Academic journal article National Institute Economic Review

EU Membership, Financial Services and Stability

Academic journal article National Institute Economic Review

EU Membership, Financial Services and Stability

Article excerpt

This paper examines whether EU membership enhances or diminishes the UK's financial sector stability, and therefore its prominence in global finance. The UK is host to the largest share of financial services in the EU, despite being outside of the Eurozone. An important reason is that, as a member of the EU, the UK has direct access to the Eurozone's financial infrastructure. If the UK leaves the EU (and EEA) banks and other financial services firms may continue to have access to the Single Market, but they are unlikely to have direct access to the Eurozone's infrastructure. Banks in the UK will no longer be direct members the Eurozone's payments system. The swap arrangement between the European Central Bank and Bank of England would have no legal enforcement mechanism. Resolution of cross-border banks would be more challenging with less incentive for a cooperative outcome. While some may welcome the reduced size of the financial system, not without reason, this could be achieved more effectively with domestic regulation than by leaving the EU. Given the uncertainty that would follow a vote to leave, there is a risk of capital flight.

Keywords: governance: financial infrastructure

JEL Classifications: E52; E58; F33; F36; G00; G001

"Respecting the powers of the central bank in the performance of their tasks, including the provision of central bank liquidity within their respective jurisdictions"

From the Agreement of the European Council Meeting, 18 and 19 February, 2016

The UK joined the European Economic Community in 1973, the same year as the collapse of Bretton Woods. This was a system of closed capital accounts and fixed exchange rates designed to overcome the financial instability of the interwar years.

The demise of Bretton Woods led to a gradual opening up of capital accounts. The UK led the way in 1979 by abolishing exchange controls. In the same year, other members of the EEC created the European Exchange Rate Mechanism of pegged exchange rates from the remains of the 'Snake in the Tunnel' system. Despite the movement of capital being a fundamental freedom in the Treaty of the Functioning of the European Union (TFEU, 1958) progress was slow due to excess capacity in many countries and the new pegged exchange rate regime. The rise of cross-border capital flows coincided with a revolution in IT that transformed financial intermediation. Batch processing allowed bank assets, long considered unsuitable for transfer, to be bundled up and traded. International financial borders were torn down, enabling financial institutions to merge into conglomerates operating around the globe. The regulatory framework was designed in such a way as to support financial sector growth. (1)

Continental Europe began to catch up. EU leaders either recognised the need for more efficient financial markets, or accepted that they could no longer defend domestic financial behemoths. Europe's largest banks made strategic decisions to become global players. (2) The EU Financial Services Action Plan (1998) accelerated the creation of a single wholesale market allowing regulated financial firms of any Member State to operate in the markets of any other Member State without any further restrictions (so-called 'passporting'). (3)

With repeated financial crises culminating in the global financial crisis, it is clear that global finance is a challenge to traditional governance structures. (4) Lord King's famous remark that banks are "global in life and national in death" indicates a profound misalignment between incentives and responsibility. The lack of congruence in traditional governance structures is expressed in many ways e.g., Rodrik (2000), Schoenmaker (2013) and Avdjiev et al. (2015).

The common thread is an inconsistency between internationalism and the policy domain of nation-states.

In the financial context, this inconsistency is between the global financial institutions operating in multiple jurisdictions and with multiple currencies, and the domestic governments which stand behind them with their taxpayers' funds and domestic currencies. …

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