The EU must wean itself off its dependence on the City of London for access to capital markets and toughen up its financial regulation to prevent a race to the bottom after Brexit, the European Commission warned on Thursday.
London is Europe’s biggest capital market, but Brexit means that the EU’s major source of non-bank capital will be outside the EU’s regulatory framework.
Brussels fears that could pose a challenge to its abilities to set rules and regulations in the sector, and is looking to break its addiction to the City by onshoring capital markets and establishing new ones on the continent.
“This is particularly important in light of Brexit, as Europe's biggest financial centre is leaving the single market,” said Valdis Dombrovskis, an executive vice-president of the European Commission.
EU efforts to improve access to capital markets date back to at least 2014 but the commission hopes that Brexit, the economic hit of coronavirus and the need to finance the Green transition will give it fresh impetus.
Mr Dombrovskis admitted that the EU’s dependency on financial centres outside the EU was “one of the reasons why we are developing capital markets”.
“Brexit has made it more urgent - there are specific risks which we are seeing with so much financial activity now effectively moving out of the EU,” he said.
The Commission has published an action plan to build a capital markets union, a long-term strategy to establish large integrated sources of finance for businesses in the bloc.
"Brexit has a significant impact on the Capital Markets Union. It further strengthens the need for the EU to have well-functioning and integrated capital markets,” the Commission said in a communication to EU governments.
The EU would have a number of lesser, fragmented financial centres dotted around the bloc after Brexit, rather than a single dominant hub in London, it added.
That made it even more important to have strong financial supervision at the EU level to prevent competition from lower standards in London or elsewhere in the bloc.
“An enhanced single rulebook and effective supervision will be crucial to prevent regulatory arbitrage, forum shopping, and a race to the supervisory bottom," the Commission said.
Jonathan Faull was the top EU civil servant on financial services regulation and the most senior British official in the commission. He oversaw earlier work on the Capital Markets Union.
He told The Telegraph: "It’s not all or nothing. The EU cannot and will not ‘shut out’ the City, but the relationship will be different as Brexit takes hold, regulation and supervision diverge and international developments are negotiated and implemented differently.”
Mr Faull, who is now chair of European public affairs at the Brunswick Group, said UK-EU links remained deep and both sides faced similar challenges. He said the relationship “could settle down to a stable mixture of competition, cooperation and management of differences”.
Emma Reynolds of lobby group TheCityUK said: “The UK’s capital markets have been – and will continue to be – essential for firms across the EU seeking to raise capital to fund growth and create jobs. Britain’s financial services industry has some of the highest standards in the world and is clear about maintaining that position."
The EU has already begun the process of bolstering its financial regulators ahead of the end of the transition period on Dec 31.
Policymakers face a balancing act between not shutting down EU businesses’ access to capital in London at this stage but keeping regulatory control. London and New York are far larger in the sector and could carry more heft in setting rules and regulations.
“The EU is having one of the most open financial systems in the world," Mr Dombrovkis said. "We remain open for financial services with the US... and we remain open for financial services in the UK.”
The UK will also have to weigh up how far to diverge from EU standards because it could risk losing access to the single market if its rules are too different from those of the bloc.
After the end of the Brexit transition period, UK financial services’ access will be governed by equivalence - a system of regulatory recognition that can be withdrawn unilaterally by the commission at as little as 30 days notice in some cases.
Earlier this month, the Commission offered EU banks an 18-month extension on access to UK based clearing houses, which minimise the risk to financial stability posed by some deals.
Mr Dombrovskis will forego direct responsibility for EU financial services regulation in favour of Ireland’s likely next commissioner and fierce Brexit critic Mairead McGuinness. He will take up the trade portfolio, if the reshuffle is approved by the European Parliament.