The City: can it stay on top?

London has grown over the last two decades into the world's most successful financial centre, and Britain's most lucrative industry. This week the Economist has a leader on The City: How to protect an industry, which argues that the City of London's success shows that exposing it to foreign competition is the way to do it:

...On October 27th 1986, pressed by Margaret Thatcher's government, the City blew apart the closed shop of the London Stock Exchange in a reform known as Big Bang (see article). Out went minimum commissions and other restrictions, and in came a stampede of foreign firms. The government stood by and watched as they swallowed the old British firms that had previously dominated the City.

...The results are hard to argue with. London has kept its long-standing dominance of foreign-exchange trading; its share of the market for over-the-counter derivatives has increased from 27% in 1995 to 43% in 2004. A fifth of the world's hedge-fund assets (including 80% of Europe's) are managed out of London, compared with a tenth in 2002. Though London's insurance market has suffered from tax competition, the City has powered ahead in services such as the law and ship-broking. In equities, the business Big Bang was designed to secure, London has hosted 172 international listings so far this year, compared with 134 in regulation-bound New York.

There are threats, of course. This week the two Chicago derivatives exchanges merged to create the world's largest futures exchange (see article). There is a constant danger of over-regulation, either after the next scandal or from the European Union, which is tempted to burden wholesale markets with regulations designed for the small investor. And London's transport system is dismal and its property overpriced.

Yet Britain's politicians understand—or at least they say they understand—what the City needs. This week they have been queuing up to announce pro-City taskforces and reforms. The recipe is as straightforward in principle as it is hard to provide in practice: open industries to new talent and expertise and to constant innovation, and regulate lightly. Get it right, and clusters start to grow. Financial markets are a striking example of how buyers and sellers of skills and know-how crowd together; but the effect has worked in Britain in other industries, too, such as carmaking and design.

This is the lesson of Big Bang: to protect an industry, sacrifice your national champions. That brave decision 20 years ago brought wealth, jobs and cosmopolitan buzz to a once-sleepy City, and banished the overcooked cabbage for ever.

An accompanying piece, Capital City, considers the factors behind that success and how London can keep its lead:

..after thriving for most of the 1980s, the City looked fragile ten years after Big Bang. The early 1990s brought recession to Britain and cuts in the number of City jobs. Then the two main British contenders as investment banks fell by the wayside. In 1995 S.G. Warburg was bought by the Swiss; and two years later, Barclays pulled the plug on BZW. As if this was not enough, Nick Leeson's rogue trading brought down Barings, a centuries-old merchant bank once called the sixth great power of Europe.

Ahead loomed the euro. The risk was that footloose financial firms might forsake the City and cluster instead in Frankfurt, home of the new European Central Bank. The fears proved groundless. Far from undermining London, the euro strengthened the City's grip in European finance...

Over the same period, London surfed the next big breaking wave of products. Although Euronext took over LIFFE in 2002, 98% of the value of the Paris-based exchange's trading in derivatives was done in London last year. More important, the City secured a commanding stake in “over-the-counter” derivatives, which are traded off exchanges primarily with banks. The value of these commitments is now four-to-five times greater than those on exchanges owing to investors' ravenous appetite for financial products that parcel up and repackage risk. London's share of this booming market has risen from 27% of daily turnover in 1995 to 43% in 2004.

Some of the biggest customers for derivatives are hedge funds, which offer sophisticated investors opportunities to gain from trading strategies (for example, making money in falling stockmarkets) as well as through asset allocation. Here again, London has elbowed its way into a high-growth financial industry. The global value of assets in hedge funds has doubled since the end of 2002 to reach $1.2 trillion. Although the industry is dominated by the east coast of America, investments managed out of London are worth a fifth of the world total, up from a tenth in 2002, and almost four-fifths of those in Europe.

The City's record over the past two decades has not been an unqualified success. International insurance has been a weak spot, in part because of the travails of Lloyd's of London, a market founded in a coffee house in the 17th century that was hit by 20th-century scandals and huge losses from asbestosis claims. London's share of net premium income in marine insurance, a traditional mainstay of Lloyd's, has shrunk from around 30% in the mid-1980s to 20% in 2005.

Set against that, other less salient parts of the City have been thriving. Shipping services have made a recent comeback; overseas earnings rose by a quarter between 2002 and 2004. London's 400 shipbroking firms match ships and cargoes in 50% of tanker chartering. And there has been a spectacular growth in legal services, which are vital in backing the work of a global financial centre. Over 200 foreign law firms have offices in London, which is also headquarters for three of the four largest firms in the world. Exports from Britain generated by international law firms are now three times higher than they were in 1995.

