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City faces taxing future despite fading crisis

With the equity market performing strongly and job numbers in the City back to pre-crisis levels, the mood in London is at its most upbeat since 2007. But is this optimism misplaced? As Philip Moore reports, the threats to its status as the world’s premier financial centre are greater than ever.

For the City of London, until mid-September no news over the last year or so had been probably been good news. The chorus of public disapproval about the City, which reached a discordant crescendo at the height of the Libor scandal, had gone reassuringly diminuendo over the last 12 months. 

It remains to be seen if the fine levied on JP Morgan in September provokes a fresh wave of vilification of the banking industry, and by extension of the City of London, which is where the dodgy derivatives dealings that prompted the $920m settlement took place.

But prime time media coverage of Jamie Dimon describing a $6.2bn loss as a “tempest in a teacup” is unlikely to have gone down well with the British public, many sections of which continue to attach frequently ill-informed blame to bankers for the wider economic downturn. 

It would be a pity if the so-called London Whale shenanigans are allowed to reverse the progress that has been made in rehabilitating the image of financial services, which is an important pillar of the UK economy.

According to TheCityUK, financial services posted a trade surplus of £46.3bn in 2012, down slightly on 2011’s total but “still by far the biggest net contributor to the UK balance of payments.”

“Restoring confidence among politicians and the general public is critical, not just to the financial services sector but also to the wider UK economy,” says Leo Ringer, head of financial services and corporate governance at the CBI. “The regulatory response has already gone some way towards bolstering public trust through, for example, the establishment of a professional body on banking standards.”

This new entity, headed by former CBI head Sir Richard Lambert, was one of the recommendations made by the cross-party Commission on Banking Standards, which in June released a devastating excoriation of the conduct of UK banks. 

The opening paragraph of its summary set the tone for the indigestible volume, saying: “Banks in the UK have failed in many respects.” They have failed taxpayers, it added, they have failed retail customers, they have failed their own shareholders, and “they have failed in their basic function to finance economic growth, with businesses unable to obtain the loans they need at an acceptable price.”

Criminal acts

It included the dire warning that “a risk of a criminal conviction and a prison sentence would give pause for thought to the senior officers of UK banks.”

The City strongly endorses this threat. “Our stance on the Libor scandal is very clear,” says Alderman Roger Gifford, Lord Mayor of the City of London and UK head of SEB. “If there was criminality involved, the guilty parties should be brought to court and be prosecuted. That would help to show that it was a criminal act, not something that was symptomatic of a broader market malaise.”

Gifford insists, however, that the mood is upbeat. “London is feeling much better about itself than it did a year ago,” he says. “The economy has picked up, the equity market is performing well and job numbers in the City are back to their 2007 levels, so there is plenty of quiet optimism.”

Perhaps. But there have been some unsettling recent signals about the degree to which the UK financial services sector has recaptured the confidence of the young people upon whom its future depends. A Lloyds Bank survey in May found that 28% of students would be “embarrassed” to tell their friends if they worked in a bank, 41% distrusted banks, while 56% trusted them less than five years ago.

In a speech to at Oxford University’s Said Business School shortly after this survey, Lloyds Bank’ chief executive, Antonio Horta-Osorio, was frank about the need for the industry to rebuild its reputation to attract good people. “The next generation should see banking as an industry that helps to build economic wealth and is playing its part as a useful member of our local communities,” he said. “We want the best and the brightest to see banking as a credible career choice. This is vital for the industry’s long-term viability.”

It will be important for London to maintain its vigilance against complacency and hubris, because it still faces a number of formidable challenges and no shortage of competitors and antagonists only too eager to take the City down a peg or two. As the CBI’s Ringer says, one of these is the Financial Transactions Tax, proposed by 11 EU member states, including France and Germany, but fiercely opposed by the financial centres with the most to lose from the tax, most notably the UK and Luxembourg. 

“Our main concern about the financial transactions tax is that it underestimates its impact on basic services provided by financial institutions such as risk and cash management that are fundamental for businesses,” says Ringer. “Our argument is that the tax will not achieve what it sets out to do, which is to reduce risk. Instead, it will hamper the financial services’ support of economic growth.”

