Assessing the likelihood of ‘Soft Brexit’

Over the last year British politics has had a recognisable theme; unexpected ballots with unintended consequences – particularly for financial markets. The global financial crisis exposed overzealous, risk-taking behaviours which were deemed to be against the national interest, as shown by the vast Government bailouts. Yet as financial markets have recovered, it could be argued political risk-taking and uncertainty have created a new level of volatility. Given the fact that the UK financial system has absorbed this political uncertainty, what does this say about its resilience – particularly to Brexit?

To assess the outlook for financial services, we first need to understand the current political climate and project the likelihood of a ‘Hard Brexit’ verses ‘Soft Brexit.’ To explain, a ‘Hard Brexit’ is the scenario where the UK forfeits its access to the Single Market and attempts to negotiate a bespoke trade deal. In a situation where there are unconstrained negotiating boundaries, this is a realistic ambition.

“Given the events in June, many commentators predict that we’re headed toward a ‘Soft Brexit’”

The EU has forged free-trade deals with nations outside the EU bloc before; the Comprehensive and Economic Trade Agreement (CETA) signed between the EU and Canada is the most recent example of this. However, if the UK was to follow CETA as the template for a EU-UK trade deal, it would most likely be unachievable in the two-year timescale triggered by Article 50 in March 2017. CETA was agreed after a seven-year negotiating period and contains no provisions for Canadian firms regarding passporting for financial services. Canadian financial services will still have to establish a presence in the EU and comply with local regulations to serve member states freely.

In contrast, a ‘Soft Brexit’ is the scenario where the UK withdraws its European Union membership but retains its access to the Single Market. This is advantageous in the sense that it maintains without hindrance the continuation of London-based firms offering financial services across EU member-states. However, it comes at the cost of the UK forfeiting its influence over European policy, meaning that UK financial services would be subject to regulation without prior consultation. Given the events in June, many commentators predict that we’re headed toward a ‘Soft Brexit.’

“For banks to manage their business in such a turbulent market both financially and politically, they must consider all outcomes”

The UK General Election in June 2017 resulted in a hung parliament and further political uncertainty that would make a ‘Hard Brexit’ less likely, and the possibility of a ‘Soft Brexit’ more likely, depending on the form of support received from the Northern Irish Democratic Unionist Party (DUP). If a deal with the DUP fails to adhere to adhere to The Good Friday agreement, the UK Government may be forced to hold another General Election, resulting in further uncertainty for financial institutions.

Over the next few years’ banks must manage the ongoing uncertainty surrounding Brexit, especially given the fact that negotiations will focus on separation issues between the UK and EU before trade talks can begin. For banks to manage their business in such a turbulent market both financially and politically, they must consider all outcomes. On the one hand, given the increased likelihood of another general election and a ‘Soft Brexit’ looking more likely, financial institutions should prepare for further political uncertainty and manage these risks accordingly. On the other, banks should be buoyed by the recent performance of financial markets to have absorbed the political uncertainty and the reduced relocation likelihood resulting from a ‘Hard Brexit’ scenario.

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Dominic Mac