London is a textbook example of an economic cluster, in which businesses locate close to one another because they gain from proximity. “The big warehouse of markets is in London,” says Pascal Boris, chief executive of BNP Paribas's British operation. The distinctive feature of the City cluster is the pre-eminence of foreign financial firms. In this sense, London has become to finance what Wimbledon is to tennis: a place where the best international players come to compete.

Yet modern communications and information technology allow people and businesses to operate from virtually anywhere nowadays. And there are obvious disadvantages in locating at the heart of a metropolis. Property costs are extremely high in London by international standards. Public transport is overcrowded and often unreliable.

The City's vibrancy shows that it offers compelling advantages that outweigh these drawbacks. Financial firms cluster in London because they derive external economies of scale. By thronging together, they create large, liquid markets that drive down trading costs and reduce risks by allowing large deals to be handled.

...Underpinning the hub is access to talent. Firms locating in London can tap into a huge specialist financial workforce drawn from both domestic and foreign sources. “It becomes a self-fulfilling prophecy,” says Mr Boris. “If you want to be hired you go to where people will hire you: London is this magnet in Europe.”

A continuing tradition of “light-touch” regulation has proved to be another essential ingredient. In 1997 the new Labour government announced reforms to replace what had become an untidy muddle of statutory and self-regulatory bodies with one regulator. This offered the advantage of a single port of call for the City's big financial conglomerates, but held the risk that they might get unduly caught up in rules to protect the individual consumer. In 2004 the Financial Services Authority responded by introducing a separate division for wholesale and institutional markets, headed by Hector Sants, previously an investment banker. “We recognise,” says Mr Sants, “that good regulation is a key component of a successful marketplace.” The FSA is now highlighting the need for regulation to be based on principles rather than detailed prescriptions.

But if the FSA has seen the light, European directives that pay insufficient heed to the City's unique position increasingly tie the regulator's hands. These absorb 85% of the FSA's policy time, says Mr Sants, who sounds a cool note about the worth of the latest directive—on markets in financial instruments—for the City. Against this background, Mr Lascelles gives the FSA grudging praise: “It's not so much that it has been good but that it has been less bad than elsewhere.”

America's ability to score regulatory own goals continues to help the City. The Sarbanes-Oxley legislation, passed after the collapse of Enron in order to stiffen up corporate governance, has put off foreign companies from listing there. The London Stock Exchange (LSE) has been the big beneficiary. Foreign firms have flocked to list on its main market and AIM, a less regulated market that it established in 1995.

In an ironic coda to Big Bang, which saw the stock-exchange's member firms gobbled up by foreign owners, the LSE—since 2001 a listed company itself—is under siege from NASDAQ, an American exchange, which already owns 25% of its shares. Tellingly, the government's only worry about the deal is that it could lead to a back-door introduction of heavy-handed American-style regulation—a threat it will block through a change in the law. That apart, it is unfazed by the prospect of this citadel of British capitalism falling to a foreign predator.

London's success as the Wimbledon of international finance is now such that New York is trying to fight back. Michael Bloomberg, its mayor, has called in McKinsey, a management consultancy, for advice. But Mr Bloomberg will find it difficult to alter America's regulatory approach. Lawmakers in Washington, DC, are generally swayed by domestic rather than international concerns.

Some recent talk about London has smacked of hubris, confusing its success as a financial centre with the favourable cyclical conditions that investors and traders have been enjoying. That froth will be skimmed away by tighter money and a slowing world economy.

However, the City will be hard to dislodge as a financial hub. Sir David Walker, who worked behind the scenes in the early 1980s to reform the stock exchange and is now a senior adviser to Morgan Stanley, an American bank, gives warning against complacency but says: “Over time a virtuous circle, supported by sensible regulation, has developed to such an extent that London is more than a network: it's become a knot and it's very difficult to disentangle a knot.”

Comments

[angry economist]

What is impact of Sarbanes-Oxley - is this helping boost London's position even further?

I think the competition in Europe just couldn't reproduce the scale economies of London - Frankfurt and Paris financial centres are just so much smaller.

I'm not so enamoured by anything the economist prints any more. its mostly just brazen journalism.

With very successful UK commercial and retail banking corporates in recent years (record profits), we also have a very healthy domestic sector that brings advantages in terms of international comparative advantage more generally.

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