Ruth Lea - Speech 18th June 2008

IEA/Cass Business School, panel debate, 18 June 2008

Can the City Survive the EU's Financial Services Action Plan?
Ross Barrett (British Bankers Association), Martin Howe QC, Ruth Lea (Global Vision): Ruth Lea's speaking notes

1 Introduction
I'm delighted to be here to discuss this vitally important topic. I shall discuss the broad economic & political aspects of the FSAP and the City.

2 The City: global financial centre without equal
Firstly, let's remind ourselves of the some key features of the City of London.

It accounts for 3½% to 4% (3.7%) of UK GDP. It's a major tax payer, makes a substantial contribution to the Balance of Payments and is a major employer. Around 345,000 people work in wholesale finance and the professional support services.
It's, by far, the largest financial centre in Europe, and its lead is increasing. Even though New York is larger, a substantial proportion of New York's business is domestic reflecting the size of the US economy.
London is probably the world's leading global financial centre. It's complex and international. It's a unique organization in the EU.
It has more international banking, foreign exchange dealing, trading in international equities, international bond issuance & international bond trading than any other centre. It is also the world's leading market for international insurance.
Research by the Z/Yen Group, for the City of London, confirms this. They regularly compile a Global Financial Centres Index (GFCI) for the major financial centres. London is number 1, with New York a close second. These two are followed by Hong Kong, Singapore, Zurich, Frankfurt, Geneva, Chicago, Tokyo & Sydney.
The Z/Yen Group also compile a list of relevant business factors listed by their relative importance. The availability of skilled personnel comes top with the regulatory environment close behind. This is significant. For all the criticisms it receives, the FSA and its relatively light-touch, principles-based regulatory approach comes out well in international comparisons. It is greatly preferred to the heavy rules-based, prescriptive approach of the Continent or indeed New York (SEC).

In conclusion: the City is economically hugely important, it's unique in the EU and probably the world, and one of its great competitive strengths is its regulatory regime.

3 The Financial Services Action Plan (FSAP) is part of the Single Market
Now may I discuss the FSAP? The FSAP was, of course, developed to complete ("fill in the gaps of") the Single Market in financial services. It was agreed to develop the plan at the Cardiff Summit in 1998, under the British Presidency. The subsequent framework document, released by the Commission in 1999, contained 42 separate measures. These measures covered both the retail markets and, crucially for the City, the wholesale markets as well.

The measures included the Markets in Financial Instruments Directive (MiFID), Market Abuse Directive (MAD), Capital Requirements Directive (CRD, Basel II), the Transparency Directive and the Prospectus Directive etc. When I first saw the FSAP, it was obvious that it had all the makings of a complex and intrusive bureaucratic nightmare.

And, of course, as the FSAP has been implemented, its legislation has been strongly influenced by the Continental regulatory culture. Not just is it heavily prescriptive, but it puts consumer protection at the top of the list of priorities. This is appropriate for retail markets but not the City's wholesale markets.

4 Single Market
I shall now digress and say something about the EU's Single Market, the "four freedoms", the freedom of goods & services and capital & labour. Many British commentators seem to believe that the Single Market is equivalent to a straightforward free trade area in which there are unfettered free markets. But, this is not the case. The overwhelming characteristic of the Single Market is harmonisation of rules and behaviour through prescriptive, protectionist, regulations. Thus "level playing fields" are created and "unfair competition" is abolished. The Single Market, in many ways, is more to do with the politics of social solidarity than free trade and economics. Only in the UK did we ever think it was predominately about economics and business.

There's a related factor is at work. And that is the view, commonly held on the Continent that Anglo-Saxon free markets are "chaotic", out of control and prone to malfunction. Free competition is also seen as slightly suspect. As the markets are "chaotic" they must be controlled and regulated. Just look at the horrors of the Anglo-Saxon credit crunch. There's little doubt that the "credit crunch chaos", emanating from our "casino" markets, will lead to more regulation.

Moreover the Single Market's regulations are costly. Günter Verheugen, EU Commissioner for Enterprise and Industry, announced [in 2006] that EU regulations were costing the European economy some €600bn a year (this was almost twice as high as previous estimates). Concerning benefits, Commission estimates suggest they may be €225bn a year. By any standards this is bad economics. But, of course, the Single Market is not primarily about economics.

