By David Milliken, Huw Jones and Alessandra Galloni
LONDON (Reuters) - Bank of England Governor Mark Carney called on Friday for Britain and the European Union to reach a sweeping deal to recognise each others' bank rules after Brexit, or risk a potentially damaging hit to financial services across Europe.
Speaking at Thomson Reuters' London office, Carney said the outcome of Brexit for financial services would be a "litmus test" for global banking rules and warned against the temptation to try to put up barriers to capital flows.
"The United Kingdom has been at the heart of the global economy for centuries. Throughout that period the City has channelled the life blood of the world economy, finance," he said in a speech.
"It is all too easy to give into protectionism, but the road less taken is often the most rewarding."
Banks, including many from the United States and other countries around the world, use London as their base for operating across the European Union, making the British capital the biggest financial centre in the region by far.
But their EU "passports", which enable them to operate throughout Europe from a single office in London, are set to be lost once the UK pulls out of the bloc in two years' time.
British hopes of securing a generous new deal are likely to be contested by politicians in many EU states who were jolted by the decision of British voters last year to leave.
Recognising the risk of future barriers, Carney said banks had to be ready for a "hard" Brexit and set a July 14 deadline for all cross-border finance firms operating in Britain to tell the BoE how they would cope with an abrupt EU exit.
It is not just banks that cluster their EU operations in Britain which face risks.
European firms which operate in London via EU passports should be prepared to set up separately capitalised subsidiaries in Britain and submit to BoE regulation if Britain and the EU cannot reach a deal, the BoE's top banking regulator Sam Woods said on Friday.
DON'T RUSH TO LEAVE
Banks are making contingency plans but Carney said they should not rush to leave London. "In my view it would be extreme to take precipitate action."
Lenders are concerned that Britain and the EU will not reach a deal in time for Brexit which is due in two years' time, and are preparing to move staff from London. Germany and France are trying to lure jobs to their financial capitals.
HSBC , UBS and Morgan Stanley have decided to move about 1,000 staff each from London in the next two years, sources familiar with their plans have told Reuters.
Goldman Sachs said last month it would begin moving hundreds of people as part of its contingency plans.
Prime Minister Theresa May mentioned the importance of reaching a trade deal with the EU that includes financial services as a "crucial sector" when she triggered the two-year process of Britain's exit from the EU last week.
But many bankers have said they are not convinced the government will prioritise their industry, with May making controls on immigration a top aim.
Carney said he expected financial services to be part of a "bigger deal" on trade between Britain and the EU.
He warned of the potential hit to the economy in Europe from a hard Brexit for banking, saying it would be tough for other EU countries to match the scale and expertise of Britain. "That's very difficult to replicate," he said.
To reduce the risk of disruption, the Britain and the EU should take "the high road" of mutually recognising their financial rules, allowing companies to operate smoothly across the English Channel as they have done until now.
"The EU and UK are therefore ideally positioned to create an effective system of deference to each other's comparable regulatory outcomes, supported by commitments to common minimum standards and open supervisory co-operation," he said.
Major global trade deals to date have largely excluded financial services due to their complexity, however.
Recognition of financial rules has not been tried before on the scale envisaged by Carney, which could make negotiations tricky and protracted. The EU may also be reluctant to forgo the jurisdiction of the bloc's top court in policing rule breaches.
Sean Tuffy, head of strategy for Europe at private bank Brown Brothers Harriman, said Brussels was unlikely to offer Britain more than sector-specific deals on mutual recognition, such as in asset management.
"Barring a huge shift in the UK's negotiating position, it strikes me as very unlikely that we're going to see a broad mutual recognition deal for financial services," he said.
Carney said the system could be bolstered by third-party peer reviews and a new independent dispute resolution mechanism, adding that this could be a template for the wider world.
He also said he would push to ensure some clearing of euro-denominated transactions remains in London after Brexit.
TRUMP REFORMS AFFECT U.S., NOT WORLD -CARNEY
Against a backdrop of global concern that U.S. President Donald Trump may undo some of the reforms implemented since the financial crisis, Carney said the global financial system was at a "fork in the road".
Governments had to choose between maintaining high standards of regulation and respecting each others' rules, or looking inward with big costs to global trade, he said.
Trump has said that banking rules are holding back U.S. lending, and has ordered a review of regulation, raising concerns that the relatively unified global approach to financial regulation will splinter.
Carney said the United States under Trump seemed focussed on rules unique to the country, rather than a radical overhaul which would have global implications.
"I'd be very wary of interpreting anything that the U.S. administration does as a rollback of regulation, of a turning inwards, of a fragmentation," Carney said.
(Editing by William Schomberg and Catherine Evans)