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The Bear's Lair: London won't get its primacy back

March 24, 2014

The Global Financial Center Index, released last week, showed that New York had supplanted London as the world's premier financial center, albeit by a tiny margin of two points out of 1,000.
With British financial capability hollowed out, and nearly all the major London investment banking operations foreign-owned, it's a change that has been coming for nearly thirty years and it won't quickly reverse. In the very long run, as well as in the short run, London's changes of the 1980s were highly destructive for one simple reason: the big trading operations, around which the whole restructuring of the City of London revolved, are about to be replaced by machines.

London as a financial center would not be recognizable to those who knew it 40 years ago. The few merchant banks that still exist are no longer a significant factor in the market. Instead, it is dominated by behemoths oriented primarily towards trading. Very few of the major institutions are British-owned: There's HSBC, which is headquartered in London but whose profits come overwhelmingly from Asia; Barclays, whose investment-banking operations are struggling and barely profitable; Lloyds, an almost purely retail operation; and RBS, which is government-owned and struggling against insolvency. The commanding heights of international finance, whether capital raising or merger advice, are controlled by the major non-U.K. houses, mostly American or from continental Europe.

This development was inevitable to those of us who watched in horror the progress of the British bank and securities regulatory "reform" in the 1980s. The merchant banks had been shrunk by the combination of high inflation, high taxes and poor markets in the 1970s. Whereas in 1970 the larger ones had been capitalized at twice the level of the major U.S. investment banks, they were now minnows by comparison. The well-capitalized British houses, the retail clearing banks, had already demonstrated that they could neither carry out investment banking business effectively nor act as responsible owners of houses that could. 

Consequently, the 1986 "Big Bang" became Big Crunch. The merchant banks were bought out or, in one notorious case (Barings), went bust. And the clearing banks spent oodles of money building up investment-banking operations, without succeeding in developing capabilities that were truly competitive. The playing field was level but, as on most level playing fields, the smaller and less agile home team was eaten up by the behemoth visitors.

With so little of the City locally-owned, it's not surprising that its previous dominant position is slowly being lost. After all, those controlling the destinies of the major houses are sitting in New York, Frankfurt or Zurich. While caring greatly about the overall fortunes of their institutions, they see London as their location with the highest overhead and the most intolerable egos, but not necessarily the greatest profitability. Meanwhile, the politicians in Britain care deeply to keep the revenue coming in from the City, but not necessarily all that much about the fortunes of its employees, who, if of foreign origin, don't vote in British elections and are not big donors to its politicians. This has produced a situation where marginal business is likely to be diverted away from London and marginal costs are likely to be imposed on London's banks and bankers.

In New York, on the other hand, the banks are stuck—heaven forbid the top management should have to move to New Jersey. And so are the politicians. Wall Street represents their major source of both tax capacity and campaign cash, so they treat it with the importance it deserves. If left-wing mayors of New York are elected, they make sure to confine their depredations to the middle classes, who are dependent on the city and don't make the big decisions about the finance business.  Big hedgies and top managements get a much better deal.

In a six-part series on the City of London in 2002, I wrote that I expected the investment-banking business to migrate to boutiques, as the behemoths were both too bureaucratic and hopelessly conflicted to provide the best service to clients. In New York, there are signs that this is happening. For example, in 2013, 30 percent of advisory-fee income in mergers and acquisitions went to smaller "boutique" houses, up from 15 percent a decade earlier. This does not yet seem to be happening in London; for one thing there are very few boutiques remaining. In any case, you wouldn't expect a move to boutiques to gather momentum in present market conditions. Half a decade of "easy money" policies have subsidized size and leverage to an inordinate extent, while regulatory policies have cemented "too big to fail" and the likelihood of bailouts into banking systems worldwide.

Apart from the likelihood that ultra-sloppy monetary policies cannot be sustained for much longer, technological advance may now be about to cause the behemoths' downfall.

Big banks will rejoice to tell you that local retail bankers have been made obsolescent by computerized credit scoring, so that home mortgages and credit card loans can be made without human intervention (except for a salesman to muddle the paperwork and collect a large fee). However, what technology giveth—in removing retail bankers from the system and allowing bank top management to engage in acquisition sprees and pay themselves Pharaonic amounts of money—technology also taketh away. And it is about to do so. Just as Jimmy Stewart has been replaced by a machine, the same process is about to happen to Nick Leeson and the London Whale—and it couldn't be more deserved.

There are actually two processes at work here. The other is a new aggression by the regulators, who have handed out whacking fines for LIBOR manipulation and are about to do the same on an even larger scale in respect of manipulation in the global foreign exchange markets.

The combination of machines and regulators is about to kill off the rationale for the behemoth universal banks. Just as human floor traders on the London and New York Stock Exchange were replaced first by screen-based traders and now by algorithmically-programmed machines (which account for more than half the trading volume in U.S. equities), so the same process will shortly occur in FX, bonds and the derivatives markets, where human traders had previously made an excellent living through their superior knowledge of the market's order flow. To the eyes of a jealous regulator, trading based on the knowledge of order flow obtained at a large house is insider trading, just as surely as is trading based on inside knowledge of a company's earnings for the next quarter. And of course, in London, as in the U.S., what profits the regulators don't take the trial lawyers will, once the institutions' defalcations have been explained to them—very slowly and patiently—by the regulators and the media.

Hence, in the new world of beefed-up regulatory resources and rigor, FX and money-market dealing by humans is becoming as unprofitable as equities floor-trading by humans, and as replaceable by machines.

With their loans being made by machines to all but the largest corporations and their trading operations replaced by machines, the big banks will no longer be particularly profitable. Nor will they need squadrons of highly paid management, any more than does an electric utility where giant machines hum away doing the work, with little need for decision-making and regulators setting most of the terms on which the company does business. 

In the U.S., this process may be helped along by legislation such as the admirable provision in the proposed tax bill of Rep. Dave Camp (R.-MI), in which banks with assets above $500 billion will be taxed at 0.035% of assets per quarter, thus costing them 0.14% of their balance sheet each year. In London, it's unlikely the British government, in thrall to the present City behemoths, will follow the same pattern. However, they should, as it makes the behemoths pay for their "too big to fail" status and incentivizes cutting them down to size.

Globally, with trading operations mechanized and excess size penalized, the rise of the boutiques will continue. Financial operations with substantial intellectual value added, such as acquisitions, corporate finance, complex financings and specialized trading, are much better done in houses with small highly skilled staffs and moderate-sized balance sheets, whose liabilities can if necessary be backstopped by pools of passive or near-passive capital in insurance companies or pension funds. Meanwhile, the behemoths, to the extent they exist at all, will be confined to the mechanized trading and finance operations for which economies of scale and mechanization overwhelm any need for purely human input.

One would like to think that some of those boutiques will arise in London and that after several decades they will be able to transform themselves into merchant banks, gentlemanly codes of conduct, excellent lunches and all. However, London is today an extraordinarily expensive place to do business. The double-regulatory structure of Britain and the EU is extremely burdensome and the dubious ethical standards of the wealthiest "Russian Mafia" residents are all-pervasive. Thus the chances are most of the new boutiques will grow up in offshore centers where taxes are low, regulation is light and the living is easy.

Measured by assets built through excessive leverage, London may temporarily regain its international crown. But by intellectual value added, volume of truly significant deals and skill, it's unlikely it ever will.


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