Imagine several northeastern states, New York, New Jersey and Delaware, voted to form an independent nation apart from the United States. This hypothetical exercise isn’t a perfect comparison, but it might help explain why so many financiers in London are scrambling in the wake of June’s Brexit vote. Long the financial capital of the world, London will likely suffer human and financial capital losses as systematically essential financial systems shift to cities within the European Economic Area (EEA).
If New York, New Jersey and Delaware left the United States, the new bloc would face three major structural issues imperiling the region’s hold on U.S. and international finance: regulatory, legal, and institutional.
First, the bloc would suffer regulatory impediments to accessing U.S. markets: instead of complying with U.S. and state law, the new bloc would need to promulgate new rules and certification procedures. To be sure, U.S. law is highly influenced by Delaware corporate law and New York standards for finance, but other states would compete to fill the void left by the exit of the formerly essential bloc. This separation would impact every aspect of Wall Street’s business in the U.S. Each firm headquartered in New York would need to complete mountains of paperwork to comply as foreign firms, so long as these firms hoped to continue operations within the U.S. and with U.S. currency.
Second, the bloc would experience overwhelming legal uncertainty. Most companies operating in the U.S. register in Delaware or New Jersey, relying on the business friendly corporate and tax laws in these two states. Every firm registered in Delaware or New Jersey would need to register and comply with the law of a state that remained in the Union in order to continue doing business there.
The UK now faces a similar set of problems. The finance industry accounts for about 12% of UK economic output, with nearly 2.2 million people working in financial services fields, including 700,000 in London alone. The UK is seen as more business friendly than Germany or France, which have higher corporate taxes and stricter employment laws. Of course, England’s history as an imperial power informs its position as the finance capital of the world, and the high quality of life in London attracts talent from around the world, including other states in the EU.
The terms of Brexit are unknown, and will likely remain so for months or years before the EU and the UK negotiate the terms of exit. The uncertainty alone is the most significant variable at this point, as companies, banks, and individuals struggle to anticipate changes in European markets as a result of Brexit.
The third substantial burden facing the UK is institutional. Years of dependence on the EU to provide crucial services has left the UK without the critical human capital resources necessary to rebuild economic ties. For instance, the British civil service lacks trade negotiators due to its reliance on the EU. Simultaneously, Brexit casts doubt on the immigration status of European employees working in London. Without an established system of international trade to rely on, the UK will scramble to reestablish essential ties, without which even data cannot flow between the UK and the EU. Finally, the court system faces a challenge as well, as investors in products originating in or clearing in the UK will not have access to EU courts for redress, whenever necessary.
In addition to human resources, financial capital faces particular uncertainty. Presently, massive amounts of European capital in the form of hedge funds, asset managers, insurance products, and market infrastructure of Euro currency transactions take place in London. The only way the UK can retain control over these investment markets would be to negotiate into the EEA via the bank passport system, which would require accepting the free movement of European workers into the UK as well as accepting all of the EU market rules - a prospect which would frustrate Brexit voters.
To make the scenario more relatable, it is again worth considering what would happen to the bloc of New York, New Jersey, and Delaware under this hypothetical. All of the state pension funds, such as California’s $300 billion CalPERS fund, would cease routing transactions through New York exchanges and managing their investments through New York entities. This massive loss of capital would devastate the economy of the new, three-state nation.
Whether, and how, the UK will move forward with its exit from the EU remains to be seen. But through this lens, it is easier to see how Brexit will cause calamity rather than prosperity for the UK. It is true that Brexit could allow the UK broader regulatory authority within its borders, allowing further liberalization of financial and human capital markets. Such a regulatory “race to the bottom” might keep some of London’s business within the UK, but it is unlikely to stem the tide of fleeing human and financial capital, in addition to the massive costs of redefining the UK apart from the EU.