groups. Capital injections were needed from central governments and institutional investors to reinforce the precarious financial position of many banks, weakened by declining underlying transaction volumes and profit margins.

One of the main impacts of this was pressure on the banks to simplify their organisational structures. Regulators and legislators called for increased transparency to ensure that banking groups could not be destabilised by under-capitalised ‘rogue’ entities. In turn, all legal entities needed to be capitalised in line with regulatory requirements and stakeholder expectations, and legislation was put into place requiring all banks to demonstrate adequate and orderly plans in the event of a corporate insolvency, otherwise known as ‘living wills’. Demands were also made for the rationalisation of trade-booking models and risk-management frameworks to mitigate both credit and operational risk, while duplication and inefficiency across business and technology architectures were removed.

As a result, many banking groups have spent much of the past decade delivering complex organisational transformation programmes, which in many cases have been centred around the rationalisation of legal entity structures, with subsidiaries or associate companies being wound down. At the same time, many banks have withdrawn from countries and locations no longer regarded as being ‘core’ to their banking models.

While this trend towards organisational and legal entity simplification has begun to realise organisational synergies and cost benefits for many institutions, it may be stopped in its tracks by the UK’s planned withdrawal from the EU. The extent of the disruption is obviously not yet clear and will depend on the terms of the final arrangement agreed between the UK and EU. In addition, each bank operating in the UK will have a unique business model combination, which will be affected differently by the Brexit process.

It is, however, possible to identify key elements that banks will need to consider. Many transformation initiatives have focussed on developing global booking models across asset classes and concentrating both capital and liquidity in UK-domiciled entities. For example, many US banks used London as a booking centre to service their international or ‘rest of the world’ business. In the future, banks may be required by EU regulators to set up or upgrade EU-domiciled booking centres, replicating the current arrangements in London and effectively splitting their trade booking models. Additionally, banks would also be forced to choose between servicing their non-EU international business from either London or a location within the European Union.

In order to maintain adequate access to EU markets post-Brexit, banks will need to ensure they have both sufficient balance sheet capacity and operational capabilities within the EU. EU-domiciled institutions typically have this within their primary commercial entity or in key subsidiaries operating within the EU, but for many non-EU-domiciled banks, subsidiaries operating in the EU will not have the required balance-sheet scale or operational capacity. In some cases, banks will not have a subsidiary operating within the EU and will have to consider how best to set up such an entity, either from scratch or by converting a main bank branch in a specific country. Deutsche Bank recently said it may shift about 300 billion euros, equal to almost a fifth of its balance sheet, to Frankfurt from London in order to facilitate trading in the EU post Brexit[2].

Either transition scenario will necessitate a significant migration of roles and infrastructure to the EU, a figure which has been estimated to be as much as a quarter of the roles currently supported in London. In the same vein, EU-domiciled banks operating in the UK will need to consider how to maintain, or gain, access to UK markets. They will again need to ensure some measure of balance sheet capacity and operational capabilities, which could be achieved either by leveraging an existing subsidiary operating within the UK or by converting a UK branch of the main banking entity.

In short, there is no doubt that Brexit will have an impact on the banking sector in more ways than originally anticipated. Amongst this uncertainty, one thing that is for sure is that the trend towards organisational simplification will be reversed, a move that will inevitably incur significant costs for the banks. Moreover, there will also be some migration of capital, liquidity and infrastructure out of the UK and into the EU. This may however be mitigated by inflows from the EU for banks wishing to gain access to UK-domiciled clients, the UK’s highly-liquid capital markets, favourable regulatory conditions or any free-trade benefits the UK is able to negotiate with non-EU countries.

As with any marketplace disruption, Brexit offers banks a strategic opportunity for fast-movers to gain competitive advantage. Now is the time to act.

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