EU Membership and the 'British Dilemma'

The impact of European Union (EU) membership on financial services will be at the centre of the referendum debate. On the one hand, membership provides access to the world's largest borderless economic market. But on the other hand, the price of EU membership is giving up the right to independent action on certain areas of financial policy. The key issue will be the benefits from access to the single market, versus any possible limits on financial policy which may increase the risk of future financial failures.

The UK has been a world leader in finance for two centuries. It is the largest net exporter of financial services in the world. The UK hosts more overseas banks than any other country in the world and also hosts the largest insurance, wholesale finance and asset management markets in Europe. Finance is also vital part of all our daily transactions, and hence the overall performance of our economy.

However, there is a downside to hosting a global financial centre. Chancellor Osborne calls this the "British dilemma": while we enjoy the benefits of the largest global financial centre, the inherent risks are large relative to the UK's tax base. When large banks fail, the buck stops with national governments. The dilemma is even sharper today than seven years ago given our high level of public debt and limited capacity for fiscal support.

Former Bank of England Governor Lord King made a similar point that "banks are global in life, but national in death." When large and important cross-border institutions fail, residual losses tend to fall on domestic taxpayers. For example, in 2009 UK tax payers were exposed to more than £1 trillion of losses in the banking sector. This was the cost of having global banks and being a global financial centre.

Countries in the Eurozone are responding to the crisis by forming a European Banking Union. This is the most significant integration in the EU since the Maastricht Treaty. When a bank fails, the losses will be shared though a resolution fund and a systemic crisis would require a shared fiscal backstop. This crosses the political Rubicon of sharing taxpayers' liabilities across borders within the EU with far reaching consequences. The current UK Government has made clear that it will not join the EBU.

The UK has a number of options inside and outside the EU. One option is to insist that all foreign banks in the UK are individually capitalised and regulated by the Bank of England. This would be similar to the Swiss option outside of the EU. This contradicts branch banking rules under the EU and would put at risk our leadership in global banking. Another option is that the UK stays in the EU and accepts less control over its domestic banking agenda and eventually considers joining the European Banking Union, where some of the risk associated with its large banks can be shared with our European partners.

Still another policy option is that the UK remains in the EU and exerts greater influence on European banking regulation (as it has in the past). European banking regulations are made in Brussels but within the global regulations set at the G20 and the Financial Stability Board. The UK has been particularly successful at representing its interests in both forums in the past.

Is this last option achievable? If the UK stays in the EU, the single market will have two global currencies (Euro and Sterling), along with two of the most powerful central banks in the world, two supervisors and sets of prudential regulations and two resolution procedures backed by two distinct groups of taxpayers. This does not look like a sustainable 'single market'. This Fellowship will investigate the trade-off, how the UK financial sector could be accommodated within the EU and compare this to the plausible options of being outside of the EU.

Of all of the issues in the ESRC UK and Europe programme, I believe the impact of banking and financial services will be particularly important. First, because this is by far our most important cross-border industry (as well as for tax revenues), second because we know the serious costs of an incoherent financial structure and finally, because substantial financial events in Europe are unfolding as we head into the referendum debate. For these reasons, I expect there to a wide interest in the 'outputs' from this Fellowship.

The Official Sector (the Government, Treasury and Bank of England) will be keenly interested in the analysis. They are grappling with the same issues, and having clear research which addresses the forthcoming issues will be welcomed. I expect that the Treasury will follow our analysis closely and look to engage on a regular basis.

The City is one of the most important sectors of the UK economy. When it performs well its earnings and tax payments make an enormous contribution, and when it performs badly there is a very substantial cost to the rest of the country. The largest single market for UK financial services is the EU. Therefore I would expect the City to show a very keen interest in our analysis. We are proposing to engage directly with the City through a large conference and a survey of the intentions of foreign banks based on possible referendum outcomes.

Officials in the EU will also be very engaged with the outcome of this Fellowship. Since the UK is host to a large share of the Eurozone wholesale markets, our fellow EU members will also be keenly interested in the sensitivities of the UK with respect to finance and also the potential outcome of any negotiations and the referendum itself. It is in everyone's interests to have financial stability which is a public good that does not stop at any borders.

Think tanks and 'opinion formers' (including leading press commentators) will also benefit from this Fellowship. Several think tanks are well aware of the weaknesses in the evidence base. We have had some discussions and they welcome our new research proposed in this Fellowship as making an important contribution to improving the evidence base. We are pleased to provide analysis freely to all think-tanks and 'opinion-formers' for them to include in their analysis.

Universities and students will benefit for this Fellowship. Many of the issues are currently unfolding and our analysis will (a) form a useful input into the important financial policy aspects of the EU, (b) raise current issues to engage and teach students.

The potential implications of the referendum on the movement of cross border capital should not be understated. If the UK withdraws from the EU, depending on the situation in the Eurozone at the time, there could be significant capital flight. There are many possible permutations and the least that could be said is the impact would be uncertain. I would expect the IMF, credit rating agencies and possibly sterling investors will follow our analysis closely.

The Scottish Government has suggested that if the UK withdraws from the EU then they are minded to hold another independence referendum. A vital issue is how they will manage the currency question. However, depending on how the European Banking Union and any concessions to the UK emerge, this could open up new possibilities for the Scottish Government. Therefore, I would expect considerable Scottish interest in the financial consequences of the EU referendum.

Finally, the most important beneficiary from this research will be the general public. Every effort will be made to inform the public in a clear and non-partisan way of the choice that is before them. We hope that through our Pathways to Impact we have shown how we intend to engage with the public, across all sections, and that they can therefore benefit from our findings helping them to make an informed decision in this momentous referendum.