London as a Financial Center
The Economist, October 19, 2006
Background: The following article is an excellent presentation of the historical development of London as an international financial center. While it is somewhat out of date in terms of data and certainly in terms of some recent issues facing London (and other financial centers as well) – such as those resulting from the global financial crisis – it is still a valuable contribution to how a city can position itself to become a world class international financial center.
Twenty years ago London embarked on a remarkable transformation to become a global financial center. It now has to keep its lead
ONCE a year the Lord Mayor of London invites top financiers to the “City Banquet” at Mansion House, his official home. It is one of many opulent functions hosted by a Gilbert-and-Sullivan-sounding figure whose grand title harks back to the middle ages, when the Lord Mayor really did run the capital rather than act as an honorific salesman for its financial center. But although the old City of London still celebrates its ancient traditions—today's Lord Mayor is the 678th—the new City has discovered a modern destiny as a hub of international finance since far-reaching reforms transformed the London stockmarket 20 years ago.
That revolution was called “Big Bang” because new ways of trading shares came into effect on one day, October 27th 1986. Just as the universe exploded after Big Bang, so the City has burst from its former boundaries around the old “square mile” of the Lord Mayor's domain and, in the process, redrawn the capital's skyline.
Twenty years ago, Canary Wharf was a wasteland in east London's docklands. Now it sprouts skyscrapers, including Britain's tallest, that provide palatial premises for global banks with giant trading floors. There are now almost as many financial staff working in just this one area as in the whole of Frankfurt, London's main European rival, says George Lacobescu, Canary Wharf Group's chief executive.
The City has also expanded to the west. Hedge funds have plumped for boutique offices in the choicer parts of the West End, like Mayfair. And a short cab-ride to the north at Marylebone, BNP Paribas employs 3,100 staff—the most in any of its buildings in the world—at a swish office that opened in 1997. The French bank's trading floor, with 850 desks and 2,550 screens, could double as a football pitch.
Within the square mile itself, the City's incessant demand for more space has led to a huge wave of new developments. To the east of the great dome of St Paul's Cathedral, built in the late 17th century, a cluster of 21st-century skyscrapers is planned as new towers with names like the “Helter-skelter” join the “Gherkin”, completed three years ago. Within less than a decade, the view from the Thames may look like the illustration above.
The property boom reflects the City's expansion since Big Bang. The specialist workforce that carries out international financial business has risen by a half in the past 15 years, according to CEBR, a consultancy that monitors the London economy. These highly paid financiers, traders and professionals are now much more cosmopolitan. At BNP Paribas, for example, 35% of its staff in London are foreign nationals; less than half of these are French.
Few doubt that London's élan owes much to the revolution in its securities markets. “There is just no comparison now between the City's standing today and 20 years ago,” says David Lascelles, co-director of the Centre for the Study of Financial Innovation, a think-tank. “London wouldn't be in this position without Big Bang.” But can the City maintain its role as a global financial centre? Just this week the British government set up a taskforce, partly to signal to the City that it values London's standing. Other cities, not least New York, are keen to steal footloose financial transactions away. Exchanges are joining forces, making trading hubs, such as Chicago, potentially more powerful (see article). For all its historic success, London will be relentlessly tested in the future.
Even before the revolution at the stock exchange, the City had defied historical odds by re-establishing itself in the 1960s and 1970s as the top international financial center. Just as London had gained that position at the height of British economic supremacy in the 19th century, so New York might have been expected to take on the role after the second world war, when the dollar was pre-eminent. Instead heavy-handed regulations (such as interest-rate ceilings that made it unattractive to leave short-term deposits in America) drove international finance out of Wall Street. It found a ready home in London where the Bank of England monitored foreign banks with a feather-light touch.
By the early 1980s, the City had become an international banking bazaar. Walk down any of its narrow streets and you could enter banks from around the world; Moorgate was nicknamed “the Avenue of the Americas”. London played host to far more foreign banks than any other financial center and had the biggest slice of the foreign-exchange market.
Business had gravitated to the City because its role was based no longer on sterling but on offshore currencies, predominantly dollars, held outside America. Yet there was a missing dimension. Although the City had opened up to the world in international banking, it had kept the shutters firmly closed in its stockmarket.
The London stock exchange was a closed shop, marked by an antiquated division between brokers who brought the business and jobbers who made markets in shares. Brokers were paid a fixed minimum commission on shares and gilts, which ripped off big clients, and jobbers lacked the capital to deal in big amounts. Trading in top British shares was starting to move to New York, where investment banks were able to offer keener prices because they could combine broking and market-making as well as underwriting new issues. The stock exchange was unable to reform because its rulebook was due to come under legal attack in a court case brought by the Office of Fair Trading. In July 1983 the exchange reached a historic deal with the Conservative government. The case was dropped. In return the exchange agreed to get rid of minimum commissions by the end of 1986.
Well before then, a bidding war had started for the stock exchange's Victorian-sounding member firms. In a giddy rush of deals, banks both domestic and international took stakes in virtually every broker and jobber worth having. Two British ventures raised especially high hopes. S.G. Warburg, a merchant bank that had pioneered London's eurobond market based on offshore dollars in the early 1960s, plunged into the fray. And Barclays, a high-street bank, created BZW, an investment bank, from its acquisitions.
Big Bang was a turning point in the City's postwar history, securing its position as a centre for trading international equities. The City signaled its welcome to foreign financial firms by sweeping away cozy club rules that protected domestic incumbents. American commercial banks, at that time unable to carry out securities business in the United States, were able to treat London as a laboratory.
By October 1986, the City already felt quite different. American investment bankers brought a brash new style to its financial markets, including breathtaking bonuses and early starts. The City, long notorious as a stuffy place where the old school tie mattered more than talent, became more meritocratic. The boisterous colour-jacketed traders in financial futures at LIFFE, a market founded in 1982, typified the new unbuttoned style of business.
But 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, says Douglas McWilliams, chief executive of CEBR. With the fading of the small centers that had specialized in bilateral trading between the former currencies, London dominated euro trading.
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 center. 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.
There are further benefits from locating in the cluster. Firms, large and small, can call upon all the external services needed to put together a complex financial deal, such as advice from lawyers and accountants, or the use of specialist markets. This in turn creates a fertile environment for innovation to flourish—a vital attraction for a global financial center.
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 Labor 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 recognize,” 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 center with the favorable 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.”
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