Stress Test: Will Sunak and Hunt’s Brexit Banking Reforms Weather the Current Financial Turmoil?

Stress TestWill Sunak and Hunt’s Brexit Banking ReformsWeather the Current Financial Turmoil?

Anthony Yates explains how Brexit caused Sunak and Hunt to think about deregulating the banks to gain competitive advantage. Now they may have to think again

There is now heightened concern about the global banking system after the failure of Silicon Valley and Signature banks, and the swallowing of Credit Suisse by UBS, pushed by the coercion of the Swiss regulators.  Calm has not yet returned.   The end of last week was coloured by worries about a short-lived fall in Deutsche Bank’s share price and also the possible failure of First Republic Bank in the US, [which is roughly the same size as Silicon Valley Bank was before its demise].

Back in December of last year Rishi Sunak and Jeremy Hunt announced proposals for deregulating the UK financial sector that they dubbed the ‘Edinburgh Reforms’.  The initiatives are aimed at boosting growth in financial services.  They derive from justified anxiety at the unprecedented stagnation in GDP per head since the onset of the Great Financial Crisis in 2008, amplified by the failure of Brexit to deliver what supporters hoped for it.

But the reminder – if one was needed – that financial fragility was not abolished by the post-financial crisis reforms after 2008 makes these reforms look imprudent.

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Undermining Ring Fencing

One change is that the two bodies responsible for regulating the banks, the Prudential Regulatory Authority and the Financial Conduct Authority, would have ‘growth’ and ‘international competitiveness’ inserted into their missions. 

Writing words into an objective often does very little.   So this change may just sum up the dangers the Government is running rather than contribute to them.  But to the extent that the real effect of regulation runs not via the application of formal quantitative rules but through the attitude and behaviour of regulators when they use their judgement and discretion in directing banks, the change in mission could be harmful, encouraging regulators to downplay concerns about financial risk.

Another proposal chips away at rules that ‘ring fence’ investment banking activities from regular retail banking.  Ring fencing policy grew out of the commission led by former Bank of England Chief Economist Sir John Vickers. 

‘Ring fencing’ is meant to keep the balance sheets of investment and retail banking separate so that if the investment banking business loses money, the retail business does not implode.  Without the separation, there could be a run on the retail bank as depositors worry that the investment banking losses mean the whole entity is going to go bust and they will lose their savings if they don’t beat the queue and withdraw;  and of course in withdrawing they sink the bank and make the concern a self-fulfilling prophecy.

The Edinburgh Reforms would increase the threshold at which activities have to be ring-fenced from £25bn to £35bn.   The largest institutions would still be well above this threshold, but nevertheless, the change invites entry and growth and increases risk in the system.  Vickers himself judged the change to be ‘pointless or dangerous’.  

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The Brexit Effect

It is hard not to see these proposals as stemming from the fallout created by Brexit.  Jeremy Hunt’s written statement in December refers to hoping to take advantage of “our regulatory freedoms outside the EU”  First, these proposals are one facet of the Conservative Party’s anxiety about the UK’s historically unprecedented stagnation in income per head since the onset of the financial crisis in 2008. 

That in turn has been caused in large measure by Brexit, by the raising of trade barriers with the EU’s single market, our disputes with the EU over the Northern Ireland Protocol, and the potential chaos in domestic business law caused by the EU Retained Law bill, has played a large part.  Second, Brexit excluded the UK’s financial sector from the EU single market. 

The Government had hoped – and prominent Brexiteers had confidently forecast – that the UK would be granted regulatory ‘equivalence’, meaning that our UK regulations would be judged to be equivalent to EU regulations and that UK-domiciled financial firms could do business seamlessly with the EU. 

That did not happen, for reasons to do partly with regulatory caution – the ECB/EU don’t want a large financial centre taking risks on behalf of entities within its borders – and partly to do with commerce – no equivalence means more business and tax revenues domestically.  Consequently, there has been and will continue to be a slow leakage of jobs as financial firms relocate parts of their business into Amsterdam, Frankfurt and Paris.

The Edinburgh reforms – of which only a few are mentioned here – illustrate much of the post-Brexit problem for the UK and the Conservative template for a solution.  A search for ways to take risks, try to gain competitive advantage against the EU,  and boost growth.  This was the driver behind the disastrous Truss-Kwarteng mini-budget in September 2022; in that episode, we saw large, unfunded tax cuts for higher earners, accompanied by hopeful deregulation in ‘investment zones’, childcare and planning. 

The Edinburgh Reforms are more subtle and probably less harmful, but they are the product of minds concentrated by the same problem.  We have to hope that the renewed financial fragility stops the worst of them.