Although the UK has the right to remain outside the so-called 11 member FTT zone, the potential impact of the tax on London’s leadership in the European capital market would be devastating. This is because the architects of the tax propose that it should extend to any transactions involving counterparties headquartered in the FTT zone, including overseas branches of firms with their HQs in the zone. In other words, a transaction between the London offices of, say, Deutsche Bank and BNP Paribas, would be subject to the tax.

That, however, is only the half of it. Consider, for example, its potential impact on the European government bond market. Although primary issuance by debt management offices would be exempt from the tax, a presentation prepared earlier this year by ICAP cautions that “the FTT will significantly increase funding costs for governments and corporates in the FTT zone, and to a lesser extent those outside the zone, with consequences for the real economy.”

This, says ICAP, is because the proposal does not safeguard secondary market trading in public debt, which is an essential component of the effective operation of public finances. “This would result in an increased cost of funding and capital burden for governments,” says ICAP. “Bank of America Merrill Lynch estimates the FTT will result in an increased annual cost of €6.5bn-€8.5bn for Germany, Italy and France in the first year.” The implications for London are obvious enough, given that it is the fulcrum of international bond trading, accounting for an estimated 70% of secondary market turnover in 2012, according to TheCityUK.

Although the European Council’s legal services commission has recently questioned the legality of the planned tax, the CBI — for one — remains wary of the threat it poses to the UK. “The tax would have an impact on centres such as New York and Singapore, but we feel it would hit London disproportionally,” says Ringer. “The proposal remains on the table, and we see it as very much a live issue.”

The bickering over the FTT is one of several examples of Europe’s fragmented approach to regulation that some bankers see as a menace to London. “I worry that London may have seen the zenith of its importance as a financial centre and that its leading position is potentially under threat for a number of reasons,” says Colm Kelleher, president of institutional securities at Morgan Stanley in London. 

His concern is that a side-effect of competing regulations are going to hand a competitive advantage to centres such as New York — and possibly Chicago — where the regulatory reform agenda is at a more advanced stage. “For example, we all operate under Basel II or Basel III,” says Kelleher. “But risk weightings are still applied on a national basis, and 87% of RWA models in Europe are self-certified. That risks creating regulatory arbitrage, which will lead to more pressures from the regulator.”

London’s to lose

A more distant, but very dangerous, threat to London’s future comes from those whose hostility to Europe extends to a desire to pull the UK out of the EU altogether. Kelleher says that although he regards this as a tail risk, it would be very damaging for London. Gifford agrees. “A substantial number of US and Asian companies have located themselves in London because of the access it gives them to the European market,” he says. Japan, for one, has made it clear that its investment into the UK would be jeopardised if it were to withdraw from the EU. 

The prize is London’s to lose, because by a host of qualitative and quantitative yardsticks, the figurative Square Mile continues to be the world’s premier financial centre. It was ranked first among 79 cities by GFCI in March 2013, scoring 807 points to New York’s 787. 

TheCityUK says London accounts for 37% of global foreign exchange trading and 19% of international bank lending. There are 251 overseas banks in London (more than in New York or Frankfurt) and 588 foreign listings on the London Stock Exchange (compared with 524 on the NYSE and 290 on Nasdaq). The UK is also home to more than 800 hedge funds, with about 85% of the industry’s total European assets.

Areas such as foreign exchange and equities trading, cross-border lending and investment management are all long-standing fortés for London. Perhaps more significant, however, is the UK’s commitment to ensuring that it captures new opportunities. When Gifford spoke to EuroWeek, he was in China, between meetings with the mayors of Shanghai and Beijing, and few new business opportunities for the global financial services industry are as exciting as those in the rapidly internationalising renminbi (RMB) market. 

In 2012 alone, spot RMB trading volumes in London rose by 240% to $2.5bn a day. RMB bond origination rose by 36%, although disappointingly dim sum bond trading fell sharply. Nevertheless, London has clearly positioned itself to play a pivotal role in the inexorable growth of the RMB market, which is another positive signal for the UK and its much maligned financial services industry.   

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