Commentary: UK Finance and Europe

By Armstrong, Angus | National Institute Economic Review, May 2015 | Go to article overview

Commentary: UK Finance and Europe


Armstrong, Angus, National Institute Economic Review


The UK relationship with the European Union (EU) will be a defining issue for the new government. The EU is undergoing profound changes in the aftermath of the global financial and its sovereign debt crisis. Accordingly, a thorough analysis of the pros and cons of EU membership and the scope for reform is required. Following our assessment of the 'Scottish Question' around the independence debate last year, the 'British Question' is one of our top research priorities.

The EU is the UK's most important economic partner. Over half of exports are sold to the EU, almost 60 per cent of inward foreign direct investment comes from the continent and almost half of all migration is with the EU. However, critics argue that the EU is in relative decline and that membership limits our sovereignty and our ability to compete in new markets. Moreover, the EU cannot be considered to be in a steady state. Assuming no further enlargement, in five years' time 23 out of the 28 EU states will be Euro Area members. A new equilibrium might be an EU with a closer political union and a pooling of fiscal resources that resembles a 'United States of Europe'. An alternative scenario is that at least one country might leave the Euro Area. (1) Either outcome would have important consequences for the UK.

An important part of this debate will be around financial services. This is inevitable given that the UK is effectively host to the Euro Area's wholesale financial markets, the EU's key decision to create a European Banking Union (EBU) and the fundamental differences between the UK and continental European models of financial intermediation. This is especially important to the UK because financial services have long been one of our most successful economic sectors. A House of Lords report suggested that the consequences of the EBU for the UK could be 'momentous'. (2) For non-Euro Area members of the EU the EBU may create either centripetal or centrifugal forces. This commentary raises four questions regarding financial services and the UK's EU membership.

UK financial services and the EU

The UK has been a leading global financial centre for two centuries. British institutions financed development across the Empire, created capital markets for trading companies and government debt and famously financed South America's railroads in the late nineteenth century. Until the recent global financial crisis the UK had not allowed a bank to fail since 1866 and had a strong reputation for self-policing and upholding high standards of behaviour. (3) There have been a number of official reviews over the past century suggesting that the system may be sub-optimal for the broader economy, but any changes that followed failed to alter the UK's dominance in international finance. (4)

Financial services (particularly banking and insurance) is one of our largest economic sectors. Output accounts for over 8 per cent of total national output and so its success is important for the overall success of the economy. UK exports of financial services as a share of GDP are greater than any other country (excluding city states), the UK has a trade surplus in financial services of 2.5 per cent of GDP and the sector is estimated to contribute up to 11 per cent of total tax revenue. (5) The growth of financial services reflects the role of the UK as an international centre of capital markets. Over 150 foreign banks have branches and almost 100 have subsidiaries in the UK (see box 1 for the distinction between branches and subsidiaries). The UK is also home to four of the thirty Global Systemically Important Banks (GSIBs) and host to two large GSIB subsidiaries from Switzerland. (6)

The UK joined the European Economic Community in 1973, which became one part of the EU in 1993. (7) All members of the European Economic Area are permitted to open branches in other member countries. Since former Bank of England Governor, Mr Eddie George, negotiated UK membership to the euro payments system, the introduction of the euro further strengthened the UK's position. …

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