5 FSAP: some considerations
Every measure under the Single Market cries out for a thorough and rigorous Cost-Benefit Analysis (CBA) - for thorough and rigorous regulatory impact assessments. But it doesn't happen on the whole. And it has not happened for the FSAP and its component measures, e.g. the hugely costly MiFID. As FSA Chairman, Sir Callum McCarthy said to the Treasury Select Committee "it is deeply unsatisfactory that UK financial services firms face major changes, with the associated costs, for an initiative which has been subject to no comprehensive EU CBA".

But in the absence of a proper CBA, we can, however, say something about the likely costs and benefits. Let's start with the benefits.

The benefits of the harmonisation of the EU27's financial markets:

There are several estimates of the potential benefits, e.g. London Economics (2002) suggested that the long-run increment to GDP could be 1.1%.
But there are major doubts that a genuine single market in financial services will ever be achieved. So the potential benefits will be severely curtailed. Implementation of many measures has clearly been slower than expected as national governments have interpreted the measures in ways designed to protect their domestic markets. Last year, Charlie McCreevy, Single Market Commissioner, said that, "he feared that there was a real risk that the dream of a single new rule book replacing 27 existing rule books could turn into a real practical nightmare".

Turning to the costs:

Keith Boyfield did a very fine study for Open Europe in 2006, and concluded that the FSAP's costs could be between £14bn and £23.5bn for the UK up to 2010. Suffice to say, costs will continue to be incurred past 2010. The minimum costs for MiFID, for example, were around £1bn in initial implementation costs, with around £100m of annual ongoing costs.
There are other costs issues. For example, all firms whether involved in cross-border trade or not, have to adopt the regulations. This advantages the large, established businesses at the expense of the small, innovative businesses and creates real barriers to entry and growth. This is anti-entrepreneurial.
But even for large firms located in the UK, heavy costs coupled with illusory benefits can be disadvantageous. The general international competitiveness of London as a financial centre is damaged & undermined. And this can clearly be a factor in driving business offshore. May I remind you that the Z/Yen research showed that good regulation was the second most important factor for assessing the competitiveness of financial centres?
But most significantly of all, by signing up to the FSAP we have comprehensively handed over the regulatory initiative relating to the City to the EU. In the EU we are one voice amongst 27. Moreover, of those 27 most of them are not interested in, or understand and/or are sympathetic to the City. Some are downright hostile.

There are serious consequences of handing over the regulatory initiative of the City to EU:

More regulation will surely come whether we like it or not. As already indicated, given the credit crunch, the pressures are mounting. This will create a process of continuous change and a horizon of uncertainty, which financial services firms won't like. And, as the EU has no reverse gear, the trend would be towards closer integration, greater harmonisation and more rules.
There will continue to be pressure for an EU-wide regulator, a "European Securities and Exchange Commission". This would probably largely replace the individual Member States' regulators, including the FSA. It would probably not be located in London. Its sympathy (and understanding) of the City's unique role could only be limited. And, politically, it could not treat the City's needs as a priority. On the contrary, an EU-wide regulator would probably focus on the retail side rather than the wholesale. The FSA can concentrate on the City, an EU-wide regulator never could. The prospect of having such an EU-wide financial regulator based outside the UK and operating a set of rules originating in Brussels, with the UK as one voice amongst 27, should be sounding alarm bells in the City.
Given the EU's legislative procedures, it is very difficult to amend legislation and virtually impossible to repeal legislation. Any amendments need to satisfy 27 different member states, most of which aren't interested in the City and some of which are hostile. The case is very different in, say, the US where Sabox has been amended already and will probably be amended further.
A final thought... The current Commission is led by the "free market" Jose Barroso and the "free market" Single Market Commissioner is Charlie McCreevy. Their terms of office are due to expire in October 2009. Who will take their place?

6 Conclusion
Will the City survive the FSAP and its aftermath? Yes, it will survive. But will it thrive able to innovate rapidly and respond flexibly to the changes & challenges of the 21st century. Will it remain the world's number 1 global financial centre? I doubt it. A City hampered by the EU's unsuitable and costly regulations and, possibly, being regulated by an EU-wide regulator, is most unlikely to remain at the top of the global game.