Jeremy Warner's Outlook: Lasting damage to London's reputation

Merrill reports $5bn write-down
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The Independent Online

Two clear losers are emerging from the wreckage of this summer's turmoil in credit markets. One is the investment banking industry, which besides the massive losses clocked up on sub-prime and other forms of suspect lending, is again painted as the main cause and villain of the piece. The other is the City's reputation for sure-touch regulation.

Of the two, the second is by far the most worrying. Investment bankers are at the heart of most big financial crises and are, therefore, used to getting it in the neck for the error of their ways. They soon recover, and move on to sowing the seeds of the next crisis. The damage to London as a financial centre could well be more lasting.

Up until a few months back, the City was widely regarded as a near-perfect environment for wholesale financial markets. Rival financial centres, from Paris to Hong Kong, Tokyo and even the mighty New York, struggled to emulate its success, a large part of which was thought to be down to benign regulation – not so tough that it stifled innovation, but not so soft that London became a haven for rogues. The system inspired international confidence and trust. The money flowed in and so did the bankers.

The sure hand of the Bank of England on monetary policy was seen to be uniquely complemented by the Financial Services Authority as a separate prudential supervisor. The division of of responsibility was thought a masterstroke that others rushed to copy.

The long-term damage to London's position as the international financial centre of choice is still hard to gauge. I, for one, don't think the crisis was as badly handled as many have said. Despite the failings in supervision that led up to the Northern Rock débâcle, and the following U-turn by a previously intransigent Bank of England in offering liquidity to the markets, the bottom line is that disaster was averted and the banking system survived. This is surely the outcome that everyone hopes for.

Yet, in a sense, the rights and wrongs of the way the authorities handled the crisis are beside the point. What matters is how they are perceived, and in this regard the overwhelming view of international bankers I have spoken to is that the system somehow failed and is now, therefore, seen as flawed and unsafe.

As Richard Lambert, director general of the CBI, has observed, the spectacle of angry depositors queuing around the block to get their money out before Northern Rock went under made Britain seem more like a banana republic than the mature, post-industrial economy it aspires to be. If Aunt Molly's nest egg is at risk, what does that say about the billions of Middle Eastern oil money or Asian trade finance that pass through London on an almost daily basis?

One of the most interesting things about the credit crisis of the past few months is that it is an almost entirely Western, or "old world" event. The fast-growing economies of Asia and even Latin America have been almost entirely unaffected.

This says much about the way the balance of economic and perhaps even political power is shifting. While China booms, America crumbles. What's more, the financial markets of London and New York are seen to have made the world a more dangerous place. It scarcely needs saying that their purpose is supposed to be that of reducing risk.

These changes in perception may be temporary setbacks which will soon be reversed. Certainly, the credit crisis seems to be abating with a speed which nobody would have anticipated a month or so back. Yet the longer-term consequences are still impossible to predict. One thing is certain: the world will not easily return to the way it was before the crisis hit.

One entirely plausible consequence might be a permanent weakening of the hegemony in financial markets enjoyed by London and New York, with business seeping away to the rival hubs of Asia and the Middle East. This won't happen overnight. And the Government is plainly going to do its utmost to ensure that any failings exposed by the Rock crisis are quickly and effectively addressed. Yet in time, the events of this summer may come to be seen as a turning point. I don't want to sound melodramatic, but, for Britain, the stakes could hardly be higher.

A large part of the present, golden age of prosperity in Britain's history is based around the success London has achieved as a financial centre. If Britain loses its leadership position in financial services, just what will the economy be left with?

Merrill reports $5bn write-down

Markets hate uncertainty, so though it looks perverse, it should come as no surprise that shares in Merrill Lynch actually rose yesterday in response to news of a $5bn write-down of collateralised debt obligations, subprime mortgages and leveraged finance obligations. This is by far the largest such write-down so far declared by the big Wall Street investment banks and will have the effect of tipping Merrill into loss for the third quarter.

Earlier this week, the "thundering herd", as Merrill is sometimes know, dismissed a number of senior executives, so markets were primed for bad news. Whether anyone expected anything quite as bad as this doesn't really matter. The full extent of the damage has been exposed, providing the markets with a reasonable degree of certainty about the future. Or does it?

The write-downs are one thing, and presumably do indeed draw a line for Merrill under the direct losses attributable to the summer's debt crisis. Yet in finance there is no such thing as absolute certainty. The big unknown for banks remains the state of revenues and profits going forward. The crisis of the summer months will have removed a substantial chunk of credit and related fixed income business on a possibly permanent basis. Finding other sources of revenue to replace it is not going to be easy at a time when the US economy is slowing sharply.

With investment banks, there are other, more worrying reasons too for questioning the sustainability of current levels of revenue and profitability. Never mind the degree to which revenue has been inflated by the sale of essentially bogus product, there is also the issue of how real the profits were in the first place.

As a percentage of GDP, corporate profitability both in the US and the UK is at record levels. The last time it was quite as buoyant as this was back at the turn of the century. As it transpired, quite a bit of it was pure illusion and in some cases – Enron, Worldcom and others – it was outright fraudulent. Nobody is saying that about investment banking profits this time around - or at least not yet. But there are one or two worrying oddities exposed by the recent round of quarterly results.

For instance, some $270m of the quarterly revenues recently reported by Goldman Sachs is attributable to write-downs in the investment bank's liabilities. Lehman's saw its profits swelled by a similar order of magnitude by the same thing. Nothing wrong with that, it might be said. US accounting rules oblige investment banks to do this, and, in any case, if they are being forced to write down their assets on a mark-to-market basis, the same should apply to the liabilities. In plain English, the repricing of credit risk means that they don't owe as much as they used to. Even so, it looks odd, to put it mildly, to be treating what is no more than an accounting profit as an addition to cash revenues.

Fair value accounting was meant to introduce greater clarity into the way financial services companies report their profits. Paradoxically, it may be working in the opposite way. There's always been a problem in understanding the "black-box" activities of investment banks.

The difference between a real and an accounting profit is only the half of it. For all the outside world knows, the numbers are entirely made up. What happened over the summer, when supposedly triple A-rated debt was suddenly exposed as essentially worthless, has only further weakened public trust in the value of the investment banking prospectus.