The City must reinvent itself - again

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The Independent Online
ONE OF those recurring debates recurred last week with a bout of stories about the City and EMU. The Treasury and the Bank of England, we were told, disagreed about the impact of EMU on London's financial business. The Treasury thought it would harm it, while the Bank thought EMU created as much of an opportunity as a threat.

This gives a further twist to related concerns that have been bouncing around for the last year: that the City would suffer from the transfer of ownership of most of its remaining investment banking businesses to foreign ownership. The City matters a lot to the balance of payments. Does the fact that we have ceded control of a large segment of the business to foreign houses matter, given that the creation of the euro will (unless it is a total catastrophe) mean that a large slice of international business will be conducted in it? Is it logical, people ask, that continental European banks should come to London to do deals in their home currency?

These are big questions, and the answers will tend to be skewed to support the prejudices of the speaker. The City's earnings do matter - even with the telephone-number size of national accounts these days, pounds 22.7bn is a lot of dosh.

Some figures for the City's foreign earnings (that is, the foreign earnings of the British financial institutions, not just those that happen to be in the City of London) are set out in the two pie charts, one for 1986, the other for 1996, the latest year for which figures are available. We tend to think of the City as monolithic - everybody dressed the same, going to similar offices and doing similar things on screens - but actually the financial services business is very segmented. It is not one business; rather it is two very big businesses, two pretty big ones and a host of smaller ones.

The two big ones are banking and insurance. Back in 1986 insurance was the largest measured by foreign earnings, with banking second. By 1996 the position had reversed, with banking earning the most at pounds 7.1bn and insurance at pounds 6.1bn. But both are very cyclical operations and it is quite possible that these will reverse again in future.

The two pretty big industries are pension funds (pounds 2.3bn in 1996) and securities dealers (pounds 2.2bn). The smaller ones are: commodities traders; money brokers; fund managers and unit and investment trusts; the Baltic exchange, and so on. The big gainers over the last decade have been pension funds and various other forms of fund management, with commodities markets and shipping losing ground, in relative terms.

Any analysis of both the likely impact of the euro and the long-term effects of foreign ownership has to look at these segments. Banking and insurance are in rather different positions: international banks are largely foreign-owned while insurance is still quite largely UK-owned.

Question one, therefore, principally concerns banking. Does foreign ownership matter? I'm pretty sure that, for commercial banking at least, it does not. Remember that the whole revival of London's international banking business in the 1960s was the result of US banks choosing to base international operations here rather than New York. That decision was the result of a couple of fortuitous accidents: the invention of the eurodollar (dollars deposited outside the USA) by UK banks unable to use sterling for foreign business because of exchange controls, and the near-closure of the New York international bond market by the imposition of a tax, the Interest Equalisation Tax, on most foreign bond issues.

So London's commercial banking business has been mainly foreign-owned, and conducted the bulk of its business in a foreign currency, for more than 30 years. I really cannot see that the invention of a new currency will change things. Both New York and Tokyo have made attempts to prise away market share in international banking, but have failed; or rather, they did for a while gain market share but at the cost of expanding bank credits to areas which proved less than wholly credit worthy - Latin America and East Asia.

International insurance? Well, like banking it is so divorced from anything the UK does with regard to the euro it is hard to see quite how a new European currency would shift business away. At the moment it is largely a dollar business, and I suspect the dollar will remain dominant even after the euro is created. The greater concern might be the gradual increase in foreign ownership that is taking place in the insurance business, though it is hard to know quite how concerned to be.

What about fund management? If you lump pension funds with unit and investment trusts and fee income earned by managers, the total is beginning to creep up to rival both banking and insurance. If the trend continues, in another three or four years fund management could be the largest single source of foreign earnings. This industry is rapidly consolidating, and inevitably some firms are being bought by foreign interests.

The background here is that the various forms of portfolio management have been a boom industry worldwide in which London seems to have been increasing its market share. It is second only to New York in total equity funds managed, and is by far the largest place in the world for international (cross-border) fund management. I'm not worried that this will suddenly shift away, but rather that London's special qualities will gradually decline.

Now, it unfortunately happens that scepticism has given the wrong answers in fund management for the last year. To generalise, London did not expect the continuing rise of Wall Street, so funds managed here have tended to underperform. But if rising foreign ownership makes London fund managers behave as they do in New York, people might say "Why bother?" and look elsewhere.

Another concern is in the securities dealing business. This is almost entirely foreign-controlled, and it would be surprising if some of the international securities dealing side were not repatriated in the next few years, particularly to continental Europe. Deals tend to be done where fund managers are located, so while fund management remains locked in, the dealing operations will stay. But expect some loss of market share.

But that has always been the way City business has developed. It starts something new, dominates the world market for a while and then slowly loses market share to other centres. Losing share does not matter; in fact, it is probably inevitable. What matters is that new areas of business are still found and nurtured.

You see, the City, like any other industry, has to keep driving itself up market. Once a business becomes standard, other places can do it. So the real test to be applied - both to the creation of the euro and the surge in foreign ownership - is not: "Will these people take business away?" That is a terribly old-fashioned way of looking at the business, for it assumes that financial services is a simple, static industry. The test is rather: "Will these changes inhibit the ability of the City to find new corners in the financial services forest and developed these profitably?"

The euro will create great new business opportunities which may be more easily grasped by being out rather than in. If the City remains innovative all will be fine; if it loses its edge there is a problem. Will foreign owners crush this initiative, or will they be better at extracting it than their British counterparts? The last 30 years is quite encouraging on this score, but the City would be right to keep alert. It is a good sign that these concerns are being discussed: the moment complacency seeps into the City is the moment to sell.