On June 23, the British people voted to leave the European Union, a victory for “Brexit.” The short-term reaction from markets was panic, as stock values crashed and the pound dropped to levels not seen since 1985. The longer-term consequences for British exit from the E.U. remain unclear – but one clear problem area for Britain is financial services. London is now the financial hub of Europe and a key driver of the British economy. It may lose this crucial role after Brexit.

Financial services are crucial to the British economy

Britain used to be a manufacturing powerhouse. No more. Today, Britain is a world leader in selling services, especially financial service. The services sector makes up 78 percent of the British economy, and the financial services sector specifically counts for 8 to 10 percent.  Britain is one of the three most important global hubs for financial services, along with New York and Tokyo.

While other regions of Britain have stagnated, London has thrived. London is the center of the British economy, and financial services are the center of the London economy. London has thrived not only because of the skill of London financiers, but also because London provides financial firms with access to one of the largest and wealthiest markets in the world: the European Union.

 E.U. membership is crucial to British financial services

Two key factors have made London into Europe’s center for financial services: a favorable regulatory environment in Britain and access to customers across the European Union via the so-called financial passport.

The financial passport is an agreement among European Union members that any firm in an E.U. member state can sell financial services to customers in other E.U. member states. Thus, a British citizen can open a bank account in Ireland, and a German investor can rely on a London-based brokerage firm.

This means that financial services firms that want to sell to Europeans have a lot of free choice over where they locate their business. One important factor in their location decision is whether financial sector regulation is demanding or light. The British lay a higher emphasis on light-touch regulation than other Europeans, making it easier for financial firms to take on bigger risks and increase their profit margins. This has made London the destination of choice not only for European firms, but also for non-European firms looking to sell to customers anywhere in the European Union. U.S. firms in particular have seen London as the gateway to Europe and concentrated their European activities there.

The U.K. financial sector has succeeded in large part because London was the best place from which to sell financial services to all of the E.U. This will be called into question after Brexit. Broadly speaking, three scenarios exist for the U.K. financial sector post Brexit: preservation of the status quo, a loss of Britain’s regulatory advantages or the loss of the financial passport entirely.

The best case would be to preserve U.K. access to European financial markets and regulatory advantages

By far the best option for British financial services would be an agreement that preserved the financial passport and London’s regulatory advantages. This would let London continue to thrive as the low-regulation gateway to Europe and thus a global hub for financial services. However, this is probably the least likely outcome.

Germany and France have long vied to make Frankfurt and Paris rival financial hubs to London. They have been thwarted by Britain’s tolerance for light regulation and London’s first mover advantage as an already-established financial center. Both countries will therefore have a strong incentive to negotiate terms that will make Frankfurt or Paris more attractive locations for financial firms. One obvious way they can do this is to make London less attractive, by limiting the access of London-based financial firms to the E.U. market.

There was discussion already about creating a European capital market union, which would replace the patchwork of national financial market regulations with a single common European standard and a single common European regulator. This spring, a banking regulation union was completed, creating a single regulatory standard and a single regulator for banks in the euro zone (the group of countries using the euro as its currency). National regulators were brought under the supervision of the European Central Bank (ECB), which also now directly regulates the largest banks.

Although membership of the banking union was mandatory for the euro zone, Britain was able to negotiate an opt-out for E.U. members that retained their own national currencies. However, as a nonmember, Britain will not be part of the negotiations over capital market union and thus will find it hard to preserve both access to European markets and freedom from European regulation.

Access without regulatory advantages would be a middle ground 

A second possible post-Brexit scenario would see British financial firms retaining the financial passport, but only if they submit to European financial regulation. London would retain access but lose the advantage of lighter regulation. This, too, would make Frankfurt or Paris a more attractive location for financial firms.

Moreover, Britain, as a nonmember, could less effectively protect the interests of its financial firms in debates over further financial regulation than member states like Germany or France. While France or Germany could advocate for terms that would help their respective financial centers, Britain would be on the outside looking in.

This scenario wouldn’t lead to London collapsing as a financial services hub, as firms already in London would keep their access. It would, however, diminish the importance of London. British financial firms might stay in London, but American or other non-European firms that had set up their European subsidiaries there might strongly consider relocation to a city inside the European Union. After all, London would no longer have regulatory advantages. Furthermore, by moving base they might be able to get the support of a state that could still influence E.U. regulation.

Losing access would have enormous consequences

The worst-case scenario for British financial services would be the loss of the financial passport. This would mean that London-based firms could not sell to European customers without establishing a subsidiary in the European Union. Firms that wanted to sell services to European customers would have to relocate to a city such as Paris or Frankfurt. U.S. firms would certainly move their European branches. It’s conceivable that some of the major British banks or other financial firms might relocate their headquarters to the continent. HSBC in particular has repeatedly threatened relocation if London became less attractive.

This could have dire implications for the U.K. 

If London loses the financial passport, there would be dire consequences for London and thus for the British economy overall. As noted above, financial services directly contribute 8 to 10 percent of British GDP. This doesn’t include spillover benefits for other London businesses. Given this, it’s small wonder that London voted overwhelmingly to remain in the E.U.

British negotiators will place a strong priority on retaining the financial passport in any post-Brexit deal. However, even this may not help London very much if the city loses its regulatory advantages.

Christopher Mitchell is a visiting assistant professor of international affairs at George Washington University.